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Entrepreneurs always ask what their company valuation is and whether they are ready for investment. The answer to the first question is that the company valuation always depends on supply and demand, on the number of buyers and sellers, the more buyers you have with a strong appetite, the higher your valuation, the fewer buyers, the lower the price. And the number of buyers can go down sharply from one day to another after a market crash or after a pandemic has been declared as we have seen in the last few weeks. As for the second question, every company is investment ready at a certain price. Being investment ready clearly depends on who the target investor is. If they are very demanding, the bar will be higher. At the same time, the more demanding they are, the higher your valuation. You can be investment-ready with just a piece of paper. So being investment-ready is a question on what is the risk appetite of your target investor and the higher their risk appetite, the lower the expected valuation.
So, given that every company is always investment-ready at a certain price, the more relevant question to ask is what is driving my valuation up and what can I do to be perceived as investment-ready from the perspective of the most demanding investors?
First, valuation is closely related to a company’s fundamentals, to whether such or such company has high revenue or profit growth, whether they have high gross profit or EBITDA margins and whether they have high returns on capital employed. Of course, there are other quantitative metrics that can be relevant before you reach revenue stage, but it is unlikely investors will consider an investment without financial forecasts that include revenues and, at some point profits.
But more importantly, valuation is about the expected fundamentals of a company over the next few years. If a company is able to show very high growth over a large number of years with sustained high margins and returns of capital employed, it is likely to drive higher valuations.
The most important driver of valuation is about the certainty of those expected fundamentals. Highest valuations, expressed as multiples of current revenues or profits are at their highest when investors strongly believe that the company will continue to deliver sizeable revenues with high growth and high profit margins and returns on capital employed for a number of years. With confidence in the certainty of expected fundamentals, investors are ready to see beyond past performance and believe in the company’s forecasts not only one year ahead but even several years ahead and pay a high multiple of those far forecasted fundamentals. Companies that have consistently delivered shareholder value are generally the most trusted in their ability to continue to do so. From a financial perspective, the level of certainty in a business forecast is directly correlated with the level of risk in that business. High certainty in the forecast is equivalent to low risk in the business and low risk converts into low discount rate. So the higher the certainty, the lower the risk, the lower the discount rate and the higher the valuation.
The next key influencer of company valuation has little to do with the company fundamentals or performance but is related to the number of potential investors in the business and the level of liquidity, the ability to get out as soon as things go wrong and the ability to get out without driving the price down when selling. The larger market cap companies have the highest liquidity and benefit from a liquidity premium, smaller market cap companies are more subject to price drops when an investor is selling a large ticket. Private companies have the highest liquidity discount because they are just not liquid and are dependent on liquidity events which are very rare especially when there is an increase in risk and uncertainty in the company. This is the key reason why most investors are generally focusing on public markets rather than the private markets. This is also the key reason why a great company could have a low valuation because of the lack of liquidity at a certain time.
So, we need to focus on company fundamentals as the key drivers of its valuation. Moreover, we need to realise that the younger the business, the more uncertain and in particular the less reliable its set of company forecasts. This is the key difference between small private companies and large public companies. Large companies have sets of accounts that are generally reliable and a large number of quantitative metrics. Investors in large companies are focusing on quantitative metrics which are available. Surprisingly, they pay little attention to qualitative metrics, like the quality of the management team, which are often way more relevant to valuation than quantitative metrics. In order to value a seed stage or early stage company, there is often nothing more that qualitative metrics. The trick is to understand the qualitative and translate it into quantitative measures. Let the qualitative raise the confidence level and reduce the uncertainty component of a company’s forecast. Convert the qualitative into a measure of the risk inherent in the company’s business.
A company valuation is therefore directly related to its business risks. What are those risks? All those factors that will have an impact on the ability to deliver a vision and a business plan. To be successful, you need a vision to change a broken process and disrupt the way things are currently done. You need a group of people with the right set of skills to execute that vision, and you need a product and a market for this product. You need customers to buy the product, traction in your first interactions with those customers, a business model to generate revenues and unit economics that will generate high returns on capital. Then you need to raise sufficient funding to operate for enough time to be able to have an impact and show progress the next time you need to raise funding. Finally you need to sign the right deal, the set of proper terms that will regulate your relationship with your investors and the equilibrium price that will make everyone happy. A good deal is a deal that makes everyone happy. If you look at the above, the qualitative items we have listed are a set of risk factors, which we call the risk ladder. The more risks you address satisfactorily, the higher the valuation and the more investment-ready for the largest investors.
The risk ladder can be ordered in the following way:
If you score a 10, you are likely to be in a position to raise a significant round of funding at an attractive valuation. If you are at level 2, you are unlikely to have revenues and unless you have a stellar team with a stellar track record, you are unlikely to be able to raise a large round and if you are it may imply way more dilution than you expected. The lower you are on the risk ladder, the lower your appetite should be and you should focus on tackling those risk factors to reduce the perceived uncertainty your potential investors will struggle with.
>> Continue to Part 2: The valuation drivers investors are looking for