Option Based Valuation of a Venture Business and the Determination of its Implied Volatility

Abstract

Venture business has a high uncertainty in terms of future profit and growth prospect, which makes a common valuation method such as discount cash flow method undervalue the business by missing the additional value from upside potential and managerial flexibility. Instead, option pricing theory that was developed in financial markets can be used to deal with the valuation of venture business more appropriately. In general, venture business is funded at several financing rounds and a financial option called installment option has a functional and conceptual similarity to venture business. The most important parameter of any option valuation is implied volatility and the real option model has a difficulty in determining its implied volatility because there is no historical data of the underlying asset and the underlying asset value itself is not observable in the market. This paper suggests a novel way of determining the implied volatility in a systematic way. It is also shown that the proposed method has a limit in terms of the maximum implied volatility thus it is not possible to assign absurdly high implied volatility in order to obtain the value as high as it needs to be. To illustrate how to apply the valuation methodology to a real situation, one new venture business is valued as a case study at three different stages: at initial investment, at next financing round, and the final financing round.