Valuation

The Great Valuation Myth

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Some years ago I was asked to assist a life science start up in Scotland with their valuation. They had an interesting technology, and had received interest from potential investors. There was however a significant difference between the valuation that the investors were willing to provide and the valuation that had been calculated on behalf of the start-up by a firm of professional accountants using a mathematical method.

Remember, this company did not yet actually exist, other than as a project, in theory, and a few pieces of paper in somebody’s bedroom.

The Mathematical Valuation Method – the accountants had taken the forecasted profits of the company over the future three years, and divided this total by provided by three in order to come up with a “weighted average” profit for the company over a three-year period. They then deducted 60% on the basis that this was a “projection” of profitability. Why 60%? Who knows? There really was no logic to this, just the selection of an arbitrary discount number. It could as easily have been 50% or 70%, (or 100%, given it remains unprofitable to this day!).

The accountants then produced a price earnings value (PE value) arrived from an unnamed and unidentified publicly quoted life science-based company from the London stock exchange. The PE ratio is a calculation of the earnings a company is making divided by the price at which it is currently quoted on the stock market. Fundamentally you multiply the earnings by this number to arrive at the value of the company. They chose a company with the PE value of 8.5. Again this is entirely arbitrary and we have no idea the validity or comparison of this quota company to that of the start-up.

Thy then discounted the PE value by 25% because of “marketability” (i.e. if you invest in the start-up you can’t sell the investment very quickly, whereas you could instantly sell a quoted limited company), and also apply a further 25% discount because obviously the quoted company is “much bigger” (and actually exits, with products, sales  and stuff). Together this amounted to a 50% discount against a quoted company. Why 50%? Again there is no logical reason for this. Purely arbitrary.

The accountants then took the specified price earnings ratio of now 4.25 and multiplied by the discounted projection of profits, to arrive at a “risk-adjusted valuation” of £3.9 million.

A start up, that does not exist, has no employees, has no office, no factory, no product, no customers and no suppliers, was apparently worth nearly £4 million.

This in context the average pre-money valuation of companies achieving funding in Scotland at that time was around £600,000.

The calculation produced by the accountants was clearly absurd. Unfortunately it had been produced by a firm of “professional” accountants and the founders knew no better than to just assume that any investors offering them less were merely ripping them off.

What was required was someone who was not going to be an investor showing the founders the reality of the actual data relating to valuation in Scotland. Showing them data on actual valuations achieved over the last 5 years helped the founders realis the “professional” valuation was simply nonsense. The accountants had done a text book “MBA” valuation, but had not bothered, or did not know how, to reference this against local reality.

In the end the investment was made, at a pre-money valuation of £800,000. Higher than the prevailing local norm of £600,000, and higher than the new angel group who did the deal wished they had agreed to following a few years of slow progress. Down rounds were to follow.

Whatever valuation methods are used the outcome must be tested against the local reality.

What Is It Worth? Valuation of Investments

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Valuation is probably the most emotive issue to be addressed in any investment negotiation.

Both entrepreneurs and investors seek reassurance that they are not agreeing to an inappropriate (unfair) valuation that will result in them receiving an inadequate share of the anticipated future exit proceeds. Both seek to find definitive valuation techniques that will give them the “correct” valuation. Both are often attracted to the more mathematical, formula based valuation methods involving discounting future values of potential exit values to present day money values.

While many of these methodologies have some merit, it is appropriate that whatever valuation they suggest, that this is sense checked against what is happening in the local market at the time of the deal. Always compare proposed valuations with other comparators in the local market. If you and the company are not based in Silicon Valley then Silicon Valley valuations are largely irrelevant.

Bill Payne carried out a valuation survey of US angel groups collecting pre-money valuation data for pre-revenue company investments from 35 angel groups in 22 states. He found that valuations ranged from $0.8 million (Boise Ohio) to $3.4 million (Silicon Valley), with an average valuation of $2.1 million. The survey showed wide geographic variance, with, perhaps not unsurprisingly, Silicon Valley, New York City and Boston showing the highest valuations, and Idaho, New Mexico and perhaps surprisingly, San Diego at the lower end.

There are a number of factors that likely result in these regional variations. The nature of the business will have an influence, with Biotech, life science and medical devices typically funded at higher pre-money valuations than, say, software and Internet companies. Increased competition among investors for “good” deals will tend to drive up valuations. Valuations in Silicon Valley are driven by the need to have much larger investment sizes because of the significantly higher cost of operating a business there.

However the size of the investment round seems to be one of the most influential factors.  Some investment rounds can be for £2 million or more, while others may be for £100,000 or less. Since angels typically prefer purchasing less than a majority ownership, a higher pre-money valuation is more likely for a larger round size. 2016 valuations may have been up at $3.6m (notably down from a high in 2015 of £4.5m), but the Angels still took 22% of the equity

The Angel Resource Institute’s annual report (The HALO report) on Angel activity in the USA constantly shows that while valuations vary both by geography and by year, the amount of equity taken by the Angels remains remarkably consistent at between 20% and 30%.  So a higher valuation does not result in less equity dilution of the founders.

Having empirical data on local valuations will provide extremely valuable in the negotiation process, providing a “reality check” to both aspirational values put forward by entrepreneurs and “scientific” valuations produced from mathematical formula. Angel groups should seek to cooperate in collecting and sharing local valuation data to ensure their own investments start out on a solid foundation.

“First Mover” is not a Strategic Advantage.

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Far too many times I see company barely past the idea stage claim “First Mover Advantage” as a justification (or at least a major one) for their proposed pre investment valuation.

More likely, this should go on the other side of the evaluation equation – it’s a disadvantage.

  • “Google? Not the first search engine.
  • Facebook? Not the first social network.
  • Groupon? Not the first deal site.
  • Even in the mists of software industry time: MS-DOS – not the first operating system.

It’s not about having the idea first – it’s about having the best execution of the idea. Who can quickly and effectively engage with a profit paying customer base. It all comes back to the effectiveness and skill of the management team. So when doing due diligence look for real evidence that this management team have the experience, and skills and focus needed to rapidly engage with a critical mass of paying customers.