A version of this article first appeared in FT Adviser.
Valuing companies is complicated. McKinsey & Company’s latest book about company valuations is an overwhelming 896 pages long. For a shorter read, you can pore through the 70 pages of the latest International Private Equity and Venture Capital (IPEV) valuation guidelines, widely adhered to by many EIS investment managers.
Thankfully, there is no need for investors to be familiar with all the ins and outs of start-up valuation methodologies.
But there are some key points that are worth understanding.
‘Fair value’ is not the same as ‘expected return’
Like many firms, Vala provides investors with statements twice a year, showing the value of the shares in their portfolio. To do this, we’re guided by the central premise of the IPEV guidelines, defining ‘fair value’ as the price that would be received ‘in an orderly transaction between market participants at the measurement date’.
This might seem obvious. But it’s important to stress that there is often almost no relationship between the value shown on statements and the value we expect to achieve when we eventually sell the shares. For example, if we hope to sell a company five years from now, then our estimation of the company’s current value is of only academic interest, particularly since the shares are illiquid.
Valuations are inherently subjective
The Discounted Cash Flow (DCF) valuation method will often be used as part of the valuation process at the point that shares are purchased, but it is less common to rely on DCF when producing interim valuations.
DCF involves building a financial model which projects the expected cash flows of a business into the future. Those cash flows (including a prediction of an eventual future sale price) are then added together, before applying a discount rate to adjust for the level of risk and uncertainty faced. Out of this equation drops a figure that shows the value of the business today.
This is about as rigorous and scientific as a valuation method can get. But there is still a huge amount of art involved, because the financial model will depend entirely on subjective inputs: estimates for everything from the rate of sales growth to the company’s salary costs for the next five years.
For smaller companies, it not possible to forecast financial results with much accuracy, so DCF models tend to be taken with a hefty pinch of salt. Founders generally want to raise a specific amount of money and will want to give away as little equity as possible. Investors want to maximise returns by not overpaying at the outset. Ultimately, agreeing a valuation is a process of negotiation, and a DCF model will be just one input into that process.
Often, ‘Fair value’ = latest share price…
At Vala, the share prices we use in our six-monthly investor reports are often identical to the share prices agreed when companies last successfully raised equity funding. The price that has been paid for shares in a real-world transaction is generally going to be a better guide to fair value than anything produced using another technique.
…but things will change over time
However, as the gap between funding rounds increases, the latest share price will start to become a less robust indication of the current value of a business.
Furthermore, sometimes circumstances can change quickly for an early-stage company. Hitting major milestones, such as successfully launching a new product or securing a key strategic partnership, can start to strip uncertainty out of a business, which in turn can have a big impact on its value. Significant underperformance can also result in a material change to a company’s likely fair value.
For making interim valuations, Vala therefore has to consider whether it is really still appropriate to use the latest share price as a guide to fair value. If not, there is a variety of techniques that can be used to reach a better answer. Perhaps the most common approach is to use ‘comparable transactions’ - extrapolating a valuation from the known sale prices of similar companies. For example, if a company has EBITDA of £1m and operates in a sector where companies typically achieve exit values of 4x EBIDTA, then £4m could be a good fair value for that company.
The process of valuing companies every six months is important, and over the whole investment holding period fluctuations in value provide a useful guide to the progress the portfolio companies are making. But in the end, the only value that matters is the cash returns from exits. And because valuations are so subjective, that figure may prove to be quite different to the fair value shown on investor statements.