The Valuation Monologues

[Note:  long post,  specific to entrepreneur/investor dynamics]

Deal making is picking up in the VC/PE world, and in my corner of it (currently India) it is reaching pre-slow-down levels.   Valuations are headed up since the Sensex generally determines what Indian entrepreneurs think their businesses are worth.    As I find myself getting deeper into the world of growth equity, memories of a prior life in early-stage investing continue to remind me about how much easier it was to deal with the V word during negotiations.    I want to focus today on helping  entrepreneurs understand where VCs/PEs come from when discussing valuations.

I have been there myself so I fully understand the visceral reactions entrepreneurs generate when they first get a valuation estimate.   Although the discussion may seem to be all about how much of your company the investor wants, one simple concept that entrepreneurs would do well to grasp is  “expected returns as a multiple of invested capital” which is what investors care about.  The amount of ownership sought today is related to this  and unless the linkage is accepted and understood by a founder, any investor offer will likely seem irrational.

The process is long but not very complicated; a back of the envelope calculation and some assumptions about market conditions can work almost as well as an Excel workbook and thorough research:

  • Come up with realistic projections for your business. If you are a growth business, generate atleast three or four years of projections based on a proven business model.   If you are an early stage company with everything untested, then your projections do not mean much unless you painstakingly model the business with reasonable assumptions.  If you are at the seed/idea stage, your valuation is a function of who you are and how much you are trying to raise, and is beyond the scope of this post. [Let me know if you want to hear more on this topic.] [Update: Rob Go just put up a good post on this very topic]
  • Determine when and how big will your exit be? Figure out when you will be at critical mass to get an exit;  model this as an IPO.  Now what makes a business IPO ready depends on both current markets and the sector/geography you are in, so do some research on recent IPOs.  For example in the US, in a technology business I would generally look for $100M-$200M in revenue with over 10% net income margins, sustained and growing over 6+ quarters.  In India, a similar business would need about $100M+ in revenue at $20M+ PAT over several years but growth rates in excess of 30% to get a healthy IPO.  If a trade sale happens before you IPO it will likey be sooner than the projected IPO date and likely be at similar or higher valuations so you can ignore this possibility for the purposes of this analysis.
  • Determine future dilution: how much capital (in successive rounds) will you need to execute on the business plan?  Future financing events will dilute both yourself and the investor.  Build out a capitalization table (share holding) and model how much the investor would own at exit based on the percentage ownership of the company sought today for the current round of financing.
  • Multiple of Invested  Capital (MOIC) makes the world go around:   Assuming an IPO valuation as determined above, assign a value to the entire company and the fraction that would accrue to the investor if he sold his entire position.   This value expressed as  a multiple of invested capital (e.g. 3x, 5x, etc.)  is the magic number that most professional investors obsess over.  Although a lot of investment literature focuses on IRRs, these are sensitive to the time that an investment is held and although across all investments in a fund VCs and their investors (LPs) care about IRRs,  in real terms they care more about the fraction of the fund that each individual investment returns.  Most investors have rules of thumb on what makes a good investment: growth equity investors for example would seek 3x their money in 4 years with more certainty than venture investors who may seek 10x in 6 years with less certainty.
  • Tying it all together: Do you think the investor is getting a fair multiple of invested capital from the investment in your business?   In some businesses, he may need 20% ownership and in others 40%.  That in general determines where the valuation today ends up.  Of course there are many assumptions made here: your projections, time to exit,  market conditions at exit and future capital needs.  Each of the parties will model these to favor their ownership in the valuation discussion and this is what negotiations should all be about.  There are creative ways to bridge the gaps in the assumptions so a deal gets done, but that will have to wait for another post. [Ask me if interested.]
  • Cross-check with other valuation methods:   Look at relative valuations like listed comparables and acquisitions as multiples of profits, EBITDA, book value or revenue (my preferred order).  Discount these for the uncertainty and illiquidity of your own business, and see if the valuations still make sense.

[Caveat: This is a very generalized discussion of how you could go about trying to rationalize your thinking.  I am on thin ice trying to discuss valuations in small, unlisted companies but we need to start somewhere.   And yes the invisible hand shows up in these markets as well  but seek professional help if you need to, but let us go out and get some deals done at the right price.]

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