The valuation of a venture-backed, early-stage company requires a disciplined application of methodologies that are often misunderstood or misapplied. Also, while the fundamentals in valuing this type of firm haven’t changed, some nuances have emerged.
Ingenious ways: “There have been a number of insightful valuation and allocation methodologies developed over the years to value early-stage companies that don’t have reliable forecasts, but may have transactions in certain classes of stock,” says David Dufendach (Alvarez & Marsal) who will co-present a four-hour workshop on this topic on August 18 (see below). “For example, while the backsolve method has been around for a while, there are some new and interesting ways it is now being implemented,” he says.
“There are basically two methods for allocating the value of an early-stage company we see most often: an option-pricing framework and a scenario-based framework,” he observes. Both are based on the evaluation of potential future liquidity events and are covered in the AICPA guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, issued in 2013. In some cases, the option-pricing approach may not be suitable for certain firms or industries because they don’t “follow the pattern” that forms the basis of option-pricing theory. In those cases, according to Dufendach, you go to a scenario-based method, which in its most basic form is akin to a best-middle-worst case analysis. Practitioners typically will choose one or another but not both, so a crucial step is determining which method to use.
Common error: The valuation and allocation methodologies are based on certain critical assumptions, so a common error is when those assumptions are not developed in a rigorous enough way. There can be wide variations in a valuation if you assume, for example, that the company will be sold in two years as opposed to seven years. Therefore, valuation specialists should make every effort to develop assumptions that have a reasonably objective basis, Dufendach advises, consistent with the guidance for forecasts and projections.
While the description of the workshop mentions “venture-backed” start-ups, the methodologies and approaches to be discussed are relevant for companies with a complex capital structure that arefinanced from any source, both external and internal. Of course, you would have a different view of a startup if you assume the investment has come from a sophisticated and disciplined investor as opposed to “friends and family.” Our primary focus will be on venture-backed companies as these types of companies typically follow a similar financing and development cycle.
The four-hour advanced workshop, Early Stage Companies: Mastering Valuation from Start-Up to Success, will be co-presented by Dufendach and some of his colleagues at Alvarez & Marsal: Jason Andrews, John Sawyer, and Tommy Tu.