Valuing young companies is a difficult task. Because a new company is early on in its lifecycle, it can be hard to project what it will be worth in future – especially when it has no established products or services yet. So, how do you go about valuing it accurately?
In his paper, “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges,” New York University Professor and worldwide valuation authority Aswath Damodaran outlines the methodology he uses for early stage start-up valuations. In doing so, he identifies some of the main challenges involved. At EquityMaven, our algorithm is based off Professor Damodaran’s valuation methodologies – so in this article, we outline some of the challenges that he identifies, along with our approach to each.
By their very nature, early-stage companies have very little history, which usually plays an important part in any regular valuation. Some new companies, for example, may only have a year or two of data available, while others may only have financials for a portion of one year. At EquityMaven we therefore rely heavily on the user’s financial forecasts into the future for young companies – as we do with all our valuations.
Many don’t survive
Young companies are risky, and many don’t survive the first year or two. This is backed up by several studies that Professor Damodaran highlights, although he does note that the failure rates vary widely among them. In one study he cites, Knaup and Piazza (2005, 2008) used data from the US Bureau of Labor Statistics’ Quarterly Census of Employment and Wages (QCEW) to compute survival information on nearly 9 million US businesses in the public and private sector. Between 1998 and 2005, only 44% of the businesses surveyed made it to four years, and only 31% made it through all seven years. EquityMaven addresses this issue by using survival probability: in other words, we weight our valuations based on the business’ probability of survival using the probabilities contained in the Knaup and Piazza survival statistics.
Investments are not liquid
Since equity investments in young firms tend to be privately held and in non-standardised units, they are also much more illiquid than investments in public companies. At EquityMaven we apply illiquidity discounts to our valuations of private companies based on academic studies.
As outlined above by Professor Damodaran, a combination of factors – short histories, high probabilities of failure, and extreme illiquidity – mean that valuing a young company can be very uncertain. By being aware of the challenges, valuation service providers like ourselves can build these factors into our methodologies, to make the final valuation as accurate and reliable as possible.