Valuation of Early-Stage Ventures: Option Valuation Models vs. Traditional Approaches

Abstract

This paper presents a new method for valuing early stage ventures, a method which views new ventures as multi-stage call options. It examines the traditional methods for valuing such ventures--the ubiquitous Discounted Cash Flow (DCF) Method using a risk adjusted discount rate, and the Venture Capital method which uses high discount rates to offset optimistic forecasts--and describes their conceptual disadvantages visa vis the Option Method. In order to make the Option Method a practical alternative to traditional approaches, the paper presents an algorithm for valuing multi-stage options, and it develops the needed input data using venture capital archives and public offerings. The Option Method is applied to a typical early-stage investment, producing values close to those predicted by venture capital "rules of thumb." In contrast, the DCF method badly underestimates the value of the venture. At this time the Option Method is a practical way to value early-stage ventures, both internal ventures and start-up companies. It offers many advantages over the venture capitalists' s "rules of thumb."