Introduction to The Life Cycle Valuation Method

Investors funding innovators-entrepreneurs is a vital function in a capitalist economy (Schumpeter, 1936). Firms backed by venture capitalists indicated a higher growth than new ventures that do not count on their support (Davila, Foster, & Gupta, 2003). Some of the vital questions regulating investor-investee relations include: 1) how do investors select a new venture to invest in among the innumerable available alternatives; 2) how do investors price the investment and time the exit; 3) how do investors constitute their portfolios; 4) how do founders influence investment decisions, and 5) how do investors influence management decisions.

Traditional valuation methodologies are not fit to assess New Ventures and Startups, and usually takes a "one size fits all" approach to the problem. The Life Cycle Valuation Method accounts for the difference in failure rates and investors’ expectations along the life cycle of New Ventures and Startups.

During the “quest for survival”, failure rates are the highest and investors’ expectations are better depicted in terms of cash-on-cash multiples (CoCM) or a multiple over the initial investment.

During the “quest for relevance”, the lower failure rates allow investors to express their expectations in terms of annual returns, following the rationale of premia for risk taking that is the basis for the Capital Asset Pricing Model (CAPM).

Deal size is significantly different during the “quest for survival” compared to the “quest for relevance”. Investors tend to commit smaller equity investments during the riskier phase, while they seek to maximize nominal returns during the less risky and least profitable phase of a new venture’s life cycle. Founders also benefit from smaller equity investments during the “quest for survival” and larger equity investments during the “quest for relevance” because it balances the founder’s dilution over the new venture’s life cycle.

The value of the New Venture or Startup along its life cycle depends on the valuation of the New Venture of Startup at the end of the cycle (at IPO of strategic sale, for example) based on generally accepted valuation methods, and the investors’ expectations depicted on the Figure 18. The Life Cycle Valuation Method including failure rate, deal size, return on investment and investment time.

The valuation of the New Venture or Startup is done backwards: starting at the exit value (price at the IPO or M&A) and adjusting for the investor's opportunity cost at each phase of the life cycle of the firm, as depicted below:

The parameters for investor's opportunity cost shown above are illustrative. On my next article I will present an exclusive investors's survey to discuss the expectations of 105 qualified investors in Brazil.

This article is an extract of José Securato's Ph.D. thesis presented to Faculdade de Economia, Administração e Contabilidade / Universidade de São Paulo: "Classification, Investment Selection, and Valuation of New Venture and Startup Companies".

If you are interested in the presentation of the thesis (in Portuguese), or the thesis itself (in English), please refer to https://tabula.com.br/curso/tese-classificacao-selecao-de-investimento-e-valuation-de-new-ventures-e-startups