Venture capital valuation method
With the estimation challenges that analysts face in valuing young companies, it should come as no surprise that they look for solutions that seem to, at least on the surface, offer them a way out. Many of these solutions, though, are the source of the valuation errors we see in young company valuations. In this section, we will look at the most common manifestations of what we view as the dark side in young company valuations, and how they play out in the venture capital valuation method.
- Top line and bottom line, no detail: It is difficult to estimate the details on cash flow and reinvestment for young companies. Consequently, many valuations of young companies focus on the top line (revenues) and the bottom line (earnings, and usually equity earnings), with little or no attention paid to either the intermediate items (that separate earnings from revenues) or the reinvestment requirements (that separate earnings from cash flows)
- Focus on the short term, rather than the long term: The uncertainty we feel about the estimates that we make for young companies become greater as we go further out in time. Many analysts use this as a rationale for cutting short the estimation period, using only three to five years of forecasts in the valuation. “It is too difficult to forecast out beyond that point in time” is the justification that they offer for this short time horizon.
- Mixing relative with intrinsic valuation: To deal with the inability to estimate cash flows beyond short time periods, analysts who value young companies use relative valuation as a crutch. Thus, the value at then end of the forecast period (three to five years) is often estimated by applying an exit multiple to the expected revenues or earnings in that year and the value of that multiple is itself estimated by looking at what publicly traded companies in the business trade at right now.
- Discount rate as the vehicle for all uncertainty: The risks associated with investing in a young company include not only the traditional factors – earnings volatility and sensitivity to macroeconomic conditions, for example – but also the likelihood that the firm will not survive to make a run at commercial success. When valuing private businesses, analysts often hike up discount rates to reflect all of the concerns that they have about the firm, including the likelihood that the firm will not make it.
- Ad hoc and arbitrary adjustments for differences in equity claims: As we noted in the last section, equity claims in young businesses can have different rights when it comes to cash flow and control and have varying degrees of illiquidity. When asked to make judgments on the value of prior claims on cash flows, superior control rights or lack of liquidity, many analysts use rules of thumb that are either arbitrary or based upon dubious statistical samples.
All five of these practices come into play in the most common approach used to value young firms, which is the venture capital approach. This approach has four steps to it: