Since I haven’t found any book or blog article yet that explains the unique aspects of venture capital value creation, here’s a rough edge explanation. Follows IPEV guideline but goes a bit deeper.
Let’s first understand these four concepts. (1) Fair Market Valuation as practiced, (2) Steering Market Valuation, (3) optimal executable market price, and (4) Investor Interests.
These four concepts matter.
(1) fair market valuations become bozo in any highly illiquid market environment, because there simply isn’t enough liquidity to throw out a market price – GIPS guidance for PE asks for a fair value according to a private market transaction where sellers and buyers meet (a range of overlap between ranges of both parties negotiated via BATNA) assuming prudence, lack of haste, etc for both parties; IPEV looks at bid / executable prices assuming an orderly transaction – and a fair valuation. Secondly, a multiples based valuation blows up by the shere non-comparability of offers and buyers interests and impact of liquidity on the price (there are actually only transaction multiples in the VC game). Thirdly, a comparable transaction based valuation suffers the same problem and misses the volatility of buyers willingness to pay in a unstructured market. Fourthly, last round valuations miss the point of volatility of expectations from week to week even by the investors and they lack applicability in the world of “staged” / multi class fund raising environments that we have in VC. And finally, the conservative principle underlying valuations makes everything even more dubious when companies are nothing but conservative and a going concern.
But let’s assume we have something as a fair market valuation. Good. Companies try to optimize their fair market valuation and – that is the lucky and good part of it – all investors try to more or less maximize the fair market valuation of a company. It’s a non competitive metric.
(2) Steering Valuations. No investor would under-value an investment if a fair market valuation of an unsold company is higher than what the investor might really think he can get. Let’s consider a company that performed nicely but hasn’t found a buyer or new investor for 10 years. Are you still expecting an investor to suddely pop up or a buyer buying the company? Nope. It’s out. It doesn’t offer anything. Is the liquidation value necessarily executable? What if the company is basically just people and unfinished products and no capex? How do you value this using balance sheet or liquidation value? Without a chance for heading to an IPO – assuming it is profitable, but it doesn’t grow enough, its revenue streams are not stable or the market position is not defensible, a classical “living dead” – and no chance of surviving, the DCF and a conservative multiple valuation and a market typical DLOM (discount for lack of marketability) will still give it some value. But on the balance sheet of the fund, it’s dead capital. Eventually, it will restructure using debt and there might be a management buy out. But if markets are competitive and good human resources hop fast, the chances are high that the company will lose its edge and eventually key personnel will run. The company will liquidate. If you acknowledge this, hey, you still can use the liquidation value of the company and you head for it. But that is not how you are steering a company. If you want to steer this risk, you have to progressively increase the DLOM to make the company basically go to zero the moment it hits an age where it won’t run on the normal treadmill of the private equity playbook. And putting founders and investment managers into the responsibility and making them suffer with this valuation decline should be the steering metric for a company.
(3) Executable prices: So fair market was about what you carry in your fair market books and your reports. Steering metrics was about increasing the efficiency of incentive systems. But the real question in the end is if the executable price or value of the company when it exits is solid. When looking at executable prices, fair market rationales break down. First of all, the company really might be unique in the sense that neither multiples, comparable transactions nor a DCF model with sensible discount factors truly represents what the market is willing to buy. How do you value an acquihire or a patent that the market expects to be worth billions when owned by a 100 million company? Secondly, multiples can be volatile or even shocked and being far off what the prior multiples looked like. This is why DCF is the worst method. No matter how much you twist your WACC or re-project your projections, you might simply miss the value at the moment you want to sell. But before we look at how evil and bad multiples are, let’s look at reasons for favourable unorderly transactions. Your potential buyers might just be in the urgent need to buy something to fill their M&A budgets and the current company might be the only target. The company might desperately need the personnel and be willing to acquihire. The patent ownership might stand in the way of a new product release and estimations for “Standing it out” against the young company might look bad. The company might be highly sought after by a competitor and the patent issue is a biggie. Identifying hot deals and hot buyers is one of the key responsibilities of a solid VC firm. Knowing who is hot for a purchase and how to place a company into the right light and radar is key and can lead to far more favorable valuations if the competitor interest is high. This becomes even more relevant if the company is not even ripe or in need of an exit and could easily head for an IPO or a PE buyout. In regular asset management (fixed income and equity private placement), prices of some illiquid instruments are determined by signalling a sale and aborting it when things get hot. That is a solid way of getting a market price or executable price for the instrument. And the same is a good strategy in private equity investments if the transaction costs are low.
But coming back to multiples, they make little sense if the buyers market is heterogeneous and the willingness to buy is less defined by orderly transaction interests that particular interests of the universe of potential buyers. This can become unfavorable and favorable, depending on the skill of the manager of the investment. But in no way this relates to any fundamental value of the company and allows for a meaningful application of comparable transactions as a means to identify company value. Worse even, if a potential buyer is in line with market multiples, this is likely a sign of being a needy buyer. If you are a company heading for an exit or a VC fund trying to maximize the sales price of the company, that’s what you have to become good at playing with.
(4) Investor and Founder “Interests”: All previous considerations took for granted that the company value is what matters to investors or founders. That is entirely off and just plain WRONG. Almost any venture, before failing, spits out a set of class shares with different features that dilute different classes different. Company value may be a shared interest metric for all stakeholders in venture capital equity investments. But what ultimately matters is the interest in the own position on a fully diluted basis. When you stop thinking about the VC funding game as a fundraising leads to an exit game that would equal the buy and sell game of a equity in public equity, you start to understand that all that matters for investors and founders is the defense of their interest position and the return on that position. And this is the tricky part.
What you maximize as an investor is the IRR and/or MOIC of your investment interest. This means timing matters for your IRR, CoC multiples matter for your MOIC, and interest or fully diluted ownership matters four your actual cash return, as well as terms negotiated during the exit – shares, warrants, cash, escrows, etc. all mess up the return on interest. So timing and interest dominates actual value of the company and the buyer is in the ned buying the company and not a set of different share classes. This misaligns interests of early and later investors and the ideal selleing price. This distortion is somewhat limited by contracts and share classes being in some sense plain vanila – no barrier option-style caps that blow up ownership if the company performs very well, mostly just liquidation preferences increasing ownership if things go wrong. The plain vanilla case also creates an interest in “killing” a company and selling it below the value that it could have gotten to preserve interest and share in profits in some cases. Typically, good lawyers should prevent this from happening and if markets are fair and functioning, this should never occur. But in reality, these skews in interest and favoruism to exit in particular valuation windows exists and does matter.
So be sceptical and keep your eyes open. Get someone fluent in Backsolve/OPM models to help you project your interest under various financing and valuation scenarios and manage the cap table as to prevent ill-ridden incentives from entering the whole game and you are safe. Your public market, if you head for IPO, will thank you!