“Valuing high-growth, high-uncertainty, high-loss firms is a challenge (…) although DCF [Discounted Cash Flow] may sound suspiciously retro, we believe that it works where other methods fail, reinforcing the continued importance of basic economics and finance, even in unchartered Internet territory […] these stocks are highly volatile for sound and logical reasons.” – “Valuation, Measuring And Managing The Value of Companies” by Tom Copeland, Tim Koller, Jack Murring. Published by McKinsey & Company.
“For early-stage companies, the projections usually focus on the uses of funds; for later-stage companies, the projections should be more complete financial statements. In general, VCs (correctly) take all such forecasts with a grain of salt […] qualitative elements remain the key focus of the next phases of diligence […] they can both be phrased as questions: does this venture have a large and addressable market? (market test) and does the current management have the capabilities to make this make this business work? (management test) […] the market test is much more of an art when the VC is evaluating new markets, either because there are currently no products in that space, or because the products have not yet found any path to profitability.” – “Venture Capital and the Finance of Innovation” by Andrew Metrick.
“This topic gets very important in situations where an entrepreneur has a good idea but few assets. In such cases, it’s very hard to determine what the company is actually worth and valuation becomes a subject of negotiation between the entrepreneur and the venture capitalist.” – “What’s the difference between pre-money and post-money?” by Investopedia.
The cloud age is fostering two effects:
- (1a) democratizing access to all kinds of technologies and markets, which (1b) lowers barriers for entrepreneurs
- (2a) raising the stakes to differentiate and (2b) forcing the creation of unique value
We all get into discussions about a good idea and proceed with some web searches and conversations with people in that space. Then we might quickly realize that there is someone out there making it happen already. What first comes to mind is that speed and agility are of the essence even more than ever before. Though a deeper dive can reveal opportunities for differentiation even in crowded markets. This is a dynamic market environment where there are first mover advantages as well as aggressive fast followers whose businesses leverage the learning from others’ failures and successes.
The cloud age fuels innovation and enables opportunities that “grow and diversify the pie.” This also makes Clayton Christensen’s Innovator’s Dilemma more and more apparent for large established players who get to face serious competition from nimbler unconventional companies. When successful, a cloud start-up can feature high adoption rates, take market share away from powerplayers and even shift demand curves with disruptive innovations. However, as more competitors join the fray, it is increasingly challenging to spot the few future winners in an ever larger pool of startups.
Riding a hypergrowth’s wave can result in becoming a victim of success when failing to scale. Some of the cloud’s business models allow companies not to own equipment and related facilities, which is provided by suppliers of infrastructure as a service. When growth calls for further investments these are expensed in the income statement instead of capitalized on the balance sheet.That situation makes traditional valuation benchmarks far less reliable and, interestingly enough, losses are more apparent in the mix of thriving growth.
Promising start-ups might not yet generate revenues either. McKinsey’s manual on valuation asks the question on how to do a DFC analysis when there is no CF to D and makes a case for making financial projections coupled with conducting a level of business analysis that allows to develop an “understanding.” From a quantitative standpoint, we are left with some basic valuation tools to work with. Examples:
- Discounted Cash Flow – outlines trends and growth assumptions driving a scenario that renders future projections for both incoming and outgoing cash; the exercise entails estimating the present value of that cash flow and risk is factored by the interest rate set in the calculations.
- Real Options Valuation – credited with considering alternative scenarios where the more options available in terms of management decisions the higher the value.
- Comparables – seeks to exemplify what other seemingly equivalent enterprises have already proven; assumes that the start up under analysis can either come close, mimic or outperform those references.
- Balance Sheet Analysis – looks into assets (including know-how and goodwill), liabilities and ownership equity.
- Replacement and Replication – this valuation considers costs already incurred, choosing whether to account for hindsight (replacement) or factoring all efforts spent on experimentation and course corrections (replication).
Why is this important? Early on, a pre-money valuation (before receiving financing) will define the entrepreneur’s ownership and how that could change post-money. External investments in exchange for a percentage of the shares and services compensated with options will dilute ownership for the company’s founders. Valuing business prospects and R&D priorities will also influence technology roadmapping, as well as future negotiations involving financing, partnering, mergers and acquisitions.