Valuing and Financing Early Stage Companies
Early (or development) stage companies are defined by businessdictionary.com as “a business whose primary functions center on launching itself, and whose intended main operations have not begun, or main operations have begun, but there has been no major income.” These types of companies are often associated with today’s “high tech” industries but they are not restricted to only the high tech sector which tends to incorporate the following broad categories:
• Alternative Power
• Health Care Devices
Early stage companies share many, if not all, of the following common characteristics:
1) Lack of an established customer base.
2) Unproven products and/or services.
3) Management responsibility primarily rests with the inventor/entrepreneur.
4) Key contracts and/or supply chain still being developed.
5) Significant early investment in equipment and facilities.
Outside factors that are often in favour of the early stage company include the following:
1) Positive industry outlook.
2) Significant market potential.
3) Strong economic outlook, at least within your sector.
4) Lack of significant competition, especially for innovative and/or high tech opportunities.
5) Receptive government regulatory climate, subject to public health and welfare issues.
Early stage companies require business valuations for a number of reasons including raising capital, possible sale or merger, buy/sell agreements, tax reporting, stock based compensation and financial reporting. In order to have a quantifiable value these businesses must be able to demonstrate many of the same characteristics as established companies. These include the following:
1) The value driver(s) must be transferrable to a third party.
2) The business must have economic substance. It must be able to be monetized.
3) The value will be driven by risk and return. Sweat equity means little or nothing to a buyer.
4) Higher growth potential will almost always translate to higher value.
5 ) Value is “in the eye of the beholder”. The broadest target base increases the chance of maximizing value.
Valuation methods follow the traditional approaches including replacement cost, income and market. However given that much of the replacement costs are “sunk” development costs, they often have little or no value to a buyer. Market approaches are also difficult to assess as guideline comparables will be difficult to locate and quantify. Ultimately any proven value is going to stem from some form of discounted cash flow methodology, placing a present value on potential future earnings. Therefore, as the predictability of those cash flows improves, value increases.
The stage of development is critical to the predictability of cash flow. All businesses, high tech or otherwise, have to get through a few rounds of preliminary hurdles before the quantum of future cash flow can be predicted with enough certainty to reduce risk factors to the point of getting a reasonable multiple from a buyer. These hurdles can be broadly categorized into the following four stages:
This is a company with an idea and not much else. At this point revenues are not even part of management’s goals. This is the riskiest stage for investors and requires the highest rate of return.
The company will have a prototype, product or service with proven capabilities. However, work still needs to be done to develop commercial scales of production, supply lines, distribution channels and customer base. Positive net cash flow can still be years away.
The company has experienced success in commercial production, development of human capital, product supply lines, distribution channels and at least the availability of a customer base. Often at this point the ability to make a profit is proven, but rapid expansion requires working capital and possibly further infrastructure investment.
Fast growth and strong profitability have been achieved but funding is required for national or global expansion.
The risk/return proposition is never more evident than when you are valuing a business for a capital raise. Investor assessment of earning potential vs return expectations will require a significant investment by both sides in the due diligence process. Venture capital rates of return expectations for early stage companies can be approximately as follows:
First Stage 40%
Second Stage 30%
Third Stage 25%
Of course, as the business proceeds into these later stages, more traditional financing sources are available and make up a significant portion a business’ total capital requirements. These financing sources come with a much cheaper cost of borrowing and drive down the business’ overall cost of debt, thereby increasing the rate of return to the shareholder, which is after all, the ultimate goal.
For more information please contact a member of our BV Team.
Dwayne Pyper, CPA, CA, CBV, Q.Med
Partner, Business Valuations
DJB Financial Services
February 6, 2012
WIPFLi CPAs and Consultants