Many startup ventures have never generated positive cash flow — or even revenue. How can a valuation analyst value a startup business when it has no track record? Without historical performance to rely on, valuators often turn to the entrepreneurs’ forecasts. However, no one can see into the future. So, prospective financial statements can be subjective and risky, especially in today’s volatile marketplace.

Professional skepticism

When evaluating prospective financials, valuators must exercise professional judgment and consider making adjustments where necessary. For example, whether or not an entrepreneur has put together formal financial projections can provide insight into the most important determinant of a startup company’s ability to succeed: management.

Other important considerations include the startup’s competitive advantage, business type, market size, and potential growth opportunities.

Lifecycle of a startup

The stage of development is also an important factor — each stage has different implications for the company’s value. Initially, in the “seed” stage of development, the entrepreneur simply has an idea. At this point, venture capitalists and other investors may provide seed capital or first-round financing. As the company continues to develop a product or service, it may begin to test the concept and seek further financing. However, it’s not yet earning revenue.

After the product or service is fully developed, the company may start reporting revenue, but it might not be profitable yet. The company graduates to an established business once it’s consistently earning revenue and has achieved positive operating cash flow. At this point, the entrepreneur may decide to sell the business or negotiate an initial public offering.

As a startup evolves through these stages, entrepreneurs and investors agree that the company’s value grows. But their perceptions of value often conflict, because each has different ways of estimating value.

Dueling perspectives

Put simply, the entrepreneurs that start a company want the highest possible value. These owners believe they should be compensated for their “sweat equity,” research and development costs, and forgone salaries, bonuses and benefits. The further along a company progresses in its evolution, the more entrepreneurs invest — which translates into a higher value.

Conversely, outsiders want to pay the lowest price possible for the largest piece of the pie. Investors are usually skeptical and will want to discount management’s projections. They want to minimize risk — not only through lower initial values, but also through liquidation preferences, conversion options, preferred dividends, redemption rights and restrictions on the entrepreneur’s actions. They may also require a seat on the board of directors.

A balanced approach

Discussions with investors, partners and potential buyers can begin only when the entrepreneur knows the startup’s value. An independent valuator takes an unbiased look at the company’s financial projections. Using objective sources — such as marketing data, industry benchmarks and comparable companies — the valuator blends the owner’s financial projections with the investor’s concerns to come up with a market-based estimate of value.

(This is Blog Post #1351)