Valuation methods for young companies
There is one important attribute all early stage companies have in common: limited earnings track record. Young companies are usually busy trying to figure out the best ways to coordinate their key resources – labor, capital, and entrepreneurial skill to come up with a winning business model.
If you need to value a young company, these considerations should play a key role in your business valuation method selections. You can value any business using one or more of the three key approaches:
Asset based business valuation for growing firms
As we mentioned above, the early stage companies spend a lot of time optimizing the use of their asset base. They may also be involved in heavy development of key intangible assets such as technology, vendor and customer contracts, and intellectual property.
One important intangible asset you may be aware of is business goodwill. Yet goodwill takes time to build and is typically a large portion of an established firm’s value, not a young start-up.
Hence, the valuation methods under the asset approach are unlikely to help you establish the true economic value of a young growing company.
Market approach and young company appraisal
Market-based valuation methods let you develop business value based on comparison to recent sales of similar businesses. Bear in mind though that the vast majority of private business ownership transfers involve established firms.
Many of the valuation multiples used under the market approach depend on various earnings bases to do the comparison. The typical examples are the company’s EBIT, EBITDA, discretionary cash flow, net income and net cash flow.
There are a number of challenges you may face when using the market valuation methods. A young company may not yet be optimized for profitability. In addition, comparison to well-established firm values makes little sense. Hence, the market-based valuation methods are not the best choice for early stage company valuation either.
Income-based valuation for early stage companies
This leaves us with the methods under the income approach to business valuation. These methods help you determine the value of a business based on the expectation of earnings and risk going forward. This is a good match since young companies have yet to demonstrate their true economic potential and generate an income stream at a risk level acceptable to the owners.
Perhaps the best business valuation method you can pick is the Discounted Cash Flow technique. This powerful method lets you calculate business value directly based on your earnings forecast and risk assessment which is captured by the discount rate.
Given a degree of uncertainty in realizing the future earnings, you may consider running a number of valuation scenarios. The typical format is to repeat the Discounted Cash Flow valuation under the base case, worst case, and best case assumptions. You can then conclude what the company is worth today based on a weighted average of your results. The weights should represent the likelihood of each scenario.