Pricing . . .
refers to the method investors use to determine the
percentage of total equity they will require in return for providing a
company with funding.
How much equity must a company sell to attract an
investor? Unfortunately, there is no easy answer. Venture capitalists
weight many factors when deciding how much equity they want in return
for their investments. The amount of equity (or price) they want for
their money depends on:
when they think the company can "go
public" or attract a buyout,
what they expect the total value of the company to
be at that time, and
how likely the company is to reach that goal on
Investors also consider:
how much of its own money management has invested
in the company,
how much more money the company will need before
it can support a public offering, and
how likely the company is to fail and how much of
the investment they will recoup if the company does fail.
Other factors affect pricing as well. For
instance, if a venture capitalist invests all of his money in stock,
he will probably expect a higher percentage of equity than if he puts
part of his money into stock and the rest into a senior security or
debenture. An investor who puts his money into the company in stages
instead of all at once can afford to take less equity since a portion
of his money is invested only after the company has met goals that
reduce the risk of later investments. The availability of collateral
can also reduce a company’s cost of funding by reducing the downside
risk of the investor.
The stock market affects pricing too. If the initial
public offering (IPO) market is supporting high price-earnings (P/E)
ratios for businesses in the company’s industry, investors are more
likely to be enthusiastic and use a higher P/E when evaluating the
company. This higher P/E means the company can raise its funding with
fewer shares of stock. By contrast, if the market is doing poorly,
investors will tend to think in terms of lower P/Es and require more
shares to do the same funding.
Despite all these variables, venture capitalists do
make concrete funding proposals to companies that are specific about
price. How do they do it? Most often, the process goes something like
this: After reviewing the company and its business, the venture
capitalist determines what rate of return he thinks he needs to
justify the investment. He knows the return he normally requires in
similar-stage investments, but in making this one he will determine
whether the risks are greater than normal. If he usually requires a 40
percent compounded annual rate of return and this investment is
riskier, he may require a higher rate. If the company’s success is
more certain, he may take less.
Having arrived at an appropriate rate of return, the
investor next analyzes the company’s projections to determine when
he thinks the company will be ready for a public offering (or other
profitable exit) and how the company should be performing by then. The
sooner the venture capitalist thinks the company will be ready for a
public offering, and the greater he believes its after-tax earnings
will be, the lower his price for providing the funding.
After this, the investor investigates the P/Es of
publicly traded businesses in the same industry as the company.
Usually, this means that the venture capitalist compares the P/Es of
several of the company’s competitors in the present market. If there
have been any recent initial public offerings by competitors, he will
be most interested in the P/Es of those offerings. Although the
investor is really interested in the approximate P/E when the company
is ready to go public, the present P/Es of the company’s competitors
usually make the greatest impression on the investor. If the stocks of
the industry leaders are selling at twenty times earnings, and smaller
competitors are selling at between fifteen and ten times earnings, the
venture capitalist will probably pick a number between fifteen and ten
depending on when he expects the company to be ready to go public.
Once these decisions are made, the investor computes
what percentage of the company’s stock he needs to acquire in order
to give him his rate of return based on his assumptions of value,
timing, and P/Es. After this, he may adjust his percentage up or down
depending on whether he feels he has adequately considered his
downside risk or the likelihood that the company will not make its
For example, an investor who needs a 38 percent annual
rate of return may determine, that the company he is considering will
be ready for its initial public offering in five years when, he
estimates, its sales will reach $8 million and its after-tax earnings
will be $800,000. A company of that size with those earnings, he
believes, should support a P/E of fifteen. If he invests $600,000, and
no additional equity funding is needed before the company goes public,
the investor would compute his price proposal by multiplying the
company’s projected earnings of $800,000 by the P/E of fifteen to
project a value for the company of $12 million in five years. In order
to obtain a 38 percent rate of return in the fifth year, the investor
must receive five times the amount of his $600,000 investment, or $3
million. To do this, the investor must own 25 percent of the company’s
equity when it goes public in five years with a $12 million valuation.
This is a simplistic example of pricing, and it is
only one way of arriving at a valuation. The actual process can be
less analytical or more so. The investor can employ a number of
different techniques that evaluate not only the prospect of success
but also the probable value of his equity if the company is only
moderately successful or unsuccessful. He may also place more emphasis
on other methods of valuation, such as the discounted cash flow
method. Factors such as the need for additional funding and the
structure of the funding can complicate the pricing analysis.
Nonetheless, this example portrays the fundamentals of venture capital
pricing and provides management with a yardstick it can use to
evaluate an investor’s funding proposal.
How does management evaluate a funding proposal and
negotiate a better price (that is, reduce the percentage of equity the
company must sell)? First, ask the investor how he arrived at his
price. Sometimes the investor will give a detailed explanation of his
assumptions and method of pricing so that management can evaluate its
fairness. Even if the investor is vague, often he will explain when he
thinks the company will grow to a size large enough to support a
public offering and what size and how profitable he thinks it will be
then. He might also tell management what he thinks will be an
appropriate P/E for the company.
Even without this information, management can still
analyze a funding offer and respond with intelligent proposals for
reducing the company’s cost of capital. Consider the following
scenario: Zappy Computer Co. develops and markets specialty computer
software. It has current sales of $500,000 and is looking for $700,000
to fund expanded activities, which management asserts will position
the company to conduct its public offering in three years. At that
time, management forecasts sales of $20 million and after-tax earnings
of $500,000. At present, the stock market is sluggish, and Zappy’s
publicly held competitors support P/Es of between five to twenty times
earnings. Publicly held competitors with sales and earnings similar to
Zappy’s projected sales in three years are supporting P/Es of
between ten and fifteen. Six months ago, when the market was bullish,
similar companies were supporting P/Es of between twenty and thirty.
The venture capitalist says he thinks the company’s
projections are unrealistic and that it will probably not be able to
support a public offering until its fourth year. At that time he
thinks the company may have reached $20 million in sales and $500,000
in earnings. He offers to fund the $700,000 needed in return for 56
percent of the company’s outstanding common stock.
Is the offer fair? What assumptions is the investor
making? To answer these questions, management needs to conduct its own
analysis of pricing.
The first thing for Zappy’s management to do is pick
a P/E for the purpose of estimating company value. The P/Es for
similar companies range from a high of thirty in the best markets to a
low of ten in sluggish ones. Assuming a P/E of ten in the worst case,
the investor is asking for 56 percent of ten times the $500,000
earnings he projects the company will make in its fourth year. In
other words, the venture capitalist expects a return equal to 56
percent of $5 million in four years. Assuming the lowest P/E, this
means that in four years the investor expects to hold $2.8 million
worth of company stock in return for making a $700,000 investment
today. Stated another way, he expects to receive a return of $4 for
each $1 he invested four years earlier. In percentages, this is a
compounded annual rate of return of 41 percent.
Assuming a P/E of twenty makes the investor’s return
much higher. At this rate, the company’s $500,000 earnings will be
worth twenty times $500,000, or $10 million, and the venture
capitalist’s 56 percent will be worth $5.6 million, or eight times
his original investment four years earlier.
Now management should evaluate the company based on
its own projections and a fair but conservative P/E. These projections
assume the company will generate $500,000 of profits in its third
year. If management splits the difference between the best and worst
possible P/Es and uses twenty, then Zappy could be worth $10 million
in three years. To give the investor a 44 percent compounded annual
return on his investment would triple his money in three years. In
other words, the investor’s stock should then be worth three times
$700,000, or $2.1 million. The percentage of stock necessary to
generate this value would be 21 percent. This is much less than the 56
percent originally proposed.
Despite all the computations of management and
investors, the price the venture capitalist will receive for his
investment will be the one the parties agree on. The foregoing
illustration, however, does give management some clues as to how to
negotiate to reduce the percentage of equity the venture capitalist
will be willing to take and still do the deal. To reduce the price,
management must convince the investor that some of his assumptions are
unrealistically conservative or that his return on investment is too
high. (The latter may be close to impossible to accomplish.)
This can best be done by discussing those assumptions
with the investor. Several pricing assumptions are always open to
further analysis and refinement. These include the following:
A higher P/E
ratio would reduce the cost of the company’s funding. How did
the investor arrive at the P/E he chose? Have higher P/Es
dominated the industry? Is his P/E based on current P/Es in a
sluggish market? Does the investor really believe the low P/E he
chose will prevail when the company is ready to sell its stock to
The P/E employed by the investor.
Does the return his pricing proposal
generates reflect the rate of return he usually requires, or is it
significantly higher? Is the return on investment in line with
those commonly quoted within the venture capital industry? If not,
The return on investment the venture capitalist
expects to make.
How does it compare with the company’s
projections? Certainly, it will be less optimistic. But should not
the valuation be a higher number that is closer to that projected
by the company?
The future valuation of the company assumed by the
Most likely this will be later than when the company projects.
After all, things never go according to plan. But if the company’s
projections were well done, they should have provided for some of
the unexpected contingencies. If they have, perhaps the investor
should move his projected exit date forward.
When the investor expects to be able to cash out.
This may be difficult to quantify, but it plays an important role
in the investor’s pricing. Is his analysis of the downside
realistic? Does he think company failure is more likely than it
is? (Certainly, he will think it is more likely than management
does.) What does he think his likely loss will be if the company
fails? Should his expectations be mitigated by factors he did not
What the investor thinks his downside risk is.
The price of a deal can also be reduced, sometimes, by
changing its terms to reduce the investor’s risk. For instance, if
collateral can be given, the venture capitalist’s downside risk will
be reduced. Issuing senior securities to the investor can give him
priorities in the case of liquidation and thereby reduce his risk.
Recasting some of the investment as debt that will be repaid even if
the company is not successful enough to support a public offering at a
high P/E also reduces risk. Raising more of the needed money from
other sources does the same, especially if the source is management.
The most effective way for a company to use this
information about pricing, however, is for its management to conduct a
serious and realistic pricing analysis before it begins it’s search
for capital. Armed with this information and a good plan for raising
funds, management can then attempt to attract more than one potential
investor and create competition for its stock. Nothing softens an
investor’s negotiating position over valuation like a little
competition from his colleagues. See:
Preferred Stock Umbrellas,
ROI (Return on