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

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Author Info

  • Robert H. Keeley

    (University of Colorado)

  • Sanjeev Punjabi

    (Deutsche Bank North America, New Yor)

  • Lassaad Turki

    (Menlo Park, CA)

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    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."

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    Bibliographic Info

    Article provided by Pepperdine University, Graziadio School of Business and Management in its journal Journal of Entrepreneurial and Small Business Finance.

    Volume (Year): 5 (1996)
    Issue (Month): 2 (Summer)
    Pages: 115-38

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    Handle: RePEc:pep:journl:v:5:y:1996:i:2:p:115-38

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    Postal: 24255 Pacific Coast Hwy, Malibu CA
    Web page: http://bschool.pepperdine.edu/jef
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    Related research

    Keywords: Early-Stage Ventures; Startup; Valuation; Open Valuation Model;

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    References

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    1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 47(2), pages 427-65, June.
    2. Jain, Bharat A & Kini, Omesh, 1994. " The Post-Issue Operating Performance of IPO Firms," Journal of Finance, American Finance Association, American Finance Association, vol. 49(5), pages 1699-1726, December.
    3. Nerlove, Marc, 1971. "Further Evidence on the Estimation of Dynamic Economic Relations from a Time Series of Cross Sections," Econometrica, Econometric Society, Econometric Society, vol. 39(2), pages 359-82, March.
    4. Barraquand, Jérôme & Martineau, Didier, 1995. "Numerical Valuation of High Dimensional Multivariate American Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 30(03), pages 383-405, September.
    5. Megginson, William L & Weiss, Kathleen A, 1991. " Venture Capitalist Certification in Initial Public Offerings," Journal of Finance, American Finance Association, American Finance Association, vol. 46(3), pages 879-903, July.
    6. Robert H. Keeley & Lassaad A. Turki, 1993. "Risk-Return Profiles of New Ventures: An Empirical Study," Journal of Entrepreneurial Finance, Pepperdine University, Graziadio School of Business and Management, Pepperdine University, Graziadio School of Business and Management, vol. 2(2), pages 87-109 , Spring.
    7. Bygrave, William & Fast, Norman & Khoylian, Roubina & Vincent, Linda & William Yue, 1989. "Early rates of return of 131 venture capital funds started 1978-1984," Journal of Business Venturing, Elsevier, vol. 4(2), pages 93-105, March.
    8. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 12(04), pages 541-552, November.
    9. Scholes, Myron & Williams, Joseph, 1977. "Estimating betas from nonsynchronous data," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(3), pages 309-327, December.
    10. Clarkson, Peter M & Thompson, Rex, 1990. " Empirical Estimates of Beta When Investors Face Estimation Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 45(2), pages 431-53, June.
    11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    12. Ritter, Jay R, 1991. " The Long-run Performance of Initial Public Offerings," Journal of Finance, American Finance Association, American Finance Association, vol. 46(1), pages 3-27, March.
    13. Jèôme Barraquand, 1995. "Numerical Valuation of High Dimensional Multivariate European Securities," Management Science, INFORMS, INFORMS, vol. 41(12), pages 1882-1891, December.
    14. Blume, Marshall E, 1971. "On the Assessment of Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 26(1), pages 1-10, March.
    15. Bardia Kamrad & Peter Ritchken, 1991. "Multinomial Approximating Models for Options with k State Variables," Management Science, INFORMS, INFORMS, vol. 37(12), pages 1640-1652, December.
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    Cited by:
    1. Wolfgang Stummer, 2002. "Some Potential Means for Venture Valuation," Journal of Entrepreneurial Finance, Pepperdine University, Graziadio School of Business and Management, Pepperdine University, Graziadio School of Business and Management, vol. 7(3), pages 39-52, Fall.

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