Value, like beauty, is in the eye of the beholder. While experienced investors use a range of tools to calculate the worth of a start-up or early stage company, some also believe that valuation is more art than science. So what is this ‘black art’ and how do experienced investors make their decisions? By John Harris
The greatest barrier to calculating the value of a new-born business is the disconnect between the company’s founders, who often nurse it into life with blood, sweat and tears, and the potential investor, who wants to see it achieve big goals.
Initially, founders love the companies they have poured their time and energy into. They regard every day spent on it as another brick added to a magnificent edifice, a uniquely designed structure that needs just a bit more money to gain the success it deserves.
Battle-scarred investors view each investment as a potential money sump, capable of sucking up capital without delivering promised return. They won’t walk in the front door with cash unless they know where the exit is.
These divergent views meet over the deal table where the founders and the investors attempt to reconcile their differing perceptions with a number – the all important ‘pre-money valuation’ – which determines what percentage the founders will own at the end of an investment round.
VALUATION VOODOO
There is no rule book on valuing a start-up company. It’s a tough gig making predictions based on scant financial data, with millions of dollars riding on it. To inform the investment decision, a variety of valuation methods are applied and cross-checked. The results will vary though, and the most appropriate method depends on the type of company and the type of investor.
“The same company can have a different value for different buyers,” says Amanda Heyworth, CEO of Playford Capital, which invests seed capital into start-up and early stage technology companies.
“A stock broker with standard investment methodologies might value a company much lower than a strategic investor who sees a close fit with its existing product set.”
The risk/reward ratio is determined by answering the questions: how much money does the company need to succeed? How far and how fast will net revenues grow? What is its probability of success?
“It’s important that both founders and investors answer these questions in detail so that they start ‘on the same page’. Compatible goals and expectations help when negotiating valuation as well as other deal terms like funding milestones and management incentives,” says Heyworth.
Even if you’re not actively seeking capital, knowing the value of your company is sound business practice. Several valuation methods are used in the VC industry, often with the Venture Capital method as a starting point.
The VC method assumes the company is being built for capital gain by trade sale or IPO. It estimates a terminal value – the ‘exit price’ at which the company can be sold at a future date. This figure is discounted back for the amount of time, money and risk involved.
Other methods can then be employed to cross check the VC Method.
“Theoretically, the Discounted Cash Flow method produces the same result as the VC Method,” says Heyworth. “In practice, this is hard to do because it involves a lot more assumptions about the precise timing and size of future cash flows.”
For an IP-rich start-up, another useful cross check valuation is the Technology Replacement Cost method, which calculates the time and money an acquirer would have to spend to recreate the technology.
PREDICTING THE FUTURE
Geoff Thomas, CEO of Paragon Advisory, the investment advisor to Adelaide-based venture capital firm Paragon Equity, says valuation techniques usually fall into one of two camps: measuring the past or measuring the future.
“As a rule of thumb, the more mature the company, the more it relies on measurement of the past,” he says. “The Multiple of Earnings technique – which applies a multiplier to current or past earnings – works best for established companies with steady profits.”
However, it is inherently difficult to value a company with a limited history. This is where the black art comes in – how do you measure the future? You don’t measure it, of course, you forecast it.
“Ultimately, companies are worth the sum of their future free cash flow – that’s how much cash they can distribute to their shareholders,” says Thomas.
“While discounted cash flows are the main measure of very early stage companies, the challenge is in deciding who will produce the cash flow forecast to make it believable.”
Thomas recommends a bottom-up approach, where turnover projections and costs are built from the bottom up rather than from the top down. This method uses actual figures as a base for calculating how much it will cost to get into the market.
“Costs come before sales – that point is often missed,” he says.
SUBJECTIVE MEASURES
The valuation of start-up companies is difficult not only because it involves measuring the future, it also involves measuring intangibles, such as ideas and passion.
“When a company does not have a trading history, we tend to look at three areas: market potential; the quality and uniqueness of its ideas and IP; and the passion of its people,” says Garry Whitelock, Associate Director of growth-focused accountancy firm BDO Chartered Accountants & Advisers.
“They are very subjective measures and sometimes you can’t turn them into numbers,” he says.
To a certain extent, the VC or business owner can avoid assigning numbers to intangibles by looking for comparables. In performing a comparable evaluation, the VC looks for established players in the same industry, with financial history and a similar business model. Public companies usually start with private financing and, thus, a valuation. Combined with a history of financials on the public record, realistic growth rates and cash flows can be projected.
While it is prudent to base any valuation on as much actual data as possible, Whitelock says there is no “algebraic formula” for valuing a company because there is never a perfect market.
“Sometimes the valuation process is just smoke and mirrors,” he says. “Some people lick their finger, hold it to the wind and say ‘it’s about right’.”
As the main negotiating tool in the equity stakes, the pre-money valuation can be manipulated to suit the purpose of investor or founder. There is no definitive answer to the valuation question, and price is only one aspect of the deal.
“Founders must also evaluate the other things an investor brings to the table – including their contacts, experience and ability to work with you to help you succeed,” says Heyworth.
“It comes down to a fundamental choice – do the founders want a big piece of a small pie or a smaller slice of a much bigger pie?”
John Harris is Managing Director of Impress Media Australia.
* Disclosure – Playford Capital is a client of Impress Media.
