2 major factors that determine a company’s valuation or cost of capital are Risk and Supply/Demand. The following WSJ article demonstrates, as an example, how supply and demand influences the yields for Treasurys, the ROI for investors worldwide and the Cost of Capital for the U.S. In spite of raising the interest rate, the Federal Reserve had not anticipated that the Treasury yields would drop. http://www.wsj.com/articles/fed-hikes-but-some-rates-veer-lower-1450402769 Why did the yields drop? International investors see the purchases of U.S. Treasurys as lesser risk than other investments worldwide. Several economists foresee weakening economies of BRICs and developed countries. In response, the overall, strong demand for Treasurys pushed down the yield curve.
How does the Treasury example is identical to a startup’s cost of capital? I can use an actual example. I was introduced to a small, NorCal sensor manufacturer, which raised $2 million several years ago through an international investor at the then valuation of $5 million. In return for that investment, the foreign entity received approximately 40% of the equity. Over a year and half ago, the NorCal company requested another capital infusion of $1 million from the same international investor. However, this time the cost of capital came at 3% per annum. For over a year since that round, this same company sought over $10 million at a $15 million valuation. What changed, they argued? It has begun to sell proprietary sensors (claims to have over 17 patents) to various local customers. But the projected revenues cannot match its capital burn. And additional capital would allow it to expand its manufacturing. They are pointing out that product sales seem to be ramping up.
In its many fruitless Pitchdeck presentations, the company claimed that its valuation had tripled to $15 million, from its original $5 million valuation. Yet, by early 2016, it will be in the red at the current burn rate. And after a year of attempting to raise capital from other investors, it dramatically failed to attract any other investors. Now it was forced to revisit its first investor — its only financier.
Is the $15 million valuation correct? Wrong. Of course, the company doesn’t understand its current position. In terms of supply/demand, any other investment banker would conclude that no other investor was interested in investing in this company, given its earlier failed attempts. Those other potential investors passed on this deal; therefore, something is wrong with this company, whether from its bloated term sheet or its hopeful valuation. Unlike the U.S.Treasurys, there are no investors knocking on the door for this company. Had there been many suitors, then this company’s business could have justified the new valuation. That was not the case and the first investor knew that.
Then there are the cash flow risks. Unlike the U.S. which we hopefully believe will be around for many more years, there is a major risk to invest in smaller companies that can easily fold. And those risks are extremely high for this company. First, it required a $2 million round, which it exhausted quickly. Then came a $1 million round, and still the company is not cash positive. To any third party investor that second return to the “cash well” represents a risk since that company made promises to the first investor that it would hit its milestones after the first round, and it hasn’t done so. In fact, I am willing to argue that its current valuation is far less than the original $5 million.
So for the company fails in two valuation fronts – no demand for its securities (supply/demand), and that non-existing demand represents a higher risk (risk factors). In fact, I am willing to state that the company’s putative valuation of $15 million as plain chutzpah (which is defined as killing both your parents and then asking the court for mercy since you are now an orphan). Granted that this company might hold 17 patents, but patent holders can go bankrupt (e.g. Kodak). And that patent ownership alone doesn’t determine valuation. That is why I use the U.S. Treasury example – valuations are determined in a world of risk and by supply and demand.
Another pertinent risk to this deal is reflected on its investment tranches that have yet to deliver results. This alone already suggests the company’s unsuccessful attempts to meet milestones. A major risk: company might well fail with its current management team.
Let’s look at another actual company’s management facing that lack of credibility to meet milestones and questionable executive leadership: Yahoo. The following references plainly shows that the failure to meet its investors’ expectations falls on the shoulder of the leadership. https://medium.com/@loukerner/poof-how-yahoo-made-20-billion-disappear-through-the-magic-of-m-a-63d5d2e50cc#.emqdffqs9, http://www.forbes.com/sites/mikemyatt/2015/11/20/marissa-mayer-case-study-in-poor-leadership/, http://www.businessinsider.com/yahoo-shareholder-presentation-2015-12.
In New York, having worked for major law firms and merchant banks in the world of finance and billion dollar deals, I noticed the impatience of investors when milestones are not met on a quarterly basis. One can fail at the helm after the first 1Q and investors will give some leeway. One can fail by 2Q, but the leadership’s credibility begins to erode. By a 3Q failure to meet all milestones, then expect investors grab a shepherd’s crook and pull that CEO off the stage. Credibility to meet your milestones is key to maintain the investors’ trust. Without it, valuation falls. From these series of references, one notices that Yahoo’s Marissa Mayer leadership has been challenged for failing to meet milestones and investors’ expectations. Therefore various assessments on the Yahoo valuations believe it to be negative for its core business. Yahoo’s current leadership is a major risk.
Are there solutions to improve this NorCal company’s valuation? Yes- like Yahoo, dismiss the leadership as a first step. The first investor has already put in $3 million, and, if the company fails, the initial investor will lose everything so far. It needs to reduce the risk represented by the current leadership. And maybe change the demand/supply factor by creating a new, forward looking strategy that would attract other investors.
So in summary, whether it be the U.S. government, a publicly traded company (Yahoo), or a small Californian sensor manufacturer and designer, valuations are influenced by the perception of risk by the investors and by the supply/demand for that same investment.