Valuing an early-stage company poses unique challenges for you, your expert, and your client. The task requires knowledge and a technical skill-set unfamiliar to many appraisers.
By David Witherspoon, Business Valuator
When a child is born into this world, who knows what she might become: a doctor, a lawyer, a teacher, or maybe a President. Even if she shows an early predisposition towards one field of study or another, we simply cannot know with certainty how her life will unfold. The same is true of an early-stage company.
In 2013, the AICPA released a guide (the AICPA Guide) detailing, among other things, a framework for assessing the typical stages of a business’ lifecycle. In summary, the guide breaks it down into the following six stages:
- The enterprise has no product revenue, limited expense history, an incomplete management team with an idea, and possibly some initial product development.
- The enterprise has no product revenue but substantial expense history related to product development, and business challenges are thought to be understood.
- The enterprise has made significant progress in product development, key milestones have been met, and product development is near completion.
- Initial sales have been made, but the enterprise is still operating at a loss.
- Product sales have grown and initial financial success has been attained, such as positive operating profits or cash flows.
- The enterprise has an established financial history of profitable operations.
Valuing an Early-Stage Company in Marital Dissolution
When most people think of business appraisals, they think in terms of valuing a mature company in stage six: an established company that has been around for some time. Indeed, most of the core valuation courses, which lead to traditional valuation credentials, focus primarily on valuing mature companies. A stage six company has extensive historical financial information for the appraiser to review, and this helps inform the valuation. But what if you are valuing a company at stage one or two?
Hypothetical Scenario: Valuing an Early-Stage Software Company
Your client has founded a new software company. Three patents are pending, but the product is not fully developed, the company has no clients, and it has earned no revenue. Management recently began pitching venture capital firms in an attempt to raise $5 million for a 33% interest but has found only tepid responses with no commitments. The financial forecasts presented to those potential investors show substantial growth (and cash flow) beginning three years from today after $8 million in operating losses. Opposing counsel has indicated they believe the business is worth $15 million based upon the sought – after capital raise ($5million/33%). You and opposing counsel are miles apart from a settlement and you are fairly certain this case is going to go the distance.
What Does This Mean for the Family Lawyer?
First, you need an expert witness who can properly value the business and testify to that valuation. Valuing a mature software company is not the same as valuing a startup. Indeed, many business appraisers have never valued an early-stage company. Even fewer have studied any published literature on the topic, understand the market of investors, or are even aware of some of the applicable valuation methods. Valuation literature is constantly being added to and updated, and your expert should be familiar with available peer-reviewed resources.
You should ask your prospective expert witness if they have any experience valuing early-stage companies and if they are familiar with the methods promulgated in peer-reviewed publications such as the AICPA Guide.
Expert Knowledge Beyond the Valuation Basics
Valuing an early-stage company in divorce will likely require technical skills and perspectives not taught in the basic coursework required to attain a valuation credential. For example, it is common to offer stock options to key employees and preferred stock to investors in an early stage software company. Stock options provide their owner with the right to acquire shares at a future date at a set price. Preferred stock may have various rights and conversion factors. Both of these equity securities can act to dilute the ownership of the current common stockholders.
Traditional valuation courses focus on valuing the entire enterprise. However, if your client owns common stock – which is subordinate to the rights and privileges of preferred stock and would be diluted by the exercise of a pool of options – then you need to understand how to allocate value across a complex capital structure in order to value the client’s common shares. That is a technical skill-set unfamiliar to many appraisers.
The AICPA Guide provides a framework for considering the lifecycle stage of a company, discussing why and how some valuation methods may be more appropriate than others depending on the industry and lifecycle stage.
Your expert should be familiar with relevant peer-reviewed literature, know it, apply it, and be able to explain it to the trier of fact.
Your Client Needs to Understand What Is at Stake
Your appraiser’s job is to determine the value according to your state’s standards for divorce litigation. But they will be basing their appraisal on information provided by your client and observed in the marketplace – and so will the opposing expert. Without a financial history on which to base the analysis, the appraiser will seek other indicia of value. Some of these may include:
- The company’s business plan,
- Correspondence with current or potential investors,
- Financial forecasts,
- Management’s history of successfully developing and commercializing similar products,
- Market studies and surveys,
- Interviews to understand the product idea and how it solves a commercial problem,
- The expected pricing model,
- The unknowns.
That last point is critical to an appraiser who is assessing risk. Early-stage companies have numerous unknowns: will the product be capable of doing what we want, will the market accept it, will the market accept our pricing, will our invention spur unforeseen competition, etc. In business, unknowns increase perceived risk, and risk affects value. Your client should understand that and answer questions candidly. “I have no idea,” is perfectly acceptable (assuming it’s true, of course).
This article is meant to provide a brief introduction to the issues involved with valuing an early-stage startup in the divorce context. Nothing in this article should be taken as definitive for any given case as each case depends on its own facts and circumstances.
David Witherspoon (MBA, CVA, CEPA) is the director of business valuation and the litigation support division at KatzAbosch. He has provided consulting services to middle-market businesses for more than 15 years and specializes in business strategy, value creation, exit planning, modeling, statistical analysis, and data analytics. www.katzabosch.com
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