Value is not always what you think. In the startup world, everyone is talking about it, tech news are filled with funding round valuation analysis and exit stories. Yet the talk often only touches the surface of what there is to know about the valuation of early-stage investments, or even the valuation of any company or asset.
Value is a numerical value that indicates what benefits a company or asset will bring to the prospective owner. Price can variate from value due to misinformation in the market, different negotiating power of the parties involved, market trends/ hypes and competition or lack thereof among acquirors, as well as goals of the negotiating parties that are not cash-related (which could make the parties more likely to compromise).
Most believe that valuation at early-stages only depends on negotiations, but this is only true if there are no facts and validation to support a more structured approach. These facts are not easy to find but they exist, and validation of the market, competition and exit possibilities can be carried out. Valuation is not a static value, it changes whenever factors such a strategy and market trends change, and it can change based on the scope of that valuation (who the acquirer or financier is and the terms of that transaction). Carrying out a valuation is about processing all the information concerning the company: the output is not just a number or a multiple, but why and how you arrived at a certain number, which gives the investor or founder information about the startup story and suitability of an investment.
Many believe that it is impossible to calculate financial projections at early stages. I even hear it from financial consultants and investors sometimes. The popularity of startup ventures and the changing players in the seed and early-stage investment market has brought many things with it: the startup market the way that it functions today, is new, and it is a large and growing market. Everyone wants to be part of it, with marketing, technology and later stage fundraising or M&A consultants entering the early-stage fundraising market. Everyone is helping to shape the early-stage investment market with their own ideas and specialties. It’s a loud place with a lot of information-overload, but sometimes little depth on the subject of finance. I have heard many say that “Numbers are boring and you shouldn’t focus too much on them, focus only on your pitch”, “Financial analysis and valuation are irrelevant, recognising good startup investments is all about instinct” or that as an investor “You should invest in the team not in the product”. These voices are welcome by anyone who doesn’t like dealing with numbers, and they are true, but only up to a certain point.
This is incompatible with the reasons to start a business or to invest in a business: the ultimate goal is to earn a return, and if a return would not be foreseeable or expected, you would not start that business or invest in it. It is certainly true that numbers can be boring, instinct (which gets better with experience) is very important in recognising potential, and that the team is fundamental to any success. Preparing a financial plan is based on a strategy and if that team does not validate or carry out the strategy and tasks that they are set out to do, or is able to react fast to market changes, a financial plan becomes redundant. However, investing in a product, company or market where the return or chances to succeed, despite future product adjustments, will be low, does not seem like a good strategy either. There are sometimes great teams, who look like winners, who present themselves very well and who bring a useless product into the market. Maybe they will succeed with the next venture but not with this one.
What shapes startup investing is also the trend of following leading investors, meaning that less experienced investors are very likely to follow recommendations or to only co-invest with leading investors, which concentrates funding in certain sectors and leaves other sectors dry based on the latest trends, and FOMO (Fear Of Missing Out): startups in hyped sectors or that promise large disruptions in the market can more easily find investments and support. Investors know that often 80% of their returns comes from 10% of the companies in their portfolio, so these investments are highly sought out. Sometimes this takes place to the detriment of businesses that can achieve profits much earlier, are more stable but look boring.
So how can we avoid investing 80% or 90% of a startup portfolio in companies that will not generate sufficient returns? We often hear that ‘1 in 10 startups will succeed’ or better, only 1 in 10 startups is expected to return a high multiple on the initial investment, whereas 2 or 3 may just return the initial investment without a significant mark-up. This puts a lot of pressure on startups to scale and grow fast, whereas in some cases they may develop a healthier and more sustainable business model and return 2-3x the initial investment. This is often not sufficient in startup portfolios because the winners will have to make up for the companies in the portfolio that will fail with a 10-15x return.
Valuing large companies and SMEs can be a challenge, but valuation professionals have developed a set of methods to estimate this. Even though no method is perfect, and the Capital Asset Pricing Model has its critics, these methods are the best we have at estimating value, and valuers can do a great job at uncovering a lot of information useful for the transaction during the valuation process. Startups and early-stage investments are another subject. Typical valuation methods are hard to use here, revenues are sometimes scarce or non-existing, growth rates are hard to predict, multiples make little sense and the market takes over. Fundraising rounds are often priced by angels and VCs who apply their own valuation methods or just rely of comparable transactions. Even IPOs and exits often involve loss-making companies, which shifts the burden of estimating future prospects from the valuation professional to the technology or sector expert. Knowing a sector, how the trends will develop and who will take advantage of the technology or business model become fundamental in the valuation. However, outside of the technology and expert talk, the way that valuations are carried out is often simplified, with probability values used that are not properly assessed.
In reality, typical valuation methods can also be used for startups, or they can form the basis of a startup valuation after some adjustment. There are a variety of applicable methods that include adjusted income and market methods, rule of thumb methods and startup-specific methods. Valuation of startups and early-stage investments is a practice in development, and will likely change together with the changes in startup fundraising and exit trends.
This market may now be revolutionised by blockchain technology and the possibility for startups to have Initial Coin Offerings, which open up a world or higher liquidity and earlier exits, higher misinformation and risks, different investment strategies and motives, fast changing legal frameworks and higher global investment flows, which influence both the value and price of the single investments.
I will not discuss ICOs here, but let’s take a look at Bitcoin and generally cryptocurrencies aas a way of understanding value.
Blockchain allows decentralisation may be a more efficient management system without a single point of failure, which in the long-term can have the effect of reducing volatility in our organisations and systems, which is a benefit. Cryptocurrencies are perfect for testing this new system, its likelihood to be hacked and to develop more and more efficient systems who can be used for other scopes: the function of validating a technology and allowing it to improve its quality is a benefit for the overall economy, even though you might not take advantage of this benefits directly by investing in a single currency. The price of Bitcoin in the long-term is determined by those who believe in it, even more in volatile times when trust in the overall economy and the stability of currencies is low. It provides security from property repossession and gives more power and control to the single individuals, which is another benefit.
The value of cryptocurrencies underlie the same assumptions that the value of other currencies have: they depend on its current and future use as well as its implied risks. Currencies are backed by an economy and a central bank that implements monetary policies, regulates interest rates and money supply. Cryptocurrencies are regulated by their underlying technology. Since the increase in money supply has often disadvantaged the poor who are cut out from larger investments, and therefore are more likely to suffer from inflation, cryptocurrencies were built to ultimately avoid the loss in value that other currencies experience. How this will play out in a real economic setting in too early to say.
What we know is that money has a value, it’s not only the little value of the paper or coin itself, its value mostly lies in its function, which is immense. We can trade every day, have secure and clear transactions and liquidity: money makes every transaction go faster than if you had to trade assets: that in itself creates more time and benefits to you and others. Whether cryptocurrencies also have this function (and therefore value) will depend on its acceptance as payment.
Most of the companies, assets or things we try to assess, have a value depending on the function that we assign to them. The value of a house mostly does not come from its single parts, but on the fact that it will be inhabited at some point in the future: the value of real estate does not change as much as the value of a new technology from year to year, because it is likely that our use and need of real estate will not change dramatically from year to year, like a technology may be become completely irrelevant when a better and cheaper technology enters the market.
A store of value is also a function. The value of gold does not only depend on its use, which is far inferior that its actual value, but it serves as store of value because humans have collectively decided that gold can have this function. Its quantity is limited and therefore its value is more stable that a currency, which can be printed. A cryptocurrency may also one day become a universally agreed store of value, as the number of coins issued will be limited within its technology.
Its success depends on how long these benefits will last, how many of us will use and prefer it to the current available systems and in its safety. We don’t know which currencies will prevail, or whether new hybrid systems will emerge that would render part of the technology outdated.
What we know at this point is there are huge advantages and potential developments, huge risks, maybes and what ifs as to how far cryptocurrencies and blockchain technology will form part of our daily lives. Today we can tell what its price is, which is the price that we assign to it, but hardly it value, because that may involve being able to see how our world would change in 100 years from now, unless we think that this change will occur much faster. What we can say for sure is that there is a value in it for as long as it is used, transacted and has a function.
Bitcoin and other cryptocurrencies are an extreme example, but the same exercise can be carried out with a simple early-stage company. Valuing it correctly involves trying to see a little ahead in the future into what kind of impact a company can have in the next 10-15 years on average. We can measure the most likely outcome and additional possibilities which result in an income for the company (or future acquiror), how fast the company can grow and achieve its goals, and the internal and external risks involved in achieving all this. The world is changing faster and faster, so this is far from easy, but some markets and trends change far less than we expect them to. That’s why we may often see new hypes, new sectors that everyone will want to invest in, that do not materialise: because the likelihood of a new technology or trend changing our lives within a few years is unrealistic with how fast humans can adapt, and how a market structure can change in the short term. Some trends will materialse and some will not. That’s where sometimes we can identify mispricing, with a combination or financial, logical and sociological information available to use.