What approaches are there letting asses a financial model of a company? What should a financial plan include to convince an investor? Is a financial model needed at all if a startup is going to sell its technology in the future?
Sergei Mikhailov - the author of the financial model and risks evaluation methodologies on the Rocket DAO platform - answered the questions of Andrew Miroshnichenko about the methods of the startup’s financial model evaluation, about the reasonable ways of evaluating a startup which cannot provide necessary data (because it doesn’t have any traction so far), and about the things an investor should pay attention to studying a financial plan.
—Tell us a bit about yourself: what experience do you have in business and startup evaluation and where did you get it?
For 10 years, I worked in large consulting companies (Ernst & Young, KPMG, BDO, Grant Thornton). During this period, I took part in different projects - starting from audit to supporting the companies amalgamation and takeovers, and business valuation. Working on various positions - from the assistant to the partner - not only I could scrutinize certain process stages but also to complete this process from the beginning to the very end, to see so-called “big picture”. For the last year and a half, my partners and I are developing our own company, the activity area is still financial consulting, auditing, etc. In such a way, the experience of evaluating a business was obtained both while working in large companies, and over the past year and a half. But if previously, these were very large-scale processes: large investments, transnational corporations, etc (For example, transaction support for the arrival in Belarus of a large manufacturer of railway electric vehicles, whose trains now run throughout the country, consulting Chinese construction companies that were considering the acquisition of local construction enterprises). Now we are providing our services to the mid-size businesses. Usually, Due Diligences were accompanied by a detailed assessment of the business valuation. All these valuation techniques are suitable both for estimating the value of a business and for estimating the value of assets. Any audit according to international standards includes a procedure of evaluating fixed assets, i.e., testing them for depreciation. Accordingly, the same models as the approaches to estimating the business value work there.
Over the past year and a half, we have been approached by venture companies for the startup Due Diligence, and even companies not from the IT-sphere - a real business that is at the initial stage (therefore, it has something in common with startups). To my mind, deep knowledge of the business environment and experience of working with companies of different industries helps a lot while working with startups, as startups are not that much about finances, but about general things (business model, market, and much more).
—Among business angels, there is an opinion that it is difficult to value a startup because it does not have any cash flow. At the same time, many are guided by Y-Combinator and other accelerators (although there is a different model there). Do you think it makes sense to estimate the valuation of a startup not by the methods that accelerators use? In what cases valuation is a must?
Partly, I agree with business angels: it is quite difficult (or almost impossible) to make adequate financial evaluation and determine the valuation of a startup at the Pre-Seed or Seed stages. It is even hardly possible for the companies of Big Four:
regardless the fact that specialists of the consulting companies have deep knowledge in finance and experience in valuating the business, startups are not their cup of tea, at least because they do not have such financial resources to attract specialists of such a level;
secondly, the Big Four does not work with the companies with such high-level risks (as startups are) when the Big Four evaluates an existing business, its forecasts are to be fulfilled. In the case of startups, evaluation can be a shot in the dark, as the risks are too high. Knowing that the startup evaluation will not be accurate in any case, the Big Four are unlikely to risk their reputation.
Thus, in my opinion, at the moment, there is no reliable methodology for the financial valuation of a startup at an early stage. The person or a company that will be first to come up with an accurate way of evaluating startups will make good money off it. Which startup evaluation should be considered the accurate one? Let’s take a startup with a preliminary evaluation. It receives the first investment from a business angel or a fund becomes interested in it, the project begins to make the profit. After that, you can evaluate the project again, but now with the help of traditional models of business evaluation. If the evaluation prognosis made at the initial stage coincides with the evaluation made after receiving the first profit and investments, then the initial evaluation is made accurately.
—Why many accelerators do not differentiate the valuation of startups and give them the same amount of investments for the same number of shares? When such an approach is not suitable for the assessment of the startup’s valuation?
The mid-range valuation is used because there is always a high level of uncertainty: before serious investments appear, a business model can change many times, there is no traction on the base of which it is possible to make the evaluation. That’s why, in order to save the nerves, resources and time of founders and investors, we came to the conclusion: we can make the average evaluation of all startups grounding on previous experiences.
At the initial stage, every business angel or venture investor has a goal - to fill a portfolio with 10 to 20 startups, a couple of which will rock. Spending money on an expensive in-depth evaluation of such a number of projects is inexpedient.
That is why on the current stage such a method may be fairly justified.
However, in any case, even if it is not possible to make accurate financial evaluations, it will be more expedient to ask a startup to present a budget and/or a financial plan. At the current stage, it won’t be the evaluation itself, but more like the adequacy test of founders.
—What approaches to assessing the valuation of a startup exist if the Y Combinator method is not suitable? Whose and what tasks do these approaches to assessing the valuation of a startup solve?
There is no exact answer but we can discuss it. If a startup already has an MVP, if they have already sold their product to someone and successfully do their business - taking all these into consideration, we can assume whether there is a market and how it can scale. If a startup conducted serious research and it has results, then there is a chance of more than 50% that the startup can predict the rise in sales per period and the other data, which the startup can analyze and use - then there is a sense in the individual startup evaluation.
There is an evaluation model when for the startup evaluation a similar existing business is taken, which is considered a benchmark for a startup. After that, a startup is divided into metrics (team, business model, etc.) and compared with the benchmark (the existing business).
However, the approach, when the existing and working solution is taken as a benchmark does not always work. Often a startup is something new that creates a market for itself. And it can be difficult to find an existing proxy company.
If to talk about the financial models - it is possible to make a try to define the value on the basis of EBITDA or FCF. In simple words: we take the anticipated money flow from the operational activity by year, it is discounted (the planning horizon is not more than 5 years, or 5 years + terminal value), and the result is business valuation. Repeating myself, it is a very general example, and as it is well known the devil is in the details. A lot depends on whether all the factors are taken into account while calculating EBITDA, forecast accuracy and discount rate (as you know, among other things, it should reflect the level of risk).
Usually, positive EBITDA is not about startups, even on the IPO, many “unicorns” end up as loss-making.
Another evaluation method, used for startups, is about revenue. The anticipated (or the operating) revenue is multiplied on the multiplier and in this way we get the value. However, frankly speaking, such method is a bit vague from the point of view of the secureness of the benchmark data: revenue (from the point of view of financial reports) is the indicator that is the most easily manipulated, and “at the moment” you can show the desired for this very situation result (for example, before the next round).. There is even a definition of “creative accounting” in financial accounting - this means that “at the moment” you can get yourself the desired result: for example, present the information about a great number of sales. And whether the money will come or not, and whether the revenue will really be like that, it will be clear only in the following periods.
That is why, the evaluation according to the revenue can be used, and many do so, however, it is at their own risk. So to say, the evaluation, that was made according to the revenue, will differ, depending on the used method of encountering: whether the revenue figures are used encounting the discounts or not, whether the backlogs are encountered or not.
—Where does the cost of startups that do not yet have data come from? What approaches are used to count the negative EBITDA?
The same example of Uber - the value is based on the evaluations of previous investment rounds. Most likely, that earlier, the evaluation was made with the consideration of the future potential connected with the distribution of the unmanned vehicles
There is a possible variant of calculations using normalized EBITDA - this is when expenses that are not typical for this business or expenses that the company can avoid when certain events occur in the future are eliminated. Then EBITDA can become positive and can be used. For example, in Uber, as we know, a significant part of the costs is paid to drivers. Suppose that after a certain number of years, the technology of unmanned driving will reach the required level of reliability and will be legally allowed in the main markets for the functioning of the company. Accordingly, the need to pay drivers will disappear and Uber will receive 100% of the revenue and, possibly, will finally show a profit. Therefore, having excluded the calculation of payments to drivers, we may be able to get a fairly reliable company valuation.
—There is a startup. Its task is to sell the project as expensive as possible during the deal with the investor. Investor’s task is to lower the startup’s value to buy the bigger share. Long story short, everybody has their interest. Which evaluation model should the investor choose to ‘lower’ the startup valuation, and which model should the startup choose to “raise” its value? Which model will be a compromising one?
Let’s start from the fact that the investor doesn’t want to lower the evaluation of a startup - he has an aim to make an investment according to the adequate evaluation. If the evaluation was lowered in the first rounds, the tendency is likely to continue in subsequent rounds. Nobody benefits of this.
The startups’ task is to prove the investor, that it is worth more than it is, to sell the smaller share for a bigger price, and (so to say, this is a good sign for the investor) prove that the evaluations is trustworthy. How to do this? Conduct deep market analysis, test the idea and prove that your guesses and plans are not based on dreams, but on facts, buttress up by real pieces of research. Present this data to the investor and say: "I understand your concerns, but we have assembled a focus group of 100+ people who expressed a clear desire to purchase a product, created a prototype, received real pre-orders, etc."
In general, for startup evaluation, I would recommend a model, which encounters optimistic and pessimistic variants, and you should not forget that the truth is somewhere in the middle.
In addition, in the very early stages, he invests more in a team than in a product itself.
—Why does a startup have to make the financial plan? Why does the startup need it?
“Successful investment requires a smart plan and following it. And the latter is the most difficult, ”said Warren Buffet, and it's hard to argue with that. However, if we talk about startups, plans constantly change, and actually, it is the main point of a startup.
With that, a method of trials and errors requires resources, primarily - financial resources. Perhaps, some founders are ready to work for a bare enthusiasm, but good specialists are expensive, and it is hard to keep them only by the shares and warranties.
The financial plan is necessary to understand what is prepared for the next day, month or year. How fast startup is “burning” money and what for? When money from the previous investment round will run out and when it will be necessary to go for the next one.
During pitches, a large number of startups cannot clearly explain why they need exactly the announced amount of money and what exactly it will be spent on. It seems that it was taken simply “from the ceiling” - there are no specific calculations. Besides, the ability to clearly explain and justify to the investor how much money is needed at this stage, on what his money will be spent and what kind of result it will bring, all these will significantly increase his desire to invest.
Сash deficiency (a situation, when comes the deadline of vendor reporting for salaries and etc., and there is no money on the account) - one of the most common financial problems that startups face. The thing is extremely unpleasant and does not add enthusiasm to anyone. Proper financial planning allows you to minimize the likelihood of such situations or at least prepare in advance and take the necessary measures.
—What a financial plan should demonstrate to the investor?
There are two main forms for a startup: the financial plan of income and expenses, and monetary movement. The first form is more strategic and is built by an accrual method. The second form is used for operative management and planning of the money flows - and it is compiled according to the cahs method. Let’s talk about the first form.
There are two parts - expenditure and revenue. Revenue has to be based on the natural and value metrics (sales in items, item value and etc.), which are interconnected with metrics of the unit economy (market fit, MAU, conversion, ARPU and etc.) and reflect the real startup capabilities for product realization, which they create. Expenditure has to divide into expense items - salary, marketing, etc. For instance, from the salary expenses, the investor will see what kind of salaries the founders are counting on and evaluate their real goals: do they just want to make more money or are they ready to refuse from the part of an income for the sake of the startup? An important point: the level of salary should be comfortable, and at least it should cover all current needs. If this level does not exist, the team will need to look for additional ways to earn money, which means they will not be able to focus completely on the startup. This is also an indicator for the investor. A similar situation will be in other items: the investor will evaluate how adequately the expenses are distributed by the items, and how all this corresponds to the goals of the startup.
—Which criteria indicate that the financial plan is good enough? What should it include?
It is great when the financial plan is maximally advanced to the normal financial reporting and is specified to the smallest details (there is a specification of the general expenditure - salary, rental, appreciation of equipment, etc.). Ideally, if the financial plan includes both financial and non-financial startup metrics (booking - number of the existing contracts, that are not out-pictured in the reports, churn and others).
—One of the most widespread stories of startup success is that strategic investor bought a startup, but in fact, he bought a technology, not the mercantile component (remember MSQRD), herein, that the model of direct sale to the final customer is stated in the financial model. Is it worth for such a startup sales option to write its own financial model?
Such kind of story is more peculiar for our latitudes. In other cases, the most successful exit option, in my opinion, is an IPO, and successful for everyone.
So I think that it is more about the exit strategy but not about the financial plan. That is why it has to be pre-seen at the early stage. Founders must clearly understand, whether they want to, sell to the company to a strategic investor on a specific stage or the main goal is the IPO. Even on the seed-stage, they have to understand, what will be the exit strategy. A strategist is interested, for example, in technology (how it can be used in existing services/products), new markets, the new audience (gender, age and etc.), and not in selling the product. Accordingly, the financial plan has to include all these A startup can think like this: this technology can be downloaded by a certain number of people, but they are not ready to pay at the stage when revenue can cover expenses on the project, then accordingly, our strategy is to roll back technology and capture the market However, if, for instance, Facebook will build-in this technology in their services, then, taking into account the involvement of new groups, the entrance to the new markets, it will be able to monetize more effectively its revenue on advertising and multiple it (as Facebook earns mainly from advertising).
An IPO is a completely different story and other requirements for a company, its structure, business processes, and reporting. It is important to lay the right foundation at the initial stage to build all these.
—Give any motto or a piece of advice for startup?
I worked in different companies - successful and just-founded IT companies. The main piece of advice can be said by the words of S. Kovey - Begin with the End in Mind: either you will sell your company at the early stage, or one day your company will stop being a startup and started to function according to different mechanisms (yeah, precisely according to those corporate-bureaucratic ones from which you tried to escape by going into a startup:) ), thus, think about the maximum available number of things at the beginning, and as a result it will pay you off. A correctly laid “foundation” will help to avoid many problems associated with building a structure, restructuring business processes, and involving management techniques. Experience has proven that correcting those at later stages is difficult and expensive.
The main point - never give up!
Author of the article: Andrew Miroshnichenko, Head of Experts, Rocket DAO
Editor: Valeria Laskova
Translated by: Dmytro Basok