Market Approach vs. Income Approach: Navigating Early-Stage Valuation Strategies

The valuation of early-stage companies, especially those that are unprofitable and have uncertain long-term financial performance, presents a unique challenge. Two primary approaches have emerged to navigate this complex landscape: the Market Approach and the Income Approach. Each method offers a different lens through which to assess a company's value, with specific scenarios where they are most applicable. These methodologies are foundational in determining the fair market value of a company's stock, especially in the context of issuing stock options such as BSPCEs to employees. In this article, we will explore each approach, and many nuances, in detail.

Market Approach

When it’s used: For unprofitable, early stage companies where it’s difficult to predict long-range financial performance.

How it works: The market approach functions as a comparative valuation technique. In this method, the company in question is benchmarked against a group of similar public companies, often chosen based on their industry. This group of companies, known as "trading comps," helps in determining the right valuation multiple to be applied to the subject company's metrics, leading to its enterprise value calculation. Generally, for profitable companies, a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is used. However, for early-stage companies that frequently have negative EBITDA, revenue multiples are more common. This method is referred to as the Guideline Public Company method.

Pros and cons: The advantage of this approach is the simplicity of calculating multiples for publicly-traded companies. However, a significant drawback is that the comparison set may not accurately represent the peer group, especially if the company doesn't neatly fit into a specific category. This issue is particularly relevant for startups that are pioneering new industries or markets. In these instances, comparison companies are inherently imperfect because they don't engage in identical activities. Often, the growth rate of the company being valued differs significantly from that of its public counterparts – ideally at a much faster pace, but on a much smaller scale (comparing a small startup to large public companies).

To address these discrepancies, statistical linear regression analysis is used. This involves correlating valuation multiples with other financial metrics to develop a more accurate linear equation, which is then applied to the financial metrics of the company being evaluated.

If a company has recently completed a fundraising round, the process of determining its enterprise value becomes quite straightforward: the value established in that funding round is used. This method is known as a "backsolve." It is typically the first instance where a founder encounters a BSPCE (Bons de Souscription de Parts de Créateur d'Entreprise) strike price valuation, particularly after securing funding and beginning to hire employees. A backsolve is categorized under the "market approach" for calculating a company's enterprise value. However, unlike the Guideline Public Company method, which involves comparing with public companies and applying multiples to financial metrics, the backsolve method directly uses the valuation from the recent funding round. This valuation serves as a basis to deduce (backsolve) the overall equity value of the business, taking into account the various classes of shares and their respective rights and preferences.

The valuation provider is able to use the valuation from that fundraise because the new preferred investors (e.g. VC firms) are assumed to be sophisticated, with the transaction done at arm’s length, with both buyer and seller acting independently from each other and in their own self interest.

Income Approach

When it’s used: The income approach is mainly employed by businesses that have reached a significant scale, possess a high level of clarity and predictability in their financial results, and have a clear understanding of when they anticipate becoming profitable.

How it works: This approach is based on the principle that the value of a company is derived from its anticipated future earnings. To estimate these earnings, the company's long-term financial forecasts are utilized.

These projected income levels are then discounted to their current value, or "present value." This technique is also known as the discounted cash flow (DCF) method.

Pros and cons: The advantage of this method is that it directly reflects the company's anticipated future profits. However, the drawback is the need for dependable, long-term projections that must be well-founded. Companies lacking a robust financial planning and analysis function may find it challenging to provide the necessary evidence to meet their auditors' requirements.

Determine the fair market value (FMV) of the common stock

In the uncommon scenario where a privately-held, venture-funded company has only common shares, determining the Fair Market Value (FMV) is straightforward: simply divide the enterprise value by the total number of fully diluted shares. However, most private venture-backed companies have multiple classes of equity, such as Series A/B/C/D/etc. preferred shares along with common shares. In these situations, a more detailed analysis is needed to calculate the FMV of the common shares.

Three methods exist for distributing the enterprise value among different classes of shares. We'll explore these methods starting from the most commonly used in venture capital-backed companies to the least.

Option-Pricing Method (OPM)

How it works: In this approach, all the different stock classes within the company are regarded as call options, each assigned a specific exercise price (the price at which the option can be purchased). For preferred stock, the exercise price is set based on its liquidation preference.

For common stock, the exercise price is calculated using the remaining funds after all liquidation preferences are met. In scenarios where a company is acquired for a value that is less than or equal to the total liquidation preferences, common stock shareholders end up receiving nothing (€0), assuming there are no carve-outs for management.

When it’s used: OPM is most frequently used for companies that are still too early in their development to identify specific exit scenarios and their timing.

Black-Scholes

The Black-Scholes model is the most widely used method for setting the strike price of stock options. While a detailed technical explanation is complex, essentially, the model estimates an option's value by averaging all potential future profits when the option's strike price is at or above the future stock price, known as being "at or in the money."

In determining the BSPCE strike price, several key assumptions are crucial in the Black-Scholes model: the company's enterprise value (as previously discussed), volatility, and the expected time until an exit event (TTE).

The company's volatility is gauged using the publicly-traded companies identified as "trading comps" in the initial step. A stock's higher volatility increases the likelihood of the option expiring in the money, thus raising its value.

Adjustments are made here, as in the determination of the appropriate multiple, to account for the imprecise nature of the trading comp set.

The expected time to exit refers to the duration until a liquidity event occurs, such as an IPO or M&A. The longer this period, the more valuable the option becomes, as there's more time for it to potentially expire in the money.

Probability-weighted Expected Return Method (PWERM)

How it works: This method involves modeling different potential outcomes such as an Initial Public Offering (IPO), Merger and Acquisition (M&A), dissolution, or ongoing operations, each with their projected values. Then, a probability level is assigned to each outcome, taking into account how each class of shares participates based on their specific rights. In this method, the value of common stock is often higher compared to other methods like the OPM, particularly in the IPO scenario. This is because, in an IPO, all preferred stock converts to common stock, thereby eliminating the liquidation preferences.

When it’s used: This approach is commonly employed by companies that have reached a level of maturity where they can confidently predict potential exit events and their timing, such as anticipating an IPO in 18 months.

Hybrid Method

How it works: This method merges the OPM (Option Pricing Method) and PWERM (Probability Weighted Expected Return Method) approaches. It involves calculating the value by weighting probabilities across various scenarios, while employing OPM to determine how value is distributed within one or more of these scenarios.

When it’s used: The Hybrid Method can be a useful alternative to explicitly modeling all PWERM scenarios in situations where the company has insight into one or more near-term exits (e.g. M&A in 6 months), but is unsure about what would occur if those specific plans fell through.

Current Value Method (CVM)

How it works: This method estimates the company’s present-day equity value (in other words no assumption of future progress) and assumes there is an immediate sale or dissolution of the company. Value is then allocated across the share classes based on liquidation preferences, conversion ratios, and participation rights.

When it’s used: For venture-backed companies, the use of the CVM is quite uncommon. It is only considered applicable in situations where the company is at a very early stage and either has not made significant progress compared to its expected goals, resulting in no added value beyond the liquidation preference, or when it is not feasible to reasonably predict a timeframe in which the company might generate value exceeding its liquidation preference.

Apply a Discount for Lack of Marketability (DLOM)

The final step in determining a BSPCE strike price involves applying a Discount for Lack of Marketability (DLOM) to the common stock value calculated earlier. The equity allocation models assume the existence of an active market for immediate buying and selling of the common stock, akin to publicly-traded stock. However, this is not usually the case for most privately-held companies, making their common stock less valuable due to "lack of marketability." To account for this, a DLOM is applied to the previously calculated fair market value.

The significance of this marketability discount diminishes as the company grows and the likelihood of its success increases. For example, a company that has recently completed a Series A funding round may not find any interested buyers for its common stock, hence a higher DLOM. Conversely, a company that has scaled and is poised to go public may see a much smaller discount.

The key factor influencing the size of the DLOM is the expected duration until a liquidity event – the length of time shareholders must wait before they can freely trade and sell their shares. Most DLOM studies suggest a discount in the 25%-35% range for a holding period of two years. Larger discounts may be justified if the timeframe to a liquidity event is significantly longer.

In a backsolve scenario, the DLOM might be lower than these standard ranges because the 409A valuation benchmarks against a preferred instrument, which already factors in a certain degree of marketability as priced by the VC investor.

To determine the DLOM, three well-known mathematical models might be considered: the Chaffe, Finnerty, Ghaidarov, and Asian models.

Conclusion

Determining the value of an early-stage company for the purpose of issuing stock options like BSPCEs is a nuanced process, requiring a blend of art and science. The Market and Income Approaches provide frameworks for this valuation, each with its advantages and limitations based on the company's stage of growth and financial clarity. Additionally, advanced techniques and adjustments, such as statistical linear regression analysis and applying discounts for lack of marketability, refine these valuations to reflect more accurately the unique circumstances of each company. These valuation exercises are not only critical for regulatory compliance and financial reporting but also play a strategic role in aligning the interests of employees and investors towards the company's long-term success.

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