My kids are inclined to binge TV-watching, especially in the winter, and this Christmas break, when they were all home, they were at it again. Having gone through all the Walking Dead
episodes during the summer and Criminal Minds
multiple times, they chose Shark Tank
as the show to watch in marathon format. For those of you who have never watched an episode, it involves entrepreneurs (current or wannabe) pitching business ideas to five ‘sharks’, who then compete (if interested) in offering capital (cash) for a share of the business. Like some large families, we make even TV watching a competitive sport, especially when there are multiple shark offers on the table, with family members ranking the offers from best to worst. In one episode, a contestant was faced with two offers: the first shark offered $25,000 for 20% of the business and the second one jumped in with $100,000 for 50% of the business. While one family member suggested that the second offer was obviously better and everyone else in my family concurred, I was tempted to argue that it was not that obvious, but wisely chose to say nothing. A late night family gathering is almost never a good teaching moment, especially when your own children are in the audience.
Pre-money & Post-money: The VC playbook
In public company valuation, the contrast between pre-money and post-money valuations almost never is an issue, but in venture capital valuation, it is front and center. Given the central role it plays in venture capital investing, and the consequential effects it has both on capital providers and capital seekers, I assumed that the venture capital playbook would have detailed instructions on the contrast between pre-money and post-money valuation, but I was wrong. In fact, here is what I learned from the playbook. If you pay $X for y% of a business, the post-money value is the resulting scaled-up value and netting out the cash influx yields the pre-money value:
- Post-money value = $X/y%
- Pre-money value = $X/y% – $X
Using the Shark Tank episode in the last paragraph, you can compare the two offers now in post-money and pre-money terms:
Thus, the two offers effectively attach the same value to the business and at least on this dimension, the entrepreneur should find them equivalent. While the VC definition is technically right, it is sterile, because if you have a pre-money value for a business, you can always extract the post-money value, or vice versa, but both estimates are only as good as your initial value estimate. It is also opaque, because the process by which value is estimated is often unspecified and and made more so when the simple exchange of capital for a share of ownership is complicated by add ons, with options to acquire more of the business, first claims on cash flows and voting rights thrown into the mix.
While some of the opacity that accompanies pre-money and post-money valuations is related to the fact that you are dealing with young, start-ups, often without operating histories or clear business models, I believe that some of it is by design. By leaving the discussion of value vague and/or making the exchange of capital for proportion of the business complicated, venture capitalists can create enough noise around the process to confuse entrepreneurs about the values of their businesses. By the same token, the sloppiness that accompanies much of the discussion of pre-money and post-money valuations in venture capital can also lead to excesses during periods of exuberance, where the fact that too much is being paid for a share of a business is obscured by the confusion in the process.
Pre-money and Post-money in an Intrinsic Value World
I know that intrinsic valuations (and DCF valuations, a subset) are considered to be unworkable by many in the venture capital community, with the argument given that the young, start-ups that VCs have to value do not lend themselves easily to forecasting cash flows and/or adjusting for risk. I disagree but I think that even if you are of that point of view, the path to understanding pre-money and post-money values is through the intrinsic valuation of a very simple business.
The Franchise Stage
Let’s assume that you are politically connected and that the government has given you a license to build a toll road. The cost of building the road is $100 million and to keep things really simple, let’s assume that the government has agreed to pay you $10 million a year in perpetuity, that you live in a tax-free environment and that the long-term government bond rate is 5%. To get a measure of the value of the license, all you have to do is take the present value of the expected cash flows, net of the cost of building the road:
- NPV of road = -100 + 10/.05 = $100
While a conventional accounting balance sheet would show no assets and no value for the business (since the road has not been built), an intrinsic value balance sheet will show this value:
Note that the $100 million value attributed to you (as the equity investor) in the intrinsic value balance sheet is based on a notional toll road, not one in existence.
The Capital Seeking Stage
Now, let’s assume that you don’t have the capital on hand to build the road and approach me (a venture capitalist) for $100 million in capital that you plan to use to build the road. Assuming you convince me of the viability of the business and that I invest $100 million with you, here is what the balance sheet will look like the instant after I invest.
Note that the business value has doubled to $200 million, with half of the value coming from the cash infusion. That cash is transitory and will be used by you to invest in the toll road, and the minute that investment is made, the balance sheet will reflect it.
While the value of the business has not changed from the post-cash number, the nature of its assets has, with a physical toll road now setting value, rather than a license and cash. Thus, the value of the business after the cash infusion is $200 million and this is the post-money valuation of the company.
The Negotiation Stage
The question at this point is what proportion of your business I should get as the venture capitalist. At first sight, the answer may seem obvious. The value of the business, after the capital infusion (and investment) is $200 million, and the capital I am providing is $100 million, entitling me to 50%, right? Not so fast! The actual answer will depend upon your bargaining power (as the entrepreneur) and mine (as the venture capitalist), and the easiest way to see this is in the limiting cases:
- Case 1 – Only entrepreneur in market, Lots of capital providers: Assume that you are the only entrepreneur with a valuable franchise in the economy and there is a large supply of capital (from banks, venture capitalists, private equity investors). You (as the entrepreneur) have all the power in this negotiation and I will end up with a 50% share of the post-money valuation ($200 million).
- Case 2 – Lots of entrepreneurs with valuable franchises, a monopolist capital provider: At the other extreme, if I (the VC) am the only game in town for capital, I will argue that without me your franchise is worth nothing, and that I should end up with all of the value (thus giving me close to 100% of the business).
The reality will fall somewhere in the middle. In general, the value that you will use to compute your percentage ownership will be neither the pre-money, nor the post-money value. It will be the value of the business, with the next best capital provider providing the $100 million in capital. In the toll road example, assume that you can borrow $100 million from a bank at 7.5%, a rate that is much too high, given the risk of the investment (zero). The value of your equity in this toll road will now have to reflect the interest payments on this debt.
Cash flows after debt payments = $10 million – .075 (100) = $2.5 million
Value of equity = $2.5 million/.05 = $50 million
The new balance sheet of the business will reflect this expensive debt:
Note that the bank has effectively claimed $50 million of the value of the business by charging you too high a rate and netting out the bank’s surplus yields a value of $150 million for the toll road, the “ownership value”, since the ownership stake will be based on it. As the venture capitalist, I recognize that this is your next best option and demand two-thirds of your business for my $100 million. In summary, then the ownership percentage of your business that I will get in return for my capital provision can range from 50% to close to 100%, depending on the relative supply of entrepreneurs and venture capital in a market.
1. A DCF valuation, done right, always yields a pre-money value for a business.
2. The value of a business, after a capital infusion, will have to incorporate the cash that comes into the business, pushing up the post-money value.
3. The “ownership value on which the ownership proportion is negotiated will move towards the post-money value, when there is an active and competitive (venture) capital market, and towards the pre-money value, when there is not one.
The Pricing World: Pre-money or Post-money?
As I noted at the start of the last section, most venture capitalists swear off DCF for many reasons, some justified and some not. Instead, they price businesses using a combination of a forecasted metric and a multiple of that metric (given what others are paying for similar businesses right now). Thus, if you were valuing a start-up money-losing technology firm with no revenues today, you would forecast out revenues three years (or five) from now and apply a multiple to those revenues (based on what the market is paying for public companies in this space) in the third year to get an exit value, which you will then proceed to discount back at a “target” rate of return to get a value today:
Pricing: Pre or post-money?
When you price companies, the question of whether the value you arrive at today is a pre-money or post-money valuation becomes murkier. The forecasted revenues that you forecast in year 3 is not (and often are) only based on the assumption that there is a capital infusion in the firm today but that there may be more capital infusions in the future, in which case it is a post-post-post money valuation and adding cash to this value will be double counting. (As an analogy, consider the toll road example that I used in the intrinsic value section. The earnings on the toll road are expected to be $10 million a year and the toll road should trade at about twenty times earnings, given its fundamentals. Using the VC approach, the value that I would get is $200 million, which is the post-money valuation).
A pre-money pricing?
Can you modify the VC approach to deliver a pre-money pricing? Yes, and here is what you would have to do. You would have to forecast two measures of future earnings, one with the capital infusion and one without. In the extreme scenario where the start-up will cease to exist without the capital and there are no other capital providers, the expected earnings in year 3 will be zero, yielding a pre-money valuation of zero for the company. Consequently, you will demand all or almost all of the company in return for your investment.
- Pricing is opaque: While pricing is market-based, quick and convenient, the cost of pricing an asset rather than valuing it is that the process glosses over details and makes it difficult to figure out what exactly you are getting for your investment today and what you have already incorporated in that number.
- The Target rate is Swiss Army knife of VC valuation; In the VC approach, the target rate (though called a discount rate) is like a Swiss Army knife, serving multiple purposes. First, it is a reflection of the expected return you should make, given the risk in the investment, i.e., the conventional risk-adjusted rate. Second, it incorporates the survival risk in the company, i.e., the reality that many of the companies that VCs invest in don’t make it and that you have to lower the value of start-ups to reflect this risk. Third, it includes a component to cover the future capital needs of the business, with a higher discount rate being used for companies that will need more rounds of capital. Finally, it is a negotiating tool, with VCs pushing up the target rate, if they feel that they have a strong bargaining position. While it is impressive that so much can be piled into one number, it does make it difficult to figure whether you have counted all of these variables correctly and not double counted or miscounted it. It also implies that the actual returns generated by VCs will bear little resemblance to the target returns; the table below summarizes venture capital returns across VC funds over the last year, three years, five years and ten years and compares them to returns on growth equity mutual funds and the S&P 500.
|Through Sept 30, 2014; Source: National Venture Capital Association (NCVA)
- Winners and Losers: It is not clear who wins and loses in the pricing game, when sloppiness rules. In periods where entrepreneurial investments are plentiful and venture capital funding is scarce, it probably leads to venture capitalists claiming too large a stake in the businesses that they invest in, given the capital invested. During periods when entrepreneurial investments are scare and venture capitalists are plentiful, my guess it that it leads venture capitalists to overpay for businesses.
A Plea for Transparency
I am not making an argument that venture capitalists and other early stage investors shift to intrinsic valuation. While I believe that they under use and often misunderstand intrinsic valuation, I think that the attachment to pricing is too deep for them to shift. I do believe though that everyone (founders, entrepreneurs, venture capitalists) would be better served if there was more transparency in the process and we were more explicit about the basis for assessing ownership rights (and proportions). Perhaps, I will start by making myself unpopular in my household and bringing up the discussion of pre and post money valuations during Shark Tank!