THE SECRET OF EARLY-STAGE COMPANY VALUATIONS
Alternative investments have seen a huge rise in popularity, especially over the course of the last year. It comes as no surprise since the new lifestyle caused by the pandemic encouraged the majority to rethink the ways they spend and earn their money. Therefore, intangible assets as stocks and cryptocurrency, SPACs continued to attract more and more investors. And, speaking of a more professional investor landscape – early-stage private equity investments were no exception. Based on the study of Venionaire Capital, the first quarter of 2021 has seen an all-time high in VC investor sentiment.
Such shift has obviously given a publicly visible edge to smaller and more agile enterprise structures over their larger competitors. Just see how many startups attract considerable amounts of investments on a daily basis!
However, despite all the limelight, it is also well-known that such investments are associated with higher levels of risk. After all, there is a reason behind traditional financing methods (e.g. bank loans) being much less available for such ventures.
So, what path startup takes to encourage a professional investor to invest and which role does valuation play here?
To answer this question, one needs to understand investors’ logic and expectations, as well as the market trends investors operate within.
In this article, we highlight the specifics of the private equity market and explain the key elements of early-stage valuations.
Understanding the early-stage investment market
Despite the high levels of risk, the underlying opportunities in early-stage tech companies have led to the formation of the early-stage investment market.
Though, growth equity investment has very different investment market dynamics from other equity markets.
The market has a unique hybrid structure in which individual investors in the face of Business Angels (BA) play a key role in the early formation of the company by providing it with much-needed capital to conceptualize their products and to lay the groundwork of the firm. This enables larger investors such as venture capital (VC) funds and other organisations to screen slightly more matured ventures with some sort of a track record.
However, it is well known to both the academic and business professionals in the sector that there are significant differences in the valuation methods employed for that valuation of early-stage and later-stage ventures.
The difference between early and later stage company evaluations
The complexity involved with later-stage ventures stems from the sheer amount of work necessary to collect all necessary legal and financial information to construct a valuation that accurately represents the company’s current and future performance. Young ventures on the other hand often offer a product that is not yet fully or at all developed.
However, to develop the product and subsequently, attract more customers the company needs to dedicate the appropriate resources and starts looking for investors who are willing to support the idea. This creates a need for external funding but as mentioned earlier traditional financing instruments such as loans are rarely available without security or a strong track record. Additionally, larger growth-equity investors are also reluctant to invest in very early-stage ventures due to the higher levels of risk.
Key factors for early-stage evaluation
This is where BAs most often join the game. In fact, recent studies suggest that
Business Angels are indeed better at evaluating early-stage businesses than VC. So, how a sole individual can outperform a structure of educated professionals when picking a riskier investment?
The answer can be said to be rooted in the methodology employed. Due to external and internal pressure large investors are often bound to base their investment decisions on quantitative factors. However, with early-stage companies, this is hardly possible as they most often lack having any track record of past performance and even if they do it is rarely detailed enough.
For this reason, in earlier stages, qualitative factors are much more important for the understanding of the venture. Questions associated with early-stage assessment often revolve around the company’s team, the product they develop and the market they try to conquer.
- One key aspect of the team is their professional level – whether they possess the necessary knowledge and experience to drive the idea from a concept to a market-ready product.
- Another important point is their personal qualities – whether they have the energy and the entrepreneurial spirit to adapt quickly and effectively to market changes and fight off fierce competitors.
- Another important element to consider in early-stage investing is the market. It is crucial for every company’s success to operate within a market and to target segments that are large enough to facilitate an attractive 10x or 20x return. A good approach is to consider the overall market size as well as the current market trend – Is the market in decline or in the growth phase?
- Another aspect important for the company’s product success is the current state of the technology and whether it is suitable for the development of the founder’s idea.
- The last point which we would like to direct your attention to s the company’s product. The best possible action would be for investors to undertake substantial market research in order to check whether the product is answering relevant market challenges and what benefits it brings to a potential user.
Early venture investing is quite complicated
As you might have already guessed assessing these factors is often quite complex and very tightly connected to each specific venture that is assessed. For this reason, BAs often invest in industries and sectors that they are familiar with which to a large extent compensates for the advantage of a VC’s teams of analysts.
Another important tool they use are highly tailored valuation models. Over time different valuation methods for early-stage companies have emerged. Among the more popular ones are the Berkus Method or the Payne Scorecard Method.
However, investors rarely use the plain theoretical framework of the methods. They usually put a lot of energy and effort to adjust each method according to their preferences and personal expertise. It often involves a lot of work in excel which tends to be time-consuming and leaves a large room for error for many who invest on the side.
The secret of successful angels lies in their personal preferences that stem from their industry knowledge and personal risk profiles.
The new path towards startup valuations
Dealmatrix offers 5 different valuation methods for both early- and later-stage ventures packed in a user-friendly interface. What is particularly unique about Dealmatrix’s approach is that it also offers adjustment of personal preferences which is the hardest piece of work for individual investors. To eliminate many errors, Dealmatrix software provides brief and accurate explanations for each method and the required inputs.
This is truly an excellent example of how modern technology continues to close the gap between the individual investor’s expertise and capabilities and the large institutional investor.
Prepare for your upcoming negotiations by having the first valuation overview in hand.