Abstract
The research topic will explore various valuation methods for start-up companies mainly technology and social media or social network ‘SocNet’ companies. Startup companies are recognized as young business ventures just beginning to develop. These are small companies whose initial financing and operations are catered for by the founder, family, friends or a single individual. In most cases, such companies offer unique products or services which are not common in the market or which the founder is passionate about. This dissertation seeks to evaluate the operation of such companies focusing on high-tech companies. Such companies are known to have existed for a short period in the market and are characterized by low cash flow. It has been established that the valuation of such companies is largely dependent on the stage of development of the company. According to Leiblein, Chen,and Posen (2017), the valuation of start-up companies is influenced by the business model, the team, the risk, the market and the option to exit from the market. Actually, venture capitalists founded their valuation on the potentiality of the company to grow.
This paper will factor the issue of intangible assets. As noted by Mehralian, Akhavan, Reza Rasekh and Rajabzadeh (2013), hi-tech companies earn most of their value from their intellectual capital, websites and brand equity. We shall analyze how such intangible assets are treated. The study will evaluate various methods applicable in valuing start-up companies. As indicated before these companies are characterized by pure equity financing, negative earnings, and binary business models. The earlier methods used to value them which include discounted cash flow, comparable transactions or valuation multiples cannot be applied because these companies have a high degree of uncertainty, volatile discount rates, short histories, limited financial data, comparable transactions or comparable companies. In this case, new valuation methods such as venture capital, real options valuation, and discounted cash flow will be evaluated and applied to a case study. This dissertation will also discuss non-financial aspects in valuation since experience, and personal skills of the management team and the founder have a great impact on the value of a start-up. The structuring will include an introduction, aims, and objectives of the study, literature review, methodology, analysis and discussion. The conclusion will include proposals for further research which is crucial in understanding the operation and valuation of start-up companies.
Introduction
According to Ruokolainen and Aarikka-Stenroos (2016), startup companies are firms in early stages of growth and have unique characteristics. In most cases, they have new products or services and ideas that have market potential. They are run by the founders who capitalize on innovation and quality services and products. Such companies require more funding from venture capitals (VCs) since they not only have limited revenue and have high operational costs and more importantly because the founders lack enough capital. Startup companies can seek to fund from angel investors, venture capital firms or commercial banks. However, investing in such firms has a high risk, as well as high reward, in case the business succeeds. Investors in start-ups risk a lot due to the uncertainty of the business. Once they invest in the firms, they take an equity stake and share in the company’s upside and downside. According to Caldararo (2015), most of the startup companies have been trying to chase unicorn valuations. Investors such as capitalists are evaluating new ideas, great business models, and improved management skills to make huge success through investments.
As noted by Weinman (2007), startups in areas of technology, internet and digital health are some of the common trends in the current business environment. Many graduates are inspired by the tremendous growth of startups such as Snapchat, Dropbox, and Facebook. Some veterans like Bill Gates are of the opinion that people should be cautious when valuing unicorns since young companies such as cloud storage company Box and Payment Provider Square have been on record due to stock market fluctuations that have disappointed the investors. Before agreeing to finance startup companies, it is inevitable that investors and founders would determine the value of the company. Sophia van Zyl (2009) asserts that some websites among the YouNoodle have been tailored to predict the value of startups through algorism. However, such valuations are not factual. It has been established that assessing the value of a startup company is not an easy task due to their uncertain growth, short financial history, past transactions and little comparability to other companies. Therefore, more investors and founders of such companies have been wondering how best to assess the valuation of start-up companies.
Research Aim and Objectives
This research will evaluate various methods used to value start-up companies and how the process is done during early stages of the business. The seeding phase, growth and exit phases will be discussed. Also, this research will factor the process undertaken by start-ups when the matters of fundraising and investment arise. We shall discuss how the companies are valued during exit to facilitate IPO, acquisition, and merger. It shall be noted that at the initial stage the valuation of a start-up provides investors with a high share price than the pre-IPO stage where the valuation is at a lower price. This creates doubts and questions about the accuracy of various assumptions adopted in valuation as well as the process of valuing a new business. This research aims to understand various methods used to value a new start-up company and one at the exit point. We shall note the similarities and differences of various methods of valuation and how they interlink. This will help in understanding whether the valuation of a start-up company at its initial stage is correct and if the value of such a business is the same today as predetermined earlier. The objective of this work is to note how various valuation methods relate and the relationship between early stages valuation and exit stages valuation. As observed by Saunders and Lewis (2012), the use of case study assists in understanding a concept. This research shall adopt a case study to explore different valuation methods of start-ups.
Literature Review
The valuation of start-ups is difficult due to various reasons. According to Backes-Gellner and Werner (2007), start-up companies are characterized by negative cash flows, little or no revenue at all, making losses, binary models, equity financing, and short history. This results in uncertainty and volatility since economic models have to be built. Such volatility and uncertainty affect the valuation of start-up companies at their primary stages, and just a small percentage of them survive in the market. Different researchers have published data showing the longevity of startups in various sectors showing that only an average of 44% of the companies makes it through the fourth year. The data shows an average of 31% of the startups survived the seventh year. Therefore, the rate of failure of such companies decreases at a decreasing rate hence if a startup survives for long the possibility of it growing in employment and sales is high. The table below portrays statistics of startups’ survival over the last seven years (Pryor, 2017).
| Sector
| First year % | Second year % | Third year % | Fourth year % | Fifth year % | Sixth year % | Seventh year % |
| Natural Resources | 82.3 | 69.5 | 59.4 | 49.5 | 43.4 | 39.9 | 36.6 |
| Construction | 80.7 | 65.8 | 53.6 | 42.6 | 37.0 | 33.4 | 30.0 |
| Manufacturing | 84.2 | 68.7 | 57.0 | 47.4 | 40.9 | 37.1 | 33.9 |
| Transportation | 82.6 | 66.8 | 54.7 | 44.7 | 38.2 | 34.1 | 31.0 |
| Information | 80.8 | 62.9 | 49.5 | 37.7 | 31.3 | 28.3 | 24.8 |
| Financial activities | 84.1 | 69.6 | 58.6 | 49.3 | 43.9 | 40.3 | 36.9 |
| Business services | 82.3 | 66.8 | 55.1 | 44.3 | 38.1 | 34.5 | 31.1 |
| Health services | 85.6 | 72.8 | 63.7 | 55.4 | 50.1 | 46.5 | 43.8 |
| Leisure | 81.2 | 65.0 | 53.7 | 43.8 | 38.1 | 34.6 | 31.4 |
| Other services | 80.7 | 64.8 | 53.3 | 43.9 | 37.0 | 32.3 | 28.8 |
| Total start-ups | 81.2 | 65.8 | 54.3 | 44.4 | 38.3 | 34.4 | 31.2 |
Fig 1: The probability of start-ups’ survival per industry
Davila and Foster (2007) assert that startup companies take a lot of time before flourishing into established ventures. In the process, they experience different stages ranging from the early stage, middle and the final stage as analyzed below:
Idea Companies-At the first stage the founders work on their idea and test it to evaluate whether further investments are necessary. During this phase, no income is generated because the product has to be developed first. The testing and the development cost a lot of revenue leading to huge operating losses. This is considered the highest stage of risk since the product has to be tested, developed and launched to access the market.
Start-up Companies-At this level the company launches its product and receives the first revenue from the customers. However, the revenue generated is not enough to position the company steadily in the market. This is due to high cost of development, growth, and marketing. A start-up at this stage proves to have succeeded in marketing for presenting its product but requires strategizing on profit making to survive.
Second Stage Companies-At this level the company increases its revenues to the point of generating profits. It is characterized by a laid down business model and operating history as well as reduced losses. Start-ups at this stage try to access more capital through IPO or merger or acquisition to expand their ventures hence the need for valuation (Clark & Mills 2013).
Figure 2: Different phases of start-ups (Duarte 2016)
Figure 3: Different phases of start-ups
As noted by Damodaran (2009), investments in start-up companies are usually illiquid due to the fact that they are privately owned by the founders and follow the negotiated terms. Such terms are agreed upon depending on the level of the investment risk. In this regard, the company is valued at different intervals to establish the share of the investor. The founder focuses on getting as much investment as possible from external investors to foster growth while the investors aim at buying shares at a low price waiting to sell later at a higher price. Damodaran observed various risks associated with start-ups. For instance, such companies have limited information available as compared to larger listed companies thus exposing investors to information risk. Also, considering that the investors are likely to gain value in future, the companies are characterized by uncertainty and one cannot be sure what value the start-up will provide. Such companies are privately owned which makes investment process a risky venture. Therefore, start-ups are expected to carry out liquidity discount because investors are faced with liquidity risk. Such companies require a higher estimate of returns of about 20% to 30%.