Glorious growth shares

November 7, 2023

An interesting case study demonstrating that growth share valuations are not as simple as you might think

Our approach to valuations has always been a two-step process; a numerical analysis of a company’s financial data, followed by arguments to uncover and articulate any hidden value or risks that might not be immediately apparent. One of the things we consider when preparing the arguments is wider market sentiment, and the investment landscape at a macro scale. There is no doubt that it has been a difficult year for equity fundraising both in the UK and internationally. The global economy has faced significant headwinds; wars and central banks pushing up interest rates to deal with significant inflation, to name but two. All this has caused valuations to suffer.

We recently had a very interesting valuation project, regarding the planned issuance of several classes of growth shares in a deeptech company. The company was still pre-prototype, but with a visionary and mature management team supported by an equally visionary and committed investor.

The growth share issuance was part of a funding round by the investor at what appeared to be a rather high valuation for a company at concept stage. Some patents had been filed, the management and the investor clearly believed value was there, but where was it? Especially when there is so much negative sentiment currently attached to private company valuations of all types.

With no sales and forecasts that showed that revenue, let alone profit, was some way off, a valuation using multiples-based methodologies was impossible. The forecasts (including the underlying assumptions) were pure speculation, given that market demand had yet been proven, so a DCF valuation, whilst it could have been performed, would not been worth the paper it was written on – and certainly not if HMRC wanted to challenge it.

Meanwhile, the sector is out of favour, meaning there was no evidence, for example, that pre-revenue start-ups of this type could command say a valuation of 5x sales in 2028!

BUT, as I mentioned earlier, the intended fundraise at a high valuation, of itself, was evidence that those who knew the company best saw significant value in it.

We solved the bottom-up company valuation exercise by using a Balanced Scorecard valuation methodology which measures qualitative features and scores the, but that did not consider what the company was worth in the context of current market conditions.

So, we looked at the macro-economic headwinds the company was facing.

Having been very much in fashion a few years back, the sector is now being largely ignored by the investment community – they are off chasing the “Next Big Thing”.

However, the sector has quietly made great strides forward and it is now much more certain that those players who are still alive (including the client) will create highly profitable businesses, sooner rather than later. With its patents filed, the client was in a great position relative to its peers.

Even though most investors are not looking in this direction, they are probably missing a trick. Investing in this company now was perfect timing. One investor had spotted it, even if his peers had not and, crucially, he was prepared to buy shares at a high valuation. So, we had a willing buyer in place.

We finished the company valuation exercise, adjusting for these and a few other pertinent issues.

Interestingly, our valuation ended up very close to the proposed pre-money valuation, shown by the funding round terms; not because we wanted it to, but because the evidence proved it so.

So far so good, but what about the growth shares?

The growth share class valuations provided an interesting challenge because there was more than one class being issued and each had their own terms.

And there were also dependencies, because one growth share class, de facto, had seniority over the others. The value that could one day be generated for the shareholders of each class had the potential to vary markedly, depending on different scenario outcomes.

Fun, eh?

We cracked this by doing a probability-based scenario analysis. If you are curious about how we do this, do call and I can arrange a meeting to explain.

When we looked at the facts, we discovered that one of the proposed growth share classes had technically already reached its hurdle because of the proposed investment round valuation. (The other classes were ok, their hurdles were high and there was a considerable degree of uncertainty, given the conditions regarding flowering, that they would ever deliver a return).

Had the first growth share class been issued as proposed in the new articles, they would already have been ‘in the money’ specifically because the new funding round meant that the hurdle had already been reached. As a result, the per share value in the share class was near identical to the most comparable share class in issue. The cost of buying those shares on these terms was high enough for the investor and the management to reject the whole thing and possibly for the investment round to then collapse.

Yikes!

So, what did we do?

As independent valuers it would have been a conflict of interest to make any recommendations as to what the hurdle should be.

However, we explained how growth shares work and why it matters that the hurdle is sufficiently stretching so that a growth share class is markedly different from its nearest comparable share class (in this case the ordinary share class).

The client and the investor asked us to pause and went away to consider the right answer for them, such that the deal could get done.

They soon returned and presented us a new description of the troublesome share class.

In the revised scenario, the hurdle had been made much more stretching.

They asked us to re-run the valuation.

I am pleased to say that the new description of the share class did indeed satisfy us that the share class had significantly denuded value. Once again, not because they said so, nor because we thought so, but because the evidence said so.

Phew.

The client was very happy.

Using the evidence to support a valuation is always the answer to getting it right. And it means we can all sleep soundly at night.

It’s also important to note that time was of the essence in completing the valuation. Although the investor was supportive, too much delay might have put the deal at risk. We finished the work in time. I was pleased that my team were complimented by the client on their serious interest in making sure not only that they had got the maths right, but also that they had worked hard to properly understand and contextualise the market, the company and the cap table, so the valuations really were right.

The Athla team love these challenges and are delighted when a happy client tells us that we’ve cracked it.

We love to hear from lawyers with clients who need a valuation that is evidence based, comprehensive and delivered fast. We are here for you at any time. We understand that when a problem needs solving, it is our responsibility to solve it, fast and right.