Valuation Blog – Clarity in Complexity

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  • Practical Considerations for Reviewing Early Stage Company Forecasts

    Following my previous article about the importance of forecasts in enterprise valuation, I’d like to share practical techniques I use to review early stage company forecasts—and recommend to my colleagues.

    Start with Context

    The first step is understanding what you’re looking at.

    Most forecasts come to us through portfolio valuation exercises. While presented by venture capital investors, they typically originate from the portfolio companies themselves. This matters because these forecasts often contain aspirational elements rather than balanced market participant views. They may need adjustment to reflect realistic development scenarios and broader stakeholder perspectives.

    Early stage company forecasts typically share common characteristics: high growth assumptions, significant gross margins, substantial marketing and R&D spend, and a notable lack of alternative scenarios.

    Given these companies’ limited revenue track records and often basic financial reporting practices, here are techniques that can help analysts, auditors, and investors assess forecast reasonableness.

    Assess Financial Reporting Integrity

    Cases of fraud in early stage businesses are well documented, and their likelihood is not minimal. Understanding the financial reporting processes, whether such functions exist, what operational tools are used, and whether controls and oversight are in place is crucial. When audited financial statements are absent despite significant investments, the reasons should be understood and documented as part of the forecast review.

    Gauge Market Demand

    High revenue growth rates imply expanding demand for the company’s product or service. Understanding the offering, market fit, and segment economics is crucial. It’s easier to justify significant growth in an expanding market than in a mature or declining one based solely on market share gains.

    Understand Sales Process Limitations

    Unless the product has achieved significant market recognition and adoption, high growth forecasts depend on substantial customer acquisition investments. This requires not just advertising spend, but also customer relationship management capabilities. Sales function bottlenecks can cap growth even in favourable market conditions.

    Understand Cost of Sales Structure

    In early stage companies, it’s difficult to differentiate the cost of sales from R&D. However, this differentiation can be achieved by understanding the business and its products—specifically, the expenditures needed for day-to-day service delivery versus product development investments. This may require employing a subject matter expert or conducting a detailed financial review. Understanding the cost of sales accuracy helps build confidence about gross margins, one of the most important metrics for M&A targets.

    Track Product and Operational Milestones

    Financial forecasts are the monetary reflection of real-world business activity. Understanding product development milestones, investment milestones, marketing targets, and other operational benchmarks—and how the company tracks against them—helps assess forecast reasonableness.

    Analyse Churn Rates

    Aggressive sales targets often drive high churn rates. In some businesses, these rates can approach annual sales growth levels, significantly impacting recurring revenue projections. Analysis of the reasons, the client profile, product affected by churns can result in valuable insights for further review of the forecast.

    Assess Growth Readiness

    Significant revenue growth demands substantial investment in infrastructure, working capital, and continued R&D. For companies that have already depleted cash from previous funding rounds, capital constraints may be severe. Understanding the capital requirements underlying growth targets—and whether the company can or is willing to attract new funding within forecast timeframes—is essential.

    Evaluate R&D Effectiveness

    Examine where substantial R&D expenditures are going and whether they’re creating real assets: know-how, software, or technology that can generate significant returns. If R&D has been cumulatively spent on discontinued ideas and products, proceed with caution. Revenue ultimately comes from deploying assets created through R&D and investment. Prior period write-offs suggest the asset base may be disproportionally smaller than total spend.

    Review Forecast Revision History

    While the company may be early stage without significant revenue history, it may still have a substantial history of revised forecasts and plans. Understanding the scale and reasons for prior period forecast revisions can deepen understanding of factors affecting the company and aid current forecast assessment.

    These are some techniques I find applicable when reviewing early stage company forecasts. The specific techniques and review vectors can vary based on facts and circumstances, but these aspects are important for many early stage companies.

  • Understanding Business Valuation Fundamentals: Why Forecasts Are Key

    Understanding business valuation fundamentals reveals why forecasts sit at the heart of every meaningful valuation exercise. Under IFRS 13, fair value represents the price that market participants would pay to exchange equity in a business in an orderly transaction at the measurement date. This seemingly straightforward definition masks a more complex reality: today’s value fundamentally depends on assumptions about tomorrow’s cash flows.

    The Evolution from Transaction to Model

    At the transaction date, market participants embed their expectations about future performance directly into the pricing. In an arm’s length transaction, these assumptions materialise in real money changing hands, providing the most reliable indicator of fair value. However, as the valuation date moves further from the initial investment date, we increasingly rely on models to estimate value.

    This evolution makes forecasts fundamental to the valuation process. Reliable forecasts allow auditors and valuers to accurately calibrate transactions at the pricing date, establishing benchmarks for estimating relative valuations through market multiples.

    In subsequent periods, particularly for private equity investments, forecasts become the primary driver of mark-to-model valuations. The confidence that market participants place in management forecasts determines how reliably we can establish comparable company sets. When forecasts lack credibility, the entire comparable company analysis becomes questionable, potentially leading to significant valuation errors.

    Therefore, the quality and reliability of these projections directly impact valuation changes that flow through profit and loss statements.

    Building Confidence Through Consistency

    Market participants assess forecast reliability by examining historical accuracy, the robustness of underlying assumptions, the company’s management’s ability to execute the business plan, and the consistency of methodology over time. Companies that demonstrate strong forecasting disciplines typically enjoy tighter valuation ranges and more stable market multiples, reflecting reduced uncertainty about future performance.

    This confidence dividend extends beyond this. Robust forecasts enable valuers to employ the income approach as a meaningful validation tool, cross-checking results from market-based approaches and identifying potential valuation anomalies.

    The Auditor’s Perspective

    The auditor’s role is much more than simply reviewing the mathematical accuracy of forecasts. We evaluate the reasonableness of assumptions from a market participant’s point of view, assess the consistency of methodologies, and challenge management on scenarios that could materially impact valuations.

    The interaction between forecast quality and valuation reliability creates a multiplier effect. Small improvements in forecasting discipline can yield disproportionate benefits in valuation accuracy and stakeholder confidence.

    Significant Impact

    The practical impact of this forecast-valuation relationship cannot be overstated. Portfolio companies with well-developed forecasting capabilities typically command premium valuations, not just because their projections appear more achievable, but because the reduced uncertainty allows the acquirer to achieve smoother integration or more confidently implement value creation plans, in the case of private equity buyers.

    For auditors, this reinforces why thorough forecast review represents one of our highest-value activities. The quality of our work in this area ripples through to valuation accuracy, financial reporting reliability, and ultimately, market confidence in our clients.

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