Startup Valuation Conundrum

Introduction

Valuation is a key element of financial management, and startup enterprise valuation is a fundamental component of the free enterprise system, the driver of the U.S. economy. As problematic as valuation is for the ongoing enterprise, the task of valuation for the pre-money startup assumes Nostradamus-like proportions due to the new venture’s lack of a deep history of financial activity or other reliable forecasting metrics. Because cash flow is the bedrock of firm valuation and new firms typically lack consistent cash flow histories, the valuator must rely on financial modeling in the absence of usable financial statements and projections, a process entailing assumptions and arbitrary educated guesswork (Vara, 2013). Economist Joseph Schumpeter viewed capitalism as an evolutionary process, with innovation driving progress and development via a mechanism known as creative destruction, and the entrepreneur serving the role as agent of change (Audretsch & Link, 2012a). The ignition for the entrepreneur’s innovative zeal is the investor, whose willingness to fund new business ventures is dependent on enterprise valuation. Hence, the overriding purpose to finding satisfactory resolution of the startup valuation problem is to expedite the movement of investment funding from where it is located (e.g., Wall Street) to where it is needed (e.g., Main Street) via the entrepreneurial process of new business creation.

Startup valuation is important not only to the entrepreneur (who is seeking funds for a new business) and the investor (who is seeking a return on investment), but also to the community in which the new business operates and the overall national economy. Because valuation determines the equity allotment for each party of the entrepreneurial investment negotiation, new business valuation is a key determinant of investment yield for the entrepreneur and investor (Bell, 2014): For the same dollar investment, the higher the valuation, the greater share of the company retained by the entrepreneur; conversely, the lower the valuation, the greater share of the company acquired by the investor and a greater potential investment yield.

The community benefits, too, because each newly funded startup equates to new incomes (associated with the new firm’s staff and employees), which will be spent on goods and services provided by local businesses. Clearly, in the aggregate, the sum total of new jobs/incomes derived from each funded startup gives a boost to the overall economy, as quantified by an uptick in the nation’s gross domestic product (GDP). An added benefit of quality full-time employment is that it enables more people to become more self-reliant, which means there is less need for government support payments to citizens, a scenario that reduces the federal budget deficit. More generally, the act of funding new business ventures represents the movement of investment dollars from Wall Street (e.g., big investment banks, securities traders, hedge funds, corporate coffers, etc) to Main Street, where most American citizens live and work.

Even in the best of economic climates, the funding of new ventures is essential to the health of the economy, as the new business creation process is the mechanism by which the free enterprise system regenerates, reinvigorates, and rejuvenates itself (i.e., Schumpeter’s creative destruction process mentioned above). In more challenging economic conditions, such as those experienced today with millions of people not working, where recent college graduates have trouble finding employment, where older workers have been flushed permanently from the labor force, and far too many folks are being forced to subsist on the paltry income derived from various part-time jobs (which often lack adequate health and retirement benefits, if any at all), the successful funding of new business ventures is of paramount importance.

Solving the startup valuation puzzle potentially could be a big step toward unleashing vital quantities of investment funding. Of course, this perspective presumes that ineffective or inconsistent startup valuation is an impediment to investment funding, a circumstance that may or may not be supported by evidence. Conversely, it would be worth demonstrating that consistently incontrovertible startup valuation would unleash massive amounts of pent up investment funding, perhaps the task of ancillary research to shed light on this contention.

Currently, the startup valuation process is at best a tug-of-war between investor (typically savvy and confident) and the entrepreneur (often naïve and desperate), with neither party particularly satisfied with the resulting valuation nor confident that the inherent value of the enterprise has been determined (Bell, 2014; Heughebaert & Manigart, 2012; Miloud, Aspelund, & Cabrol, 2012). With so much uncertainty about the true value of the new firm, finding agreement on valuation between entrepreneur and investor often takes the form of a “contentious negotiation,” embittering both parties going forward (Bell, 2014, p. 60), with the potential negative consequence of limiting funding opportunities for new startup ventures. The valuation negotiation is among the challenges addressed by this research inquiry, and is an important theme driving the literature review that follows.

Startup Valuation Literature Review

A review of the literature pertaining to new entrepreneurial venture valuation reveals a multitude of methods and techniques available to the startup valuator, none of which seems particularly suited to the task. These methods were developed mainly to value ongoing business concerns, but have been adapted, perhaps none too successfully, to the startup venture. Startup valuation methods showing more promise are based on an amalgamation of traditional spreadsheet based approaches (e.g., discounted cash flows, asset- and income-based multiples, etc) in combination with the novel inclusion of non-financial qualitative factors (e.g., management team composition and experience), while also incorporating real options or multi-staging aspects. From an examination of this valuation goulash, the researcher ponders whether or not it is possible to develop a startup valuation model or methodology that can be attenuated to the idiosyncrasies associated with each type of industry and valuation scenario, perhaps with the side effect of freeing investors to pour significantly greater sums of investment capital into new ventures (with the macroeconomic consequence of boosting the overall economy).

The Venture Capital Method

The venture capital enterprise valuation method is widely used and relatively simple to formulate. According to Vara (2013), it consists of four steps: (a) project the company’s net income for a terminal year; (b) calculate the company’s terminal value using a comparable company’s P/E ratio; (c) calculate the present value of the terminal value using a high discount rate (e.g., 50%); and (d) using the just-calculated present value as the company valuation, determine ownership percentage corresponding to the amount of the investment (p. 5). Sammut (2012) applies the venture capital method to a hypothetical new biotech firm in need of early stage funding to illustrate the principle of arriving at an appropriate valuation in the absence of historical financials. From this valuation is derived the ownership percentage by the investor (i.e., the VC firm), premised upon a predetermined required return on investment at the time of exit from the investment.

Sammut’s process is based on the establishment of a Year 5 terminal value for the biotech firm ($250 million via a method described as arbitrary) discounted back to the present using a discount rate equal to an eye-popping 50% (= the VC’s annual expected rate of return), which represents the totality of risk known and unknown associated with the investment. This exercise is useful to outline some of the issues associated with the dance between investor and entrepreneur in establishing valuation for the purpose of determining post-investment equity shares. Noteworthy, too, is that valuation is directly impacted by the assigned value of the discount rate, which could have been set at a lower rate by a different valuator even in the presence of the exact same data. Eliminating the apparent arbitrariness of the discount rate in startup valuation would ensure much greater credibility to the valuation process (and, consequently, the post-money equity shares of the investor and entrepreneur).

One end around for the problem of insufficient financial history is the use of comparable companies, where the new firm’s financial projections are based on appropriating those of the comparable firms, which are already operating in the pertinent industry and marketplace. This approach is a key part of the venture capital method just described. However, as indicated by Audretsch and Link (2012), this method is inadequate for startup valuation, mainly because by definition the new firm is unique and therefore no truly comparable firm yet exists. Even if an identical firm could be found, its financials would not be usable for this purpose because the comp is already established and is not facing the same marketplace challenges as the newly-minted firm.

Discounted Free Cash Flows

There are many facets to the startup valuation puzzle, and discounted cash flow (DCF) analysis is among the most important. The following collection of research effectively puts the DCF approach under intense scrutiny. Awasthi, Chipalkatti, and De Mello e Souza (2013) examine the various free cash flow (FCF) valuation techniques, noting that there does not exist an accepted standard version of the FCF valuation method. This latter fact, of course, highlights the problem of reliable enterprise valuation: Valuation can change based on the whims and preferences of the valuator, as he or she chooses (somewhat arbitrarily) a particular formulation of FCF, each of which produces a different firm valuation.  Each method scrutinized by the researchers utilizes some combination of operating cash flows, capital expenditures, and other metrics (e.g., EBITDA). The researchers conclude that among the various FCF flavors the most accurate for the purpose of valuation is the approach that includes “net cash flows distributed to claimholders, adjusted for accounting distortions and omissions, plus net changes in the balance of surplus cash” (p. 105), a method determined by their analysis to produce the most accurate, least biased, and closest firm valuation than any of the other FCF methods. Despite identifying a best FCF valuation method, their research does not include any comparison with other valuation methods, implying that future research is needed to determine if this optimal FCF method is indeed the best overall valuation method or simply the best of the FCF methods. Further research is needed to determine if Awasthi’s optimal FCF method could be adapted to the pre-money startup enterprise for the purpose of valuation. If not, is there something that can be gleaned from this FCF approach that could improve valuation accuracy for startup ventures? Further research is needed to determine how this FCF approach compares to the other valuation methods.

According to Audretsch and Link (2012b), the present value of adjusted future net earnings valuation method is inadequate for the startup because the life of the firm is unknowable, the discount factor is not derivable (due to a lack of comparable firms from which to derive market risk and related parameters), and the lack of net earnings prevents the calculation of present value. Additionally, the price-to-earnings (P/E) ratio valuation method, reliant as it is upon using the P/E ratios of comparable firms, is deemed insufficient by the research team due to the problem (noted above) of finding comps for the nouveau venture. The researchers suggest, as the key to valuing the new entrepreneurial enterprise, an approach involving the forecasting of alternative or complementary technologies, and not basing valuation on existing companies that sell substitute products. The existence of related technologies indicates a business environment conducive to the offerings of the new venture and, thus, improves the likelihood of success of the new company. The researchers also note that the adjusted net asset valuation method fails the startup, too, as the infant firm’s major assets are cognitive or intangible, with their value heavily dependent on the future (unknowable) performance of the firm.

Damodaran (2013) adds to the discounted cash flow approach the notion of uncertainty (in all its various forms), while noting the four drivers of valuation: cash flow from existing assets, expected growth in operating income, discount rate, and the terminal value of the firm. Based on the age of the firm, its financial history (or lack thereof), various marketplace factors, and related, uncertainty is introduced in different ways to each of the four valuation drivers, and variations in the way each valuator quantifies such uncertainty is one reason that enterprise valuation generates such disparate results. Damodaran’s remedy for the uncertainty problem is to keep the valuation process as simple as possible (by reducing the number of valuation-related inputs), while making sure not to overreact by resorting to “denial, paralysis, outsourcing, herding and rules of thumb” (p. 22). Reducing the number of inputs effectively means relying more heavily on a greater number of guesstimates and approximations for key valuation metrics. The process of simplification, in this light, seems to increase the lack of certainty, consistency, and credibility of the firm’s valuation.

Brotherson, Eades, Harris, and Higgins (2014) examine how the DCF approach is applied to enterprise valuation in merger and acquisition (M&A) deals by leading practitioners from major investment banks. Their study provides direct feedback about real world utilization of DCF methods in enterprise valuation, showcasing some of the different issues and approaches associated with the technique. While the focus is M&A, effectively ongoing business concerns, insights can be gleaned and applied to the startup situation, as DCF and variants are used routinely in the startup valuation process, too. The researchers, in a series of interviews with the bankers, discover that “analytic techniques such as DCF do not make decisions but only inform them” (p. 51), implying yet again that the valuation process contains some element of smoke and mirrors, even at the sophisticated level of stodgy investment banks and high-profile merger and acquisitions.

Festel, Wuermseher,and Cattaneo (2013) offer a twist to the DCF valuation technique by focusing on the beta value (associated with the capital asset pricing model, or CAPM) in order to generate unique firm-specific adjustments to the discount rate utilized in the DCF calculation, which then should produce a more accurate valuation. By assigning values to various factors (and relevant sub-factors) related to the particular firm being valued, including technology, products, implementation (business plan, etc), organization (management team, etc), and finances, the standard CAPM beta is adjusted (either higher or lower) to generate an objective DCF-based valuation that better reflects accurate valuation of the specific firm under review, ultimately serving the interests of both entrepreneur and investor to produce a mutually acceptable valuation. This method presumes the efficacy of DCF-based valuation methods (as applied to startups), and purports to generate an objective, more accurate valuation, especially when used to value a series of startups via the same method (from which group an investor might choose one or more targets for investment). The idea of establishing a more accurate firm-specific CAPM beta to be used in the standard DCF calculation is an insightful approach, which further tweaks the valuation process to the uniqueness of the firm in question, and presumes the analysis of quantitative and qualitative factors can be successfully or coherently or consistently quantified for the beta adjustment factor (and that all parties to the negotiation agree to the adjustment assessment).

Saha and Malkiel (2012) extend DCF valuation theory by demonstrating that the discount rate must be adjusted substantially higher in DCF calculations if there is a finite probability of a cessation to the stream of cash flows upon which the DCF calculation is based. The researchers found that “even a small chance of cash flow cessation implies a significantly lower NPV and correspondingly implies a higher discount rate” (p. 179) and that the CAPM-based discount rate is lower than the true discount rate because it makes no allowance for cash flow cessation risk. The assumption implicit in DCF valuation calculations is the perpetuity of cash flows, which in reality is not always the case nor can be guaranteed, especially in the case of the new enterprise, and thus must be remedied by increasing the discount rate by an appropriate factor. In the context of startup valuation relying upon DCF calculations (for any part of the valuation process), the typical risk-based discount rate is likely to be lower than necessary because it does not account for cash flow cessation risk, a risk which must be high due to the uncertainty of success associated with the startup enterprise.

Multi-Stage and Real Options Methods

The multi-stage valuation method presented by van de Schootbrugge and Wong (2013) is related to the real options approach described below. The researchers examine the utility of traditional valuation theory before presenting their multi-stage technique. They assess the cost approach (which accounts for actual development costs related to the firm’s technology, but does not reflect the intrinsic value, or potential, of the technology itself); comparable company’s multiples (as noted above, using established companies as comps for startups is a crapshoot); discounted cash flow methods (among other concerns, the discount rate chosen by the VC is often way too high for the new venture’s financial success); real options (which requires a level of computational complexity that is impractical for most valuators); and the venture capital method (which requires the use of comparable companies and discount rates and the previously described flaws associated with each). The researchers explain that the multi-stage approach succeeds where traditional approaches fail, and it is especially suited for high tech startup companies, which tend to be associated with high levels of uncertainty and tend to require lengthy incubation periods before commercially viable products are available. In such a setting the entire process can be separated into stages, which enables incremental, or staged, investments to take place, beginning with the pure research stage, through proof of concept, prototype development, and full-scale production. At each stage, an assessment (based on a set of business- and marketing-related factors) is made about the future viability of the product and the costs associated with continued development, and an increasing dollar investment is made, before calculating the net present value using a very low discount rate (e.g., that of government bonds). This multi-stage approach avoids many of the problems associated with startup valuation methods by choosing not to set a pre-money valuation for the firm; instead, calculating the level of investment necessary to complete the current stage of development, a de facto surrogate for firm valuation.

Another branch of new startup valuation methods involves the use of real options and multiple stage valuation to break down the new business valuation process into components or stages that can be assessed independently and then rolled into a total valuation for the new enterprise. Both Vara (2013) and van de Schootbrugge and Wong (2013) offer different flavors of this approach, with the former focused on real options (aka risk-based valuation) and the latter introducing the multi-stage approach while also embracing traditional valuation methods (e.g., cost approach, comparable company’s multiples, DCF, real options, venture capital method). Real options, at each decision juncture, enable the investor to (a) invest the next round of funds, (b) make changes to the firm or its operations or strategies, or (c) abandon the investment completely. In practice, a small amount of the total investment required is put forth initially (when the investment is riskiest), and later when certain benchmarks are achieved (which serve to lower the applicable risk) more funds are added until the full investment is made (thus sheltering the majority of the investment funding from the largest risk).

From a valuation standpoint, each stage is assessed using a method akin to the Venture Capital method [see above], i.e., by establishing terminal value using established comparable companies as validating reference points for each (future) stage and realizing reduced risk for each progressive stage. The problems associated with choosing appropriate comps (see above) are mitigated somewhat via this approach (mainly because the comparable firms are chosen based on their anticipated similarity to the new firm’s projected status at future times corresponding to each stage), and the diminution of risk throughout the process aids in valuation accuracy. The real options method yields the dual objectives of maximizing entrepreneur retained equity and minimizing investor risk, presumably narrowing the range of potential valuation fluctuation associated with other techniques. Information asymmetry between investor and entrepreneur, which tends to tilt the negotiating advantage toward the investor, is another issue addressed by the Vara study. The risk-based valuation technique resolves information asymmetry and other startup valuation problems, generating a realistic valuation figure for the new venture. However, this method is not without its fair share of hocus-pocus, particularly the matter of choosing appropriate comps (addressed above).

Non-Financial Qualitative Considerations

Miloud, Aspelund, and Cabrol (2012) have developed a theoretical framework for enterprise valuation that includes not just the typical financial statement information, but is based upon empirical analysis of non-financial qualitative factors including strategic management theories, which comprise impacts of industry organization economics (which relates to market structure), resource-based effects (which frame the firm as a collection of valuable resources), and network theory (which describes the impact of external relationships on firm performance and strategic decision-making), to develop a comprehensive valuation method comprising both qualitative and quantitative factors. The researchers essentially confirm the utility of existing valuation models, methods, theories, while tweaking, refining, and extending them to generate a higher degree of startup valuation accuracy. Furthermore, the researchers demonstrate that investors and entrepreneurs, utilizing this approach, will be able to collaborate better as a consequence of greater consensus regarding the startup’s valuation accuracy. Again, exact weighting of the various valuation metrics (both qualitative and quantitative) lacks ultimate precision and certitude, with the likelihood that each valuator (representing either entrepreneur or investor) using the Miloud-based valuation algorithm, but assigning different weights to the key metrics, will generate a different valuation for the same new business venture. However, the valuation approach proffered by Miloud et al. demonstrates potential as a standardized solution to the startup valuation problem, deserving of much more rigorous testing and analysis via future research, despite the inherent weaknesses associated with the assigning of dollar values to qualitative factors and the often capricious application of financial statement data to the valuation process.

For new or early stage firms, Sievers, Mokwa, and Keienburg (2013) assert that utilization of both financial and non-financial information achieves startup valuation results that are more accurate than results relying on financial statement information only, and models based on the combined approach specifically outperform valuations based on “industry-specific revenue or total asset multiples” (p. 505). Typically, such nascent firms have little or incomplete financials upon which to calculate firm value via standard techniques (e.g., use of discounted cash flows); hence, the need to seek non-financial qualitative factors upon which to base valuation. The researchers identify five such factors relating to team quality: “team composition, founding team size, management team size, CEO education, and team experience” (p. 473). They make an excellent case for including qualitative factors in the startup valuation process, but further research is necessary to specify with precision (if possible) which factors should be used and how their effects should be weighted.

Stankeviciene and Zinyte (2012) offer a mechanism, based on an amalgamation of valuation factors, to differentiate between potential startup venture investment opportunities for the purpose of determining the most promising of the group, without calculating a particular valuation figure. They propose using the method of simple additive weighting (SAW), which involves utilizing the weighted average of multiple factors impacting startup valuation, where different criteria, parameters, and weights can be selected by different valuators to suit their preferences and goals. Their model is based on the use of an integrative strategic management framework, which incorporates 22 sub-criteria grouped into six global criteria categories (e.g., owner’s profile, market opportunities, financing model, etc), each of which is weighted according to an assessment by six industry experts (as selected by the researchers). While the model developed by the researchers does not produce a specific valuation for the firm, it does underscore the necessity of including non-financial qualitative information in the valuation process. However, the arbitrariness of this approach, as to which factors to include or exclude, seems to limit its usefulness as a dependable valuation technique. Much more research is necessary to determine a consistent mechanism to choose and discard valuation factors.

The contribution to the startup valuation conundrum offered by Romanova, Helms, and Takeda (2012) is the addition of the 5R Model, which serves as preventative medicine against a gold rush frenzy of over-investment, the type of which gave rise to the dotcom bubble of the 1990s and the subsequent crash in 2000-2001. The 5R Model (revenue, risk, research, range, and results) is a kind of investment insurance against hasty valuation decisions regarding Internet startup companies (although the approach can be generalized to any startup), as it forces stakeholders to ensure that the valuation effort includes “all relevant components of sound investment strategy” (p.51). The model requires an overall holistic analysis of the firm under examination beginning with revenue per share valuation (Revenue), discounted cash flow valuation (Risk), and research and development expenditures (Research), while establishing a range of firm values each with an associated risk premium (Range) and implementing ongoing re-assessments of firm performance to modify valuation as necessary (Results). If there is a negative associated with the 5R Model, then it resides in the choice of traditional (flawed) valuation tools utilized to review investment decisions, which allow the introduction of errors into the assessment process. Also, the 5R Model itself does not generate a stand-alone value for the startup enterprise that otherwise would be used by entrepreneurs and investors in a funding situation.

Kiss (2015) examines a variety of enterprise valuation methods: ratios based on accounting data (profits) which are not good measures of changes in the firm’s economic value; asset-based methods which ignore the asset’s income-generating capability; income-based methods which differ in part due to variable approaches to free cash flow definitions; discounted cash flow methods, which are comprehensive and favored among many valuators; etc. The researcher concludes that each method produces significantly different valuation results, that a best model cannot be identified, and that the selection of a particular technique is based on the firm’s circumstances and related situational factors plus the requirements and preferences of the valuator.

Adding yet more confusion to the startup valuation process, Huang and Pearce (2015) find that experienced angel investors routinely rely on intuition, in addition to financial analysis, to make investment decisions regarding new entrepreneurial ventures. In their quest for extraordinarily profitable investments, angels focus on startup enterprises rife with knowable and, particularly, unknowable risks, accepting a high failure rate in order to cash in on the few bonanzas. This approach implies that part of the formula for startup valuation is simply a belief by the investor that the entrepreneur has the ability to make the new firm profitable, in the face of the many daunting challenges plaguing every new business. Optimally, the gut feel aspect of the process occurs after valuation has been negotiated between entrepreneur and investor, and the angel simply uses intuition to pull the trigger on the deal, which implies a measure of cautious sensibility versus reckless dice-rolling. Amazingly, according to Huang and Pearce, this approach seems to produce a sufficient number of winners to compensate for the high failure rate. Of course, because intuition is non-quantifiable, the entrepreneur might be tempted to push for a higher valuation if he or she feels that the investor believes strongly in the entrepreneur’s entrepreneurial ability, thus skewing the valuation process and adding yet another factor to the startup valuation puzzle.

Investor Bargaining Power & the Valuation Negotiation

In addition to the quantitative and qualitative factors impacting the derivation of startup enterprise valuation, the effect of investor bargaining power and the valuation negotiation between investor and entrepreneur are examined in this section. Douglas, Carlsson-Wall, and Hjelström (2014) start with the premise that startup valuation, in essence, is the end result of a negotiation between entrepreneur and investor, and that there does not exist an absolute or true valuation defined explicitly by formula, formulation, or other related analysis. They contend that the process works best when information asymmetries between the negotiating parties are reduced, and they propose six key (valuation) variables to alleviate the asymmetries and become the focus of the negotiation. The variables include “revenue estimates, estimates of cash outflows, the risk premium, the planning horizon, the end-of-horizon earning multiple and the value added by the [top management team]” (p. 298). The researchers purport that the valuation solution for the startup enterprise is achieved via negotiation between the investor and the entrepreneur, with each party “pitching” quantitatively rigorous estimates of firm valuation (based on the six main variables) as a starting point for the negotiation, where typically the entrepreneur pitches a high valuation and the investor pushes for a low valuation. From this point, each side enters into a give-and-take on the value of each of the six variables involved in the valuation calculation, eventually arriving at a mutually agreed valuation and equity allotment for each party, a figure situated somewhere between the initial high-low salvos. Furthermore, the knowledge displayed by each party during this process builds trust between the parties and expedites resolution of the gap between the respective initial valuations. Also, the researchers include both share of equity and share of decision-making control as the two negotiating points in the valuation process (not just the former), which helps move the two parties closer to agreement. Also of note is that the six-item negotiation framework established by the researchers empowers the entrepreneur in the valuation negotiation process (versus the typically much more knowledgeable investor), which serves to reduce or eliminate the information asymmetries that often hamper such negotiations.

Heughebaert and Manigart (2012) look closely into the effect of investor bargaining power, noting that the valuation process is a protracted negotiation between the entrepreneur and the investor (e.g., a venture capital firm). They affirm that “enhancing negotiation power is key to maximizing firm valuation” (p. 527) for both the investor and the entrepreneur. From their research, one can see the value of equalizing bargaining power on both sides of the entrepreneur-investor relationship, so that both parties optimize their respective post-investment equity stakes (and, thus, maximize their respective ROI’s). The researchers emphasize that the entrepreneur’s retained equity is crucially dependent upon on the negotiated value of the startup enterprise; hence, the long-term value of the valuation process to the firm’s founder(s). The researchers build on theoretical frameworks that model the negotiating process to demonstrate that some VCs have more bargaining power than others, which directly impacts the startup valuation process, particularly in conjunction with entrepreneurs who are less savvy or knowledgeable (i.e., where valuation information is asymmetric). They also note that the entrepreneur can minimize or eliminate information asymmetries to improve startup valuation by increasing negotiation power via increased knowledge of the valuation process.

In an examination of angel investor sophistication, and the impact such sophistication has on the valuation process, Bell (2014) makes clear that pre-money startup valuation is a determinant for the ownership percentage of the investor and, thus, has significant bearing on the return on investment anticipated by the investor. This point is underscored by the following two valuation equations:

• Post-money valuation = Pre-money valuation + Investment amount
• Investor ownership percentage = Investment amount / Post-money valuation

Furthermore, the literature indicates that increased understanding of the various valuation mechanisms by the investor should lead to better valuation negotiations with the firm’s ownership, at least from the perspective of the investor. Miloud, Aspelund, and Cabrol (2012) affirm for the venture capitalist that firm valuation determines post-investment proportion of shares received, thus underscoring the importance of effective valuation. For example, if the pre-money value of a new company is $750,000, then an investment of $250,000 creates a post-money valuation of $1,000,000 and buys a 25 percent stake of the post-money firm. Instead, if the pre-money value of the same company is only $500,000, then that same $250,000 investment creates a post-money valuation of $750,000 and is now worth 33 percent of the post-money company. If the company grows into a successful enterprise generating annual revenues of hundreds of millions of dollars, then the difference between a 25 percent stake and a 33 percent stake is immense in terms of dollar value; hence, the importance of finding a solution to the startup enterprise valuation puzzle.

Impact of Funding Sources on Valuation

Lurking in the shadows of the startup valuation problem is the status of funding sources; specifically, does the type of funding source have an impact on valuation? If so, should research be dedicated to determine the precise impact of funding source on firm valuation, perhaps ascertaining which funding sources consistently produce the best valuations, for either the entrepreneur, the investor, or both? Kunz and Dow (2015), in a case study, list numerous options for startup funding, which include personal sources (self, family, friends), business colleagues, and credit cards, noting that these comprise last resort funding sources to be utilized when angels or VCs are not available. Later, as the firm establishes itself, retained earnings from profit-making operations also become a source of funding for projects and the general growth of the firm. The implication here is that the particular source of funding chosen or utilized by the entrepreneur seems likely to have an impact on valuation, as the entrepreneur who secures funding from personal sources must establish an enterprise value that conforms to the valuation perspective of the source of the funding (e.g., a family member or former colleague), which may or may not be a valuation figure that conforms to a valuation based on objective metrics and analysis. In other words, in exchange for seed money from his uncle, the entrepreneur might be forced to give up too large of a piece of the nouveau company.  Valanciene and Jegeleviciute (2013) present a theoretical framework which purports to examine and elucidate the strengths, weaknesses, opportunities, and threats (SWOT) of crowdfunding, the nouveau faddish Internet-based funding option that connects entrepreneurs directly with the potential users of their (not yet developed) products and/or services. Many questions arise regarding the crowdfunding approach, and its implications on firm valuation. Among them are the following:

• Does the crowdfunding process offer an alternative to existing valuation methods for the budding entrepreneur?
• Is crowdfunding a sufficient and/or reliable source of seed or early stage funding for the new entrepreneurial venture?
• Is startup valuation relevant in the crowdfunding milieu, or is this unconventional funding option mainly a way to generate (very early) seed money during the pre-valuation stage?

The Startup Valuation Conundrum

From an assessment of the preceding literature review, valuation methods for ongoing business entities, despite bountiful firm-related financial data, do not produce uniform or standardized valuation results. Instead, each method produces a unique valuation for the firm, resulting in great uncertainty as to which method produces the true valuation (i.e., a valuation that accurately reflects the future growth of the company), if indeed such a valuation can be postulated. Perhaps, because the process of valuation is as much art as it is science, the notion of a true valuation for any particular firm at any particular point in time is moot. Perhaps the only true valuation is the practical valuation, the one negotiated between investor and entrepreneur (Douglas et al., 2014; Heughebaert & Manigart, 2012) to determine the percentage of the investor’s equity in the new firm, with each party to the deal using one or another valuation method to support that party’s position, with higher valuations desired by the entrepreneur and the lower valuations required by the investor.

From a review of enterprise valuation methods literature, as presented above, the valuation problems facing ongoing business enterprises are trivial in comparison to those associated with startup ventures, where the lack of relevant financial history is a formidable obstacle to effective valuation. Existing research indicates various approaches that yield superior results, but thus far there is still no consensus about which method in particular is the most accurate, credible, or useful. Future research is necessary to scrutinize each of the startup valuation methods described above for the purpose of determining which among them might produce the best results and become the standardized approach.

Conclusion/Summary

Enterprise valuation is problematic, in part because there is no one method that produces consistent, accurate, or credible valuations across all the various business enterprise manifestations, whether in the case of the ongoing concern replete with an extensive financial history or the startup venture that lacks quantifiable financials upon which to anchor valuation (Audretsch & Link, 2012; Kiss, 2015; Sievers, Mokwa, & Keienburg, 2013; Stankeviciene and Zinyte, 2012; and others). As noted in the referenced literature, the pre-money startup’s lack of financial history (e.g., sales, revenues, earnings, etc) prevents the utilization of standard enterprise valuation methods generally associated with ongoing businesses (where P/E ratio and/or projected cash flows are required in the valuation process). As echoed throughout the literature, each enterprise valuation method produces unique and non-equivalent valuation figures for the new pre-money startup enterprise as well as the ongoing venture, underscoring the importance of establishing a standardized valuation method or process that would produce consistently accurate valuations, which would serve to benefit the entrepreneur, the investor(s), the firm’s customers, other stakeholders, and the overall U.S. economy. In the event that such standardization is not possible, the task remains to determine an effective means to manage the reality of variable enterprise valuations, especially in the context of the associated investment dollars.

A review of the literature pertaining to new entrepreneurial venture valuation reveals a multitude of methods and techniques available to the startup valuator, none of which seems particularly suited to the task. Showing more promise are methods based on an amalgamation of traditional spreadsheet based approaches in combination with the novel inclusion of non-financial qualitative factors, while also incorporating real options or multi-staging aspects. From this valuation goulash, an important question emerges: Is it possible to develop a one-size-fits-all universal startup valuation methodology, perhaps with the side effect of freeing investors to pour significantly greater sums of investment capital into new ventures (with the macroeconomic consequence of boosting the overall economy)? Conversely, will an in-depth examination of the relevant literature render the valuation quest irrelevant, providing compelling evidence that the startup valuation conundrum can be tweaked but never resolved? It is also possible that an examination of the relevant literature might point to a tiny part of the overall valuation process that needs to be scrutinized in depth, which might move the impetus of research toward a micro factor such as the specifics of the free cash flow valuation methodology, the particulars of assigning a (credible) value to the enigmatic discount rate, or the importance of qualitative factors such as the qualifications and character of the new firm’s leadership. Also, from the standpoint of utility and efficacy, how has the real world business community responded to research on startup valuation? Is there any evidence that entrepreneurs and investors are using the methods and techniques described in the literature, or are they content to rely on simpler rules-of-thumb approaches that have been in practice for decades? The derivation of a mutually accepted accurate valuation method could be viewed as a valuable goal of future research, and the development of a framework for achieving such a valuation would be an important accomplishment in valuation theory.

Perhaps one solution to the new enterprise valuation conundrum is simply to perform a study of a statistically relevant number of startups from the same general time period, perhaps drawn from a variety of industries, and apply to each firm the full-spectrum of valuation techniques referenced above. Then, compare this initial set of valuations with actual performance of each firm at three years, five years, and perhaps seven years to determine which techniques generated the most accurate firm valuations. Such a study, based on side-by-side comparisons, would help eliminate some of the uncertainty about the relative effectiveness of the various valuation methods.

In sum, a review of the literature generates three compelling questions:

1. Is it possible to devise a valuation method for new entrepreneurial ventures that is universally accepted as the standard valuation method by both investors and entrepreneurs, that is, can a best practices startup valuation process be developed?
2. Is there a relationship between effective valuation and the willingness of investors to fund new ventures? If so, would a universal valuation method compel investors to pour dollars into a greater number of startups? Because such a valuation method implies a minimum of uncertainty in (a) the investment opportunity, (b) the future performance of the venture, and (c) the all-critical return on investment (ROI), one would expect an uptick in investment funding as a result.
3. If “no” to either of the above questions, is the search for standardized valuation unnecessary and research related to this investigation also unnecessary, essentially implying that the valuation status quo is acceptable or immutable?

The following set of questions (continued from those above) pertains to specific issues in the research presented in the literature and how these issues might impact the valuation process:

4. How credible and reliable is the research examined herein regarding methodology, or how much wiggle room exists in the methods/techniques contained in the research? Are there other formulations that can be used within these techniques? Is it possible to improve the valuation formulations used by the researchers to improve valuation results?
5. The discount rate is a key component of many valuation methods (e.g., discounted cash flows, present value of terminal value, etc); it is based on the investor’s required rate of return, the firm’s cost of capital, or risk. However, the actual value assigned to the discount rate is as much due to smoke-and-mirrors (i.e., a guesstimate) as objective quantifiable factors. Discrepancies in the calculation of the discount factor alone can attribute the wide fluctuations in enterprise valuation. Is there any way to quantify the discount rate derivation in a consistent streamlined fashion to eliminate the guesstimate factor? Is there any discussion of this problem in the literature?
6. Qualitative non-financial statement related factors (e.g., company leadership) are included in some of the valuation methods described in some of the literature. Is there an effective and consistent method to attach dollar values to these factors for the purpose of firm valuation? How is this issue addressed in the literature?

 

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