Start-ups and

Early Stage
Companies
A Valuation insight

May 2021

kpmg.com/kw
Dear reader
Although (some) lockdown measures are still in place, many countries
have begun to see signs of hope as large-scale vaccine campaigns
progress.

With a renewed focus on the future, we can look forward to the promise
of greater workplace flexibility and innovation in remote collaboration.
Against this background, we want to celebrate the businesses that
innovate, sculpt our future and address some of the world’s greatest
challenges head-on: start-ups and early-stage companies.

Start-up founders, entrepreneurs, venture capitalists and state-owned

agencies bolstering young businesses are forging the world of tomorrow
through innovative products, services and solutions. Their efforts advance
our quality of life and make the world a better place. That’s why we’re focusing
on early-stage companies in this edition of our insight, where we explore the
many ways, they give us hope for a brighter future.

In this insight, we address typical questions that arise when valuing early-stage
companies:

–– Which methodology should be used to properly capture the value

potential of an early-stage company?
–– How is the specific risk profile of early-stage businesses reflected in
a valuation, even when they have zero sales or have not yet obtained
required regulatory approvals?
–– Is there a way to assess potential value development over time?

Answers to these questions would facilitate more transparent discussions

between founders and investors regarding value and price of early-stage
companies – allowing for a better allocation of risk and return.

We look forward to discussing how we could help you assess the potential of
your business and the possibilities the future holds. Stay safe, stay healthy.

Yours faithfully, with optimism

Ankul Aggarwal Nitin Bahl

Partner, Deal Advisory Associate Director, Deal Advisory
KPMG in Kuwait KPMG in Kuwait
Early-stage companies: From
unicorns to decacorns!
Investments in early-stage companies represent an asset class
of their own, attracting growing interest across the world. The
number and size of successful start-ups is on the rise; investors
have never seen unicorns at such unprecedented levels.

4%
Despite the COVID-19 crisis, global venture capital
998 bil ion
Total venture capital (VC) investments (assets under
funding increased 4.0% year over year to USD 300 management) came to USD 998 billion as of H12019,
billion in 2020. The funding growth was attributable with North America leading the pack (43%), closely
to industries such as healthcare, education, finance, followed by Asia (42%) and Europe (11%)2.
retail and entertainment, which migrated their service
offerings online as a result of the global pandemic.1

154 bil ion

In OECD countries3, out of the VC investments of USD
18%
In the US, total VC investments2 totaled USD 136 billion
154 billion made in 2019, USD 8 billion (5%) went to in 2019, compared to USD 30 billion in 2010, representing
seed financing, USD 55 billion (36%) to start-ups/early- 18% CAGR over the last 10 years.
stage companies and USD 89 billion (58%) to later-stage
ventures.

2.8-fold increase
Based on VC investments2 in 2019, the main markets
265
In 2010, 33 companies were newly listed on the
in Europe are the United Kingdom (USD 2.9 billion), NASDAQ4, the emblematic stock exchange of internet
followed by France (USD 2.3 billion) and Germany (USD and tech companies, of which six were unicorns.5 In 2020,
2.1 billion) – a 2.8-fold increase on 2010 (USD 2.6 billion the NASDAQ welcomed 265 new companies (eight-fold
for all three countries combined). increase), of which 79 were unicorns (13-fold increase).

Public vs. Private exit

Exit via acquisition is the long-term exit strategy for
30
As of February 2021, it is estimated that there are now
most US (58%), UK (58%), and Canada-based (60%) 30 decacorns (valued at over USD 10 billion) in the world7.
entrepreneurs. Among Chinese entrepreneurs, 46%
expect to exit via an IPO6.

Quarterly Brief – 15th Edition of the International Valuation Newsletter 3

Volatile capital markets – agitated by crisis-related corrections – also affect
transactions involving early-stage companies. Alongside general market risks, start-
up-specific risks should be considered in any early-stage company valuation. Failing
to appreciate a start-up’s specific risk profile can lead to inaccurate assessment of
its full value potential in an exit scenario unless there is sufficient transparency of
existing risks and opportunities to promote robust price negotiations. How can this
be considered in the valuation approach? Do the special characteristics of start-ups
require unique valuation procedures? We examine these questions, discuss the
archetypical evolution of a start-up’s risk profile and explore how this can be
reflected in valuations through a dynamic valuation approach.

Start-ups – a somewhat traditional critical in making valuation “alternative” valuation methods are
asset class assumptions. often applied to start-ups.
From an economic viewpoint, start-
ups are investments involving an Regardless of the valuation purpose, a Market multiples as an alternative
upfront payment today – e.g. company’s value is always based on valuation method
founders’ labor and intellectual the expectation of future uncertain For early-stage companies there are,
property, the contribution of business payments – usually in the form of without doubt, challenges associated
ideas or financial resources – with the distributions or exit proceeds. with forecasting future cash flows,
expectation of receiving (higher) Founders and investors expect correctly reflecting the risks (specific
financial resources at a later date, e.g. adequate future remuneration for their and systematic) as well as capturing
upon (private or public) sale. How high invested capital, and start-ups are no the evolving risk-return profile over
expected future cash flows should be exception. Forecasting future financial time. Start-ups typically face a high
depends on the perceived level of risk returns therefore plays a central role in number of valuation events, e.g.
of the founders and investor. It is the valuation of start-ups. The time development milestones reached as
hardly surprising that the respective frame (usually the exit time of a well as transactions due to investor
parties may have vastly differing participant), absolute expected amount changes. Alternative valuation
opinions as to the future development (reflecting the performance) and methods, typically based on the
and financial outcome of an early- expected range (reflecting the risk) of market approach and comparison of
stage company. Founders and possible returns are all relevant. In this specific price multiples, are therefore
investors may have greatly diverging respect, start-ups are no different from frequently used. These alternative
views on what should be contributed any other investment. Taking an valuation methods, however, typically
by each party, and what share in the investment-oriented view, forward- do not offer a solution to the problem,
start-up each participant should looking valuation methods based on but abstract from the problem itself by
receive. Many start-ups already had future cash flows, i.e. a discounted greatly simplifying it. As a result, they
numerous financing rounds and cash flow (DCF) method, should be sometimes result in a high degree of
changes in ownership behind them, the preferred valuation method for uncertainty of the value conclusion,
especially at the beginning, meaning start-ups. lack transparency, or mix up long-term
that issues around proper distribution company values with short-term
of value (i.e. financial performance When considering the peculiarities of achievable company prices due to
and risk) between the participants are start-ups (e.g. absence of revenue, initially rather short-term investment
more common than in deals with unknown interest of customers in the horizons. In particular, methods that
established companies. Insufficient new product or service, evolving are strongly oriented toward purely
information makes it difficult to get operating model, etc.), the traditional operational key figures (e.g. number of
expectations right and find alignment. application of the DCF method may customers, click rates, etc.) attempt to
With future operational performance not appropriately reflect the risk-return compensate for the lack of information
still to be proven, the various profile of start-ups at first glance. This or even readiness regarding the start-
stakeholders are most likely to may suggest established cash flow- up’s operational business model
disagree on value expectations. With oriented valuation methods may be (organizational and cost structures).
this in mind, utmost transparency is difficult in practice. Therefore Methods based on financial key

Quarterly Brief – 15th Edition of the International Valuation Newsletter 4

figures (e.g. sales) are intended to brought by a specific start-up cannot performance and, then, forecasts of
circumvent the problem of negative be captured through the application of the financial KPIs provide a solid basis
earnings in the initial loss-making price multiples observed for other for a valuation analysis. This method
phase. These multiple-based methods, companies as their business models results in more transparency and trust
which focus on operational or financial are different. than a simple multiple-based approach.
KPIs, assume that key figures obtained It also paves the way for a robust DCF
from – somewhat – comparable The disadvantage of missing or valuation.
companies can be transferred to a insufficient financial information for
start-up for pricing purposes. They are start-ups is often put into perspective, Finally, the question of a “pre-money”
technically quick to apply, replace the since the initial focus on the and “post-money” valuation, which
subjective price perceptions of the operational value drivers requires a considers the value before and after
participants with the alleged objectivity thorough assessment of the business the injection of new funds, can only be
of the market, and can appear to save and operating model. Every sound disclosed consistently by performing a
time and costs. Ultimately, however, valuation assessment should consider future cashflow-based analysis – and
they provide an initial, very rough price the operational value drivers of the not with a multiple-based pricing
(but not value!) estimate. While business model and not only on the estimate.
multiple-based methods play an resulting financial KPIs. This is often
important role in determining an initial neglected when valuing established Transparency on return and risk
rough price estimate based on limited companies or is justified by the The addressee of a valuation should
information, the result cannot be (implicit) assumption that established always be aware of the purpose of the
compared to the detail of a more business models can be reflected in a valuation and the level of scrutiny it is
intrinsic, future-oriented valuation consistent future financial intended to withstand. To speak for the
based on expected returns specific to performance. Since financial KPIs are development of a specific early-stage
the valuation target. merely the result of a transformation company’s business and operating
process from operational value drivers model – and the associated value
Start-up valuations are complicated by into financial figures, unsupported development – it is essential to show
the fact that the multiples typically financial KPIs should not be the transformation of the expected
observed for other companies cannot considered as isolated value drivers. operational value drivers into financial
be applied due to the limited empirical Only a transparent transformation of models. This is initially simple but
basis available for new business the operational value drivers into gradually becomes more complex.
models. In other words, the innovation forecasts of the operational Transparent transformation also

Quarterly Brief – 15th Edition of the International Valuation Newsletter 5

enables consistent communication
regarding the expected development
of the company’s performance and
risks.

While performance can generally be

measured by financial KPIs, the
question arises – especially for start-
ups – of how to measure risks
appropriately. Not doing so makes it
difficult to allocate risks appropriately
to all stakeholders.

This brings us back to the special

feature of early-stage company
valuation described above: views can
diverge greatly when it comes to
determining the contribution of
founders versus investors, and the
entitlement of individual stakeholders
to shares in the early-stage company.
Missing, insufficient or inadequately
transparent information not only makes
it difficult to form the right expectations
regarding future performance, it also
hinders any fundamental assessment
of assumed risk. This is precisely
where the multiple-based valuation
method fails. For start-ups, this is
critical as the financial contribution of
an investor often represents the start-up valuation to be a reliable basis only a technicality, in the form of
urgently needed financing of the for an appropriate distribution of building forecasts of integrated
business. If the founders cannot stakeholder shares, it must answer the financial statements.
transparently demonstrate the risks of two key questions clearly and
their business, investors may only be coherently: What’s in for me? What Considering the business and
willing to invest if they can pay less risks am I taking? These questions operating model transformed into an
than the fair price (given the difficulty reflect the risk/return profile underlying estimate of the future financial
to assess risks) or are promised more every investment decision. With the performance provides insights into the
than the fair future return for the right approach, this can be fully “What’s in for me?”, but what about
amount invested. depicted using established valuation the risk a founder or investor is taking?
methods, even for start-ups. Academic research and empirical
If one group of stakeholders receives evidence from polls on expected rates
more return than they should The venture capital (VC) approach of return by venture capitalists
considering their risk position, this is Due to limited history and significant investing in early-stage companies are
inevitably at the expense of the other change in cash flow generation over a valuable resource for assessing
stakeholders: founders in the case of time, a start-up valuation requires a relevant discount rates. Depending on
start-ups. They pay the price for the clear link between the expected the development stage, rates range
risks such that, due to lack of risk business model, operating model and from 70% or higher in the seed stage,
transparency, they must assume more financial KPIs. This can be achieved falling to 20% in the late stage. While
of the overall risk than would be through proper business plan these discount rates appear high, it is
allocated to them in relation to their modeling, complemented by a robust important to bear in mind the high
expected return. This often comes commercial due diligence on the failure rates of early-stage companies.
down to a lack of transparency and assumptions used (market share The table below provides a high-level
consistency, not only with regard to acquired, pricing, cost structure, etc.). summary of selected studies and
how the start-up’s performance will The translation of expected operational briefly describes the characteristics of
develop, but also its risk profile. For a performance into financial KPIs is then each development stage.

Quarterly Brief – 15th Edition of the International Valuation Newsletter 6

Overview of expected rates of return by venture capitalists

Stage of development Plummer / QED Scherlis and Sahlman, Stevenson Damodaran (10)
median (7) Sahlman (8) and Bhide (9)

Seed stage 50% - 70% 50% - 70% 50% - 100% 50% - 70%

First stage 40% - 60% 40% - 60% 40% - 60% 40% - 60%

Second stage 35% - 50% 30% - 50% 30% - 40% 35% - 50%

Bridge/Initial Public 25% - 35% 20% - 35% 20% - 30% 25% - 35%
Offering (“IPO”)

the target company. Appreciating the

Seed stage current stage of development of the
company being valued as described
The seed stage corresponds to companies that are less than a year old, above is critical in order to identify the
have completed or are completing research and development of their corresponding discount rate, i.e. risk
product and have a business plan. The venture funding provided in this expectation, from VC investors.
stage is to be used toward product development, prototype testing and
marketing. Like the multiple-based approach, the
expected rates of return from VC
investors depend on the comparability
of the risk profile within a given stage.
First stage
It is certainly arguable that a first stage
Sometimes also called the “emerging stage”, enterprises in the first stage company in the financial services
have developed prototypes that appear viable and for which further sector that has already received an
technical risk is deemed minimal. However, the commercial risk operating license from a regulator
associated with the product may be significant. might be less risky than a first stage
company in the biotech sector where
final approval from a drug
administration agency is outstanding.
Second stage The observable ranges within each
stage are nevertheless broad and
Also commonly referred to as the “expansion stage”, enterprises in the
require additional assessment. That
second stage have usually shipped some products to consumers (including
being said, the applied discount rate is
beta versions) and received feedback.
a risk measure that provides more
transparency than a multiple.

The probability-weighted DCF

Bridge/IPO approach
In order to reflect the risks and
The final stage of venture capital financing, the bridge stage is when uncertainties specific to the early-
financing is required for activities such as pilot plant construction, stage company being valued, various
production design and production testing, as well as bridge financing in business plan scenarios can be
anticipation of a later IPO. developed. Typically, these scenarios
are structured around a “base case”,
which reflects the most likely expected
scenario for the start-up (usually, by
The specific elements of an early- requirements, etc. should be their founders). Variations then reflect
stage business plan such as the considered in the cash flow additional upside potential (“best
addressable markets, volume and projections. However, those cash flow case”) or specific risks such as delayed
pricing assumptions, the operating projections do not reflect any particular market entry, change in pricing
model, investment and funding risk associated with the early stage of assumptions, etc. (“worst case”). In

Quarterly Brief – 15th Edition of the International Valuation Newsletter 7

practice, as many as four or five scenarios provide different possible stage, the CAPM alone will not reflect
different scenarios could be outcomes to the “What’s in for me?” the risk associated with the target
established – each with a consistent question. company.
set of correlating assumptions –
including a scenario where the Once the various scenarios have been As the DCF method can now be
company fails. Given the very high developed, a DCF valuation can be implemented for the different
growth rates typically expected at first applied separately for each one. The scenarios, the probability of
for early-stage companies, forecasting traditional Capital Asset Pricing Model occurrence – also referred to as the
periods for each of the scenarios may (CAPM) can be used to determine the probability of success (PoS) – can be
be extended to include a slow-down discount rate. This involves identifying defined. Each scenario should be
phase. From this point onwards, cash listed companies in a similar (sub-) weighted such that they total 100%.
flow growth decelerates progressively sector to the early-stage company The final value concluded for the early-
to reach a steady state where cash being valued. As listed companies stage company is the aggregate of the
flow increase in line with market tend to be more mature and less risky DCF values for each scenario weighted
growth and currency inflation. All than companies still in their early by the PoS.

Reflecting risks with transparency: Probability-weighted DCF approach

While in the VC approach the risk of The estimate of the PoS is subjective, underlying thought process and
the early stage is fully reflected in the with founders typically putting more acceptance of all stakeholders.
high discount rate, the same risk is weight on the base case and potential
reflected in the probability-weighting of upside scenarios, whereas VC Last but not least, it should be noted
the different scenarios, and the applied investors may be more skeptical. In that – as everywhere in competitive
CAPM-based lower discount rate is that respect, the use of the expected markets – transparency from the
neutral with respect to the early-stage rates of return of VC investors in the perspective of an individual
risk. While there is some element of probability-weighted DCF approach stakeholder is always helpful if it
personal preference, we clearly favor may be appropriate, i.e. a supports a better negotiating position.
the probability-weighted approach as it combination of both approaches. This Prices in real markets are not formed
is much more reasonable to discuss requires a sensible and pragmatic in theory, but on the basis of
assumptions for the various scenarios assessment of the various key inputs. negotiations. Negotiating advantages
and the likelihood of each scenario Parties should also observe the come from information or any other
than to argue over an abstract early- common valuation principle of not factors that improve the lack of
stage risk premium in the discount accounting twice for the same risk – transparency so often cited as
rate. By transparently presenting the here, in the cash flows and in the justification for price reductions.
expected performance (return) and discount rate. A triangulation of
risk, the probability-weighted DCF different sets of probabilities and Value increase over time based on
method makes a valuable contribution discount rates might be used to an evolving risk profile
to the reduction of any expectation support convergence on a central Early-stage companies typically have in
gaps among stakeholders and value through this multi-scenario, common an extremely high speed of
supports fair allocation of value probability-weighted DCF result. This development. As the company evolves,
between founders and investors. all increases transparency of the the business model becomes more

Quarterly Brief – 15th Edition of the International Valuation Newsletter 8

robust and operational milestones are conclusion for a future date – in six- or only the expected performance and
reached, reducing the risk of the twelve-months’ time, for example – risk, but also the value upside.
venture. The figure above showing would not change. The probability
expected VC rates of return illustrates assessment of the different scenarios Engaging the right experts to deal
how risk clearly declines from one may vary, however, and the risk (i.e. with the complexity of early-stage
stage to the next. the discount rate) will be lower. These company valuations
two factors do have a material impact KPMG Valuation Services regularly
A value conclusion is a statement at a on value and could be quantified assists founders, VC investors as well
single point in time. It is of enormous applying these three steps: as corporates investing in start-ups at
interest to all stakeholders, and new various scales, from high-level value
investors in particular, to understand 1. Define key milestones over the indications to deep dive analyses. Our
how the value of an early-stage business plan period valuation experts have profound sector
company is likely to increase over time. 2. For each key milestone knowledge in technology, fintech,
achievement, review the biotech, pharma, health science
To address this need, the probability- probability-weighting (PoS) of the equipment and other common start-up
weighted DCF method is once again already developed cash flow businesses.
especially relevant: the scenarios – scenario
and the PoS attached to them – can 3. Reassess the applied discount rate Many clients have benefited from our
also be related to future milestones. under the assumption that the key approach combining commercial due
These can include operational milestones have been met diligence, financial modeling and state-
(successful prototyping), regulatory of-the art valuation concepts as
(administrative approval approval) and Adapting these inputs in a dynamic, described above. They appreciate the
commercial (securing key client probability-weighted DCF analysis value our methodology adds beyond any
contract) aspects. At the point of the enables future value developments immediate need for a value indication
valuation analysis, assumptions over time to be anticipated based on for events such as an upcoming
relating to financial performance will expected business achievements and financing round or investments. We help
remain the same. Except for the risk development. The result is a our clients to better understand the
different time value of money (which healthy basis for discussion between opportunities and risks associated with
is usually immaterial in the context of founders and investors in an approach a venture – and we help them make
high-growth cases), the overall value which transparently lays down not better-informed decisions.

Value development over time

Quarterly Brief – 15th Edition of the International Valuation Newsletter 9

References
1 Global VC Report 2020: Funding And Exits Blow Past 2019 Despite Pandemic
Headwinds, Crunchbase news

2 McKinsey Global Private Markets Review 2020

3 OECD Entrepreneurship Financing Database Venture Capital Investments

4 S&P Capital IQ data. These numbers do not consider companies that got
acquired in a reverse merger transaction or public to private transaction after
their IPO and for which market data is no longer available

5 Defined as company being listed with a market capitalization at IPO greater than
USD 1.0 billion.

6 2020 Global Start-up Outlook, Silicon Valley Bank

7 Fortune Magazine

7 James L. Plummer, QED Report on Venture Capital Financial Analysis

(Palo Alto: QED Research, Inc., 1987)

8 Daniel R. Scherlis and William A. Sahlman, - A Method for Valuing High-Risk,

Long Term, Investments: The Venture Capital Method, Harvard Business School
Teaching Note 9-288-006 (Boston: Harvard Business School Publishing, 1989)

9 William A. Sahlman, Howard H. Stevenson, Amar V. Bhide, et al., – Financing

Entrepreneurial Ventures, Business Fundamental Series (Boston: Harvard
Business School Publishing, 1998)

10 Damodaran, A., 2009 - Valuing Young, Start-up and Growth Companies:

Estimation Issues and Valuation Challenges (Stern School of Business, New York
University)

Quarterly Brief – 15th Edition of the International Valuation Newsletter 10

Your contacts

KPMG in Kuwait
Al Hamra Tower, 25th Floor
P.O BOX 24, Safat Kuwait
13001

Ankul Aggarwal Nitin Bahl

Partner, Deal Advisory Associate Director, Deal Advisory
KPMG in Kuwait KPMG in Kuwait
+965 5044 4964 +965 9000 7510
ankulaggarwal@kpmg.com nitinbahl@kpmg.com

Our Global contacts

Johannes Post
Partner, Deal Advisory
Global Head of Valuation Services
+41 58 249 35 92
jpost@kpmg.com

Rolf Langenegger
Director, Deal Advisory
Valuation / Financial Modelling
+41 58 249 42 71
rlangenegger@kpmg.com

kpmg.com/kw

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