This last weekend, twice I was asked about the valuation topic, from one CEO with a M.D. and another, with a Ph.D. So this issue cuts across a great swath of owners/managers from varying backgrounds and experiences. And, on a recent investor presentation, the valuation issue became a hot topic. My first approach at dealing with valuations I tend to think about an investor’s two “R” concerns: Risk and Return (“R&R”).
By the term “Risk” I mean that the investor is concerned about the return of his original investment. One colleague related to me that an investor he knew lost every cent in his last 5 investments. Now he is focused on investing only in businesses he knows well. However, with that negative experience, his concept of risk is a high one: he will restrict the terms and conditions in such a way to mitigate risks. Actually, he demanded from my former colleague for a “dividend” to at least get something in return. This investor now needs some cash flow, whether through interest or dividend payments, to manage his risk.
The other key word is “Return”. Now I related in an earlier blog that one major VC firm had only a 4% ROI after 14 years in a medical device investment. The Limited Partners found that return so unsupportable that they redirected the investments in other sectors. Why is the return of 4% meager? CALPERs, probably one of the largest and most influential institutional investor, has an internal mandate to provide a “return” to the school teacher retirees no less than 7% annually. Supposedly, the VC returns average for 2014 have been over 25%, whereas Private Equity came back with 22%. VC funds must show double-digit returns since their model demands fees, high risks that the ROIs must be close to 25% or the Limited Partners will not return to fund the VC firm.
Now that the overall motivations are addressed – R & R, we can calculate the valuation of newco and see whether the newco will hit double-digit return. I use two tools: one, the classical business school model, and the other, market based which is the average pricing set from valuations established in that sector.
Let’s looks look at the business school technical model: calculate the NPV or EVA to be positive within a 5 year time frame. In an earlier blog, I state that you must build a rigorous financial model as part of business planning. From the model, you calculate your EBITDA over 5 years. And, by using the discount rate of 25% or more, you see that you have positive results, then you have passed the 2 Rs for the investor. Then take a similar industry, using EBITDA multiples, one then finds out the total value for newco divided by the total number of shares outstanding. Now you have a company’s valuation.
The other valuation model relies on accumulating data on the various companies financing in the region, see what capital was raised in relation to the valuation. In Silicon Valley, the valuations are based on certain parameters: no customers, no IP, the valuation is about $2 million. A company with IP, decent management team, some traction, that company becomes valued at $4-$5 million. And, if the newco claims that the valuation is over $10 million, VCs shy away. I observed that this valuation model changes on variables such as market demand for quality companies, higher costs for startup companies, or too much capital pursuing fewer quality deals.
I use both models, and rely on the calculated model to determine a floor pricing. Recently, one angel group wanted to reduce $4 million valuation to half that value. Why? I believe that the group was misinformed as to the actual “R & R” , which were well addressed. And I can show comparable companies that demonstrate the future cash flow model falls well within the newco’s projected parameters. So to reduce the valuation by 50% was incorrect. Again, one prepares for the worst valuation scenarios by applying both valuation models. If not, the lack of due diligence will prove to be risky, or worst yet, costly.