Investment is the magic growth pill sought by countless start-ups. But in order to raise funds, how do you conjure up a credible valuation when, by definition, a start-up still has almost everything to prove?
EDHEC Professor of Finance and Accounting, Philippe Foulquier regularly preps his students on the question. Explaining the basics, he points out that three classic methods for making valuations of traditional companies do not apply so neatly to start-ups in a digital economy. The three classic methods are Discounted Cash Flow (or DCF); the Peers approach which compares performance with equivalent listed companies; and the combined Asset Value-Cash Flow approach. They all evolved in a pre-digital world. According to Philippe Foulquier, too many young entrepreneurs dismiss the DCF method as “too complicated,” but they do so at their peril. Certainly there are limitations with DCF, notably because it seeks performance history – of which there will be little to show. Also, young companies often start with private investment; they have a high probability of failure; often require significant liquidity; and they burn cash faster (OPEX) than traditional (CAPEX) companies on their fast track to growth.
With the new digital era have come new ratios to help investors make more accurate projections" says Philippe Foulquier
Despite the difficulties, says Foulquier, it’s worth working through to arrive at a number that will give investors a tangible starting point. Contrary to popular belief, venture capitalists are not beneficent angels sprinkling funds like fairy dust; they are in it to make a profit. Therefore building a convincing case is key. Typically the Venture Capital method is based on potential fundraising strategy over 3-5 years, expectation of improving on their own investment, and capital dilution. With the new digital era have come new ratios to help investors make more accurate projections: indicators such as the AARRR model, digital traction metrics, and customer life value. The world has changed and so has the way to put a value on it. And the lesson from all this? Do your homework!
This article was first published on Otherwise magazine (#5 issue). If you enjoyed reading it, subscribe here and receive the next issue for free !