Maximizing Value of Early-Stage Tech Companies in the Current Environment
As the saying goes, “Cash is King.” While many early-stage tech companies have started to generate revenue, they are often not cash flow positive, which presents a challenge to valuing these businesses. These challenges have been amplified by the spotlight put on the industry by the pandemic, historically high public and private market volatility, and economy-wide uncertainty caused by macroeconomic factors including, but not limited to, the war in Ukraine, high levels of inflation, rising interest rates, lingering supply chain disruptions, staffing shortages, and the potential for a recession. These complications don’t change the fact that management teams of early-stage tech companies still need to have reasonable, supportable estimates of company value, whether it be for raising capital, issuing shares and/or options to employees, or a host of other reasons. This article examines how current market conditions affect value conclusions and how management can maximize their company’s valuation.
Current State of Deal Environment
Management can’t control market volatility, interest rate levels, the overall receptiveness of public markets, other macroeconomic factors, or the effect each has on value. Unfortunately for tech companies, these factors have generally exerted downward pressure on valuations in 2022. After a record level of IPOs in 2021, the IPO and follow-on windows for tech companies have effectively closed thus far in 2022. M&A activity in tech has come off the astronomical highs of 2021 to slightly below pre-pandemic norms, bucking the multi-year uptrend. With recent increases in interest rates, the capital that is available has become more expensive. While the prevalence of down-rounds has not yet substantially increased, venture capital and private equity investors are insisting on more protective deal terms. Tech companies also face the operational challenges resulting from a shortfall of available talent for vital roles within the company.
There are some bright spots for the industry, though. Venture financing for very early-stage companies remains strong in terms of valuation and deal count as investors are confident in the long-term viability of many of the industry’s subsectors. The necessity of responding quickly and effectively to the worldwide threat of COVID-19 resulted in a dramatic increase in the market’s adoption of new technologies across a wide range of industries, especially in the areas of information security, supply chain, and enterprise SaaS. The niche emerging industries of food tech and clean tech have also witnessed spectacular acceleration in the last couple of years. Early-stage companies in the industry have long embraced the virtual work environment, helping to escape the employer/employee friction of “back to the office” policies being increasingly implemented in other industries.
Investors are aware of these bright spots, and valuations are still generally down (especially at the later stage). So, what can companies do to maximize their valuation? The answer is relatively simple – remove uncertainty and grow. Regardless of the industry, uncertainty equals risk, and investors require compensation for assuming it. For equity investors, that compensation comes in the form of a higher expected return resulting in a lower pre-money valuation at the time of investment (i.e., a higher discount rate in a discounted cash flow analysis / lower multiple). Certain risks cannot be avoided, like those uncertainties associated with the greater economy. While these risks need to be monitored and planned against, management must work to minimize company-specific uncertainties, namely execution/projection risk.
One way to reduce risk is to move along the company life cycle: from start-up to early development to expansion to IPO. At the start-up phase, companies are spending substantially on product development and test marketing. Early development companies have viable prototypes with minimal technical risk, but substantial commercial risk. Companies in the expansion stage have some sales and are growing to profitability. In the mature stage / IPO, companies have historically coupled strong but declining revenue growth with increasing profitability margins. Execution and projection risk is reduced as businesses move along this continuum and are rewarded by investors in the way of lower discount rates / higher multiples.
Investors need to clearly see how their investment of financial capital into the intellectual and human capital assets will eventually translate into positive and growing cash flows for the business. Companies illustrate this in the form of financial projections. The level of confidence an investor has in the forecast being realized ultimately determines the value they place on the business. Companies can increase the certainty in their projections by ensuring they are built with sufficient detail and are based on reasonable, market-based assumptions.
As many early-stage tech companies lack the internal resources to research and prepare detailed projections, such companies wishing to maximize their valuation need to partner with knowledgeable, reputable advisors to ensure that the projections are prepared with a level of diligence and care sufficient to ease potential investors’ concerns over the company’s ability to achieve these future results, thereby decreasing the discount rate applied to the projections.
Companies should also work to minimize operational uncertainties. Just as many early-stage tech companies lack the internal resources to research and prepare detailed projections, they may also lack the internal resources to fulfill the financial reporting responsibilities that accompany pursing outside capital and keeping investors appropriately apprised of the company’s financial position. Having appropriately prepared financial statements removes another potential uncertainty for investors and can help give them additional confidence in the company’s financials, both historical and projected.
Lastly, companies seeking to maximize their valuation should consider having an independent valuation completed by a valuation firm familiar with the complexities of valuing early-stage tech companies. Not only will such a valuation help management set reasonable value expectations as they seek to raise capital, but it can also help identify weaknesses that are constraining the company’s valuation and demonstrate to potential investors that management has done its due diligence.
How Centri Can Help
At Centri, we’re dedicated to providing high-quality business valuation, financial modeling, and financial reporting services for technology companies. Our professionals are responsive to your needs and objectives, and create tailored solutions that help you measure, analyze, and report on valuation and financial issues, no matter your size or business stage. For more information or questions, please contact us.
About Centri Business Consulting, LLC
Centri Business Consulting provides the highest quality advisory consulting services to its clients by being reliable and responsive to their needs. Centri provides companies with the expertise they need to meet their reporting demands. Centri specializes in financial reporting, internal controls, technical accounting research, valuation, mergers & acquisitions, and tax, CFO and HR advisory services for companies of various sizes and industries. From complex technical accounting transactions to monthly financial reporting, our professionals can offer any organization the specialized expertise and multilayered skillsets to ensure the project is completed timely and accurately.
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