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 schedule.

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 projections.

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:

• The P/E employed by the investor. 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 public?
  

• The return on investment the venture capitalist expects to make. 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, why not?
  

• The future valuation of the company assumed by the investor. 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?
  

• When the investor expects to be able to cash out. 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.
  

• What the investor thinks his downside risk is. 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 adequately consider?

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: Convertible Securities, Debentures, Discounted Cash Flow, Negotiation, P/E, Preferred Stock Umbrellas, Price-Earnings Ratio, ROI (Return on Investment).