Venture Capital Discount Rates
The average Price Earnings ratio for the largest public companies on the London Stock market stood at 16.29, 26.12 and 8.74 on March 1st 1997, on September 20th,
2000 and on Dec 11th, 2008 respectively (A PE ratio is the number of years of post tax profits a company is worth). Therefore faced with valuing a private company, let’s say, the objective is to buy it, how would you solve the problem? Use a PE ratio? But which one, which sector, which country and at what date?
Let’s look at a framework for valuing private companies. Every sector uses specific rules of thumb alongside the traditional methods. In the software sector that special rule: valuations equate to a multiple of sales. Using a worked example let me demonstrate how a buyer might value the private US software company, Smithforce, which is in the security infrastructure space.
Firstly the psychology; sellers can’t value businesses, only buyers can. Sellers aspire to price, buyers perceive value. Each buyer stands in their unique footprint of value, looking at the post acquisition value through their lens. The acquirer has established some key facts on Smithforce and US Public company comparables.
Smithforce has an adjusted historical post tax profit of $4.6m, historical EBITDA (profits pre interest, depreciation, amortization and tax) of $6m, trailing 12 months sales of $25m, net assets of $1.4m. Future pre tax profits accruing to the buyer over the next 5 years are $7m, $9m, $12m, $15m, and $20m. Capital expenditure is negligible. Research suggests that the “infrastructure sector of software” for public companies trades at a ratio of Valuation: EBITDA of 8.98 and a Valuation: sales ratio of 1.67 (real numbers from a recent Corum report). Let us assume Smithforce has a direct Public company competitor, which is ten times larger, that trades at a PE ratio of 30, EBITDA ratio of 9 and a trailing sales ratio of 2.52. Similar acquisitions to Smithforce completed in the last 12 months, whilst virtually unusable in a declining market, let’s say show on average, prices paid to sales ratios of 1.8.
Building a table of logic from this data produces the following:
(Note private companies often attract discounts of 25% to 50% compared with public company comparables to reflect risk, lack of liquidity and scale).
Line 1 Using Sales as a basis, and applying Public Co averages adjusted for 40% discount – valuation $25m
Line 2 Using Sales as a basis, and applying Specific public company competitor with 40% dis. – valuation $38m
Line 3 Using Sales as a basis, and applying previous deals done – valuation $45m
Line 4 Using EBITDA Public Co averages with a 40% discount – valuation $32m
Line 5 Using EBITDA of a Public company competitor – valuation $38m
Line 6 Using Post tax Public company averages – valuation $34m
Line 7 Using Post tax profits of a public company competitor – valuation $83m
Line 8 DCF basis -valuation $34m
Line 9 Net Assets – valuation $1.4m
Interpretations and Conclusions> Here is where art meets science: I would lean heavily on lines 1, 4, 6 and 8, as highlighted, giving a range of $25m to $34m. In today’s declining market, line 3 is optimistic and out of touch. A valuation derived from much larger competitors, lines 2, 5 and 7, won’t fly. Line 9 tells you how much goodwill you’ve just paid! Factors that would influence me include – dependence on a few customers, level of owner benefits, exceptional costs or gains, historical growth rates, quality of product pipeline, IPR, competence of second tier management, competitive profit margin, market share, sales pipeline, simple share structure and compliant GAAP in place.
Of course a company, like a house is only worth what a buyer will pay and that is where the comparison with house buying ends.
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