When you work with startups, like me, you often hear the phrase: “Valuating a startup is more art than science.” If it’s implied that it’s hard to give value to a new company, there is some truth to this indeed.
But the statement is often used to suggest that the value of a company is pulled out of a hat – like it’s a made-up number. I would argue that this statement is both inaccurate and also something companies should avoid conceding. Company founders should resist being lax about valuations. If you don’t take a rigorous approach, you may end up undervaluing your startup. And this could ultimately diminish your economic stake in the company.
It is true that traditional methods of valuation like Net Present Value (NPV), comparables, and growth models are better suited for more established companies with a steady stream of revenues. On the other hand, startups are usually in the red. But not all startups are created equal, and we see plenty of cases of new companies that not only are generating revenues, but also are profitable.” So if an emerging company is forecasting future earnings, we can use that to determine a value for the company in the present. When that happens, we won’t be pulling a number out of thin air because we’ll be using methods that are standards in financial modeling.
Of course, there is greater uncertainty when it comes to emerging companies. The way we incorporate uncertainty into our analysis is by assigning probabilities to future outcomes, such as future earnings. We use a sophisticated method called Monte Carlo Simulation that hypothesizes a range of probabilities and runs thousands of simulations, and then the earnings projections are adjusted accordingly. When it’s used in combination with other valuation methods, Monte Carlo can generate a pretty good estimate of a company’s worth. It is one of my favorite methods because it’s both powerful and transparent.
We also must not forget that startups can be valued based on their intangible assets, like their intellectual property. Even when companies haven’t locked in their patents, there are ways to value their creative projects.
Recently, there has been interesting work on estimating the economic value of research and development (R&D). For example, if a certain pharmaceutical company wants to develop a drug that cures breast cancer, it might estimate that the R&D expenditure required to develop the drug will be around $5 billion. But if the drug proves to be successful, the company will probably generate $25 billion in revenues over the life of the patent. The pharmaceutical company understands that there is no way to know how effective the drug will be: It might not be effective or somewhat effective. Of course, the range of possibilities will affect the future payoff of the drug, so should the company spend $5 billion in R&D?
There are methods of financial modeling that can answer this. One approach basically treats R&D as a real option and uses what is called an options method to assign a value. Historically, methods developed to price options were used to value derivatives traded on the market. But now they are also used to price assets, including intangible assets. In our pharmaceutical example, using an options method, if the value of R&D exceeds its expense – the $5 billion price tag – it becomes worthwhile for the company to spend the money in developing and selling its cancer-fighting drug.”
Something similar can be done with startups that are in the process of developing a product or service. You can treat this as a real option and then try to put a value to it. The value of the option can then be viewed as the value of an intangible asset possessed by the startup. There is some conjecture involved in pricing real options, but there is always guesswork when you’re pricing something under conditions of uncertainty. What is important to note here, however, is that there is a basis for the estimate that makes the valuation more credible.
Startups now have the resources to justify their company’s value to VCs. With these sophisticated methods of valuation, startups can strengthen their position when they’re negotiating a finance deal. So even if VCs reject your initial estimate and propose their own numbers, you can always challenge them and appeal to bring their estimate up. Using this as a negotiating tactic can make a significant difference for you in the end.
When the discussion of the value of your company is at hand, don’t presume it’s more art than science. That’s because good science (and math) are involved, and you’ll want to use these to your advantage. And there are experts out there who can help entrepreneurs navigate this complicated terrain.