Valuation of Early Stage Companies

Many experts refer to valuation as an art rather than science. However, in my opinion it is primarily a craft (that can be learnt) and secondarily the art (or science) of choosing and estimating the right assumptions and linking these to the underlying stories.

The main challenge arises from the fact that valuation methodology has been primarily developed for established (and public) companies. These companies have plenty of history, a significant size (in revenue) and usually a good level of predictability. All this falls apart when valuing young and high growth companies. These often have no history, little or now revenues and profits and high risks of failure.

In this context any valuation is only as good as its assumptions, and as a matter of fact these will change frequently. Therefore it is important to understand that there is no “one right” valuation, but a valuation in a very specific contact at a very specific point in time and from a very specific (investor) perspective. A company may be valued at $10m or even at $100m by different investors – and both may be right (or wrong), depending on their assumptions.

Therefore, the hard part in valuing a company is to get the story and assumptions right. And as nobody can see in the future, to think in different scenarios. Any “known” facts should be incorporated (like conversion rates, cost structure, required investments) and the unknown needs to be modeled in a robust way (this often means in the most simple way – as complexity in the model will most likely not increase “model-reality fit” – refer to ockham’s razor).

If these foundations have been set, one can use any valuation methodologies, like real-options, discounted cashflows (DCF) or pricing methodologies (like comparable or multiples). Personally I prefer using a DCF because it is a robust and well proven method that everybody can understand and replicate. It is also focused on cash flow – a very important KPI for any (cash burning) company and it allows a clean separation between the assumptions (predicted free cash flows, discount factors) from the methodology (calculus). This makes it easy to run scenarios or even use it in Monte Carlo Simulation.

You can copy and use the simple DCF calculation template from here and adopt it to your requirements. You may also rely to one of the many templates of Damodaran, who provides a rich set of templates and comparable and who’s insights and sample valuations are always a good and thoughtful read.

The German article “Unternehmensbewertung aus Sicht von Private Equity Investoren” (valuation from a private equity investor’s point of view) co-authored by Peter Lasinger and published in the book “Unternehmensbewertung für Praktiker” (Linde Verlag, 3rd edition, 2017), goes into more depth about the challenges and best practices of valuing companies from an investor’s perspective.

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