he traditional manner of assessing business plans, sitting through presentations, working out a valuation based on the revenue and profit being achieved and then setting up a deal simply won’t work in 95% of the cases. What is very obvious from my work with entrepreneurs, Angels and VC investors is that few people understand how to identify strategic value and, even if they can, have little idea of how to execute a strategic sale.
When you couple this with the fact that most entrepreneurs will approach a request for investment from a traditional revenue and growth profit perspective, you are being presented with the wrong information from the outset. Basically, you will need to take time to work with the entrepreneur to assess their strategic value potential and then work with them to build a plan for a strategic sale.
Once you have engaged in a discussion of how a strategic sale might be achieved, you can no longer build an investment case based on conventional financial value. The EBIT multiple simply does not apply to the exit and therefore it is inappropriate for the investment valuation.
A business which has underlying assets and/or capabilities which a large corporation can exploit is a very different investment proposition to that of a traditional business. These are businesses based on patents, brands, copyright, trademarks and deep expertise. The exit valuation in their case is not based on what their business can generate in future profits but how much profit a buyer can generate by exploiting their underlying assets and capabilities.
Imagine a very large corporation which has a customer base one hundred times that of the potential investee and where their customers would be highly receptive to the investee product or service. The large corporation may be able to quickly sell these products or services into an existing customer base reaping ten times the investee’s revenue, or greater, in the first year of the acquisition.
Therefore, what is the investee business worth to a large corporation which has a ready market for these products or services? The value of the investee business to the buyer is based on what the buyer can do with the investee business not what the investee can do with it. In fact, the investee’s revenue, profits, customers and numbers of staff may be quite irrelevant in putting a value on their business.
There are some markets where strategic value is the norm in the sale of a business. If you look to the drug discovery sector, you often see small development companies which get a drug to a certain stage of development and then sell it off to a large pharmaceutical corporation for the next stage of commercialization. The value of the drug is related to its potential long term revenue and the risks associated with completing the development and approval stages. Many of these development firms have few staff, no customers and no revenue. However, within that market, there are established norms for valuing drugs at different stages of development.
Unfortunately, we do not have the same set of norms across a wide variety of sectors, so we need to be somewhat creative in how we approach the initial valuation problem. You can hardly engage in a discussion of a strategic exit with an entrepreneur, say, putting the potential exit at $40 million in two years and then argue that, because they don’t have any revenue, you value their business at $200,000.
Working out a valuation based on strategic value is very difficult but not impossible. What you have to do is estimate the revenue and profits that the acquirer will generate from your business. If you have customers and some revenue and they have a customer base one hundred times yours, then it might be fair to say that the value is one hundred times your conventional valuation. Will you get that for your business? Probably not, but you will gain some portion of that value if you set the deal up correctly with the right potential buyers and ensure you have a competitive bid running when you come to sell.
It is somewhat more problematic when you have no revenue but there is a clear case for a strategic value sale. In this case, you might start by estimating what it would be worth to a large corporation and then discounting this back to arrive at a NPV for the investee business. This number then becomes the post money valuation.
However, estimating what the buyer could earn from the use of the strategic asset or capability is highly uncertain. Different buyers will have different opportunities and this might create a wide range of potential valuations. Also, you can’t be certain how long it will take to get the deal done. A delay of even one year can make a large difference to the NPV.
Of course, you have no certainty that any deal will occur. In these ventures, you are often dealing with emerging technologies, uncertain future markets, competitors who are yet to appear and IP which is incomplete and yet to be registered. The potential might look outstanding, but it still comes with a level of uncertainty and risk.
Understanding the strategic value, identifying strategic buyers and working out some crude calculations of the revenue and profit to them are essential steps in putting a present value of the investee business.
Another way in which a valuation might be arrived at is to consider the alternatives to the strategic buyer. A corporation may be willing to pay a premium on an acquisition if they can enter a strategic market early by acquiring the right product, process, or intellectual capital. That is, what would it be worth to them in additional profit if they bought now rather than wait to develop their own solution?
Large corporations generally have very high R&D costs due to their overhead costs, bureaucratic processes and higher remuneration and benefit levels. The research shows also that they are not good at developing breakthrough technologies or processes. Small firms often bring new products to market faster and with more creativity than large corporations, offering the large corporation a possible supply of innovation. The small firm that can provide a proven solution, often developed at a fraction of the cost which a large company could do it for, can sometimes be acquired for less than the corporation would have to spend developing a comparable product.
At the same time, the corporation needs to consider the additional revenue they might achieve by bringing an acquired product to market early. With a much larger existing customer base and/or distribution channel, they might readily recoup an investment even if they pay considerably more than the development cost of the product.
It might be possible to arrive at an estimate of what it would cost a large corporation to develop a similar solution. You also need to estimate the time it would take them to begin introducing the new product or service to the market. Next you should estimate how much gross margin the corporation could generate in this gap between an acquisition now and when they could bring a product to market. If you discount this gross margin back to the present by a reasonable risk rate, you will have a NPV for your investee firm.
You might also consider what a buyer would lose by not acting early. Timing is always relative to the impact of a threat on the potential buyer. Where the prospective buyer has a choice to delay doing something about a threat or problem, the strategic value is reduced. However, where a threat exists, the impact of not doing something to counter or mitigate it may be very serious.
The time factor is most impacted by the resilience of the potential buyer to withstand the threat. The lower the damage forecast, the less the need to look for alternative courses of action. The longer the time available to seek an alternative or to manage the situation, the more likely the damage can be minimized. The size of the threat is another way to estimate the strategic value of the investee firm.
In assessing the value of a potential acquisition, the potential buyer also needs to consider the impact on their business if a competitor acquired the investee firm. If the selling firm has on offer some unique product or technology which is heavily protected by patents, the corporation which misses out being the acquirer may not be able to counter the competitive effect of another company aggressively marketing the products into their marketplace. By forgoing the opportunity to acquire the firm, they may hand to their competitor a weapon which will be used against them.
Some opportunities are very time and place dependant. It may well be that the timing of the strategic sale impacts on the value to the buyer. Timing is relative to the impact of the opportunity on the potential buyer and whether the opportunity will evaporate or decline if not acted upon. Where the potential buyer has a choice (such as whether to pursue an opportunity or not), the seller needs to be able to show that the opportunity will reduce if not acted upon. The opportunity cost, that is the cost of not doing something, might be high, but it may not reduce current revenue.
In essence, the more time the potential buyer has to find an alternative solution, the lower the strategic value of the acquisition. In turn, where corporations are forced to seek solutions externally to a potential opportunity and where time is short, the more likely they are to pay a premium on the acquisition.
A good rule of thumb for arriving at the maximum sale price of a strategic acquisition is to discount the first two years of gross margin on new revenue generated by the strategic asset or services. Alternatively, what is the discounted gross margin on current revenue which would be lost if there is no acquisition. If this calculation is undertaken for the top half dozen potential buyers, some idea of the potential of the investee can be arrived at.
Once you have a determined a potential exit value, you need to decide if you have the resources to secure the strategic sale. The quality of the management team then becomes of critical importance.
The literature in the venture capital area is dominated by the quest for the ‘A team’. This is the super team. The ‘A team’ has done it all before and has the skills, capabilities and diversity to cope with anything under any conditions. Regrettably, they rarely exist and Angel and VC investors have to put up with business plan presentations from ordinary mortals.
However, that is not to say that their objective is wrong. It is simply that executives who have done it before have probably learnt from their successes and failures. They are well connected in the industry and are knowledgeable of other experienced executives and can easily recruit additional team members. For the investor, it is all about reducing risk. If they can invest in a well rounded team with experience, they have a greater chance of achieving their minimum targets.
The ‘A’ team also brings with them the following:• A knowledge of the investor investment requirements
• Willingness to negotiate a realistic valuation
• Experience with an exit
• Not as emotionally attached to the ‘product’
• Networks within the industry and with potential alliance partners
Although the venture capital market has been operating in Australia and New Zealand for over 20 years on a formal basis, there are still very few experienced management teams that have gone through a formal private equity investment and exit cycle more than once, unlike the US and European markets that have floating management teams that move from one investment with a Angel or VC firm though to exit and on to another investment.
Many of the deals brought to an investor for funding simply lack an experienced set of executives. There can be no question that the entrepreneur brings the idea, the passion, the vision and the energy, but other people usually make it work.
When the investor looks over the business plan, they are working out what activities need to be executed to deliver the critical targets and to secure the strategic sale. This might be sales, marketing, product development, quality control, setting up relationships with strategic buyers, working with advisors and so on. For each of these activities, you want to know who on the team will deliver this operationally.
The real test to be applied here is operational. Given where the business is today, can the team execute, with reasonable confidence, the activities needed to get them to the exit conditions within the target period. In some cases, the investor will be making a judgement as to their own impact on the ability of the firm to achieve such results. So the fundamental question that the investor has about the management team is: ‘Can the team and I together achieve the targets needed to exit?’ Basically, this will be a strategic sale and the management team may not be needed beyond that event. Not all proposals need the 20 year veteran or the executives recently cashed out from their recent IPO. In fact, this may be the wrong team for a clearly defined strategic exit.
However, the business proposition still needs to show who is going to deliver on each of the major activities needed to reach the exitconditions. Any weakness in the team will need to be corrected or undertaken by the investor. This is a critical time for the entrepreneur, as they need to put together a team with a high probability of meeting the targets. Some of the founding shareholders may have to step aside and new executives recruited to meet the experience requirement. Where the management team is not complete, the investor will want to see an acknowledgement that the existing management recognizes this deficiency and accepts that new talent will need to be recruited to deliver on the business targets.
The management team can be supplemented with experience from a Board of Directors, a Board of Advisors and external consultants.You also need to acknowledge that the whole notion of a short term strategic exit may not have been considered by the entrepreneur. The team which they have assembled to grow the business may be the wrong team for an exit program. It may be that they will need to change direction completely. Instead of pursuing customers, they might need to spend more resources on product development. Instead of working to generate cash, they might be better off taking a larger investment to secure a short term strategic exit.
This entire discussion may be very confronting, even ifexciting in possibilities. You may end up restructuring the business. Instead of a plan to grow the business over the next few years, you might be confronting them with a potential sale inside a year. This is going to take some discussion and planning. Once accepted, you still need to set up the investment deal.
It is unlikely that the investor will ever know as much about the product as the entrepreneur and his team. Even if the investor has a technical background, this can quickly be outdated and thus they are rarely in a position to adequately judge the quality of the product development systems or the realism of the timescales. This is, therefore, a high exposure area for the investor. So, on the one hand you have a very strong possibility of a high value exit and, on the other, a number of tasks which need to be done by the investee firm, some of which may have some uncertainty about its timing or outcome.
Before you take this too far, you need to ascertain what the entrepreneur wants to do. You can’t assume that they will want to take their venture to an exit, especially over a short timescale. Effectively you would be asking them to drop everything they are doing, change direction and take it straight to a strategic sale. If they are in the middle of a longer term plan involving developing markets, growing a business and setting themselves up as a CEO of a growth venture, this is quite a change. Not everyone will want to go on a different path.
However, you might simply ask why they are doing it? What is their long term objective? Basically, as I often express it – ‘what do they want to be when they grow up?’ Usually an exit is somewhere in their plans but is some distance off because they see how much they still need to do to build out their business and establish a reasonable level of profit to justify a good exit price. When you present them with an strategic exit possibility, potentially many times what they thought their business could be worth, they generally change their mind and come on board. But they do need to make that switch if you are to work together on a strategic exit.
Another important consideration for the investor is whether they have sufficient trust in the entrepreneur and the management team. Recall that it is the management team which will be using the investor’s funds and it is they who will have to deliver on the exit strategy. Unless the investor has faith in the team and is comfortable with letting them loose to execute on the strategy, the investor should be very wary of entering into an investment agreement.
It ishighly unlikely that the investor should expect the entrepreneur to come with a business plan in hand which sets out a strategic sale opportunity. Almost without exception, it will be up to the investor to identify the possibility of a strategic sale and to bring this to the attention of the entrepreneur. Even if the entrepreneur sees the possibility of a strategic sale, they will not know how to execute it. You can expect that the investor and the entrepreneur will need to work together to build the investment case; identifying the strategic value, selecting potential strategic buyers, working out a possible exit value and then determining what needs to be done to prepare the business for the strategic sale.
The agreed business plan is simply about execution. The business is at point A (now) and it needs to get to point B (the exit), what needs to be done to get there? You need to see exactly how the strategy will be put in place over the preparation period.
Knowing that the management team is somewhat green and will need help to develop the business for the exit, the investor needs to work with the entrepreneur to determine the investment required and the program that needs to be undertaken to drive the strategic exit.
There is nothing wrong with the entrepreneur admitting they need help to develop such a detailed exit plan, but the investor should delay making any substantial commitment until a proper plan is in place, even if they help develop it. Only by getting down to this level of detail will you understand just how much finance and effort you need to contribute, but also, just how likely the business is to succeed in getting to a strategic exit.
Before committing to the investment, you should be able to review every part of the plan and see exactly what each person will be doing to contribute to the overall plan. This should be set out in an organizational plan, including recruitment and training, office accommodation, manufacturing and warehousing space, infrastructure planning, a finance plan and a set of resulting financial statements and so on.
The more that you can define how to achieve the exit, the more convincing the plan is, the safer the investment will be.Before the Angel or VC investor contributes funds to the venture, they will need to agree with the entrepreneur some basis for an equity share – the valuation.
Entrepreneurs have always seen the initial valuation as the most important part of the investment process – as this can impact greatly on what they walk away with on the exit. At the same time, the investor sees entry valuation as the key to the investment return – if they get too little equity they may not see a reasonable return on the exit if the venture is not overly successful. Thus valuation discussions can be stressful on both parties and often emotional. Finding a path through this discussion is critical if both parties are to proceed with the investment and still retain a positive working relationship.
Historically, few Angels or VC investors have given the exit event much detailed consideration at the time of investment, leaving this to be undertaken further into the investment when they have a better idea of the market and the venture capabilities. Investors normally believe that a successful venture will provide adequate opportunities to exit and leave the exit planning to later. But in fact, this is the critical event and should play a much greater part in the investment decision. A venture with a highly probable exit path should be a preferred investment.
Valuation of an existing business before external funding and the subsequent valuation of a business with funding has to be the most controversial topic in the venture capital literature. It is the greatest source of conflict between entrepreneurs and external investors, is plagued by emotion, misunderstanding, entrenched position taking and ignorance. It has often been said that 40% of deals fail to secure VC funding due to a failure to agree a valuation. What is regrettable is that it is highly possible that many of these ventures could have made both the Investor and the entrepreneur considerable wealth.
Valuation is the process of estimating the monetary amount the firm is worth based on its future expected returns. Historically, this has been based on the NPV of the future net earnings. But this is often a highly problematic calculation.
Consider the typical early stage entrepreneurial business. It often displays some or all of the following attributes:• uncertain cash flows;
• few tangible assets;
• some specialised equipment which often becomes technically obsolete;
• few debtors;
• little inventory;
• new and sometimes unproven products or services;
• often an immature management team;
• an emerging market which is yet to be stabilized;
• no established market for shares, especially a minority holding; and/or
• uncertain timing of revenue and profitability.
So, unlike the secured investor such as a bank, the VC investor has an illiquid market in which to sell the shares, is dealing with high levels of uncertainty in the business, the market and the management team and has little security for the investment.
Which valuation method should you use?Traditional valuation methods have been established to value existing business where historical data can be used to show revenue and profit trends and where established products have a market presence. However, most emerging ventures which seek Angel or VC funding are of limited life, have little history and a somewhat speculative future. Traditional methods of valuation don’t really apply.
In order to start any sort of meaningful discussion, the conventional approach to an investor has been to write a forward projecting business plan and use this as the basis for a valuation. However, too many entrepreneurs produce fiveyear forecasts based on assumptions which are, at best, guesses as to the state of the economy, the reaction of competitors and the behaviour of prospects. Then they use complex formulae to work out a Net Profit After Tax (NPAT) over five years. From this profit forecast they calculate a valuation to four decimal places using an assumed discount rate. At the very best, it is one person’s view of the future, but it fails to recognise that any other view may be equally valid.
In truth, no one can accurately predict the future. The entrepreneur is generally going to be optimistic and the investor somewhat pessimistic. Somehow, they have to come to an agreement on a valuation or the negotiation simply goes nowhere.
Entrepreneurs should be highly averse to high valuations. While they look good at the start of the venture, they place unrealistic expectations on the business to perform. Even the slightest slippage can lose the entrepreneur his business. Investors are not known to take shortfalls kindly. Far better for both parties to agree a lower/negotiated valuation where the investor can readily make the hurdle rate and the entrepreneur has a better chance of staying in control and making a reasonable return on their effort.
Now lets throw a strategic exit into the equation. The situation may change dramatically. No longer are we talking of 3 – 5 years and considerable execution risk. It is highly probable that the exit could be undertaken in less than two years. Former plans to expand the market, develop new products and grow the number of employees may all be discarded. A new plan is constructed which focuses entirely on preparing for the strategic exit. No longer are net earnings the key factor, it is the exit valuation which determines the value of the venture, but this can be highly speculative. Depending on how successful the buyer approaches are and the timing of the exit, the potential valuation could vary from the worst to the best by a factor of 10.
In this situation, a flat percentage of the equity will be difficult to negotiate. A $500,000 investment that could result in exit values of between $10 and $100 million needs a different approach.
Negotiated valuationOne method of arriving at a valuation which reflects a better balance between risk and reward for both parties and provides a fair method of compensation for their respective contributions, is to consider what the valuation of the business may be at a future exit event and discount this value back to today’s dollars. The future exit valuation of the firm is a metric that is of real interest to both parties. If it was known with some certainty, the current valuation could be more readily determined by using a discounted cash flow methodology. The discount rate could be adjusted for higher levels of uncertainty but it would still be a place to start.
So, for example, a firm with an exit valuation of $10 million in three years with a discount rate of 40% would be worth $3.64 million now. A $1 million investment would thus gain the Investor 27.5% shareholding.
Possible alternative valuation scenarios to the above are:• The Investor wanted some higher comfort factor. A higher rate of discount could be used, say 50%, which would result in a lower Net Present Value (NPV) of $3 million giving the Investor 33% equity.
• The Investor wanted some higher comfort factor. A lower exit valuation could be used, say $8 million, which would provide a NPV of $2.9 million, giving the Investor a share of 34.5%.
• The entrepreneur is more optimistic than the Investor and believes that an exit valuation of $20 million is likely. This would give a NPV of $7.3 million and the Investor share of this would be 13.7%.
The real problem lies in the balance of risk and reward. If in fact a low exit value was achieved, both parties lose but the Investor is likely to be the one with the highest cash investment loss. The entrepreneurial team will have put in time and sweat but probably much less cash.
At the same time, if a high value is achieved, both parties would seek the upside. The entrepreneur would most likely claim that he deserves the most credit because it is his vision, business model and leadership that are probably the key to success, not the cash from the Investor. The Investor would most likely argue that the business could not have achieved the high valuation without the cash injection from the Investor. The Investor, of course, wants the lower valuation in case things go wrong and so the upside is much higher. The entrepreneur wants a higher valuation to limit the equity of the Investor if the venture proves very successful.
The Investor would like to ensure that they don’t lose any money on the deal. They are much more sensitive to a loss than to a significant gain. Thus there is considerable pressure on them to push down the valuation. However, a lower valuation means that the entrepreneur makes much less on exit and, therefore, is not as motivated to go through with the deal or work hard to make the exit happen. The Investor needs to find a valuation figure which strongly motivates the entrepreneur.
External investors can use a variety of techniques to achieve this balance. One simple technique is to set the return to the Investor at a specified rate of return. Any excess over this amount from the exit goes to the entrepreneurial team. Another technique is to set the external investment as preference shares with an accumulating dividend. Since preference shares are paid out before ordinary shares, the investor will recover some or all of their money before other shareholders share in the proceeds. An Investor might also have some ordinary shares to give the Investor a share of the higher exit valuations.
Some external Investors use options to provide additional incentives to the entrepreneur and senior management to allow them to accumulate additional equity in the business. The options may be set against certain milestones or performance targets which represent higher potential exit proceeds. The entrepreneur gains a greater percentage of the proceeds as the options kick in at higher exit valuations.
An anti-dilution clause in favour of the investor in an investment funding agreement has the effect of protecting some or all of their investment in the event that the valuation falls with a subsequent funding round. This clause adjusts the shares of the Investor so that their original investment retains its monetary value under the new valuation. In this situation, it is the original founders who suffer the negative adjustment. This type of adjustment, however, typically will not be readjusted with subsequent higher valuations.
A solution for both parties lies in negotiating a valua