Commentary: The Investor's Art and Science of Valuation

Article excerpt

Every investor has had the following experience.

An entrepreneur delivers a professionally developed, spiral- bound, four-color business plan accompanied by a snappy Power Point presentation. After 20 minutes of discussion, the presenter states their investment opportunity is valued at $30 million. The logic for the valuation is based upon the entrepreneur's belief that in five years the company will have sales of a "cazillion" dollars in spite of the fact that there have been no sales to date and for only a $5 million investment today, the investor can get 15 percent of the action. The end result is the investor wasted an hour of time.

This scenario explains why investors typically get to the following key questions early on: How much money do you need? What equity percentage are you offering? What are you proposing to do with the money? How and when will the liquidity event occur? What market pain does this venture cure? And, why is your product the dominant solution?

Another more frequent and realistic scenario is one where the investor and entrepreneur have spent weeks in discussions only to discover that the investor's analysis leads to an enterprise valuation of $5 million and the entrepreneur's estimate is $8 million.

They are only $3 million apart, but they might as well be $30 million apart.

The logic is very much like buying real estate. The buyer compares the property value to sales of similar properties in the neighborhood and determines that the purchase price is above the highest range of properties sold in the last six months. If the property is commercial real estate, the buyer might calculate that it will not generate sufficient rent levels to reach a positive cash flow nor appreciate in value over time to offer an expected rate of return. A disciplined, sophisticated investor, who never become infatuated with the opportunity and remembers there are always more investment opportunities than there are investors, moves on.

Determining a realistic valuation for a given venture is a fundamental requirement for seeking equity financing. In a sense the investor is "buying" into the future value of the business when it has fully optimized its potential and is "for sale" to the public or an acquiring company.

Investors take no interest in a venture that does not have a realistic liquidity event in its future. Liquidity events are what equity investing is all about.

Many entrepreneurs fail to realize that arriving at a venture valuation is part science and part art, based upon mathematical formulas, knowledge, experience and negotiating skills. The more knowledge the entrepreneur has about various approaches to arriving at a valuation, the better they are at developing realistic valuations, defending their logic, and negotiating terms.

Investors set values based upon rates of return they hope to achieve. The rate depends upon the stage of the company and the expected time to an initial public offering. Earlier stage ventures and longer time to an initial public offering implies greater risk and a higher expected rate of return. …