Why Traditional Valuation Methods for Companies Are not Applied to Value Startup companies?

The main reason for the limitation of traditional valuation methods is the absence of typical information needed to implement traditional valuation methods. There are no data on past revenue or cash flow since the company is a short history. In the absence of comparable firms, often, there is no market data. Companies' assets are intangible and difficult to evaluate objectively.

The Asset-Based Valuation (the cost approach) is based on an analytic valuation of the value of assets and liabilities the company currently has. It is static since it does not consider the future evolution of the company. Generally, the cost approach is the least suitable to assess the economic capital of startups. Indeed, the startups' value is in the founders' ideas and subsequent development, not assets. The newly started company usually has very few tangible assets and is undercapitalized. However, the cost approach could help assess the value of startups only if the valuation is done early when it is impossible to make reliable projections for the future. The value of the startup could be approximated by the amount invested by the founders.

The Discounted Cash Flow (the income approach) is based on the company's ability to generate prospective cash flows, using three valuation steps:

1. Set the timeframe for the flow review.

2. Evaluate the "normal expected" income/cash flows.

3. Establish a suitable discount rate.

The discounted cash flow (DCF) method could help assess firms' economic capital quickly growing that have not yet reached a level of operational maturity. Nevertheless, there are many problems in applying the DCF method to measure startups' value.

The financial literature found that firms' traditional valuation methods do not work for startups

It is based on assumptions regarding the projected payoff. However, the payoffs are uncertain and risky.

Given the firm's risk - a discount rate should be determined. Discount rate calculation for young firms is questionable. Traditional models, such as the Capital Asset Pricing Model (CAPM), are inadequate because they determine the discount rate considering sector characteristics and the company's historical background. Still, startup companies can't extrapolate back past returns to get the firm's beta. Often startup companies have features that are very different from other companies in the sector. Moreover, traditional models assume uniform market risk over time, but risk changes over time, especially for newly created companies. Traditional approaches to assessing the discount rate concentrate on market risk, whereas the main risk for startups is the firm's specific risk.

The second problem is the Terminal Value (TV). The DCF includes projections regarding the Terminal Value. Sometimes, TV equals more than eighty percent of the total value of the company. The definition of the TV for a startup company, however, is much more complex because it is impossible to consistently establish the companies' growth pattern - if, when, and how the company is expected to grow.

With the market approach, the company's value is based on market multiples. It refers to comparable multiples or transactions in the stock market. This approach is difficult to implement with newly created companies because multiples are generally based on profits or revenues. Still, in young companies, these economic variables are often negative (usually startups record losses, not profits, and at the beginning, revenues are meager). It is challenging to find comparable data in the market as every company has specific and not replicable features. Furthermore, in general, market data available are for mature companies, not early-stage firms.

A fundamental assumption for traditional valuation methods is the efficiency of capital markets. This hypothesis could approach reality in the case of the public capital market. There are legal regulations that require a public company to show all relevant information to stakeholders. The situation is different in the private capital market, where the information asymmetry is higher. This condition can create evaluative inefficiency because prices in the market do not reflect companies' real value. Firms are tempted to publish only partial or distorted news. On the other hand, investors defend themselves by raising their caution in evaluating these firms. These factors create resource allocation that is far from Pareto optimal. It generates an information reliability issue, which may explain why startups have difficulties getting funding.

To sum up, in this valuation blog, we have explained why Traditional Valuation Methods for Companies Are not Applied to Value Startup companies. However, the value of a startup company can be calculated using a variety of valuation methods. Equitest platform offers a simple business valuation tool that enables anyone to find equity value in a matter of minutes.