Achieving a precise and dependable business valuation could be pivotal in driving a business success forward. Tech companies typically experience an increase in value as they expand, as profits are often linked to valuations. However, sudden growth spurts or market fluctuations can make profit projections difficult.
It is essential to understand when the appropriate time is to initiate a valuation. In addition, one must locate an advisor who understands the unique challenges involved and can guide how to overcome them.
This article looks into the reasons for conducting a business valuation for a tech business. It highlights key considerations during the process. It also offers an overview of different valuation methods and why selecting the right advisor is crucial when valuing your business.
Assessing the valuation landscape: the UK perspective
Establishing the value of tech businesses can be complex. Start-ups may lack a revenue history or tangible assets, and even those with prototypes may grapple with gauging market demand. While patents and intellectual property rights hold value, approximating revenue based on such intangible assets presents its challenges.
Moreover, the value of tech businesses tends to escalate as they expand, but growth spurts can make profit projections difficult and market conditions can cause demand to fluctuate unexpectedly.
Understanding the right time to instigate a valuation is crucial, alongside enlisting an advisor familiar with the unique challenges inherent in the tech sector.
Exploring valuation imperatives: key considerations
In their quest for funding, tech companies often rely on funding rounds for product development or ongoing initiatives. Investors keenly scrutinise the destination of their investments and the anticipated returns. Consequently, a valuation can provide prospective investors with insights. Certain investment funds will mandate an independent valuation. In the prevailing economic situation, a well-founded strategic growth and business plan, complete with detailed forecasts, is important.
Facilitating employee incentives
Businesses that are expanding rapidly continually scout for talented individuals to support the execution of their strategic growth plans. Introducing employee share incentives, such as an Enterprise Management Incentive (EMI) scheme, can incentivise and help retain key employees to grow the business over time. However, prior to introducing such schemes, a valuation is recommended to mitigate potential HMRC challenges and optimise tax advantages.
Pondering shareholder perspectives
To unlock value from their investment, shareholders can initiate a valuation exercise, subject to permissions outlined in the Articles or Shareholders’ Agreement. Whether considering share buybacks or investigating restructuring options, gaining insight into the commercial worth is crucial for making informed decisions and strategic planning.
Understanding influential factors
Tech businesses pose valuation challenges owing to their diverse characteristics and market dynamics. Factors that could influence your business valuation include:
- Business maturity
- Your business’ revenue-generating model
- Current economic conditions
- Business assets
- Funding requirements
- Timing of the valuation
- Whether the business is in a developing marketplace
Exploring valuation methodologies
When determining the value of a business, there are several factors to take into account, and often, there is no single correct answer. That is why it is important to consider timing, key financial information, such as tax, earnings before interest, depreciation and amortisation (EBITDA) or EBIT, and assets. In particular, asset value, cash flow and performance trends of the business, as well as market trends and benchmarking data.
The rights attaching to the share and intellectual property in the Articles of Association and Shareholder Agreement, if any, must also be reviewed during the valuation.
Some of the traditional methods that could be used to value a tech business, include:
Capitalisation of earnings
A capitalisation of future earnings with a multiple applied to various earnings levels, including EBITDA, EBIT, and revenue. The method is appropriate for established businesses with steady growth forecasts, so it may not be suitable for tech start-ups.
Discounted Cash Flow (DCF)
The valuation is calculated value based on expected future cash flows and is appropriate for high-growth tech businesses or where there are irregular cash flows.
Net Asset Value (NAV)
This methid is not traditionally suitable for a trading entity as it will not take into account any intangible value in a business, which in a tech business could include computer software, patented technology, databases and licence agreements. Intangible assets should be considered as part of any valuation as this could make up a large part of a tech business’ value.
Traditional methods may not always be suitable for valuations of tech start-ups and these alternative methods may be more appropriate:
Scorecard method
The scorecard method involves comparing a startup with recently funded similar companies to determine an average pre-money valuation. This is then adjusted based on specific factors relevant to the startup. These factors include the management team, product or service offered, technology used, market size, competition, and funding requirements.
Each factor is given a percentage score based on its importance, compared to similar companies, and assessed for its relative strength. The weighted average of these factors is then applied to the average pre-money valuation to determine the startup’s value. This method is suitable for startups lacking historical financial data but requires a deep understanding of the startup, its industry, and the method itself.
Venture Capital method
The Venture Capital method determines the pre-money value through an assessment of the exit value. This is projected at the time of exit and calculated based on anticipated earnings multiples. This value is then discounted back to the valuation date. Reliable forecasts are essential for this method, along with the ability to identify an appropriate discount factor.
Berkus method
The Berkus method provides a way to value companies through an initial assessment of five key areas. Each area is assigned a value ranging from £nil to £400,000 based on its quality. These areas include the management team, the company’s concept, prototype, board of directors’ quality, and product rollout and sales potential.
The total of these values forms a foundational pre-money valuation. While this method can be useful for startups lacking financial forecasts, it necessitates a comprehensive grasp of the company, its industry, and the method itself. However, it isn’t applicable for companies with recurring revenue streams.
Selecting the right advisors
It is important to choose the right team of advisors who possess the relevant skills and experience, along with a genuine interest in supporting your business.
Additionally, your advisors should be willing to work closely with you to gain a comprehensive understanding of your tech business and its potential market. Key considerations, include:
- Knowledge of the technology sector
- Awareness of specific challenges and opportunities facing the business
- Business strategy and objectives
- Experience of preparing valuations using more than one appropriate valuation methodology
Having the right advisors by your side can enhance your readiness for negotiations with investors, current and prospective employees, or exiting shareholders. It will also increase your chances of achieving growth as you move towards a prosperous future.
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