The Life Cycle in Startup Valuation

Abstract

The business valuation process begins with the projection of the company’s sales or income, so it is important to establish how they will evolve over time. It is possible to verify that the businesses follow a common pattern in the evolution of their income, and these have a trend line in the form of an S inclined forward, defining the life cycle of the business. When new companies (startups) are valued, it is important to visualize their life cycle, since it usually takes time for them to generate profits or positive cash flows, therefore the investment stage and the moment where they prove their viability are prolonged. If these startups correspond to businesses based on the intensive use of technologies, their life cycles show an even greater trend in the duration of the investment stage, the introduction stage is slow, but if they managed to be successful ventures, they have rapid growth and their largest dimensions market, until reaching the stage of maturity. However, not all technological businesses are similar, so for the analysis the type of innovation with which the business worked must be considered, since the shape of the life cycle will be different in the investment period, the speed of growth and the size of the market.

1. Introduction

1.1 The life cycle in business

The valuation of the shareholders’ equity is made from the projection of company profits (income minus costs) or cash flows (income minus expenses). The construction of these statements and economic flows means that each of its components must be projected, for which assumptions are made about the evolution of the company’s fundamentals (prices, sales volume, costs and expenses). The projections of each variable are not independent, since they are carried out taking as a point of reference the projection of sales or income of the company. Based on this projection, those corresponding to costs and expenses are made, including projections of investments in assets and working capital.

From this process, the importance of the way in which sales evolve is clear; In this sense, it is important to analyze the concept of the business life cycle, since it describes the evolution of sales since the beginning of the company’s operations. The first sales with Chart with the product introduction stage; if the company’s products reach market acceptance, the growth stage begins; When sales are consolidated in the target market and the sales growth rate decreases, it is known that the company has entered the maturity stage. This can be seen in Figure 1, which corresponds to the development of the business over time, which since its introduction has seen sales grow with an S-shaped trend line inclined forward.

Figure 1.

Development of the business over time. Source: Prepared by the author.

1.2 Incorporation of a new stage in the business life cycle

In business theory, the introduction, growth and maturity stages of the business life cycle are established¹; however, based on the observations of the evolution of the companies, it is considered important to incorporate an additional stage: the stage of business development. In this period, the products are formed until the moment where they are incorporated into the company’s sales, generating the first income. Figure 2 shows this stage where the investments are mainly made, which will be extended over time depending on the business that is being developed, closely related to the type of innovation involved in the company’s products. The incorporation of the development stage will make it possible to use the business life cycle in terms of the evolution of investments, its Income Statements and Cash Flows.

Figure 2.

The stage of business development. Source: Prepared by the author.

The development stage results in a series of investment flows until the company achieves a minimum viable product (MVP) that can be sold in the market. From this, the first sales and, consequently, the first income are achieved, thus starting the introduction stage of the business life cycle, as shown in Figure 3. Then the familiar stages of the business life cycle will follow.

Figure 3.

Investment and first income. Source: Prepared by the author.

1.3 The development of revenue in a business valuation model

For a company valuation process, it must begin with the projection of sales or income, since, as previously mentioned, these will define the construction and expected evolution of the Income Statements and Economic Flows, which are used in the two most widely used business valuation methods. According to Fernandez “to value a company with expectations of continuity, it is based on the discount of fund flows, with which the company is considered as a flow-generating entity” [1]. In this sense, for an existing company, income can be projected from the historical information found in the financial statements of past periods. However, in new companies such as startups, the evolution of sales or income must be built based on market studies or taking businesses from the same sector or with similar business units as a reference. The latter is typical of technological businesses in which this document focuses.

Thus, for example, we establish that after the development stage (between period 0 and 3) of the products of the startup being analyzed, sales of the product begin in period 4, which grow moderately during the introduction stage. It is expected that the market will accept the product from periods 9 or 10 and there will be high sales growth rates until around period 18 -where the growth stage would end- a period with moderate growth rates is entered, establishing the maturity stage. This description of the business life cycle through the evolution of expected sales can be seen in Figure 4.

Figure 4.

Sales. Source: Prepared by the author.

The products or services will be sold at the price or rate established according to market conditions, based on the products to be replaced or the market’s willingness to pay. Consequently, the behavior of the income will be defined, which will have a behavior similar to the evolution of sales. Figure 5 shows the evolution of sales and income, in a double scale Graph to appreciate that they have the same trend.

Figure 5.

Sales and income. Source: Prepared by the author.

1.4 The relationship between the income and the projected costs and expenses

After projecting income, the evolution of costs and expenses must be projected, concepts that are closely related, because although they do not vary perfectly proportionally, costs and expenses evolve in the same direction as income. On the one hand, fixed or semi-fixed costs will have to be projected, which have a stable behavior for a period of time, but grow over time with the increase in the company’s capacity; on the other hand, there are variable costs that do evolve proportionally to income.

The projection of the expenses shows a behavior similar to the semi-fixed costs, the projection of the depreciation -or amortizations- is also carried out,² which will depend on the investments made in the development stage and the additional investments in fixed assets. In Figure 6 it can be seen that in several periods -from 4 to 8- costs and expenses are greater than income despite the fact that the company has sales. This happens, because to achieve sales targets, the company must have a production capacity prepared to support growth and an organization that drives sales so that revenue forecasts are met. This means that initially the income cannot cover the costs until a certain moment in which the break-even point is achieved. It is expected that, from then on, revenues will grow at a higher rate than costs and expenses.

Figure 6.

Income, costs and expenses. Source: Prepared by the author.

1.5 The profit projection

To project the profits, the Income Statements are built in the valuation horizon, as shown in Figure 7, finding the difference between the Income and the Costs and Expenses, which will result in the projection of Profit Before Taxes for each period. If this is positive, then the income tax is calculated, which the company must pay to the treasury, in the corresponding period; if it resulted in a loss then the tax would not be paid in that period.³

Figure 7.

Statements of Income. Source: Prepared by the author.

As previously seen, between periods 4 and 8 costs and expenses are higher than sales revenue; consequently, it will be observed that there will be losses in each of these periods. Subsequently, in period 9, the income manages to exceed costs and expenses and there is a growth in profits following the pattern of the business life cycle; that is to say, that there is a notable growth rate in the growth stage and then it slows down until it has a more modest rate in the maturity stage, as see in Figure 8. In these periods of profit before positive taxes, the corresponding income taxes will be paid.

Figure 8.

Profit. Source: Prepared by the author.

It is highly probable that, in the initial stage of the company, losses will be obtained by not obtaining sufficient income to cover its costs and expenses; however, a situation of losses could be maintained for a long time, since an organization is still proportionally large for the initial income. This scenario will be reflected in the need to make additional investments to sustain the business until the moment where profits are achieved (break-even point) and then have a surplus cash flow, where income is greater than expenses; which is generally achieved in the final stage of growth and especially in the stage of maturity. According to Tsorakidis, et al. Break-Even Point is determined as the point at which total sales revenues are equal to total expenses (both fixed and variable). That is, it is the point that corresponds to this level of production capacity, under which the company operates at loss [2].

In the company valuation process, having an overview of the evolution of profits is important because it allows identifying the representative profit that will be used in the net profit valuation method, which will be explained later.

1.6 The projection of the economic cash flow

The other most widely used method for company valuation is the discounted cash flow method, which consists of updating the company’s projected economic flows. To build the economic flow, the company’s operating cash flow, investments in fixed assets and investments in working capital must be projected. The operating cash flow is the difference between income and expenses of each period, where the income is the same as that which has been considered in the Income Statement, similarly the expenses are the costs and expenses of the same financial statement, with the difference that the cash flow does not consider the depreciation or amortization of tangible or intangible fixed assets, as appropriate. The operating cash flow is subtracted from the investments in fixed assets and working capital that are made in the first periods -from 0 to 3- and the additional investments that are projected to be executed in the operational stage of the company. These last investments are necessary to support the growth in sales, since they imply increasing the capacity of fixed assets and a greater contribution of working capital to finance higher costs and expenses of incremental sales. The structure of the economic flow can be seen in Figure 9.

Figure 9.

Economic flow. Source: Prepared by the author.

In Figure 10, you can see the preoperative stage where only investments are made—period 0 to 3—; subsequently, the operational stage begins with the first sales, but for a period of time—from 4 to 10 it is not possible to have a sufficient operating cash flow to finance investments in fixed assets and investments in working capital; finally, the stage is reached where the cash flow is surplus and therefore can cover the necessary investments.

Figure 10.

Projection of the economic flow. Source: Prepared by the author.

In the economic cash flow of the previous Graph, it can be seen that there is an extensive period of negative economic flows that represents investments to be made, and from period 11, positive economic flows are obtained that grow in the same configuration as the cycle of life of the business or sales, which from a stage of growth passes to a stage of maturity. This process is important, since it indicates that in the end the cash flow will have a value that grows at a moderate rate, important data for the treatment of perpetuities in the valuation process.

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.

Figure 11.

Company balance sheet. Source: Prepared by the author.

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.

$$\mathit{\text{Price}}\mathit{per}\mathit{\text{Share}}=\frac{\mathit{\text{Market capitalization}}}{\mathit{\text{Number of Shares}}}$$E1

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 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.⁴

Figure 12.

NLS balance sheet. Source: Prepared by the author.

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 13.

Income Statement. Source: Prepared by the author.

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.⁵

Figure 14.

Perpetuity growth at 3%.

Figure 15.

Net profit. Source: Prepared by the author.

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

$$\mathit{\text{Present Value}}=\frac{\mathit{Net}\mathit{\text{profit}}1}{K-g}$$E2

Where:

Net Income 1	Corresponds to the profit of the initial period of the series of net profits ($21.7 MM).
K	It is the shareholder’s cost of capital that corresponds to the business risk (8%).
g	Is the growth rate of net profit (3%)

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).

Figure 16.

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

$$\mathit{\text{Present Value}}=\frac{\mathit{\text{\$}}{21}^{\prime }7}{8\%-3\%}=\mathit{\text{\$}}{433}^{\prime }9$$E3

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.

1.8.2 The PER method

In the market or stock market, the names of the components of the valuation formula are usually varied; however, the concepts that determine the valuation through the net profit method are maintained. The formula that is being used is the updating of the Net Profit of period 1 that grows at g% and the series of profits is discounted at the cost of capital K.

$$\mathit{\text{Equity Value}}=P_0=\frac{{\mathit{UN}}_1}{K-g}$$E4

That same formula can be expressed by separating the Net Profit (UN1) from the quotient $\frac{1}{K-g}$, leaving it as follows:

$$P_0=\frac{1}{K-g}x{\mathit{UN}}_1$$E5

The quotient $\frac{1}{K-g}$ is renamed as the Price/Earnings Ratio or the PER (Price-to-Earnings Ratio) multiplier so that the formula for calculating the Equity Value is expressed as a multiple of the Net Income. This is the formula that is applied in the stock market, but as can be seen, it is the same that corresponds to the net profit method.

$$P_0=\mathit{PER}x{\mathit{UN}}_1$$E6

Then the PER could be calculated that corresponds to a cost of capital of 8% and a growth rate of profits of 3%.

$$\mathit{PER}=\frac{1}{K-g}=\frac{1}{8\%-3\%}=20$$E7

Thus we will have that the equity value can be calculated by multiplying the Net Profit by the PER, obtaining the same equity value:

$$P_0=\mathit{PER}x{\mathit{UN}}_1=20x\mathit{\text{\$}}{21}^{\prime }7=\mathit{\text{\$}}{433}^{\prime }9$$E8

However, the use of the PER is made more frequently on the price per share, which initially results from dividing the Equity Value by the number of shares, which results in $8.97/share.

$$\begin{array}{c}\mathit{\text{Price}}\mathit{per}\mathit{\text{share}}=\frac{\mathit{\text{Equity Value}}}{\mathit{\text{Number of shares}}}\\ p_0=\frac{P_0}{\#\mathit{Acc}}=\frac{\mathit{\text{\$}}{433}^{\prime }9}{{48}^{\prime }4}=\mathit{\text{\$}}8.97/\mathit{\text{Shares}}\end{array}$$E9

The Equity Value formula could be expressed in the price per share by dividing the equity value and net income by the number of shares. Then the formula for the price per share based on the PER multiplier (20) times the earnings per share ($0.448/share) will be obtained, which will result in the same value of the price per share of $8.97/share.

$$\begin{array}{c}{P}_0=\mathit{PER}x{\mathit{UN}}_1➔\frac{p_0}{\#\mathit{Acc}}=\mathit{PER}x\frac{{\mathit{upa}}_1}{\#\mathit{Acc}}\\ p_0=\mathit{PER}x{\mathit{upa}}_1\\ p_0=20x\mathit{\text{\$}}0.448/\mathit{\text{shares}}=\mathit{\text{\$}}8.97/\mathit{\text{shares}}\end{array}$$E10

1.8.3 The net income in the life cycle of a startup

In calculating the Equity Value, it has been assumed that the Net Income of $21.7 MM was in period 1 and from that period it grew at a rate of 3%, however, as can be seen in the Figure 18, In the initial periods there are losses in each annual exercise and then small profits until reaching a profit of $21.7 MM in period 12.

Figure 18.

Net profits updated at present value. Source: Prepared by the author.

Then the Equity Value determined previously is located in period 10 and not in the initial period 0. In the following Graph 14 it can be clearly seen that the update of the series of net profits that begins with UN ₁₁ of $21.7 MM, generates a Present Value in period 10 (PV ₀₁) of $433.9 MM.

This Present Value at period 10 will be the Financial Value of the Shareholders’ Equity, which will be related to the rights of the shareholders for that period. Once the business and equity have been valued, this value can be expressed in period 0, for which they must be updated together with the investments made up to the time of valuation (period 10) and thus have the value of equity in the initial period.

However, this financial value of the equity (located for the example in period 10), which is shown in Figure 19, is usually used to determine the right of the different shareholders that are added to the company, such as the initial promoters, venture capital funds, among others.

Figure 19.

Financial value of the equity (located for the example in period 10). Source: Prepared by the author.

1.8.4 The life cycle and valuation by discounted cash flows

The discounted cash flow valuation method begins with the determination of the projected economic flows of the business, which unite the investment flows in fixed assets and in contributions -or increases in working capital-, as well as the cash flows that are observed in Figure 10.

As can be seen in Figure 20, the economic flows are negative until period 9 and then they become positive and gradually grow until their growth rate decreases in the maturity stage, thus following the development of the business life cycle. This extended period of the business development stage corresponds to disruptive innovation businesses; however, in each case they can be varied periods. As can also be identified in the previous economic flow, the first investment to be made is $12.3 MM and if we assume that the valuation will be carried out after having made this first capital contribution, we would have that the opening General Balance would be established with this investment and economic flows would be expected to occur from period 1 onwards.

Figure 20.

Economic flow. Source: Prepared by the author.

Once the investment has been made, the financial value of the equity will be determined by updating the economic flows at a discount rate that in most cases is the weighted average cost of capital⁶ (Ko), which in this case is 12%, as it can be seen in Figure 21. Initially we will assume that the economic flows reach period 20 to later incorporate the effect of perpetuity. Thus, using the formula of the Net Present Value of Excel, where the economic flows and the discount rate are incorporated, the Present Value of the economic flows will be determined.

Figure 21.

Present value of economic flows. Source: Prepared by the author.

$$\mathit{VP}\mathit{\text{Economics Flows}}=\mathit{VNA}\left(\mathit{Ko},{\mathit{FE}}_1{\mathit{FE}}_2{\mathit{FE}}_3\dots \dots \dots \dots {\mathit{FE}}_{19}{\mathit{FE}}_{20}\right)$$E11

From the extract of the spreadsheet presented in Figure 22, it can be verified that the Present Value of the economic flows between the periods 1 to 20 is $54.5 MM, which will be located in the initial period 0. This value represents the net value of the update of all flows up to period 20.

Figure 22.

The net value of the update of all flows up to period 20. Source: Prepared by the author.

Consequently, as shown in Figure 23, it will be necessary that the flow of the business throughout its life cycle is producing a value of $54.5 MM greater than the initial investment of $12.3 MM, which establishes the possibility of generating added value over the initial investment.

Figure 23.

Generation of added value. Source: Prepared by the author.

1.8.5 The effect of perpetuities

In business valuation, the life cycle of the business generally extends for several years after its maturity stage. However, when using the perpetuity method, it is important to be sure that the business being valued is expected to have a duration of at least 40 years.⁷

In the maturity stage, the growth rate of economic flows is approaching an almost vegetative growth, which in the case being analyzed is considered a g of 3%. Consequently, the Perpetuity Value can be determined as follows.

$$\begin{array}{c}\mathit{VP}\mathit{FE}{\mathit{\text{Perpetual}}}_{20}=\frac{{\mathit{FE}}_{21}}{\mathit{Ko}-g}\\ \mathit{VP}\mathit{FE}{\mathit{\text{Perpetual}}}_{20}=\frac{{\mathit{FE}}_{20}\left(1+\mathit{Ko}\right)}{\mathit{Ko}-g}=\frac{109.1\left(1+12\%\right)}{12\%-3\%}=\mathrm{1,357.8}\end{array}$$E12

The Present Value of the perpetual economic flow is found updating the flows that begin the following period, 21,⁸ which is discounted at the difference between the discount rate and the growth rate. To calculate the economic flow of period 21, the economic flow of period 20 is taken and carried to 21. Thus, it is finally obtained that the Present Value of the perpetuity for period 20 is equivalent to $1357.8 MM, as presented in Figure 24.

Figure 24.

The Present Value of the perpetuity for period 20. Source: Prepared by the author.

The value of the perpetuity determined from the last economic flow of period 20 ($1357.8 MM) is added to the economic flow of period 20 ($109.1 MM), obtaining a total flow of $1466.9 MM, as shown in Figure 25.

Figure 25.

Total flow. Source: Prepared by the author.

Then, in Figure 26, using a discount rate of 12%, the economic flow that considers the value of the perpetuity is updated and thus the Present Value of the economic flows is determined, which amounts to $195.2 MM.

Figure 26.

Present value of the economic flows. Source: Prepared by the author.

Considering an evaluation horizon of 20 periods, the Equity Valuation results in $54.5 MM and if the value of the perpetuity of economic flows is considered, the value increases to $195.2. Note that it is a significant increase, so it is important to keep in mind for the use of perpetuity that the business must reach at least 40 years or a discount rate must be considered that incorporates the little certainty that the business will mature. It is also important to determine the growth rate of economic flows (g), since this value can strongly modify the present value of the perpetuity.

1.8.6 Identifying differentiated discount rates

The capital costs that can be obtained in the market are generally from companies in progress and with a history of operating in the market, this is not the case of startups because by definition they are new companies that need investments in their stage of development. Development and in the introduction stage, even in part of the growth stage. These are periods where it is not yet possible to obtain profits or positive economic flows. Consequently, what must be done is separate the updating of the economic flows into two stages, one where the flows already reflect the consolidation of the business and another where the flows show that greater net investments are still being made.

The consolidation stage is from period 11 where the first positive economic flow is achieved and from then on it can be considered that the business is growing, which then enters maturity and finally has a perpetuity behavior with growth of g%. Then you can start to replace the average rate of 12% with a cost of capital of 9%, an expected return that corresponds to similar businesses but that are already in the market. With this modification, the value of the perpetuity of the flows from period 21 onwards increases from $1357.8 MM to $1982.2 (see Figure 27).

Figure 27.

New perpetuity value. Source: Prepared by the author.

Since the idea is to have the value of the business at the stage where it could be similar to a business of the same type but that is already on the market, then we discount the positive economic flows from period 11 to 20, which includes the perpetuity value considering that this update is made at the cost of capital or expected return of 9%. Thus, the Present Value of the business is obtained $1231 MM, which will be located in period 10 and which represents the value of the business when the investments have already been made, as shown in Figure 28.

Figure 28.

The Present Value of the business. Source: Prepared by the author.

Then the economic flows from period 1 to 10 are updated, which includes the Present Value of the flows from 11 to 20, including perpetuity. Figure 29 shows that, in this period a discount rate of 20% higher than the 9% that corresponds to the business consolidation stage is used. The reason is because at this stage investors assume the risk of the company’s default without being sure of being able to reach the period where profits or positive flows begin to be generated, so this risk assessment derives in the use of a high expected return.

Figure 29.

Economic flow from 1 to 10 with perpetuity (11–20). Source: Prepared by the author.

From the update, there is a Present Value of the economic flows of $157.5 MM that considers the effect of the perpetuities and the discount rates in stages and that can be seen in the Figure 30.

Figure 30.

Effect of the perpetuities and the discount rates. Source: Prepared by the author.

2. Startups by type of innovation

Schumpeter highlighted the leading role of innovation as a fundamental internal engine for the economic growth of companies and nations. Therefore, regardless of the origin of the companies, the innovation of processes, products and services constitutes a strategy that allows companies to project greater added value, increasing the possibilities that they can become competitive organizations and manage to adapt to the demands of world markets.

For Schmookler, innovation arises after the need to solve a problem, creative and innovative ideas respond to a demand originating in the environment [3]. Sherman [4] defines innovation as Ideas originated after identifying a need, resulting in the invention of new products, processes or techniques to achieve success in the market. Malerba and Orsenigo define innovation as a dynamic and interrelated process, with continuous feedback effects between the different stages, and, furthermore, this entire process takes place in a changing environment in which agents and competitors react, in turn, before each of the changes [5]. Likewise, the OECD defines innovation as the creation or improvement of a product, process or in turn the combination of both [6].

There are various authors who have defined innovation; however, in most definitions it is understood that innovation is associated with the use of knowledge for the creation of strategies capable of generating improvements in the product or process. For this reason, process innovation and disruptive innovation will be defined below.

2.1 Process innovation or frugal innovation

When you talk about innovation, you have the preconceived idea that it means the creation of a totally new product; however, innovation could also occur in the modification of a current process to make it more efficient. This is known as process innovation -or frugal innovation- and consists of the application of knowledge that develops new tools or methodologies that allow optimizing the behavior and results of the processes ([7], p. 19).

Through process innovation, companies manage to increase their competitiveness, reducing costs and times, improving customer satisfaction rates. In this way, the returns on investment are increased and the participation of the company in the market is increased ([7], p. 23).

Process innovation must meet certain conditions to be considered as such. This type of innovation must increase the productivity or yields obtained so far and there must be a significant and demonstrable change, otherwise, it cannot be considered as innovation, but as an improvement in the process, also called Kaizen (see Figure 31).

Figure 31.

Differences between Kaizen and innovation. Source: [7].

The kaizen method has the same objectives as innovation in terms of increasing competitiveness; however, this is achieved through the constant improvement of the business productive apparatus. That is, through “small improvements made in the status quo as a result of progressive efforts” ([7], p. 31), while innovation implies a drastic improvement in the status quo.

2.2 Disruptive innovation

Various academics such as Danneels [8], Bass [9], among others, define disruptive innovation as the evolution of a product or service, using technologies to increase current returns. This causes companies that go through this process to displace established competitors. This type of innovation has as its main characteristic the transformation potential of industries and considers the process from the introduction of changes to the acceptance of the new offer in the market by new consumers [10].

For disruption to be successful, it must have the potential to improve steadily over time; For this reason, the innovation process includes “subsequent developments that raise the attributes of the new product to a level sufficient to satisfy the main customers” ([11], p. 13; [12]). Figure 32 shows the fundamental characteristics of disruptive innovation.

Figure 32.

Subsequent developments that raise the attributes. Source: Prepared by the author.

2.3 Compared life cycle of startups

2.3.1 Differences in risk

All companies face constant challenges that put business stability at risk. Companies that decide to innovate are not exempt from these dangers. For this reason, this section will discuss the main types of risks faced by companies that are committed to innovation.

The implementation of any innovative idea requires previous studies that evaluate the feasibility, development of the prototype, the business model, among other previous steps, which represent an investment in research and development. Even, on some occasions, transferring the innovation from the prototype to reality is highly expensive and sometimes it is not possible to have a viable product or that the market can demand, so the investment made is risky.

As for companies that choose to innovate in their processes, most of the risk is found in the Research, development and implementation process, since it is at this stage that the greatest investment is needed. On the other hand, disruptive innovation is conditioned by a type of additional risk, given that, once the implementation investment has been made, the product or service may not be well received in the market. Disruptive innovations usually have unattractive performance in the short term, since they assume a different value than the one established, so that new products or services are not initially competitive and have a slower maturation process. The initial rejection or little acceptance of the product will be reflected in a low level of sales.

Although “not all paths of disruption lead to success” ([10], p. 9), various authors argue that this type of innovation takes years to disrupt the market, but when they do, their growth is amazing. However, it is not without risk; for this reason, investors tend to be more conservative, since if the business does not work it would represent an economic loss for them and the company, associated with the high costs of research and development and the uncertainty of the results.

Based on the above, it is evident that uncertainty is one of the risks associated with innovation and that, in general, disruptive innovation is perceived as riskier than process innovation.

2.3.2 Differences in the duration of the startup life cycle

It had been argued that to analyze a company it is convenient to locate it in the stage of the business life cycle that corresponds to it, it was also previously mentioned that the life cycle shows business development through the evolution of its sales over time. In general, when a company begins -especially in startups- it goes through a stage of development of its products that it then submits to the market and begins its introduction stage. If the company exceeds its germinal stage, it will begin to develop its potential in the growth stage. Finally, the company will enter its maturity stage when sales growth rates slow (see Figure 2).

There is a close relationship between the life cycle of a company and the decisions of the type of innovation it wishes to undertake, and the life cycles of startups that develop disruptive innovations will be different from those that opt for process innovation; The product development processes will be different and consequently the investments to be made, which for example leads to the perception that disruptive innovation is riskier than process innovation and this fact alone will generate differences in the life cycle of companies that opt for one or another type of innovation.

It can also be seen that the disruptive startup causes the shift towards a completely new paradigm; however, this change is not immediate, since it involves the adaptation of consumers or the creation of a new market. For this reason, the introduction phase of a disruptive startup is usually longer than the introduction phase of a startup that focuses on process innovation, as shown in Figure 33.

Figure 33.

Comparative cycles. Source: Prepared by the author.

The startup that innovates in processes presents a lower risk of market adaptation, since this type of innovation starts from an existing market that seeks to make the client company more efficient and competitive, but does not alter the final product or service. However, since the market is defined, the growth in product sales is limited by its demand, since the production rate must not exceed what the market needs. In this sense, the growth stage of the company that innovates processes is more limited than in the case of the startup with disruptive innovation, where the growth stage is more pronounced, since in this case innovation has the potential to create a new market. and thereby grow to a higher level. Once the growth stage is over, both startups reach their maturity stage, with the process innovation startup arriving first.

2.3.3 Investment level according to the type of innovation

Both in startups with disruptive innovation, as well as in those with process innovation, the investments made consider the research, development and implementation of the innovative idea, as well as the formation of the business, which defines its stage of development. Given that startups with disruptive innovation have a longer development and introduction stage, then investment levels will be higher for two reasons: first, because of the magnitude of the investment involved in developing a new product for the market and the longer investment period because while in process innovation the process to be optimized is known and therefore the research is limited, on the other hand, in disruptive innovation, research processes have to be carried out with many hypotheses and test models, which mean a longer period of investment- This can be seen in the Figure 34.

Figure 34.

Investment level. Source: Prepared by the author.

2.3.4 Economic flows, profits and business value

In the previous Graph it can also be seen that the potential for generating economic flows by a startup that promotes a venture based on a disruptive innovation needs to be greater, since it must repay the larger and prolonged investments that the development of this type of investment entails. Products and for what should be done the analysis of the potential acceptance that it may have in the market. In process innovation, investments are lower and therefore market demands and economic flows are proportionately lower.

The profits of the business follow a similar evolution to that of the economic flows, possibly there are profits before having positive flows, but they will follow a similar trend. The previous considerations that have their origin in the business life cycle, which will correspond to each type of innovation to be developed, influence the process of valuing the company and the parameters to be used to calculate the value of shareholders’ equity.

3. Discussion

The analysis of the life cycle of a business is the starting point for determining the projection of profits and cash flows, which are the basis for the valuation of companies. The construction of the life cycle of a startup makes it necessary to introduce a development stage prior to the introduction stage where sales begin, the reason is that these companies involve extensive periods of product development where investments must be made without still starting the commercial stage of the company.

The life cycle of a business represents the projection of sales of the company’s products, in the development stage investments are concentrated to obtain a minimum viable product and then the expectation of initial sales of the product is represented describing the stage of introduction. Subsequently, the stage of expected sales growth is built and the projection ends with the configuration of the maturity stage, where the business is expected to grow at a slower rate until it has a growth rate close to zero.

This projection of sales multiplied by their respective prices allows the construction of business income, and these in turn the evolution of costs (semi-fixed and variable), of investments in fixed assets and working capital. With the information described, the projected Income Statements and the economic flows of the business can be prepared. Thus, the necessary information will be available to apply the methodologies to value the startup, by the net profit method or by the discounted cash flow method.

Properly constructing projections makes it possible to identify the necessary investment amounts, estimated investment times, and expected economic flows. These components make it possible to determine in advance the profitability of an investment and the value of a company. Although the projections made in the early stages are expected and possibly differ from the real ones, it allows modeling the behavior of the business that the investor will take as a basis to adjust his expectations of remuneration for his investment.

The development of the life cycle also allows the separation of two important phases of a business where two expectations of expected return -or discount rates- will be applied to value a business. On the one hand, the business incubation phase, which includes the development stage and the introduction stage. On the other hand, the consolidation phase, where the startup is expected to position itself in the market. Likewise, the cost of capital or expected return in the business incubation phase will be significantly higher, as it reflects the risk that, at this stage, the startup will not be able to position itself in the market. After this stage, the expected capital costs may coincide with the expected returns of a similar business in the market.

The life cycle is not the same for all businesses or startups, as it depends on their nature. For example, companies that invest in disruptive innovation products will have a longer development stage with longer and more intensive investment periods, but with the expectation that they will obtain significant growth once they are consolidated. This is different in startups that innovate specific industry processes, since their development stages are shorter, they have a known market, but also more limited since they are based on existing industries.

Finally, an analysis of the life cycle of a business that is evaluated from the development stage to its consolidation makes it possible to anticipate the levels of investment and to know what financing needs to look for in the different venture capital or investment funds. These investments can improve business expectations, but it also depends on the correct identification of this business life cycle, which allows an adequate risk analysis.

4. Conclusions

• By reviewing the literature, it can be identified that the life cycle of a business is made up mainly of three stages: introduction, growth and maturity. And this because generally the investment stages for the introduction of the products in the market have been of few periods.

• In the study of the behavior of the startup, it can be understood that they have long periods until they reach the consolidation of the business. In the early stages they have losses and negative cash flows and it may be necessary to wait a long time until this situation is reversed. For this reason, this chapter incorporates one more stage in the business life cycle: the development stage, which precedes the introduction stage. During this period, investments are made until the sales that generate the first income begin.

• In the development stage, a series of investments are made until the company obtains a minimum viable product that is later incorporated into sales, thus beginning the business introduction stage.

• With the sales projection, it is possible to estimate the income, costs and expenses expected in the evaluation horizon of the startup, projecting the income statements and economic flows. Since the starting point is the sales projection, it is important to have an adequate market study.

• The projection of the Income Statements allows the startup to be valued through the Net Income Valuation Method or the PER (Price-to-Earnings Ratio) Method, which consists of updating the relevant Net Income that has a growth rate, at a cost of principal or discount rate.

• The relevant net profit of the business and its respective growth rate, which is used to obtain the value of the business, occurs when the company is in its consolidation phase after the development stage. When the business is considered consolidated, it is possible to value the company considering capital costs or expected returns. This is based on taking similar businesses as a reference or using PER (Price-to-Earnings Ratio) indices of referential businesses. Usually, Business Value is realized in a period after the development stage. If you want to know how much the value is at the initial stage or at the time the valuation is carried out, then you must update the value of the business previously obtained at a cost of capital corresponding to high-risk businesses.

• The Discounted Cash Flow Method uses the economic flows expected from the business, that is, the operating cash flow -income minus business expenses- also considering additional investments in fixed assets and working capital. With this method, the economic flows of the growth and maturity stage must be updated at a cost of capital corresponding to similar businesses. The previous cash flow and the development and introduction stage cash flows must then be updated to the expected return or cost of capital of high-risk businesses. The magnitude will depend on each case.

• In general, business life cycles based on disruptive innovation processes have life cycles with longer development and introduction stages, implying longer investment periods and where losses are expected to occur over a longer period of time.

• In general, in a startup that develops a product based on process innovation or frugal innovation, it tends to have relatively fewer investments because it supposes a substitution of a process that has an existing technology. This means that the new product has a better chance of becoming established in less time, taking into account that it already has a defined market but that it is also more limited.