Textbook methods of valuing young and startup firms have been described in considerable detail by authors like Aswath Damodaran in his seminal paper “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges”. He contends that valuation has been practiced poorly by VC firms, and often comes down to a bargain between the entrepreneur and the venture capitalist. This has been dramatized in the American TV Series Shark Tank, where entrepreneurs seek investment to start, grow or save their business, and five VCs fight each other for a potential deal.
The landscape is changing fast, however, and VC firms have realized that true gains can be achieved by estimating value of a firm accurately to win the confidence of the entrepreneur. By understanding these new methods, entrepreneurs stand to have a better visibility of how venture capital firms think and act.
Adopting the life-cycle view of the firm helps VC firms estimate cash flows, investments, revenues and ultimately returns on equity. This becomes the basis point for buying the right equity at the right price. Discounted Cash Flow model for valuation then becomes the preferred tool, however, there are a few caveats to its application that most VCs have learnt to cope with over time:
- Estimating Future Cash Flows: There are two popular approaches to doing this, top-down and bottom-up, of which we will focus on the first one. Starting by estimating the market size during the lifetime of the company and market share achieved every year going forward, revenues are estimated. From an understanding of typical industry operating margins, pre-tax income is calculated. Carefully adjusting for tax every year (since cumulated P&L losses remain untaxed), after tax income is derived. Assuming an industry standard for Sales/Capital Employed, amount of reinvestment required can be calculated. This reinvestment is further checked with the evolution of Return on Capital Employed, and compared with industry leaders. Removing reinvestments from After-tax income results in free cash flows.While the entrepreneur cannot do much in the final stages of valuation i.e. tax effects and free cash flow calculation, he must remain cautious at first four steps to achieve higher valuations:
- Estimating Discount Rates: To begin, the WACC rate needs to correspond to the target capital structure and the right estimates of cost of debt and cost of equity. For Cost of Equity, the firms will attempt to find average beta across public firms in the sector, and using the average D/E ratio of the sector, find the unlevered beta for the sector. Since the firm typically starts out with the owner pooling 100% of equity, the unlevered beta is scaled up by the average correlation of publicly traded firms to get a total beta. As the firm progresses, it will approach VCs who will offer equity at a higher level of correlation with the market, thus reducing risk (total beta) accordingly. When the firm finally goes public, sector beta will apply as the firm is completely exposed to market risk. At the same time, cost of debt will depend on interest coverage ratio and the implied synthetic bond rating (adjusted for firm size). The entrepreneur then sets in stone the target D/E and how he intends to grow towards it, and this helps in formulating WACC for every year of operations.In this process, the entrepreneur does not have too much influence on the computation. However, sector definition and identifying the right peer group in the public market becomes crucial to achieve better valuation from VCs. Also, being adamant about not taking debt may actually lead to higher discount rates and lower valuations if equity can be procured at a lower cost, and therefore target D/E structure should be decided early on and reflect optimality.
- Estimating Present Value and Adjusting for Survival: Now that the cash flows every year and discount rates have been projected, a few key factors that the VC will attempt to assess will be A) Terminal value, B) Survival of the firm and C) Risk of losing key management.
- The VC try to classify the firm among three broad categories. First, firms that will grow on to go public one day, second, firms that will grow conservatively beyond the forecast horizon, and third, firms that will liquidate at the end of the forecast period. Accordingly, the firm’s terminal value be calculated based on its growth rate at stability.With this in mind, the entrepreneur should assess the nature of his own business, and rather than designing fancy and far-fetched long-term mission and vision statements for his company, align his own aspirations for the business with the commitments made towards continuous double digit growth. The promise of continuous innovation and competitive differentiation, and the capability to do so, are the surest ways to ensure higher terminal value estimations.
- VCs have realized that valuations remain incomplete if the risk of firm failure is not built into the computations diligently. For this, either they will factor in survival rates of typical firms in that industry from past research, or use probit regression models based on firm specific features (like cash holdings, history of founders, the business it is in, debt conditions) or use more complex simulation models.This will be the hardest part for the entrepreneur to sell. If the VC decides to use any of its in-house models, only robustness of the business idea and simplicity in execution are what can save the entrepreneur’s skin. At the same time, correct valuation of tangible assets built over time becomes important in case the distress sale is actually carried out, and the entrepreneur will need to vouch for the quality of resources that he promises to bring in.
- Loss of a partner or a managing director due to either personal or professional reasons can slow down operations drastically, leading to either a capacity crunch or withering of demand, and VCs have come to realize that replacement of these key personnel within a firm needs to be accounted for too.As the VC assesses the topline and bottomline impact of such events, the entrepreneur will need to convince that his firm is not a one-man show. Having a cross-functional team where people are ready to wear multiple hats to run the business will boost the confidence of valuation experts.
Rijul is a PGP2 member of Entre Club, IIMA. He has been reading Damodaran a little too much these days, trying to find ways for entrepreneurs to outsmart sharks.