Someone recently asked me how Wall Street had valued Facebook for $20 billion. I am always intrigued by this question since I have encountered many business plans with interesting valuation approaches, worked with a start-up that did make it to Wall Street – had been valued by the investment banks – and shut its doors only a couple of years after its IPO, chatted with newly minted financial analysts at the International Finance Corporation who addressed questions to me – What is NPV, DCF? What is cash flow? Then I began to reconsider that the first year of business school mathematical approach was too limiting.
I do believe that the Corporate Finance course at the average business school programs can provide you with a yardstick to measure such values – NPV, EVA, P/E Multiples, Cost of Capital techniques. But these are static analysis just like an accounting – it only measures the past, while vaguely incorporating the future and avoiding factoring in other elements that have a stronger impact on valuation.
Once a colleague provided me with a business plan for a wireless network in Eastern Europe. The appendix included a valuation report authored by a local Chartered Financial Analyst (“CFA”), indicating a well calculated valuation, comparison to other wireless companies in the U.S., and giving its imprimatur about the value of that company. I thought about it…the CFA quickly applied the projections, the NPV, and P/E multiples and concluded: great investment! To quote a British Prime Minister, “there are lies, damn lies, and statistics.” I thought otherwise when I looked at the body of the business plan. When one reads the tactical plans with the management team’s background, I noted that not one senior manager had ever worked in telecommunications. Given the complexity of the industry that requires experienced engineers, I could only disagree with the CFA’s assessment. The caliber and experience of the management team can make or break a business. The more complex the industry, the greater the need for the business to include a more experienced team.
On the other extreme, I have noticed that software oriented businesses are being founded by very young managers. One can easily argue that software programming is mathematical. Having studied mathematics, I remember reading somewhere that mathematicians are more prolific and creative when younger — whether in their teens or twenties. Since software has similar characteristics to mathematics, I am not surprised about these young entrepreneurs identifying and developing new software applications. But virtually all other industries do demand seasoned and experienced managers who know their specific industries well.
Going back to the Eastern European wireless start-up, I immediately decreased the value by 50%, reflecting the importance of the management team. I also subtracted the valuation by another 40% because of the competitive environment. I believe that the competitive environment tells me a great deal about the chance of survival as a new entrant. In the specific country the company was considering operating in already had 2 wireless operators. In every country I have done some due diligence, there are about 3 wireless operators. The first two operators normally have about 80%-90% of the market, and the third operator feeds off the crumbs. So the chances that this company will be wildly profitable, I found very suspicious.
The combination of the inexperienced management team and the competitive environment clearly discounted the CFA’s valuation model. Frankly, I would like to see a financial model that can incorporate the other elements to determine the true value of a company. I have seen too many spreadsheets that simply address the NPVs, P/E multiples, etc. These measuring sticks are helpful but are not determinative of the true value of a company. Even on Wall Street, valuations are still a mix of science and art.
I myself do use those standard measuring sticks, but I also look at other factors that will impact valuation over time, both the short and medium terms. One can put together a spreadsheet that can incorporate projections and the valuations, and, through the understanding of the competitive environment over time, see how the valuation changes. At least this approach takes into consideration the other factors beyond strict numerical financial analysis.
Some VC funds have adopted a 10 point approach for each element of the business plan, and, like American Idol TV show, the business plan with the most points wins and gets funded. For example, with “10” points the highest to “0”, the lowest, how do you rate the management team? How do you rate the competitive environment? Is the financial spreadsheet reflective of a detailed, well thought out projection? How is the marketing strategy drafted?
The spreadsheet should have incorporated how would an investment fare after 3-5 years, since the spreadsheet should project earnings over time. The retained earnings should give someone an idea of what the shareholder value will be. Then NPV tested generally uses 35% for the cost of capital, and the business should be EVA positive in 5 years. If the sum of the rating system turns out to be 100%, then one can safely assume that the projected value is correct. If less than 100%, one starts to discount the value of that share. This mixed approach seems to be a decent evaluation of the value of the startup.