How to Value an Investment?

There are two Primary methods used by VCs to value Private Companies.

1. Comparables

2. Net Present Value

1. Method of Comparables.
1. Most commonly used in the venture capital world. 2. Determining the valuation for the company of interest by examining the values known to have been placed on like companies in like transactions. 3. Uses Financial Ratios such as Price Earning (P/E) ratio (mostly for Public Companies) or the ratio of TEV/EBITDA or TEV/Revenue.

Identifying Comparable Companies.

The companies being compared to must belong to the same Industry as the target company. The closest comparables are the target companys competitors. The revenue (Top Line) of the comparison companies must be same as the revenue of the target company. The Cost Structure of the Comparison and Target companies must be then same in terms of expenditures on Marketing, R&D etc. The Year on Year Growth rates of the two companies must be Similar. The Distribution strategies of the companies should be similar eg Direct Sales or Distributor based. Do the Companies have a similar prospect of Profitability.

Identifying Comparable Valuations.

The Venture Capitalist or Entrepreneur must approach the Problem in Several Ways. 1. By Looking at the Value placed on Publicaly traded companies. 2. By looking at price paid for related private companies when they are acquired by another company. 3. By studying any recent similar venture investment.

Comparable Valuations.
1. Using Publically Traded Companies (PTCs).

Pros. Data Readily Available on a Daily basis. Many investment banks and trade analysists prepare research reports on such companies which can be looked upon for a detailed analysis.
Cons. Public Traded companies are usually of a much bigger size than a private company. Thus PTC is a much more stable company and hence less risky. PTCs are mostly always profitable and have a positive cashflow. This is not true for Private companies. Again positive cashflow implies lesser risks. PTCs have a consistent positive financial performance and thus attain the status of a Public firm. However Private companies either havent been around long enough to have much of a history or are in a expanding state and thus have a financially flat record. PTCs have much better Liquidity and solvency compared to Private companies.

Nevertheless, with appropriate adjustments, Comparison with PTCs can be made.

Using Mergers and Acquisitions Transactions.

Depends on historic data. It sees what prices have been paid for comparative private companies, that have been acquired in M&A transactions.

Pros. Since it is direct value based method, it covers the Liquidity and Size concerns that are raised in using PTCs method.
Cons. Detailed Financial Information on M&A transactions are usually not available as they are bound by contracts. Thus critical ratios such as TEV/Revenue or TEV/EBITDA are not readily available. Thus drawing a proportionate Value for the Target company may become a difficult task. If a M&A is done for a very specific reason such a for a Specific Technology or Strategic reason, then the buyee company may overpay for the M&A. In that case, one must observe caution in using the data of that firm. Nevertheless, Even though M&A data is not readily available, it is accessed via a number of sources like Financial press, Balance sheets, Income Tax statements, investment banks and M&A consultant companies. Overtime the details are made public and recorded. Using such data and making corrective changes, we can compute proportionate value for our Target Company.

Using Other Venture Investments.

Uses direct references to other venture investments made by VCs in other comparable companies, provided those investments were correct. It utilizes the database of VC firms (specialists). A good way to judge the present worth of a entrepreneurs firm and of a Competitor.

Metrices to be Used.
Once the Comparable companies have been determined and their Data as well as the Transactions that valued them collected, it is time to apply those values and data in finding the value of the Target Company. For this various Ratios are computed and boundary of Evaluation Values are calculated. The value of the Target Company will lie between this Bounded Region.

Metrices.
Metric P/E Ratio Use Always a useful ratio. But mostly unavailable as most venture investments are in Non Profitable companies or Companies under recovery. Always useful. Eliminates the distortions of different capital structures inherit in P/E. Venture Investments are usually in Companies that are EBITDA negative. Useful in cases where company has Revenues. Not so useful for Start-Ups. Useful in cases where company has Gross Profits. Not so useful for Start-Ups or Expanding firms. Caution If unavailable, use forecasts for calculating Profits but also include uncertainity factors. Not to be discouraged by a negative EBITDA.

TEV/EBITDA

TEV/Revenue

Must ensure Cost Structure of Comparision companies is similar. Cost Structure of Comparision companies is similar under Gross Profit Line.

TEV/Gross Profit.

Metrices
Metric TEV/ Actual Revenue Versus TEV/ Forecast Revenue Use One of the best ratios to use. Since most Venture investments are made in fast-growing companies; only using Historical data can penalize the investment firm. However since there is limited Historical data available in the first place, accurate forecasts are impossible to make. Thus the best approach is to use both the timeframes in making a estimate value proposition. Caution Make necessary adjustments and corrections, wherever required, in both the historic and forecast data.