How to value early-stage companies

More and more private investors are looking to throw their money behind early-stage companies on peer-to-peer platforms, but how can you ensure valuations are realistic? Kirsty Grant writes

 How to value early-stage companies

‘If you buy a share in an early-stage business today at £10, likelihood is you will not know whether or not you got it right in terms of valuation for some time’

There is a plethora of articles and blog-posts out there on valuing early stage businesses and most inevitably start with a series of disclaimers such as ‘valuing early stage business is an art not a science’, ‘there is no universal method for valuing start-ups’ or ‘the correct valuation of a start-up is the price at which a founder is willing to sell equity and an investor is willing to purchase equity’.

Unfortunately, all these platitudes are true. It is notoriously difficult and there is no universal calculation that can be applied to the process.

However, one very simple fact is often overlooked: the valuation at which you invest is nothing more than the base price for calculating your eventual returns.

If you buy a share in an early-stage business today at £10, likelihood is you will not know whether or not you got it right in terms of valuation for some time. What matters is how much you eventually sell your one share for: what is the difference between your eventual exit price per share and your starting price per share? That’s what determines your return on your investment and, fundamentally, that is what we are talking about when we talk about valuations of early stage companies.

Fundamentals explained

In early-stage investing, you’ll often hear the terms “pre-money valuation”, “post-money valuation”, “share price” and “equity on offer”. These are all just elements of the same calculation of the basic question: how much of this company will my money buy me?

A pre-money valuation is the valuation of the business before the new investment comes in. For example, Company A is ascribed a pre-money valuation of £1,200,000 by a prospective investor.

A share price is the price per one share of the company. The share price is entirely dependent on the number of shares the company has issued, so it is not a useful figure for comparing one investment versus another. Share price is calculated as: pre-money valuation ÷ number of shares (and potentially options) in issue.

Continuing our example, Company A has 150,000 shares in issue, so the share price is: £1,200,000 ÷ 150,000 = £8 per share.

Post-money valuation is considered the valuation of the business after the new investment comes in. It is calculated as the pre-money valuation plus the amount of new investment. Company A’s post-money valuation is £1,500,000 (£1.2m + £300k).

Equity on offer is the percentage of the company that investors will own after their investment, i.e. what portion of the company, as a whole, do your shares represent?

Our investor into Company A invests £300,000. This means the investor’s equity, after the investment will be 20%. There are two ways of calculating this to get to the same result. The first is investment amount ÷ post-money valuation (£300k ÷ £1.5m). The second is shares issued ÷ total shares and options post-investment (37,500 ÷ 187,500).

So…how are valuations determined?

Equity crowdfunding platforms operate as a marketplace and therefore, like any other marketplace, valuations are inherently linked to market forces: how much capital is currently available in the market for this asset class and how many similar investment opportunities are available to those potential investors?

The biggest determination of valuation is investor demand to get in on the deal versus the urgency and scarcity of funds for the entrepreneur.

Specific factors that can influence this dynamic, and which investors may want to consider include the following.

Comparable companies/industry averages

One of the most useful factors for investors to consider is the valuations generally being achieved by companies at a similar stage in the same or similar industries. Investors may then also wish to look at recent exit valuations achieved in that industry and timeframes to exit. This takes us back to the basic question: how much will I be able to sell my share for, and when?

Traction or ‘lead metrics’

One of the reasons traditional valuation methods (e.g. discounted cash flow models) aren’t suitable for early stage companies is that they are reliant on lag metrics, such as historic revenues, as a predictor of future financial performance. Many early stage businesses have little or no track record of financial performance. Investors will instead need to turn to lead metrics, such as user numbers and growth rates as a proxy for indicators of future revenue potential.

Market size/value

Generally speaking, a company that is targeting a large or very valuable market will have bigger the potential upside and this generally translates in valuation.   Investors also tend towards investing in what they know, so it can be more difficult to secure investors for products aimed at niche markets.

Team

An amazing team with high profile or experienced key members will be able to command a higher valuation as the higher the quality of the team, the more likely they will be able to build a successful company (or so their track record would suggest). For many investors the team is the most important factor in determining whether or not to invest

Stage of development

If a business is still just an idea then it is very unlikely it will get the same valuation as a company that has a product in the market with customers or user base.

Future financing

Considering how many rounds of finance a business will need to reach an exit point is another important factor. Is this a capital-intensive industry? This is important for a number of reasons.

Firstly, the need for extensive further capital will mean dilution for the founders and early investors, which investors should factor into their decision to invest. Secondly, if the business is highly dependent on further capital investment, this is another risk factor for the survival of the business.

When looking at an investment opportunity, I am not asking “what would I buy this company for today”? Contrary to the view of some investors, the task is not to guess at the exact value of the company as at today or even as at tomorrow.

For me, the pertinent questions are: is this a product that I can see being adopted and monetised? Is the product addressing a large enough (or valuable enough) market to sustain its growth/expansion targets? Is this the team to deliver on the above? All going well, what is a likely exit scenario for this business in terms of achievable exit valuations and time frame and further capital required to get there?

Taking all that into account, am I happy with that sort of return on my investment balanced against the risk of investing?

 

Kirsty Grant is investment director at Seedrs

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