Acquisition of shares in start-ups – special aspects to consider in the valuation of shares

published on 10 November 2021 | reading time approx. 3 minutes

by Cyril Prengel, Rödl & Partner Nuremberg, and Florian Hildesheim

Throughout the life cycle of a start-up all the way up to an exit, shares must be valued on multiple occasions. For example, in secondary transactions or when granting employee options or participating in rounds of financing. In addition to these voluntary transaction-related situations, valuations are required for reasons arising from company law or tax law. Company law aspects include severance payments, the redemption of shares, as well as contributions or mergers. A valuation is necessary for tax reasons, for example, if gift tax risks must be examined due to a transfer of shares to the founders. This article deals with the special principles of valuations of shares in start-ups.

The determination of values of shares in start-ups is subject to special principles which make the process difficult in practice. In contrast to established companies, shares in start-ups normally carry different rights. In addition to control rights, they can also include special cash flow-related rights such as anti-dilution clauses or liquidation preferences. The latter guarantee holders of liquidation preferences in the event of an exit – a preferential order of payout of their invested capital increased by one or more times – often before other investors.

If such special cash flow-related rights are included in capital structures or are negotiated during rounds of financing, the shares are classified into different share classes, which also involve different values. A simple pro-rata allocation of the enterprise value between shares is therefore no longer possible. This is because the additional cash flow-related rights granting preferences to individual investors cause a deviation in the allocation of proceeds in the exit event from the nominal value of the capital share and thus increase the value of these shares.

In Germany, there are currently no comprehensive recommendations for determining values for different share classes. It is therefore helpful to refer to e.g. the American literature and tax legislation regarding valuation. The US professional association AICPA lists the following approaches to the valuation of shares in start-ups:

• Current Value Method (CVM);
• Probability Weighted Expected Return Method (PWERM);
• Option-based models (Black-Scholes OPM, Monte-Carlo simulations, binomial trees).

Generally common for all approaches is that they can take into account different cash flow rights of the shareholders. Nonetheless, the approaches are based on different assumptions and should therefore be used with caution and depending on the situation of the respective company.

CVM assumes the allocation of the current enterprise value based on the mechanism agreed between the shareholders and thus assumes an exit event in the near future. In most cases, this leads to a situation where the shares of the founders – usually common shares with the lowest-ranking claims for exit proceeds – are assigned a very low, or in extreme cases, even no value. Methodologically, this is due to the fact that CVM does not allow the possibility of future value increases due to an assumed exit in the near future.

By contrast, PWERM or the simulation- or option-based approach assumes future allocations of exit proceeds and is therefore preferable where the exit is not planned until several years later. In PWERM, the future exit price is allocated to share classes in several scenarios and then probability-weighted and discounted. This approach not only allows mapping future developments in the start-up company compared to the strongly present-oriented CVM, but also makes it possible to include in the valuation specific business plans and their upside and downside cases. This makes the communication related to the valuation method more transparent and comprehensible, especially compared to the option-based approaches described below.

The option-based approaches differ in that the future development of the company is depicted by means of stochastic processes. In general, this makes them more abstract, but these approaches are always preferable in situations where the future development of the start-up is subject to high uncertainties and the scenario planning and the weighting of individual scenarios via PWERM is also subject to high uncertainties. For example, the development of future enterprise values using the Black-Scholes model is modelled using the geometric Brownian motion. As a result, future enterprise values are distributed on a log-normal basis in a model-driven manner. Alternatively, future enterprise values can be simulated using a binomial tree. The binomial tree enables tracing the development step by step; it not only enables the modelling of special cash flow-related rights but is also suitable for the modelling of anti-dilution rights. The Monte Carlo simulation offers more flexibility when preparing simulations for future enterprise values. In addition to the geometric Brownian motion, also other distribution functions or stochastic processes can be used to depict the development of the enterprise value up to the exit event.

The share valuation can be based on either a well-founded company valuation (e.g. according to IDW S 1) or values derived from values from the last round of financing. Assuming that the current round of financing was carried out at market values, the implicit enterprise value and the value of the shares held by the remaining shareholders can be derived from the prices of the newly issued shares. This procedure is also known as the backsolve method.

In the case of transactions relevant in terms of income or gift tax, the framework conditions of the German Valuation Act (Bewertungsgesetz or BewG) regulating the determination of the fair market values (of shares) must also be observed. Also according to the German Valuation Act any deviating profit allocations or deviating share in liquidation proceeds  affect the value of the share. However, in its statements on the valuation of shareholdings, expressed among other things in the decrees of the same wording, the legislator is oriented at the value of income as of the reporting date rather than at uncertain future allocations in the exit event.

In summary, in the case of start-ups, investments require deeper reflection regarding the determination of share values than in the case of established companies. The negotiation of the enterprise value goes hand in hand with the negotiation of special rights. Both aspects are mutually dependent and are prerequisites for determining share values and share purchase prices. The appropriateness of a share purchase price in a round of financing or a secondary transaction can therefore only be determined by taking these two aspects into account. The valuation method for determining the share values depends in particular on the planned exit timing and the degree of uncertainty of future developments.