Is Venture Capital in need of new valuation tools and methods?

1.0 Introduction: Venture Capital Valuation

Venture capital investments have become a major contributor to the growth of start-up firms. Investing in start-up firms carries a substantial risk of failure, only a minority of start-ups is high-return investments. This put great responsibility to the valuation methods used by the venture capital firm. It is argued that when uncertainties about future pay-offs are high traditional valuation tools are of little help, they are said to be too static and not to comply with change. A valuation method that is alleged to act in accordance with a changing environment where uncertainty is high is a real option which is said to consider these variables, thus giving a more accurate valuation. The structure of venture capital funding can be seen as well suited for real option valuation.

Company valuation is a critical part of any business transaction and will be required for many reasons. Regardless of whether you seek to complete an investment, an Initial Public Offering (IPO) or a Merger & Acquisition (M&A), the valuation forms an integral part of negotiations and can ultimately determine the success of a given transaction.

Identifying the crucial value drivers behind the business model is a key to success. Valuation methods assist in clarifying and identifying these critical factors with a thorough assessment of financials, technology, market and management. The valuation process is meant to provide an objective evaluation of the company, but will also present valuable feedback about how to increase its long-term valuation and to prepare it for key questions to be asked by potential investors. Risk analysis and company financials make up an integral part of valuations. Hard data as well as soft factors are considered when conducting our risk analysis. The financial aspect of the valuation is then performed using a variety of accepted and proven methods. Depending on the specific circumstances of the company, a combination of the following methods is used.

2.0 Types of valuation methods

Discounted Cash Flow (DCF) The discounted cash flow method takes free cash flows generated in the future by a specific project / company and discounts them to derive a present value. The discounting value usually used is the weighted average cost of capital (WACC). DCF calculations are used to estimate the value of potential investments. When DCF calculations produce values that are higher than the initial investment, this usually indicates that the investment may be worthwhile and should be considered.

Risk adjusted NPV The risk adjusted net present value (NPV) method employs the same principle as the DCF method, except that each future cash flow is risk adjusted to the probability of it actually occurring. The probability of the cash flow occurring is also known as the ‘success rate’. Risk adjusted NPV is a common method of valuing compounds or products in the pharmaceutical and biotech industry, for example. The success rates of a particular compound/drug can be estimated, by comparing the probability that the compound/drug will pass the various development phases (i.e. phases I, II or III) often undertaken in the drug development process.

Venture Capital method The venture capital method reflects the process of investors, where they are looking for an exit within 3 to 7 years. First an expected exit price for the investment is estimated. From there, one calculates back to the post-money valuation today taking into account the time and the risk the investors takes.The return on investment can be estimated by determining what return an investor could expect from that investment with the specific level of risk attached. The Venture Capital method is often used in valuations of pre revenue companies where it is easier to estimate a potential exit value once certain milestones are reached.

Market comparables method The market comparables method attempts to estimate a valuation based on the market capitalization of comparable listed companies. The market comparables method is a simple calculation using different key ratios like earnings, sales, R&D investments, to estimate the value of a company.

Comparable Transaction method The comparable transaction method attempts to value an entire company by comparing a similar sized private company in a similar field, and using different key ratios. The price for a similar company can either come from an M&A transaction or a financing round. The comparable transaction method is a simple calculation estimating the value of a target company based on comparable investments or M&A deals.

Decision Tree analysis Decision trees are used to forecast future outcomes by assigning a certain probability to a particular decision. The name decision tree analysis comes from the ‘tree’ like shape the analysis creates where each ‘branch’ is a particular decision that can be undertaken. Decision trees are used to give a graphical representation of options, strategies or decisions that can be undertaken to reach a particular goal or “decision”.

2.0 Advantages and disadvantages of valuation methods Discounted cashflow method can provide an intrinsic value of a business based on estimated future cash flows. The disadvantage with this method is “Garbage in, Garbage out”: it’s only as accurate as the cash flows that you predict. It’s highly speculative beyond a few years out, especially for startups where that is where the majority of startup value comes from. Most appropriate for more mature businesses with predictable growth. Because the DCF method relies on accurately projecting future revenues, it is more suitable for mature companies with predictable growth rates and existing revenues. This is because if you try to predict what the future cash-flows of a pre- or early-revenue startup will look like, your best-guess is at best an approximation. What’s more likely, though, is that your projections are way off in either one direction or the other. No one can predict the future.

The venture capital method is quite useful for calculating required or expected valuations for pre-revenue businesses. However, it doesn’t look at aspects of the business (i.e. team, product, traction, risks, etc.) in determining a valuation, it only depends on your required rate of return. It still requires a selection of representative startups to estimate future potential terminal values. However, one shortcoming is that unless you use the company’s anticipated growth rate for the ROI number (which can be nearly impossible to estimate for pre-revenue startups), it’s only telling you what valuation you need to invest at, not what the valuation of the startup is worth based on the team, product, or anything else.

The risk adjusted NPV considers areas that the Berkus and Scorecard methods overlook, and is relatively straightforward to apply when comparing other startups. It shortfalls however this is a glass-half-empty way of assessing a startup, it looks at all the things that could go wrong, but doesn’t consider what could go right. It also assumes everything is equally weighted (e.g. a strong management team only gets the same weighting as a good litigation risk, whereas a team is generally much more important than other areas). Lastly, it still relies on the initial group of startups that you select as the representative benchmark for comparison.

3.0 Are new valuation tools and methods needed?

Estimating the value of the investment is a fundamental part of the investment decision. The closing of the deal depends on the agreement about the amount of funding that is required. Valuation concerning start-up firms can prove to be a tough nut to crack especially if there is no previous track record and highly risky market 11with poor economic and financial performance. The first problem that analysts face is how to choose a proper method of valuation. A couple of determinants that can be used and considered to assist in this process.

Type of industry Different industries have different value drivers. Industries where the firm has a large part of its employed capital as fixed assets and working capital (tangible assets) the analysts should choose a balance sheet based method. Typical industries would be manufacturing, real estate and chemistry. Companies whose competitive strength is invested in intangible assets, such as research and development (R&D), which do not show in the balance sheet should use cash-flow and income based methods.

Availability and reliability of valuation based data The type of data available highly influences the choice and accuracy of the valuation methods. Information regarding the past, the present and the future value of all relevant variables affecting the performance of the firm is desired. If the information gained is not reliable enough, forward looking methods such as cash flow or income based methods can be strongly subjective.

https://www.nexea.co/venture-capital/ Anders, G. (2006). Venture capital In need of new valuation tools? INTERNATIONELLA HANDELSHÖGSKOLANHÖGSKOLAN I JÖNKÖPING, 1(1), 12. https://www.diva-portal.org/smash/get/diva2:4148/FULLTEXT01.pdf Miloud, T. (2014, April 10). Startup valuation by venture capitalists: An empirical study. INSEEC Arild Aspelund. https://www.researchgate.net/publication/241733865_Startup_valuation_by_venture_capitalists_An_empirical_study Weitzel, T. (2003). IS Valuation Methods: Insights from Capital Markets Theory and Practice. Otto-Friedrich-Universität Bamberg. https://www.researchgate.net/publication/228735941_IS_Valuation_Methods_Insights_from_Capital_Markets_Theory_and_Practice