In a world where messaging app Snapchat could be valued at $20 billion (£13.5 billion) the maths behind tech company valuations is as murky as ever. The reality is that valuing a tech startup is as much of an art as it is a science.
Speaking as part of London Tech Week, 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.” Instead, “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,” says Griffin.
Griffin laid out three preferred methods that investors and startups take when it comes to valuing a tech company as well as the pitfalls of each:
Price earnings (PE):
Use 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 and if your business is loss-making then use the peer group to map your future profitability.
“The obvious problem with that is that, especially in tech, valuations change all of the time.”
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.
“The problem with DCF is you get a very wide valuation range and that it isn’t absolute at all. There is just as much subjectivity as anything else.”
Return on investment based valuation:
Griffin warned that this is a rare valuation technique in the technology sector but it is a useful sense check against more gaudy valuations.
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?
“If you understand return on investment valuation you are going to attract the Warren Buffet type, long term, proper investors. The ones that really understand your business and won’t be put off if the share price falls twenty percent or you go through an evaluation round that isn’t as much as you hoped.”
Griffin warned 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.”
Griffin was a little more polite, saying: “It’s fine to use it but make sure you use other metrics too and be aware that investors will mark you down if you make a big deal about EBITDA.”
How to value a loss making company?
However, many startups, and even established tech companies like Jack Dorsey and Jim McKelvey’s Square, are loss-making. So, how do you value a company that has no profits?
“The industry norm in the tech world is to use price to sales ratio to prepare a valuation,” says Griffin. “This is a really dumb way to value your business. If you are dealing with an investor who insists on, or accepts price to sales, just be aware that this guy has no idea what he is doing. Those guys are the ones that sell your shares the quickest when things go wrong.”
So what do you? First off you need to have a good handle on where your revenues and profits are going, then you start running a set of scenarios. Griffin laid out a hypothetical scenario: “So let’s say you decide that your budget is to grow revenues 20 percent in the long run and keep your cost base growth at 10 percent so that you roll into profit by 2018.”
You take this profitability figure and multiply it by the price earnings ratio (PE) for your sector, say 20x for a fintech company, and then apply a discount rate to account for the risk. “Ten years of chatting with investors in public markets shows me they will use between an 8-15 percent discount rate,” says Griffin.
He then ran this scenario for the loss-making company Square and derived a value of $7 billion, over double their current valuation of $3 billion. “That might be optimistic but it gives you a start. Even for loss-making companies this forces you to think about your profit model not just your revenue model. I have seen loads of business models that underestimate the cost base.”
But Griffin does warn that: “You want to scenario this to death […] It is about understanding the levers of your valuation, because until someone buys shares you don’t have one."
Griffin spoke about the importance of getting 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”.
There are alternatives to VC funding though. Griffin said: “Angel investors probably want a 3-5x multiple. Get yourself on an incubator, get on high net worth groups, enter entrepreneur networks. If you are insistent on going down the VC route find a company they have invested in, befriend them and get them to introduce you. Do not pay anyone to introduce you to a VC, there is a really nasty market in paid for introductions.”
Don’t discuss your valuation
As a final tip to founders, Griffin put up an anonymised quote from the Financial Times from David Richards, the chief executive at WANDisco, a UK data storage company:
“I’d be lying to told you [sic] if we weren’t frustrated, because our valuation is very different to our peers in the US,” he said. “But as long as we demonstrate traction with customers, the market will get it.”
Griffin called this “a stupendous own goal, it’s like ten own goals” and said that startups should “never discuss your valuation with investors or journalists”.
Why? “One: you are highlighting that you are undervalued. Two: in the most read investment newspaper daily. Three: investors think they are very clever and they are also sheep, so if they see a bunch of other investors thinking you are crap, then you are crap.”
“[Investors might ask:] He actually doesn’t understand valuation, and if he doesn’t understand valuation then why would I trust him with my money?”
The final lesson when it comes to valuing your company is that all investors are different, so a responsible founder should have all of their bases covered.
Griffin said: “A lot of nonsense is spoken about valuation. There are lots of ways, do look at all of them because it helps you understand your business better and it means you will be able to communicate better with investors and maybe give you some more leverage when speaking to VCs.”