How to value your deal like an investor?
How to Value Your Deal Like an Investor
One of the entrepreneur’s most difficult challenges is assessing and determining a value for the emerging growth venture. Simply put, value is determined by the interaction of three major ingredients: cash, risk, and time. Valuation depends mainly on understanding the venture, its industry, and the general economic environment, combined with a very prudent job of forecasting. Investors know that careful thought and hard work leads to foresight.
The financial world has developed many methods that can be used for valuing an ongoing firm or a publicly traded company. Since no single method is universally accepted to all purposes, valuing a private venture can be complex and often confusing due to the different types of values that can be considered. Likewise, there are certain difficulties with attempting to value a new business venture. It has no track record of earnings and will not pay dividends for a long time, if ever, so common methods like P/E ratios or dividend yields are therefore useless. And many early stage ventures have no tangible assets, like property, plant, and equipment, so they have no “book value.” So most of the value lies on the capability of the venture team and future professional management team on putting the plan to action, hence, demonstrating the potential future streams of income.
In our research we discovered that there are a multitude of methods, ideas, and concepts developed by schools, organizations, and individuals used to measure future streams of income. Harvard Business School Professor William Sahlman created the “Venture Capital Method.” The “First Chicago Method” was developed at First Chicago Corporation’s venture capital group. There is even a “Rule-of-Thumb Method” developed by Frank Singer, an angel investor.
Finally, there is the discounted cash flow method. Shannon Pratt, in Valuing a Business: The Analysis and Appraisal of Closely Held Companies, provides us with a comprehensive definition of value, using the discounted cash flow method. He states:” In the simplest sense, the theory surrounding the value of an interest in a business depends on the future benefits that will accrue to the owner of it. The value of the business interest, then, depends upon an estimate of the future benefits and the required rate of return at which those future benefits are discounted back to the valuation date.”
There are two approaches to making investment decisions by means of discounted cash flows. One is the net present value method (NPV), and the other is the internal rate of return (IRR) method.
Discussing Net Present Value
NPV is an intuitive and powerful financial concept all entrepreneurs should understand. The NPV approach to investment appraisal was introduced by American economist Irving Fisher in The Nature of Capital and Income (1906). In essence, NPV is simply a recognition of the fact that value of a dollar today is worth more than a dollar tomorrow. NPV calculations help you evaluate the value today (present value) of some future cash flows or expenses related to your venture.
The NPV is calculated by adding the initial investment (which is considered as a negative cash flow) to the present value of the anticipated future cash flows. A comparison of the NPVs of alternative investment possibilities indicates which of them is most desirable. An NPV of zero signifies that the investment’s cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return on that capital. If an investment has a positive NPV, then its cash flows are generating an excess return. In essence, the greater the NPV, the greater the increase in the financial value of the investors’ assets.
Obviously, in a perfect world, venture capitalists would never consider a deal with a negative NPV. However, there are reasons large, profitable corporations (corporate venture investors) may choose to pursue an entrepreneurial endeavor like a new product project even if the financial analysis reveals a negative NPV.
The reasons for accepting a negative NPV are:
– To finance the development of core competencies or new product platforms
– To create complementary products to more profitable products in the company’s product line, like creating a new razor to sell more blades
– To develop innovative products for lead users
– To implement environmental policies and other projects based on ethical grounds
– To make a competitive response, either to signal a new lead into a space or to increase barriers to entry
– To develop goodwill with customers and ecosystem
– To bet that the cost of capital will decrease in the future as the project progresses
In using the NPV method, it is necessary to choose some rate of return for discounting cash flows to present value. The interest rate used in these calculations, also called the discount factor or hurdle rate, is what the finance world calls the “opportunity cost of capital.” This rate converts all of the expected future return on investment to an indicated present value. It is the financial return forgone by investing in this deal rather than making other investments. In other words, the discount rate is the reward that investors demand for accepting delayed return on their investments.
There are entire books and courses on calculating NPV and dealing with uncertainty and the impact of risk in cash inflow and outflow estimates. In fact, some financial analysts will add special premium factors to the discount rate to offset uncertainty about the outcomes.
However, such factors are invariably arbitrary and are used to offset the uncertainties inherent in the forecasting of cash flows. Instead of using such arbitrary adjustments, we advise venture teams to focus on creating very realistic forecasts of cash flows and uses. These forecasts should be supplemented with careful sensitivity analysis, in order to understand and communicate the full impact of the range of possible outcomes.
Brief Evaluation of the NPV Method
As we first stated in the previous Articles, cash flow is more accurate than net income as a measure of economic value because it avoids distortions due to accounting presentation or comparability issues. The NPV method links value to expected performance, and thus eliminates reliance on historical performance. It also reflects risk and time value of money.
But you will find that the NPV method involves numerous uncertainties and forces you to make certain assumptions. The first and most significant is the projection of future cash flows, both in amounts and timing, since they are based on pure conjecture by the entrepreneur, the venture team, and its stakeholders. Others include the determination of the appropriate periods of projection and the discount rate or risk premium. As a result, the specific numbers used in the financial analysis may create the illusion that they are the actual or correct numbers. More often than not, the assumptions for the projections may be obscured by weak and unsubstantiated business logic.
Overall, we feel it is always better to be approximately right than to be exactly wrong. Diligent professional investors know that the NPV method is widely agreed upon to be the superior method for evaluation and ranking of investment proposals. One advantage of the NPV method is that it is very popular. It is part of a common language among all financial managers because it completely exposes all business logic behind the economics of the deal and financial modeling.
The time required performing NPV analysis is very minimal, as it can be accomplished with Microsoft’s Excel and HP-12C calculators using your pro formas. Using NPV, the details are in the budgeting, assumptions, and financial modeling, not in creating comprehensive audited financial statements. So the future income can be expressed year by year with any desired detail in pro forma income statements. This exercise becomes the final and most important check on a business plan’s overall consistency and attractiveness to potential investors.
We have found that it can be a serious mistake to approach the valuation task in hopes of arriving at a single number, or even providing a narrow range. All one can realistically expect is a range of values with boundaries driven by the different methods and underlying assumptions for each. So keep it simple. As Michael Curry, CFO for Kleiner Perkins, says, “The valuation process is not numbers-crunching. It’s really based on experience. If you can’t do the math in your head, it’s probably not a venture deal.” We hope that this analytical exercise in valuation will help entrepreneurs create a mindset of “cooperative value building” instead of “individual value surrendering,” or the feeling that investors are “claiming” more than their share. We know that the NPV method can be a simple exercise to help determine how much value the venture is actually expected to create in the future.
Discussing the Internal Rate of Return
Recall from our discussions in previous Articles that performance for the venture capital industry is traditionally measured by the internal rate of return (IRR). The IRR considers “cash-on-cash” returns from the sale of shares and disbursements from the liquidity events back to investors like dividends. It is calculated by taking inflows of cash as negative cash flows, and distributions of cash and stock to investors as positive cash flows.
Now, before we discuss the IRR in more detail, it is important to understand the concept called the “time value of money.” This means that investors would rather receive a dollar today than wait a year from now. If they had that dollar now, they could invest it, earn interest, and end up with more than one dollar. Hence, those investments that promise favorable returns earlier in time are preferable to those that promise returns later in time. In essence, IRR is defined as the interest yield promised by an investment. For instance, the IRR answers this question for an investor, “How much interest would I have to receive on my money today in order to equal the return on investment I will get from investing in this deal?” Technically speaking, the IRR is the rate of return at which the discounted future cash flows equal the initial investment. It is the discount rate at which NPV is zero.
From a venture capitalist’s viewpoint, the IRR relative to the present value discount rate indicates the net result of the investment. For example, if the IRR is greater than their desired rate of return, the investment is financially attractive. Since the IRR exceeds the costs of the funds used to finance the growth, a surplus remains after considering the cost of the capital, and this surplus is passed on to the venture capitalist’s investors, the limited partners. If the IRR is equal to their desired rate of return, the investor is indifferent toward the investment. If the IRR is less than their desired rate of return, the investment is not financially attractive. Once the IRR for your deal has been computed using your pro formas and a financial calculator, go back to some of the previous Articles and check with the historical returns for venture capitalists presented in them. If your IRR is equal or greater to their requirements, then your deal could be acceptable to a venture capitalist.
Venture capitalists and their limited-partner investors also tend to think and discuss valuations in terms of “capital gains multiples.” For example, a venture capitalist might say something like, “We expect to see a 10x in our investment within four to six years.” With this in mind, we have included a conversion table for IRRs and multiples over time (see below). So what makes a deal attractive to venture capitalists? What is the “sweet spot” for each type of investors? Remember, since there is more risk involved in financing a venture earlier in its development, more return is expected from early stage financing than later stage ventures. For a comparison, see the Figure below, which shows what investors prefer in their deals according to each development stage of the venture.
What Makes A Deal Attractive to Venture Capitalists?
– For Start-Ups: 58% IRR, 10 times the investment in 5 years
– For ventures under 1 year old: 48% IRR, 7 times the investment in 5 years
– For ventures 1-5 years old: 38% IRR, 5 times the investment in 5 years
– For ventures over 5 years old: 25% IRR, 3 times the investment in 5 years
Discussing Capital Structuring
There are many choices available to an emerging growth venture that needs expansion capital, but basically the choices are limited to two flavors: debt and equity. Defining your “optimal capital structure,” which those in the financial world use to describe the proper balance between the two, is a challenge, as is finding those sources of capital at affordable rates. What is considered affordable varies, depending on whether you are pursuing debt or equity. The Figure below lists some important factors that affect capital structuring.
Factors that Affect Capital Structuring of a New Business Venture
– Availability of sources of funds to the venture and founders, i.e., bootstrapping vs. internal sources like revenues, debt vs. equity, local vs. foreign.
– Marketing and sales traction, market acceptance, marquee customers.
– Degree of entrepreneurial risk in deal.
– Degree of industry risk in deal.
– General appetite of investors and lenders in the marketplace.
– Liquidity needs and timing of exits for investors.
– Financial markets composition and depth locally.
– Prevailing general terms of the current investments like Term Sheets etc.
– Negotiations skills of entrepreneur and completed business plan; deal making is ultimately a combination of art and science and it comes down to the human components.
– Handling “hairs-on-the-deal” and “deal-killers” which we explore and discuss the Article.
Affordability in the “debt” context refers to the terms, the interest rates, the amortization, and the penalties for non-payment. In the context of “equity,” affordability refers to valuation, dilution of the shares or control held by the current founders, and any special terms or preferences such as mandatory dividends or redemption rights. As we discussed in previous Articles, your first available option is to issue securities. Recall that there are essentially three types: common shares, preferred shares, and debentures. Each has certain characteristics, variable features, and attendant costs.
To continue our discussion with the equity route, understand that professional investors focus on the IRR to them and their investors, not the amounts of equity they own in each deal. In fact, the equity percentage is a function of the IRR and the risk in actually putting the entrepreneur’s business plan to action. Our research has shown that, as a rule of thumb, the investment community defines a successful entrepreneurial venture as one that returns at least 40 percent IRR to investors over a holding period of four to five years. Roughly speaking, the percentage of ownership required to provide investors a 40 percent return on a $1 million investment. So if your projections support a valuation of $15 million in five years and you needed $1 million to get there, then investors would need 36 percent ownership.
Keep this example in mind when analyzing the capital structure of your deal. One of the best hits over the fence in the modern era of private equity investing was Netscape for Kleiner Perkins. Jim Clark, founder of Silicon Graphics and partner at Kleiner Perkins, was a very tough, professional, experienced negotiator. In 1994 they placed a $20 million valuation on Netscape, investing $5 million for 25 percent in equity. Kleiner Perkins in turn made some $400 million, or 80x their money in the deal.
As we discussed in the previous Articles, the message is clear, strategically “spreading the wealth” through equity to employees who produce is critical to the simultaneous pursuit of growth and profitability. Winning big requires a great team, so be prepared with a stock option pool to offer, attract, and retain great people. Siebel Systems, the fastest-growing company ever, issued more options as a percentage of diluted shares outstanding by 2001 than many of the other technology companies.
However, be advised that there are no tried and proven formulas for setting aside stock for key players on your team. But the Figure below shows the interesting results of stock ownership of key stakeholders. For attracting a branded CEO, expect to offer 8 to 10 percent in stock; for attracting marketing and technical executives, expect to offer 2 to 3 percent each; for attracting salespeople, be prepared to offer 1 to 1.5 percent, plus commissions; and set aside 20 to 30 percent in an option pool for future employees. Be sure to get advice from the legal experts, who can help you set up the initial capital structure correctly. Otherwise, the venture could be “plagued with problems throughout its life.”
As with most start-ups, the entrepreneur and members on the venture team have probably made considerable sacrifices, called “opportunity costs,” such as not having worked full time in the workforce and perhaps having been without earning an income from the start-up for a while. Entrepreneurs commonly refer to such endeavors, and sacrifices, as “sweat equity.” But when discussing capital structuring in the financial world, this sweat equity is considered “sunk costs” and bears no immediate entitlement to equity in the venture. So while information about the venture’s past and the founders’ great efforts in getting the venture launched help tremendously in demonstrating commitment and assessing future performance, investors are only interested in the equity capital that has been invested into the venture to date.
Process Leads to Success
Often valuation and the process of putting a deal together is an “arm wrestling contest” between the entrepreneur and the investors. It becomes a struggle what investors are willing to pay and what the entrepreneur is willing to “give up.” But there is a little-known insider secret we would like to share. In valuating a venture, investors actually look more into the process of the negotiations with entrepreneurs than at the cold-hard numbers. The way entrepreneurs handle the initial stages of valuation demonstrates their maturity. It also demonstrates their ability to understand the environment and the job of putting together a venture using risk capital. So the process itself is almost as if not more important than the end results.
This means that you shouldn’t get stuck in the “valuation trap.” Why struggle with this? Focus more on working with your investors, growing your venture, and moving forward. Arguing over a split between 23 percent and 25 percent of equity versus owning 100 percent of nothing is not worth it. As Pyrrhus said, “One more such victory, and we are lost.” A higher valuation may mean you have done well in the negotiations but it may become a Pyrrhic victory, meaning you have won the battle, not the war, and at what cost? You could end up with ill feelings instead of mutual respect and support. Think about developing relationships with your investors, not winning.