Valuing Startups Using Real Options

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A startup is a fledgling company or entrepreneurial venture in its early stages of development, typically characterized by innovation, a focus on disruptive technology or business models, and the pursuit of rapid growth. Startups often face high levels of uncertainty and risk, seeking to fill a gap in the market or introduce a novel solution to a problem. These young companies frequently operate with limited resources, employ a small team, and are driven by a strong entrepreneurial spirit, aiming to scale their operations, attract investors, and ultimately establish a sustainable and successful business.

Valuing startups is a challenging task, especially compared to mature, public companies. In reference [1], a method for valuing technology startups based on real options analysis is proposed.

A real option is a financial concept that applies option pricing theory to assess and value opportunities in projects or investments. It recognizes the flexibility to make strategic decisions during the life of a project, like expansion, abandonment, or switching strategies, which can significantly impact its overall value. Real options are particularly useful in assessing investments with uncertain or volatile future outcomes, as they provide a framework to quantify the value of managerial flexibility.

The article illustrates the utilization of real options for valuing startups at different stages: the Survival stage, the Growth stage, and the Consolidation Stage. The authors pointed out,

Why is the RO approach pricing the startup business at different stages higher than the NPV approach? The answer relies on the fact that any option may hold an Intrinsic Value and a Time Value. Even though the Intrinsic value of the option would be zero at the expiration date, the option would still have value because the probability that market conditions could change may also be favorable to a change in the underlying asset (revenues). The probability of change over time makes the option to get Time Value. In addition, there is always someone willing to pay for the opportunity that in the future will get better benefits than what were originally expected.

Our thoughts are as follows,

  • Traditionally, applying the NPV approach to value technology startups lacks significance since their valuation is more contingent on future growth and market shares rather than current cash flows.
  • By integrating real options, we can consider the probability of NPV change. Even if the present NPV is negative, there is still the potential for it to turn positive in the future, making the real option approach more sensible.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Jesus Cuauhtemoc Tellez and Aqila Rafiuddin, Startup Valuation Based on the Real Options Approach, 2023, In: Derindere Köseoğlu, S. (eds) A Practical Guide for Startup Valuation.

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