Valuing Young Companies

One of the biggest challenges in valuation is valuing a young company, early in its life cycle, especially when that company has not established products. There are six reasons why valuation is difficult under these conditions:
1. No history: At the risk of stating the obvious, young companies have very limited histories. Many of them have only one or two years of data available on operations and financing and some have financials for only a portion of a year, for instance.
2. Small or no revenues, operating losses: The limited history that is available for young companies is rendered even less useful by the fact that there is little operating detail in them. Revenues are small or non-existent for idea companies and the expenses often are associated with getting the business established, rather than generating revenues. In combination, they result in significant operating losses.
3. Dependent on private equity: While there are a few exceptions, young businesses are dependent upon equity from private sources, rather than public markets. At the earlier stages, the equity is provided almost entirely by the founder (and friends and family). As the promise of future success increases, and with it the need for more capital, venture capitalists become a source of equity capital, in return for a share of the ownership in the firm.
4. Many don’t survive: Most young companies don’t survive the test of commercial success and fail. There are several studies that back up this statement, though they vary in the failure rates that they find. A study of 5196 start-ups in Australia found that the annual failure rate was in excess of 9% and that 64% of the businesses failed in a 10-year period. Knaup and Piazza (2005,2008) used data from the Bureau of Labor Statistics Quarterly Census of Employment and Wages (QCEW) to compute survival statistics across firms. This census contains information on more than 8.9 million U.S. businesses in both the public and private sector. Using a seven-year database from 1998 to 2005, the authors concluded that only 44% of all businesses that were founded in 1998 survived at least 4 years and only 31% made it through all seven years.
5. Multiple claims on equity: The repeated forays made by young companies to raise equity does expose equity investors, who invested earlier in the process, to the possibility that their value can be reduced by deals offered to subsequent equity investors. To protect their interests, equity investors in young companies often demand and get protection against this eventuality in the form of first claims on cash flows from operations and in liquidation and with control or veto rights, allowing them to have a say in the firm’s actions. As a result, different equity claims in a young company can vary on many dimensions that can affect their value.
6. Investments are illiquid: Since equity investments in young firms tend to be privately held and in non-standardized units, they are also much more illiquid than investments in their publicly traded counterparts.
In the new edition of my book titled "The Dark Side of Valuation", I have a chapter dedicated to young companies. I have excerpted the section of the book on young companies in this paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1418687
I hope you find it useful.