Science Ventures Series: Valuation of start-ups as a seed investor

Andy Muir – Investment Director at UKI2S
Alexander Leigh – Investment Director at UKI2S

How does UKI2S approach valuation?

We base our business model on the “power law” and estimate two out of ten early-stage investments will generate extraordinary financial return to cover the entire value of the fund. We focus on a valuation based on an upside exit scenario which could be generated by a sale to a financial buyer based on the multiple of expected revenues, or a lucrative strategic sale to a competitor, customer or supplier.

A good return on our investment is essential because the profits we make are re-invested into future innovative and high-impact companies in the UK. It is also essential for venture capitalists (VCs) to generate risk-adjusted returns to attract fresh capital, thereby ensuring the longevity of the overall start-up ecosystem.

As a team, we operate on a consensus model. If the valuation is too low, there could be too much dilution and company founders may be less incentivised. It may also send a signal to other investors that the company is of lower value and typically we would like other investors on board with the companies at a later stage. If a company’s overvalued, it can make raising the next round challenging, particularly if the company hasn’t yet reached specific milestones. It may additionally make the eventual exit more difficult.

What key pieces of information do you need to judge a company’s value?

Since we are exposed to numerous companies and investment deals, we can use benchmarks to compare a particular company against another company in the same sector. We also consider the size of the problem that this company’s technology or service will address – how big is the accessible market?

However, this can differ across markets. US valuations tend to be higher, probably reflecting US companies’ access to more capital. Certainly, in the last few months that was the case and we saw US investors migrating to UK markets, placing an upward pressure on UK prices.

Valuations did get out of hand as demonstrated by the recent stark contraction in revenue multiples ostensibly caused by the economic uncertainty expected of the next 12 – 24 months. Perspectives have shifted and there’s a greater sense of realism, particularly for post series A, series B and beyond rounds. This sense of realism is good for valuations as it allows companies to progress at the right pace and sets them up well for the next round of funding. Overall, a healthy start-up ecosystem relies on entrepreneurs and investors being aligned and excited about the future company prospects.

What are the specific risks related to start-up companies that contribute to the valuation process?

It’s important to remember that risks compound. Even if the company has a 90% chance of overcoming a specific challenge, the chances of success after combining all risks are much lower. Some of these may include:

  • Customers – will the customers love the product or the service?
  • Fundraising – will the company be able to raise follow-on capital?
  • Scalability – can the company develop a highly-scalable product?
  • Team – can the company build an effective team, both at the senior level and the junior level?
  • Technology development – can they translate laboratory research into a real-world product? Is the product roadmap aligned with the commercial and financial plan? Is the intellectual property defensible?

What methods do you use to assess these different risk factors?

There’s no mathematical formula to valuation. It is largely based on experience and exposure to similar companies. We can use pattern matching, which involves considering past success trends.

At a later stage, valuation can be more objective since companies have a track record of generating revenues or profits. At seed or early-stage, it is hard to be fully objective. We’ve got to feel excited about the company, and the founders have got to be excited about working with us too.

Once we’re invested and there is a fair valuation, investors and the founders can be properly aligned to increase the value and propel the company forward. There is something in it for both of us – and that’s a healthy position.

Based on your extensive careers in venture capital, what are your three key takeaways about early-stage valuation?

  1. Recognise both sides of the negotiation – investors and founders need to reach an agreement that works for both parties. It doesn’t help anyone to have a valuation that is clearly too high or too low.
  2.  The main objective is to get money into the business – both parties need be careful about being overly fixated on valuation, it is only one part of the fundraising process.
  3.  Model each round through to exit – the fundraising roadmap is just as important as the product roadmap. Maintaining a clean cap table and appropriate valuation for the stage of business is key to fundraising success.

July 2022