Business valuations are generally seen as an arbitrary measure. While there are several nuances to valuation, the core methodologies of using comparables or building a cash flow model has not changed. We have historically created valuations using financial metrics. Today, marketplace companies can using their proprietary data to predict performance and lend capital - creating a new frontier for marketplaces to compete on.  

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Valuations are Arbitrary

At a high level, there are three ways that a business can get valued today. 

Comparable Companies: Looking at companies that have similar characteristics, normalizing for those characteristics and creating the basis for a valuation. A common multiple that is used to value a company is the ratio between Enterprise Value (EV) and Earnings Before Interest, Tax and Depreciation (EBITDA). You would take a company’s current EBITDA and multiply by the EV/EBITDA multiple associated with a comparable group of companies. 

Precedent Transactions: This is very similar to the previous approach. Instead of using a multiple associated with comparable companies, you’d use a multiple associated with precedent transactions. 

Discounted Cash Flows: This is where you build out a forecast of expected cash flows for the foreseeable future and discount the cash flows based on an appropriate risk factor. This method is sensitive to a number of assumptions and can easily change. 

Note: I know there’s a lot of variation and nuance to this topic but let’s keep going for the sake of brevity. 

As someone who's studied finance and business valuations, I know all too well that the assumptions going into the forecast can wildly influence the outcome. A small change in the multiple that you use or the risk factor you apply can significantly impact the valuation you project using the frameworks above.  

As a result, founders need to take an incredible amount of personal risk (i.e. personal guarantees) to receive the funding they need to grow their business. 

This tweetstorm by Erin Bury - CEO of Willful explains the challenges she has with raising capital despite having clear signs of traction. It is clear that Willful’s inability to meet arbitrary benchmarks (e.g. $150k in monthly recurring revenue) is limiting the company’s capacity to invest in its growth (without giving up equity). 

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Alternative Funding Models

We are starting to see a number of alternative lending platforms gain traction in the market. Here’s a few that I personally find interesting: 

Ario: Invoice financing (borrow money against the amount due from your customers) and working capital advances to small/medium-sized businesses. This allows you to build leverage into your business without taking on formal vehicles of debt.

Fundsquire: Government tax credit financing to businesses in Canada and Australia. This provides quicker access to tax credits - giving companies liquidity they need to move quickly. 

GreenSky: Financing for home improvement projects (with loans up to $65,000) via a network of contractors and bank partners -- without itself taking on the risk of defaults.

Clearbanc: Financing for ad spend for ecommerce companies with positive unit economics (e.g. spend $1000 on ad-spend and get $3000 in revenue). Ad spend is one of the biggest expenses for consumer companies today. The ability to finance that without having to take on debt is a huge value add.  

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Opportunity for Marketplace Companies

Marketplace companies today have the data to understand their customers at an incredibly deep level. This is especially true for businesses that facilitate a core function of the businesses (think payment processing, sales, marketing and etc). 

With scale, the availability of data allows platform companies to predict the success of their commercial customers. This predictive layer can be used by marketplace companies to deepen their relationship with businesses by providing access to capital that they otherwise would not be able to get. A company that funds its growth using capital provided its marketplace will find it very difficult to leave the marketplace. 

Here’s a list of companies that already provide financial services or will provide them in the near future: 

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Case Study: Stripe Capital

Stripe started off by building a global payments and transfers network that allows companies to manage payments with ease. Using the data that it has collected, Stripe can now predict the success of certain businesses and lend accordingly. The excerpt below goes into detail about the benefits of Stripe Capital. However, I think it applies to any marketplace business that provides capital to its businesses.  

Access is quick: no lengthy applications or collateral obligations and approved funds typically hit a business’s account the next day.

Eligibility is data-driven: eligibility is determined based on a company’s history on Stripe. Drawing on data from Stripe’s extensive business network, advanced algorithms analyze hundreds of relevant signals for each business, including payment volume, percentage of repeat customers, payment frequency, and changes in revenue growth.

Repayments are automated and flexible: businesses repay money as they make money. They repay the loan with a fixed percentage of daily sales; there are no recurring interest charges or late fees.

Now, replace the word Stripe with any other marketplace company and you’ll quickly see how financial services will be an integral part of marketplace companies. 

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Outlook

The recent launches of Stripe Capital, Square Cash and Shopify Capital make it clear that financial services will be next frontier for platform companies. Having a user that is literally indebted to you provides marketplaces with the ultimate form of stickiness. I expect this phenomenon to extend into B2C companies with the standardization of income share agreements (more to come on this!).