No two businesses are completely alike. Human resources make the difference. This leads to problems when applying multiple approaches to valuing businesses, whether small or big. Furthermore, for small businesses - "A small business is not a little big business", WELSH and WHITE, 1981 - the capital market is utmost imperfect. For this reason the several variations of the DCF approach are not convincing for the purpose of valuing entrepreneurial businesses. So an alternative approach to valuing entrepreneurial businesses is necessary. Such an alternative is the Functional Valuation theory:
Editorial: Research on entrepreneurial finance - today and tomorrow. Michael OLBRICH, IWP Institut für Wirtschaftsprüfung, Saarland University.
Int. J. Entrepreneurial Venturing, Vol. 4, No. 3, 2012.
The success of a new business mainly depends on two factors: the uniqueness of the business model and the ability of the entrepreneur to properly turn this idea into reality. However, it is also because of these two factors that entrepreneurial initiatives almost always go together with certain challenges. On the one hand, due to the singularity of the business concept, there are no experience values on which one can draw upon when appraising a new venture’s strengths and weaknesses. Moreover, since there is no data history at all, or just a very short one, the forecast of a young company’s turnovers and profits turns out to be an extremely demanding task. On the other hand, it is often the case that although the entrepreneur does have the technical skills to develop the product or service he has in mind, he lacks the required funds (Olbrich, 2002; Hering and Olbrich, 2002), business experience, and/or network to put his ideas into reality. Furthermore, entrepreneurial firms act in the environment of a highly imperfect capital market. This means in particular that debit and credit rates are unequal, the market participants’ ability to raise capital is limited and their tax burdens and information levels differ (Dixon, 1991; Hering, 2000; Brösel and Matschke, 2004) [...]Valuation plays an important role in venture financing. For instance, when shares are issued to business angels or when an IPO is prepared, the parties involved have to determine the minimum/maximum price they have to demand/are able to pay if they do not want to change their initial wealth position for the worse. However, due to the capital market imperfections as well as the high degree of uncertainty, valuation models have to fulfil multiple requirements [...]
BRÖSEL, MATSCHKE and OLBRICH present an approach to valuation which feature a technique sophisticated enough to fulfil these requirements:
In their article, ‘Valuation of entrepreneurial businesses’, Brösel, Matschke and Olbrich describe the functional theory of company valuation as an alternative approach to valuation. First of all, the authors work out the characteristics of small businesses and show that traditional methods like multiples, DCF, and real option approaches cannot handle the specifics of those valuation objects adequately. With the future earnings method and the state marginal price model, Brösel, Matschke and Olbrich then present two tools to derive the decision value of the entrepreneur. On this occasion, they also consider the problem of uncertainty and come to the conclusion that the way DCF methods process risk is flawed in many respects, while a Monte Carlo simulation leads to better results, in particular because such simulations show the complete range of possible outcomes of the decision value [...]
truthisithurts by Tauba Auerbach
Valuation of entrepreneurial businesses
Abstract: "A small business is not a little big business" (Welsh and White, 1981) - this also holds true for valuing small businesses. Such companies act in utmost imperfect markets, are generally unique and the forecast of their future profit is rather difficult. These characteristics impede the use of DCF and real option methods, as well as of multiples. Therefore, this paper presents the functional valuation theory as an alternative approach to valuation. Its partial and general models allow a better adaption to the characteristics of entrepreneurial businesses, especially when these models are combined with a Monte Carlo simulation.
Brösel, G., Matschke, M.J. and Olbrich, M. (2012) 'Valuation of entrepreneurial businesses', Int. J. Entrepreneurial Venturing, Vol. 4, No. 3, pp.239-256.
Gerrit Brösel is the Head of the Department of Auditing at the FernUniversität in Hagen. His research focus is on financial reporting, statement analysis, auditing and business valuation.
Manfred J. Matschke holds the Chair of Business Administration and Corporate Finance at the University of Greifswald. His research focus is on business finance and business valuation.
Michael Olbrich is the Chairman of the Institute of Auditing at Saarland University. His research focus is on accounting, auditing and business valuation.
Access to Full Text