When I was a visiting professor at Moscow State University, teaching Russian entrepreneurs valuations and strategies, I was taken aback by the fact that my student-entrepreneurs had done very little due diligence – almost as if Google did not function in Mother Russia – to examine valuations and competitive environment for their respective industries. Now I realize that market ignorance is not exclusive to Eastern Europe; the valuation obliviousness hits my backyard as well. So I will address on how valuations are determined and where to find that information.
Now, valuations are not carved in stone. Values will fluctuate according to the free market rules of supply and demand and macroeconomics. For example, on January 15th, 2016, the Dow Industrials lost over 400 points in one day. How does that impact the valuation of my startup? Well, a VC or Angel would believe, correctly so, that public market recovery will take a while to recover, denying the investor the best exit strategy – the IPO. That VC firm will conclude that any current investment will be riskier and, to compensate for that risk, will require a higher cost of capital. The best strategy, though, to mitigate risk is to transfer funds to safer investments – bonds (corporate or governmental), which is what the WSJ observed on the 15th. Or, alternatively, when seeking investments in startups, investors will demand higher yields in the uncertain climate. Unsure markets lead to higher risks; higher risks demand higher returns.
Let’s take the average valuation in the healthcare field – 11x EBITDA. Now, after 15th of January, I would not be surprised that the valuation will drop to 8x EBITDA or even less in this current economic climate. Neophytes believe that these numbers are fixed. They are not.
How does “smart” money gets its financial information in my industry? Virtually all managing directors attended business school, which instructed them on where to look in the WSJ for daily financial benchmarks and the systemic analysis in each industry. These MDs attend many investment meetings related to industry startups and the annual conferences in each industry chaired by leading NYC investment banks and CEOs of publicly traded companies. They share information with their peers at these annual meetings and listen to trends from business leaders in the industry. I recently attended the JP Morgan Healthcare conference, the world’s leading healthcare congregation, as many healthcare investors and companies converge in one week to gain new technological and valuation information and to lock up investments.
At these meetings and conferences, investors are informed about the current trends in valuations, competition, and new technologies. Now, if healthcare valuations are 11x EBITDA, it does not mean that it applies to other asset classes and industries. For example, the purchase value for a simple consulting firm goes for 1x-2x EBITDA. And these EBITDAs multiples can fluctuate depending on market forces.
Besides attending meetings and conferences, one can explore online the many sources to find valuations and trends. Here are various sites for startups in many industries: www.angel.co, www.funded.com, http://www.vbprofiles.com, www.mattermark.com, www.crunchbase.com, www.pwcmoneytree.com. There are also the financial wikipedias/dictionaries. Then I normally check for industry regulations that might impact that company online. For healthcare, FDA. For telecommunications, FCC. For ecommerce, FTC. And so forth.
Let’s go back to the 5th “T” – terms. Just recently, a friend informed me that he had to rewrite his “deck” (A.K.A. private placement memorandum, Teaser, or Pitchdeck). I informed him that his “valuation” will still be extraordinarily too dear to any investor in Silicon Valley or anywhere else for that matter. I quoted him that he is only offering another “dog to investors but with different fleas” (from the movie, Wall Street.) Since the valuation offering is over 12x EBITDAs, yet the company has a consulting arm worth only 1x EBITDA, the company should only be worth 6x EBITDAs; the company cannot attract any investor at that 12x valuation. Hence, the dog with different fleas analogy. Again, to attract the investors, one has to fulfill the 5Ts expectations for any investor. Without meeting these clearly understood criteria, there is no deal.