Valuing a venture requires us to look into the future, to use estimates and weigh up risk versus reward

Valuing a venture requires us to look into the future, to use estimates and weigh up risk versus reward

Valuing a venture requires us to look into the future, to use estimates and weigh up risk versus reward.  Leach & Melicher (2012, pp319) quite succinctly put it  “Valuation is how visions of the future are translated, quantified, interpreted, and made relevant to current investor negotiations”.  Venture valuation is important to not only the investor but also to the owner due to the impact it can have on ownership percentage and control of the firm.  Numerous methods exist to value a venture however this paper will focus on two areas, the equity method and the venture capital shortcut (VCSC) method.

 

The ventures ability to generate future cash flows is connected to the investor’s willingness to provide the capital required to generate those funds (Leach & Melicher, 2012) through the equity method of valuation.  The equity method of valuing the venture relies on the compilation of projected financial statements to enable us to discount future cash flows to derive at a present value of the firm.  Discounted Cash flow analysis is the basis of this and often uses historic data as the base for future projections. Whilst it is theoretically correct it is often difficult to get right due to the number of future predictions required to make the model work.  If any one factor is wrong in the DCF it can cause large swings in the valuation of the business.  If no historic data is available on the firm, i.e it is a pre revenue firm, this method inappropriate to use and we may turn to the VCSC methodology.  It has been noted the younger the company the more difficult the valuation is due to the lack of historical data and the numerous uncertain elements that could influence the firms future path (Peemöller et al., 2001).  This combined with the ambiguous nature of determining the growth rate of the venture along with deducing the firms cost of capital raises questions on the application of the traditional equity method of valuation for new ventures.

 

The Shortcut method of valuation used by venture capitalists is an alternative to the traditional DCF approach.  It focuses on the ventures terminal value and work backwards from the VC’s required rates of return to determine the percentage ownership the venture owner needs to give up to obtain the venture capitalists capital. Metrick & Yasuda (2010) purport there are four elements to the VC method of valuation:

 

  1. Terminal / Exit Value of the business
  2. An estimate of the VC’s target multiple of money.
  3. An estimate of the expected retention percentage between the current investment and a successful exit.
  4. VCs investment recommendation which looks at the required investment balanced against the proposed ownership %.

 

This shortcut method is dependent on the application of an earnings multiplier to project future terminal value of the venture.  There are a couple of ways to derive at this multiple, we use a relative valuation or we use an absolute valuation.  Using a relative valuation can be short cut further, the PE multiplier specifically applies a direct comparison say for example a comparable business and/or industry or growth rate.  It can however be argued that this is subjective particularly for new startups in new industries where no comparable company is in existence.  In scenarios like this the absolute valuation may be used where the more traditional discounted cash flows method may be a more suitable alternative to valuing the venture.  Whilst DCF can be used as a method for valuing the business it also can be deployed in working up the exit value of the business.  However the VSCS method may be deemed more appropriate where the venture is operating in a well-established market, or even a new venture in a new market but comparable company data is available.  The VC may have in mind a target multiple to use in the valuation of their portfolio due to the adverse selection risks which exist.  However rather than increase their target return VC syndicates could be used to mitigate the selection risks associated with investing in firms with varying capital structure decisions (Cummings, 2006).

 

In many start-ups it’s likely that retained earnings will need to be reinvested into the business to facilitate growth in later years.  The advantage of using price-earnings multipliers is that it provides us with a method to value ventures that not only growth through internal and external funding but also a way to value those venture that grow through retained earnings (Leach & Melicher, 2012).  Both the age of the industry and the stage of the venture life cycle may determine the suitability of the application of VCSC methodologies of valuation.  In the mature stage of the venture the equity model using DCF may be used as positive cashflow before the Terminal date often exist.  In the VC shortcut model negative cash flows are often common which makes it more suitable for the valuation of start-ups as most early start-ups don’t have positive cash flows hence why banks ask for personal guarantees to enable borrowing (Brophy & Shulman, 1992).

 

The basic shortcut valuation method can be extended to incorporate what if analysis and modelling of various outcomes.  For example the VCSC methodologies can be flexed to consider the injection of multiple rounds of financing.  What does however become clear in working these calculations up in this way is the realization that multiple rounds of financing results in the entrepreneur/founder’s ownership being diluted whilst the VC’s ownership percentage remains intact.

 

Valuation is key to the firm’s investment decision and subsequent capital structure.  Valuation frameworks attempt to incorporate important concepts such as risk/return and the time value of money (Brophy & Shulman, 1992).  The firm’s capital structure, life cycle stage, market factors, accessibility to historic data and comparable data along with the complexity, accuracy and speed are all factors which can influence the valuation method applied to a venture. Brophy & Shulman (1992) purport venture capital is a field that can connect finance and entrepreneurship.  Valuation is only the first rung on the relationship ladder between VCs and entrepreneurs.  Once the valuation is reached next comes the negotiation where we can see the actual valuation and the final purchase price can vastly diverge.  Take HP and the 3 Par deal as an example.  HP paid over 3 times the share price for 3 Par to acquire the business, with the market determining its worth at $9.65 per share pre acquisition but HP ended up paying $33 per share (Campbell, 2010)!  Whilst valuation may give us a starting number it’s unlikely to be where we actually finish up.

 

 

 

 

 

 

 

References

Brophy, D.J. & Shulman, J.M. (1992) ‘A finance perspective on entrepreneurship research’, Entrepreneurship: Theory & Practice, 16 (3), pp.61-71

Campbell, S, (2010), “HP Paid Too Much for 3Par, Analysts Say”, CRN News [online], accessed 3rd April 2015, available from http://www.crn.com/news/storage/227300135/hp-paid-too-much-for-3par-analysts-say.htm

Cummings, D. (2006) ‘Adverse selection and capital structure: evidence from venture capital’, Entrepreneurship Theory & Practice, 30 (2), pp.155-183

Leach, J.C. & Melicher, R.W. (2012) Entrepreneurial finance. International ed., 4th ed. Mason, Ohio: South-Western Cengage Learning

Metrick, A, & Yasuda, A (2010), Venture Capital & The Finance Of Innovation, n.p.: Hoboken,

Peemöller, V.H., T. Geiger, and H. Barchet, (2001), “Bewertung von Early-Stage Investment im Rahmen der Venture Capital Finanzierung“, Finanz Betrieb, 5, 334344.

 

 

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