Valuing tech startups has long been considered more of an art than a science.
Speaking as part of London Tech Week in 2017, former Bank of America Merrill Lynch technology analyst and now a consultant with his own company Oakhall Advisors, Andrew Griffin said: “There is no right way to do valuations. It’s what you can sell your business for.
“What you can do is take tried and trusted methods and triangulate them, and this is what investment bankers would do.”
Valuing is crucial when you are planning to sell your company, but also when seeking investment.
However, your business doesn’t operate in a vacuum and there are a number of factors that can influence your valuation.
In terms of your business, finances are vitally important, including historical and projected profit, cash flow and costs. External factors that come into play include the performance of the wider economy, and the existence and size of competitors. Some other factors include assets and debt, and any intellectual property your business owns.
Here are the preferred methods that investors and startups take to value a tech company – as well as the pitfalls of each:
Multiple of Profits
This refers to the average monthly or annual profits adjusted to not include one-off factors such as exceptional costs or one-off purchases. This will give you a good idea of immediate future profits. To get the valuation, multiply this number between three and five, but don’t be too optimistic if you’re only a small company.
Price earnings (PE):
Use a broker/websites to find a consensus price earnings (PE) and earnings per share (EPS) growth among your peer group (say SaaS, fintech, analytics etc.) – check if they have a similar cap structure, think about when you will be considered a mature business and what that implies about the investor’s required return, as well as if your business is loss-making. Then, use the peer group to map your future projected profitability.
Discounted cash flow (DCF):
Run cash flow forecast scenarios for your business, ask investors what their required return is or what cost of capital they would assume, map the resulting value range and don’t panic if it is wide, then check your long-term growth forecast with a compound growth analysis.
Return on investment-based valuation:
First you need to know the difference between your return on equity (RoE) and return on capital employed (ROCE). If you are a loss-making company look at expected future profit when mapped to invested capital, if you are reinvesting all surplus cash think about incremental return and if you are not reinvesting, what about dividends and buybacks?
There have been warnings against using the Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) metric when speaking to investors. The investor Charlie Munger famously stated: “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”
It’s important to get into an investor mindset when it comes to valuing your business. Venture capitalists (VCs) tend to look for home-run companies, an Uber or Facebook. They will gamble on a portfolio of startups with the hope that one gets them a double digit multiple on their investment.
The risks of taking venture capital are well known but basically, as Nic Brisbourne of The Equity Kicker says: “Venture capital is only appropriate for a small percentage of businesses that want to go loss-making to grow very fast.”