The Cap Raise: Valuation

EDITOR’S NOTE: This article is a collaboration between Cairn Cross of FreshTracks Capital and Diane Abruzzini ’17 of Holdings, Inc. It is one of a series we will be publishing concurrently with FreshTracks Capital.  Cairn Cross co-founded FreshTracks in 2000, and has worked as Managing Partner of the firm since that time. Notable FreshTracks VC investments include SunCommon, Mamava, and Eating Well. Cairn has helped to build a true Vermont entrepreneurial ecosystem by hosting pitch events, accelerator programs, workshops, and teaching at multiple Vermont universities and colleges. He is a former co-chair of The Sustainable Innovation MBA Advisory Board.  Diane Abruzzini has built her career as a food and agriculture entrepreneur and business consultant. She was a student of Cairn Cross during her time at UVM’s Sustainable Innovation MBA program. After completing her degree, she spent time working for FreshTracks partners as an analyst. She currently works in marketing and communications at Holdings Inc, who’s wholly owned subsidiary Brokerage Services LLC is a FINRA-licensed broker-dealer.

The valuation process can be murky for both entrepreneurs and investors. Private company stock is typically a “Level III” asset under ASC Topic 820 and its value “cannot be determined by using observable inputs of measures such as market prices or models.” Fair value is estimated rather than observed through readily observable market prices.

Entrepreneurs and investors often disagree on the valuation approach that should be used in a particular transaction. Should one base a private company’s valuation on the comparable metrics for publicly traded companies operating in the same industries, or should one base valuation on the estimated present value of a projected stream of cash flow? If you use public market comparables, which metric is most important to valuation? Revenue? EBITDA? Users? Growth Rate? If estimating the net present value of a stream of cash flow, which discount rate do you choose and are you being too aggressive or conservative in cash flow estimates? Do you arbitrarily choose the mid-growth position? Every entrepreneur, venture capitalist (VC), broker-dealer (BD), and investment bank will use a variety of criteria in order to determine valuation. None of the approaches are perfect–there is no secret sauce–but there are important differences to how VCs and BDs tackle company valuations.

First, we must consider to whom VCs and BDs have responsibilities. VCs are trying to create strong investment returns for the Limited Partners (LPs) who are the investors in the VC fund. Valuation and other terms such as dividends will be negotiated to give the venture investors an investment return commensurate with perceived risk. Before making an investment, VCs rely on the business plan and financial projections supported by company documentation as well as prior investment experience among the VC partners and external due diligence efforts to determine a reasonable company valuation.

Broker-dealers are held accountable by self-regulating bodies such as FINRA and the regulations promulgated by the SEC. Now, the question of what “fiduciary duty” broker-dealers are responsible to is a legal grey area because of opposition within the industry, discussed here. For the sake of staying on topic, we are coming from the position, supported by FINRA Rule 10-22, that broker-dealers must make “reasonable examination” of private offerings. Beyond these general principles, broker-dealers must perform very specific acts of due diligence in accordance with the principles laid out under federal law.

VCs typically achieve the majority of their investment returns from a very small fraction of their portfolio. They often prefer to invest in new industries, business models, or technologies that have the ability to, if successful, create significant value for investors. In many cases, these investments occur before the company has successfully created a product or determined a target market or generated revenue.  In these cases, a VC’s “intuition” and negotiating ability come into play when determining valuation.

Broker-dealers inherently will have a more difficult time pricing true startups. This has historically not been of much consequence. Before the JOBS Act of 2012, offerings of less than $25mm were unattractive to broker-dealers because they earn commission primarily based upon success. Large legacy-model broker-dealers were uninterested in smaller offerings because their fees are generally earned as a percentage of capital raised, and a similar amount of work goes into preparing a $25mm offering as a $1B offering, with vastly different investment banking fees.

Now that the investment banking process has moved in part online, disruptors have entered the broker-dealer market, decreasing the cost of raising capital, opening up smaller offerings as a viable source of revenue. Now companies, even startups, which never thought to consider using a broker-dealer to manage their offering have a new option. Yet broker-dealers will have more difficulty pricing startups because their value is often determined by intuition or high growth market potential, rather than established industry benchmarks and suitability standards set by the SEC.

As we’ve mentioned, VCs will act in a manner that they believe will provide their investors with the highest return commensurate to risk. As such, VCs are negotiating against the entrepreneur. Broker-dealers, however, are agents acting on behalf of entrepreneurs, who are their clients. The BD will work to create an appropriate valuation so the internal rate of return, relative to risk, makes the security attractive to potential investors.

In summary: Valuation is one of several economic terms which primarily govern how much money investors make under different circumstances. VCs and BDs are both options for raising capital, and both will work with clients to come to a shared valuation. A VC is likely to work with a company that is a true startup or disruptor –- their experience will often lead them to back companies for reasons that have nothing to do with their current cash flow. A VC will negotiate for a valuation that is in the best interest of their limited partners within the broader context of that fund’s entire portfolio. A BD will work within the bounds of federal and state legislation to come up with terms that will be appropriate for a certain subset of suitable investors.