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Last updated on May 4th, 2023 at 08:57 pm
Entrepreneurs usually need to negotiate a term sheet. Negotiating a term sheet is usually a daunting task, especially for a startup.
Since the venture capital method is novel in Uganda, there is no benchmark of how valuations should be conducted for emerging growth technology companies. In this article, we navigate the best practices used in established technology ecosystems drawing inspiration from bodies such as the National Venture Capital Association (NVCA).
A sophisticated entrepreneur should have an understanding of basic valuation methods and terms used by venture capitalists ( VCs). This knowledge beforehand is usually good armor in negotiation for an investment. These are my observations of the methods commonly used by VCs:
EBITDA Multiples and Comparables
This method requires the investor to start by developing several EBITDA multiples in their industry of practice. The major hurdle to overcome is usually acquiring information about similar companies in a specific industry.
If the entrepreneur has access to information such as market capitalization (usually for public companies), the value of debt, and cash of private or public companies, they can derive a multiple. This multiple can signify to the investor the potential value of the company.
For instance, if the multiple is 12X, then the investor/analyst will multiply the earnings of the company by 12 to determine the valuation of the company.
This method remains the usual suspect in determining viable candidates for an acquisition/merger but can be used by an entrepreneur whose company has early revenue or projections of revenue to determine the value of the company.
Discounted Cash Flow analysis
Most times the startup will often be required to pitch their anticipated cash flows. It is helpful to understand the market size and how you intend to make money from the market.
This will be useful to generate forecast revenue, expenses, capital assets, and capital structure. An investor may decide to discount these cash flows to understand the present value.
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Venture capital Method
A commonly used method by VCs is the venture capital method, this method is originally from Silicon Valley in the United States, and it is the gold standard used by venture capitalists to estimate the value of a company.
Venture capital firms/funds usually finance small, early-stage, emerging firms that are deemed to have high growth potential, or which have demonstrated high growth. Usually, companies that get this financing do not have a financial history to go by when determining their valuation.
This challenge was explored by Harvard Professor William Salman in 1987. He realized one way to analyze the value of a start-up, is to look at what the value of the start-up could be on its exit.
The exit is usually a liquidity event and in this sense means a merger, acquisition, or an initial public offering (IPO), in 3 to 5 years. The method relies on terminal values derived from other methods. It is usually the case that the VC will use the EBITDA multiples and discounted cash flow (DCF) to arrive at a meaningful valuation.
The investor will determine a terminal value by applying a multiple to the future forecast earnings/revenue. This terminal value is then discounted with a high discount rate of 40-75%. Initially, the investor makes several assumptions about a company such as;
a) Estimation of the company valuation in some year of interest, usually this is the year the investor intends to exit the investment.
b) Estimation of the VC’s target multiple of money in a successful exit
c) Calculation of the required final percentage ownership.
d) Estimation of future dilution and the required current percent ownership.
However, in Uganda and most of East Africa liquidity events/exits are usually rare. IPOs for instance consistently remain a rare event for technology companies in all the four markets we have practiced in.
This is partly because of the stringent approval requirements of the capital markets regulatory authority. This exit gap inhibits VC financing since investors remain skeptical of the likelihood of a substantial return.
As a stop-gap measure, companies have out rightly convinced venture capitalists to look at alternative exit return schemes such as; spin-offs, negotiating licensing arrangements, and slow buy-outs.
A basic and simple illustration is this; if you have a business plan that you could value at 15 million shillings, the prospective investor would multiply this valuation 10 times.
When the investor has an opportunity to sell this business as an exit, he would dispose of it at 150 million shillings to a big company such as Facebook.
The VC investor values your start-up at a point of exit at 150 million shillings. It’s trite that the VC would seek to double his investment each year which means a 100% return on investment each year.
Therefore, if a company is valued at 150 million in the third year, by discounting at 100%, you can calculate that its worth 75 million shillings in the second year, 37.5 million shillings in year one, and 18.75 million shillings on the very day the VC invests his money.
Louis is a lawyer in general Commercial law with expertise in Capital Markets, Securities law, structured financing, Fintech, venture capital and data protection