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Demystifying unicorns: How startup valuations really work

Shutterstock_386762398Near daily headlines tout the massive valuations of startup companies and their potential public offerings. Some of these entities are valued well into the tens of billions of dollars. Private market investors continue to pump money into technology-based companies with the hope of cashing in on the next unicorn—rare startups valued at more than $1 billion.

At the same time, many of these companies have yet to produce positive net income, with some reporting growing quarterly losses in the millions of dollars. What’s more, some of these organizations are lacking clearly defined plans for how to pull a profit from their operations.

For many casual observers, these two facts seem quite contradictory. How can a company be worth billions of dollars when it is losing hundreds of millions each quarter? The answer often isn’t found in the income statement.

Intangible assets are largely driving many of these valuations, and putting a dollar figure on those assets is both an art and a science. The AICPA and its partners have created the Certified in Entity and Intangible Valuation (CEIV) credential and an associated framework to build consistency and transparency around those valuations.

To get a better sense of what early investors see in these companies, we recently spoke with Antonella Puca, CPA, ABV, CEIV, managing director of BlueVal Group LLC, a New York-based valuation firm, about how intangibles impact the valuation of companies that are aren’t yet publicly traded.

James Gallagher: What are intangible assets, and how can they impact the value of a private enterprise?

Antonella Puca: Intangible assets are non-physical assets, like copyrights, goodwill, patents, an assembled workforce or customer or client lists. Patents and customer lists are probably the two most notable intangible assets among many of the recent startups we’ve seen go public.

The companies reaching major unicorn status, those with valuations in the tens of billions of dollars, are doing so by creating new technologies to disrupt traditional companies and markets. Under current accounting rules, these assets are often not included on financial statements, but they’re something a valuation professional needs to consider.

On top of that, these assets bring growth potential. When valuing a company, one must consider how to generate future revenue from them.

JG: How can some companies have massive valuations while still posting regular losses?

AG: There are several things going on here. First, many of these companies are still developing. That means they’re spending a lot of money to grow—­investing in their assets, hiring employees, developing new technologies, enhancing existing software system, and building their brand through advertising and marketing. They’re are bringing in revenue, but they’re spending more than they bring in because they’re scaling up.

Many investors in these pre-IPO startups are looking at the potential of the intangible assets being created rather than their current value. And the billion-dollar question here is to what extent are they going to capitalize on the new technologies they are creating or the customer list they are building going forward?

At the same time, investors are often valuing a company on a multiple of the revenue it’s generating. When you focus on the revenue and not just the intangible assets individually, you may give you a better sense of what the organization as a complex entity can do. This is important at this stage in the game.

Investors usually expect that as the company develops, it will continue to grow revenue while keeping expenses level and ultimately become profitable.


JG: How does the Certified in Entity and Intangible Valuations (CEIV) credential and framework improve the understanding of how startup companies are valued?

AP: For a public company, the market sets a price, and there is clear guidance that tells us what we need to use to determine and document the fair value of the company going forward.

When a company is still private, the requirements to document and disclose the key assumptions that go into a valuation are different than what is required in the public markets, but no less important. Investors need to understand the company’s potential to generate revenue from its intangible assets, how it will scale and how these factors will support its growth and overall strategy. That is where a CEIV credential holder comes in.

An analyst that has a CEIV background is well aware of the role intangibles play in determining the value of a high-growth company and the importance of documenting all of the unobservable inputs and assumptions that go into a valuation. They understand the variety of methods that can be employed to evaluate the worth of intangible assets and to determine how those assets can drive revenue and scalability.

The CEIV gives us a framework to document how we assess intangible assets and calibrate an approximate value, within the context of fair value standards. And by using a standardized framework, investors can be more confident that the valuations are well documented, supportable and ultimately more reliable.  

JG: As you look at the current startup market, what thoughts or concerns do you have about the current valuations?

AP: Even with our best valuation efforts, these are frequently risky investments. Some of these companies are going to be very successful, but many are not. But with the size of some of these companies, once they go public, it is likely they are going to end up in a variety of large-cap indexes and investment portfolios, including pension funds, 401(k) funds, and mutual funds, particularly those targeting high-growth companies.

The average investor doesn’t necessarily know what is in all the funds in which they invest their money. It’s incumbent upon investment professionals to make sure they’re accurately assessing the risk of these companies so that they end up in the right investor portfolios.

A CEIV credential holder can help portfolio managers enhance their valuation process for some of these companies, especially ones operating in niche areas. They ensure that valuations provide a comprehensive overview of key relevant factors and are thoroughly documented and supported, paying attention to inputs that rely on information that is not available to the general public, such as management forecasts. That will lead to a better understanding of some of the risk involved and if that level of risk is appropriate for the portfolio they are managing.

More information on the CEIV credential is available on the AICPA website.

James Gallagher, Manager - Media Relations, Association of International Certified Professional Accountants

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