Musings on Entrepreneurship and Innovation
Thursday, August 12, 2004
Structure Makes VC Industry Smart
Economies of scale, communication and coordination costs, self-interest, and cultural inertia ensure that rank-based hierarchies are likely to be with us for a long time to come. Nevertheless, it's also true that in an Information Age, the pace of change and uncertainty are increasing, to the disadvantage of such organizations. The virtues of staged investment, systematic experimentation, and peer organizations have been well known in the context of research and product development. The venture capital industry's gift to us is the legacy of one class of business organization that persuasively demonstrates that such concepts can be applied successfully at the more abstract level of venture creation. Consequently, the VC experience is fertile ground for insight into adaptations of organizational design that can be applied in other sectors of the economy, including economic development, advisory services, and other, related, forms of finance.
Pick a Number
Immediately after I made my previous posting regarding the Venture Capital Method, I read the following from Guy Kawasaki's Art of the Start column in Forbes:
Is there a general formula used by VCs to establish a company value when sales are too incipient or there are no sales yet?
...[A]t the end of the day, venture capitalists look at similar deals and pick a number out of the air. There's certainly no formula to do this.
So, ignore my preceding comments. Trust in your local VC. They know.
A Simple Valuation Model...but How Useful?
A recent del.icio.us bookmark refers to "a simple way to value a start-up company." The reference is to a valuation process that is most often referred to as the Venture Capital Method. Here's how it works:
- Develop a forecast of revenues, cash flow, or earnings that represents a success case for your company.
- Apply an appropriate exit multiple to the relevant performance metric in year 3 to 5 (e.g., a public P/E ratio times earnings or an acquisition multiple times EBITDA) in order to estimate the future value of the company. For instance, assume a success case in which earnings in year five are projected to be $5 million. Furthermore, assume that comparable companies are valued at 15 times earnings. The exit valuation of the company, therefore, could be estimated at $5 million x 15=$75 million.
- Calculate the required future value of an investor's investment using an appropriate hurdle rate (FV=PV(1+r)^n). For example, assuming a $1 million dollar investment, a five year investment duration, and a 50% IRR hurdle rate, the future value of the investment is $1 million(1.5)^5=$7.6 million. In order to achieve this return, the investor would have to own $7.6 million/$75 million=10.1% of the company at the time of the IPO to hit his or her hurdle rate.
Depending upon your assumptions regarding the amount and timing of subsequent funding rounds, you can use the preceding method in a stepwise, retrocasting fashion in order to calculate current equity splits.
As the authors of the referenced bookmark suggest, the Venture Capital Method has the virtue of being relatively straightforward and understandable. The methodology offers the benefit of making explicit some key assumptions about the company's trajectory, investor expectations, and exit timing, mode, and value. By making such assumptions visible, they are more readily discussed and tested. In short, the Venture Capital Method beats the heck out of arbitrarily drawing a valuation line in the sand and the stubborn (albeit unsubstantiated) assertion of value.
On the other hand, the Venture Capital Method, like all models, is wrong and is most useful when its flaws are recognized. There are many important assumptions imbedded in estimates of future performance, public market valuations, and hurdle rates. Seemingly minor changes in assumptions can yield material differences in valuation and ownership estimates. Taken together, use of the Venture Capital Method can result in a false sense of precision.
Ultimately, the value of a model is in how it makes assumptions visible and discussable. The collaborative development and exploration of a valuation model that involves the management team and the investor is a good way to test whether you'll be able to develop the shared understanding and commitment you're likely to need to be successful.
For a good reference on different valuation methods, including the Venture Capital Method, see Entrepreneurial Finance by Janet Kiholm Smith and Richard L. Smith.