Everyone Is Getting Discounts… VC’s Want One Too (Part 1)

Posted by Jeff Lu on March 12, 2009

My colleague on Twitter... the 2nd time someone commented to me on VC down rounds

Last week I heard two people comment to me about venture capital firms (VC’s) making a collective effort to use the economy as an “excuse” to lower valuations… and why shouldn’t they want a discount? Everywhere I look I see clothes, electronics, cars, services and, of course public equities being sold at a significant discount from what they were sold for the same time last year.

Originally, the main purpose of this entry is to talk about private company valuations and how VCs can make capital more expensive without lowering valuation, but now I’ve decided to divide this into a 3 parts.  Part 1 will cover valuation of early stage companies, part 2 will cover how the the public equity markets are affecting private equity valuations and part 3 will cover down rounds and intricacies of term sheets.

So are private company valuations being depressed because comparable public company valuations are being depressed?

The short answer is “Yes” but valuation is more of an art than a science.  It involves 2 components: 1) the financial analysis and 2) supply and demand.

Financial valuation of companies usually involves 2 types of analysis: 1) comparing the valuation of similar publicly traded companies or similar recent M&A data points and 2) discounted cash flow; for early stage private companies that’s looking for venture funding, only the first analysis is appropriate.

For example, if I wanted to do a financial valuation of an e-commerce company, I would use comparable public companies like Amazon, GSI Commerce, Blue Nile, etc. and get an average of their valuation metrics (enterprise value/revenue, enterprise value/EBITDA).  Valuation metrics are useful data points that tell us how much the market is valuing each $dollar of revenue and each $dollar of EBITDA (earnings before interest, tax, depreciation and amortization).  The same valuation technique can be used for comparable companies that have been recently acquired.  I can get the same data points (EV/revenue, EV/EBITDA) from the M&A comparable target companies and average them to get what the M&A market is paying for each $dollar of revenue and each $dollar of EBITDA.

Now there are some caveats to keep in mind.  In the case of an acquisition, the buyer pays a premium for control of the company (control premium).  In an investment round, the VC is making a minority interest investment and not taking over the company, therefore M&A valuation data points should be discounted.  There are some discounts rates floating around but I think the Mergerstat studies are a good source.

There’s also been empirical evidence for discounts to be applied public company valuations because publicly traded equities is a liquid asset class.  People can easily sell or buy (trade) stocks on major exchanges and there is a huge market for any given stock.  The equity an investor owns as a result of their investment in a private company is not nearly as liquid.  This is also called a “marketability discount” and some discount rates based on empirical studies can be found here.

What about early stage private companies that have little or no revenue but project to grow at an attractive rate and could eventually become wildly profitable?

Financial analysis valuation methods are inadequate at valuating early stage and other high growth companies in which venture capitalists like to invest.  The return that these companies offer is typically in later years and if investment professionals only invested using financial analysis valuation methods, then many successful VC stories would never be funded.  On the same token, if VCs believed every management team’s financial model of 1000% growth year-over-year they would lose their shirts (or at least their LP’s shirts).

This is where the 2nd component of valuation comes into play: supply and demand.  When raising a round, an investor will present their business, vision and capital needs to a bunch of VCs and if the fund is interested, it will submit an offer or “term sheet” which will include the valuation of the company and how much money the fund is putting in (usually close to what the entrepreneur is asking for).  The idea is to create a bidding dynamic with competing term sheets (having options is nice).  Therefore management should present to as many VC’s as possible, at around the same time and to have interested parties submit term sheets in a small time window.  This is an important point because term sheets usually have expirations on them so you want all your term sheets in at around the same time so you can evaluate your options and pit VCs against each other to create a bidding war (this is also where engaging the services of an investment bank can really help).  This bidding dynamic can also be considered a marketplace and any good capitalist will tell you that the market is a good evaluator of intrinsic value.  The marketplace you created tells you how many VCs believe in your growth story and how much they are willing to pay for it.

At the end of the day, you’re creating a mini IPO stock market for a short period of time for your company and letting the market dictate the valuation.  However, what’s happenening in the equity public markets is distorting private company’s capitalistic mini VC market and I’ll cover that in Part 2.