Reflecting back to my days in the banking world when I had many discussions with our colleagues in credit and risk as to the certainties that a loan would be repaid, the plain fact was that until a loan had been fully repaid, which in some cases was for a tenor of 20 years or more on some projects, it was impossible to predict and guarantee with absolute certainty that it would be repaid because of the number of different events that could occur during that time. One can assess the risks known at that time, but one cannot really accurately forecast all the risks when advancing money.

The same applies to valuations and in a similar way because, although different methods can be used to reach a valuation, there is no way that it can be proved in advance that a valuation is correct by either the entrepreneur or investor. Even the term ‘correct’ is questionable because even if a company is much more successful than anticipated by the investor then there might still remain a feeling with the entrepreneur that they had been too generous with their shareholding allocation in the first place.

Whilst fully understanding that potential investors need to receive some guidance on valuation to make their decisions on whether to invest or not, our advice to founders/entrepreneurs is to not to be to prescriptive in this regard because certain smarter investors can bring much more strategic value than just the funds.

Let’s look at the models that might be used for valuation purposes, but prior to this we should perhaps look closer at some of the other non-financial elements that might impact a valuation.

The Management team

• Honesty and integrity: Investor needs to be convinced that the team is honest and truthful in its representations.

• Size of the team: Two or more people are preferred and one must be capable of managing the financial side.

• Commitment: Investors like to see that entrepreneurs have “skin in the game” with a vested interest to succeed and not slip back to previous roles when the going gets tough.

• Chemistry: Investors like people they can trust, share common ideas and are receptive to take on suggestions.

• Determination: Investors like the entrepreneurs to be focused, tenacious and enduring.

• Low starting salaries: Investors are not there to finance a lifestyle. Compensation can revert to more realistic levels when profitability is achieved but against KPIs.

The business concept

• High return on capital: Investor is looking at a return on capital at an IRR of 40 percent plus per annum – this reflects the risk in investing in early stage businesses.

• Revenue stage: Investors ideally like to see some form of revenue or least commitment of revenue.

• High growth potential: Businesses should be highly scalable

• Competitive analysis: The fact that there is competition should not be a deterrent, but at the same time there might be a good reason why there are not any market players currently.

• Intellectual property: This needs to be secured in the company.

• Financial forecasts: These need to show ambition but at the same time be realistic.

• Investor-ready: A comprehensive business plan with detailed financial forecasts should be available

• Exit route: Investors need to see a way of getting back their money, either through cash dividends or a trade sale, sale to other shareholders, re-financing or very rarely a flotation (IPO).

First step towards a valuation

A financial model must be prepared against a full list of possible assumptions which might impact the business. Typically, a five year financial model should be prepared projecting the following:

• Profit and loss account

• Cash flow statement (on a month by month basis until at least breakeven)

• Pro forma balance sheet (particularly for capital intensive businesses)

Reflecting this, close examination of the cash flow statement is critical for early stage businesses because they go bust due to a lack of cash not profitability, particularly in the current market where payment is notoriously slow. Analysis of the monthly burn rate is key.

The choice of a valuation method depends upon the type of business which is seeking the funds.

For example, if it is a standalone business where it is expected that there will be no further investment beyond the initial investment and that the returns will be generated purely through dividends, the approach might to use a sweat equity valuation model.

On the other hand, if the business is fast-growing and the expectation is that profits will be reinvested and that there will be further rounds of funding, and related dilutions will occur, then a price earnings valuation model is more appropriate.

Let’s now look more fully at valuation methods – this I have left deliberately to the final section because that is how it should work in reality. Discussions on valuation should only take place when all the relevant factors are reviewed. Contrary to other parts of the world, there is a tendency among GCC investors to make valuation their first assessment which will determine their interest to invest or not.

Sweat Equity Valuation Method (simplified)

The Sweat Equity method is often used in the very first fundraising of a company when the funds are provided by family and friends.

If it is a business which needs subsequent rounds of financing to grow, this is a significant disadvantage to the entrepreneur, as investors will be concerned that dilutions will reduce the founder’s stake to such a low level that this might coincide with their reduced commitment in some instances.

It might be more prudent for convertible loans to be provided rather than equity at this stage.

The Sweat Equity method is much more suitable for businesses, such as F&B or retail establishments, where the founders might have limited capital to invest but their continued involvement is key to the business.

The expectation will be that the operations will become cash flow positive almost immediately after launch, and therefore the investors will be looking at the time when the business has generated sufficient cash flow that could ostensibly repay their investment. This is called the payback period.

It should not be confused with a loan because it is still an equity investment, but it demonstrates that the business will have a capability to pay dividends to investors. It is at this point or when full payback is achieved that founders might be able to exercise clawback clauses to obtain a larger equity share.

Price Earnings Valuation Method (simplified)

The price-earnings ratio (P/E Ratio) that should apply is one that is used in the listed stock markets for the entrepreneur’s kind of activity, but to be realistic this ought to be at a discounted rate of up to 50 percent because it is not a liquid investment.

One of our partners in the UK has been quoted as saying: “When valuing businesses, the entrepreneur tends to presume that the risks are minimal and the chances of achieving their hockey stick ‘conservative’ projections are entirely realistic. In reality, it is estimated only around 4 percent of companies that achieve funding in the UK actually exceed the projections outlined in their business plans.”

This does not mean to say that these companies are not successful, but not as quickly and not to the degree forecasted so some realism on behalf of the entrepreneur needs to exerted.

Just under four years ago, Envestors was introduced to a couple of very dynamic entrepreneurs, we were immediately impressed with their energy, enthusiasm, knowledge and professionalism and we were pleased to be appointed as their advisers to their first external fund raising.

A short while after being appointed, they approached us to say that they had received directly an offer of financing.

We asked if they could share the valuation and having crunched the numbers we had no hesitation in telling them that, in our view, they would be unable to match or better this valuation offer from other regional investor sources. So, we encouraged them to proceed.

It is no surprise to us that this dynamic team has gone on to become one of the region’s first unicorns – yes, in case you have guessed – the name of the company is Careem.

It is a perfect example of how the strengths of a management team and robust business model outweigh the pure mechanics of early valuation processes.

In conclusion, I would add that whilst almost all investors will probe deeply with entrepreneurs and their plans, it is very seldom that an entrepreneur will ask an investor what they expect to get in return for their investment.

I would encourage such conversation to take place because then misconceptions can be avoided and perhaps a more flexible shareholding structure adopted without immediate relevance to the usual valuation methodology.

Source: Arabian Business