About 6 months ago I did some research for a presentation I was asked to do for the board of directors and senior management of a large credit union. The topic they wanted a briefing on was the causes and implications of the subprime crisis on Australian lending institutions.
I concluded that the following were the root causes:
1. Extremely low interest rates (enabled people to borrow who could not otherwise service a loan; this also tempted investors to chase higher yields, unfortunately in products they didn't really understand)
2. Fierce competition in lending (encouraging lenders to take more risk to drive growth)
3. Incentives which worked very well (mortgage brokers earned commissions so they were incented to write the loans; investment bankers got large bonuses for packaging them up and selling them to people who didn't really understand the risks of the products)
For a number of years the sales people and deal makers were in charge and now the risk people are in charge.
The pendulum will eventually swing back but not before quite a bit of pain has been inflicted, quite a bit of it on innocent bystanders.
But I am optimistic. Down markets and times of fear and panic are great opportunities for clever buyers!
That of course is a view from a long way off - here in Australia. But the repercussions in Australia have been heavy with a few companies (RAMS Home Loans, Allco) coming undone that had a dependence on securitization and wholesale funding.
Sunday, March 23, 2008
Friday, March 21, 2008
Start Up Company Valuations - the upper boundary
I had a talk with Aaron Fyke from Starfish Ventures recently. Aaron is originally from the US and is now a clean tech investment specialist with Starfish in Melbourne Australia. He got me thinking about valuation of early stage companies by potential investors.
Valuation of early stage companies is hard. Often its just valuing an idea or a concept. There is little or no revenue, only negative cash flow and frequently few or no customers.
Here are some guidelines:
1) Because there is considerable guesswork and estimations and fairly long time horizons, discounted cash flow methods are not commonly used.
2) Start with setting a range of what the business might ultimately be worth by looking at what companies in similar industries have been acquired for or what market cap they listed on a stock exchange at.
3) Lets say for example most recent acquisitions and IPO's were at multiples of between 10x profit and 20x
4) We estimate that we can get to $10m profit and to do so we will need total funding of $10m over 3 years
5) Investing in early stage companies is very risky so investors will want a gross return of 5x or 10x their investment back when the business is sold or IPO'd.
6) If businesses in similar sectors have sold for 10x profit and we get our business to $10m profit, then our business will be worth $100m
7) If businesses in similar sectors have sold for 20x profit and we get our business to $10m profit, then our business will be worth $200m
8) If the investor requires a return of 10x their investment and they have invested $10m, they want $100m back.
8a) So based on the 20x profit exit scenario, the company would be worth $200m so investors need to own 50% of the company when its ready for exit (50% of $200m = $100m). This is probably a do-able deal for investors.
8b) Based upon the 10x profit multiple, the company would be worth $100m, so investors would theoretically need to own 100% at exit. This is not a do-able deal because an investor cannot and will not dilute the founder and team to zero! Investors want highly motivated teams and that means the founders and team need plenty of equity as an incentive.
The moral of the story for entrepreneurs:
1) Start with the end in mind (like the eMyth says!)
- what size business are you trying to build?
- what have other companies in the same industry sold or IPO'd for?
- how much capital will it take to get there? (truth is it will probably take 2x as long and cost 2x as much as your base case to build the company, especially for global markets)
2) Work up your own scenarios to ensure its all worth while
3) Early on, talk to people who have experience in building businesses, in finance, in sales & marketing, in your potential customers and so on.
4) Make sure your target market is big enough to enable you to build a business with sufficient profits to have a shot at delivering an exit that makes great returns for everyone - founders, team and investors!
5) Even if your aspirations are much smaller, you should do a similar exercise - just what might the business look like, who might buy it and what might it be worth if you ever want to sell one day (in 3, 5, 10 or 20+ years). More on this for smaller business in future posts.
Does anyone else out there have experience with setting the upper limits on start up company valuations?
I am currently co-authoring the 5th Edition of Enterprise and Venture Capital so I welcome your thoughts, examples and alternative ideas!
Valuation of early stage companies is hard. Often its just valuing an idea or a concept. There is little or no revenue, only negative cash flow and frequently few or no customers.
Here are some guidelines:
1) Because there is considerable guesswork and estimations and fairly long time horizons, discounted cash flow methods are not commonly used.
2) Start with setting a range of what the business might ultimately be worth by looking at what companies in similar industries have been acquired for or what market cap they listed on a stock exchange at.
3) Lets say for example most recent acquisitions and IPO's were at multiples of between 10x profit and 20x
4) We estimate that we can get to $10m profit and to do so we will need total funding of $10m over 3 years
5) Investing in early stage companies is very risky so investors will want a gross return of 5x or 10x their investment back when the business is sold or IPO'd.
6) If businesses in similar sectors have sold for 10x profit and we get our business to $10m profit, then our business will be worth $100m
7) If businesses in similar sectors have sold for 20x profit and we get our business to $10m profit, then our business will be worth $200m
8) If the investor requires a return of 10x their investment and they have invested $10m, they want $100m back.
8a) So based on the 20x profit exit scenario, the company would be worth $200m so investors need to own 50% of the company when its ready for exit (50% of $200m = $100m). This is probably a do-able deal for investors.
8b) Based upon the 10x profit multiple, the company would be worth $100m, so investors would theoretically need to own 100% at exit. This is not a do-able deal because an investor cannot and will not dilute the founder and team to zero! Investors want highly motivated teams and that means the founders and team need plenty of equity as an incentive.
The moral of the story for entrepreneurs:
1) Start with the end in mind (like the eMyth says!)
- what size business are you trying to build?
- what have other companies in the same industry sold or IPO'd for?
- how much capital will it take to get there? (truth is it will probably take 2x as long and cost 2x as much as your base case to build the company, especially for global markets)
2) Work up your own scenarios to ensure its all worth while
3) Early on, talk to people who have experience in building businesses, in finance, in sales & marketing, in your potential customers and so on.
4) Make sure your target market is big enough to enable you to build a business with sufficient profits to have a shot at delivering an exit that makes great returns for everyone - founders, team and investors!
5) Even if your aspirations are much smaller, you should do a similar exercise - just what might the business look like, who might buy it and what might it be worth if you ever want to sell one day (in 3, 5, 10 or 20+ years). More on this for smaller business in future posts.
Does anyone else out there have experience with setting the upper limits on start up company valuations?
I am currently co-authoring the 5th Edition of Enterprise and Venture Capital so I welcome your thoughts, examples and alternative ideas!
Subscribe to:
Comments (Atom)
