Reprint permission from and Originally published in Deal Terms, Aspatore Books, All Rights Reserved.
Every entrepreneur who aspires to raise capital looks forward to "talking valuation" with potential investors. Some dream about it, only to wonder, once a deal has closed, what exactly they have agreed to. Whereas the central chapter of my previous book, Term Sheets and Valuations, serves to demystify many seemingly complex terms of a financing by explaining their implications, the topic of valuation and how it is determined warrants a chapter of its own.
Many people end a negotiation, agree to terms, and walk away unclear as to how the final valuation of the company was determined. The entire topic of valuation is often shrouded in mystery, largely because of the private nature of the venture capital industry and the extent to which valuation methodology is rarely openly discussed. A valuation is a function of a myriad of elements, none of which will necessarily apply equally when assessing any two companies. Factors that influence a valuation include:
Valuation and Confidentiality
In this chapter, we will examine some of the methodologies applied by venture capitalists in determining valuation. Before doing so, it is important to understand why discussion of valuation is most often a private or confidential matter for most private companies.
Entrepreneurs and VCs alike benefit from keeping the financial structures, terms, and valuations of each company confidential until a company does a road show before an IPO or is brought to the table to discuss a sale by a prospective acquirer. Even when a company is on a fast track to a future round of financing or on the block to be acquired, documenting valuation in the press or in trade circles establishes a data point that can be used to decipher a company's revenues, assess the value investors are placing on the company's technology or offering, and even bias how a subsequent round of financing may be approached by outside investors or by a future acquirer. Doing so may also negatively bias existing and prospective customers. Companies often announce the closing of a financing and report the amount raised; when substantial, this signals staying power to existing and potential customers, as well as the competition. Reporting a post-money valuation in essence allows a competitor or potential acquirer to decipher more information about a company than may be strategically advantageous in the future.
When a company does announce a valuation, it may do so to send a clear message, perhaps to a potentially crowded space or to potential acquirers. This can be a way to signal to the market and to customers that a company has a sustainable business, is gaining momentum and credibility, and is well ahead of existing or prospective new entrants. A private company that is in the process of expanding and has yet to become cash-flow positive may feel that in announcing an impressive valuation and round of financing through a press release, it can signal market leadership in a potentially crowded space. Assuming that such a round has been led by a new investor and included the participation of existing investors, the market will likely interpret such an announcement as validation that an existing player has produced significant shareholder value.
Perhaps prospective investors of earlier-stage competitors will take heed. But such tactics have clear downside. If the same company fails to execute to plan and goes back to the market 12 months later for financing, competitors and outside investors could suspect damaged goods. In an uncrowded market vertical, crowing about the high valuations investors have provided a company can be the rallying cry that motivates other investors and VCs to consider backing new entrants.
Fair Market Value and the Use of Comparables
There are two generally accepted ways to determine fair market value for a company. The first assesses cash flows on a going forward basis to determine a present value. The second approach determines value by looking at comparable companies to come up with a fair valuation. Both require close examination and assessment of the nature, quality, and predictability of future revenue streams, as well as earnings before interest, depreciation, and taxes (EBITDA).
Using cash flows to determine value is generally not the primary and sole methodology applied by VCs in determining valuation; this is especially true in early-stage companies, which are by nature not yet cash flow positive. For later-stage investors who invest only in profitable companies, doing so can make great sense. My assumption in providing guidance on valuation methodology in this book is that most readers are interested in how valuations are determined for unprofitable, start-up, early-stage, or expansion-stage companies. For a good explanation of the use of cash flows to determine value, I recommend a core finance text used by Columbia Business School, Analysis for Financial Management, by Robert C. Higgins.
To briefly summarize Higgins, by assessing cash flows one can generate a present value for a company by adding together the net present value of cash flows for the first five to six years of growth in a company with the net present value of a terminal value assigned the company. The terminal value captures the cash flows for the future life of the company subsequent to the first five- to six-year period and is determined by placing a value based on assumptions about future growth and cost of capital on the subsequent period of cash flows.
Comparables are the cornerstone of valuation analysis for most VCs. VCs typically use comparables to determine a likely future exit value for an investment. Higgins may also be useful for a more detailed discussion of comparables in valuation analysis. He states:
Use of comparables in business valuation requires equal parts of art and science. First it is necessary to decide which .companies are most similar to the target and then determine what the share prices of the publicly traded companies imply for the FMV (fair market value) of the firm in question..We begin our search for comparables by considering firms in the same, or closely related, industries with similar growth prospects and capital structures. (p. 343)
A venture investor is therefore likely first to determine which basket of mature or liquid existing companies in the investor's opinion most closely resembles the profile to which a contemplated investment aspires. It is important to note that an investor's choice of comparables may work at cross purposes with the goals of the entrepreneur. One basket of comparables may point to a future valuation that is lower than that which an alternative basket of comparables could otherwise support. Whereas there may well be arguments for choosing one basket of comparables over another, investors have specific goals beyond using comparables to determine whether a specific rate of return can be generated. Investors often also want to own a specific percentage of a total company or of a specific round of financing to be assured of a specific degree of influence, should a shareholder vote be required. The choice of comparables and the discount rate therefore have a direct influence on the ultimate ownership percentage an investment will buy.
While the balance sheet of a start-up, early-stage, or expansion-stage company is unlikely to resemble that of a mature or public company at a time of VC financing, the aspiring company's business plan should be compelling enough to point to the company achieving a profile comparable to that of more mature companies in a matter of years. Assuming, therefore, that the prospective investment meets its objectives, it is possible to interpolate, based on market data at the time of a proposed private equity financing, both an appropriate current market-based valuation and an appropriate and likely value at some future contemplated time of exit. The most common ratios used to compare one business to another include market value of the firm value/revenue, firm/EBIT (Earnings Before Interest and Taxes), and market value of the firm/EBITDA (Earnings Before Interest, Taxes and Depreciation).
A critical factor in determining a company's future value as a private company or likely acquisition candidate, rather than as a stand-alone public entity, is the "Public Company Premium" or "Private Market Discount." Data tracking these ratios for private equity transactions and middle market M&A transactions are published in The Daily Deal. Portfolio Management Data also publishes M&A statistics.
Because venture investments are typically held for several years, determining the value of an investment requires ascertaining whether a current price reflects sufficient growth to allow the investor to generate a return that meets the investor's cost of capital. Alternatively, the investor can work to determine the likely value of a company at some future point and discount that value to the present. Because the future value assigned a company will vary significantly depending on whether a company is sold or goes public, the future value assigned a company must also reflect whichever assumption is preferred by the investor. In either case, the discount rate used to discount future values to the present has a significant effect on the present value attributed to an investment. For venture investors, the discount rate applied will vary. As discussed earlier, it would not be atypical for an early-stage venture investor to expect and to assume a discount rate that reflects a rate of return of 50 percent. Later-stage investors will be more likely to assume discount rates of 35 percent to 40 percent. The appendix tables in this book highlight the magnitude of the effect of a discount rate on the time value of money and should be consulted.
The extent to which valuation is an art becomes clear as we consider the variability of factors that are critical to assessing a company's likely future worth. A valuation must work closely to project how the market will view an asset at a specific future period of time, how sustainable the growth rate of a company is, and how predictably a group of companies with which the prospective investment is likely to be compared are likely to grow and be supported by the marketplace. Economic cycles and the capacity of a specific sector will necessarily influence these ratios. The venture investor who over- or under-estimates the strength of ratios and growth rates on a going-forward basis will therefore fail to come close to accurately valuing a company.
The market may, for example, assign revenue multiples of seven times revenues to a basket of companies growing at 50 percent today, but in three years assign multiples of only four because the market as a whole has come off, growth rates for the company and the basket of companies to which the company is best compared have dropped, and a sector is filled with overcapacity. A company could therefore hit its revenue target of $100 million in three years but find that to be acquired, the market will pay only $400 million, as compared to the $700 million price tag the venture capitalist assumed in a valuation analysis.
It is precisely because VCs recognize that clairvoyance is not one of their strengths and that accurately predicting markets, time to liquidity, and management performance is an art form that they work so hard to engineer financial structures and term sheets to provide significant protections. Liquidation preference is one such tool. Building in an accruing dividend and an interest rate attached to a preferred class of security also adds to the value of the preferred. If a VC can get guaranteed liquidation preference for investors of up to four times the value of the preferred in a well financed deal, investors can likely lock in a return of 41 percent or better, as long as the investment creates enough value to be purchased or go public within four years, the management team has adequate incentive under such a scenario, and sufficient powers exist to enforce this right.