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  • Writer's pictureMatt Fasanya, CFA

Four drivers of value for early-stage businesses

Updated: Jan 2, 2021

In this article, Matt explores four ways in which founders can improve the valuation of their business.

Valuing an early-stage business is not straightforward. Often new businesses are seeking to exploit an original concept or technology which is relatively untested in the market. For the time being, the business may be sub-scale with low revenues and a high cash burn rate.

This means the usual valuation techniques routinely used for larger businesses may be difficult to apply. For example, it can be challenging to apply earnings multiples to businesses which have low but fast-growing revenues and which may not have yet reached profitability. A discounted cash flow approach may also be difficult to apply, since the company is still proving itself and may have insufficient trading history from which to draw meaningful conclusions. Where you have a young company that is genuinely innovative, there is an art to adjusting the valuation metrics observed for the more established incumbents.

That is why valuing an early-stage business is never a pure science. There is often a tussle between founder expectations and those of investors. On the one hand, founders must be confident in their ideas. Otherwise, why would they be doing it? On the other hand, investors will usually apply at least some level of professional scepticism when selecting the right opportunity. In some cases, they will be institutional investors with fiduciary duties. In almost all cases, they will be looking at the risk as much as the reward.

In light of these challenges, Valuable has identified four drivers that can help to increase the value of an early-stage business:

1. A focus on people – The value of an early-stage business lies in its potential and how that potential is brought to life. That means investors are not only looking at the addressable market, but also the team’s execution capabilities. It is not uncommon that the product or service requires further development. Far more important today is the team’s skill in improving and adapting to the changing needs of the market. Any investor will want to see that key staff are incentivised to stay and grow the business. Competition for talent is fierce, meaning that a culture which attracts and retains gifted people is vitally important. So are the right share schemes or share options in place to align the interests of the team with that of the organisation?

2. Building intangible assets – Most early-stage businesses will need to think about developing their brand. Growth potential is often predicated on the ability of the business to influence customer behaviour and, for discretionary purchases, much of that revolves around brand image. Coca-Cola can sell at a premium price whether people can truly taste the difference or not. For companies selling B2B, it comes down to the quality of the client relationships. And where technology is critical to the business, founders need to think not only about how much has been invested to develop it, but also the excess earnings they can generate through monetising it effectively.

3. Strategic planning – Even if founders are not planning a major transaction event in the short-term, preparing as though they have one in mind will support the value of the business in the long-term. When the time eventually comes, business owners need to be prepared for a thorough due diligence process because investors certainly will. Continually assessing the strategy can help identify and address any gaps ahead of time and puts the founder on the front foot. That means developing a business plan and a track record, rather than retro‑fitting one when the time comes. Operationally, it also means implementing sound financial policies, management oversight and compliance, and ensuring the proper treatment of customers and suppliers.

4. Running an effective transaction process – When it comes to a fundraising or exit event, founders can drive value through the deal process itself. That means doing the work up‑front to establish value expectations for the business and identify likely investors. Pitching at the right level is vitally important in helping to present the management team as competent and organised. An effective transaction process will encourage competitive tension between bidders and put the business in a strong negotiating position with potential investors.

Most successful early-stage businesses will excel in at least one of these categories. Unlike external factors which are difficult to control, a strong grasp of these four areas can help founders to gain a competitive advantage and drive the valuation of their business.

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