Updated: Nov 4, 2018
This article is based on a response to #AskPiers: 3, for an investor who was trying to value a startup. This is an extremely complicated subject, but I have tried to provide some technical and, of course, practical insights. These approaches to valuation can be used by investors in a young private company or by founders negotiating the terms of a funding round.
Any discussion about valuation of young companies seeking investment should include structure. A high valuation means nothing if founders are quickly faced with slow sales, swamp rights, anti-dilution rights, conversion rights and debt repayments that can’t be made leading to default and the enforcement of security rights.
I used to value companies for a living as an investment banker at Barclays de Zoete Wedd (BZW) and Credit Suisse First Boston, although the companies we valued were large and well-established. My colleagues still faced challenges when valuing companies with new business models such as ISPs in 1999 with no real comparables.
There are many methodologies such as comparable company analysis (trading valuations), comparable acquisition analysis (exit valuations including premia paid), discounted cash flow analysis (DCF), economic value added (EVA) and so on. Unless you have up to date and accurate information for your valuation model, the output will be impacted by the rule: ‘garbage in = garbage out’.
More mature businesses have track records of performance and cash flows. For example, it is easier to calculate the value of a utility company using a DCF as it will have secure, long-term cash flows, but you may still want to factor in regulatory risk. You may even want to include the impact of solar power over the next decade if you are analysing the cash flows from a power station burning coal. Calculations to derive cash flows can be complicated as can just calculating the discount rate to be applied based on weighting due to the capital structure of the company and its costs of equity and debt capital.
A startup may just have a plan to launch a new product in a new market segment – the lack of data points and inherent future risk means that startups are very hard to value using standard techniques. Even after days of modelling a DCF, subjectivity will be involved to generate the final answer. Scaleups are more likely to have at least some track record, cash flow history, plans based on experience and comparable companies in the market. ICOs pose a real issue as there after often no reference points and valuations are often based on a white-paper explaining how the founders intend to leverage blockchain to disrupt an existing market, the team's expertise and then investment in persuasive PR and marketing.
Companies are usually valued by comparing them to similar ones with adjustments made for rates of growth, intellectual property, brand value, real assets, maturity, margins, capital structure, scarcity and so on. This approach provides a ‘trading’ valuation and is what is applied in investment scenarios. When a company is sold, the buyer normally pays a premium to compensate the seller for some of the future value they are forgoing. The buyer expects to be able to create more value from new growth plans or cost synergies - that is the buyer’s upside. If the buyer paid for all of the future value upfront in the premium there would be no point buying the business. The multiples that are derived from comparing the price a company was sold to its financial performance are known as exit multiples. If they are available, they can provide a guide in circumstances where, for example, there is only one close comparable and it was acquired.
You can’t value a company without reference to real-world data – otherwise, you’re just guessing.
Research comparable companies even if they are not identical, but have similar characteristics. For example, generically, established professional services or consultancy firms might be valued at around 1x revenue. Tech companies are often valued at multiples of revenue and not profits – as there may not be plans to generate profit for some time. Valuations based on revenues are focused on growth and the assumption that at some point a profit will be generated at an acceptable margin. Look at Twitter's valuation, its road to profitability and the impact of a fall in user numbers. Revenue multiples do not factor in direct or administrative costs, or the capital structure (e.g. interest payments) of a company. Some costs such as investment in sales and marketing or even software development will drive revenue growth. Profits may be re-invested for many years to drive revenue growth and a rising valuation, rendering any analysis based on profits meaningless. This would also make it difficult to use a DCF, especially if cash flow is expected to be negative.
Valuations based on multiples of numbers further down the profit and loss statement - such as on net profits - factor in margins, costs, capital structure, tax and so on. Price-earnings (PE) ratios are a measure of the value of a company compared to its net profits (earnings) and are easier to calculate for public companies as there is a market capitalisation (or share price) to use as the numerator and earnings (or earnings per share (EPS)) that can be used as the denominator. In the case of private companies, start by looking for similar public company comparables.
Also research venture capital and angel investment deals. Pull the records from Companies House (UK company registry) or look on databases such as CrunchBase for any information that may be available. You can work out valuations from just a news article or press release and publicly available accounts, although accounts may date quickly if the company is growing fast and investing heavily.
If the scientific approach isn’t an option, another approach to valuation is to look at the business plan and exit valuation potential and then reverse engineer the valuation you can accept. This will be based on your return expectations with a substantial (and subjective) discount to factor in significant risk. For example, if you think the company could be worth 3x its revenue forecasts in 5 years (i.e. £15 million) and you want a 5x return, you can’t value the company at more than £3 million today. If you are investing at the seed stage, the risk is high, so the valuation should be far lower. The discount factor may be reduced if, for example, you are backing a proven and expert team of serial entrepreneurs raising a significant sum to start a new business.
Tax breaks such as SEIS and EIS (available in the UK) can have a material impact on your risk, entry price and taxation of any capital gain at exit. However, investors can use such relief elsewhere, so it has an opportunity cost. This approach can provide a sense check on any valuation being discussed.
Typical investment parameters
You can apply complicated mathematics or reverse engineer a valuation, but most investments in young companies fall within a range regarding the equity participation of investors for a given sum invested.
This will change as professional investors are involved later as they require preferred return (i.e. getting their money back first or even multiples of it), to de-risk their investment.
As a very rough guide, in a seed round of £100,000 to, say, £250,000, investors will be issued with shares representing 20% - 49% of the business. An investor may seek a controlling stake in circumstances, for example, where the founders need a significant amount of help, the investor adds considerable value and will take an active role. However, a minority interest is a usual outcome for investors at this stage to ensure that management remains incentivised post the current and future rounds that will dilute them. Of course, an investor can request a preferred return at this stage to manage risk.
The valuation falls out of this approach. So, for example, a £100,000 investment for 25% implies a post-money valuation of £400,000 and therefore a pre-money valuation of £300,000. An investor needs to be confident that there is the potential for an exit valuation that is, at least, a high single-digit multiple of £400,000.
It boils down to this...
Even with decades of data and sophisticated models, valuations are still estimates, and they can’t factor in new technology, nascent yet disruptive competition, loss of key management or a sudden change in consumer demand due to changing trends.
It boils down to this, a lesson I was taught by a quarry owning neighbour at the age of sixteen when I moaned about his offer of £70 to buy my BMX bike for his son when it had cost £400.
Anything is only worth what somebody is willing to pay for it.
If you are an investor and the only show in town, then you are the market. If you are competing with several interested parties, one or a limited number of investors will need to set the terms as the lead(s) to avoid endless negotiations and iteration. It is then up to other interested parties to accept or improve on the lead offer.
Founders have to understand that investors have an opportunity cost to using their money to invest in any one company and it isn’t purely financial as is the case with a venture capital fund. It might be another exciting investment that they can’t make or just a family holiday in the Maldives.
Bridging a valuation gap
If you have a valuation gap that has lead to an impasse, you can attempt to bridge it by providing the founders with the opportunity to claw back equity if the business performs or after investors reach an agreed return target or by increasing a preferred return. Investment can be made in tranches to reduce risk – financial performance targets or operational milestones (e.g. MVP completed) can be agreed before the second tranche can be drawn. The reality for founders is that, unless funds for future instalments are literally held in escrow for release by a lawyer when specific and measurable conditions are satisfied, they are not certain. Few young companies can afford to pursue a broken second tranche funding promise through the courts. If agreed targets or milestones are not achieved, a formula can be used to adjust the valuation. Anti-dilution rights that protect investors from future lower valuations are common as they effectively adjust the previous valuation. However, although future investors may not wish to see management aggressively diluted, they at least provide those protected with a bargaining position.
You can structure some of the investment as a loan or a convertible loan. Convertibles provide investors with the choice of converting the loan into equity if things go well, or being repaid if they don't. At the seed stage equity is preferable and represents risk taken. In fact investments by way of loans, without credit support, are subject to equity risk and probably not priced correctly as a result. Venture debt instruments attempt to bridge the risk-reward gap by expecting repayment of a loan with higher rates of interest alongside equity participation – often in the form of a warrant. Debt and interest repayment obligations in young businesses can apply too much financial pressure if the business doesn’t perform as planned.
High valuations mean nothing if you default
Founders should be aware that if they default on any debt, they may not be in control of their company for long. This should be factored into a valuation and investment structure discussion as being clever with debt instruments to avoid dilution may prove expensive or even fatal in the future.
Some investors are acutely aware of this and can agree a seemingly attractive equity valuation for existing shareholders upfront knowing that there is a high probability that the company will default opening the door to an aggressive restructuring a year down the line.
You can be creative, but remember that future investors will probably completely restructure the deal if it is too complicated and add layers of preferred returns before ordinary shareholders (SEIS/EIS compliant shares in the UK) receive a penny.
Align interests to succeed
In the end, you have to agree on something that works for all parties which results in aligned interests. Investors can manage risk in many ways, including in contract with veto, consent, board representation, step-in, tag, permitted transfer and information rights. These are typical terms you would expect in a shareholder agreement, and there are many more to consider.
The focus needs to be on growth and supporting effective execution as no amount of negotiation, valuation calculation or structuring matters if the company fails completely with no assets for even a secured debt provider.
© Piers Linney 2018
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