Private company valuation is arguably one of the most important and often, opaque term in a private market transaction. Especially in early stage private market transactions wherein performance data is limited, the valuation can be a lot big function of the investment climate – it could be ‘entrepreneur wish’ (bull run) or the ‘investor wish’ (bear run) or somewhere in between. Having witnessed the valuation challenge from both investor and entrepreneur’s perspective (portfolio CEOs, close friends who are entrepreneurs etc.), I wanted to use this blog post to provide some thoughts around understanding some of the opaque aspects of a company valuation – (1) Highlight the risks of over-valuation – little has been said about this and I wanted entrepreneurs to appreciate the burden of unreasonably high paper valuations (2) Provide a rather simple framework around key parameters that determine the company’s valuation. While valuation will continue to remain at the intersection of art and science, having said that, this framework should give you enough to have a more intellectual conversation, with potential investors, around valuation while reducing the effect of the investment climate! This framework should also help you in identifying the right investors / board members.
Consider the following scenario – you are ‘hot’ start-up that had some of the best names in the investing industry line up outside your door. Your valuation expectations are met or even exceeded as you have chosen the highest bidder to invest in the company. The company raises more capital than initially planned. The media is ready for a front page splash. All is well! This is a great scenario for a company, having said that the valuation maximization mindset might have some consequences that many founders are ill-prepared to navigate –
1. Little room for error – the new investor wants you to grow at break-neck speed. Her intentions are obvious and justified, she wants you to raise more capital at a higher valuation (needs to justify to her investment committee that the valuation was justified or even cheap for that matter!). Just in case, the business is not ready for break-neck acceleration, you will still have immense pressure to press forward (– the board, the employees, the media etc.) – which might look good in the short run but could harm in the long run. Imagine the pain you might have to take if the company needs to pivot!
2. Down round to bring multiple complexities – investment climate has soured, you missed plan, competition raises capital, unit level profitability is back in vogue! You manage to garner capital but at a down round. Apart from the additional dilution that existing investors and you as a shareholder experience, high-quality employees will question the value of ESOPs – the trust loss can result in tricky situations with the firm finding it very difficult to attract high-quality talent.
3. High valuation with ‘crazy’ terms – you attract a higher valuation but with ‘crazy’ terms with respect to high & / or senior liquidation preferences, guaranteed IRR returns etc. While the terms might look innocuous, to the inexperienced founder, in light of the higher valuation but these terms can create value for new investors even if the valuation of the company is well below the headline number. In my experience, these terms complicate future financings with new investors either inheriting the same terms or just not investing.
4. ‘Cheer Leaders’ in the board room – existing investors have recorded the high valuation to their performance – you are golden for them and they can’t think beyond multiplying the value of their stake with the last round headline number. They stop asking important questions and the answer to all your thoughts is a resounding YES. High quality board members can definitely not save a poor business but can definitely have a multiplier effect on the outcome of good business and execution (it’s a 5-8 year relationship please choose carefully!)
5. If you have a hammer, everything looks like a nail – high valuation rounds are often accompanied by large capital infusion – makes ‘sense’ for the entrepreneur given the high price and the investor is aligned given she is trying to reach a target ownership. This overcapitalization causes founders to solve problems that do not exist or lower their bar in making new investments or acquisitions.
Well the next logical question is how does the founder (assuming she is not as sophisticated at valuing companies as investors around her) assess if the round is over-valued or not? Hard to answer this but following are some of the things to keep in mind –
1. Huge disparity in valuation offers across investors – try and understand the basis of the disparity. If there are some high quality investors at significantly lower valuation offers, you should be doing a deeper analysis of your projections and your ability to achieve them.
2. You miss internal plan (consistently!) but are still being offered a huge step up in valuation
3. Internal investor is looking to sell or not participate in the round – internal investors who could have potentially participated (barring those who have tapped out) in the round are not participating or are looking to sell
4. Global comps – check for valuation multiples of similar listed companies and understand where and why you lie on this spectrum – existing investor / banker should be happy to do this exercise for you.
VALUATION FRAMEWORK
At the cost of oversimplification, the company valuation is a function of ‘Growth’ and ‘Capital efficiency’ (I underline ‘capital efficiency’ as this is easily forgotten during the good times!). Double clicking on this, growth is a function of market opportunity, business model & business model scalability and competitive advantage while capital efficiency is simply how much capital will you burn to reach the desired market share and profitability numbers. Essentially investors are asking the following two questions before they come out with the valuation metric –
(1) “How do the numbers / key operational metrics look like when the company runs out of this round’s capital?” – the basis of this exercise is the founder’s near term financial projections. This a great opportunity for entrepreneurs to judge the investor and also educate themselves of the potential pitfalls – does the investor really understand what will it take to reach there? Does she appreciate the challenges? Has she seen such situations before? Does she call out pitfalls that they have not thought of? In my experience, highly sophisticated investors can call out some the aggressive or not so aggressive assumptions in those numbers. I believe this is the ‘science’ part of the valuation exercise wherein investors and founders can engage on assumptions that support or not support the ‘growth’ and ‘capital efficiency’ projections before the company runs of out of capital. In my experience, investors love it when founders can provide for strong basis (inside or outside data points) for their assumptions – expect a valuation bump up if you can defend your strategic positioning and plan!
(2) “If all goes well, how do the numbers look like at scale”? – this exercise typically happens without the founder and this is the ‘art’ part of the valuation which involves investors taking a leap of faith on multiple metrics basis potential market opportunity, market share at scale, profitability and a valuation outcome. I am yet to see anybody getting this absolutely right (forget getting it right consistently!) – the idea is not be accurate but be directionally correct – as vague as it may sound, the believability of the ‘entrepreneur’s vision’ and ‘historical execution prowess’ play a key role in helping the investor getting comfortable with these numbers.
It’s NOT entirely true that valuation is a zero sum game – If you create outsized returns for your investors, they will be happy to create more incentives for you in terms of salary, bonuses or MSOPs to take care of high dilution that you must have to absorb early on (this is not to say that as founders you become in-sensitive dilution because existing investors will compensate) This giveback could be very valuable for you as an individual! For example, 0.5% of $ 2 Bn valuation doesn’t dramatically alter the cap table but will create $10 million value for the founder! – having said that, this can’t happen till you have proven the fact that the company has created real value through a liquidity event (secondary sale of shares, M&A / IPO).
To Summarize –
1. Balanced approach towards maximizing paper valuation key to eliminating any turbulence / nuisance (down round complexities, crazy terms, poor board composition) from issues non-core to the business. (Keeping in mind that business issues will create enough turbulence already!)
2. High quality board members cannot save a poor business or execution but can have a multiplier effect on the outcome of a good business and execution
3. Work closely with potential investors, to understand their perspective on both near term and long term scenarios – apply judgment to what you wish to keep and what you wish to discard. These interactions should give you a sense of the intellectual depth of the investor which should form the basis of which investor to let onto your cap table (it’s a 5-8 year relationship choose carefully!). Highest bidder in the round might not be the best addition to your board.
4. It’s NOT entirely true that valuation is a zero sum game – if you create value, investors will be happy to give back amounts that will be substantial for individual founders
5. Everything starts from nothing!