Setting a fair value on an early-stage tech company is in many cases a cumbersome exercise. Neither a too low nor too high valuation is in the best interest of any stakeholder, neither existing owners nor potential investors. Setting the right price is all about knowing what to look for from a company lifecycle perspective.
With a wide array of approaches to set the value of a company, knowing which ones are suitable for the lifecycle phase of the company should a rule of thumb. While listed companies can be broken down with quantitative metrics, setting the right value of a startup is more often based on a vision and belief that the company is able to execute. As Matthew Schubring told Forbes: “A good valuation is 75% art and 25% science because it takes into account the story behind the numbers of a business.
Taking a lifecycle approach to valuations is in by book a good approach to maintain that balance between art and science.
1. As a newly started company, the facts about the company are limited, and the value is set on future expectations, rather than present facts.
In this phase, understanding the size of the target market and what share is considered addressable at which price may serve as a confirmation that there is a target market with potential value to capture, but the true value of the company is believing that the team is able to execute on their plan to penetrate that given market. One may get a sense of a potential future value of the company based on the usual suspects of multiples such as price/earnings, price/sales, but at this stage, these should be considered a theoretical future rather than a definitive indicator of a company’s value. At the conception stage, funding is usually from the entrepreneurs themselves, together with friends fools, and family, and it is, therefore, reasonable that the value of the company is set based on faith, hope, and love.
2. As a company proceeds to the next phase of its lifecycle, the initial vision is paired with some initial investments, that may act as anchoring points for both present and future valuations.
Setting a fair price on the work that has gone into the company should act as a basis for a cost-based valuation of the company. This may include but should not be limited to money spent on external services (development, legal, accounting services, etc.), the amount of time invested in the company (at a reasonable hourly rate), data integrations, existing contracts, just to name some metrics.
Since there is still a high degree of uncertainty related to potential future profits, looking at the proposed valuation at the time of investment and the potential future value at a given point in time is a useful way to do a reality check of the value of a company. As an example, if you acquire a 10% share of the company for $20 million and expect a 7x return on invested capital after 5 years, is it plausible that the company may be worth $700 million five years later?
3. When the company starts to have profits to show for, it is time to fire up the spreadsheets and start looking at valuation multiples. In this stage, what is the company’s value object in relation to the equity story? If the company is raising capital based on its ability to amass a large user base, what is the average value per user, and what is the user acquisition cost? Are you raising capital as a B2B SaaS-company, the price to profit multiple should be calculated based on the business model’s ability to scale.
To verify the numbers, a peer group analysis is a useful method. Compare valuation multiples with similar companies. If you do not have a transaction database of your own, there is a lot of great resources online such as Crunchbase.
4. Reaching the IPO-stage, one should expect that the quantitative factors outweighed the qualitative, but as the demand for tech IPOs seems insatiable, the excitement of potentially getting in early on the next big thing brings us full circle back to faith hope, and love as the approach to pricing a company.
Tesla is perhaps the foremost example of how a company is able to defy logic when it comes to the connection between fundamentals and market performance. But this heat is even more intense when it comes to new tech stocks hitting the market.
Companies like Tesla, Facebook, Netflix, Amazon, Represent some of the fastest-growing valuations the world has ever seen. Their growth is exponential, their assets are almost ephemeral, they shun all traditional economic models for valuations. The investments required to scale are almost negligible, and their market size often unlimited. However, these are rare cases. After all, there is a reason why there is one Facebook.
Traditional valuation methods are not only still valid, but it is more important than ever to understand the underlying value of a company rather than getting carried away by the excitement of potentially getting in early on the next big thing.
Even though various approaches are more suited for different stages of a company’s lifecycle, some elements should be present no matter the funding stage. Learning how to calculate and set the price on risk and risk mitigation is in my perspective a prerequisite for almost any valuation. No matter sophistication of the calculated valuation and expected returns, those numbers are only as good as your assumptions. Knowing how to quantify uncertainties and assess the underlying risk of those uncertainties is a powerful tool for both investors and entrepreneurs.
When the homework is done, and it is time to enter price negotiations, make sure to know your worth. This applies to both entrepreneurs as well as investors. If all parties are a bit dissatisfied after sealing the deal, the price is most likely right at the time being. After all, at the end of the day, the value of the company is determined by future success.