Michael Goldman & Associates, L.L.C. - Consulting
& CPA Services
|
|
|
Goldman's
Critical Support -- Summer 2002 Valuation of Start-up CompaniesAs our economy rolls through boom and bust cycles in different industries, valuation of start-up companies is becoming more contentious in bankruptcy cases, divorce cases, shareholder lawsuits, and other commercial disputes. Unlike well-established firms, most start-ups typically have little or no track record, ongoing losses, few revenues, untested products, unknown cost structures, unknown implementation timing, unknown market acceptance, unknown product demand, unknown competition, inexperienced management, an untested business model, and high development or infrastructure costs. Managers of start-up companies commonly make projections based on unrealistic expectations. Other factors that make the valuation of new companies difficult include:
The valuator needs to understand the size of the markets being served, the probability of successfully entering those markets, and the time needed to achieve the projected market share. Also to be considered are the costs of product development, bringing the product to market, and making subsequent improvements to the product, service, or technology. Evaluate management team In many cases, only broad estimates of the above factors are available, and the valuation must be done within wide ranges of possibilities. It is important to develop a base case with which to start quantification and decision making. The best place to start is with a critical look at the management team. Management traits needed for a successful start-up venture include:
Analyze financial projections Reasonable projections are also key to the valuation process. Any market-based approach or discounted cash flow analysis depends on the reasonableness of financial projections. Projections must be analyzed in light of the market potential, resources of the business, management team, financial characteristics of the guideline public companies, and other factors. Start-ups that do not grow quickly enough will not survive, and start-ups that do grow quickly usually have operating expenses and investment needs that exceed revenues, at least until the growth starts to slow down (and the resource needs begin to stabilize). This means that long-term projections, all the way out to the time when the business has sustainable positive operating margins and cash flows, need to be prepared. These projections will depend on the assumptions made about growth. Growth in operating income is a function of management’s investment decisions - how much a company reinvests and how well it reinvests. Examples of this reinvestment include research and development, expansion of distribution and manufacturing capacity, human resource development to attract new talent, product pricing to undercut competitors, and development of new markets, products, or techniques. Growth also depends on market acceptance of the product, the skill of the company’s execution, competition, finance, and risk. Of course, all of these factors are interrelated. How to project growth There are basically three ways of estimating growth – extrapolation (if the company already has history), industry projections from securities analysts (not a source acclaimed for accuracy and objectivity), or qualitative evaluation of the company’s management, marketing strengths, and level of investment. Obviously, the results of this analysis will highly depend on the assumptions made, and good judgment is critical. Valuation methods Once growth rates have been estimated, the valuator can turn to the three basic valuation approaches – assets, income, and market. Since growth is the primary attraction of start-up firms, you might think the asset values would have little relationship to company valuation. In turbulent markets, however, the level of cash and the liquidity of the company may be primary drivers of value. I recently prepared a valuation of a high-tech company in the telecom market, and was surprised to find that none of the traditional value drivers showed strong relationships to the price-to-revenue ratios. After regressing nine different variables against the price-to-revenue ratio for 72 different companies, I found that the only variables having a decent correlation to value were working capital and debt-to-equity ratios. Even the size of the company didn’t matter – recent start-ups flush with IPO cash but with minimal sales were selling at much stronger valuation ratios than industry giants such as Lucent, Nortel, Ericsson, and Solectron. Income-based methods Other than in turbulent markets, the asset approach is generally not used for valuation of start-ups. Valuing a start-up company is very similar to valuing intellectual property or innovative technology, in that the value rests more on the potential than on the assets in place. For this reason, many more subjective factors enter the income methods of valuation for start-ups than for established companies. Value is derived from profits that the new company is expected to generate. Sometimes superior technical innovation and subsequent production efficiencies do not suffice. Lack of reliable distribution systems and availability of the product in only a few outlets, for example, may limit its appeal. Sometimes large additional investments in selling, advertising, and marketing are needed. Poor administration and management can generate losses no matter how great the product, [making investments in management and systems a necessity]. A company that does not take steps to control expenses, for example, will choke on new growth rather than profit from it. These expectations of future investment needs may eliminate the value potential from what originally seemed like a brilliant idea. With Discounted Cash Flow valuation methods, the analyst forecasts free cash flows and then discounts them to the present using a risk-adjusted cost of capital. A big problem with this method: Start-up cash flows typically exhibit non-linear behavior, and Discounted Cash Flow is a linear model. Cash flow spreadsheets often cannot reflect managerial flexibilities and the strategic options to expand, delay, abandon, or switch investments at various decision points. The biggest problem in projecting income from a new company, technology, or product remains assessing the likelihood of success and the risk of failure. This assessment by definition will be speculative, rendering any discounted cash flow valuation speculative as well, no matter how precise it appears on the spreadsheet. King Cash In start-ups, even more than in established businesses, cash is king. Estimating cash flows is critical. The value of an asset, or a company, comes from its ability to generate cash. When valuing a company, cash flow should be evaluated after taxes, before debt payments, and after reinvestment needs. For young firms that are growing rapidly, historical numbers are often obsolete by the time they are available, and therefore the valuation is going to heavily depend on the use of estimates. Market-based methods The market approach to valuation also presents special problems for start-ups. This valuation process involves finding other companies, usually sold through private transactions, that are at a similar stage of development and that focus on existing or proposed products similar to those of the company being valued. Generally a good source of information is press releases from publicly held acquirers. Complicating factors include comparability problems, differences in fair market value from value paid by strategic acquirers, lack of disclosed information, and the fact that there usually are no earnings with which to calculate price-to-earnings ratios (in this case price-to-revenue ratios may be helpful). Growth is easy Good entrepreneurs (especially since the dot-com bust) know that a good idea does not equal positive cash flow, and technical success does not equal commercial success. It is not growth that creates value, but profitable growth. Businesses need to earn more than their cost of capital, or the growth will be more detrimental than positive. Increasing growth is often easy – doing it profitably is not. When it comes down to it, the valuation of a start-up is very often a valuation of the company’s managers and their ability to perform.
© Michael Goldman 2002 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.
|
Send mail to
michaelgoldman@mindspring.com with
questions or comments about this web site.
|