Taking a valuation approach for early stage investments? You're probably wasting your time.
At SUMF when we consider an investment we spend a lot of time first working through how much value a fully funded and matured marketing function can generate.
This focus, however, has not left the fund free from the challenges of creating a definitive answer to an investee’s valuation. Establishing a value of an early stage investment has been in our experience both subjective and emotional, with tension between existing owners seeking a high number and new investors who would prefer a low one.
The text books tell us to use a range of classic valuation tools
Classic valuation tools that look to place a value on the smallest businesses through to large listed ones, including:
- Discounted cashflow
- Comparable earnings multiples, that is PE multiples
- Comparable valuations based on recent M&A activity
- Tangible and intangible asset valuations
Each of the tools look to calculate the worth of a businesses based on its capacity to generate cash. Of course judgement also has a role with an effort required to assess the strength of the market position, what may change in the future and the ability of the investor to actually access the cashflow.
When valuing older and listed companies the task of building out a valuation model and forming a judgement is relatively straightforward given the wealth of accounting data that can be used to infer future performance and form a view on ‘value’ that is reasonably free from calculation error.
But these tools do not work for early stage Startup or a Scaleup which have few customers, little operating margin or accounting history – too many assumptions and guesses are required. Alternatively, arguing that the valuations should be lower because the tools can’t be applied is also the wrong answer and would leave the fund with no ability to participate in strong investment prospects.
At SUMF we are adopting a price-approach to placing a value on early stage investees
By adopting the concept of a price-approach the issues associated with classic tools can be avoided. With the price being based on:
- The drivers of demand for an investee, and
- That investee’s stage of growth.
This is not to say that price and value should not be equal. The statement that price equals value must ultimately hold, however, the point in time at which it does is something both investors and the founders seek to control. And, we know by taking price approach in the earlier phase of an investee’s growth (versus a text book valuation tools which becomes available in the later phases) the focus on inputs we seek and interpret are more agreeable to what is available and more likely to mitigate the impact of value error by improving access to, and selection of, the better investments.
Required Data for Pricing versus Valuation
Starting with pricing an investment we have three benchmark based approaches available:
- Last price: This looks to the prior round and judges if the current price is reasonable given the businesses growth.
- Comparable private and public companies: Which look to what investors are paying for private or public businesses in the category. The price is then scaled to revenues, or a traction metric. For a public company a discount that adjusts for liquidity can be applied. The discount can theoretically be 30% or more but in reality this is difficult to justify given in practice funds seek to hold through to a timed exit which may be a public listing.
- Forward pricing: With startups having no established metrics this approach to price is to take a multi-year forecast and then apply a comparable pricing multiple to a forecast year. The fund’s target rate of return is then used to discount the forward price to a current one. Importantly, the target rate of return differs from cost of capital in that it would include the risk in the expected cash flows, survival risk and dilution expectations.
However the discovery of the price for an investment through benchmarks is challenged on a number of fronts including:
- The Last Price is simply an extrapolation of the prior price which may be under or over
- The sporadic nature and inherent complexity of preference clauses of comparable transaction may hide the true price.
- The feedback loop of pricing in ‘incomplete’ markets means a pricing error may leads to further errors including bubbles.
- Many investment display the properties of a Giffen good, which in pricing theory is a good that is in greater demand as its price increases. I have seen this outcome often in the ‘narrative’ of an investment which, if strong, becomes the most influential component of the price.
- The subjective judgements of ‘similar’ and ‘category’.
- Decision biases in subjective judgements and forecasts.
What matters most is timing the selection of the right investments.
The math of a Startup or Scaleup once time and dilution is considered also shows that what matters most is timing selection of the right investment rather than price.
This is best explained through an example. Consider the evolution of a Scaleup which is say priced aggressively and with the benefit of hindsight turned out one year ahead of its value or has a price premium of 100%. The Scaleup at the time is growing by 100% annually and over 5 years the business may: 1) Thrive to own its market and grow to be say 10x what it was at the time of investment; 2) Stall with a plan failure that achieve a 4x growth with additional raises required diluting the investment by say half, or 3) Fold.
The possible investment returns considering price premium and selection:
In this example, selection of the right investment is what mattered – and price premium can be easily justified if that is required for investment access. That is, the ‘thrive’ outcome is well worth the price premium, while a ‘stall’ outcome with premium paid simply returns the invested funds. If the problematic nature of the stall outcome was recognized at investment and a premium is not paid then the return would be 200% or an IRR or 14%. Obviously the ‘fold’ investment is best avoided.
Extending the example to a portfolio approach, price premiums can be embraced when they provide access to better investments and they probably also provide a signal that an investment is probably a better investment prospect.
We can also say the portfolio outcomes can be improved with a price-approach. Contrast a fund which takes a traditional value approach and invests when an asset is ‘under’ priced. This fund may likely hold a few tightly priced assets and may lack the diversified holding risk that is required to be successful in early stage markets. Alternatively, if ‘price’ is adopted and premiums are taken as an indicator of future value as well as the price of access to the better investees, the fund is more likely to create a larger more diversified portfolio and to hold the performing businesses. In other words, the scenario outcome is, it is a better risk-return position to hold say 20 investments where the price to value relationship was unclear than say 2 investments that were tightly price with weaker prospects.
In my experience price is driven by what we call the investment “narrative”.
A summary of the components of an investment narrative is:
- The balance of investor and founder price expectations: Investors logically want a low price to maximize share but immediately seek growth and a high price in subsequent raises to protect against dilution. What is more, an investor will probably cap the price by the sizing the likely value at exit of a business in order to ensure it meets the IRR expectations of the fund. While founders take the opposite view and aim for the least dilution as possible over time in the context of growing the business. Arguably dilution through time in this context is a price concept as well, where business owners look to growth in share price that offsets the loss in ownership through subsequent raises.
- The balance of showing a favourable growth path for price: With multiple raises likely a price that is too high at too early stage is best avoid. A too high price will act as a driver of urgency, high burn rates and poor marketing executions that can ultimately drive a flat or down round which complicate further financing. So, early overpricing risks killing a business or, in any case, result in greater dilution in the aggregate than if the earlier round had been done at a lower price.
- Quality of existing investor: Some investors having high performance reputations that support the overall narrative. While new investor may also use price to gain access to a strong prospective investment.
- The market opportunity itself: The strength of the specific market and related performance of private or public comparisons will drive price. and so too will a great management track record which adds faith to the plan.
- The traction metrics of the product and marketplace, for example customer growth, life-time-value, acquisition costs, NPS and referral, so on…
- The cash runway: Cash raised needs to be sufficient to show demonstrable progress in the business to avoid a future flat or down round – progress usually takes more time than planned. The sweet spot for runway looks to be 1 to 2 years where the business can demonstrate customer traction metrics across 12 months and then spend months landing the next raise, if required, at a higher price.
But ultimately, value is excellence in marketing execution that services a growing customer base profitably.
When I see a potential investee it has usually had success attracting early adaptors and its founders feel ready to start rapidly expanding. This is a real challenge, which is well described in “Crossing the Chasm” by Geoffrey Moore. Geoffrey argues that the product and a systematic marketing execution are the cornerstones of value creation and success is driven by an execution that recognize the evolving challenges of different market segments.
At SUMF, for a new marketplace or product that appeals to an existing market we like to understand how the marketing plan will fuel adoption process and the resulting unit economics. While for new markets, especially ones that have B2B properties we like to understand how the business will meet the needs of the more pragmatic majority of a market that need to see tangible and well supported benefits.
As a result our view on the potential value of a Startup or Scaleup and our confidence in price and the investment ‘narrative’, is influenced by two key questions:
- Knowing that the product or market place has picked up some early adopters, can it also actually access and be used by the majority of the market? This is a question aimed at avoiding investments in products like Segway that effectively failed because of stairs (there is plenty other examples of this); and,
- Do we believe management, marketing team and resources of an investee, with SUMF investment and support, can take on the challenge of building and delivering a marketing strategy that takes the business beyond earlier adopters to the more pragmatic, wait and see, customer segments that represent the majority of the market?
 Price is said to be the equilibrium of demand and supply where the market price of a good tends to increase as long as there is a positive excess demand, while it tends to decrease when there is a positive excess supply.
 For incomplete markets John Maynard Keynes (1936) offered the following comparison: “... professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees”