Editor’s Note: Technology entrepreneurs are unique. It takes courage, skill, perseverance, domain knowledge, and just a little mania to start a company in any economic environment. To start up under current conditions is even more challenging. Entrepreneurs need specific business knowledge to attract management, address market requirements and secure financing. The goal of this column is to contribute to the growth of regional technology companies by providing straightforward business information that is useful to technology entrepreneurs.
Entrepreneurs need to know what their companies are worth. Surprisingly, many do not. When it comes to capitalization strategies, financial transaction, mergers and acquisitions, the most important number to business owners is their valuation. Yet many technology entrepreneurs do not know what sort of magic the financial community and investors apply to come up with a rational valuation. Understanding valuation will improve an entrepreneur’s chances of raising money.
The first round of equity financing is tough. According to Jeanne Lazarus Metzger, vice president of the National Venture Capital Association, "There is approximately $90 billion that has been committed to venture firms nationwide and not yet invested. However, venture capitalists are being extremely selective… and are taking months to conduct due diligence before closing a transaction so entrepreneurs need to be well prepared." Preparation has to include a clear model of valuation.
Beyond Cash Donations: How New Forms of Giving Are Transforming Not-for-Profit Accounting
Evolving Funding Landscape for Not-for-Profits Not-for-profit organizations are being asked to do more with less,…
Learn More
Without a valuation model that makes sense, one of two things will happen to an entrepreneur during the investors’ due diligence period. The first is failure. The second is loss of opportunity. The failure scenario occurs when investors and entrepreneurs cannot agree on valuation, which makes it impossible to close equity financing. The loss of opportunity scenario occurs when entrepreneurs abdicate their responsibility to participate in the valuation discussion and capitulate to the valuation assigned by the investor. With a solid understanding of valuation, entrepreneurs are better equipped to avoid either of these negative outcomes.
Unfortunately, there is not one formula to calculate the value of a company, especially at the early stages. And recently, we have all learned that even traditional methods for large corporations (such as EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization) are not always reliable. However, a few basic methods can be applied in any valuation discussion. For start-up and early growth stage companies, tools such as price to earnings ratios, multiples tied to inventory, or other financial metrics do not work well because the necessary data are either non-existent or not measurable as a variance against historical data. And statistical based valuation models are heavily dependent on historical data.
A valuation based on net present value of future revenue streams is often a useful metric for early stage companies. In broad terms, net present value (NPV) is the value today of a future stream of earnings over a fixed period of time. A "discount rate," usually the rate of return on a relatively risk-free investment such as US Treasury Bills, is applied against the future stream of earnings to determine its value today. If the NPV of a future earnings stream is positive at a given discount rate, then that earnings stream is better than investing your money in the risk-free investment for that period of time.
A pure definition of NPV, however, relies on the assumption that an earnings stream is risk-free. Since early stage companies face many risks, the interest rate used in the NPV calculation can my adjusted upwards to factor for risk. This risk-adjusted interest rate is often called the hurdle rate, since the company’s performance must overcome this hurdle to achieve positive NPV. The hurdle rate can be used to represent a number of uncertainties. Management’s credibility in their forecast, competitive forces in the market, customer service, changes in cost structures over time, and other hard and soft factors influence the achievability of a future earnings forecast.
By evaluating the forecast in your business plan using NPV, an investor can make a rational decision. Venture capitalists use valuation models all the time to help them sort through the vast number of business plans they consider. They may fund only one in hundreds they evaluate, and they know from experience that out of each 10 companies they invest in, 3 will fail, 3 will return their money with little or no appreciation, 3 will be a modest success and one will be a home run. However, at the time they invest in a company, they have to believe that it will be a home run, because those are the companies that give them the desired return for their portfolio as a whole. Over time, the venture capital industry as a whole has generated strong double-digit returns and most venture capital investors are seeking annual returns on their portfolios of greater than 20%.
Once the mechanics of NPV are evaluated, then business issues such as pricing and cost structures can be assessed relative to their respective impact on the NPV. So if you have a good NPV model, it can be a dramatically effective operational tool as well as a valuation tool.
To be candid, it is not always easy to forecast the variables that go into an NPV analysis. You need a solid plan, with clear identification of revenue and cost strategies. You will need to make and document assumptions, and take a position theoretically on what you believe your assumptions mean. These are appropriate steps to take in any event, and if you take them, you will be better prepared to actively negotiate valuation with your financial partners. That, in the end, is worth it.
Cliff Dutton is Managing Director of Providence River Group, LLC and a member of the board of directors of the Rhode Island Technology Council. He co-manages the Rhode Island $50K Business Plan Competition and co-chairs RITEC Venture2003. He can be reached at cliff.dutton@providenceriver.com.
