Valuation – How the Perception of Cost of Capital Impacts Valuation

In a recent summit related to valuation of technology companies, I attended a session on current valuations and whether there is a bubble, which is expected to burst soon. Yes – history has shown us, from the tulip craze several hundred years ago (https://myweb.rollins.edu/jsiry/Tulipmania.html) until the last technology bubble from 15 years earlier (https://en.wikipedia.org/wiki/Dot-com_bubble), there is a correlation between too much frothiness and peak valuations. One hears from this week's panels that believed that the valuation offer for Uber or Salesforce had been too high, and then regret being an investor in that round.  It reminds me of the story of the Great Depression when the investor was receiving stock picks from his shoe polisher. And this week's conference demonstrates that even experienced Ivy League MBAs feel that their concept of valuations underestimated the true value. Or it could be the beginning of joining a new band wagon that accelerates valuations in spite of the company's multiples. It also shows that the art of establishing the right valuation does not rely on a simple business school yardstick or algorithm, but economic trends that impact the numbers as well as the investor profile. So during a pitching session, I noted that a company's Powerpoint identified the company's valuation at the end. I recommended leaving that valuation blank, since it is a moving number. And I told him that stating a number might be a deal breaker – if too high, the potential investor might walk away. Too low, and the company or earlier investors might complain. Generally, I recommend leaving it blank while having some numbered range in your head that fits the investment profile and then begin a point of negotiations to see what the investor expects or hopes for.

I had at this same conference the opportunity of discussing his thoughts about the valuations for a specific company in Palo Alto, CA. He replied that this PA company had established too high a bar for his VC to be interested. And the company refused to budge from that number. And if the company gets that investment from another VC firm, time will tell – usually in the span of 4-7 years – who was right, and who was wrong. Given the fact that a VC's portfolio will have a 33% batting average, the likelihood that the VC guy is right, and the company wrong, falls into the VC perception of valuation.

But look at this matter from the perspective from the company. Everyone knows the current trend of high valuations in Silicon Valley. Soon enough, that peak will become a valley. So he throws a higher end offer, but apparently, this offer had been too high. I also know another company in the semi-conductor space, which valuation brings about the sarcastic question from the potential investor – “how did you reach that valuation number?” And I know the founder of this company and why sets up such a high valuation – as a means to retain to control the company after the investment.

From these situations, one can glean that the professional investor will reach a number that meets the expectations of the limited partners and what is the average valuation for similar companies in the same industry. The company will attempt to get the cheapest cost for capital. However, I see many of these companies don't understand the process on how these VC firms reach their perception of valuations. And VC firms have one set of numbers, and so do Corporate VC firms – with the higher ROI demanded by the former.

And guess what, the 5T's are the basic criteria. (For more on the 5Ts, look at a previous blog.) The cost of capital is directly proportional to the risk involved in investing in that particular company. Since growth is a business school barometer of the potential valuation, Traction is key. But to reduce risk, the VC looks at the Team. In other words, the prospective company must look to mitigate every risk imaginable for the potential investor in order to reduce the cost of capital. And they look at other factors.

As a real life example, I am involved in a medical device company that requires over a $1 million to reach traction. There are three steps here: prove that the device works, whether someone is willing to purchase it, and whether 10X sales are achievable. The potential investor offered $1 million for 40%. High cost of capital for a first round of funding. Why? There is no solid proof that the device actually works. That offer was not accepted, as we knew that the important hurdle to cross is to have some clinical trials about the validity and effectiveness of the medical device. Once that is proven, that capital should cost about 20% of the company, not 40%.

Another example is a semiconductor sensor manufacturer attempting to raise $10 million for expansion. Every time it goes out to raise that round, it hits a hurdle – too high a cost of capital. Why? It has 2 major weaknesses. Its projected sales growth is less than $30 million in 5 years – far less than 10X. Its other weakness is the Team. It has Traction with decent sales to Intel, and with several patents under its belt, it has the Technology - another "T". But not enough to surmount the risks and return factors. Hence, any experienced investor is seeking no less than 25%-35% of the cost of capital.

And even these yardsticks can change. If the technology bubble bursts, then we will see higher cost of capital than average. To loop back to the beginning, the cost of capital varies based on how the market behaves, the type of investor (VC vs. Corporate VC), market sector, and the points awarded for each T (note that I refer to a point system during due diligence by VC firms in an earlier blog). Those companies that receive a lower cost of capital are the ones that fulfill or understand the VC risk evaluations.

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