Not the usual article!
This article is not the usual article you can find in our blog. Instead this is an essay on startup valuation that I wrote a couple of months ago. It presents a completely new way of looking at startup valuation and division of equity. The answers to a survey on valuation are presented first while later on the new framework and its advantages are discussed. Do you want a complete new and detailed point of view on startup valuation? Read the following!
Abstract
The purpose of this paper is to present a new framework of startup valuation and division of equity. This framework is based on the intuition that the process of investing can be interpreted as a merger between the company and a firm that has cash on its balance sheet. This intuition clarifies the notion and the importance of synergies in this operation as well as the outcomes. Indeed, without a proper identification of the synergies amount, the investor will push for a lower valuation in order to get a higher percentage of equity. This can create frictions with the other party and lead to a deal break. Given the strong financial constraint of a startup, this inefficiency could lead to the anticipated termination of the activity, even when positive NPV projects could be pursued. Other minor implications are also discussed. The paper will also present the results of a survey conducted to investigate how the valuation is done in practice and will compare these results with the new framework.
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I. Introduction to the problem
Valuation of startup companies is usually problematic because of three factors. First, often the company does not have revenues, stable cash flows or even a market share, since the novelty of its idea. Second, the entrepreneur’s knowledge about finance and valuation is seldom deep enough to be able to use proper valuation metrics and to forecast future cash flow. Third, these firms are already financially constrained and they often cannot afford a formal advisor to help in this respect.
These conditions lead to the fact that valuations in this environment are not sophisticated enough. Furthermore, this situation creates opportunities for sophisticated investors, like venture capitalists and business angels, that can use their deeper financial knowledge to lower the valuation computed by the entrepreneur in order to obtain a larger amount of equity in return for their investment.
From internet research and a survey, it appears that the most widespread procedure to calculate the equity percentage to assign to the investor is a simple calculation: the investment over the valuation of the company (as the money was effectively at its disposal) plus the investment. The denominator is referred to as “post-money valuation”, while its first term, the valuation, is referred to as “pre-money valuation”. The method would be correct into a competitive market where all the synergy premium is attributed to the seller and the buyer pays the fair price. However, for startups, the market is less competitive and a more sophisticated technique is required.
The technique proposed in this paper is based on M&A theory and on the fact that investing into a company can be assimilated to the M&A process of merging the standalone company to a new-co which only asset is a certain amount of cash in the bank, the investment. From this framework, we can already add an important distinction to the process outlined above. This distinction concerns the stand-alone valuation of the company and the merged-valuation, being the first the value of the company without any external financing, and the second the value of the company as if the investment was possible but not still on the balance sheet (pre-money valuation). This distinction has its focus point on the concept of synergy. Synergies, in M&A theory, are all the value improvements that the two companies can obtain being merged and that enhance the value of the merged entity compared to the value of the two separated companies. These synergies are particularly important in the startup process since the fact that the company is strictly financially constrained, and thus the infusion of capital is critical and creates important financial synergies. As discussed further on in the paper, the splitting of synergies between the investor and the entrepreneur is of utmost importance in determining the percentage of equity to assign to the investor. This split is determined, among other factors, by the bargaining power of the two parties. The new framework allows the identification of problems and frictions created by the old one and improve the understanding of the true value of the company and of the bargaining positions of the parties involved.
The paper will proceed as follows: The next section presents the results of the survey and the interpretation of how the valuation is done in practice. Starting from these basis, the third section will discuss the strong and the weak points of the various methods and will detail the proposed new framework. The advantages and disadvantages of this method are also presented in this section. The fourth section draws the conclusions and the recommendations derived from the new framework.
II. Survey results and startup valuation in practice
Before proposing a different way to value startups that takes into account synergies, there is the necessity to know how startup valuation is done in practice. I try to address this question by the means of a survey. The survey was posted online on different LinkedIn entrepreneurship group reaching an audience of almost 300.000 people. The survey was posted on June the 5th, 2012 and in 20 days it collected 16 responses. The answering ratio is low but it is common with this type of media. Indeed, everybody can post on LinkedIn and the time that the single user dedicates to each post on average is really limited. However, the answers gathered with the survey are just a reinforcement of the belief that improved techniques of startup valuation are not used in practice and are not included in the theoretical mainstream on this topic. Indeed the methodology proposed and the conclusion derived from it are new to common textbooks on the matter (Smith, Smith, Bliss 2011). Regarding the audience, the persons frequenting these LinkedIn groups are either entrepreneurs, investors, or business services that focus on the startup market. The exposure of the survey then should be targeted to the right persons. Indeed, investigating the answers to the question: “What is your role in the company?” 66% responded “Partner”, 16% “CEO/founder” and 18% “Founder”.
The survey includes 13 questions related to valuation practices and the importance of financial knowledge when dealing with investors. To the purpose of this paper, an important question that tries to gather information about the usage of synergies computation in practice is: “Does the valuation change when pitching the company to different investors (following the fact that they may contribute in different ways to the company)?”. This question aims specifically at the synergies concept, even if the word is not stated in the question. The reason for not stating the word is that this paper wants to investigate the way in which things are done in practice and thus phrasing the question using highly theoretical words would have lead the answers in a different direction.
To this question, the 86% of the results indicate that the valuation did not change. This result is important to the extent of this paper and means that startups are not considering synergies when valuing the company. Indeed, we can infer that the selling side of the transaction, the startup, does not take into account synergies created by the relationship with different investors, with different capabilities, experience and network. This is important and surprising to notice since the importance that the startup attributes at the financing process. When faced with the question “How do you rate the importance of the financing process in the startup?” and the possibility to give an answer between 1 and 10, the average person answered 8.6 with 10 staying for “Of outmost importance” and 1 staying for “Not important at all”. Furthermore, when faced with the question “Do you think that you should improve your financial knowledge in order to better deal with investors?” the average person answered 2.4 in a scale to 10 with 1 being “Yes, definitely!” and 10 being “No, I have all the instruments to deal with investors”. Knowing this, it is surprising that the average person did not ask for help in dealing with investors while only one answer indicated a fellow entrepreneur helped in the process. The last important result that we can infer from the survey results is that the bargaining power is really important in the final outcome of the valuation process. This result will be discussed further on in the paper since its key role in the splitting of synergies between the two parties.
The survey also asked the known methods to value a company. The results clearly indicate that the majority of people know how to compute a standard Discounted Cash Flow (DCF) valuation and a multiple valuation. The venture capital method is also known by the vast majority of the people surveyed. The Business Angel method, that involves a simple calculation of the value based on a checklist of physical attributes that increase the value of a company, is known to only the 26% of the persons surveyed. While the more sophisticated Certainty Equivalent Method (CEQ) that involves the adjustment of future cash flows based on their risk and then a discount rate equal to the risk free rate, is fairly unknown with just the 8% of the answers. The same question was asked to investigate methods used by investors with fairly similar results.
Other questions investigate the knowledge and the methods used to value the startup and starting the financing process. From the answers we can infer that the method to compute the valuation of the startup and the percentage of shares to assign to the investor is in today’s practice, pretty simple. A valuation is computed as if the company could actually raise the money and to this valuation the amount of the investment is added. This procedure leads to the computation of the post-money valuation. The percentage of equity to assign to the investor is then the investment over the post-money valuation.
As explained in the next section, this method is incomplete and simplistic. It has also some important drawbacks since it can create tensions during the negotiation and can possibly decrease the amount of startup funded.
III. M&A theory and application of models to startups
The main intuition of this paper is that the process of financing a startup can be assimilated to the merger of two companies. The first is the startup, with its own assets, people, debt, intangibles and future prospects. The second is a company that has cash in the bank as its unique asset. The amount of cash the company has in the bank is the amount of the investment that the investor want to put in the startup. This merger is carried through by issuing new shares and giving them to the shareholder of the “investor company”.
This intuition creates a new perspective in startup valuation. This new perspective is based on the concept of synergies and that the combined value of the two companies is bigger than the sum of the two separated entities (Ficery et Al. 2007 among others).
a. Synergies and Valuation, M&A and Startup environments
Theories and methods to value synergies in mergers and acquisitions are already consolidated in financial literature (e.g. Bruner 2004, Arzac 2007). The methods discussed involve discounted cash flows, trading and transaction multiple valuation. Only the DCF method however can thoroughly model synergies. The usage of transaction multiples can be also intended as a calculation of synergies. However, in this case, synergies are not transaction specific but are averaged over the whole number of transactions taken into consideration in the computation of the multiples.
The usage of the DCF method and the modeling of synergies is pretty straightforward. A deep discussion of this method is out of the purpose of this paper however we can summarize the main steps of the method without mentioning calculation details. If the two companies are traded, the valuation of the standalone entities is expressed by market values. However, when the merger is completed, the company can take several actions to increase the valuation of the combined entity. Examples of these actions are the layoff of employees or duplicate divisions, the increased revenues driven by cross-selling advantages or the decrease/increase in leverage. These are just few example that can be modeled when computing the present value of the merged entity. When this value is computed, it is sufficient to subtract the present value of the two separated entity to observe the value of synergies. This amount is accounted for in the price, in case of an acquisition, or in the share ratio, in case of a merger. In both cases the amount of synergies creates a premium that have to be split between acquirer and target (Varaiya 2006).
As discussed in the previous section, in practice the premium related to synergies is not valued separately during the financing of a startup. The reason for this is probably that the players involved are not really knowledgeable about finance and startup valuation is already a difficult matter. Furthermore, it could complicate the negotiation. However the synergy premium in this environment can be even more important than in a public merger or acquisition.
My suggestion is to apply the M&A framework to the financing process of a startup. From the method used in practice, it is not clear whether financial synergies are computed into the initial startup valuation. It seems they are since the valuation is done taking the investment as a given. However this method does not explicitly model the synergy and still lacks the model of the value added by different investors. The explicit modeling of the synergy increases the comprehension of the bargaining power of the two parties and improves the allocation of the equity. This reasoning would be clearer with an example. Let’s assume that the startup A has a standalone value of €1Mln. It is seeking an investment of another million € to expand in other countries. The post-money valuation is €3Mln. The percentage of the equity that the investor get in return is 33%. However from this valuation it is not clear which are the synergies and if synergies are computed. The problem is particularly important when considering the bargaining power of the two parties. If this valuation accounts for all the synergies, it is easy to compute them as combined valuation minus the value of the separate entities. This would lead to a valuation of the synergies of one million. Having clear the fact that the synergies are one million can improve the outcome of the valuation and can clarify the reasons for a defined percentage of equity. Indeed, knowing that the synergies are valued one million, the investor can bargain to get a percentage of them. Depending on the bargaining power of the two parties, the amount would be split in favor of one of the two. The fact that the investor is driving a substantial part of the synergies for the company can be then accounted for properly.
The application of this method is particularly important for two reasons. The first is the magnitude of the synergies in this particular environment. The second is the fact that the distribution of the bargaining power is much more varied than in the case of a public acquisition.
b. Importance and magnitude of synergies
The magnitude of the synergies derives from different factors. The first important synergy that is peculiar to this type of transaction relates to the financial constraint faced by the startup (Bosma et Al. 2004, Livingstone 2007). Under the assumptions of Modigliani and Miller (1958), a company can always finance all its positive NPV projects and the value of the company is the sum of all the present values of those projects. In this framework, the NPV of cash is zero and its present value is just the amount invested. From this, the conclusion is that merging a public company with a company that only has cash would add exactly the amount of cash to the company valuation. In the process of financing a startup, this theory cannot be applied since the assumption of unlimited capital for positive NPV projects is not verified.
The level at which the startup experiences these constraints is well expressed by the burning ratio. This ratio measures the time that a certain amount of money buys to the company. In other words, it measures how long the company can survive with a certain amount of money. This ratio is based on the business plan and on the forecasts made by the company and it is watched really closely by investors when considering to invest in a company. At the end of the period the company has to attire the next round of capital or it would not be able to meet its financial obligations with employees and suppliers. In this scenario, the company often goes bankrupt if it is not able to find another investment. In this case synergies are extremely important. Indeed, in the extreme scenario in which the company goes bankrupt if it is not able to find capital, the whole functioning value of the company is created by the synergies with the investment. An assumption of this statement is that the bankruptcy leads to a value of zero and even if it is to some extent extreme, we can argue that most startups do not possess physical assets and they possess few, highly specific, intangible assets that do not maintain their full value when sold. The amount gathered with the “merger” allows the company to survive and to complete its current projects coming closer to making revenues and meeting the required return of all the capital contributors.
The second type of synergy that is important for startup regards the collaboration of the investor and the startup manager. Certain startups (Iris Associates, Groove Networks [1]) that do not need capital, sometimes attire investors just for the importance of their network and experience. Indeed, the investor usually knows people that are key to the survival or to the development of a startup. Examples of these key people could be later stage investors that will invest in future rounds or connections in the distribution chain or in areas of which the founder cannot hire the right people because he lacks the understanding of that area. This second type of synergy is as important as the first for companies that are not extremely financially constraint. Naturally, the more the company is financially constrained, the more the first type of synergy becomes important relatively to the second one. As we have seen, synergies are extremely important in this kind of investments. Just considering these two types of synergies, it seems fair to argue that they can be more important than in the case of public companies.
c. Distribution of bargaining power in the startup environment
The second factor that increases the importance of this more sophisticated method is the variance of the bargaining power for this type of transactions. Theoretically, in the M&A framework of public companies, the majority of articles found that usually the acquirer pays a fair price and thus the premium is fully paid by the acquirer to the seller. This result has many explanation in literature but the most important one is competition Ficery et Al. 2007, Harris Ravenscraft 1991 and Jaggia Thosar 1993 among others demonstrated that when there is competition from multiple buyer on the same seller, the premium paid is higher. Regarding the startup environment, the competition is weaker. Indeed, in this kind of market investors prefer local companies (Elango 1995, Von Burg Kenney 2000, Chen et Al. 2010), transactions are usually private, the transaction is not rumored and investors try to avoid competition through syndication.
For these reasons, the bargaining power of the investor is on average higher for the startup environment. This leads to the fact that splitting the synergies between investors and startup is much more difficult and the simplistic approach that takes into account just the post-money valuation is incorrect. The recent expansion of the startup community and the amount of money conveying into venture capital (Jeng Wells 2000, Kelley et Al. 2011) create extreme situations regarding the bargaining power of the parties. The best startups encounter a surplus of capital offers and can put pressure and competitions among the investors. Lower lever startups have to pitch multiple investors and have less bargaining power since they can generate the interest of just one or maybe two of them. These two extreme cases lead to extreme splits of the synergies and different valuation outcomes with the old method. Indeed, in the first case, the valuation is likely to be excessive since the only way to incorporate the fact that the investor is not getting any percentage of the synergies is to increase the valuation. For the second case, the opposite is true. The startup would be undervalued as the only way for investors to increase their percentage of the synergies. The importance of a clearer model can be clearly grasped form these key-facts.
d. Problems and frictions created by the old approach
Apart from the clarification of the bargaining power of the two parties, the use of simplistic valuation technique creates additional problems in the negotiation process and frictions between supply and demand of funding.
The first phenomenon created is the following. In practice, the investor is well aware of its contribution to the success of the company, as well as its own and the company’s bargaining powers. Without this type of framework, the investor will just push for an unrealistic post-money valuation that would be deflated to account for the percentage of synergies that should be attributed to him. This low valuation disappoints the management that does not understand why the investors does not see the true value of the startup. It could also lead to the termination of the negotiation and a failure of the financing process. Adopting the new framework implies that a more correct valuation is attributed to the company. This valuation is not deflated due to the fact that the investor has to find a way to get a higher percentage of equity. This increases the comprehension that the startup’s management has regarding the true value of the company, decreases the possibility of important frictions in the financing process, increase the probability of a successful outcome for all the parties involved and specifies the distribution of powers internally and externally. The startup, indeed, knows exactly why and how big should be the contribution of the investor in order to give away a certain percentage of synergies. It can furthermore improve its bargaining position due to the clearer framework. And finally it can evaluate different investors based on the amount of synergies they create and which is the percentage of the synergies they require in return.
The application of the current framework can also lead to another distortion phenomenon. Since the startup does not adjust the valuation based on the different investors that it is facing, it has to decide which kind of synergies to account for. This creates different possibilities and each of them has different outcomes. First, the valuation could be calibrated on the investors that can bring the highest synergies to the company. If this is the case, investors that are not able to bring those synergies would be either left out or would buy an overpriced company. In the case the valuation is calibrated on the investors with the lowest synergies, the company would be undersold to investors that could bring high synergies and, if sold to investors with low synergies, it would create an undervaluation that is contrary to the value maximization purpose of a firm.
In this section we have outlined how to apply the M&A framework to startup valuation and negotiation and we have outlined the different advantages of this method over the one used in practice. The thoroughly analysis of every outcome and friction created by the old or the new methods are out of the purpose of the paper. However it is my opinion that this method, even if more complicated, can introduce several advantages in dealing with the negotiation and the valuation of a startup and can significantly reduce frictions that could lead to lower efficiency of the funding market.
IV. Conclusion
The purpose of this paper is to apply the intuition that an investment in a startup can be seen as a merger between the company and a firm that as only cash on its balance sheet. The application leads to a new framework of startup valuation that can significantly improve the clarity of the negotiation process and can influence the outcome regarding the equity share to assign to the different parties. This approach also allows to better model and understand bargaining power and how it affects the outcome of the negotiation. As we have seen, the post-money valuation is too simplistic and leads to problems in the negotiation. One of these problems is the fact that investors, to account for the fact that they should get a part of the synergies, push for a lower valuation. This could lead to unjustified disagreement on the true value of the company that can in turn lead to a stop of the negotiation. As we have seen before, for the vast majority of the startups, the financing process is extremely important for the continuation of the company. This means that these incomprehension and disagreements could lead to serious problems concerning the continuation of an activity that could have positive NPV. The application of a more sophisticated and elaborated procedure could seriously affect and improve this outcome decreasing these frictions significantly.
V. References
Arzac, E., 2007, “Valuation for Mergers, Buyouts and Restructuring”, 2nd Edition, John Wiley & Sons.
Bosma, N., Van Praag, M., Thurik, R., Wit, D. G., 2004, “The value of human and social capital investments for the business performance of startups” Small Business Economics 23(3): 227-236.
Bruner, R., 2004, “Applied Mergers and Acquisitions”, John Wiley & Sons.
Chen, H., Gompers, P., Kovner, A., Lerner, J., 2010, “Buy local? The geography of venture capital”, Journal of Urban Economics 67(1): 90-102.
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Ficery, K., Herd, T., Pursche, B., 2007, “Where has all the synergy gone? The M&A puzzle“, Journal of Business Strategy 28(5): 29-35.
Granstrand, O., Sjölander, S., 1990, “The acquisition of technology and small firms by large firms”, Journal of Economic Behavior and Organization 13(3): 367-386.
Harris, R.S., Ravenscraft, D., 1991, “The Role of Acquisitions in Foreign Direct Investment: Evidence from the U.S. Stock Market” The Journal of Finance 46(3): 825-844.
Jeng, L.A., Wells, P.C., 2000, “The determinants of venture capital funding: evidence across countries”, Journal of Corporate Finance 6(3): 241-289.
Kelley, D., Bosma, N., Amoròs, J.E., 2011, “Global Entrepreneurship Monitor 2010 Global Report”, Babson College and Universidad del Desarrollo
Livingstone, J., 2007, “Founders at Work: Stories of Startups’ Early Days”, Apress.
Modigliani, Franco and Miller, Merton H., 1958, “The cost of capital, corporation finance, and the theory of investment” , American Economic Review, 48(3), pp.261-97.
Sanjiv, J., Thosar, S., 1993, “Multiple bids as a consequence of target management resistance: A count data approach” Review of Quantitative Finance and Accounting 3(4): 447-457.
Smith, J.A., Smith, R.L. and R.T. Bliss, 2011, “Entrepreneurial Finance: Strategy, Valuation and Deal Structure”, Stanford University Press.
Varaiya, N.P., 2006, “Determinants of premiums in acquisition transactions”, Managerial and Decision Economics, 8(3): 175-184.
Von Burg, U., Kenney, M., 2000, “Venture capital and the birth of the local area networking industry”, Research Policy 29(9): 1135-1155.
[1] Livingstone, 2007.