Entrepreneurs: It’s Time to Put Your Big Kid Pants On and Be Realistic About Your Valuation
By: Meagan Crawford
No mother likes to hear that their baby is ugly. And let’s face it, as an entrepreneur, your company is your baby. So, when an investor tells you that your valuation is too high, it hurts. It’s as if the investor is saying that they don’t see the value you’ve created, or as if they don’t appreciate all your hard work. It’s like someone telling you your baby is ugly.
But in the current market, ALL the babies are ugly. Not just yours. It’s time to be realistic about market conditions and how they are affecting ALL valuations. In the space industry, specifically, company valuations tend to be sky-high (pun intended), even in the best of times. SpaceFund has spent considerable time over the years educating our startup partners about how we value companies, using standard methods and metrics. We use these tried and true financial tools as the basis for negotiating valuations on deals we lead. We don’t buy into the hype, or as we like to say, “we aren’t blinded by the magic space sprinkles.”
The current valuation crunch is affecting companies across the globe, in every industry. The space sector may be one of the hardest hit, as valuations are becoming more realistic and in line with other hardware-centric industries. If you’re trying to fundraise in the current down market, you have to be realistic about your valuation, or you’ll get laughed out of the room.
We’ve heard venture capitalists say that valuations are ‘more art than science.’ BS! If you’re not doing the math, you’re doing it wrong. This article is meant to give you the financial tools to back up a realistic valuation so you can walk into those tough negotiations with confidence. We’ve even included a handy dandy calculator you can download in XLSX format, to ensure your math is correct.
There are a variety of standard valuation methods that are used throughout the finance, corporate, and investment communities. It’s important that entrepreneurs understand these methods, and do their calculations before their first investor pitch. This will help you ensure that valuation conversations are productive and that you and the investor are at least speaking the same language. Below, we’ll discuss the most common valuation methods and how to go about applying them to your business.
Discounted Cash Flow (DCF)
A discounted cash flow (DCF) analysis is a tried and true methodology commonly used to assess the value of a project or company. It is frequently used in the investment community, as well as within corporations when assessing the viability of a new project or line of business. The underlying concept is simple; project the future cash flow of the project or business, and then ‘discount’ that future value back to today’s dollars. So there are two basic inputs to this model, future cash flows and a discount factor (more on those below). It’s also important to note that all DCF analysis should be done on a maximum of seven-year time frame if your audience is venture capital investors. In venture capital, most funds have a ten-year lifetime, with a three-year investment window at the beginning of the fund. This means the VC firm is looking for companies that can gain enough traction to be sold for significant gains in less than seven years.
Future cash flows are not just simply future revenue, but the future ‘free cash’ that the business will have on hand to pay back investors or reinvest in the business. There are widely accepted accounting practices for determining free cash flow from your existing financial projections (a simple Google search will show you how to do this). Once you’ve determined your free cash flow for the next seven years, you’ll then need to estimate the terminal value of the business. How much could the business be sold for at the end of the estimation period? Add that number to the final period of free cash flow, and that’s it!
The discount rate is less straightforward and more subjective. In an extremely low-risk business, this discount rate may only be counteracting the effects of inflation and may mimic typical savings account interest rates (if you didn’t invest in this business, and kept your money in a savings account, how much would it make?). However, very few projects or companies are as low risk as a savings account, so a typical discount rate consists of this basic interest factor plus a risk factor. The risk factor is subjective, as many people assess risks in different ways, but for a startup company, the standard minimum discount rate is usually 25% and can go up from there in times of high-interest rates (like today), and for higher risk businesses (like space). Most financial professionals will use a range of discount factors during a scenario analysis to determine a range of potential valuations.
The DCF method can be punishing, especially for companies whose revenues are more than five to seven years in the future, or if the company is particularly high risk. Historically, this is why a lot of space companies were not a fit for venture capital. SpaceFund is happy to say this has changed considerably in the last few years, as risks and timelines have gone down, and because the cost of capital was relatively cheap (vibrant market with low-interest rates). However, as more market uncertainty is projected for the coming years, discount rates are starting to go up across all industries, and this must be considered in any DCF analysis.
This great article from Ernst & Young describes the DCF method in more detail, and the spreadsheet linked above can help you do the calculations. The default discount rate in this spreadsheet is set at 35% to account for the risks inherent in space businesses as well as the current market conditions, but you can use the drop-down menu to choose the discount rate that you believe is most appropriate for your company. Don’t be afraid to work through multiple analyses in this section, and be prepared to back up the discount rate you’ve chosen and why.
Another standard way of assessing company value is called a revenue multiple. It’s as simple as it sounds – you multiply your expected yearly revenue by a ‘multiplier’ and voila, you have a valuation! But what multiplier? Each industry has a standard range of revenue multiples that are usually very well-known among financial analysts. These multiples are specific to the industry and will fluctuate between private and public markets. These multipliers are sometimes expressed as P/S (company Price divided by Sales) or as EV/EBITDA (Enterprise Value divided by current year Earnings Before Interest, Depreciation, and Amortization). They are common ways of assessing industry performance year over year.
This is a fairly simple calculation for publicly traded companies, whose EBITDA and Enterprise Value are public information. However, private companies can be trickier to find data on, and typically their revenue multiples are only available when companies are sold if deal terms are publicly announced.
Primary research by SpaceFund has shown that of the private space companies that were sold in the last decade the average revenue multiple was 6x the current year’s revenue. Keep in mind that this was the valuation at Exit, not during the startup phase. Presumably, this means earlier-stage space startups would have revenue multiples in the 4 – 5x range. This stands in stark contrast to software and technology companies that might have a 14x revenue multiple, even in today’s down market. One reason for this difference is likely due to the small number of data points for space startup companies (only 50 exits were in our data set and even fewer than that publicly disclosed deal terms). Additional reasons for this discrepancy could be that the traditional financial markets are less sophisticated when it comes to valuing space companies, and because of the type of companies that buy space startups (typically aerospace prime contractors or private equity firms) and those companies’ valuation models.
This calculation also becomes more tricky if you’re a pre-revenue startup. If you have no revenue this year, zero times any multiplier is still zero. So, pre-revenue startups will sometimes use the next year’s revenue (commonly referred to as ‘forward revenue’) for this calculation. But what if you won’t have any revenue next year either? That’s when you have to seriously question any valuation for the company that’s higher than a single-digit millions.
For the purposes of this valuation method, the spreadsheet linked above defaults to a 5x revenue multiple, but you can use the dropdown menu to select a multiple based on your assessment of your company and the current market conditions. Whatever multiplier you choose, be prepared to back it up with data and reputable sources.
Another common way that investors value a company is by looking at the value of comparable companies that are very similar to the one in question. In much the same way that consumers comparison shop, value can be quickly determined by comparing the prices of two similar items. Again, this is quite simple with publicly traded companies, as enterprise value is calculated simply by multiplying the number of shares the company has issued by the current price of those shares. With private market companies, this data can be harder to come by. It may be difficult to find companies that are exactly comparable to yours, and when you do find comparable companies, you might not be able to find the data about their recent funding rounds and valuations. Expensive subscriptions to services like Pitchbook or CB Insights might be able to provide this information, but many startup companies cannot afford such subscriptions.
The investors you talk to during your funding round may have some available data on companies they’ve recently invested in, so this can be a good source of information if you’re interested in valuing your company this way. However, you’ll need to ensure that the data you’re collecting is for companies that are comparable in product, market, size, and stage.
Accounting for the Markets
While the methods used above are a great way to communicate the future value of your business, you must also take into account current market conditions at the time of investment. At the time of this writing in late 2022, those conditions are not favorable to startup companies. This must be accounted for in any discussion of company value, as market conditions often drive investment decisions as much, or more than, the actual asset being valued.
Technology Company Valuations (Private Markets)
Often, technology markets are used as a metric for the overall health of the broader economy, and startups in general. Unlike more nascent industries such as the space sector, there are thousands of technology companies that are well understood, well tracked, and data is plentifully available. Technology company valuations are down, significantly, amid continued market uncertainty and rising interest rates. A recent (November 1, 2022) report from CB insights described this stark downturn:
Median tech company valuations declined across most stages as investors continued to limit their risk exposure in Q3’22. Notably, declines in mid- and late-stage valuations accelerated, with Series D+ valuations falling by 27% quarter-over-quarter (QoQ), bringing them nearly to 2020 valuation levels. Deal volume was equally stark, falling by more than 20% QoQ across most stages, indicating that investors remain cautious.
As an indicator of wider market volatility and venture capital activity, the change in technology company valuations can be a fairly accurate barometer of what to expect when speaking to investors about your space company valuation. This means if you had a funding round in 2020, and are expecting an up-round in 2022, you will be sorely disappointed. While company valuations typically go up over time if the company is doing well, in today’s market, a technology company can expect the same valuation today as it received in 2020, even if everything is going well. Entrepreneurs must keep these market dynamics in mind during investor conversations and valuation negotiations.
Space Company Valuations (Public Markets)
While, as mentioned above, there is much less publicly available information about private space companies than the more well-known and understood technology sector, there are enough public space companies now to provide some credible data on space company valuations and how they’re being affected by current market conditions.
In a recent (September 10, 2022) article from CNBC, author Michael Sheetz said, “Most space stocks, many of which went public last year through SPAC deals, are struggling despite the industry’s growth, off 50% or more since their market debut.” While not all of these companies were necessarily the best representatives of the industry, and many are failing for reasons having nothing to do with the economy, this metric is still going to be a common theme in investor discussions. This means that a space company’s valuation is likely to be reduced even more than the 27% decrease seen in the technology sector, with private space companies seeing valuations decline up to 50% in the last year alone.
Before you put together your deal deck, or tell an investor what you think your valuation should be, it’s imperative that you have all the necessary information to ensure that you don’t get laughed out of the room. Your baby may not be the Gerber baby, but if you can be realistic about your company valuation, you might be able to have a productive conversation with investors that can lead to a ‘yes’ instead of a giggle.
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