Valuation Approach

Valuation Approach

Mar 30, 2016
The valuation conundrum!!!!
Luisa Sykes Luisa Sykes

Fintech is booming and valuations are achieving sky high levels with money flooding into the sector. Some companies have reached the unicorn status with a value of over $1 billion. In the UK two companies reached unicorn status, Transferwise and peer-to-peer business lending firm Funding Circle. Transferwise is now experiencing significant set-backs with operating costs running out of control.

The valuation of fintech or any other tech start-ups is never a straight forward process. What are the determinants of value in these sectors? Some companies raise funds easily while others struggle. What is the secret? Often start-ups benefit from the guidance and knowledge of angels investors or a lead investor capable of steering the company through the hurdles of the investment cycle.

Most VCs would want to invest in the next unicorn and look for the 100x or 200 x returns on their investment. In reality this is a rare outcome and nobody knows for sure if a start-up will be the greatest ever. A great number of investors are chasing the same deals for fear of missing out – this is the ideal conditions for creating the next investment bubble. The chase of extraordinary returns also persuades investors to fund hundreds of start-ups at seed stage hoping a few will succeed.

The determination of value is often not subject to very rigorous analysis. Value of a start-up is often determined by the amount of money raised at seed rounds. But is this the reflection of careful estimates of the future value of a company or just empty hyped bubbles? We find that both investors and start-ups are in too much of a hurry racing ahead to beat the next competitor – so no time for detailed analysis of company prospects.

The determination of value and consequently the amount of money raised is often tied up to tax benefits. Angel investors usually commit only £150,000 which is the SEIS limit for any UK company. Early-stage tech companies are often forced to have 2 seed rounds before they are in the position to raise some serious money on Series A round from institutional VCs. This can lead to some heavy equity dilution and we advise start-ups to manage their investment strategies defining what they are prepared to give away. It also happens that start-ups are often not ready at this stage to come up with a solid financial case to win over VCs. VCs want to see convincing arguments and solid business plans to justify the $1 million plus investment. The starting-point approach for valuation of a start-up is often the cost to duplicate – for a tech start-up would be the time to programme, cost of research and development, patent protection and prototype. This does not reflect the company potential for generating revenue.

Financial valuation of start-ups based on future returns is traditionally based on 0.5-1.5x net revenue for early stage start-ups and 2-3x revenue for later-stage growth capital investment. This is considered to be conservative in the fintech sector with investors using much higher multiples as the expectation of future growth are much higher too.

We can talk about evaluation based on the fundamentals of the business – by doing this type of analysis we are not free of subjective judgments but we are able to carry out an in-depth analysis of the market and strategize to make maximum industry impact. The valuation depends on two factors supply and demand and should be the result of the analysis of key elements such as value propositions, market segmentation, key resources, partnership options, cost structure, revenue streams and distribution channels.

VCs take a systematic approach looking at technological innovation and competitive advantage looking at companies that can influence the industry. VCs are also beginning to be more cautious and analyse potential high value in the future versus current ‘reasonable valuation’ which will maximize VCs returns.

  • VIA
  • Luisa Sykes