Valuation - Neither here nor there

In my first year at IIT Madras, I learnt the difference between accuracy and precision. Accuracy is how close a measured/estimated value is to the true or actual value (assuming that one exists). Precision reflects the repeatability or consistency of measured values across different experimental set-ups and observers. Nowadays, I am reminded of these whenever I get into discussion (debate, really) on valuation.

In early-stage investing, valuation is simpler. There is no question of being either accurate or precise, since valuation has little to do with the company’s worth at that point of time. Valuation is a derived number from how much capital the company needs and the % of the company the VCs would like to own given the high-risk nature of the investment. Except for a vague sense that the market being addressed is adequately large, there is no pretense of knowing future revenues or profitability. Almost all early stage investments are through preferred instruments that are more like a loan with an option than straight equity and traditional valuation techniques are irrelevant. Brad Feld and Fred Wilson’s posts on this topic are quite insightful.

At the other extreme, valuation of large publicly-listed companies is simple too! Not so much in an absolute sense, but relative to smaller, less-predictable companies. Besides the traded stock price, these companies have dozens of equity analysts figuring out what the stock is worth and which way it will move. The true value of these stocks is as much a function of supply-demand and investor preferences, as they are of cash flows and discount rates. So, accuracy is questionable, but the level of precision is far higher. Analyst estimates and the actual stock price typically fall within a reasonable band. Most prospective investors are price-takers and the only decision to be made is whether to buy or avoid (alternately, sell or hold).

It is hardest to agree on a valuation in those companies that are somewhere between the above two extremes. In India, most investment opportunities that we see are in companies that are somewhere between $5 million and $100-odd million in size. These are often privately-held and almost always project rapid growth (that’s why they need the funds in the first place). The valuation dance gets messy, as these are neither here nor there. Given the small size and relatively early stage in their lifecycle, their future performance is subject to a high level of variability. At the same time, they are not starting from zero, and offer some basis (or at least, pretense) to link valuation to past or future financials.

I believe that the agreed valuation has little to do with the projected financials. It is a lot more about the softer factors – supply-demand for deals, relationships, competitive dynamics, bull or bear nature of the investing environment. The actual projections and valuation techniques tend to be more distracting than helpful. Traditional approaches that are used in valuing larger companies are mostly irrelevant:

• Forward P/E: This is the most popular metric, and people spend days arguing over what the multiple should be. My view is – forget the multiple, even the next 12 months’ earnings are debatable in such companies. Typically, the company expects to double earnings and the investor thinks the company will be lucky to grow at 50%. If you get past this, then try agreeing on a roughly comparable listed company. Most benchmarks are from companies that are a lot larger and less risky, and tend to vary widely even within a sector.
• Discounted cash flow: Expectations on projected growth rates and profitability vary so widely for this method is the least useful. Between a company growing at 30% (investor’s view) and 50% (company’s view), the DCF outcome varies by a factor of two.
• Other comparable deals: Baidu’s valuation is nice, but pegging off this to value an Indian internet company is a big stretch. M&A valuations are even more amusing – “Did you know that Cisco bought TinyCo for $ _ million”! Sure, but strategic buyers have an entirely different rationale for investing in start-ups.

The above techniques and numbers are ok for the both sides to separately figure out what they are willing to pay/accept. Arguing over input-metrics - growth rates, profitability, multiples – is futile. Simply ‘agree to disagree’ and move onto price. If the gap is over 30%, shake hands and get on with your lives (by the way, walking away can call any bluffs that were there in the first place). If the gap is under 30%, keep going. Time and sheer attrition will narrow the gap! Or, someone else will offer a higher price and its back to ‘take it or leave it’.

My philosophy in such discussions is simple. As an investor, I am entering a 5-year partnership with a great team going after a large market. Both sides are seriously clueless on where the company will be after 5 years. It is more important for all parties to feel positive and motivated about getting into this partnership than it is for any one party to get the best bargain. Obviously, both sides are unlikely to be wildly happy at the end of the valuation discussion. The ideal outcome is one where both sides come away thinking “I’d have been really pleased if the price was 10% lower/higher, but I am ok with this deal. More importantly, I liked the way these guys handled this.”