Entries by Matteo Marchesini

Business Plan and Valuation: their value beyond fundraising

In the startup world, two key topics emerge time and again (sometimes becoming ubiquitous) are business plan and valuation. Although these concepts are often associated with the fundraising stage and the subsequent due diligence, their importance goes far beyond that.

The objective of this in-depth focus is therefore to explore more closely the importance of the business plan not only as a tool for attracting investors, but also as an internal operational guide and to give criteria on the valuation process of a startup highlighting how it represents a “flexible” starting point subject to multiple factors and market dynamics, rather than an immutable value.

THINKING A BUSINESS PLAN: WHAT IS ITS USE?

As mentioned, the business plan is not just a formal document, necessary to attract financing, but is the cornerstone on which the company’s entire operational strategy is based. Its job is to serve as a detailed guide to outline the company’s goals, the strategies to achieve them, and the operational and financial plans to keep the company on a sustainable growth path.

The final document also provided with a financial plan must clearly define: mission, vision, the company’s short- and long-term goals (roadmap), the activities put in place to achieve them (activity plan, business model and marketing plan), and the economic and financial fallout of this action. In this sense, it is evident how a well-crafted business plan is not only a key document for investor due diligence, but also directly helps the founders and the team to keep the focus on what matters most at a given historical moment in the life of the company and to work toward common goals, reducing the risk of dispersion and disorganized efforts. In addition, a well-articulated business plan that presents clear activities, tasks and sub-tasks (gantt) facilitates internal communication, aligning the expectations and responsibilities of all team members.

A special note is in regard to the financial planning part (the output of which is mostly rendered in excel).

In fact, a good business plan must include a financial plan consistent with the goals of the company. This document is as crucial for the investor’s evaluation during due diligence as it is for the founder(s). In fact, the goal is to reason and understand what the expected cash flows are (in terms of revenue, costs to be incurred and cash flow), funding needs (defining the ask for fundraising – how much money the company needs before reaching breakeven) and operating budgets for various activities (e.g., marketing plan) allowing the startup to effectively manage its resources, be they physical, tangible and intangible and to prepare for possible financial difficulties (sensitivity analysis). Indeed, on this last point, a well-designed plan must allow for the identification of potential risks and the possibility of having drivers for the development of mitigation strategies ensuring that the company is ready to respond to challenges and opportunities with agility and speed.

THE ROLE OF VALUATION

Analogous discussion is what is carried out for the valuation of a startup, which, in fact, represents the estimated economic value of the company. This process, which combines qualitative and quantitative data, is crucial not only to determine the price of the shares to be sold to investors (and fuel the exit fantasies of the founders), but also to properly understand and communicate to the outside world the growth potential of the company. 

However, a valuation, no matter how well executed, does not return a value that is certain and unchanging; on the contrary, it is inherently dynamic and subject to interpretation. The variables involved, from growth projections to market risks, are often complex and susceptible to revision, making the entire effort prone to major revisions.The final number obtained, therefore, is not a static number, but a real starting point necessary for subsequent negotiations between founders and investors. 

Indeed, investors may require further evidence of the growth potential or business model, leading to a revision of the company’s value. Likewise, founders may need to consider new economic conditions or changes in the competitive landscape, which affect the perceived value of their company.

Valuation, in short, is not a trivial task, but to navigate this complexity there are various approaches that can help shed light on how to determine the value of the startup. The following are 3 that often turn out to be the ones given the most attention:

  • Method of Market Multiples

The market multiples method is one of the most common approaches to valuing a startup because it is extremely simple and intuitive. 

This method compares the startup with similar companies that operate in the same industry and are of comparable size.When we talk about multiples, we most often refer to revenue multiples (ratio of market value of comparable companies to their annual revenues) or EBITDA multiples (ratio of market value of comparable companies to their EBITDA).

  • Discounted Cash Flow (DCF) Method

The DCF method estimates the present value of expected future cash flows by discounting it to the present through the use of a discount rate that reflects the risk of the investment.

In order to reach at the final value, it is then necessary to estimate future cash flows (free cash flow) and the appropriate discount rate, often based on the weighted average cost of capital (WACC), and finally the residual value of the company from the end of the forecast period to the future (terminal value).

  • Venture Capital Method

This method consists of two moments: “pre-money valuation” (i.e., the pre-investment valuation) to which once the total funds put in by the investor are added, the “post-money” valuation follows. In order to carry out the pre-money valuation it is necessary to:

  • Estimate the investment needed (define the “ask”).
  • Predict the startup’s revenue and cost data.
  • Determine the timing of the exit (e.g., IPO or M&A).
  • Calculate the exit multiple (based on comparable transactions).
  • Discount the future value (PV) with a discount rate that coincides with the ROI.
  • Determine the % ownership stake you want to leave to the investor.

For a startup, a robust business plan is more than just a fundraising tool and can determine whether or not an investment is successful. Valuation, on the other hand, is a complex and dynamic process that establishes an initial value but is subject to negotiation and revision.

However, what is clear is that both of these tools are critical to successfully navigating one’s entrepreneurial journey and building a solid foundation for the startup’s future.

Venture capital: who they are and what they want from startups

The reasons that drive venture capitalists to invest in companies and startups are many and range from the possibility of monetizing opportunities with high potential returns, to supporting innovation, to diversifying investments in other industries to balance their portfolios. It is no secret that venture capital compared to other types of investment, is particularly illiquid and risky and therefore the expected return must be significant to encourage investment. 

In this context, founders in the fundraising stage, are caught between two fires. On the one hand, the nature and product of the startup must match the VC’s investment thesis (since if not in line, the likelihood of investment is greatly reduced), and on the other hand, the startup itself requires an investor who has experience in its target industry, especially in those situations where the product/service involves complex sectors such as the deeptech.

While it is true that a startup’s fundraise, path is frequently through venture capital, it is necessary for founders to first try to understand how a VC works.

In a general way, the average duration of a VC fund is 10 years; this time frame can be divided into 3 different phases:

  • initial investment (duration 2-3 years) – during this period the fund actively seeks and makes investments in new startups.
  • portfolio development (3-5 years) – in this later phase the VC focuses on follow-ons and on finding new opportunities for follow-on investments.
  • exit (2-3 years) – at this final stage, the fund seeks to exit its investments as it considers the investment cycle to be over.

Venture capital firms may have several funds at once (thematic funds), so it is not unusual for them to raise new capital every 3-5 years to launch new ventures. Intuitively this might lead one to think that a VC is therefore inclined to invest in a large number of startups. However, on average, a venture capital model does not work by ensuring a small return over time on a high number of investments, but exactly the opposite VCs favor a few investments in search of the outlier that brings huge returns (the famous “100x”).

This process is governed by the “power law,” meaning that a very small percentage of startups carries most of the fund’s returns. An example is Sequoia’s investment in Whatsapp, which was acquired in 2014 for $22 billion by Facebook, where the venture had invested in $60 million in Series A, eventually achieving a return of $3 billion.

This is why the startup ecosystem is obsessed with unicorns (companies valued at least $1 billion): VCs need them to stay alive. Any company that VCs invest in must have the potential to become a unicorn, otherwise it is meaningless in terms of “value for money.”

Given this premise then, how can a startup in the fundraising stage succeed with a VC?

As much as predicting the future of a startup (especially in early stage) is a very difficult task, there are some points that VCs look at very carefully when evaluating a new investment opportunity: people (team), product/service, and market. 

The importance of a good business plan lies entirely in the startup’s ability to be able to clearly define and communicate and persuade that the team is working on an innovative product, within a market with great potential.

TEAM

The team is the backbone of any startup (“execution is what matters the most”). The ability to “pivot” when needed and at the right time in search of market-fit, the ability to innovate the product/service by implementing new features and identify new market segments is only the result of the commitment of the people who make up the company.

Knowing how to navigate adverse and unforeseen events with agility is a basic requirement for those who do (and want to do) startups. The most capable founders lay the foundations of their company culture and governance from day zero, knowing that the goal is to build and lead a team that can sustain the company, make the right decisions, and act quickly in difficult times.

PRODUCT/SERVICE

The product/service offered by a startup is the beating heart of the company and the main pull factor for venture capital investors. For a VC, innovativeness, scalability, and the ability to respond to a real market need are key aspects that are evaluated very carefully. In this context, traction metrics assume a key role, as they provide a concrete measurement of the growth and market adoption of the product/service. Metrics such as monthly/annual user growth rate (MRR/ARR), lifetime value (LTV) of customers versus customer acquisition cost (CAC), daily active user (DAU), and conversion rate are vital indicators that VCs use to assess a startup’s potential for success. Strong traction, demonstrated through solid and growing data, can significantly increase the chances of obtaining investment, as it demonstrates the validity of the product/service and the startup’s ability to generate value and interest.

MARKET

The size and attractiveness of the target market are two other crucial elements that venture capitalists consider when evaluating a potential investment. A large and growing market provides the preconditions for significant scalability, which is essential to a startup’s success and the return on investment expected by VCs. In addition, an attractive market is often characterized by strong unmet demand or disintermediation opportunities, where a new entry can revolutionize existing offerings with innovative solutions. VCs look for startups that not only address broad markets, but also have the potential to become market leaders or create new market segments. Therefore, a thorough understanding of the target market, including market size, competitive dynamics, barriers to entry, and emerging trends, is imperative for founders seeking to attract venture capital investment.

The venture capital investment process is a complex and selective mechanism that prioritizes quality over breadth, strategic vision over mere market opportunity. To stand out in this highly competitive environment, startup founders must not only align themselves with VCs’ expectations of performance and innovation but also demonstrate a deep understanding of their product/service and target market. It is a team game where the synergy between the team’s executive capability, the uniqueness and scalability of the product, and the size of the market define startups potential and ultimately their success in the fundraise phase.

How strategy can help companies being better at decision making

For both established corporations and nascent startups, strategy functions as an influential countermeasure against the sway of the “self-serving bias” within the decision-making milieu. It acts as a guiding beacon, enabling the scrutiny of information sources, fostering introspective analysis of historical decisions, and challenging personal predispositions. Through a meticulously crafted strategy, individuals can embrace a more impartial, enlightened, and equitable approach to decision-making.

The self-serving bias entails interpreting data to validate existing beliefs and personal agendas. Amid ambiguous circumstances, individuals often make assumptions that bolster self-worth and ego. People selectively analyze information to bolster their stance while disregarding contradictory viewpoints. In the corporate realm, succumbing to this bias can lead to suboptimal decisions or even precipitate conflicts and crises. Companies entrench themselves in entrenched positions, becoming averse to alternative perspectives, thereby instigating instability. To counter this trend and foster sound, enduring decisions, corporations, and startups should assess the reliability of their information sources, engage in counterfactual analysis of past decisions, and rigorously challenge their assumptions.

Rigorous evaluation of information sources bolsters corporations’ confidence in employing pertinent data to deliberate on subsequent steps, incorporating different perspectives alongside their own thoughts and actions.

Simultaneously, indulging in counterfactual contemplation empowers businesses to broaden their assessment scope, considering different frames of reference beyond immediate outcomes. This reflective process encourages acknowledgment of various perspectives, culminating in a more balanced appraisal of decisions made. By employing counterfactual thinking, corporations ensure a more impartial examination of existing data. Moreover, corporations and startups can combat self-serving biases by actively pursuing information that challenges their entrenched beliefs. This proactive stance, although discomforting as it threatens established identities and worldviews, represents a pivotal stride toward cultivating a more nuanced and informed outlook.

Yet, transcending self-serving bias marks merely one facet; for corporations and startups aiming to elevate their decision-making wisdom, fostering distinct behavioral attributes pivotal for transitioning from a “tactical vision” to strategic thinking is imperative. These attributes encompass the ability to discern situational intricacies, adept resource allocation, and precise strategy execution. Such competencies form the bedrock for individuals aspiring to assume more strategic roles within organizational frameworks. Foremost among these traits is the development of “acumen”. This encompasses an individual’s cognitive process: the adeptness to comprehend situations, conceptualize pathways from current states to envisioned futures, and surmount challenges to engender novel value. Subsequently, corporations and startups require an ingrained sense of “allocation”. Strategic thinkers delineate objectives, allocate resources, gauge risks, and navigate trade-offs, leveraging advantage via premium value propositions.

Ultimately, formulating a business strategy merely represents the initial stride; the manner of strategy implementation constitutes the fulcrum of success. Collaboration epitomizes the proficiency to collaboratively exchange knowledge, data, and insights toward delineated objectives, while execution encapsulates disciplined resource deployment to attain said objectives.

Evidently, strategy not only augments individual decision-making prowess but also delineates organizational trajectories, steering decisions, and their realization toward coveted objectives.

Business Model – The virtuous example of Start-Ups

The strategy of a company is a fundamental element used to express a competitive advantage in the market, however, when we ask ourselves how to make this advantage lasting and economically sustainable over time, we end up talking about the business model.

When we refer to a business model, in essence, we are referring to a set of (ideally long-term) assumptions and hypotheses on which companies in every industry plan their revenues. These assumptions reflect notions about client preferences, the role of technology, regulation, costs and market competitors. Companies often (wrongly) consider these assumptions untouchable, until someone comes up with new assumptions that work better.

It has been a reality of recent times that business models have become less ‘durable’ than before. In the past, business models and value propositions were fixed for years, and the company was required to perform the same processes better than their competitors. Today, however, business models are subject to rapid change and sometimes outright destruction. The common denominator of this change of pace has been the advent and pervasiveness of digitalisation, that enabled companies to build new tools to increase competition within all markets.

Today, if companies want to survive, they must be able to create business models that are based on accurate assumptions, supported by objective data and therefore able to change as the market in which they operate changes. Iterate to innovate is the mantra to adopt in order to build a business model capable of navigating the complexity of the contemporary economic system and build a competitive advantage that is durable.

One category that has the possibility of approaching the market in this virtuous manner are start-ups, companies that have not yet found the right fit around their business model and that by their nature are prone to experimentation and iteration and keen to test the market. This mix represents an advantage over companies already established in the market, because the effort to embrace the iteration process aimed at innovation can be built by design from day 0. This approach saves time, resources and minimises the risks associated with investing in an inadequate business model by making timely changes.

The most important component remains market analysis. Testing a business model means that starting with a BM idea is

  • Declined the BM idea into a main proposition (for monetisation) and build on this other minor propositions
  • Launched the BM on the market
  • Collected feedback from potential customers and partners on the main and minor proposition.


business model: scheme

The main proposition is the main assumption on which the business model is built. In the case of a computer repair shop, the main proposition will be the sale of emergency computer repair services. With regard to the minor proposition, it refers to ancillary services that characterise the computer repair but do not define it; in this sense, the shopkeeper might try to set a different price if it is a hardware or software problem, he might sell spare parts for replacement instead of repairing them, or implement the sale of useful accessories (such as mice or speakers) to be sold after the repair. These characteristics describe the main activity, which is to provide an emergency service for computer repair, and help the trader to understand what the ‘taste’ of the market is and how the main proposition should be declined in order to give it the greatest competitive advantage (measured in terms of revenue over competitors). 

Start-ups represent a segment that, out of necessity, finds itself adopting a method that is as effective for its needs as for those of more mature, established companies. Adaptation of the business model based on user feedback and data collected from the market is the key to adopting a more solid growth trajectory and securing a lasting presence within one’s sector.