January 20, 2020January 21, 2020 // Entrepreneur Valuation – Art not Science | Part II In my last article I discussed the idea that Valuation isnāt Everything, though it is still an important piece of any fundraise (even for the ever popular convertible notes, where valuation caps triangulate as a pseudo proxy for todayās value). While it will be a negotiation with any investor, having as much analysis and confidence to support your ultimate valuation number will only strengthen your case. Traditional Methods of Determining Value When newly minted analysts and associates matriculate from college or business school to Wall Street banks, they are immediately immersed in weeks of training on financial statements, presentation skills, and the art of valuation. We are told that there are three main ways, amongst many, to value a business, which include: Public comparables analysis – This is great if you are a large company who has peers and competitors that are publicly traded, but isnāt relevant for startups (scary words like āEBITDAā and āprofitā are the baseline variables used as well).Ā Ā Precedent transactions analysis – This can actually be a really good mode for early stage valuation, with sales multiple obviously being the main or only metric of interest.Ā The downside for this method is that private company information is very hard to come by, especially for cash efficient entrepreneurs. Large data providers such as Pitchbook.com, CapIQ, FactSet, Crunchbase and others are pricey, and even their information probably needs to be taken with a grain of salt as they are generally crowdsourced from founders and service providers (bankers, lawyers, etc.) who have a vested interest in showing the best multiples, and will have undoubtedly used a variety of pro forma and run-rate arithmetic to get there.Intrinsic Value – From a theoretical perspective, the true value of any business is the present value of all future cash flows.Ā That is a fun way to say many people like to create a DCF (discounted cash flow analysis) to ascertain what theyāre worth.Ā The problem here for most is that even very mature companies that have been in operation for many years can have trouble predicting income statements six months into the future, let alone 5 years out.Ā How on earth can a growth stage company, with a straight face, tell you they have accurate future cash flow projections? Further, what should a discount rate be for those future cash flows? Now, I donāt want to be all negative here.Ā I think it is good practice for entrepreneurs to put together financial models (do not kill yourself with complexity) and have conviction around the input variables that will drive a business. I just donāt think they will carry much weight in a valuation discussion. Venture Capital Methods There are a few VC specific methods as well, such as IRR analysis (cousin to the LBO analysis with private equity buyouts), simplified to where a certain hurdle rate or range is determined, and based on a range of possible outcomes, investors work backwards to understand what an acceptable current valuation would be to achieve that threshold. For the earliest stage companies (think pre-revenue), there are many scorecard based models that take a baseline value (maybe $3-5 million) and then āgradeā a company up or down based on a variety of factors, such as business model, competition and leadership. The important thing to remember in all of this is that valuation is largely an art and not a science – which was at times very difficult for this left-brained loose cannon to come to grips with during my own formal valuation training. It is best to use as many techniques as possible, with a defensible thought process around any input variables or selected comparables, and to lay them out as a range (football field). An investor will do the same. They will just argue for the lower end of their range, while you do the opposite. But at the end of the day, something is really only worth what someone else will pay for it. If you would like to learn more about capital, visit our Connect to Capital page or connect with us to learn more about how CED can connect you to resources.Ā