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Valuing startup companies: Lessons learned from a Grilled Cheese Sandwich and the Virgin Mary

Nov 19, 2019

Determining the value of startup companies can be challenging. Complexities arise from the lack of meaningful historical financial results and from uncertainties involved with startups in general. 

Founders of startups can be too optimistic in their projections, resulting in higher valuations. 

Investors and buyers, on the other hand, often temper those projections since there is a large amount of risk involved with startups failing. The perspectives of both parties should be considered when valuing an early stage company. 

What is value anyway? Is it simply the cost to produce something? Is it the price paid in the marketplace for similar goods or services? Or is it based on the future benefits provided by the asset?

The answer may be yes to any or all of these questions. 

Under Revenue Ruling 59-60, which set the basic framework for business valuations, the IRS recommends we consider all of those questions and take three approaches to value a company: the cost approach, the market approach and the income approach. 

An interesting illustration of this is the infamous “grilled cheese Mary” story

In 1994, Diana Duyser made a grilled cheese sandwich. After taking the first bite, she saw an image resembling the Virgin Mary. She stopped eating the sandwich at that point and placed the sandwich in a plastic box with mothballs. Approximately 10 years later, she entered the item up for auction on eBay, claiming it had never sprouted a single spore of mold. 

Let’s attempt to apply the three approaches to value to the “grilled cheese Mary” anecdote. 

Using the cost approach, which simply adds up all of the costs to build a sandwich — two pieces of white bread, a slice of cheese, and a little butter — results in a value of roughly 10 cents. 

Application of the market approach and the income approach is not that simple. 

The market approach determines the value based upon the selling price of similar assets while the income approach looks at future earnings or cash flow. Finding comparables for a grilled cheese sandwich with a spiritual image would be difficult, if not impossible to find. And there is no valid way to determine how much cash flow could be generated by this sandwich. 

This brings us back to speculation and emotion. 

If you are Diana Duyser from Miami, Florida, that sandwich is worth $99,999,999, which was the opening bid she set when she put it up for sale on eBay.

Similar to “grilled cheese Mary,” appraisers will weigh all three approaches when valuing startup companies.

  1. Income approach: The lack of historical profitability means appraisers will have to estimate the value of the company based upon projections of how much cash flow it will generate in the future. For very early stage companies, that often means looking 10 or 15 years into the future. Additionally, the discount rate may range up to 40% or 50%, given the risk associated with investing in early stage companies. The discount rate is intended to be the rate of return an investor would require if they invested in an asset, accounting for the risk involved with that investment. As a company becomes more established the inherent risk of that company should decline, effectively reducing the required rate of return as certain milestones are achieved. Another way to think of this is through an investment in Facebook. An investment in Facebook in 2004 (when it was run out of Mark Zuckerberg’s Harvard dorm room) was significantly riskier than an investment today (with Facebook being publicly traded).
  2. Market approach: This approach involves appraisers attempting to find comparable publicly traded companies or comparable transactions of similar companies. The market approach can be challenging to employ when valuing startups. It may be very difficult to find comparable companies for niche startups. Additionally, since most startups lose money in the first few years, profitability multiples (i.e., EBIT, EBITDA, net income) likely will not produce a meaningful result. Projected profitability measures can be used but the resulting values are only as good as the inputs. With no historical profitability, multiples of revenue are frequently used for early stage companies. The benefit of using revenue multiples is that they are difficult to manipulate. But the challenge here is that revenue can be meaningless if a company sells its goods or services for less than what it costs to make/provide them to the customer. 
  3. Cost approach: Finally, a cost approach attempts to estimate value through the costs to replicate the company. This is achieved via adding up the costs to re-create the various tangible and intangible assets of the company, which may include: equipment, inventory, capital contributions, contracts in place, trademarks, work in process, employees, technology creation and processes. This approach would put the valuation at how much it would cost to get the startup to the point in time when the valuation was conducted. This value may be understated as it is difficult to estimate the intangible asset values of the business. Or it may be overstated if excess time and resources were spent creating some of these assets.

Like our “grilled cheese Mary” scenario, all three valuation approaches should be considered, but they may produce widely varying values. 

Ultimately, it is up to the appraiser and the user of the valuation to work closely together to ensure that all of the risks and opportunities are appropriately considered for the valuation. 

Entrepreneurs often have great ideas, but until profitability or other milestones are met, it is difficult to convert this idea into value. 

Projections generally will be needed to perform valuations for early stage companies. These should be heavily vetted and tested for reasonableness. Investors in startups will often be less optimistic in their own projections and will likely apply higher discount rates, resulting in lower valuations.

By the way, Diana Duyser did not receive $99,999,999 for her partially eaten sandwich, but she did get significantly more than 10 cents. 

GoldenPalace.com, an online casino bought it for $28,000 on eBay. The partially eaten sandwich, which is now 25 years old, doesn’t appear to have netted $28,000 in cash for the casino, but has paid off with “millions worth of media mentions” (including this one). 

From 10 cents to $$99,999,999 and $28,000 to millions — value for many assets, including startups, truly is in the eye of the beholder.

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Francis P. Egan, CFA, ASA
Senior Manager, Valuation Litigation and Transaction Services
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