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The Mystery Of Early Stage Valuations: Using Data To Support Negotiations
Advisers and investors are increasingly seeking data to support early-stage valuations. With valuations fluctuating due to the re-pricing of public market equities, there is a lot of interest in how this could feed into valuations of private start-ups.
MarktoMarket’s May 2022 webinar explored these questions, and more. Over 150 people joined CEO Doug Lawson and panellists Adam Baron, Director of Growth Advisory at BDO; Aidan MacMillan, Senior Investment Manager at Par Equity; and Paul Tselentis, CEO and Board Member at 24 Haymarket.
MarktoMarket data suggests that Seed and Series A stage investments typically result in dilution of 15-20%. Is this consistent with the panel’s experience?
Adam takes the view that investors will see anything up to 30% as a fair take, depending on the value that they could bring and the stage of the company. Seed valuations have not changed much in recent years. The same metrics matter to investors today that mattered before COVID.
2021 saw a peak in Series A valuations, which is likely to lead to a softening in valuations in 2022. This means that some companies that raised money last year may be looking at down rounds this year. Adam’s suggestion is that what we are currently seeing is less a downturn, and more a rebalancing of Series A valuations. Series B and C, however, are where the most dramatic changes will be seen. The example was made of Gorillas. The on-demand grocery delivery service raised $1 billion in 2021, before being forced to make major staff cuts in 2022 due to changes in the plan. With the benefit of hindsight, the valuation was too high.
Are revenue multiples relevant when assessing startup valuation?
As a Seed and Series A-level investor, Aidan invests in businesses which show early signs of revenue. This minimises the relevance of multiples within the negotiation process, but it remains a consideration. In general, and especially when investing in a new industry that is not familiar, Aidan advocates having as much data to hand to frame negotiations and investments. This allows everyone to understand if the business is likely to hit the required rate of return for the risk profile. It also helps to be able to point to specific data when dealing with founders. Should the business be in an interesting space, then there will be market comps suggesting there will be good exits.
Aidan maintains that it is critical to avoid over-dilution of founder stakes when considering valuation. These individuals are often highly motivated, which is what drives success. It is important, therefore, to find a balance between retaining their motivation while gaining a worthwhile stake.
Adam‘s advice is to not only look at the entry pre-money valuation of a company relative to peers but what the potential exit value could be by coming to a view on future earnings and applying appropriate exit multiples. You can then estimate an investor’s required rate of return and work back to an entry valuation. This entry valuation can be compared against companies in the same sector raising capital at a similar stage of development. Most investors at Series A will look for a 4-5x return so the entry valuation must stack up with this equation. Companies want to know the pre-money valuations of their peers, so having as much data as possible is crucial to triangulate and understand potential returns for negotiation. Having entry and exit comps available using data is vital to understanding if the pre-money stacks up.
What does it take to achieve a premium valuation?
Paul’s belief is that comparable data for revenue at early stages in a UK context is pretty thin on the ground. If you look at big tech companies such as SalesForce and Google, they are trading on attractive revenue multiples. This begs the question of why would you invest in a startup for 11 or 12x in this environment? He hopes that we will return to a point where startup revenue multiples will normalise at 5-7x levels again.
In his business, Paul is always looking at seed stages of £1-£3m, and whether they can 10x the money from any particular opportunity? One way of doing this is by looking at the market share the company could reach. Can the company win 10% of their served market with the current product set within 6 or 7 years? In these early stages, this is the level of return necessary to justify the level of risk. 5x is considered a better proxy multiple to use at Series A levels. Generating a more accurate figure requires an in-depth market analysis of the company on an individual basis. He analyses what results they are achieving with their current set-up, and what they need to do to reach the desired profit levels. These questions lead Paul more than revenue multiples.
For a company to become worth a double-digit revenues multiple model, it has to be extra special. Deep intellectual property protection is a good example of what makes a startup worth double-digit its revenues. However, there would be reservations to go that high for any kind of traditional enterprise software.
Is the sell-off in public market equities filtering down into startup valuations?
Paul believes that what is happening is more comparable to interest rate sensitivity of anything that is generating little to no profitability. His example was to look at the sell-off in tech companies focusing on areas such as gene therapy and biotechnology. These are all businesses that operate on the basis of redeploying profits back into growth for a long period of time.
Continuing, Paul stated that we are in the midst of a paradigm shift from a low-interest-rate environment to a higher one. American companies, in particular, have had the mantra to burn aggressively in order to gain market share. While this philosophy made sense in a low-interest-rate environment, the model of generating huge losses to buy market share needs to shift. Already, we are seeing Series B valuations start to fall back, led by the US (see above).
In the UK, Seed and Series A valuations did not see the same levels of aggressive valuation inflation in 2020 and 2021 as listed technology companies or later-stage private fundraises. Because of this, the deflation on the way back down should not be as dramatic. Paul feels this slow deflation will bring stabilisation and normalisation back to pre-covid (2019) levels by the end of the year.
The Covid-19 pandemic was a driving factor in the increase in valuations. There was a great deal of capital being raised and deployed in this time. This has given 2020-2021 an unusual bump in the curve, however, Aidan speculated that it is still too early (May 2022) to see what effect the NASDAQ correction will have for early-stage Seed and Series A-level companies.
When looking at startup valuations, do you ever factor in a higher cost of capital as discount rates increase?
From the perspective of working at 24 Haymarket, Paul’s valuations are influenced by the market opportunity, the people, the execution risk, and whether there is headroom to avoid over-dilution of founders and the ability to make a strong return for investors when the next round of capital is deployed. He thinks more tactically about valuations. Fundamentally, investors want to get what they want for the lowest possible value while making the most money out of it.
If they have done a good job at early-round pricing, and have good working dynamics, it does not make sense to force a down or flat round on founders.
From a geographic perspective, why does data show higher valuations in London and the South than in the North?
As an Edinburgh-based firm, Par Equity focuses on companies in Scotland, Northern Ireland and the North of England. Aidan explains the reasons for this are threefold.
- They want to be close to their clients. Providing advice and support is a lot easier when there is geographic proximity.
- In London, there are a large number of VC businesses, investors and funds. This means that there are more opportunities available, a rich talent pool, and infrastructure to support it. However, there are also higher levels of competition for each deal. This impacts valuations. If you receive two or three term sheets, you can negotiate a better offer than if you only receive one.
- People are overlooking Northern regions and Scotland in particular. There is a lot of talent coming out of universities, in particular in STEM subjects. This talent, coupled with success stories, such as SkyScanner and Canos, provides a compelling narrative. These young businesses are producing talent who are acting as board members and advisers to the next generation of startups.
But what about a London-based company?
For Paul at 24 Haymarket, even though the business is headquartered in London, increasingly they are looking outside the M25 to find new opportunities. They are now viewing the UK as a series of regional industrial hubs. In the UK, businesses in particular sectors tend to cluster together, giving that area international comparative advantages. For example, Cambridge is seen as a global leader in cell and gene therapy and bioinformatics – investors seeking exposure to this area will pay a premium.
In the same vein, London has a significant concentration of financial and insurance services. This means investors have the potential to tap into a leading market and all of the advantages that this offers. From a commercial perspective, many of the largest businesses and their decision-makers are based in London. Being able to access these decision-makers and have those connections remains key in any commercial venture.
On a more practical level, hiring talent is more expensive in London. Therefore, to make the same progress, you have to deploy more capital. If this is the case, you will seek a higher valuation to avoid over-dilution.
How is remote working changing the environment?
In a post-Covid world, remote working is allowing everyone to have access to a wider scope of companies than ever before. The dream scenario for Paul would be to find companies coming out of regional areas where you can still achieve low valuations with the best talent. However, these businesses may have to be selling to decision-makers in London and even attract investment from the US. The idea of doing everything in the same region is fanciful.
Adam agreed with Aidan’s point that more term sheets equate to a higher valuation. Historically, there have been more investors focused on London, and a higher concentration of capital in the city, therefore, a greater chance of attracting more interest from venture capital. However, with more business being done virtually, it is easier to set up meetings that would not have happened before. This is allowing regions outside of London to begin catching up. He also pointed out that regional matched funding will drive where capital is deployed and may influence valuations.
What other factors make a company extra special? What else justifies those premium valuations, for example, Intellectual Property (IP) and Total Addressable Market (TAM)?
IP is difficult to value. Aidan’s view is that if a company has spent years of academic or grant-funded research developing a new piece of tech, then it is likely to enhance the defensive moat and, therefore, the intrinsic value, of the business.
For Adam, TAM is important. Investors want to know how large companies can get to judge what their exit and returns could be. They often look at TAM in conjunction with management. They then look at whether the management team will be able to take a large enough proportion of that TAM to sufficiently grow the business. A lot of the time, you hear that TAM needs to be £1bn. If the management team is really strong, then they could win a small percentage of that market. If they do, the return should be there. Whereas if TAM is only £100 million, then the team needs to be good enough to own the market. Very few, if any, management teams will be able to convince investors of this.
Using MarktoMarket’s data platform, you can ensure you are selecting the right data to gain the most informed insight into business valuation. MarktoMarket’s auditable data gives users the confidence that they are dealing with intelligence that can be trusted.
To continue the discussions about early-stage valuations and to see how data can support your negotiations, contact Doug Lawson.