Valuations in early-stage investments
Recent posts have focussed around the technical aspects of structuring a transaction. We’ll be returning to that theme, but in the meantime, we’re going to take a look at the massive issue of how venture capital investors value a business when they first invest.
Valuation is a big topic. Books galore have been published about company valuations. It could sustain a career in academia.
David Smith sets out some thoughts about one approach over a longish blog, which might help both founders and investors understand each other’s position – and get to a deal.
It must be stressed: this is just one approach. There are many. But it’s food for thought.
Let’s keep it simple
Initially we’re going to look at valuations based only on simple equity investment: £X of cash for Y% of the company = £Z headline valuation. Things get complicated if you introduce, say, convertibles, discounts, or liquidation preferences. For the moment, just note that as soon as you move away from plain ordinary share capital investments, both founder and investor will start to struggle to work out what valuation has been agreed. Maybe that’s the point.
Quick introduction to a valuation methodology
The value of an investors’ stake today is the value of his stake in the future, on some hoped-for exit. It may be that they get bought out by a later-stage investor, or on an IPO, but generally it’s a trade sale, if it happens at all (and of course, it generally doesn’t).
Here are the moving parts that together drive today’s valuation:
- What is the business going to be worth?
- How much will the investor still own?
- What’s the chance of success?
- How to account for differing hold-periods – the time-value of money
Let’s take these parts one at a time.
The future valuation
It’s really about discounted cashflows…
An acquirer will value the business based on the net future cashflows they expect to acquire.
That doesn’t necessarily mean that the target will be cash-generative (or even have any revenues) on exit. So an acquirer may buy out a possible competitor before they get traction – maybe a start-up barely in revenues that they can commercialise better than the target. A lot of Big Tech’s M&A falls into this category.
Whether or not the target exits on the back of historic revenues, acquirers value the target based on what that future earnings the target could deliver by itself, if any. They will also add-in any extra cashflows due to the acceleration in revenues and any cost savings which the acquirer can deliver (how much, if any, of the value attributable to those synergies gets paid over to the target shareholders is a matter for negotiation).
The acquirer will typically value those cashflows using a long term discounted cashflow analysis. That is the business’s net present value, or NPV. The stock market works in the same way.
….but we tend to use multiples of revenues and profits…
This NPV basis of valuation tends to throw up statistical patterns and groupings. A bunch of similar businesses valued on an NPV basis may also demonstrate fairly similar ratios of valuations-to-current revenues, with some outliers. This grouping likely implies that buyers and investors have broadly similar expectations of future growth in earnings between these various companies. SaaS businesses quoted in the US, for example, are presently (early July 2020) grouped with a valuation / revenues multiple of mainly between 4X and 8X, with some outliers valued much lower and some much higher. Differences within the cohort will owe a lot to their varying individual growth rates. You see a similar grouping in multiples of profits.
These ready-reckoner multiples are genuinely helpful but it’s worth remembering that they are a by-product of more fundamental NPV analyses. Remember also, in using revenue multiples, that it’s ultimately cash-profits that really count.
We can get data on valuation multiples either from published information on quoted companies in the same sector, or the much skimpier disclosures on private company sales. There’s an element of interpretation needed for both that would fill an article in itself. The main point is that the target will almost certainly get bought for a lesser multiple of revenues or profits than the acquirer itself commands, reflecting synergies, differing growth rates, scale and the relative stability of acquirer versus target.
When DSW Angels make an investment, given so many uncertainties, there’s little point putting us in the shoes of some hypothetical future buyer and creating a full NPV valuation model. But we do need a guide to what we expect a successful exit to look like – for which we use the above rules of thumb. Typically, we apply revenue or EBIT multiples relevant to the particular company’s sector, flexed for factors such as the forecast growth rate and relative levels of recurring revenue. We tend to assume that market multiples will remain stable over time – at a long-term average, not at the top of the market.
Let’s take the case of little SaaSco. Revenues might only be tiny. But, if it delivers its plan (the realistic one, not management’s stretch case or boldest dreams, and one which they’ve as much chance of beating as falling short) then in five years we believe it might be capable of £25m revenues with EBIT of £6m. We’ve been offered the chance to invest £1m for a 20% post-round stake, valuing SaaSco at £5m post-money. Question: is this good value?
We map this profile (size, growth rate) against a bunch of comparable SaaS businesses in its sector. There’s a range of valuation multiples but, having factored in our growth rate and size, comparable quoted companies seem to get on average a multiple of, say, 5X revenues and 18X EBIT. We also assume we get a lower multiple than listed peers for the reasons outlined above – maybe a 40% discount. We also have some exit valuation data for comparable private company transactions, but this is much sketchier: likely we only have revenue multiples and in this case an average of 4X.
Our rule-of-thumb exit analysis, based as it is on plenty of assumptions, estimates, and simplifications, is as follows:
There are plenty of other ways we could have arrived at our exit-valuation guesstimate of £80m. This is just one of many arguable figures. But the important point is that we’ve at least got some idea of where we might be heading.
Remember, we’ve been offered a 20% post-round stake so, by the above analysis, our share could be worth £16m on exit.
Timing of exit
So, we now have a (very) rough feel for what our investee company SaaSco might be worth on an exit. But when will that be?
This matters because of the time-value of money. An early return can be recycled to earn another return. An early return is also at risk for less time.
Investors might get the opportunity to cash-in before an overall exit (maybe a series A investor might buy-out the seed-stage investors for example) but that is an exception, so expect to be locked in for the whole journey.
How long that journey takes for a successful scale-up business is partly a function of the stage at which you make your investment. A pure start-up is, on average, further away from being bought-out than a scale-up business with substantial revenues – for example, early stage investors Nesta quote an average hold period for their deep-tech start-ups at around nine years.
We also need to consider what factors crystallise a successful exit. These vary by sector and individual. Development of a novel therapeutic, for example, is a notoriously slow process. Contrastingly, the software vendor which scales quickly and poses a threat to a big tech group might exit early (or miss the bus and get crushed; life’s like that). So, understand the sector: who’s buying and what do they want – scale, or new ideas; revenues, or profits? Look back at the business plan. If the business succeeds, when would it be primed for an exit?
Absent any market intelligence, use some market averages. Our present focus is software and consumer businesses. In those sectors, our working assumption is that a successful scale-up with early revenues should be able to exit in three to five years. Add an extra two years if the founders are still trying for product-market fit.
In the case of little SaaSco let’s assume that year five has the right feel. Much sooner and there’s not much evidence of M&A, much later and we worry that market opportunity might be running out.
Of course, real-world outcomes will be all over the place, and driven by factors like global financial crises, poor execution of the plan, or founders who just don’t want to quit just yet. But it’s better to have some idea on timing than none at all.
How much will I still own
So now we have a hope, if not an outright expectation, that SaaSco will exit in about five years’ time for £80m valuing our stake at £16m (maybe).
But how much of our stake will we have left?
The issue is the dilution caused by subsequent funding rounds, and it’s important to split the analysis into three cases:
- In some cases, we absolutely know that there will be a need for follow-on funding. This is a given for most SEIS investments, or early investments into deep-tech ventures, but less so for in-revenue software or consumer propositions for example. In the former cases, dilution needs factoring in – we pretty much are guaranteed to be diluted.
- Most scale-up business plans forecast that the business can scale to profits with the monies from the planned investment round. In reality often they don’t. So, even if the business gets to an exit as planned, your investment takes a hit along the way, as you make room for further funding. For these cases, the prudent investor might plan for some dilution.
- In others, there may be an opportunity for super-charged growth, funded by additional rounds of investment. Maybe there’s an acquisition possibility, or a move into a new set of geographies. We might get diluted in these circumstances but, as this bolt-on strategy should move our exit valuation upwards, at least in theory it should more than pay for the dilution and we can ignore it.
Back to SaaSco. The hoped-for growth in revenues is uncertain, but the proposed spend is discretionary and controllable. It doesn’t feel too risky. There’s no absolute requirement for follow-on funding. That said, once we’ve started hiring staff and developing a market presence, we won’t want to stop. If revenues are promising but just a bit behind plan, it might well make sense to raise more funds. There’s a half-chance that this might happen. So, just to be on the safe side, let’s factor in a (finger-in-the-air) dilution of, say, about 15% to 20% – meaning our share wouldn’t be £16m, but nearer to £13m.
What’s the chance of success?
Investors know that any one investment is likely to disappoint – only a minority meet their potential. So, we need to work out what the average outcome is likely to be by factoring in probabilities.
As you’ll see in the next section, we also need to factor in a further discount for timing.
Valuation models often conflate the two factors. In our view, that makes it impossible to make sensible estimates of either so we recommend that risk and timing be kept separate.
So how do we work out an average, probability-weighted outcome? Well, it would be possible for those with the time, insights, and technical capacity, to produce a multi-scenario analysis. This might model numerous exit valuations and timescales Bearing in mind just how rough-hewn are our estimates, however, we tend to keep the analysis simple, focussing on a very limited number of outcomes.
Here’s how the analysis might work in the case of SaaSco. It takes into account some rough statistics about the success rate of early stage VC backed businesses generally (see our previous blog on the importance of creating a portfolio) overlaid with the investor’s own intuition. In this case, we are mindful that around nine in ten venture-stage investments return an overall average of just cost but, conscious that SaaSco is already in revenue, with an excellent team, and well-developed strategy, we’ve improved the odds slightly.
We model just a single success scenario, where SaaSco returns the valuation modelled above (this simplification bundles together a range of outcomes, from a so-so exit right through to hitting the ball out of the park). Remember the assumptions: that the funding round is for £1.0m, that we are investing it all ourselves, and remember our rough guess estimate that the stake we’ve been offered could be worth £13m on exit.
So £1.0m in gets you £2.8m out. A 2.8X cash-on-cash return or, to put it another way, a 180% clear profit. Not so shabby. But is this return good enough?
How to account for differing hold-periods – the time-value of money
Future monies are worth less than money today (usually – we’re entering a world of negative interest rates, but that’s beyond today’s discussion). A longer investment hold-period drives the need for a bigger return. Reversing the logic: the longer the hold, the less your gain on exit is worth on a per annum basis.
First up: calculate what per annum return you expect. This is a compound-money calculation, so the annual return is the nth root of the cash-on-cash return where n is the inverse of the hold period, less your stake monies. In this case, the calculation is:
2.8(1/5) – 1.0 = 22.9%
So we reckon we’ll earn an average 22.9% per annum over each of the five years, compounding up to our overall five year 180% gain. But, to repeat the above question, is this return good enough?
To answer that question, you need to establish a benchmark or minimum return. This benchmark will vary from investor to investor, fund to fund, but the top-level consideration is common to all; how to price-in the downsides of venture capital investments:
- Equity risk: venture capital investments are usually equity investments, like stock market quoted shares. They should earn at least the same return.
- Illiquidity: unlike listed company shares, however, they’re unquoted and illiquid. There should be an extra return for being tied-up for 3, 5, or maybe 10 years.
- Volatility: they are individually riskier than their listed counterparts and, although a portfolio approach can diversify away much of that risk, it’s harder to create a portfolio of 100 VC investments than with listed shares. So, there’s some residual un-diversifiable risk. Even a diversified portfolio of fragile venture capital investments might prove more volatile than a listed equivalent. This all needs pricing-in as well.
- Costs: a diversified portfolio of listed shares can be bought nowadays for almost a negligible percentage dealing cost. Venture capital investments are more cost-and-time-intensive. A direct angel investment is going to need your time, attention, and sometimes emotional capital. Venture capital managers charge fees and carried interest charges (note: DSW Angels charges a carried interest but no ongoing fees directly to its angel investors).
Let’s put some numbers to the above. Continuing a theme, where data is available it is opaque, and some of the above factors will be subjective or specific to your own circumstances. Let’s do our best in the circumstances:
- Equity risk: we should aim to make a return at least as good as listed equities. This is usually estimated by academics at the long-term gilt yield (the risk-free rate) plus an equity risk premium. The risk-free rate is nowadays barely positive, even on long-term investments. The equity risk premium is usually estimated at about 5%. Put the two together gives you a figure of around 7%, probably a little less in the present market. That’s the expected return on the stock market that we should aim to better.
- Illiquidity: There is precious little market data on the illiquidity premium; most analyses are about private equity investments and they highlight the extra returns that come from high levels of gearing, not from illiquidity. In any case, the cost or inconvenience of illiquidity is largely a personal issue. A younger investor with strong income and reserves will be more relaxed about being locked-in than an investor close to retirement with a limited portfolio. Let’s assume our hypothetical investor is healthy and wealthy, and looking for just an extra 2% for illiquidity.
- Volatility: there’s an academic way of calculating this premium, assuming we had the data. Maybe in years to come we will have some reliable data about this asset class: at the moment we don’t. Let’s make a guess: our investment individually and even as part of a portfolio is 20% more risky than the stock market, so let’s price-in an extra 20% of the equity risk premium of 5% – so that’s another 1%
- Costs: let’s do the maths. A 20% carried interest over a five-year hold is a 4% annual cost. Together with other fees, let’s add in a total of say 5% for costs.
It adds up quickly: our benchmark return needs to be 15%.
So, is this a good investment?
The estimated annual compound return: 22.9%
Our benchmark annual compound return: 15.0%
So yes, it passes and with some margin, but we do need to bear in mind the sweeping assumptions we made along the way. The investor should therefore be alert for any disappointing due diligence, or weak investment agreements, and maybe they should think about putting in place some liquidation preference protection?
This exercise doesn’t just generate a yes / no answer, but gives food for thought, and maybe it generates some actionable insights.
Calculating what stake the investor needs to take
Next question; what’s the lowest stake we could take and this investment still be worthwhile? Let’s say that SaaSco’s management have had a competing offer of investment: still £1.0m, but for less than our proposed 20% stake. We are minded to counteroffer. How low can we go?
Now we need to reverse-engineer the above calculations.
Let’s suppose the following variables remain unaltered: the amount of investment at £1.0m; the benchmark return is still 15.0%; we reckon to exit in 5 years; the post-round shareholders will get proceeds of £80m, less 20% for dilution; we reckon just to get our money back 85% of the time and on the odd occasion, we get a genuinely successful exit.
- We need to target average exit proceeds representing our cost of investment compounded up at our minimum rate of return, being £1.0m x 1.155 = £2.01m.
- Of that amount, 85% of the time we just get our money back, so across a portfolio of similar investments that would yield 0.85 x £1.0m = £0.85m.
- Which means that the remaining return has to come from the 15% of the investments that deliver a successful exit. At this stage in the calculation we are short by £2.01m – £0.85m = £1.16m of proceeds. We get this just 15% of the time, so when we do get a successful exit we need to target proceeds of £1.16m / 0.15 = £7.74m. That’s our share, out of total estimated proceeds of £80m as reduced by the 20% dilution we reckon will flow to investors in future rounds.
- That requires us to take a stake of £7.74m / (£80m x 80%) = 12.1%
Of course, just because we could theoretically drop from 20% to 12.1% doesn’t mean we should do, but at least we have a limit to stop us from completely over-bidding. We’ve now got some discipline in our pricing negotiations.
Valuations in practice
Let’s be clear about early stage businesses. There’s usually limited data about current performance (think about a pure start-up), limited visibility on the chances and likely scale of success, and future market conditions and multiples are anyone’s guess. Oh, and there’s no general agreement on what methodology to apply. Or which benchmark will be relevant.
So, you’ll understand why – whilst conscious of the underlying principles – we also use instinct and rules of thumb. These might be multiples of current revenues at the point of investment; or maybe a tariff – a valuation range for pre-MVP businesses, so much more for product-market fit, and so on. The important points are that these rules-of-thumb are ultimately derived from a more fundamental analysis and that, during the course of negotiations, you should also run even a simplified version of the above returns analysis.
If you can’t make the analysis work then, really, should you be making the investment?
There’s a real risk in venture-stage investing of overpaying. Founders will always reference the best deal in their sector. Probably a headline investment into a stellar team with a top-drawer VC based on partial information. They will want you to pay the same. Prices get inflated. Bubbles form.
So, run some version of the above analysis. It keeps you sane. It maintains pricing discipline. Share the analysis with the founders: “tell me how I don’t lose money backing you on these terms”.
Do the sums and make money!
Partner, DSW Ventures