By Toni Moreno Planas, Managing Director at Ad4Ventures Spain (Mediaset Group).
Ad4Ventures is the venture capital arm of Mediaset Group (leading free to air television broadcaster in Spain and Italy), focused on television media for equity deals. Ad4ventures has become the largest media for equity player in Southern Europe.
In the startup/venture capital community, there tends to be a certain oversimplification of companies’ valuation by applying revenue (or other KPIs) multiples, overlooking the fact that depending on its maturity, it may be too early or too late to use that approach. This can come as un unplesant surprise for businesses with lower growth rates, high dependence on performance marketing and no clear path to sustainable profitability. In this post, we comment on the different ways of looking at a startup valuation over its life.
One of the key matters that called our attention when we entered the venture capital world coming from the traditional corporate M&A activity was how to deal with valuations. We really had to make an effort and reset all we had learnt before and start from scratch.
In reality, there is not a generally accepted standard method. The way of looking at it will vary over time as the business matures and so, it is worth understanding first the different phases of what we call “startup” until it becomes a sustainable business.
In the early beginning of a startup, entrepreneurs with just an unproven business idea and a small team, will most likely only have access to F+F funding (Friends + Family…+ Fools) and the most adventurous business angels.
The main complexity at this stage is that there are no metrics or actual activity to be able to benchmark with other startups, nor any credible business plan to take seriously. Although there are several alternative valuation methodologies like the Berkus method, Risk Factor Summation or the Scorecard method (see “Valuation For Startups — 9 Methods Explained”), they end up being sophisticated “rule of the thumb” approaches (well, to some extent, all valuation methods are).
At this stage, the most relevant aspects to consider in order to build a promising business are:
1) cash needs to reach an MVP and
2) founders’ dilution
We need to bear in mind that in most cases, the company will require several financing rounds over time, and finding the right balance between valuation and dilution will be critical. High dilution can impair the ability to raise future funding as VC funds will want founders to hold a relevant stake. On the other hand, high valuation will set up expectations on the investor group which may complicate the negotiations with Series A funds.
It is quite standard for founders to give up between 10–15% equity. Therefore, if the company looks for 150k€ and founders are willing (or manage…) to give 15% equity, Premoney Valuation (value of the business before the cash of the capital increase) will then be 850k€.
When you look at the science behind this calculation, it is very clear that founders/investors should not assume that this is a good indication of actual value of the business.
Once the company has launched a minimum viable product (MVP) and has achieved initial acquisition metrics (and in some cases monetization), the business can attract more professional investors (business angels, early VCs).
At this stage, the most common way of looking at valuation would be a combination of the following methodologies:
– Dilution approach: balance between funds needed in the coming months and founders dilution (normally between 20–25%). If the company raises 1m€, then premoney valuation should be between 3m€ and 4m€
– Venture Capital Method: based on the target return on investment of a specific investor, adjusted by the expected dilution coming from future rounds.
As an example, if an investor believes that a company can be sold for 50m€ in 5 years and intends to achieve a 10x return for the 1m€ investment:
o Postmoney value: 50m/10x= 5m€
o Premoney: 5m€ — 1m€ (invested) = 4m€
o If we then expect a 25% dilution in future rounds => Adjusted Premoney valuation = 75% of 4m€= 3m€
It seems to be too early to use Multiples Approach (comparing business metrics of the company such as revenues, users, subscribers, MAUs to transactions of comparable companies, as comparable transactions are not really so (there are no real comparable exits for companies at this stage) and information is really limited.
We often use this method though, where we actually apply multiples to the expected metrics of the business within the following 12 to 18 months to see the ability of the company to raise the next financing round. As an example, in a case where we believe that an ecommerce will generate 5m€ LTM revenues in the next 12 months, if we apply an indicative revenue multiple of 1.5x, we could expect a premoney Series A valuation in the region of 7.5m€. If we target a 2x revaluation between rounds, we would aim for a postmoney valuation in the “early stage” round in the region of 3.5m€-4m€.
Startups die when they run out of cash and are not able to raise the next financing round. It is sensible to always have an eye on what the next round may look like if there is a need for one…
VENTURE CAPITAL (SERIES A-B)
A startup that reaches a Series A has already achieved certain milestones in terms of product, scale and marketing efficiency that give a better indication of value, making it comparable to other companies (although always with the caveat that comparisons are never accurate due to the lack of public info or the unique nature of each business).
The most used methodologies at this stage would be a combination of:
– Dilution approach: balance between funds needed and founders dilution (normally between 20–25%)
– Venture Capital Method
– Revenue multiples approach (or other relevant metric if pre-revenue business — MAUs, traffic, etc): The multiple to be applied will depend on:
o Revenue growth rates: higher rates imply higher multiples
o Predictability of revenues: subscription based businesses (e.g. SaaS) generate stable and contractual revenue over time, increasing multiples
o Gross margin: higher margin businesses imply larger multiples
o Revenue Model: a commission in a market place represents the take rate in a transaction equivalent to the gross margin generated in an ecommerce, and therefore the revenue multiple should be much higher
In any case, this approach should be a proxy of the future ability to generate profitability once reached a certain scale with more sustainable growth rates.
As we will comment later on, the most generally accepted valuation methods for corporations are DCF (Discounted cash flows) and comparable EBITDA multiples approach. At this stage, both methods have limitations and are not appropriate to value the business:
– EBITDA multiples: this approach is not relevant as high growth businesses will be generating losses or will be reinvesting everything they generate in marketing to fuel further growth to reach sufficient scale that will allow the company have a relevant market position and sustainable profitability (due to operational leverage)
– DCF: although the company already accounts for performance metrics that let you build a sensible business plan, uncertainties (scalability, monetization, etc) are still significant to use that projection as an accurate indication of value.
The table below extracted from the “Tech Exit Transaction Multiples Europe 2018” prepared by Avolta Partners gives an indication of the wide range of revenue multiples we can face for each category depending on business model, but also on the maturity of the business, growth rates, market positioning, etc.
Even at this stage, we will not consider valuations to be too accurate or scientific. A clear indication of this is the fact that the Series A or B investors will demand a liquidation preference right to protect their investment in a downside scenario.
CORPORATION — ESTABLISHED BUSINESS
Very often, founders, and even funds, lose perspective of what actual valuation methodologies for corporations/established businesses are, focusing in excess on revenue multiples comparisons.
In most cases, the Exit as an investor will be at this stage with declining year on year growth rates, and then it comes as a surprise that potential buyers are not applying revenue multiples any more, bringing valuation far below expectations.
As mentioned before, once the company has moderate growth rates (regardless of profitability), main methodologies become:
– Discounted Cash Flows: the most accepted method. We calculate the Enterprise Value (EV) of the company as the present value of future cash flows (applying a formula to also discount an estimate of the indefinite cash flows beyond the business plan period). In order to do all of this, we use a discount rate (WACC) which will be higher or lower depending on the uncertainty of the cash flow generation and risk profile. Once we calculate the EV we subtract the net debt of the company to get to the Equity Value.
– EBITDA Multiples valuation: this method intends to get an indication of EV based on trading prices of comparable companies (stock market) or comparable M&A transaction prices.
EBITDA multiples should reflect the expected future cash flow generation (i.e. higher multiples with higher growth rates and lower execution risk). Applying DCF calculation to different revenue growth and risks scenarios, EBITDA multiples would vary significantly (see below). If we assume a moderate revenue growth (5% p.a.) and moderate risk business (12% WACC) we would talk of 8x EBITDA (if we just consider financial returns, ignoring any other strategic considerations)
Multiples analysis, although probably the most used approach due to its simplicity, need to be taken very prudently, as there are many factors that may distort the conclusions significantly, due to the lack of accurate information, the particularities of each business and any strategic considerations which may have led deal prices up.
It is key to understand in which phase we are, as once your growth rates moderate you enter into the “EBITDA multiple” world, what may imply much lower valuations if your margins are low, you still have strong dependence on performance marketing or if retention/repetition is low. Businesses need to be built under the basic assumption that they will have to generate sustainable profits at a certain stage.
In any case, valuations can be very theoretical, and they just represent a starting negotiation point. We should distinguish betweenacquisition price (result of supply and demand) and valuation. The actual price that a buyer may be willing to pay will strongly depend on:
– Competition to acquire the company
– Market positioning (leadership, barriers to entry, brand awareness)
– Ability to replicate the same business from scratch in terms of required investment and time
– Expected synergies
All of this will help you increase your Exit value beyond any financial theoretical calculations.
Feel free to contact us on contacts@Ad4Ventures.com and we will be happy to give you our views.