Aspiring small tech businesses are often pegged as the next wave of innovation, collaboration and target investment. KPMG Enterprise’s most recent Global Venture Pulse survey revealed that venture capital investment in UK scale-up businesses – those that have progressed beyond the start-up stage but are still targeting dramatic growth – surged 19 percent during Q3 alone, with more than £7.4 billion ($9.5 billion; €8.6 billion) invested so far this year.
Buyers and investors alike are attracted to the unique characteristics and potentially vast returns associated with scale-ups. Their business models often offer innovative solutions to problems in the market that are either not being resolved or that are being delivered at a sub-par level.
Additionally, these companies are based on rapidly scalable business models, founded specifically with the intention of becoming high-growth, disruptive enterprises. So, if tech scale-ups are this generation’s ‘dotcoms’, how do we avoid the bust?
With opportunity comes challenges. At KPMG Enterprise we continue to see a set of obstacles in the market that confound participants and lead to an environment in which some investors in tech scale-ups struggle to publicly list the companies.
The question of how to value these scale-ups is particularly tricky, but it is a crucial part of the investment process. Given the potential rewards on offer, it raises the question: how are these companies valued? Is it according to the intrinsic value of the technological offering. Or is the value being skewed by the excitable association with a tech scale-up?
By no means am I suggesting that panic should ensue. There is no sign that sectors such as fintech, biotech and healthtech are slowing down, and the UK has a global reputation as home to world-leading disruptive businesses that continue to attract capital.
“We can all think of recent high-profile examples which demonstrate that value is only real if it can be achieved”
But valuing companies is a subjective undertaking, and this is particularly the case for scale-ups. Many private equity and investment vehicles still place significant reliance on the post-money price of a recent investment as a primary valuation technique. But without increased consistency and the challenging of such approaches, market scepticism will continue to rise.
For instance, questions may be asked about the circumstances surrounding the investment. Was funding provided by new investors or just existing shareholders? Was adequate information provided to allow for informed pricing decisions? Were there strategic investors or forced sellers?
The recent IPEV valuation guideline update indicated that PORI should not be considered a standalone valuation technique but should be used to calibrate the inputs used in other valuation approaches.
What makes valuation elusive
Scale-ups frequently focus on the amount of funding required and not necessarily on the price at which that funding is raised. We can all think of some recent high-profile examples which demonstrate that value is only real if it can be achieved.
There are three primary challenges to overcome before a scale-up can be valued. First, given their early stage of operations and heavy spending on developing, testing and marketing their products or services, scale-ups are often loss-making or, in some cases, not yet revenue generating. This makes it difficult to value them using traditional sales- or earnings-based methods.
The second challenge is a stifling lack of data. In addition to limited reliable historical data – only a small portion of which is shared publicly – many start-ups and scale-ups are disruptors or create new markets or fresh offerings. This means limited information is available on key considerations such as market size, competitors and future potential margins, which has an impact on the consistency of the estimation process.
The third challenge is that tech scale-ups are very illiquid and inherently high risk, and many are likely to fail. Incorporating this variability of outcomes into a view on value and pricing throughout the various milestones of a tech scale-up’s growth can be challenging.
The traditional valuation methods – including use of replacement cost, net assets, discounted cashflow and sales and earnings multiples – will remain. But an exciting part of this story is that these traditional methods can be augmented using more unconventional approaches. These include the following:
• Probability weightings: If a scale-up’s projections seem optimistic, they could be adjusted using probability weightings. For example, if a business plan is deemed optimistic or milestone-driven, a probability weighting could be applied to the proposed outcomes. At a more sophisticated level, Monte Carlo simulations could be adopted to model the probability of different potential outcomes.
• Option pricing: Real option models value potential business decisions and aggregate the value of these ‘options’ to a base valuation. Option valuation and the use of decision trees can help to build up a scale-up’s value in increments based on the business decisions it is expected to take and milestones it is seeking to achieve.
Although such approaches are established, they are not widely practised, and when they are applied it is often in concert with more traditional valuation approaches. However, as technology evolves, I can see these approaches becoming more appealing, particularly in a deal context.
We know that investments in high-growth technology assets have tremendous risk. But with a solid understanding of the valuations process that should take place between investment and disposal, private equity buyers will be better placed to consider deals in these unprecedentedly volatile portfolio environments.