Effects of the Financing Environment and Intangibles
The supply of and demand for capital play an important but measured role in the valuation a company is likely to command. Capital is most restricted or expensive and valuations under greatest pressure during and following a period involving a sudden market correction or a downturn in the economy. None of us has a crystal ball for future economic growth; pricing is therefore more a function of the current or most recent nature of the marketplace. During periods of economic softening or market correction, the public markets, as well as the market for mergers and acquisitions, are in flux and directly affect venture investors’ valuation analyses. Venture investors look to the prices established in the marketplace to put a prospective exit value on their investments. The values investors are willing to pay in a public offering and the values corporations are willing to pay to make acquisitions come under pressure and typically decline during a market correction or economic downturn. There is consequential downward pressure on valuations during these periods and, at times, a disconnect between a company’s expectations with respect to valuation and those of investors. As a result, the feeling in the marketplace is a tightening of sources of capital.
A number of intangible elements influence the ultimate valuation an investor is willing to give a company. These intangible elements are all factored into an investors’ assessment of risk.
First and most important, assessment of management quality and experience will directly influence assumptions regarding how an investor’s ownership percentage may change over time. The more management needs to be augmented, the greater the potential dilution that future needs in terms of options will have on the ultimate ownership percentage of an investor. Most investors generally start with the assumption that a base of at least 10 percent of the capitalization of the company needs to be provided for management. This figure can grow to up to 20 percent, depending on holes in the management team. Second, assumptions about revenue growth are often a source of disagreement between entrepreneurs and investors. They are arguably somewhat fungible, particularly when signed contracts cannot be used to support an entrepreneur’s projections. Third, every company has unique product development, as well as customer adoption risk. How an investor assumes either will pan out for a company will influence the investor’s assumptions regarding revenue growth. Fourth, the strength of a company’s competitive advantage and ability to create escalating barriers to entry are sometimes debatable. Fifth, the quality of the business plan and the market data, as well as testimonials, is important not only for a current round, but also in positioning a company for subsequent rounds of financing.
Finally, and perhaps most intangible, the “sexiness” of a deal in the eyes of an investor can work for and against a company. Beauty is truly in the eye of the beholder. A space perceived to be hot and inflated will typically come under valuation pressure. While the best venture investors are drawn to investments in industries they know well, it is difficult to predict how their industry bias and personal experience will influence their valuation.
Risk and Exit Strategy for Investors
Intangible risk is a very subjective measure when it comes to evaluating and valuing an investment. Similarly, the extent to which a company and an investor agree on likely future revenue and earnings and the timing and nature of an exit reflect the assessment of both parties of future risk. Investors will typically adjust future revenue and earnings projections to reflect the investor’s individual assessment of risk related to an investment. In the same vein, the VC is likely to adjust assumptions with regard to exit valuations and length of holding of an investment to factor in conservative assumptions about the likely timing, value, and nature of a prospective exit. The company that assumes with dead certainty it can go public at a specific valuation in a specific number of years is likely to be gravely disappointed by the valuation given by an investor who assumes that company is likely to generate an exit in a longer period of time through a private sale that might well be priced at a discount to the public markets.
Future Capital Needs
The extent to which companies will or may require future rounds of financing creates the opportunity for further disparity between the valuations placed on a company by investors and by its founders and employees. VCs will almost always assume that earlier-stage companies will require more time and more financing than the company projects. Management teams who believe they can do more with less, in less time, are the source of the entrepreneurial drive that ultimately propels a company forward. But more often companies face unforeseen challenges that require additional funding or slow the pace of progress. The time value of money is a critical and central factor in how investors establish their projections. When investors feel it is prudent to allocate more time and more money in their assessment of the investment horizon for a company, valuations are inevitably affected and drawn down.