Towards the end of 2013, the Belgian football club FC Racing Boxburg awarded 20-month old Bryce Brites a contract. Disbelieving commentary around the signing coalesced around the notion that the evaluation of tender sports talent is completely subjective.
Similar incredulity appears to have greeted the valuations implied by transactions involving a couple of (virtually) pre revenue start-up companies.
- Quora raises $80 million at near-unicorn valuation.
- Facebook buying WhatsApp is a desperate move. (See related – Facebook, WhatsApp, and value allocation.)
Unlike sports scouting, assessments of start-ups can (should?) include both qualitative and quantitative elements. While the list is far from comprehensive or universally applicable, start up founders and investors may assess the following factors in pondering the value of an opportunity.
- Likelihood of technical viability. Many, if not all, new ventures begin in the hopes of either tackling an unsolved problem or finding a better way to address current practices. Before a product or service can launch into the wider market, however, a new technology has to be viable. A social media company needs to be able to attract users and keep them engaged, and a medical technology start-up has to pass regulatory hurdles to develop an approved product. While feasibility may be mostly indeterminate for seed-stage ventures, the likelihood of technical viability usually becomes clearer as a start-up makes progress in achieving its milestones.
- Total addressable market reflects the scope of the unsolved problem or current practices that can be disrupted. Again, for many start-ups the size of the addressable market becomes clearer as they progress from early-stage to later stages. Even after product launch, strong platforms may be able to annex related market segments to expand the size of the addressable market. An online bookseller can morph over time to become a dominant retailer that also provides enterprise technology infrastructure.
- Market share. In a competitive economy, even the most convincing product or service may (should?) be able to garner only a fraction of the total addressable market. Market share will depend on the strength of the offered feature-set, as well as the ability to communicate the appeal of the products and services to potential customers.
- Profitability, or the efficiency with which a given dollar of revenue translates into profits, determines the cash flow potential of a business. The value of an enterprise, at least over the long run, is rooted in the amount of cash that can flow from the company to its shareholders.
- Investments necessary to achieve technical viability, and execute market launch to sell products or services profitably at some future date.
- Barriers to entry. A useful technology may confer economic value to a particular owner or developer only to the extent it is not easily replicable. Intellectual property protection in the form of patents and trade names can deter competitors and preserve market share, as can regulatory approval requirements that can only be met via investments of time and money, and a bit of good luck.
- Management quality. Talent, hard work, ingenuity, grit – take your pick.
Inevitably, time will be the ultimate arbiter of whether each of the deals being struck at present will ever make sense. Investors with a portfolio of VC investments, however, may view an early funding round as a purchase of an option with a potential huge upside and limited downside. In that sense, not all start-up companies need necessarily grow into their implied valuations for the portfolio of VC investments to be valuable.
Indeed, Belgian football also appears to have taken the portfolio approach to heart by setting up a number of youth academies around the country. For now, we will just have to wait 15 to 20 years to see if young Master Brites will someday light up the football pitch like his more illustrious compatriots, or turn out to be a proverbial flash in the pan.
Mercer Capital’s Financial Reporting Blog
Mercer Capital monitors the latest financial reporting news relevant to CFOs and financial managers. The Financial Reporting Blog is updated weekly. Follow us on Twitter @MercerFairValue.