When we value a company with the intention of potentially acquiring a percentage of its capital, the objective of an analyst is to approximate the intrinsic value of that company. This way, once we proceed to acquire a share of the firm, we’re able to determine the most accurate price possible. As investment analysts, we often find ourselves in front of entrepreneurs in search of financing who are trying to determine the real value of their company, or more specifically, at which valuation (or price) they should be “raising” capital. To better understand this, I’ll define two concepts that are crucial:
- pre-money valuation: is the value of the company prior to the entry of new capital in exchange for the issue of new shares.
- post-money valuation: is the pre-money valuation + the new capital invested.
When we talk about venture capital (VC) investment, the companies we refer to usually find themselves in early development phases. Due to this, the majority of methods known for valuing companies (e.g. cashflow analysis, multiples, …) are not entirely practical, given that the methodology has been developed to value companies in phases of greater consolidation.
Some of the main challenges that we face when we value a start-up are the following:
- Limited corporate history: Due to the youth of the company, the historic financial information normally used to project a hypothesis into the future, tends not to offer more than two years’ worth of information (this is the “best case” scenario).
- Binary events: These same companies tend to confront many “life or death situations”. For example, the signing of a contract with a relevant client, the approval of a new regulation pending resolution…
- A significant innovative component: Many start-ups today are looking to disrupt the market through a technological component.
- Typical VC market characteristics: Illiquid market, potential dilution in subsequent financing rounds…
For all these reasons, we believe that is it not always useful to concede a fixed value to a company. We understand that in some cases, future revenue expectations may be so ample that it makes sense to assign a variable valuation to a company.
How can that be done?
Given that the valuations of start-ups normally depart from a forward-looking business plan, one of the most coherent forms to assign a present value to a company, is by aligning its value with the fulfilment of the objectives set in the plan elaborated by the entrepreneurs. This is done, by applying a variable valuation clause in the case of the fulfilment of said objectives.
The idea is simple. Normally entrepreneurs and investors tend to have opposing interests when it concerns the valuation of a company. The former, tends to demand a higher valuation to that required by the latter. In order to satisfy both parties and align their interests, one of the best options in an investment round is to run it at a set valuation, but with a clause that includes the issue of new shares in the name of the entrepreneurs, in case the objectives set in the business plan are met.
A company is looking for € 400,000 in financing and believes its pre-money valuation is € 2,000,000. Meanwhile the investor, who is indeed quite interested in investing in the company, considers the pre-money valuation of the company to be € 1,600,000. Both parties could agree to undertake the capital raise with the following two conditions:
- Condition: In the case that the objectives set previously are met in the following two years, as agreed, the entrepreneurs will have the right to acquire a number of shares at nominal value, issued as new shares of the company as part of the financing round. These shares will equate € 1,800,000 at the present financing round valuation.
- Condition: In the case of achieving the previously agreed objectives set 100% in the subsequent two years, the entrepreneurs have the right to acquire a number of shares at nominal value, issued as new shares of the company as part of the financing round. These shares will equate € 2,000,000 at the present financing round valuation.
The result would be the following:
While the investor sees their percentage share in capital acquired reduced, in the case of such an instance, the shares in his/her name would have significantly increased in value and the uncertainty component would have notably reduced.
In conclusion, considering that approximating the value of a start-up is not an exact science, at Faraday we believe a practical and method of estimating the price of an emerging, innovative company in an illiquid market is setting a variable valuation based on previously defined objectives within the business plan.