The fair market value for your business
When approaching a funding round or a business exit, one of the first topics that a startup founder typically wants to consider is valuation. Essentially valuation is an output reached by balancing the beliefs held across the two sides of a fundraising or M&A transaction.
Both sides to a transaction can use an array of corporate finance tools to inform their view on the company's value, and this may influence how they offer or accept terms. However these methods rely on accurate forecasts of future performance, which are hard to generate for early stage businesses with limited track records. Even at the best of times, with access to great data, technical valuation methods are as much an art as they are a science.
Below we provide an overview of how these tools work for scaleup businesses, outlining the data inputs required as well as the merits of each approach. We then discuss what early stage startup companies should consider when meeting investors or acquirers.
Valuation for scale up companies
Most scale ups build a dynamic financial model that helps them to both track performance and prepare for the future. Using historical revenue, earnings and cash flow data, the modeler is able to identify trends and inter-dependencies in the business' performance. These are then used as assumptions to underpin forecasts of future activity.
Once a credible set of financial forecasts have been generated, they can be applied to the two most common valuation methods:
The discounted cash flow method
A discounted cash flow provides an 'intrinsic' valuation of a business, i.e. calculated without reference to the values of similar businesses. This approach involves taking the forecast 'free cash flows' for a period of 5 - 10 years, so the cash that will be available to the owners of shares or debt, and determining how much that income stream is worth today.
The concept of 'Net Present Value' suggests that the value of a payment received today is more valuable than the same payment received tomorrow, or at any point in the future. This is because that payment, and more specifically its 'purchasing power' when it is received, are uncertain. A DCF reflects that uncertainty by discounting future cash flows using the 'Weighted Average Cost of Capital'. The WACC is the blended rate of return required by your equity and debt investors, calculated with reference to your company's risk profile.
A DCF is useful as it mostly depends on the forecasts to determine the valuation. This means that it can avoid the effects of market cyclicality on the result (although these are still captured to some extent in the WACC calculation). It's main drawback is that often, and in particular for high-growth tech companies, a significant portion of the company's valuation is driven by cash flows beyond the 5 - 10 year forecast period. This element is highly uncertain and its value often approximated using either a perpetuity valuation tool or the multiples approach.
The multiples approach
The multiples approach involves finding similar businesses with known valuations, either 'trading' or 'transaction' valuations, and comparing their operating metrics to those of the business being valued.
For example, a fintech scaleup planning for a funding round will find a group of businesses in the same or adjacent sectors who have raised capital recently. If one of these raised at a valuation of £50m and had 5,000 users at the time, then it an argument could be made that a valuation of £10,000 per user is fair.
This approach relies on the reference-ability of similar businesses and their transactions. It is a less detailed approach than a DCF but also useful, not least because it can also be applied to historic data (removing the need for forecasts). Whatever metric is used to underpin the comparison, it is important to also consider how this metric is evolving. A scaleup with a high revenue growth rate will attract a higher revenue multiple than another with less exciting prospects.
The big drawback of multiples valuation is the dependence on wider market valuations. If there is a consensus that the multiples of comparable companies are unreasonable, then the effectiveness of the approach decreases.
Most startups, and in particular tech companies, have not yet built up a bank of historic performance data that they can use to accurately forecast future revenues and cash flows. As a startup develops into a scale up, potentially using financial support, their ability to forecast increases and this supports further financing rounds.
In the meantime, the fair market value of a start up should really be viewed as an intersection of the supply and demand for capital. An entrepreneur presents their vision for their business to an investor, who then assesses the credibility of the plan and its suitability for investment. When an equity investor deploys capital into a start up, they are essentially making a bet that:
- This founding team...
- ...delivering this business plan...
- ...against the expected level of market competition...
- ...to address this target market...
- ...using the money raised in this round (alongside any expected future raises)...
...is expected to deliver a return of 10x or more.
Selling the story
Your ability to evidence of the points above will contribute to the attractiveness of your transaction to venture capitalists. Preparing materials that demonstrate the appeal of your business, while answering due diligence questions that your potential investors might have, will maximise your chances of a successful raise.
A start up, when compared to a later-stage scale up, will have fewer data points to demonstrate the demand in the market for their services. Instead they must demonstrate a thorough understanding of their industry and how their product fits in - ideally gleaned through interactions with a base of 'early adopter' customers. A startup founder's initial focus should therefore be on building and documenting these relationships. The process of growing a business is rarely linear, and investors will look to see how you have adapted your business to better address the needs of your early customer base.
Your ability to attract and retain customers will become increasingly important as you move towards late Seed and Series A rounds. Here investors will seek to understand both the customer acquisition model that you will use to scale, and how much value you generate from each of your customers. Strong 'unit economics' are evidenced by the fact that each new customer generates more revenue (and cash flow) than the cost of signing them up (so customer referrals are really great here!). These factors are often shown as a ratio of Customer Lifetime Value (LTV) to Customer Acquisition Cost (CAC). If you would like to understand this metric better, our expert freelancers can help you to determine how this applies to your business.
Alongside market demand for your service, you must also articulate how your company will use the money that you are raising to win new business and increase your market share. Whether this is to be achieved by further product innovation to better match the needs of your customer base, or to drive revenue growth directly through performance marketing, you will need a clear capital investment plan. It is important that your business model is clearly explained, and particularly how you and the management team have the right skills, network and knowledge to deliver it.
Understanding how venture capital works
If you are considering approaching VC firms, it is important to have a thorough understanding of how their investment model works. It is not uncommon to see entrepreneurs with fantastic businesses that miss out on venture capital funding. This is not because these businesses are not attractive investments, it is simply because the risk profile is wrong for this group of investors.
A VC fund will invest in a broad range of portfolio companies with the expectation that 40% will fail completely, 40% will return the original investment but nothing more, and that 20% will blow the lights out and return the value of the entire fund. A fund therefore needs to focus its limited resources on finding the next unicorn that has 100x potential and that is willing to move at breakneck speeds to achieve it. Even then c.80% fall short of their objectives.
Venture capital is ideal for high growth businesses operating in an industry that is undergoing transformation, but is far from the only source of capital. Do refer to our article on investor types for your Seed or Series A funding round here.
In response to the market conditions, investors in early stage startups have also adjusted the key factors that they look for in businesses. Gone is the 'growth at all costs' approach that received record investment over the last decade. Investors now want to see 'profitable growth' in the scale ups that they invest in.