by Tom Allen
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In our recent article, Getting the Price Right, we outlined that there are a variety of methods that may be considered when it comes to valuing a company. Established companies (including those listed on a stock exchange such as the NYSE or FTSE) are generally easier to value, since they have a demonstrable trading history. For instance, they can be valued on the basis of their earnings or revenue with these metrics applied to an industry specific multiple and extrapolated into future projections, if required. However, valuing startup or early stage companies is a different story. Since most start-ups have little or no trading history, revenue (such companies are referred to as “pre-revenue”) and earnings, there is a clear lack of metrics to analyze – meaning traditional valuation methodologies may go out of the window.
Entrepreneurs and investors would benefit greatly if they could simply input traditional valuation metrics into an Excel model in order to arrive at the value of a start-up. However, there is no one-size-fits-all methodology that can be applied and for this reason many entrepreneurs and investors maintain the cliché that valuing early stage companies is more an art than a science.
Valuations of startups or early stage tech companies are certainly not a science with any consistency to the methods adopted. In recent years Stripe (a processor of digital payments) has been valued at $9.2 billion, Uber (technology based transport) in excess of $60 billion and on its recent admission to the NYSE, Snapchat was valued at $25 billion despite taking a loss of more than $500 million in 2016. The maths underpinning tech company valuations is clearly muddled. Geography is also at play when it comes to the value placed on startups. Valuations of startups are typically higher in Silicon Valley, for instance. Sector is also an influencing factor – Life Science startups (many of which are springing up in Cambridge, UK, due to its affiliation with one of the world’s leading research universities) are generally exhibiting higher valuations than tech startups nowadays.
“While the media is awash with stories where early stage tech companies have been valued on the basis of exorbitant revenue multiples it is more typical that valuations of startups will be conservative.”
Examples such as the valuation of Snapchat are exceptional in the wider context of startup valuations. Furthermore, like the real estate market, valuations will go up and down depending on market sentiment for the sector in which the company operates (the tech and life science sectors are booming at present). Additionally, lower valuations will be the norm during a recession and observably higher in boom times, when there is an abundance of capital chasing startup investment opportunities. Valuations of startups may also vary based on qualitative factors such as the perceived strength of the management team, location of the company, recent successful exits in the sector and perception of what the future holds for the sector.
Why Value a Start-Up?
Agreeing on the valuation of a startup or early stage company is often the main point of contention that must be negotiated between entrepreneurs and investors. Entrepreneurs will seek the highest value possible in order to maximize their exit value or in an investment round retain as much equity as possible in exchange for a cash injection, while investors will pursue a low value so as to own a reasonable percentage of the company given the amount they invest.
If a company is looking to raise capital, or an investor is considering making an investment, it is vital to determine the company's value to be put on the term sheet. The valuation of a company decides the percentage ownership an investor will receive in return for their investment. For instance, for an investment of $500,000, a pre-money valuation of $2 million would give the investor a 20% stake in the company – this is reduced to 10% using a pre-money valuation of $4.5 million. Looking forwards, the equity stake will determine the return an investor could make in the future in the case of a successful exit, such as via a trade sale, private equity buyout or more rarely, an IPO. The crux of the matter is the more equity the investor can negotiate for their money, the greater their possible future return.
The Psychology of Valuation
The savvy amongst tech acquirers will consider founder/owner psychology when formulating the valuation underpinning their decisions. In addition to thinking, “I want to maximize what I can get”, company founders often contemplate what would be enough for them to significantly change their life and be happy about selling their “baby." This is especially the case given the situation of a tech company acquisition. While the future prospects of a tech company may be promising, revenue may be minimal. In this situation an acquirer may ask themselves: What is the amount - $X million per founder - that would make it impossible for the founders to walk away from a deal? An acquirer may also look at the deal from the angle of needing to pay at least enough so that each founder receives $X million in order for the deal to be appealing to them and to close. In the case of investors (as opposed to acquirers), they usually apply more rational logic when it comes to appraising the valuation they are willing to pay.
In 2007, Jason Cohen, serial entrepreneur, sold his company. Cohen suggests that for a founder, after crossing a hypothetical “freedom line” of $X million there is not really that big a difference in post-deal lifestyle. Crossing the freedom line will fund a reasonable lavish lifestyle and in Cohen’s words, provide freedom from restrictions about what you do with your life, family and career. Cohen argues that a movement from left to right changes your life fundamentally – giving you the freedom to do whatever makes you happy, forever. If you are crossing from left to right, it does not matter how far to the right you go – of course, $100 million in the bank provides a different lifestyle than $10 million, but it is not as critical to lifestyle or happiness as just crossing the line.
An offer to the left of the freedom line could make the founders of a company want the valuation increased and result in them coming up with a myriad of reasons as to why the price is too low – for instance, “let’s wait a year and let revenue double”. To the right of the line the subject of valuation is mostly about if the founders wish to sell at all – therefore, how far to the right of the freedom line an offer for the company lays might be largely irrelevant.
In cases where founders have turned down insanely high acquisition offers (such as the $8 billion offer Snapchat received form Facebook after only a few years of existence) the founders have likely had their financial freedom guaranteed already (by selling some of their shareholding to investors as part of early VC rounds). Alternatively, founders may truly believe that a higher valuation will be offered in the future, with 90% certainty. If the founder is to the right of the freedom line, they can take such a gamble and walk away from astronomically high offers because it would not really make a real difference to them personally in terms of affording them even greater freedom (than was realized in crossing the freedom line in the first place).
When Finnish game studio Rovio (developer of Angry Birds) received their first major VC round of funding, the company was already so cash flow positive from their hit game that they did not require the money. The VC round was actually pocketed by the founders who could afford to gamble and subsequently turn down a $2.25 billion acquisition offer by Zynga in the hopes of becoming the next Disney as an independent company.
Why Buy a Startup?
The rationale surrounding buying a startup usually rests in the acquirer buying into fast time-to-market of the startup’s product. If it takes c.2-3 years to build a similar product, this might we worth tens or hundreds of $ millions for a large company. In the tech sector, the concept of “Local-Maximums” is observable. The premise is that at $1 million of revenue the startup has a proven product. This is the first Local Maximum. At $10 million the startup has a real line of business suitable for integrating into a large company (acquirers can start to see the startup as a $100 million -$200 million operation). This is the second Local Maximum. Moving beyond the second Local Maximum makes the valuation so high that IPO is often the only option. The problem is that, apart from the likes of Microsoft and Google, any valuation in excess of $300 million - $400 million is just too expensive for most companies.
Methods of Valuation Applicable to Startups
- Discounted Cash Flow (DCF)
- Future performance projections using metrics such as EBITDA, P/E & Revenue
- Venture Capital Method
- Berkus Method & Stage of Development
Discounted Cash Flow (DCF)
This is a common method for valuing the share price of well-established or quoted companies and also large capital-intensive projects (such as real estate, where returns may be expected over a long time period). A number of complex DCF models exist, which differ depending on the type of cash flow analysis used. However, the premise remains the same for all DCF analysis in that a company’s current valuation is pinned to the money (free cash) it is predicted to make in the future. More specifically, DCF involves forecasting how much cash the company is expected to generate in the future and applying an expected rate of investment return (discount factor) to calculate how much the cash flows are worth in today’s terms (present value). A higher discount rate is typically applied to startups since there is a far greater risk that such companies will fail to generate sustainable cash flow.
One of the flaws of applying DCF analysis to startups is that predicting future cash flows is essentially a guessing game (especially if the company is pre-revenue/in a developmental stage). Indeed, the quality of DCF analysis rests a lot on management’s ability to accurately forecast future market conditions and to make reasonable assumptions about long-term growth rates. In most instances, projecting revenue and earnings beyond the first few years for a company that has barely begun trading is fruitless. Moreover, it is notable that the output of DCF analysis is sensitive to the expected rate of return applied so this needs to be considered with some care.
Future Performance Projections - EBITDA, P/E & Revenue
Using historical evidence and projections of future performance is of relevance to early-stage valuations and becomes more important as a company builds up a trading history over time. This ‘multiples approach’ to valuing startups compares the company in question to a range of comparable ones in terms of stage of development and sector. The value arrived at is often expressed as a cash flow metric – for instance, enterprise value in the context of EBITDA (EV/EBITDA), price per share relative to earnings (P/E ratio) or as a multiple of revenue. In simple terms, if the average comparable company has an enterprise value of ten times its EBITDA and the target company has an EBITDA of $10 million, its enterprise value is $100 million. A drawback of this methodology is that under or over valuation of an entire sector could be mirrored in the valuation of the company. Furthermore, if a startup is being valued on the basis of ‘forecast’ EBITDA, sufficient skepticism should be given to any EBITDA trend curve that increases at an unrealistic scale-rate without robust supporting assumptions.
Online M&A databases such as PitchBook and Crunchbase can be used to research EBITDA/EV multiples, price earnings (PE) and earnings per share (EPS) growth among comparable companies (for instance, across the Saas and fintech sectors). Venture Capital investors favor the multiples approach to valuation since it provides them with a good idea of what the market is prepared to pay for a company via reference to recent acquisitions/investments of comparable companies in the market.
As an example, if fintech companies are selling for 10x EBITDA, knowing what investors are prepared to pay for such companies, it would be reasonable to start at a multiple of ten times. This multiple can be flexed up/down to account for different characteristics such as the stage of development – which would warrant a lower multiple given that investors are taking on more risk.
To value a company in its early stages, extensive forecasts must be compiled to account for what revenue or earnings will be once maturity has been reached. Investors will typically invest when they believe in the product/service and the business model of the company, even prior to being profit generative. While many established companies are valued on the basis of their earnings, startups are often valued based on a multiple of revenue since it is the only metric available if they are loss making (such as Snapchat was on its admission to the NYSE). Another benefit of valuing a company on the basis of its revenue is that revenue is a metric that falls before any accounting treatment can have a distortionary impact.
The multiples approach to valuation may well yield valuations that give a close approximation to what investors are willing to pay for a company (or a percentage of it). However, comparable market transactions (those of enough relevance to be worth considering) can be difficult to find. Furthermore, it is not easy to find companies that are closely comparable – particularly in the startup scene. Deal terms are often kept a secret by startups as they may be in competition for further investment funds with competitor startups.
What if a Company is Loss Making?
Many startups (and even established) tech companies are loss making. This is one of the reasons why the industry standard in the tech sector is to value companies on a multiple of revenue, because it is the only metric available of any meaning. Trends over the past 10 years show that tech/SaaS revenue multiples can be 5-10x (see below). In the instance of startups, negative earnings are often the norm since companies cannot generate sufficient revenue to cover their base cost (which in the instance of a tech company may be exorbitant if highly educated and expensive software developers are being employed, for instance). However, within the tech sector, the risk/reward ratio of investing in a loss making company that may go on to be the ‘next big thing’ is often too compelling a prospect for many investors – hence why so many investors back loss making companies such as Snapchat when they IPO. In evaluating a loss making investment opportunity it is important to:
- (i) question if the loss making position is temporary or permanent (is the company addressing a defunct market sector?)
- (ii) consider the risk/reward ratio and
- (iii) consider the competency of management.
Berkus Method & Stage of Development
The Berkus Method - blurring lines with the Stage of Development approach to valuation - can be used in the instance of a loss making startup and negates the need to analyze forecast financials. It assigns a monetary value to certain parameters and critical foundations of a company (such as competence of the management team, proof of concept, etc.). The valuation of the company increases as the credibility of these factors increases, up to the point where the company is revenue/profit generative – at which point the methodology is no longer applicable.
"Rules of thumb" values are assigned by investors, depending on the company’s stage of development. The more advanced the company is the lower the company's risk and the higher its value. A simple Stage of Development model might resemble that below.
The value ranges decided upon will vary depending on the type of company in question (sector) and the investor. Startups with a mere business plan will receive the lowest valuation from investors but as the company succeeds in meeting tangible development milestones investors will be willing to assign a higher value to the company. Capping the pre-money valuation at, say $5 million, ensures investors can invest for a reasonable percentage of equity – therefore providing the opportunity for the investor to achieve a sizable return on investment (ROI).
Venture Capital firms may adopt a similar approach where they provide additional investment when a company reaches a set milestone. For instance, the funds from a Series A investment round may be ring-fenced for the development of a prototype product. Once proof of concept is achieved a subsequent Series B investment round may help the company take the product to market.
Venture Capital Method
The Venture Capital Method uses multiples in respect of future earnings to work back to a valuation in the present day. In essence, after-tax earnings for the expected year of the company’s sale (a five-year exit window is typical for many startups) must be forecast and an industry specific P/E ratio then applied to determine the company’s anticipated selling price. Taking the selling price and desired return (expressed as a multiple of initial investment – ROI) it is possible to work out the post-money value of the company (equal to sale price on exit divided by the desired return on investment). Subtracting the amount of investment in the round yields the pre-money valuation for the company. A worked example would be where after-tax earnings in year five are to be $5m with an acceptable industry P/E multiple being 7x. This would give an anticipated selling price of $35m in year five. If a 4x ROI is required by the investor the post money valuation of the company would be $35m/4 = $8.75m. If the investment in the round is $1.5m the pre-money valuation of the company would be $7.25m.
A Word on Discounts
When a company is bought the stake in question is very important – majority shareholders (typically in excess of 50% of the voting rights) have access to their share of profits and, because they can petition for a winding up of the company, their share of net assets. Minority shareholders have access to the dividends majority shareholders may elect to pay and a share of the net assets if the majority shareholders wind the company up. Accordingly, since minority shareholders have little power and no control, a 10% share of a company should be less than 10% of its aggregate value. Conversely, an 85% share of a company would typically be worth more than 85% of the aggregate value of the company. Majority shareholders should therefore be prepared to pay a premium for control when buying/investing in a company. It is for this reason that founders usually do not accept acquisition offers at the same valuation as they are willing to take investment money in for. Furthermore, private companies usually should have a valuation discount (compared to public companies) as their shares are less liquid. However, because they are scaling at a much faster rate and offer greater upsides for a buyer, they warrant higher multiples (even after the discount).
Summing Up - Common Themes
There are a number of common factors that will influence the value of a startup company. While some of these relate to the type of company (tech/fintech/SaaS) some factors relate specifically to the company – these cover the competence of the management team, stage of development/proof of concept and the overall business plan. Others factors influencing the value of a startup relate to the potential market, the size of comparable deals in the sector, the size of previous successful exits in the sector (plus the perceived likelihood of an exit) and the number of competitors. In summary, a startup company is likely to achieve a higher valuation if a number of factors are met:
- Attractive Sector – investors will be more likely to queue up and invest in an attractive sector and may even pay over the odds to do so (tech and life sciences are hot right now);
- Functioning Prototype/Proof of Concept – this serves to validate the business model (to an extent) and lends credibility to the venture;
- Strength of Management – a strong management team provides investors with the assurance that the business plan will be realized and that value will be returned to them in the future via a successful exit;
- Customer Validation – a company that has already on-boarded customers will demonstrate to investors that the company has value;
- Cash Generation – a company with the ability to generate cash will be a much more attractive prospect to prospective investors.