The Valuation of Start-Up or Early-Stage Companies: Marital Dissolution Considerations

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By David Rudman, CPA/ABV, CVA – Sigma Valuation Consulting, Inc.

The valuation of start-up companies often involves unique complexities that must be considered by an expert when undertaking such an engagement.  In the context of a divorce proceeding, there are two valuation issues that must be addressed:

  • What is the value of the company in its entirety?
  • What is the value of an interest in the company that is subject to equitable distribution?

The answers to both of these questions are addressed in this article.

Generally, start-up companies are often innovators in their field, developing new technologies, therapies, processes or products.  While some start-up companies look to replicate well-known existing business strategies, many start-ups explore new business models in an attempt to disrupt existing markets.

In most cases, such ventures are accompanied by a high degree of risk and speculation, with a significant need for capital as entrepreneurs look to build their first viable product and reach commercialization.  By their very nature, such companies usually incur significant losses in early years of operation and survival rates tend to be low.

Standard of Value

In the context of equitable distribution for marital dissolution cases in New York, experts can take divergent views regarding the valuation of such companies.

At the conservative extreme, a divorcing party (and their expert) might argue that value should not exceed the actual costs and expenses incurred by a company to date.  Alternatively, one might argue that value is significant and should be based on the company’s expected future cash flows, which are often difficult to predict and highly speculative.  So which argument holds ground?

While the valuation of start-up companies sounds complex, such companies are regularly valued for many purposes including transactions between shareholders, capital raises, public offerings, tax compliance and financial reporting.  As with any business or asset, the fundamentals of valuation still apply, beginning with the selection of the appropriate standard of value.

For New York marital dissolution cases, the appropriate standard of value is “Fair Market Value”, which is most frequently defined in reference to IRS Revenue Ruling 59-60, as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

The fair market value standard requires the expert to assess “what is known or knowable” about the company to knowledgeable parties as of the valuation date. In New York marital dissolution cases, the date of filing generally sets the valuation date.   We are asking ourselves, “what can one reasonably expect as of this point in time?”  The value of any business today is a forward-looking concept.  Stated differently, the central concept of value for any enterprise is that the value of that business today, is equal to the present value of that business’s expected future cash flows into perpetuity or over its expected life.

For many stable companies, it is common to rely on past performance as an indicator of what a company’s performance might look like in the future.  However, for start-up companies, relying on the past is less meaningful; as such periods are often characterized by little or no revenue and economic losses. Start-up companies tend to fall within a spectrum of progress, ranging from the “idea stage” to a “commercialization stage”.  The mere fact that a company has no revenue or is losing money does not however, mean that there is no value associated with a company.   To assess value, we must take an objective look at where the company stands with regard to the implementation of its business plan.  Examples of the questions that we must ask are as follows:

  • How far past the “idea” stage has the company progressed? How much progress has been made toward the company’s research and development activities?
  • How much capital is required by the company to continue its operations for the next 2 to 5 years?
  • Has the company been successful in raising capital to support its ongoing activities?
  • In the case of pharmaceutical or biotechnology companies, how much progress has been made toward obtaining FDA approvals?
  • What is management’s timeline toward achieving commercialization or exploring potential exit opportunities?

As shown by the questions listed above, for start-up companies, the reliance on management’s projections and probabilities of future outcomes is very important.

Case Study

Consider a hypothetical pharmaceutical company, Pharma-X, which is in the process of developing a vaccine for breast cancer.  The Company believes it has a highly promising vaccine and has already completed preclinical animal testing and Phase 1 human testing.  Pharma-X has begun clinical human trials and is now working on Phase 2 of its FDA studies.  Table 1 below summarizes all the steps that a pharmaceutical company must go through to get a drug approved.

The valuation of start-up companies often involves unique complexities that must be considered by an expert when undertaking such an engagement.  In the context of a divorce proceeding, there are two valuation issues that must be addressed:

  • What is the value of the company in its entirety?
  • What is the value of an interest in the Company that is subject to equitable distribution?

The answers to both of these questions are addressed in this article.

Generally, start-up companies are often innovators in their field, developing new technologies, therapies, processes or products.  While some start-up companies look to replicate well-known existing business strategies, many start-ups explore new business models in an attempt to disrupt existing markets.

In most cases, such ventures are accompanied by a high degree of risk and speculation, with a significant need for capital as entrepreneurs look to build their first viable product and reach commercialization.  By their very nature, such companies usually incur significant losses in early years of operation and survival rates tend to be low.

Standard of Value

In the context of equitable distribution for marital dissolution cases in New York, experts can take divergent views regarding the valuation of such companies.

At the conservative extreme, a divorcing party (and their expert) might argue that value should not exceed the actual costs and expenses incurred by a company to date.  Alternatively, one might argue that value is significant and should be based on the company’s expected future cash flows, which are often difficult to predict and highly speculative.  So which argument holds ground?

While the valuation of start-up companies sounds complex, such companies are regularly valued for many purposes including transactions between shareholders, capital raises, public offerings, tax compliance and financial reporting.  As with any business or asset, the fundamentals of valuation still apply, beginning with the selection of the appropriate standard of value.

For New York marital dissolution cases, the appropriate standard of value is “Fair Market Value”, which is most frequently defined in reference to IRS Revenue Ruling 59-60, as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

The fair market value standard requires the expert to assess “what is known or knowable” about the company to knowledgeable parties as of the valuation date. In New York marital dissolution cases, the date of filing generally sets the valuation date.   We are asking ourselves, “what can one reasonably expect as of this point in time?”  The value of any business today is a forward-looking concept.  Stated differently, the central concept of value for any enterprise is that the value of that business today, is equal to the present value of that business’ expected future cash flows into perpetuity or over its expected life.

For many stable companies, it is common to rely on past performance as an indicator of what a company’s performance might look like in the future.  However, for start-up companies, relying on the past is less meaningful; as such periods are often characterized by little or no revenue and economic losses. Start-up companies tend to fall within a spectrum of progress, ranging from the “idea stage” to a “commercialization stage”.  The mere fact that a company has no revenue or is losing money does not however, mean that there is no value associated with a company.   To assess value, we must take an objective look at where the company stands with regard to the implementation of its business plan.  Examples of the questions that we must ask are as follows:

  • How far past the “idea” stage has the company progressed? How much progress has been made toward the company’s research and development activities?
  • How much capital is required by the company to continue its operations for the next 2 to 5 years?
  • Has the company been successful in raising capital to support its ongoing activities?
  • In the case of pharmaceutical or biotechnology companies, how much progress has been made toward obtaining FDA approvals?
  • What is management’s timeline toward achieving commercialization or exploring potential exit opportunities?

As shown by the questions listed above, for start-up companies, the reliance on management’s projections and probabilities of future outcomes is very important.

Case Study

Consider a hypothetical pharmaceutical company, Pharma-X, which is in the process of developing a vaccine for breast cancer.  The Company believes it has a highly promising vaccine and has already completed preclinical animal testing and Phase 1 human testing.  Pharma-X has begun clinical human trials and is now working on Phase 2 of its FDA studies.  Table 1 below summarizes all the steps that a pharmaceutical company must go through to get a drug approved.

Insert 1 - Family Law

As evidenced by the table above, Pharma-X faces a long road to the approval of its vaccine.  Currently, the Company has not earned any significant revenue and operates at a net loss.  Like many start-up companies, Pharma-X has raised capital from a small number of outside investors. One investor contributed funds in exchange for convertible preferred stock with an annual cumulative dividend and a liquidation preference, and two others made loans to the Company in the form of convertible debt.  The Company’s founder, Bill Smith MD holds common stock in the Company.  Regardless of form, the outside capital that has been raised has enabled the company to continue its research and development activities and pursue the FDA review and approval process.

Dr. Smith is now getting divorced and his interest in Pharma-X is subject to valuation and equitable distribution.  Mrs. Smith knows how hard Dr. Smith has been working and believes there is significant value to the Company and Dr. Smith’s interest.  Is she right?

Possibly, but the answer is not known without further investigation.  Following the advice of counsel, Mrs. Smith retains a well-known valuation firm to value Pharma-X and Dr. Smith’s Interest.

It is at this point that one must assess the facts of the situation in order to determine if value has been created.  Clearly, the Company has spent a significant amount of money pursuing its research and development activities and the FDA approval process.  The Company has also been able to raise capital from outside investors.

Through discussions with management, it is learned that the Company also has developed a series of projections, showing losses for three more years prior to achieving commercialization and eventually becoming profitable.

From the perspective of Pharma-X, clearly there is some value associated with its in-process research and development and related intellectual property.  Mrs. Smith believes the same.  At this point, the first question that must be asked is, “Is there value that exceeds the sunk costs incurred to date?”  In other words, is there value that would exceed the valued arrived at via an asset or cost approach to valuation?

Valuation Methodology

In order to answer this question, we look to the discounted cash flow method (“DCF”) of valuation, the most common valuation method applied to the valuation of start-up companies.  The DCF Method is a valuation method that relies on a projection (or series of projections) of future cash flows for the Company.

The divorce courts are very familiar with the capitalized earnings and excess earnings methods of valuation.  These methods generally use past performance as a proxy for the future, and are applied when a company has a stable level of earnings or operating cash flow.  Conceptually, the capitalized earnings method is a single period model that captures the present value of all the expected future annual income or cash flow benefits of the business into perpetuity.  The DCF method also captures the present value of all the expected future annual cash flows of the business into perpetuity.  The main difference between these two methods is that the DCF method allows for variation in the projected cash flows during a multi-period projection window, whereas the capitalized earnings method assumes the projected cash flow will remain stable subject to a constant rate of growth.

The single period capitalized earnings method is best applied to stable profitable companies.  In contrast, start-up companies rarely have stable earnings.  Rather, most start-up companies experience significant losses for a reasonable period of time before reaching profitability and eventually achieving stability.  As a result of variations in profits and cash flows during the early years, the DCF is the most commonly accepted valuation method by the valuation and investment community for the purpose of valuing start-up companies.  In order to apply this method, it is necessary to obtain or develop cash flow projections.

Cash flow projections are typically available for start-up companies in business plans prepared by management.  Such plans are often used by the Company to raise capital.   As part of the DCF method, the risk-adjusted present value of these projections can be determined by applying appropriate rates of return that capture the risk inherent in the Company’s operations and projections.  Obviously, the process of creating projections requires management to make educated guesses as to the future performance of a Company.  Given the inherent uncertainties in this process, it is also possible to use a series of projections in lieu of a single projection, (i.e., a high case, base case and low case projections).  When a series of projections is used, probabilities of success can be assigned to each case in order to achieve a weighted blend of the range of possible outcomes.

Valuation of the Company vis-a-vis the Individual’s Interest

Continuing along with our case study, to date, Pharma-X has burned through half of its capital as it continues to operate and work through the FDA approval process.  Management believes that it will eventually be granted FDA approval, but the ultimate success of the Company is unclear, as there are other competing vaccines in development by other unrelated companies.  As with any group of competing products, often, the first to market is most visible and has the greatest probability of success.

Pharma-X management has provided a series of projections with assigned probabilities based on their perception of likely outcomes. Next, the Company was valued using a DCF methodology that incorporates the projections and respective probabilities to arrive at a weighted indication of value for the Company.

Under the fair market value standard, we are tasked with determining the value of Dr. Smith’s interest in the Company.  Like many start-up companies, Pharma-X has a complex capital structure, with Dr. Smith holding common stock.  So what is the value of Dr. Smith’s interest in the Company?

As discussed previously, the Company’s capital structure is comprised of convertible debt, convertible preferred stock, and common stock. Typically, when valuing companies with complex capital structures, value is first allocated to holders of convertible debt, followed by preferred shareholders who will receive their preferred dividends and then their stated liquidation preference. Thereafter, if any unallocated value remains, the common shareholders will receive their share of the value of the Company.  As a result, the value of the common stock is dependent on the rights of, and value allocated to the other share classes and convertible debt.  The common stock might have value, or it is entirely possible that the common shares are worthless because all of the value is embedded in the convertible debt and preferred stock.

After valuing Pharma-X in its entirety, if the determined value is significant enough, then one can assume the holders of convertible debt and convertible preferred stock would be incentivized to convert their shares into common stock because the value of the common stock would be greater than their unconverted holdings. Under this fact pattern, the value of Dr. Smith’s (undiscounted) interest would be equal to his pro-rata share of the fully diluted common stock of Pharma-X, multiplied by the value of the Company in its entirety[1].

Alternatively, if the value of Pharma-X is not significant enough, we can assume that a rational investor holding convertible debt or convertible preferred stock would choose not to convert their debt or preferred shares.   In this situation, it is necessary to allocate the value of the Pharma-X to the various capital classes by taking into account priority rights and liquidation preferences of the convertible debt and preferred stock.

For purposes of this example, valuation discounts have been ignored.  It is however, important to note that under the fair market value standard applied in New York marital dissolution matters, case law supports the application of valuation discounts for lack of control and lack of marketability when valuing non-controlling interests in a company.

Conclusions

  1. The mere fact that a start-up company is pre-revenue or not profitable is not a sufficient basis to conclude that the company has no value beyond the sunk costs incurred to date. The valuation of a company is based on expected future cash flows of a company, and as a result, the company’s projections are of critical importance.
  2. From a valuation perspective, the most appropriate and commonly used method for the valuation of start-up companies is the discounted cash flow method. This method is commonly applied and can be modified to incorporate multiple case scenarios and assigned probabilities.
  3. Start-up businesses often have significant valuations, which are evidenced by capital raises and outside investments. While a start-up company may have significant value in the aggregate, the allocation of positive value to an interest held by a common stockholder is not a certainty.  Outside investments/investors are often protected via preferential rights and/or liquidation preferences over the rights of common stockholders.  Therefore, one cannot assume that just because a company has raised capital, and investors have made investments in a company, that the interest held by a spouse for equitable distribution purposes will have value.  Accordingly, it is important to have a formal valuation prepared so that the extent of value assigned to a spouse’s shares in a company can be determined.

David Rudman, CPA/ABV, CVA is the President of Sigma Valuation Consulting, Inc., a Certified Valuation Analyst, Accredited in Business Valuation by the AICPA.  Mr. Rudman has over 20 years of experience valuing companies for marital dissolution, shareholder disputes, estate and gift tax planning and administration, and financial reporting. Sigma Valuation Consulting maintains offices at 355 Lexington Avenue – Suite 401, New York, NY 10017 and 101 Eisenhower Parkway – Suite 300, Roseland, NJ 07068. He may be reached at drudman@sigmavaluation.com.