July 11, 2016
By Chad Morrissey, PwC Deals Partner
“Are we in a bubble? Are today’s tech companies overvalued? Is higher better?”
These are questions I hear over and over again working on deals. One thing is certain: there isn’t any “one-size-fits-all” approach to valuations. Whether your company is a start-up on the way to being the next unicorn or a mature business within an established Fortune 500 enterprise, good valuations ultimately depend on an understanding of the scope and limitations of various valuation methodologies and the ability to synthesize financial/theoretical knowledge with qualitative, sometimes subjective, assumptions.
Start-ups are inherently more challenging to value as they have little to no performance history and, in some cases, are creating entirely new business models. The process should be the result of interaction with, and align the interests and expectations of, your stakeholders.
Valuations impact several stakeholders – founders, investors (early- and late-stage), regulators and employees (current and future) – in different, but equally important ways. Driven by the interests of each individual party, stakeholders’ priorities will seldom align without close coordination and frequent communication.
For example, bolstering company resources and building their start-up into a sustainable business model is often most important to founders. However, too low a value may dilute their ownership interest and disincentive their commitment, while a value that is too high may set unrealistic expectations and create challenges for future rounds. Financial returns and potential exit strategy matter most to investors, but there are many factors (time of participation, rights and attributes of securities, etc.) that may create different incentives for investors. An equally important stakeholder, the future employee, wants to be confident in the company’s purpose, longevity, and brand stature, but is also lured by the potential of financial return through equity. And in places like the Valley, where I’m based, a company’s ability to attract and retain the best and brightest talent is key to long-term financial success.
Don’t go chasing unicorns
Soaring valuations have put certain entities in an elite category, creating a fair amount of distance between the top companies and their closest competitors. The widening divide between industry leaders and followers helps attract talent, headlines and street cred. But hype that grows by itself isn’t good if growth can’t be supported long-term. In fact, it can be detrimental, leading to that ugly “down round” if valuation is not thought through strategically.
Here are a few tips to keep in mind when assessing your company’s valuation model:
- Make sure you’re working from the same framework as your stakeholders when assessing a company’s valuation – and that includes all regulatory bodies.
- Account for potential risks ahead. Valuations should always account for and agree on where potential risks and uncertainty might lie.
- Get in front of the valuation story early on. Your company should have control over the perception of your equity story in the market.
- Don’t feed into the hype cycle and be swayed by the lure of the unicorn club. Make sure your output drives value – not the other way around.
- Define your peer group and nearest market competitors accurately. Be careful about what your comps are and where your company fits in the mix.
- Don’t let bias, negative or optimistic, be the determinant of value. Valuation is an interpretation of both the quantitative and qualitative, be sure to fact check your inputs and corroborate your outputs through multiple methodologies.
One of Warren Buffett’s most cited quotes is “Price is what you pay, value is what you get.” The concept that there is a difference between price and value is especially applicable in the Valley. Even the most calibrated valuation model can be trumped by a transaction price set by investors. Value, however, is the ultimate arbitrator of price over the long-term.
For additional insight watch “Unicorns: Tracking the $1 billion dollar start-ups” below: