The Great Valuation Myth

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.