How venture capitalists price a deal
Wednesday, June 4, 2008/
Business owners and venture capitalists can have very different ideas about valuations. For the VC, it’s all about pricing risk. DORON BEN-MEIR
By Doron Ben-Meir
Whatever anyone tells you about the valuation process for early stage businesses, there are wrong answers, but no right answers. The final value is a product of art and science.
A recent deal we evaluated came to us with $3 million in revenues (marginally loss making) looking for a capital investment of $3 million to help scale internationally. Their pre-money valuation expectation was $12 million. Why $12 million…?
They had projected forward their results for five years and derived a profit figure of $4.5 million. They had further assumed that at that point they could sell the business at a PE multiple of 10 times and that a 20% internal rate of return (IRR) looked like a good deal for investors. At a $45 million sale price, this would yield the investor $9 million – three times the investment over five years.
Pretty good you say… actually, no.
The core issue is that the inherent risk of the deal has not been priced. Mature company valuation methodologies such as NPV (net present value) and DCF (discounted cash flow) are of no use in these cases as they are typically reliant on arbitrary discount factors, no historical validation and little, if any, projection verification.
Quite simply it always takes longer than projected and often requires more capital. Both these factors diminish the notional return and can result in an unsuccessful investment, even if the company eventually does make the numbers and is sold for $45 million. Combined with a generous PE multiple on exit – the deal would not be particularly attractive even if one knew it would hit its forecast perfectly!
For VCs, the statistical reality mandates that for every deal done, there must be a realistic prospect of achieving an IRR of much higher than 20%, otherwise one is more likely to fail across the portfolio with an over-reliance on so-called “fund maker” deals – the one’s that return big time.
And the art… ?
VCs have to make judgements about the projections, the capability of the team, the market, the competition, technology risk etc in order to form a view about overall attractiveness. It’s also important that for a first round, the VC takes no more than 50% of the business. To take more risks de-motivating the founding team and putting operational control in the hands of the VC – neither of these outcomes are desirable.
For early stage venture deals, if there is not a realistic prospect of returning at least five to 10 times the investment within a three to five year period, the deal is unlikely to be very attractive. This is a rule of thumb and will vary from VC to VC and deal to deal, but it is generally reflective of Hofstadter’s Law, which states that, “it always takes longer than you expect, even when you take into account Hofstadter’s Law”.
Back to our example, if the numbers presented are judged to be realistically achievable, then a more reasonable pre-money valuation would be in the range of $3 million to $5 million. Perhaps not what the founders were hoping, but actually quite generous when you consider their prospects without the investment and the inherent risks assumed by the VC.
Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.
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