Recent Equity Crowdfunding activity has brought company valuations in sharp relief. Just how do you go about valuing a new company or one that has great potential but has yet to get to the growth stage? It is more of an art than a science and relies heavily on experience.
I spoke with a very experienced PE professional recently on this topic. Taking a live case on one of our leading crowdfund sites (names changed to protect “the innocent”), he commented –
“Fundseeker” does look one of the industry’s more interesting companies. However, I agree with you, £13.5m looks unjustifiable.
As Fundseeker would appear to have an excellent product and great potential, an experienced private equity investor would most likely agree a much lower entry valuation (£2m for c30-35% = £4-5m pre-money valuation) to protect investors’ downside – but offer the founders an exit ratchet.
The ratchet would reward management for hitting business plan profit targets – or, as projected EBITDA is so high, perhaps for hitting c80% of target EBITDA.
Let’s assume the investors paid £5m pre-money at entry for 30%, and that the company hit, say, £7m EBITDA in Year 3. It could readily sell for £70-80m on that sort of growth trajectory.
If the ratchet gave management 10% of the investors’ 30% equity, the investors would still get 20% of £70-80m = £14-16m = 7-8x money on original cost of investment.
We’d also look for some downside protection. Amounts subscribed should be first money out. That way if things don’t go as planned but it’s not a complete write-off, we’d only need to sell what’s left at c£2m to at least recover the investment.
In my view, this would be a much better way to approach this particular opportunity.
This strikes me as sensible for all concerned. It means that the responsibility for the valuation, which is based the company’s projections, is spread around between all parties and doesn’t lie just with investors.
It is important we don’t get into the game of hot potato so beloved by the world’s Unicorns. It goes like this. These Unicorns, take Airbnb as a good example, are growing rapidly and making ever larger losses. The more they grow the more cash they consume and the larger the losses. At each new funding round, the hot potato is passed on at a higher value (of course) until eventually the game ends and the fool is the one holding the spud.
If the initial valuation is too high then companies requiring more cash have no choice but to increase it in the next round and so it goes on. This is not a good idea.
Recent evidence suggests that some platforms have fallen into this trap – here it is the investors who pass the spud.
What the sector needs is for the platforms to have experienced PE people on board to advise on valuations and projections to ensure they are working in the realms of the probable. It is clear looking at the various platforms operating that only the newer ones have paid any attention to this requirement.