13 Feb The black art of start-up valuation
By Matthew Cushen…
In last month’s column we explored the ingredients of a compelling investment proposal. One part of a deal to sell equity is the valuation of your business. In my experience this is where new entrepreneurs, and many an experienced one, are least confident. Valuing a new business seems like a black art, with its own language and with few rules.
Let’s try to clear some of the fog. Starting with some important language – which is actually simple with an example:
When setting the pre-money valuation, there are 2 simple principles that are worth keeping in mind:
- valuing a start-up is only vaguely related to valuing an established business;
- the only valuations that count are when two parties are prepared to buy and sell.
A mature business will usually be valued at some combination of a multiple of its profitability, the growth in that profitability and/or the value of its assets. For example, a chain of 50 fast food outlets might be generating £2.5 million profit per year. A typical ‘price earning ratio’ for the restaurant businesses might be 8, so based on profitability the business is worth £20 million. However, if the revenue and profit are growing fast then clearly the business should be worth more than if it is shrinking. So a business adding 5 restaurants a year and growing underlying revenues at 20% per annum might be worth, say, another £10 million. If the business has prime sites with long leases, with rent agreements protecting it from egregious rent rises and owns its own kitchen equipment it should be worth more than one with unprotected properties and few assets.
So it is possible with a mature business to be rational and objective – particularly in comparing the value of different businesses in the same sector. But even with plenty of information available there are also subjective judgements to make. Ultimately the valuation is a factor of what someone is willing to pay, and for what someone is willing to sell.
A start-up has much less solid data, so naturally the valuation is much more a judgement about ‘potential’. An entrepreneur needs to paint a picture across:
- revenue & profitability: Ultimately the business will be worth a multiple of its earnings. Investors won’t necessarily believe all the numbers but this is an important chance for an entrepreneur to demonstrate how they think the business model will make money – for example, illustrating how large a market it, what is the potential addressable market, an assumed potential market share, some sense of how much each customer might be worth and what it might cost to acquire them.
- speed of growth: The principle of ‘time value of money’ holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. So earlier returns to investors are more attractive than later ones. Also ambitious growth is useful for grabbing and then protecting market share.
- exit: Early stage investors are acutely aware that a business might be worth plenty on paper but they will not make an actual return until someone is willing to buy out existing investors. Stories about success, healthy multiple exits in the same sector, and that the entrepreneur is focused on an exit, will be attractive.
These points should show a healthy potential – that could be comparable to the value of a mature business. Then an early stage investor expects a discount against this valuation to reflect their risk (otherwise they’d invest in a mature business). Early proof points behind assumptions hugely help to reduce perceived risk and increase valuation.
When available, benchmarks from similar businesses are useful for both entrepreneurs and investors – and for both having an objective conversation. There is now an emerging history of valuations and deals for start-ups. Beauhurst is a database service that professional investors subscribe to. Regardless of whether you are interested in crowdfunding, those sites are useful for benchmarks. Experienced angel investors often see many pitches and will have a good sense of whether a valuation is expensive or not. When asking accountants it is critical to understand if they have experience in the start-up space – gut feel and experience are more important than traditional accounting techniques. Keep in mind, that it is the deals that get completed that provide a valid benchmark, if the potential and risk are broadly comparable. There are plenty of offers that don’t get funded – they are often an indication of unrealistic valuations.
Some investors will work back from their own targets on returns on investment. It’s useful to understand this, and provide the figure investors would require to plug into their own models (with the assumptions used to get there). But each investor is different, one using this approach might come up with a different target valuation from another so don’t get too drawn into their logic. There are some methodologies you might hear investors refer to, such as the Venture Capital Method, First Chicago, Berkus, Scorecard or the Risk Factor Summation Method.
Even if an investor is saying they are using a fancy sounding logic, the lack of quantitative data means emotional judgement features more strongly than analytical reason. It’s a human characteristic that investors do get swayed by what’s hot and how others behave. Worth Capital doesn’t directly target tech businesses, as valuations are too often irrationally high and display bubble characteristics. Crowdfunding is impact by the actions of – funnily enough – the crowd. Like a new restaurant with a queue outside, if a raise looks to be popular it will maintain momentum. Which is why the crowdfunding sites are generally saying you need to have lined up around 30% of a potential raise before kicking off a crowdfunding campaign.
Some entrepreneurs have a very clear and fixed view of their valuation. They set the price before getting in to a funding round and stick to it. This is easiest if it is further funding building on prior successful rounds or where there are solid benchmarks to compare to. Other entrepreneurs will keep the valuation discussion open and gauge interest from investors before settling on a price. Clearly this is helpful if demand is difficult to forecast and the benchmarks are opaque. And often investors are keen to follow a lead investor – where they perceive an industry knowledge that helps to understand the potential and the risks. It is not an option to negotiate different deals with different investors. Once a price has been found, different investors in the same funding round need to receive fundamentally the same equity price.
Hopefully these points clear some of the mystique. Setting a valuation needn’t be uncomfortable. But it is something worth careful thought, patience, research and conversations to establish. The results of this decision will stay with the business the whole of its life.