Valuing a Private Equity Venture Investment: the Case of a B2b Marketplace Start-up

A great number of e-business investments is initiated by early stage companies – mostly financed by venture capital or private equity. Due to the sharp declination of stock prices of new economy companies in 2000 venture capitalists have realized that they have paid too high prices for their equity stakes. They have to admit that new economy market was driven by euphoria rather by fundamental values. By such a crash, the applied valuation methods are questioned. Venture capitalists dealing with seed and start-up companies on their daily basis need realistic and sensible valuations in order to make profitable investment decisions. However, the valuation of those high growth companies is difficult and presents a big challenge. Most of those companies have negative earnings and no or only small revenues. In addition, comparable companies are rare or required information not accessible to the public which makes it difficult to apply multiple valuation. Regarding the private equity market start-up venture consists of many options due to high flexibility and uncertainty of their future development. Also from an investor’s perspective an investment in an early stage company may incorporate several options such as future follow-up investments, which will be carried out if the company proceeds successfully. Traditional valuation methods such as DCF are not able to capture and price such options, but with option theory it is possible to assign them a fair value. As a consequence, the aim of this research paper is to apply and test a variation of the real option method on private equity investments. Based on the case approach a fictive B2B marketplace at the start-up financing round in the end of 2000 is discussed. On behalf of confidentiality agreements signed within the venture capital market it is not possible to access real world cases, which makes it compulsory to use a fictive case. The goal is to precisely define and calculate the individual steps of the real option approach in order to derive an accurate and correct valuation of the B2B marketplace at the given financing round. This research paper makes three important contributions in this context: (1) it systemizes the application of real option models in the scope of private equity, (2) it demonstrates the feasibility of option theory for assessing private equity investments and (3) it shows a tendency concerning cost-benefit ratio if option theory is applied on private equity investments.