The Art of Valuation I

Everything in this world has a price. Yet, pricing is not only a science but also an art. It requires precise estimate of figures and values while also able to extract the best value out of qualitative factors. Here we will discuss pricing from a venture capital point of view.

It is often said that valuation is an important skill required by an investor (venture capitalist, bankers and business angels). Similarly, the entrepreneur needs to develop some form of intuition to how to value your company, no matter at which stage it is in.

To value a company is not just a science but also an art, because there is no clear and straight rule to get it right. The successful venture capitalists pride on good due diligence and smart financial calculations to hedge their bets. The value of the company depends on several factors: for example, the company’s stage of development (seed stage, series A, B, C or D, mezzanine), the surrounding environment (economic outlook of the industry and public stock market), the company’s position in the market, the prospects for the market which the company is moving towards and the likelihood of how much cash required to achieve its objectives. Of course, most venture capitalists and investment bankers will have their own set of tools and intuition on how to value a company.

Which stage is your company anyway

The stage at which your company is at will determine how much factual information is available to provide a basis for analysis. Obviously a startup will no financial record, and relies on projections based on what the company’s founding management team believes it can achieve. Depending on whether it is a new technology or new service, they may exist no comparable companies against which to measure such projections. Here is where the art really comes in to value such a company. Early stage companies will definitely start with loss making because initial resources are required by the founders to create the concept, product or service. The company’s historic records provide no basis for valuation. Whether it is a startup or early stage companies, the entry valuation is dependent on qualitative factors such as the investor’s return expectations, the proportion of the company that the management is willing to give up in order to attract investment and the investor’s view of the new idea. Furthermore, the investor will have to analyze the product and market opportunity in order to establish whether the company is scalable. If the market opportunity is small, even the largest company in the same market will be small.

As the company grows bigger and becomes more developed, more financial information are available. These companies seek funding to expand their businesses either by (i) opening new branches, (ii) increase the number of sales and production staff or (iii) broaden the portfolio of existing products with new ones. At this stage, the company can be analyzed with a comparative analysis to existing competitors and perform the product and market analysis to establish its maximum potential. The investor will consider his or her risk expectations and management will need to consider the proportion of the company it will be willing to sell to an investor.

Next: What are the factors that an investor need to consider?

What are the factors that an investor need to consider?

Qualitative Factors

Let’s cover the due diligence matters which fundamentally change the valuation of a company at the time of initial investment. These factors are typical textbook methods.

• Potential Sales Growth: You examine the size of the market, the position of the company in the market and the protection of the company against its competitors. A lot of this weigh on your assumptions of the market. Sometimes, it is totally wrong from what you expect. The trick to make sure that you don’t go wrong, is to discuss with people who have been in this industry for some time.
• Company Forecast: You scrutinize the management’s assumptions and see whether they are really compatible with market opportunity. Please note that disruptive technologies have a different value of matching the assumptions to the market. Sometimes, market forces change and the existing dogma may fail. A lot of attention for the venture capitalist will be on the cash flow requiremets.
• Exit Strategy: As an investor, you want to know the time scale, valuation and route at the time of exit so that you ensure that company will be suitable for realization within your expectations. Usually, you need five years to get to that stage for a startup company. For example, biotech companies take a longer time (5-8 years) to reach actualization.

Once you establish these factors, you need to bring in the figures, which is the science of valuation.

Quantitative Factors

• Investor’s return expectations: The venture capitalist needs to decide the general level of return expectation based on appropriate assessment of the company in which developmental stage and the relative risk/reward ratio of the company. The simple rule of thumb that they love to use is that the earlier stage the company, the higher the return expectation should be. That’s why the venture capitalists need to hedge on a portfolio of companies. Usually, his hit rate is one in ten, and that only one will recoup the losses that is incurred by the other nine, and then he made his profit with the last one.

  Private equity markets are competitive and sophisticated and hence the return expectations will tend to slide lower. As a rough guideline, some investors will look for the following returns. Let’s use Europe for example, since where I came back from: 60% per annum for seed or startup investment, 50% for early stage companies, 35-40% for development capital investment, and finally over 30% for MBO (Management Buy-Out)/MBI(Management Buy-In).

• Management’s expectations: Like the investor, the entrepreneur or management will consider their returns as well. For the entrepreneur, this may be his only one opportiunity to make a significant amount of capital and he or she will have a target that will allow him or her to gain maximum profits. The venture capitalists recognizes that the entreprneur’s sole motivation to be in control (as I described in an earlier article about the dark side of entrepreneurship). It is important to structure the investment in such a way that thee economic value flows substantially to the investor, while the entrepreneur retains control of the majority with a strong voting position. Usually, the investors and entrepreneur will negotiate to ensure that there is a win-win situation. The differences are usually bridged between them with the use of financial instruments (such as stock options) other than pure equity.