The venture capital method: The only way to value start-ups?
It’s always easier to value a public company that has all the data you are looking for. However, the real test of a valuation expert lies in valuing young start-up companies. These companies do not have any historical data; there are lots of uncertainties built into the process – difficult to estimate the details of cash flows and have long term estimation issues. Last but not least, there are high chances that many of these start-up companies do not make it.
Due to these reasons, the Venture capital method comes into play. The VCs estimate the expected earnings in the range of 2-5 years, that expected earnings is multiplied by market multiples such as PE ratio that provides the equity value at the end of that period. That estimated value is then discounted back at a target rate of return which is generally set high to capture the risk in the business and the likelihood that the company cannot make it.
However, there are several challenges to this model. Some of them are listed below:
- The VC method uses a short forecasting period (2-5 years) and uses a multiple based on what comparable public companies are trading at. However, those multiples that are trading are a function of future cash flows after that point. By doing this, VCs are trying to avoid the uncertainties in the cash flows but not trying to capture it does not imply that those uncertainties will go away
- This method focuses only on the revenues/earnings and ignores the intermediate steps. Hence, entrepreneurs try to push up the value by increasing the projected earnings where as the VCs try to push down by lowering earnings. This method then becomes a negotiation game rather than serious estimation
- The VCs are equity investors. Hence the discount rate that they use has to be equity value. That said, if PE multiples are used, it’s fine but if ratios such as EV/EBITDA are used, the discount rate should be cost of capital and not the discount rate demanded by equity investors.
Every method has pros and cons. There is no reason that the young start-ups cannot be valued by discounted cash flows. We will discuss that in later post. Stay tuned.
– Saurabh Mishra