Young companies are difficult to value for many reasons; these companies do not have historical information, they have little or no revenues and operating losses, they are dependent upon private capital first and venture capital and discount rates should take into account that many companies will not survive.
For these reasons traditional valuation techniques based on discounted cash flows and multiples cannot be used.
One way to solve these issues is to value existing assets estimating a cash flow from the assets and to find a value for them. This valuation method is useful for young firms whose assets represent the overall value of the firm (for example for companies with patents).
With most startups the bulk of the value of the company comes from growth assets. In this case we do not have any historicals and future revenues will be estimated by the firm. Another important fact is to measure the quality of sales growth, analyzing how much money the firm will have to reinvest. When the firm generates a higher return on capital than its cost of capital (WACC) is when it is worth investing.
Estimating the cost of capital with standard approaches is not possible due to a number of reasons; beta cannot be calculated comparing the stock return with an index, in some cases companies are fully funded by the owners or also by venture capital firms and do not use bank financing and equity claims might vary so different costs of equities should be applied.
For these companies, the terminal value might be around 85-100% of the current value of the company. We have to estimate if the company will be able to stabilize its growth and when it will take place.
But using relative valuation is not an easy task either. Ratios such as PER or EV/EBITDA cannot be used since most of the companies have operating losses. Appart from that, relative valuation is used focusing on publicly traded companies in the same sector and operating in the same geographical area and with similar margins. We would be comparing stable growth traded companies with startups with a higher level of risk, differences in equity claims and illiquidity issues. thus, this is not a valid methodology.
In conclusion, we advise to use precedent transactions in the sector with a startup database combined with an estimation of discounted cash flow valuation instead of the traditional multiple and DCF approaches.
