The Society of Shares and Business Valuers launched their 2022 webinar series last week with a challenge from Mike Blake, the managing partner of Brady Ware in the US, to add rationality to early-stage company valuation by relying more heavily on market inputs. The income approach is not always effective in prerevenue situations, so Blake turns to guideline public company and transaction method alternatives.

“Our job as appraisers is not to be merchants of hope, so our job is to cut through the fog, and that puts us out on an island intellectually,” Blake told the SSBV members. “We don’t have the benefit of an easily visible touchstone … and the markets are often irrational.”

SSBV have made the recording of Putting the Science Back Into Startup Valuations available for paid members. Blake, an ex-investment banker and venture capitalist, admits “there’s remarkably little rigor around placing rational values on these interesting companies.” Valuers must question financial motivations, and market rationality must be called into question when it turns out “someone did a deal because they wanted to sit on the same board.” There’s an element of luck. The market (Blake says the median UK premoney seed capital valuation is now approximately £4 million) is largely unobservable.

Blake compares the “binary” status of startups to Schrodinger’s famous cat. “They’re both dead and alive at any given moment.… Most startups do not succeed at the level that justifies the risk, or even return the startup capital.”

All startup financial projections are conservative: “Every founder presents their company with the descriptor that their projections are conservative,” Blake laughed. “I have yet to see an entrepreneur lay a set of projections in front of me and say that they represent the deepest and most profound fantasies they’ve ever had.” BV experts are then supposed to force some rationality into those projections.

Projections may not be as reliable—and neither are the elements of the discount rate. While the risk-free rates and market risk premia are generally determinable, Blake recognises the potential “lack of science from CSR, industry specific risk premia, and size premia.” “Most of the discount rate is the result of our professional judgement,” he concludes.

“We’re often presented with forecasts that create the uncomfortable situation where I need to go back to the client and say I can’t accept them,” Blake says. “This is not my favourite part of the job. But if I can go back to them with market data,” then valuers don’t have to argue that they know the business better than the entrepreneurs do.

Plus these market data sources offer a secondary validation tool, and “I thank god for their assistance” when defending a valuation conclusion, Blake says.

These factors lead Blake to switch emphasis to the market approach. His session offered an excellent list of places to turn to find proxy market data for a set of companies for which EBITDA and revenue multiples are less certain. Among his nonstandard approaches:

• Turn to the angel investor community. “There are groups of UK angel investors who you can talk to every day,” Blake said. Valuers can use these professionals “to establish that there is a market for your target company.”

In addition to traditional valuation multiples, “calibrate value to invested capital,” Blake advises. Like any market approach, start with:

• The relative size of the startup;
• The stage of investment; and
• How long the company has been around. The market prices a “sweet spot in investment year vintage between staleness and freshness.… If a company has been around long enough and has no inflection point, it’s worse than having no track record."
  

• Turn to Crunchbase Pro for small listed company comparables. Market cap data from the thousands of companies on the leading exchanges that have less than a £1 million in revenue show that the “markets price on a basis beyond historical revenues and EBITDA.” Blake acknowledges that “these noncontrolling shares may be trading sparsely, but at least the discounts are built in and there’s a lot of data.” Big firms with large research budgets can turn to CapIQ and PitchBook to find these comparable companies, but now that Blake’s left that world, he relies on Crunchbase Pro. (He notes that his clients love these data because they include so much information they can use about their company, their competitors, and future potential funding sources.)
• Consider risk factor summary methods. Blake offered the SSBV attendees a great scoring table based on standard risks (management, stage, competitive, litigation, etc.) with the assumption that a median UK premoney valuation would be £2.5 million. While valuation experts might not like risk rating methods, Blake confirms that “the angel marketplace uses them.”
• Add real options modeling to startup analyses. While many “clients often struggle to understand the mechanics and implications of these widely used methods,” they demonstrate the idea of value “gates,” Blake says, which calculate the negative value of events that may be terminal for the success of the company. Lattice models and their probability ratings can be particularly helpful.

Are these radical sources reliable? Blake’s experience says they support his conclusions well even though it’s hard to argue that market pressures don’t unduly influence the underlying market data. “Some of the noise can be reduced, and we have to assume some level of market efficiency and rationality in the transactions generated by these data.”

Details on SSBV events throughout the remainder of 2022 are listed in “Dates for Your Diary” and on ssbv.org. Membership in the organization is not required for the events but is available free at the student and corporate levels—and for a small fee at the Fellow, Full, and Associate levels.