Different financing strategies call for different valuations
“Would you tell me, please, which way I ought to go from here?” said Alice
“That depends a good deal on where you want to get to” said the Cat
Recently, I've been approached by a customer requesting a valuation they would need for their next financing round.
"Well," I said. "What are your goals for this round?"
The answer to this question will determine the valuation process and its ultimate success: Bringing investors, lenders, equity holders to a common ground, driving the financing round to a close.
Such valuation will determine the amount of cash injected into the company, simultaneously the amount of equity conceded.
Financing round: Motivations
Firms may have different goals for raising funds, depending on their maturity (current status), but also on their future plans and their potential.
Among these motivations some are:
Early stage financing, aimed to initial R&D, to finding Product-market-fit
These early stage rounds are characterized by extremely high risk and uncertainty, resulting in low valuations. These valuations are based on market dynamics rather than on actual financial results of the firm - these not being available.
Advanced rounds aimed for accelerated growth
In these later stages, investors are pouring cash into companies to build marketing and sales infrastructures, to scale the production (whether it is a mass production physical good or a digital service)
Project based advanced rounds
Oftentimes, firms opt to capital injection when developing a distinct project, separate from the day to day business. Realty companies developing a new property are a good example, and so are established firms, developing a "start-in": A new product, an internal project that is perceived as a major growth opportunity.
Secondary funding rounds
Other times, share holders of a well established company wish to accelerate value extraction, all by reducing tax implications. The proceeds of such round are directed to the share holders, while investors expect to share in its continuous success and cashflows.
Financing channels; investor preferences
While capital markets offer many financing channels, these are not created equal: Channels vary in their targeted firm stage and maturity, in the amounts available through them, and in the risk / reward equilibrium they require.
Venture investors
Venture investors are willing to take considerable risk in return to significant equity. As they research your firm for investment, they look for signals that your management can deliver, that a large opportunity exists, and that you are building competitive advantages to avert future competition.
These investors range from small (family and friends, angels), and scale up to venture partnerships, strategic investors, and institutional investment vehicles.
The earlier you approach, the higher the equity they take (and the lower the valuation)
Non dilutive financing
Dependent on your tolerance for bureaucracy, non dilutive capital is, equity wise, cheap financing alternative.
Available from a host of national, bi national, and international sources, they offer a structured, somewhat limiting, but often easy to repay (limited time royalties), or totally free (grant). Some of these programs operate as consortia, enabling collaboration across industries and borders, helping you to build international marketing channels and value chains.
Note that I have listed this financing channel, valuation is less in scope, because no equity is involved. The royalty payments will, however, bear on the top line, which will affect cashflow and consequently the company's valuation.
Debt
Isn't lending one of the oldest professions? Debt is an efficient financing tool today, as it always was. Your average savings and loan bank isn't usually the best go-to, though. Other sources are: From merchant banks to venture lending, these lenders understand risk and reward and can tailor financing packages that you are likely to repay, requiring collaterals you are willing to risk.
Note that the impact of debt on the firm's value derives from the tax shield on interest payments, increasing cashflows and resulting valuation.
Investors' ROI and you
Different investors seek varying return on their investment to reach their risk-reward policy.
The Internal Rate of Return (IRR) varies wildly between industries and investor types.
What is it to you, and to what does it mean for your financing efforts?
The VC food-chain
An important - and eye opening - question to ask is what is the end-game for potential investors?
It depends on close you are to an IPO.
Seed rounds ➜ Early rounds ➜ Later rounds ➜ IPO
The later stage you are at, the bigger investors step in, investing increasingly larger amounts, yet expecting lower multiples, as risk diminishes. This chain forms early investors' exit strategy: Each early investor expects later ones to buy them out, at increasing value.
For this to work, any venture must follow a virtual road map - the pace in which your valuation must grow. Early stages investors must understand how you can reach meaningful milestones that would justify the higher valuation in the next round (where they can exit).
The above behavior is industry sensitive: Timelines, required funding, expected exit amounts vary, drawing different investors.
While financial investors at later stages may be prevalent in any industry, strategic investors bring focus, substantial knowledge, and perhaps a particular a set of motivations.
Now that you have defined who are you going to raise funds from, you understand what is expected from your venture for this funding round to be successful:
What is the expected valuation for next round
What are the financial and operational milestones you need to reach
This is the time to start building your budget.
Your Strategy and Budget
No two strategies are alike, nor are the supporting budgets. Once you've chosen your target investors and set your goals accordingly, You can now build the budget leading to the milestones you seek.
Target ARR and growth
Active users
Annual contract value
CAC and LTV
These goals will be supported by actions, expenses, personnel and other resources that you allocate.
The goals will have your team commitment to them as well.
The key numbers to take from this exercise - your business plan - are:
How to calculate - and justify - the amount of funding you raise - the sum of your expected negative cashflows during the planning period;
What are your forecasted financial results, namely, your future free cash flows;
The yearly growth you expect to generate
Image taken from the article: Raising Capital for your Startup - The SHORT guide
The amount needed (393) the forecast EBIDTA amounts start negative at (86), (92), (96), are expected to break even in Q6, and then grow at an average m/m rate of 28% in the 3rd year.
Not listed in this analysis is what is called terminal growth, which is the average growth for stable / mature companies in the same industry and market.
Valuation and Equity - Round One
Once your budget is ready, an initial valuation can be made.
This valuation will be a Discounted Cash Flow (DCF) based exercise, where the result depends on the following, somewhat subjective, parameters:
Forecast period free cashflows
Forecast terminal growth
WACC (Weighted Average Cost of Capital) for the particular project
The valuation will be the sum of all the free cash flows in the forecast period, discounted at your cost of capital, plus the terminal value, again, discounted at your cost of capital:
Note the following calculations:
WACC - Weighted Average Cost of Capital (A percentage of the capital sources for the company) uses the formula:
Where:
D - Debt
E - Equity
Cd - Cost of Debt (in %)
Ce - Cost of Equity (in %)
"Terminal value", which is the value of the activity in the later years, assuming it continues in perpetuity.
Where:
CFn+1 - Is the Cash flow expected in the year after the project end date. In our example: $1'041
WACC - Weighted Average Cost of Capital, as shown above. In our example: 30%
g - Long-term growth. In our example: 10%
So, the terminal value will be:
______
The valuation of the firm would be the discounted cash flows in years 1 through N, plus the terminal value - also discounted by the WACC, as shown in the formula:
The Excel formula we'll use:
=NPV(G9*(1+C19)/(E18-E19)
And the resulting DCF would then be: $1,538
You'll notice that the investor's equity in the above calculation is 20% of the company's shares, which is the ratio of the investment (393) to the post money valuation (1538+393=1931).
393/(1538+393) = 20%
Valuation and Equity - Round two
Suppose you were to approach investors with a preference for their investment strategy: They prefer larger cheques ($1M), and demand more equity (25%).
What would that mean to your valuation and budget?
We'll work from the bottom up:
First, the easy part. We know the investment, we know the equity, we know the target valuation.
1,000/(V+1,000) = 25%
The resulting valuation we need to attain is
V = 1,000/.25-1000 = 3,000
The resulting budget will have to credibly allocate the larger investment amount - $1M - so that you cab credibly claim a $3M post money valuation. The money is not for the founders to take home: You need to adjust the budget to set more aggressive goals.
Analyzing the difference in these two valuations, it is obvious that the R&D of the project remains similar in scope, while more efforts are needed in marketing and sales, and much more aggressive sales goals are demanded:
Conclusion
In the above example I demonstrate how different investor preferences dictate a higher valuation, necessitating aggressive revenue growth and supported by marketing and sales resources.
This goes to show how dynamic is the fundraising process, and how strategy changes accordingly.
What I am not detailing are further factors that may go into consideration: The amount of debt and its implication on the company's valuation (and risk); I have simplified the financial analysis to exclude changes in working capital, amortization and depreciation.
All these factors are significant in real-world situation, and will change your valuation, the amount of venture capital you source, the risk taken, and the equity forgone to investors.
An important disclaimer: I have not covered reality checks, used by investors to curb entrepreneurs’ enthusiasm:
Industry, geography, phase comparable firms set a real world perspective on your forecasts and calculations.
If you are interested in building your own strategy to grow your company, come talk to us. We can help.
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