Are you underselling your company? Selecting the most appropriate valuation approach
Finalising deals is all about direction and momentum, and there are few issues more difficult to navigate in a transaction than valuation alignment. While it is common for buyer and seller to depart on the finer elements of valuation, in practice both sides take comfort when there is broad alignment within a reasonable range.
Accurate valuations are crucial for both fundraising and business planning, but unlike mature companies, early stage companies operate in an often uncertain environment with limited historical data, making valuation both an art and science. Another layer of complexity arises when the industry is evolving rapidly and expectations run ahead of clear product/market fit, such as we often find in emerging sectors such as soil, climate or energy tech. While both founders and investors seek a fair valuation, making a successful deal happen ultimately comes down to what both parties can agree the company is worth, based on key value drivers.
When are valuations required for early stage companies?
Businesses typically require external funding to support growth. Valuations are used to determine the amount of money to be raised and the ownership stake to be offered to investors. In addition, valuations support investors in deciding which form in it will invest (i.e., debt, preference shares, convertible note, etc.)
Valuations are also used by early stage companies themselves to assess the financial health and value drivers of the business. Valuations support strategic planning, goal-setting, and internal decision-making for budgeting, resource allocation, and capital allocation. Management can use valuations to evaluate the success of their company model, pinpoint areas for development, and allocate resources to promote growth.
Methods for early stage company valuation
The most common valuation methods for companies generating cash flows are:
Comparable company analysis (market approach): Early stage companies are often valued based on transactions of similar companies in terms of business type and stage of maturity. For example, if a similar company recently raised funds at a 5x revenue multiple, investors may use this benchmark. Differences in the businesses or markets are then factored into the valuation. For example, it is important to distinguish between companies focusing on hardware vs software products as software typically attract higher multiples due to an easier scalability and being less capital intensive. Management should remain wary of using multiples from overseas companies as the industry might be more developed or face a different regulatory environment. The most used multiples are EV/Revenue for companies that are not profitable yet and EV/EBITDA for companies generating profits. In our experience, investors will most likely apply the multiple to historical (last twelve months) financials, unless the company can provide some certainty around the next years cash flows, ideally in a form of contracts with customers.
Discounted Cash Flows (DCF): While DCF is widely used for mature companies, it can also apply to early stage companies by forecasting future cash flows and discounting them to their present value. The challenge lies in predicting revenues, expenses, and growth with historical limited data. The owners often forecast significant growth of their business, and the task is persuading investors the forecast is achievable.
Early-stage companies that have are not yet generating cash flow can be valued using:
Scorecard valuation method: This method is common for pre-revenue companies. It involves benchmarking the company against others in the same stage, industry, and region based on factors like team strength, product innovation, and market potential.
Berkus method: Designed for early-stage companies, the Berkus method assigns a dollar value to key components like the idea, prototype, team, strategic relationships, and product rollout to create a more qualitative valuation.
Cost approach: The method involves figuring out how much it would cost to recreate your company plus any intangible assets, like your brand or goodwill. Under this method, the value is estimated by adding up the fair market value of physical assets, including research and development costs, product prototype costs, patent costs, and more. One major drawback is that this method inherently does not capture the full value of a company, particularly if it is generating revenue.
Another method used mainly by financial investors is called:
Venture Capital (VC) method: Is based on estimating the future exit value of the company and then working backward to estimate the current value. The VC method calculates the exit valuation (IPO, transaction) at a specified future date, typically by applying the observed multiples of comparable listed companies and comparable transactions to the target company’s future earnings. Taking this exit value into account, it then determines the price at which the investor can invest today to achieve their target money multiple and associated Internal Rate of Return (IRR). This gives a sense of what the company is worth today.
Challenges in early stage company valuation
There are several hurdles to overcome when trying to assess how much a company is worth. These challenges may include but are not limited to the following:
Lack of historical data: Early stage companies often have limited or no revenue, making financial forecasting highly speculative.
Lack of comparable companies: It is difficult to locate comparable businesses due to their uniqueness, particularly when focusing on an industry that is developing. Alternatively, the comparable companies may have raised money or been part of a transaction but did not disclose financial information to calculate multiples.
Subjectivity: Valuation depends heavily on assumptions about growth, market size, and team capability. Different investors may arrive at vastly different values.
High risk: Early stage companies have a high failure rate, so investors often require substantial returns to justify the risk, which can impact valuations.
Market conditions: Valuations are also influenced by market sentiment and trends. For instance, tech or clean energy early stage companies may command higher valuations during boom cycles.
How to increase value of your business
Based on our experience, investors are looking for and value favourably:
Robust business plan - The plan should clearly define your target market, the unique value proposition and the revenue streams that will fuel your growth.
Competitive advantage - Proprietary technology, patents, or a unique business model differentiate the early stage company and enhances its value.
Market traction - A growing customer base, strong user engagement and retention rates increase investor confidence. Investors place more value on established recurring revenue streams through subscription services, long-term contracts, or customer loyalty programs, ideally with a diverse customer base to reduce dependence on a single client.
Clear path to profitability - The business plan and financial model should include a well-defined unit economics and a plan for sustainable profitability improvement.
Scalability - A business model that can grow efficiently without proportional cost increases is highly attractive. This is shown by software companies trading at higher multiples than companies selling physical assets.
Experienced team - A strong, capable leadership team with industry expertise reassures investors.
Accurate and transparent financials – A transparent and well organised financial model, supported by accurate financial records evokes trust in the business.
All these attributes shall be highlighted in a well-prepared investment memorandum accompanied by a clearly designed and a robust financial model. This ensures you are optimally positioned for valuation discussions with investors, maximizing potential outcomes.
Final thoughts
Valuations for early stage companies are as much about understanding a company’s vision and growth story as it is about crunching numbers. Founders should focus on showcasing their value proposition, scalability, and financial model to justify their valuation to investors. By combining robust methodologies with clear communication, early stage companies can strike the right balance between securing funding and retaining ownership. As mentioned at the beginning, the company is only worth how much market / investor is willing to pay for it. It is essential for owners to enter negotiations with investors equipped with a robust and realistic business valuation, ideally prepared or validated by an independent external party.
At Rennie Advisory, we stay actively engaged in the market, working with a wide range of financial and strategic investors. Drawing on our extensive experience, particularly in the renewables and energy transition sector, we can provide you with a realistic assessment of your company’s value. Our dedicated modelling team is also equipped to build a robust financial model that supports and strengthens your valuation.
Ultimately, a successful valuation and subsequent capital raise process are not just about portraying the highest potential value of a business, but also about finding the right partner. A partner whose expectations align with yours and whose investment structure meets your unique needs and goals.