Characteristics of innovative start-ups pose special requirements on their valuation. Owing to a business model based on innovations, they usually offer high growth potential. At the same time, they are associated with high business risk as they usually do not yet have a marketable product and they are not yet able to generate positive cash flows.
Therefore, classic valuation methods such as the discounted cash flow method or the market approach are difficult to apply to innovative new ventures. It is difficult to estimate future cash flows of start-ups required for the discounted cash flow method.
Sensitivity analysis, scenario analysis, or simulation methods can help to understand and deal with the risk embedded in the forecast of future cash flows. By applying the discounted cash flow method to innovative start-ups, the entrepreneur and the venture capitalist are forced to clearly lay out their perspective on the future growth potential of the company.
So even though a detailed cash flow analysis is difficult for new ventures, a discounted cash flow analysis based on projections of key line items can be helpful. This valuation can then support their arguments in the negotiation process prior to closing the deal.
h e market approach is difficult to apply to innovative new ventures due to two main reasons. First, the venture usually does not yet generate the required performance indicators such as earnings or sales. Second, comparable companies or comparable transactions often do not exist or their market price is not publicly available.
That makes it difficult to create a sensible peer group to calculate an average multiple. However, the market approach is easy to use and mirrors the current market price level. Hence, the value derived from the market approach serves as a good indicator for a market-based price range for the venture.
h e real option approach is often seen as a useful extension to classic valuation approaches. Using the real option approach, the benefit of future options of the innovative new venture can be considered. The real option approach can give insights into the strategic options of an innovative start-up on a qualitative level. However, as it is particularly difficult to estimate the parameters required for a real option valuation (e.g., the value of the underlying asset) a quantitative value is difficult to estimate.
In addition to classic valuation methods, context-specific approaches are often applied in venture capital financing rounds. It is possible to get quick estimates using these context-specific approaches. The venture capital method is an example of such an approach used for new venture valuation.
The value derived from context-specific approaches is likely to be biased as these approaches are mainly based on prior investment experience and on simple rules of thumb. However, for practitioners these approaches can be useful to quickly estimate an approximate value of the new venture.