Creating shareholder value is the goal of most for-profit entities, where value is viewed in a strictly financial sense. In the world of startups and VCs, this means maximizing exit valuations. That exit valuation number is of fundamental importance.
Exit valuations are built over time. Thus, tracking valuations is critical. Companies have many opportunities to track their valuations, from upgraded 409A valuations to dedicated strategic pricing studies. We discuss the areas to focus on in developing a meaningful analysis.
Income approach, market approach, and asset approach are the pillars of any business valuation. The income approach relies on a long-term financial forecast. The market approach relies on the observable transaction prices of similar or related securities. The asset approach views business valuation as a total of all contributing net assets.
The income approach is often dismissed for its inability to provide a precise valuation estimate, which is entirely irrelevant to the purpose of this analysis. The income approach should be viewed as a framework for understanding where the value is coming from. Is it growth, profitability, exit multiple, risky expansion strategies, or incremental price increases?
The first step is to run the first version of your forecast against some common-sense discount rates. Do you get the value that aligns with that in the latest round of financing, or is the value negative because profitability is too far in the future? Simply calibrating long-term projections to that valuation would bring additional clarity to the financial forecast that delivers a bowl-park valuation.
For example, many startups are focused on their cash burn rate. This measure can be misleading since the normalized DCF may require profitability much sooner than the available cash implies.
Beyond the forecast, the income approach looks at capital expenditures, net working capital requirement, and the value of the tangible net assets. For example, material changes in net working capital affect the value all the while simplistic market multiples (as implemented in many 409A valuations) would miss this factor entirely.
The recent upheaval in startup funding amplified investors’ demands for concrete financial viability. The income approach explains why they deserve the new funding and where the value will come from.
The market approach attempts to tell us what the value should be based on what other similar companies (or securities) are trading at. For its apparent simplicity, the method has a number of significant issues to be addressed.
- Most importantly, market multiples represent valuations of other companies, not the company we are interested in.
- It is a shortcut, not a fundamental analysis, that explains the origin of value.
- Truly comparable companies rarely exist.
- We rarely see a truly detailed analysis behind selecting the multiples.
- There is typically a wide range of available market multiples, so the selection of one is far from precise.
Notwithstanding the above, market multiples are fundamental to how market participants value companies. It can be much better with the focus on:
- Better comparables,
- Correlations between multiples and financial performance,
- Statistical measures such as coefficient of variation,
- Reconciliation to the DCF,
- Cost of capital as a factor for adjusting the multiples,
- Net working capital position and
- Market participant acquisition premiums.
These steps have the potential to improve selected multiples significantly. They will yield a much better number than a simple multiplication of EBITDA by a median multiple.
The asset approach is more suitable for companies where all the value can be accounted for by listing its contributing assets, tangible and intangible alike. It starts with the balance sheet, where tangible assets are typically well represented. Adding intangibles and IP is a more involved matter that often requires stand-alone valuations of technology, contracts, workforce, etc.
7 Areas to Focus On
Naturally, the company’s stage of development, business model, and many other factors will affect the availability and quality of data necessary to perform any of the above. As you consider business valuation for either regulatory or strategic reasons, below are a few areas to focus on:
- Build a meaningful discounted cash flow model based on the forecast that would extend far enough to show future profitability or exit P&L,
- Carefully select publicly traded peer companies (especially since many startups won’t have direct comparables),
- Don’t overlook a near-perfect-match M&A transaction,
- Construct appropriate market multiples based on the company’s own financial performance and operating characteristics.
- Calibrate market multiples and DCF models against recent financing rounds,
- Calibrate DCF and market multiple against each other,
- Hold deeper discussions with management to connect the valuation to their own views, intuition, or informal value indicators they rely upon.
Summary
The IRC 409A valuations are a great opportunity to foster discipline in tracking value accretion. Most minimalist or free-pretend-valuations barely scratch the surface while risking to produce arbitrary valuations. In contrast, traditional valuation firms can expand their analysis upon request. This will enable boards and executives to engage in more nuanced conversations with investors while focusing their teams on financial value creation and exit valuation.
