Good and sustainable investments are a win-win-win-situation for a business, its investors and society at large. Companies grow and innovate, investors cultivate portfolios that enable them to continue investing and economies receive the much-needed taxes to support the business infrastructure as a whole. Recent high valuations have, however, become a threat to this trinity. It is now more important than ever to understand the underlying assets that companies are built on to create sustainable growth.

A misguided trend has been developing where inflated valuations have been promoted to support the mythical beast hunt – the search for the “unicorn” company. In January, Financial Times columnist Rana Foroohar wrote[1] about the current unsustainable financing practices of the tech sector where new companies are seeking rapid growth by any means necessary. The support of sky-high valuations and massive debt financing of unprofitable companies just to build the next unicorn, have led to distorted capital and labour markets where too much money is chasing too little value, wrote Foroohar.

Inflated valuations coupled with constant media attention are producing companies that have almost a sycophantic following. Very few have questioned the real value of these companies or highlighted the threat these companies and their investors are posing to the sustainability of the financial ecosystem and for the businesses themselves. However, as we have slowly started to witness[2] the effect of the valuations on the stock markets, sparking a change in attitudes.

Valuations under the microscope

Being able to build companies on a sustainable foundation is as important to the company as it is to the venture capital industry that provides funding. In the long run, unsustainable practices eat away at the credibility of the sector and the desirability of companies as investment targets. Sustainability builds on the long-term and if companies and investors are only looking to benefit on the short-term, the whole market ends up idolising the so-called unicorns. 

To support sustainability, we must understand the underlying assets of companies with in-depth valuations. As often as we see over-appreciated companies, we come across undervalued ones. When looking at a company’s asset value – the value of assets on and off the balance sheet – it is difficult to understand how a company that has assets worth 700k euros can be valued at 100m euros on the market. Alternatively, when the balance sheet assets alone are over 30m euros and the valuation is being estimated at 12m euros. Both true examples that invite for further investigation.

Valuations can take on many forms from market-based benchmarking to cash flow-based and asset-based analysis, and they all differ a lot from each other, especially if different methods are used to compare companies. For example, a unique tech company with a disruptive idea would be difficult to benchmark with other companies of the same industry, and it is equally difficult to determine the value of the company based on previous funding rounds if, for example, the company has made major developments in between the rounds. In addition, with many start-ups, a cash flow-based analysis might mistakenly hint of future success based on projections of ostensible earnings.

Whatever the methodology, valuations are made for a reason and we should have a better understanding of what they reveal. Whether for the business owner or for the investor, a thorough valuation can act as a wake-up call or a reaffirmation that the business is on a sustainable foundation and projections for growth are believable. Going through your due diligence can show how to optimise the assets to support growth and how to mitigate risks connected to assets. The business can also realise what changes are needed in the organization or how its business model must be tweaked.

Trending ailments and how to cure them

Based on experience, there are similar problems between companies. Let us consider the examples mentioned earlier – company X valued at €100m and Company Y valued at €12m. Both companies have tremendous potential that was lost without a proper understanding of the underlying assets. After further analysis, both companies were diagnosed with very common and curable ailments.

Company X needed improvements on “future-proofing” and IPR (intellectual property rights) protection. Many R&D focused tech companies forget that it is not only important to secure patents for the IP, but also to be able to commercialise their innovation and build up revenues and scale the business for a sustainable financial future. In this case, the company had not yet fully realised how to commercialise their innovation and therefore project growth before an asset-based analysis put the expectations at a reasonable level.

Another common ailment is the activation of intangible assets such as intellectual property (IP) on the balance sheet and leveraging its value – which was the case with Company Y. IP, which is not used to drive revenues, must be considered a cost rather than an asset under the International Accounting Standards. If managed correctly, IP can underpin the future intangible assets value of companies, and to balance the equity companies are looking for in future funding rounds. Although investors are initially interested in revenue, assets become more and more important as they balance equity and are the most useful indicators of the company’s wealth at exit point. For Company Y, the cure was to start activating the intangible assets systematically to reveal the true value of the company.

As more knowledge surfaces, financial industry influencers, business owners and societies all need to carry their responsibility to curb and question the sky-high valuations that pose a threat to the sustainable future of businesses.

First published in Family Office Magazine – October 2019

[1] Financial Times, Rana Foroohar, 27 January 2019 – “Another tech bubble could be about to burst”

[2] E.g., Wall Street Journal reported (18 Feb 2019) investors being unhappy of Softbank’s tech investments and both Business Insider (3 Feb 2019) and CNBC (24 Sept 2019) have reported that rising valuations are becoming a threat to the stock markets.