It’s been an interesting spring, and not just in Tunisia, Egypt and Libya. LinkedIn finally IPO’d. Offered at $45 and going into the Memorial Day weekend at almost twice that share price, the equivalent of a market cap of $8.35B.
So if the margin of error of a private company going public is 100%, imagine what it’s like for a pre-revenue, startup?
It’s probably fair to say that acquisitions of publically traded companies can be reasonably valued. The accountants amongst us can talk Discounted Cash Flow (DCF), Capital Asset Pricing Model (CAPM) or Weighted Average Cost of Capital (WACC) – all exciting stuff — for accountants. And it all sounds very scientific. In fact it’s as close to actual science as valuation can get because the business has history of actual revenue and profit. It’s been de-risked as much as any business projection possible can be.
But an IPO is a different beast. There is some revenue history (Trailing Twelve Months or TTM) and the IPO is inevitably a bet on the come. It’s really a bet on how the market will perceive the future (not trailing) profit generation based on some trailing revenue recognition. That the experts can get the LinkedIn IPO so far off shows the spread between science and art.
Then there is valuing companies for investment. Sadly, the [chartered] accounts amongst us hold onto DCF et al, for dear life and try to map an accounting tool for established businesses onto startups or early stage companies. What’s missing in this mind set is a failure to recognize and understand risk and reward. Then there are those that do acknowledge that they don’t understand how to evaluate risk, and just ram a valuation down a naïve founder’s throat, because they can!
In this past two weeks, I’ve had an investment conversation with four companies in Ireland and Northern Ireland. In every case the answer is the same … valuation is 100% negotiation! But, the key, as always, to successful negotiation is knowledge and preparation.
I’ve a simple spreadsheet that I’ve shared with those founders. It’s based on the basic facts of risk in startups. There are four risk frontiers, and these are:
1. Product Risk.
Can this product be built and can it be built by this team? I’ve seen both extremes. The description of a product the defied the laws of physics (actually the laws of computer science). And a product that was way outside the pay grade of the engineering team.
2. Launch Risk.
Can this team successfully launch the product? I’m not a big believer in Business Plans, in fact they are little more than documentation of a series of assumptions and beliefs. Now launch is where the assumptions meet the road, it’s where you start testing those assumptions in the real world. Getting to beta is a good test of launch.
3. Acceptance [Market] Risk.
Does the market want / need this product? How many brilliant ideas have failed because they were a solution looking for a problem? Converting users to paying customers is a good test of acceptance.
4. Scale Risk.
Even with market acceptance, many businesses still fail because their business model / operations cannot scale profitably. There an old adage – “you can’t make a loss on every transaction and make it up with volume”
Understanding those risk frontiers is fundamental to valuation.
My methodology [and spreadsheet] is very simple. What valuation would you put on your company if it was to be acquired in five years? I know, I know that’s still an art, but at least its base of revenue. With a startup that is obviously based on revenue projections.
[Side note to all Irish and Northern Irish entrepreneurs – FFS use year-5 revenue NOT year-3. I don’t know who is telling you that, but they clearly have no idea about anything, let alone business.]
Now, based on which risk frontier you are facing, discount the acquisition valuation appropriately.
And it’s still an art. Valuation for acquisition is usually based on a multiple of TTM revenue. Ten years ago that multiple was about 5x. Two years ago it was 1x. Today it could be 1x-10x depending on whether the acquisition is based on market price, or synergy or strategic price.
I have my own range of discounts for each risk frontier, and my own set of multiples for acquisition valuation. And when you map them against real valuations, it’s a pretty good proxy.
But in the end, if you are sitting across the table from a charter accountant who only understands DCF – it’s all down to negotiation!