Start-Up Firm Valuation: A Real-Options Approach

Abstract

Start-up firms typically produce negative cash flows in the first years after their foundation. As a consequence, standard discounted cash flow methods are not applicable, often forcing practioneers into using theoretically dissatisfying devices like multiples. In this paper, we develop a comprehensive and theoretically more convincing valuation framework for start-up firms. Our analysis is based on a contingent claims approach in an arbitrage-free setting which - due to an alternative process assumption - explicitly allows for the negative earnings typically produced by start-up businesses in early stages of their development. The model allows for the derivation of optimal conditions for exercising the waiting option to invest in a start-up as well as its optimal capital structure upon establishment. Finally, we show how unexercised additional options to invest (growth options) - even if producing negative cash flows at the time of investment - may significantly contribute to the start-up firm's value. The explicit incorporation of additional investment options may serve as an explanation for observable high market values of start-up firms with low or negative current cash flows.

Keywords: EBIT, start-up firms, capital structure, risk-neutral valuation

JEL Classification: G12, G13, G31, G32