Everyone fights about valuation: investors, entrepreneurs, wives, husbands, kids, bankers, lawyers, ex-wives, nerds, ex-husbands – everyone.
Part of the reason why there are so many fights about technology or technology-enabled services company valuations is because most companies have some services, some technology, some partners, some clients and some vision. It’s the “vision thing” that turns heads – and calculators – but “vision” is arguably gray for lots of companies – and especially investors. Proprietary technology should also turn heads, though here too there are fights. Have the patents been granted? Is the technology really unique? Is the team any good?
You get the idea.
So what’s your company worth, or, if you’re an investor or acquirer, what are you willing to pay?
Entrepreneurs of start-up and early-stage companies need to understand the difference between two opposing valuation methodologies. Whenever they decide to raise money from either Angel or institutional investors, they need to develop pitches that emphasize strategic valuation, not valuations based on rigid or “standard” sales/profits formulae that almost always help investors acquire more equity than they deserve. Operational valuation methodologies are always a trap for entrepreneurs and always a boon to investors. Operational valuation is the oldest discount trick in the book. If you’re an entrepreneur, avoid it at all cost; if you’re an investor without much vision – or a so-called “professional investor” with impeccable “discipline” – make operational valuation your best practice.
I recently had a discussion with a prospective investor in a technology-enabled services company about valuation. He was bullish on the company and fully understood the components: a proprietary technology platform, a portfolio of pending technology patents, a world-class technology development team, a services delivery model and a basket of client logos even a global consultancy would prize. The company was increasing sales by 50% a year, had 75% recurring revenue from obviously very happy clients and was for the first time in its history profitable. The company was also in a white-hot space and had a horizontal and vertical vision that could potentially revolutionize the industry.
The investor assumed a Yoda-like pose and offered to invest in the company based solely on revenue and profit. Everything else was discounted. Put another way, zero premium was placed on the proprietary technology platform, the portfolio of pending technology patents or the world-class technology development team. Not much value was assigned to the client logos either, or data around the positive renewal and land-and-expand sales experiences. The methodology yields the lowest possible valuation for an otherwise strong, growing company with proprietary technology and a technology team that would be highly valued especially in Silicon Valley where it’s not unusual for teams to command a premium of up to $500K per engineer.
I argued that assigning zero premium to the intellectual property (IP), the technology team and the scalability and extensibility of the tech-enabled services was indefensible (and greedy). How in the world could these all be worthless? He held firm. So did I.
What’s really happening here?
Just the greed game played from both sides. Why not devalue as much as possible, invest as little as possible, and acquire as much equity as possible, or why not ignore sales and profitability altogether and focus on the big, game-changing picture and the proprietary IP? It just depends on where you sit, doesn’t it?
“So let’s see, Mr. Entrepreneur, your revenue was $5M last year and you were barely profitable, so we’ll give you 3X on your booked revenue discounted for lousy EBITDA … or a valuation of $12M.” “But what about our technology?” Mr. Entrepreneur says. “That comes with the deal,” the investor says, “you want me to pay for the forks I use at a restaurant?” “But what about the projected revenue of $9M for this year?,” Mr. Entrepreneur says. “It’s projected, not in the door,” the investor snaps: “$12M … take it or leave it, or we’ll talk about clawback!”
“Let’s look at the big picture, OK? Let’s project how much of an exploding market – some of which we haven’t even defined yet – we can control with this technology and the services we’ll build around it.” “What’s the size of the potential market?,” the investor says. “Size of the market?,” the entrepreneur laughs, “what ‘market’ … it’s endless!” “And don’t forget the IP and the engineers who created it – and are still creating more and more IP!” The professional investor, who has little market or technology vision, just shrugs.
Strategic valuation methodology triggers due diligence processes where the technology and the tech-enabled services delivery model – and their potential – are assessed from every angle. Operational due diligence processes include customer calls: “Do you like what the company does for you? Would you buy more of their services? Would you recommend them to a friend?” It also requires a proctoscopy that examines all expenses, revenue, competitors and markets over time and into the future, discounting everything along the way.
The other (dark) side of the operational valuation methodology is the wide and wonderful “comparables” equation designed to devalue every company on the planet. Why? Because it’s always possible to argue that, “well, you’re just like Company A, B & C (based on another operational valuation that’s been “set” by some investors who created the “precedents”) and they’re only worth X!” “Yes,” the entrepreneur says, “but Company A is completely different from us!” “Not really,” the investor says, “in fact, you’re exactly the same, and they missed their numbers last year.”
The best thing about the valuation dance is the source of the cash. Angels write personal checks. They understand risk and dream of strategic valuation-based exits. Venture capitalists (VCs) spend other people’s money who generally have no idea how their money’s being spent. VCs, therefore, while playing the operational valuation card over and over again, are relatively comfortable protecting – or losing – others people’s money. Obviously they want to make money for their limited partners because that’s how they make money for themselves (and generate the next investment fund), but there’s always another deal down the road. So even though they’re wired to operational valuation, they’re also intelligent enough to understand the linkage between the two valuation methodologies and how to slice companies into several pieces, or just walk away because “strategic” investments are sometimes just too expensive. (In fact, there’s a correlation between what’s happening in the venture world today and the popularity of operational valuation. As more and more venture investors move further and further downstream to later-stage investment opportunities, the frequency of strategic valuation has declined proportionately, leaving start-up and early-stage entrepreneurs to fight for strategic valuation. Some years ago, these entrepreneurs had an easier time starting valuation discussions based on the strategic impact their technologies and companies might have on the market. It’s much harder in 2015.)
The third class of investor is the companies that often buy and sell companies for operational and strategic value. Facebook paid $2B for Oculus Rex. It was strategic, obviously not operational. Technology companies buy IP and technology teams all the time, even if the revenue model around these assets is unclear. Services companies buy other services companies all the time for as little as they can. Clearly this is operational. Many technology services companies, especially those at the bottom at the food chain (like infrastructure technology providers) have no leverage in these transactions because their value has already been “set” by some relevant/irrelevant “precedents.” They’re literally trapped in their valuation category and there’s no way they can ever escape. Maybe 3X revenue; maybe not. It’s all up for discussion.
So given the nuances of each valuation methodology and each class of entrepreneur and investor, let’s build a funding strategy that optimizes/minimizes valuation for each class.
Entrepreneurs should start with Angels. Most Angels understand risk. They’re much more likely to endorse a strategic valuation methodology, though they also understand the trade-off between early risk and strategic valuation and therefore, because they’re literally seeding the start-up, deserve a good valuation, however strategic it might be. They’re also willing to write more than a single check – but beware of Angel investor fatigue. Over time, their enthusiasm will decline and entrepreneurs have to move on to a different class of investors (or different Angels).
Entrepreneurs should never forget how to monetize their strategic importance: even when revenue and profits are exploding, they should never underinvest in, or undersell, their strategic value.
VCs are valuation crushers. They will invariably try to apply the operational valuation methodology no matter what the company actually does. They do so because if you show up at a VCs office you probably need money and the first “desperation test” entrepreneurs are given is their willingness to accept a low valuation. They also do so because it protects the investment of their limited partners and, most importantly, themselves.
Corporate M&A teams are both strategic and operational valuation specialists. They understand strategic vision and operational effectiveness. Depending on the vertical industry, some value one more than the other. For example, technology and pharmaceutical acquisitions are often driven by strategic valuation models, where retail and low-end services acquisitions are often based on operational metrics. Entrepreneurs should always profile their investors and acquirers before talking with any of them.
So the protocols are clear:
Entrepreneurs optimize strategic valuation.
VCs crush strategic valuation and discount operational valuation.
Corporate M&A teams assess the strategic and operational value of potential acquisition targets.
All clear, right?
This article was written by Steve Andriole from Forbes and was legally licensed through the NewsCred publisher network.