A Checklist for Valuing a Startup when DCF is Not an Option
At the end of this post there is a downloadable synopsis of the checklist in .pdf.
All things being equal, for most equity investors a publicly traded company on a growth curve with a strong after-tax-free -cash flow (ATFCF) is a dream come true. (DCF is the algorithm used to value the net present value of a project utilizing the company’s internal hurdle rate as the discount rate)
After tax free cash flow is the funds available to pay equity holders dividends or to reinvest in the company to fund projects whose ROI will exceed the internal hurdle rate.
DCF analysis applied to the ATFCF is the standard valuation method used to estimate equity value based on expected future cash flows. Companies with a strong ATFCF are prized as having high “revenue quality”. That’s opposed to companies with low “revenue quality” which are incongruous with a strong DCF model.
DCF is somewhat unreliable for early-stage companies for many reasons including the uncertainty of model assumptions and long-term factors, such as:
Startup and emerging company variable growth rates
Business and pricing models evolving
Predicable Operating margins and Cash flows
Product(s) and product line stabilization
The mix of direct and indirect competition
Subscription versus services revenues (especially for SaaS companies), and
Capital requirements in various markets.
In the absence of a reliable DCF, a combination of other factors based on quality of revenues and growth can be used to measure the overall health of startup and early-stage companies, and as a basis for their valuations.
One VC emailed me over the weekend saying: “The other points you make are very real, but the question is does entrepreneur want a good business or a huge business?”
In this blog I put forward a “self-assessment” checklist for CEOs/CFOs in early-stage companies going into a valuation discussion with a VC, strategic or other investor. This checklist includes key business indicators (in order of general importance; your mileage may vary) that separate high quality from low quality revenue companies, and therefore are the distinguishing traits that warrant either a high or low valuation:
The Founder(s) and later, the CEO and Executive Leadership Team (ELT) —are critical to valuation. Do they have the vision, desire and skills to build a huge business. David Flaschen, my good friend and former VC, adds: “Are they must succeed or cannot fail types?”
Growth – Its axiomatic: The faster a company grows, the larger the company becomes and larger future revenues and cash flows will be. High growth also means – in all probability – that a company has tapped into a valuable new market opportunity in which customer demand may be significant. It also may mean that a company has become operationally proficient, and that its operating model is durable and will hold up over the long term. Consequently, there is a strong correlation between growth and valuation multiples. The old Wall Street axiom – P/E = G. The higher the growth rate the higher the P/E multiple.
Revenue Visibility & Predictability – Early-stage investors favor businesses, revenue, and pricing/licensing models that provide high degrees of predictability. That predictability naturally provides more trust and confidence in future cash flows. This is one of the reasons that the predictable nature of SaaS subscription models gets high valuations and thumbs-up from the VC masses when they are working well.
By contrast, the traditional software model (primarily based on license revenues), the professional or consulting services model, and many B2B business models, all tend to produce lumpy series of large sales interspersed with small sales, resulting in episodic, difficult-to-predict revenues. Business and industries based on “big hits” – such as media companies, entertainment and gaming – are also less popular among investors due to the very same trait – the lack of revenue predictability.
Gross Margins are a basic indicator of success and valuation. It is often overlooked in early-stage companies because it simply gets easier after Series A — there’s more accounting resources — especially a CFO. Also, adjustments to cash flow from operations are unpredictable but, if planned, can enhance valuations. For example, over the long-term, gross margins will impact how much spare cash is available to pay for an expensive headcount, like a data scientist or machine learning “rock star”. (Hint: This is how you beat Amazon’s and Google’s current recruiting and compensation strategies.)
Profitability & Scaling – Investors love companies that are profitable and prepared to scale. As a company scales it produces higher revenues which, in turn, produce higher profit margins. But successful scaling also means the company has the management team, technology and operational infrastructure required to make higher profit margins achievable, so its virtuous cycle carries on. To measure scaling, VCs and other investors look at marginal incremental profitability on a quarter-over-quarter or a year-over-year basis. It comes down to amortizing a slower growing fixed (overhead0 costs over a more rapidly growing revenue stream.
Emerging companies that increase their profitability while they grow carry high valuations. This is because as time unfolds, they generate higher earnings and lots of free cash flow due to the cumulative effect of growth and increased profitability.
Sustainable Competitive Advantage refers to factors that allow an early-stage company to build products or offer services that are more innovative, built better, deliver pay-back faster, or are less expensive than alternatives in the market. These competitive advantages, in turn, result in more sales generated, great buzz, and superior margins for companies as compared to its rivals. Many factors combine to result in competitive advantage, even market and industry intelligence. Competitive advantage, and the multi-dimensional ways to achieve it, was brilliantly detailed in Michael Porter’s seminal book on this subject. This factor is paired with Disruptive Innovation.
Disruptive Innovation Potential means invention, product and/or technology advances that have the potential to create a new market. Disruptive innovation also results in the creation of new value networks that eventually displace established companies, products, services, and their supply chain and partnerships. This concept was detailed in Clayton Christiansen’s seminal book called Disruptive Innovation. This factor is paired with Competitive Advantage.
Network Effects – Ultimately, network effects bring about sustainable competitive advantage, contributes to disruptive innovation potential and the product (read: unit) economics. Adding incremental customers boosts revenue quality by providing a key feature in the go-to-market arsenal.
Customers Retention is a key metric that shows up in the executive dashboards and investor slide decks of many early-stage companies. Rather than the cumulative retention rate, it’s actually the components of customer retention that are the crucial indicators contributing to a company’s valuation. Low churn and high switching costs are the key ingredients of customer lock-in which determines valuation.
Customer Concentration & Dependencies. Obviously early-stage companies have fewer customers than later-stage companies. However, the concentration and dependencies related to customers, and how dependencies impact revenue quality are key determinants of early-stage company valuations. (This is the reason VCs ask a lot questions about your license, invoicing, delivery and returns and other policies.)
The percentage distribution across the customer base in terms of size and actual purchases matters, but segments especially matter here. An early-stage company selling SaaS or other solutions should aspire to establish a critical mass of customers (for B2B pre-Series A: 20-25). Customers should be of different sizes (large, medium and small), represent different market segments or industries, and have wide geographic distribution.
These criteria obviously impact cash flow, margins and many other non-financial parts of the company. For fundraising, it is key to know and have in place offsets to the dependencies on the customer base.
Partners & Dependencies. Like customers, the concentration, terms and dependencies related to partners really matter. Here again, the number, the percentage distribution, size and market power of partners also matter.
To be successful in the market, B2B pre-Series A companies generally will need time to effect transition in their go-to-market plans toward resellers, integrators, and professional service firms. This is often why partnerships play a bigger role over time and in later rounds of financing.
Organic Demand vs. Merely Marketing. Investors rebel against a heavy reliance on marketing expenditures. It comes down to cost of acquisition of customers (CAC). As an approach, paying a lot to attract prospects and turn them into customers has too much ‘drag’ and not enough ‘lift’. Investors are far more attracted to companies with demonstrable organic demand for their product or service offerings, and the natural follow-on of strong network effects. In short, when investors see self-sustaining demand, they’ll pay a premium. If it’s pay-to-play, they’ll be looking to discount.
In summary, when investors see a company come along with strong net present value of future ATFCF DCF, they’re going to jump on that train.
The question is, what do they do when those companies are few and far between and there are new investment prospects coming through the doors with new ideas, business models, technologies with great teams, and other investors barking at them. Waiting clearly isn’t a viable strategy. They need other ways – other metrics to use – in their search for and to predict future winners.
While the above checklist of metrics won’t give them a crystal ball, it will give investors a different and potentially very effective way to measure the present strength and future potential of the startups they’re charged with evaluating.
Download a synopsis of this Checklist here:
