Venture Capital

April 6, 2021

We’ve talked about valuations quite a bit recently on our blog. And in doing so, we realized the ground between early-stage and late-stage still leaves a lot of room for discussion.

To that point, we ask, “*How should valuation practices change when looking at mid-stage companies?”* The business model is working, revenues are being generated, but the company is not mature or stable enough to begin generating solid cash flows.

In this case, is the VC Method still applicable? Is it worth considering some sort of cash flow based metric?

Today we’ll look at the use of industry-specific multiples based on fundamentals, specifically EBITDA (that is, the operating income prior to reductions from interest and taxes, depreciation, and amortization — basically an unadjusted look at the true earnings from the company’s operations).

When companies are maturing at these stages and true financial statements are compiled, analysts can get a better sense of the health of the company relative to its peers and performance. These line items on the financial statement, particularly the ratios and growth rates that are created from them, are typically referred to as the company’s ‘fundamentals.’

In this post, we will walk through this process, include some examples of how to incorporate fundamental information, and explain why VCs who learn to use fundamentals have an information advantage.

At a company’s earliest stage, the confidence intervals placed on valuations are the widest, as the least information and highest level of uncertainties are embedded within any estimations.

This is why VCs often turn to heuristics, the commonly used quick go-to methods, and other back-of-the-envelope techniques to valuation. Differences in business models and competition, among many other factors at the industry and region levels can create a wide dispersion of valuations (there are significant areas of opportunity to improve valuation techniques within early-stage venture, but that’s a blog post for another time).

*For more information and detailed analysis alternatives to early-stage valuations, check out our conversation with Dr. Gintas Vilkelis on his paper, **‘The Mathematically Correct Way to Value Startups.’*

Now we’re going to talk about some business accounting fundamentals. If you’re unfamiliar with terms like margins, EBITDA, or multiples, check out our post on Accounting 101 for VCs.

As companies begin to mature and their business model becomes more concrete,, the company more consistently generates revenue while continuing to raise capital (at this point positive cash flows are most likely still not yet achieved). This is to say, fundamentals are beginning to come into focus.

This is a critical point for valuation practices. It provides the ability for VCs to move past basic techniques and begin to incorporate more specific and more accurate fundamentals into the equation.

VCs who learn to use these fundamentals will have an information advantage. Why? Because valuations will be more in line with the actual company performance than, say, checklist-based, and qualitative valuation approaches.

To illustrate this, we use the Net Margin and EBITDA Exit Multiple data below from Professor Aswath Damodaran from NYU Stern and combine these datasets to look at the relationship between EBITDA Margins and Exit Valuation by Industry.

Top and Bottom 5 Industries by EV/EBITDA Multiple. Data Source: NYU Stern

Above we show the top and bottom five industries by Enterprise Value/EBITDA. We also include the EBITDA/Sales margin that will allow us to back into a margin-based approach to generating a valuation. This is critical because it incorporates a key piece of information from the company’s fundamentals: it’s operating margin.

Top and Bottom 5 Industries by EBITDA Exit Multiple. EBITDA represents the amount required to generate a $1B Enterprise Value — our proxy for valuation in this exercise. Data Source: NYU Stern

Beyond valuation, these margins can be used to create company goals, as well as generate estimates for valuations per dollar of operating income. Then, you can actually begin to model at what margin and EBITDA values, on average, a startup in a specific industry begins to approach ‘unicorn’ status (i.e. a valuation of at least $1B USD).

You may be asking, why do we care about margins? Well, margins represent the effective cost of doing business and how efficiently a business is operating. Higher margins mean companies can generate more income per unit of sale — and can therefore generate a significant competitive advantage over others.

Referring to both tables above, an Information Services company would require an EBITDA of approximately $38M ($1B / 26.35 multiple), an EBITDA margin of approximately 32%, and sales of roughly $118M ($38M / 0.32) in order to reach a $1B valuation. From this, you can easily approximate an average value for any dollar amount of EBITDA and sales (using the company’s margins if available) at any time.

* Data Source: NYU Stern | Higher margins ~= Higher Exit Valuations*

In the above graph, we plot the EBITDA Margins and the associated EBITDA Exit Multiples to demonstrate that there is a positive relationship. While the correlation between the two variables across all industries is only minimally strong at best (rank correlation of +0.18), there is a clear relationship between fundamentals and valuation (particularly for industries with higher margins (>20%), even in this extremely simple context. It literally pays to pay attention to margins and fundamentals).

Conversely, you can look at valuations from term sheets and determine if that valuation is justified given the company fundamentals. Keep in mind, however, that these are industry averages.

Before we continue, there are two critical things to note with this multiples-based approach:

- If you’re trying to estimate what sales or operating income is needed to generate a unicorn valuation, starting with a fixed valuation (here $1B) will lead to some funky outputs (i.e. Sales of $2.5B and a valuation of $1B— no company would sell for LESS THAN 1x Sales!) so keep in mind this doesn’t necessarily mean that companies can get to a $1B valuation with less EBITDA. It means
**companies across different industries will have higher valuations for the same dollar of EBITDA generated**. This gets to the core of why fundamentals matter — they drive valuation. More on this nuance below. - If you’re trying to understand if a company is over-valued based on its EBITDA or Margin, there are two critical missing components in the multiple-based approach: risk and growth. EBITDA is a point-in-time figure, and the multiple associated with the valuation indirectly incorporates these factors in that
**higher multiples are associated with the fact that the ability to achieve these operating earnings comes with lower risk and/or faster growth**. And, because different industries carry different levels of risk and growth rates they will therefore carry different multiples. This is the same for companies within the same industry and why some companies may be justified with higher valuations relative to fundamentals.

To complete the framework, we now need to talk about cash-flow based valuations.

The value of any financial asset is nothing more than the present value (i.e. today’s value) of all future cash flows. And by cash flows, we don’t mean net income (as this is subject to accounting manipulations and non-cash expenses), but the actual cash generated (or lost) by the company.

We mentioned above how differences in expected growth and certainty of generating earnings affect valuation, but now we need to add in a time component. As discussed above, these differences play out at the sector, industry, region, and company levels. So how do investors incorporate these three components?

*(Side note: This again follows the parallel between the importance of progressing your valuation practices alongside the investment round or company stage, and why doing so gives you, as an investor, more information to use — and if used correctly, gives you an edge).*

The first time is pretty simple — pick a time period, project the cash flows, and then ‘discount’ them back to today’s value. The second, risk, is more tricky, which is why simple back-of-the-envelope and industry averages are helpful. The third, growth, makes this entire practice more art than science and relies on estimation.

If it’s not obvious by now, these models are very sensitive to the inputs — which makes deriving a single valuation, at any stage, very challenging.

The most simplistic way to measure a stream of cash flows is to pretend the cash flows will be constant (a single growth rate) and continue in perpetuity (a single unit of time).

To do this, you can use the Dividend Discount Model (DDM) which generates value using the following:

**Valuation = Cash Flow / ( Discount Rate – Growth Rate)**

For example, a company that is expected to generate a single annual cash flow of $100 per year and grow this value by 10% per year forever at a discount rate of 30% has a present day valuation of $100/(0.30–0.10) = $500.

This is often referred to as a ‘terminal value’ because it is the valuation of the ‘final’ and ‘continual’ state of the company’s cash flows.

But what if we have a bit more clarity in the next five years and want to incorporate those views before we apply a terminal value? To do so, we need to incorporate the time component specifically — which means we estimate the cash flows for each of the next five years, and discount each period back to today:

**Valuation of Cash Flow= Cash Flow/((1+Discount Rate)^N)**

The N term represents the time component that a cash flow two years from today would be discounted at N=2, and a cash flow generated three years from today at N=3, etc. This allows anyone to estimate single period cash flows and bring them to a present-day valuation. To get a valuation over multiple years, simply add the value of all of these discounted cash flows together! Make sense?

Let’s run through an example. If you project the cash flow to be $121 two years from now and assign a discount rate of 10%, the present value of that cash flow is (121/(1.10²) = $100.

Want to conceptualize it a different way? What amount would you have two years from now if you invested $100 and it earned 10% per year? You would have $121! Check the math: $100 x (1.10²) = $121.

For more details on cash-flow based valuation, check out our discussion on Financial Valuation.

If you’re still with me, then you should have a pretty strong grasp on how risk, growth, and time affect a company’s valuation. By association, these pieces to the puzzle become more visible as more information becomes available, and as companies begin to mature.

So make sure to align your valuation method with the company stage so you can better understand risk, write better term sheets, manage your portfolio exposures, and ultimately find that unicorn — at an appropriate price of course.

Happy searching!