**1.7 Profit projections and economic flow in the valuation of a startup**

In the case of startups, despite the fact that they may imply long investment periods, loss statements and negative cash flows, businesses have value and this can be surprisingly high, since from the beginning and during the course of During these periods, investors observe the potential of the business by evaluating the business projections for the future, considering that the value of the business will be given by the profits—and positive cash flows—when they occur in the future.

When new companies (startups) are valued, it is important to visualize their life cycle, since they generally take time to generate profits or positive cash flows, which is why the investment stage and the moment when they prove their viability as businesses are prolonged. However, for the valuation of companies it is important to identify the moment in which they are expected to generate profits or positive economic flows.

So when they seek to obtain economic resources in business meetings to implement their idea or carry out an IPO (*Initial Public Offering*) for their business consolidation, the business life cycle must be projected and the expectations of income, profits and flows must be shown in each one of those moments. Now, it is important to mention that not all startups have similar life cycles. For example, start-ups that correspond to businesses based on the intensive use of technologies generally show a tendency to have a longer duration of the investment stage, since the introduction stage is slow; however, if they manage to be successful ventures, they have rapid growth and achieve greater market dimensions, until they reach the maturity stage.

From the point of view of the type of technological innovation, businesses can be classified into different dimensions, although for the purpose of projecting the economic states and flows of the business it is considered important to distinguish between process innovations—or frugal innovation—and disruptive innovations.

What is relevant about this distinction is that it will be possible to observe different durations of the stages of the life cycle of these businesses.

In businesses that break through with disruptive innovations, the introduction stage is usually longer, since as they are innovative products, market approval must be awaited; however, once this happens, the growth rate is expected to be high. It also happens that the dimension of the disruptive business market is greater compared to frugal innovations, since the latter optimize processes of broader production chains, so that the latter find their maturation stage in less time.

#### **1.8 Business valuation methods**

The financial value of a company, or more precisely the financial value of Shareholders' Equity, represented in **Figure 11**, is what the market is willing to pay for the purchase or sale of the company, proportionally to the shares of the company. This can be represented in the company's Balance Sheet, where the accounting Equity which represents what is invested by the shareholders- takes a value based on the benefits of the business, if it is good and generates high profits, then the financial value of the equity It will be higher than the book value, but if the business does not have good prospects it can even reach a lower book value.

The valuation of shareholders' equity or market capitalization serves as the basis for purchase and sale transactions of shares of minority positions, where the price per share is equivalent to the market capitalization divided by the number of shares.

$$\text{Price per Share} = \frac{\text{Market capitalization}}{\text{Number of Shares}} \tag{1}$$

The market capitalization is formed based on the expected earnings of the company and is then reflected in the price per share. For this reason, in the capital market, the net income method is used to determine the value of equity and shares.

When the valuation is carried out, for example, for the purpose of buying or selling a company, then it is necessary to have greater strength in measuring the evolution of the company's net income and it may even be necessary to carry out Due Diligence

**Figure 11.** *Company balance sheet. Source: Prepared by the author.*

processes to ensure that the determination of the fundamentals is correct. In this case, the discounted cash flow valuation method is the most appropriate.

Next, two useful methodologies will be developed to value start-ups.

#### *1.8.1 Valuation by Income Statements (Net Income)*

To estimate the financial value of shareholders' equity, it is necessary to project the expected profit of the business, which must be representative of the business. Then the one who values must project the Income Statement, analyzing the evolution of income and costs, distinguishing the company's fixed and variable costs, which will depend on the particular characteristics of the company's operation. Then, administrative expenses and provisions for depreciation or amortization of assets must be projected. The resulting Net Profit, after taxes, will give us the information to calculate the value of the shareholders' equity.

In **Figure 12**, the Balance Sheet of the NLS company, an investment of \$12.3 MM is being considered, which is financed entirely with sources of capital or equity. In the case of startups, financing basically comes from capital contributions, since the company in formation is not subject to credit and therefore does not access debt financing. This will also be reflected in the projection of the Income Statement, since financial expenses will not be considered, since the company will not pay interest on debt.<sup>4</sup>

If the NLS Income Statement is developed, as shown in **Figure 13**, the income (\$88.1 MM), costs and expenses of the company (\$52.4 MM), as well as the depreciation (\$4.7 MM) of tangible fixed assets can be established in which the company has invested. From the difference between costs and expenses, there is a profit before taxes (\$31.0 MM), which at a tax rate of 30% results in income tax (\$9.3 MM), to finally obtain a net profit (\$21.7MM).

**Figure 12.** *NLS balance sheet. Source: Prepared by the author.*

<sup>4</sup> In the valuations of companies that have access to credit, the liabilities must be considered in the Balance Sheet and the financial expenses in the Income Statement.

*The Life Cycle in Startup Valuation DOI: http://dx.doi.org/10.5772/intechopen.110765*


#### **Figure 13.** *Income Statement. Source: Prepared by the author.*

**Figure 14.** *Perpetuity growth at 3%.*

For the valuation process, it is considered that a series of net profits is obtained over time, forming a perpetuity from period 1 (\$21.7 MM) and that period by period it grows at a certain rate (3%). A series of 10 periods is presented in **Figures 14** and **15**, however, it is considered that net profits grow in perpetuity.<sup>5</sup>

In order to determine the financial value of the patrimony, this series of profits must be updated following the following formula;

$$Present\ Value = \frac{Net\ profit \ 1}{K - g} \tag{2}$$

Where:


Consequently, the Present Value of the perpetuity of the net income of \$21.7 MM of a business that has a cost of capital of 8% and that grows at 3% will be \$433.9 MM (see **Figure 16**).

<sup>5</sup> The use of perpetuities is almost equivalent to using a 40 or 50 year series, since the present value of net income or any cash flow located in those years forward is less and less significant.

**Figure 15.** *Net profit. Source: Prepared by the author.*

**Figure 16.** *Net profit and present value. Source: Prepared by the author.*

$$\text{Present Value} = \frac{\ $21\text{\AA}}{\$ 96 - \ $96} = \$ 433\text{\AA} \tag{3}$$

Then, in the absence of debt financing, the Financial Value of the Equity will be \$433.9 MM and will be located in the initial period 0, as shown in **Figure 17**.

**Figure 17.** *Financial value of the equity. Source: Prepared by the author.*
