Applying the income approach to start-up valuation

The income approach assumes that investors have a number of alternatives to put their money into, from risk-free government debt, such as US Treasurys, to venture backed start-ups. In an efficient market, sensible investors demand greater returns for assuming the extra risk. The value of a start-up is seen in the context of this question, “What kind of return can an investor expect for putting the money in a non-marketable start-up?”

The answer depends upon the expectation of future income that the company can reasonably earn. To apply income valuation methods, you need to project future earnings of the company.

This is somewhat easier to do for an established company by looking at its earnings history. The uncertainty is always there, and it is much higher for a start-up with little or no income track record.

Assessment of a public company’s potential earnings is something the investors do as a group every day. That’s the basis for setting the stock prices. In a sense, you can see the collective investor opinion better than predict what the company will actually be able to do in the future.

A number of analysts make a good living offering advice on future business performance. Yet time and again their forecasts have proven wrong. There is always a day of reckoning as the financial publications report just how close a company came to analysts expectations. Disappointing the market expectations can send a company’s stock prices tumbling down.

For a start-up, there is little basis on which to set your expectations. You have to make a judgment call as to the likelihood of business success. Even with an excellent product offering, there is the lingering questions as to whether the business team will be able to turn the potential into actual profits.

It is not unusual to consider a number of possible outcomes for a start-up. You can develop a cash flow forecast for each of the scenarios. Applying the income based methods, such as the discounted cash flow technique, gives you a business value result for each anticipated outcome.

You can then assess just how probable each scenario is. Perhaps the company can meet most of its key objectives and achieve a level of earnings as the best case. On the other hand, unexpected difficulties could limit its progress, and the earnings forecast you create would represent the worst case scenario.

You can use the results of business valuation under each scenario, then combine them to calculate the average. Alternatively, the range of business values can indicate where the actual business worth is likely to fall.

See Valuation Tour