The Dark Side of Valuation:

Valuing Start-up Companies

Dott. Alberto Canclini

Milan, 25 May 2021

1
Table of Contents

About the Dark Side of Valuation

Determinants of Value
 Valuation Challenges
 Relative valuation
 The Venture Capital Approach
 The Dark Side - Don’t Avoid Uncertainty
 The Light Side – Intrinsic value
 Survival
 Conclusion
 Q&A 2
About the Dark Side of Valuation

I have always belived that valuation is simple and the practitioners choose to make it complex. The intrinsic value of a cash-flow generation asset is a function of how long you
expect it to generate cash flows, as well as how large and predictable these cash flows are. This is the principle that we use in valuing businesses, private as well public, and in
valuing securities issued by these businesses. We go from idea business, often privately owned, to young growth companies, either public or on the verge of going public, to
mature companies, with diverse product lines and serving different markets, to companies in decline, marking time until they are liquidated. At each stage, we are called on to
estimate the same inputs – cash flows, growth rate and discount rate – but with varying amounts of information and different degrees of precision

All too often, when confronted with significant uncertainty or limited information, we are tempted by the dark side of valuation,
in which first principles are abandoned, new paradigms are created, and common sense is the casuality

Aswath Damodaran

Following the clear path outlined by Prof. Damodaran, I will try to apply the principles of intrinsic
value to the valuation of start-ups, where uncertainty abounds and the temptation to abandon the
path and embrace the dark side could be strong...

References:
Damodaran A., The Dark Side of Valuation. Valuing Young, Distressed, and Complex Business, 2nd ed., Pearson FT Press, NY, 2012
Damodaran A., «Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges», Stern School of Business, New York
University, 2009

VA L U I N G S T A R T- U P C O M PA N I E S 3
Determinants of Value

Existing Assets Cost of Capital

What are the cash flows that will be How risky are the expected cash flows
generated by the existing investment of from both existing and growth
the company? investments, and what is the cost of
funding them?

Value of Growth Terminal Value

How much value, if any, will be added by When will the firm become a stable
future growth? growth firm, allowing us to estimate a
terminal value?

The answer, and the difficulty in answering, these fundamental questions may change as we look
across firms at a point in time, but also across time, even for the same firm

VA L U I N G S T A R T- U P C O M PA N I E S 4
Valuation Challenges

Young companies are difficult to value for a number of reasons

 Little or no revenues
 Operating losses
 Little or no history at all
 Growth volatility, stable growth estimation
 Private capital (Founders, Family&Friends)
 Undiversified Investors
 Investors may have different claims on equity
 Dependance on one or a few key people
 Survival rate

As a result, many of the standard techniques we use to estimate cash flows, growth rates and discount
rates either do not work or yield unrealistic numbers

VA L U I N G S T A R T- U P C O M PA N I E S 5
Valuation Challenges – Cash flows

Existing Assets
What are the cash flows that will be
generated by the existing investment of
the company?

 There are few or no existing assets

 Cash flows from existing assets,

nonexistent, or negative

 Different claims on cash flows can

affect value of equity at each stage

VA L U I N G S T A R T- U P C O M PA N I E S 6
Valuation Challenges – Growth

 Making judgments on revenues/profit margins is

difficult because the abscence of history

 If you have no product/service it is difficult to estimate

market potential or profitability

 Return on capital is generally negative, so it is difficult

to predict the reinvestment rate

Value of Growth
How much value, if any, will be added by
future growth?

The Company’s entire value lies in future growth, but you have little to base your estimates on

VA L U I N G S T A R T- U P C O M PA N I E S 7
Valuation Challenges – Cost of Capital

Cost of Capital
How risky are the expected cash flows
from both existing and growth
investments, and what is the cost of
funding them?

 Privately held companies

 No publicly traded debt securities

 Undiversified investors

 High failure rate

 Illiquidity Risk

Limited historical data on earnings and no market prices for securities makes it difficult to assess risk

VA L U I N G S T A R T- U P C O M PA N I E S 8
Valuation Challenges – Terminal Value

 Will the firm be able to win the challenge

of market demand and competition?

 Will the firm make it to stable growth?

 Even if it does, assesing when it will

become mature is difficult because
there is so little to rely on
Terminal Value
When will the firm become a stable
growth firm, allowing us to estimate a
terminal value?

Terminal Value in start-up valuation often accounts for more than 100% of the current value

VA L U I N G S T A R T- U P C O M PA N I E S 9
Relative Valuation

The difficulties in valuing young companies in a discounted cash flow model lead some analysts to
consider using relative valuation approaches. Using multiples and comparables, however is tricky for
the following factors:

 Which multiple to use? Earnings, EBITDA, SALES may be negative or minuscle

 What are the comparables of the Company?
 What is the best proxy for risk?
 How to adjust the choosen multiple to take into account the failure risk?
 How to adjust for different equity claims and illiquidity?

Take away: use of relative valuation may seem like an easy solution, when faced with the estimation
challenges posed in intrinsic valuation, but all of the problems still remain
VA L U I N G S T A R T- U P C O M PA N I E S 10
Venture Capital approach

Estimate the expected earnings or Revenues in a future year, but not too far into the future
STEP 1

Equity Value at end of forecast horizon = Expected Earningsyear n* Forward PE

STEP 2 Enterprise Value end of forecast period = Expected Revenuesyear n* Forward EV/Sales

Equity Value today =

STEP 3

Post Money valuation = Pre Money valuation from step 3 + New capital infusion
STEP 4

VA L U I N G S T A R T- U P C O M PA N I E S 11
Venture Capital approach – Discount factor

The target rate of return (discount factor) is generally set high enough to capture both the
perceived risk in the business and the likelihood that the firm will not survive

Venture Capital Target Rates of Return – Stage in Life Cycle Returns earned by Venture Capitalists and Market – U.S. 2007

Stage of Typical target rates of

development return 5 year 20 year

Start up 50-70% Early/Seed VC 5.00% 21.40%

First stage 40-60% Balanced VC 11.90% 14.70%
Second stage 35-50% Later Stage VC 11.10% 14.50%
Bridge / IPO 25-35% All VC 8.80% 16.90%
NASDAQ 7.00% 9.20%
S&P 5.50% 8.00%

The returns earned by venture capitalists, especially on early stage investments, are significantly lower
than the target rates of return

VA L U I N G S T A R T- U P C O M PA N I E S 12
Venture Capital approach – Fashion&Lifestyle Case

 Fashion&Lifestyle (FL) is a small e-commerce company that has developed a B2B2C platform
that it believes will be more effective than existing fashion e-tailers to sell fashion and
lifestyle products in emerging markets

 The company is fully owned by its founders and has no debt outstanding

 The firm has been in existence only a year, has developed a beta version of the e-commerce
platform but has never sold the products (revenues are zero)

 During its year of existence, the firm incurred EUR 1,5 million in expenses, thus recording an
operating loss for the year of the same amount

 FL has capital needs of EUR 10 millions primarily to cover digital marketing expenses and
expanding the market for the next three years

 To value the firm, you (the analyst) decide to employ the venture capital approach

VA L U I N G S T A R T- U P C O M PA N I E S 13
Venture Capital approach – Comparables and Multiple

Comparables Multiple – EUR millions

Company Market Cap NFP EV Sales EV/Sales

YNAP                  2.495              -          2.495        1.536          1,62 
Zalando                    7.510      (1.180)       6.330        2.760          2,29 
Asos                   3.600         (360)       3.240        1.640          1,98 

Av EV/Sales 1,96

VA L U I N G S T A R T- U P C O M PA N I E S 14
Venture Capital approach – Discount factor and Post-money valuation

Since this business has a product, ready POST

RISK for the market, but has no history of
MONEY
commercial success, you decide to use a The proportion of equity offered to
target rate of return of 60%. Since the investors after capital infusion is 52%
firm has no debt outstanding, the
estimated value is entirely equity

(thousand EUR)

 Revenues YEAR 5      50.000 

 EV/Sales         1,96 
 Enterprise Value YEAR 5  98.000 
 Target Rate of Return  60% Pre-money value     9.364
 Discount factor  0,095  Capital infusion 10.000
 Enterprise Value  9.346  Post-money value 19.364
 Debt  -   Proportional share of equity 52%
 Equity value  9.346 

The investors will probably push for lower revenues, a more conservative multiple of those revenues in
the final year and a higher target rate of return in order to get a higher share of equity

VA L U I N G S T A R T- U P C O M PA N I E S 15
The Dark Side of Valuation – Don’t avoid Uncertainty

Some common mistakes made by analysts when facing estimation challenges

Top line and bottom line, no
detail
•Little attention to margins (that separate
earnings from reveneues) and
reinvestment (that separates earnings from
cash flows)
Focus on the short term, rather
than the long term
• Many analysts use the rationale of
uncertainty for cutting short the
estimation period, using only three to five
years of forecast in valuation
Mixing Relative with Intrinsic
Valuation
• To deal inability to estimate cash flows
beyond short term, the terminal value is
often estimated by applying an exit
multiple to the expected revenues or
earnings in that period

Discount rates as the vehicle Rules of thumb adjustments for

for all uncertainty
• The analyists often hike up discount rates
to reflect all their concerns about earnings
volatility, sensitvity to macroeconomics
conditions and the likelihood that the firm
will fail
differences in equity claims
• Premiums for control (for instance
20%)
• Discount for Illiquidity (for instance
25%)

Take away: Accept the fact that uncertainty will always be present and look at «healthy» ways of
responding to uncertainty, avoiding shortcuts
VA L U I N G S T A R T- U P C O M PA N I E S 16
The Light side – Intrinsic value

Top-down vs bottom-up approach

Estimating cash flows Scalability of business (top-down) vs capacity constrains (bottom-up)

Cost of capital for fully or partially undiversified investors

Estimating discount rate Privately held business

Estimating Terminal value The terminal value may be calculated when the firm reaches stable growth
and value today Three opitions  Going concern | Annuity | Liquidation

Adjusting the Valuation for Firm's value as an expected value of two scenarios
Survival Going concern scenario | Failure scenario

We will move systematically through the process of estimation, considering at each stage, how best to
deal with the characteristics of young companies
VA L U I N G S T A R T- U P C O M PA N I E S 17
The Light side – Estimating cash flows

• Define product • Asses capacity • Define target • Reinvestment • Deferred tax • Calculate
Potential market

Tax effect
Market share

Operating margins

Check for internal consistency

Investments for growth
/ service of the margin rate assets Return on
• Estimate management • Pathway to • Negative cash cumulated
market size • Investments in profitability flows capital
• Estimate capacity and • Need for invested
evolution in marketing capital infusion • Check
the market consistency
with industriy
average return
on capital
• Check
consistency
with WACC

6 steps involved in the TOP-DOWN approach for estimating cash flows

VA L U I N G S T A R T- U P C O M PA N I E S 18
The Light side – Market Share of FL

POTENTIAL MARKET
(million EUR) Current 2016 2017 2018 2019 2020 2021

 Market growth rate   NA  20,47% 17,80% 16,22% 14,22% 12,06% 8,85%

 Overall market  5.603  6.750  7.951  9.241  10.556  11.829  12.875 

 Beyond 2021, we estimate a growth rate, in the overall market, of 5% from 2022 ­to 2031 and 3% afterwards 
MARKET SHARE
(million EUR) Current 2016 2017 2018 2019 2020 2021
 Revenues  -  -  0,2  5,0  12,5  38,0  50,0 

 Market Share   NA   NA  0,0% 0,1% 0,1% 0,3% 0,4%

The Global Market is at a very nascent stage and highly
fragmented. Each segment of the value chain (Textile and
Apparel Manufacturers, Designers and Brands, Retailers) is
highly fragmented in nature, with none of the key players
accounting for more than 5 percent of the global industry
FL operates on the integrated value chain. In addition
the Company is developing B2B2C online platforms in
order to bridge the gap between demand and offer.
Consequently, we estimate that FL will be able to
capture at least 0,4% market share in 5 years 

VA L U I N G S T A R T- U P C O M PA N I E S 19
The Light side – Operating Margins of FL (1/2)

OPERATING MARGINS (TARGET)

The B2C e-commerce industry is mostly characterized by low operating margins. Ebitda margins and returns
after tax on invested capital in 2015 of the largest competitors listed in the mainstream e-commerce sector
are represented in the following table

Return on invested capital (After-

Company Ebitda margin
Tax)
Amazon 7,76% 12,97%
Yoox Net-a-Porter 6,61% 1,65%
Zalando 4,09% 110,43%
Banzai -2,85% -19,93%
Alibaba 51,82% 33,50%

VA L U I N G S T A R T- U P C O M PA N I E S 20
The Light side – Operating Margins of FL (2/2)
(thousand EUR)

OPERATING MARGINS (PATHWAY TO PROFITABILITY)  Year   Revenues   Ebitda   Ebitda Margin   Return on Capital 

2016                                       -                                  N/A  NA 

(283)
 FL Ebitda margin will converge to 11.5% by 2022 2017                                                     (1.219)
200 
-609,4% -1149,9%

2018                                5.000                    (923) -18,5% -152,8%

 The Company's operating margins will be higher
2019                               12.500                    (718) -5,7% -57,2%
than most of its competitors thanks to the
2020                              38.000                   1.139  3,0% 23,2%
contribution given from the revenue streams
2021                               50.000                   2.679  5,4% 27,1%
based on services (B2B)
2022                              62.500                    7.188  11,5% 43,8%

 However, the pathway to profitability is likely to 2023                               78.125                  8.984  11,5% 28,6%

be rocky, with margins staying negative for at 2024                              97.656                 11.230  11,5% 31,6%

least 4 years 2025                             122.070                  14.038  11,5% 34,9%

2026                            140.381                 16.144  11,5% 35,4%

 The Return on capital is aligned with the mean of
2027                             161.438                  18.565  11,5% 35,4%
the market
2028                            185.654                 21.350  11,5% 35,4%

2029                             204.219                  23.485  11,5% 33,9%

2030                            224.641                 25.834  11,5% 33,9%

2031                             235.873                  27.125  11,5% 32,3%

VA L U I N G S T A R T- U P C O M PA N I E S 21
The Light side – Investments of FL
(thousand EUR)

INVESTMENTS FOR GROWTH  Year   Change in Rev next

year 
 Noplat   Noplat/Revenues   Investment   FCFF 

2016                       200                         (283) N/A                     106                (389)

 Revenues will increase to EUR 2017                    4.800                      (1.219) -609,4%                     498             (1.717)
243 million by 2032, as FL 2018                    7.500                         (923) -18,5%                     652             (1.575)
expands its market share of this 2019                   25.500                         (718) -5,7%                  3.650             (4.368)
growing market 2020                   12.000                        1.139  3,0%                  4.980             (3.841)

2021                   12.500                        2.679  5,4%                  6.520             (3.841)

 To sustain the growth FL will 2022                   15.625                        7.188  11,5%                  5.551               1.637 
reinvest EUR 62 million 2023                   19.531                        6.289  8,1%                  2.901               3.388 

2024                   24.414                        7.861  8,1%                  3.303               4.559 

 The consistency is checked using 2025                   18.311                        9.827  8,1%                  3.764               6.063 
the Sales to capital Ratio implied 2026                   21.057                      11.301  8,1%                  4.789               6.512 
in the Return on Capital of 2031 2027                   24.216                      12.996  8,1%                  5.507               7.489 
(thousand EUR)
2028                   18.565                      14.945  8,1%                  6.333               8.612 
 Change in revenues  242.949  2029                   20.422                      16.440  8,1%                  4.855             11.584 
 Sales to Capital Ratio 2031  4,01 2030                   11.232                      18.084  8,1%                  5.341             12.743 
 Reinvestments  60.511 
2031                   7.076                      18.988  8,1%                  2.937             16.050 
 Investments  61.580 
Totals                 242.949                    124.592                 61.580             63.295 
 Consistency Check 101,8%

VA L U I N G S T A R T- U P C O M PA N I E S 22
The Light side – Estimating discount rates

• Fully or • Loans and • Absence of

Cost of equity

Market weights
Cost of debt
partially bank debts market values
undiversified to weight
investors • Default risk equity and
debt
• Firm specific
risk

• Total Beta

There are both conceptual and estimation issues that make each of these ingredients difficult to deal
with, when it comes to young companies
VA L U I N G S T A R T- U P C O M PA N I E S 23
The Light side – Cost of Capital of FL

TOTAL BETA

 Unlevered beta of the retail

online business is 1,53
 Average R-squared of etailers
firms with market is 0,0498
 Average correlation of etailers
firms with market is 0,223
 The only equity investor in the
business in the first year are the
founders undiversified (and
fully invested in the firm)
 Sector levereage is low (6%)
 FL all equity funded

 Cost of Equity  Cost of Capital

  Total beta 2016 founder

corr. 0,22
corwfunding
corr. 0,4
series A round
corr. 0,5
Series B round
corr. 0,75
IPO
corr. 1
= = 6,86 only market

2021

2026
2016

2017

2019
risk

VA L U I N G S T A R T- U P C O M PA N I E S 24
The Light side – Terminal value of FL

(million EUR)

Revenues = Revenues 2031 (1+ Stable growth

rate) 235,8 (1,03) = 242,9
After-tax Operating income= Revenues2031
(Stable Operating Margin) (1-t)  242,9 (0,115) (1-0,3) = 19,5
Reinvestment in stable growth = Stable growth
rate / Stable ROC 0,03 / 0,317 = 0,095
Free Cash flow to the firm = After-tax Operating
income * (1-Reinvestment Rate) 19,5 (1 – 0,095) = 17,7
Terminal Value = FCFF / (WACC – Stable growth
rate)
• 17,7 / (0,147 – 0,03) = 151,3

2032 is the first year with a growth rate (3%) that is consistent with stable growth

VA L U I N G S T A R T- U P C O M PA N I E S 25
The Light side – Operating value of FL
(thousand EUR)

 Incorporating the terminal value into the

expected free cashflows to the firm (slide 22)
and discounting back at the year-specific costs
of capital (slide 24), we can arrive at the value
of the operating assets today

 The mid-year adjustment factor (MYAF) takes

into account the valuation date as of
30/6/2016

 The cost of capital is cumulated to reflect the

changes in the cost over time

Based on the expected cash flows and discount rates, the value
of the operating assets
today is EUR 8.251 thousand

VA L U I N G S T A R T- U P C O M PA N I E S 26
Survival

Many young firms succumb to the competitive pressures of the market place and don’t make it.
Rather than try to adjust the discount rate for this likelihood, a difficult exercise, prof. Damodaran
suggest a two-step approach

Valuing the Estimate the

today's value at likelihood of
risk-adjusted failure
discount rate (PD)

Expected Value = Value of going concern (1 – PD) + Distress Sale value (PD)

VA L U I N G S T A R T- U P C O M PA N I E S 27
Survival – Assesing the probability of failure

According to data published by the U.S Bureu of Labor Statistic from 1994 to 2020 20% of small
businesses fail in their first year, 30% of small business fail within 2 years, and 50% of small
businesses fail after 5 years. Finally, 70% of small business owners fail in their 10th year in
business.

Survival of U.S. Small Business started in 1994 – Sector averages

 Year since Birth   Failure Rate   Survival Rate   Av

Employment 
1Y 21,00% 79,00% 6,9 
2Y 32,00% 68,00% 7,9 
5Y 51,00% 49,00% 10,4 
10Y 66,00% 34,00% 13,6 

Source: https://www.bls.gov/bdm/us_age_naics_00_table7.txt

Sector averages | Z-scores | Simulations

VA L U I N G S T A R T- U P C O M PA N I E S 28
Survival – Adjusting the Valuation of FL for Survival
(thousand EUR)
 Present Value of  Probability of
 There is the strong possibility that the firm  Year  Future Cash Flow  Failure   Value 

will not survive Current                            8.251  45,00%                 4.538 

2016                      10.861  36,00%                 6.951 

 To estimate the probability of survival, we 2017                           16.328  30,00%               11.430 

used the U.S. small business averages 2018                           23.542  26,00%               17.421 

2019                           34.490  22,00%               26.902 

 The equity default-adjusted value equals 2020                           47.971  19,00%               38.856 
EUR 4.538 thousand [8.251 (1-0,45) + 0 (0,55)] 2021                           60.982  15,00%               51.834 

2022                           71.002  10,00%               63.902 

 The value is clearly much lower than the
value we assessed, using the venture capital
2023                           81.187  5,00%               77.128 

approach of EUR 9.364 thousand [-52%]

2024                          92.148  0,00%               92.148 

2025                         103.701  0,00%             103.701 

 Determinants of the lower intrinsic 2026                         112.433  0,00%             112.433 

value: 2027                         121.472  0,00%             121.472 

 High cost of equity in the early years 2028                         130.716  0,00%             130.716 

 Negative cash flows expected in the 2029                         138.346  0,00%             138.346 

high-growth phase 2030                         145.940  0,00%             145.940 

 High chance of failure 2031                         151.343  0,00%             151.343 

VA L U I N G S T A R T- U P C O M PA N I E S 29
Conclusion

Use of relative valuation may seem like an easy solution, when faced with the estimation
challenges posed in intrinsic valuation, but all of the problems still remain

Uncertainty will always be present. Look at «healthy» ways of responding to uncertainty, and
avoid shortcuts

Use a top-down or bottom-up approach to estimate margins and reinvestment rate consistent
whit growth and market conditions

Don't use discont rates to discount every risks. Take into account undiversified investors (total
beta) and use a multi-periodal cost of capital

Estimate Terminal value when the firm is supposed to reach a stable growth, often this appens in
the long-run

Make explicit assumptions about the likelihood of survival that affects the value today

VA L U I N G S T A R T- U P C O M PA N I E S 30
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VA L U I N G S T A R T- U P C O M PA N I E S 31
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