The Role of Valuation in the Investment Decision

By Steven Kam, ASA, Managing Director of Cogent Valuation
Keiretsu News January 2005

So many times I have participated in presentations and listened to the entrepreneur summarize his expectations for growth and projections of cash flows and assign a multiple to one or both of these metrics and conclude with an exit price that is five, or ten or more times the value he has placed on the company today. Often the logic and progression of assumptions hold together throughout the short presentation, and are supported by the multicolored power point slide show. But then come the audience questions; some of which are informed, and others reflecting interest it specific points delivered in the formal remarks, but not particularly useful to the decision process.

So, what should a private investor know and how will he confirm his understandings sufficiently to make an informed investment decision? Said differently, what should the fellow seeking money cover, how should he present his points, and what should he bring to bear to support his proposition of value that is so thorough that the private investor writes the check?

When we approach the subject of valuation together, we must talk about risk, and returns, and timing, and identifiable market proxies in addition to the generally held notions stemming from unsubstantiated conclusions asserted by people whom we believe to be in a position to know, but who are obviously on the opposite side of the transaction from the investor. Sellers and buyers can differ materially on their respective perceptions, but still be motivated enough by personal needs to consummate a deal.

Below, I will talk about some of the issues, questions, and answers that everyone should be talking about relative to an informed investment decision from a financial point of view. This is an article that distinguishes, in a practical manner, a Valuation from a Schmaluation.

When the seller (that is the entrepreneur who is trying to sell investors shares in his company in exchange for cash investment in his start-up venture) begins the company valuation discussion by telling the prospective investors that the company is worth three million dollars pre-money and after this one million dollar round will be worth four million dollars post-money, the first thing that comes to the investor’s mind is: “Thank you for the arithmetic lesson.”

Often times, entrepreneurs show their projections without underlying assumptions and a basic tactical plan of how the execution of certain activities will produce customers and generate revenues. The investor expects that these activities will be brought to the bottom line and represent positive cash flow. Now this is really important, because the future cash flow of the company is the critical element to the investor’s decision. That’s the piece of the story that determines whether the investment dollars will make an adequate amount of money to justify having a stake in the company’s future.

Every presentation should address the internal rate of return on a highly risky business. The investor needs to assess the annual rate of return on his investment in order to see whether he is being compensated adequately for the uncertainty of the company’s projected future cash flows actually coming to pass. This risk/return analysis on investment can be likened to the credit officer’s determination of the appropriate interest rate on a bank loan, only here becomes a much, much higher rate because the uncertainty, which can be measured and quantified through a risk factor, is much, much higher than the uncertainty associated with the payback of loan principal.

Further, when the entrepreneur tells the investor to expect five, ten, or twenty times return on his/her investment without solid empirical data as to how he can say these things, the premise for the investment is both hollow and wrongheaded in the first place. A five times return on investment dollars in three years is far different to the investor than a five times return in seven years. The holding period is critical to the calculation of the internal rate of return on investment. A return of six times on investment in one company in five years could have a lower or higher internal rate of return than another with seven times return on investment over six years. The investor is owed an explanation regarding the uncertainties of the future cash flows of alternative investments and has a clear picture of the expected annual returns on each in order to make that informed decision.

Next, what is the genesis of the entrepreneur’s multiples? You know, when he says he priced his start-up venture today based on the multiple of revenues or EBITDA or net cash flow of other similar companies, or on multiples of similar companies that recently were purchased by a financial or strategic buyer. What similar companies? And how does or will the subject company stack-up to the ones he is identifying as comparables? Are they truly comparable and how do the differences (such as operating strengths, financial weakness, business model, diversification, growth rate of revenues, respective competitive market advantages) get translated into the appropriate multiple to be applied to the subject’s metrics like revenues and cash flow? He better have a terrific explanation if he compares his start-up venture to a highly branded company and declares they are both getting the same multiple in the market. Otherwise its checkout time; take a moment to ponder your golf game.

We want lots of support for every assertion. We need presentation on meaningful ways to gauge an investment’s merits. Finally, if the presenter’s remarks sound like too much pie-in-the-sky, he must assure the investor of what steps he took in his attempt to develop supporting data and what conclusions he draws from its absence.