Abstract
This paper exploits real options approach to evaluate start-ups with three option-like features embedded: options to defer, expand, and abandon. Based on the sequence and interactions among those options, we use the Least Squares Monte Carlo Simulation to price the options accordingly. Meanwhile, five key factors are considered simultaneously: (1) market competition, (2) opportunity cost of waiting, (3) potential competitors’ entrance, (4) growth opportunity of further and related research, and (5) the impact of different business models chosen by the entrepreneur. Given all possible combinations of option types and five factors mentioned above, we evaluate a start-up in Taiwan by both real option approach and traditional DCF method. The contribution is fivefold. First, we propose a valuation model for start-ups while considering not only three options embedded but also five key factors regarding market competition and strategic considerations. Second, we provide information for entrepreneurs to make rational decisions in a case of merger, acquisition, or IPO (initial public offering). Third, our simulation results shed light on valuation of intangible assets and/or managerial decisions with option-like features and on the information asymmetry between entrepreneurs and fund providers. Fourth, we provide predictions about the conditions under which traditional DCF method is as good as real options approach. Finally, under certain parameter settings, we specify the probability that each of the three options will be exercised. These predictions can be used for designing an option-based contract with a predetermined strike price. To verify these predictions will be an interesting empirical exercise. We initiate this project upon an invitation by a start-up in Taiwan, who is negotiating with an S&P 500 firm in a case of strategic alliance or acquisition. Our results show that the full model which incorporates five factors mentioned above is more robust than others. From sensitivity analysis, we find that key parameters are initial revenue, initial growth rate, mean-reversion speed, the effect of new entrants (competitors), and the likelihood of success in further and related research. From a scenario simulation of those key parameters, the option premium is seemingly worthless if initial revenue and growth rate are both under pessimistic settings. But in general cases, start-ups are more valuable (44% to 61% higher) under real options approach than under traditional NPV method.