Defending Your Valuation

How should an entrepreneur value their company when they seek equity financing from investors? And conversely, how do investors value a prospective company when making an investment decision? Unfortunately, there is no definitive answer to these two important questions, however, identifying solutions to these questions is vital for both the entrepreneur and investor for several reasons. For investors, the valuation is important because the value of the company determines the proportion of shares they receive in return for their investments, and as a result, their return on investment. Similarly, the valuation is important for entrepreneurs as it attributes value to the efforts and resources put into building their business. An unjustifiably low valuation is a typical source of conflict between entrepreneur and investor. Understanding valuations from an investor’s perspective is a good way to ensure you are setting realistic and defendable valuations for your company.

 

What is meant by “valuation” anyway?

A mutually agreed-upon valuation by investor and entrepreneur is at the core of every successful equity financing deal. A valuation should reflect both what the entrepreneur considers an acceptable amount of ownership that may be given in return for the investor’s capital and expertise, and what the investor considers an acceptable reward for the risks of investment. Understanding how valuations are determined and altered over the course of a company’s life cycle is crucial to the entrepreneur-investor relationship and the company’s eventual success.

Valuations, in general, are fluid, the methodologies used differ by the stage of investment and the availability of quantitative and qualitative data, therefore negotiation between entrepreneurs and investors is key in the valuation of a private company. However, any private equity deal will focus on the “pre-money” valuation of the company. This is the value of the company not including external funding or the latest round of funding¹.  The valuation after an investment of capital is received is the post-money valuation

Post-money Valuation = Pre-money Valuation + Invested Capital

Investor ownership percentage = Invested Capital/Post-money valuation

Traditional valuations rely on the historical financial performance of a firm to predict future performance. With many early-stage companies, there is no historical financial performance. The post-money valuation can be simply derived by adding a known investment amount to the pre-money valuation. The most crucial and difficult calculation is the pre-money valuation, this metric is important as it dictates how equity ownership will be shared between the investors and the entrepreneur. For example, a company with a pre-money valuation of $10 million, a $10 million investment would equate to a 50% ownership stake in the company.

 

Deciding upon an appropriate methodology

Some of the most common and widely utilised methods for valuing private companies are: the discounted cash-flow method (DCF), the earning multiple method, the net asset method and the venture capital method. However, most of these methods were developed for well-established companies or companies in the public market and so there are some flaws when applying these to new ventures. For instance, the short operating periods of new companies and limited account information make calculating an appropriate discount rate and cash flow estimates difficult and earnings multiples cannot be estimated without actual or reported earnings. The net asset method focuses on tangible assets and fails to account for growth opportunities. The venture capital method is useful for evaluating growth companies and combines the DCF and earning multiple methods but is relatively subjective and shares similar drawbacks to the two previously mentioned.

For these reasons, early-stage companies are more likely to be valued using instinctual methods and as the amount of financial information disclosed increases more quantitative methods are employed. Two methods that use this approach are the scorecard method and the valuation by stage method. The scorecard method compares your company to similar companies (deals) in the industry, based on the stage of development, region, and sector to provide an average value. The main factors that impact the scorecard method include the quality of the management team, market size and sector.

In the valuation by stage approach, valuations are driven by subjective factors in the early stages. These include but are not limited to the assessments of the management team, expected capital requirements, sector volatility, expected time to market and route to profitability. As the company matures, more quantifiable data such as performance indicators and financial metrics are produced. The table below provides a simplified overview of the stages of development and the inverse relationship between investment risk and quality and quantity of data available. The high risk of early-stage companies often leads to a low pre-money valuation. Whereas in the later stages of development, investors can utilise financial models which reduces the risk of investment and translates to a higher pre-money valuation.

 

Stage of Development	Data	Investment Risk	Est. Company Value
Has an exciting business idea or business plan	Qualitative data (i.e., unique selling point)	Very High	$250,000 – $500,000
Has a strong management team in place to execute on the plan	Product validation, time to market	Very High	$500,000 – $1 million
Has a final product or technology prototype	Preliminary revenue	High	$1 million – $2 million
Has strategic alliances or partners, or signs of a customer base	Projected revenue	Moderate	$2 million – $5 million
Has clear signs of revenue growth and an obvious pathway to profitability	Quantitative data; (i.e., EBITDA, net income)	Lower	$5 million and up

Source: Investopedia

 

Using Actual vs. Projected financials

Investors are constantly reviewing business plans, many of which predict an aggressive growth strategy with forecasts claiming to be calculated under conservative assumptions. Investors are likely to discount these multiples and may identify the need for larger capital requirements than initially predicted.  One way to ensure you have set a defensible valuation is to have a solid understanding of the long- and short-term capital requirements of your firm and to use actual financials where possible. This will help determine how much must be raised at each stage when each investment round is needed and what significant (and quantifiable) milestones must be achieved between each stage.

 

Growth Rates and Value Drivers

Valuations are essentially about the future and so it is impossible to conduct analysis without the use of estimates; multiples are commonly used to quantify a company’s growth potential. The growth rates of a new venture or an industry provide an insight into what the future revenues and other operational statistics could look like. Market forces in the industry in which your company operates have a large impact on the valuation of your company. The higher the growth rate of an industry the higher the valuation of new companies in this industry. Figure 1 provides a breakdown of what factors are typically considered to drive value and which ones are potential causes for concern. Value drivers are specific to the industry and company stage (pre-revenue or revenue-generating), the key to setting a defensible valuation is to select the right value drivers from which to set your multiples. It is also important to minimise factors that may impact the discount rate used, and lead to a lower valuation. For revenue-generating companies, common value drivers are EBITDA and, of course, revenue. Whereas for pre-revenue companies, factors such as gross merchandise value (GMV), industry attractiveness and experience of the management team are considered.

 

 

Impact of your exit strategy

Ultimately, setting the correct valuation is important in the long run as it will determine your exit value and control rights. For investors, their overall return will be determined by the exit proceeds from an IPO or an M&A deal and the price they paid to invest, so it is in the interest of both parties to determine a solid exit strategy. All things being equal, larger long-term exit opportunities are positively associated with larger valuations. Private company valuations are often considered to be more art than science, however, there are methods for building a defensible valuation using financial metrics.  Whatever method is chosen, entrepreneurs should work with their investors to produce a plan focused on building value between each stage of development and understanding the different ways in which value will be measured.