Wednesday, February 4, 2015

Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations

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.


Implications
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.

Implications

  1. 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. 
  2. 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)
  3. 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!


13 comments:

Max Power said...

"Consequently, you will demand all or almost all of the company in return for your investment."

It's a very interesting analysis, but my intuition says that it could be wrong. The fact that I have a franchise means that it must be of some value. Therefore I, as an entrepeneur would expect to see some value out of it. And why would you, as a VC, invest in a venture which you calculated has a value of 0?

My hunch is that it crosses over into the area of Game Theory, which can lead to surprising and counter-intuitive solutions.

I work in the area of Hydrocarbon Accounting, where partners use pooled resources. The principle is that costs should be shared "fair and equitably". It's a simple principle, but some strange internal contradictions can arise. It's not that anyone is out to "con" anyone, it's just that some strange mathematical "artifacts" can occur.

I think the issue may run deeper than you realise, but I'm not sufficiently knowledgeable to be able to offer pointers as to how to investigate the matter further.

Aswath Damodaran said...

Max,
That is because you will almost never have a monopolist capital provider. You will find someone (a money lender, a family member) who will provide the capital in an extremely inefficient way, but still beat the monopolist. So, perhaps the right way to think about this is that your proportion will tend towards zero, as the VC becomes more dominant.

Carlos Henrique said...

Prof. Damodaran,

Let's suppose a scenario, in an environment with few entrepreneurs and many VCs, where the capital inflow makes the business less risky, thus aggregating extra intrinsically value . (ex. a tool road franchise contract may be worth more from the time you mitigate operational risk with available cash to perform the construction and trigger the receipt of payments).

In this case, the post-money value is not only increased by the capital injection, but also intrinsically increased by the risk mitigation.

Using your example, now the $100 (pre money tool road franchise value) + $100 (capital inflow) + $20 (exemple of value gain over discount rate shifting), could total a $220 post money value for the business.

In this case, would it be possible that, due to the lack of bargaining power from the VC, the owner of the business could keep 54% ($120/$220) of the business, or in all cases the VC captures most of this adicional intrinsic value?

Aswath Damodaran said...

Carlos,
It is possible that there are some risks (distress and truncation specifically) that could be reduced by the injection of capital into an investment. Since the capital provider is the one who creates this additional value, he will bargain to keep it for himself, but if capital providers are plentiful, they may end up giving up that as well.

Anonymous said...

Prof.,

Very interesting article. It is pertinent to an investment proposal I am evaluating currently, of which I have a question. I am being approached to make a convertible note that will convert to preferred shares upon the qualified financing round. I have not made early stage investments in the past and so I do not have a process to evaluate such an proposal The company has shown me IRR/Cash Multiples that I could expect should they be able to operate according to their assumptions for both a base and stress case. The difficulty I am having in assessing this opportunity is that the returns calculations are based off of the preferred shares having x% post financing. The company has zero revenues now and without the next round of financing would be unable begin operations at all. When I asked how x% was determined, the company says that they backed into the ownership by looking at their funding requirements, and the returns that preferred investors would look for given the risks present at the time of the offering. Is this a sound/fair method of determining ownership?

Juan Saldarriaga said...

Professor,
Great meeting you last year during JPM training. Just now got a chance to see this wonderful post and wanted to ask you why in the toll road example you are using the LT Government Bond rate (5%) to discount and calculate the NPV of the project instead of using some risk adjusted measure to reflect the risk of the project? You then use this same rate for calculating intrinsic value in the debt financing alternative.

Grateful and a fan always,
Juan

Aswath Damodaran said...

Because the investment is guaranteed by the government and thus risk free.

Cheung said...

This is a brilliant article. Considering that most practitioners probably had a full education/training in corporate finance and valuation, how do we end up with intrinsic value and robust methods being a rarity? The abuse of discount rates should not be the norm.

Especially with start-ups (and like Max's hydrocarbon example), almost everyone starts with cash based modelling (P&L and B/S are created from the cash). There is really no excuse for not addressing risks explicitly, in each of the drivers and other variables. A simple set of scenarios would provide a plenty of information to come up with a valuation without descending to fudging a discount rate.

This is done routinely in some of the riskiest projects/assets such as pre-discovery prospects and pre-development oil and gas assets, when partners farm-in and effectively trade stakes. Admittedly, the use of arbitrary discount rates is also fairly common despite the efforts put into directly addressing risks/uncertainties.

With easy access of computing power, if we really insist on an arbitrary opinion, then setting up a probabilistic model (very bad idea to just substitute cells in a static model with Crystal Ball functions) and we can take any percentile outcome and negotiate around these percentiles.

I wish this topic comes up more often and the opaque and arbitrary nature of pricing ventures and assets gets a higher profile.

maxime girard said...

Professor,

I am confused by your statement that says: "A DCF done right always yields the pre-money".

It appears to me as the value of the DCf should be Post-Money? Without the capital infusion, the value of the business is lower and in the extreme, as you explained, tends towards. The stream of cash flow cannot be realized therefore without the capital injection and thus the DCF should be a Post-Money valuation.

I understand that other capital provider may step in, and in this case, the business continues to have value, but it continues to be a post-money valuation, no?

If you can enlighten me here, it would be great!

Iris Woods said...

Hello Prof. Damodaran,

Thank you another wonderful article. I had a case question regarding DCFs for a startup. While I understand that the DCF method is tricky and possibly not the best idea for valuing a startup, company law in India dictates that the method be used.

So my question is this: the company is in it’s first year and its cash flow is currently negative (and is projected to be negative for the next four years).
It is expecting equity infusions 6 months from now and another round in a year.
I am trying to find the price per share.

I have forecasted future cash flows under the assumption of the equity infusion. (without that the company will probably be bankrupt)
My question is: when arriving at a price per share, do I divide the (presumably) post money valuation by the existing number of shares or by the shares that will be arrived at after the equity influx. The problem with the latter is I am trying to arrive at the current share price and therefore cannot tell what the number of new shares issued will be without knowing this. The reasoning becomes circular.

Also, the problem with forecasting cash flows WITHOUT the equity influx is that I barely get any value as this is the company’s first round of financing. The company has no debt.

Thank you so much!

Ali Hussain said...

Professor,

When valuing an IPO, what would be the approach to pre vs post IPO valuation. Assuming a company runs a plant at 90% capacity with annual growth of 10%. The IPO proceeds will be used to double the capacity. Hence, without the additional capacity, the company would hit full capacity in one year and hence experience no growth thereafter. How should the investment be valued since any forecast beyond the first year would need to incorporate the impact of additional capacity coming online for the company to grow?

Ramzi Alostaz said...

Good Day, can I use the pre-money , post-money technique for a public company raising its capital through rights issue? If I include the raised funds in my projections, means I am getting a post money valuation? Thanks heaps

Anonymous said...

Hi professor, first of all thanks for this post, it was incredibly illustrative.

I was going through the example and am having trouble understanding how you got to an implied 66.67% ownership stake assuming the next best capital alternative ($100 bank loan at 7.5%). Shouldn't the implied ownership be 75% (at which point I would be indifferent, and anything below that ownership would be better than the bank debt)? I arrived at this simply by assuming a cost of capital of 7.5%, which gives an equity value of $133.33, so $100/$133 = 75%.

Would love to understand what I'm missing. Thanks!