A critical part of Espresso’s underwriting process is valuing the businesses we lend to. Doing so allows us to size loans appropriately and manage risks in our portfolio. Valuation matters because investors will only refinance a loan if it makes up a small portion of a company’s value. If, on the other hand, a loan accounts for too high a proportion of the total value of a business, other investors won’t pay it back. That means that understanding a business’s value is important, both before and after lending to it.
Below I outline why and how we value our borrowers at Espresso and how our approaches differ from those used to value public companies. I also look at some of the problems and issues related to valuation.
A crash course in valuing public companies
Public company share prices and values are available in real time. If you want to derive those values from first principles, it’s easy to source the inputs. Plus, there are armies of analysts who publish their notions of value and the assumptions on which those calculations are based. Importantly, they will probably involve some kind of discounted cash flow (DCF) model, which comprises a multi-year cash flow forecast. Those cash flows are allocated between a business’s stakeholders according to the nature of their claim on the business (senior debt, equity, etc.).
Forecasting is an imperfect science. Fortunately, analysts can use historical data and the current performance of related companies as a reality check. They can also use proxies for value, such as short-term earnings forecasts or numbers of users. If a business looks wildly different than its peers, it might be a terrific investment opportunity. Or the analyst might need to check her model. With so many people looking at each company from so many angles, you can be confident that the trading price of each stock is based on a lot of information.
Private companies are different
Unlike public companies, private businesses aren’t quoted in real time. Many don’t have positive cash flows, and won’t for a while, making reliable DCF models hard to build. Proxies for a formal valuation are also difficult to obtain or apply, since private company financial results aren’t widely shared.
So how do we go about valuing them?
No single approach to valuation is robust enough to depend upon in every circumstance, so we use a number of different techniques to estimate the value of our portfolio companies. First, we collect historical data from each company that we underwrite. We generate forward-looking models, and we stress test them to get a range of possible outcomes. But that range is typically very wide, so we need to narrow it down. Here’s how we do it:
We draw on our own experience
Exact comparisons for many of our borrowers are often hard to find. But what we can do in many cases is compare a business’s fundamentals with other companies at similar stages. For a start, we have long-term data on all of our historic borrowers, and can compare prospective clients to that data in a very structured way. We can also draw quite precise comparisons between our prospective and historic borrowers, and compare those to realized valuation data.
We also look beyond our experience
In addition to our historical portfolio data, we use external databases. Doing so allows us to compare our clients to a broad universe of private companies and to see how they rank in comparison. That speaks to quality. But to get from quality to value, we also have to look at the values of businesses in each quartile.
For example, companies in the second quartile for growth might be valued at 6.0x revenues, so we could use that as a starting point. But not all metrics carry the same weight for valuation (e.g., revenue growth might be more important than revenue per employee), so you can’t deduce valuation from a single metric.
Additionally, companies are rarely equally strong on every metric. Most are very good in some areas and less dazzling in others, leaving us to make a judgment call about how to weigh the implied valuation metrics.
We consider what other people think
Our clients have other stakeholders who have done their own valuations. One reality check for us is therefore the prices at which companies have previously raised money. Obviously, that number is a key consideration, but it’s not the only one. Did the round come with a liquidity preference? If so, what was it? 1.0x isn’t especially draconian, but a 3.0x liquidity preference has technical implications for the company’s valuation.
Liquidation preferences are the equivalent to a put at other investors’ expense, so the headline number overstates the value of the enterprise. And, other term sheet conditions are also relevant. Does a new investor have board seats? Control? Drag-along or veto rights? Each of these (and other) factors might prompt us to revise our estimate of value.
Is it all about the numbers?
Our data enables us to benchmark how well a company is performing against a number of critical metrics. That said, even the best quantitative analysis requires considerable judgment.
Some of that judgment might be around the people: How reliable are they? Have they managed through tough times before? Our assessment of managers as people informs our valuation.
Beyond the people, there’s also some pattern recognition. A product might have underlying characteristics that remind us of something that we’ve worked on previously. Or, a company might have intangibles that look very similar to a previous borrower.
In all these cases, there are two issues at play. The first is being able to recognize a particular quality, be it in the management team, the product, the company, or anything else. The second is being able to link that quality to a valuation driver.
What if we’re wrong?
Lenders and equity investors have different objectives, which are reflected in their thinking on valuation. Shareholders are looking for the potential to achieve multiples on their going-in cost, while venture lenders are less focused on the upside.
What’s important is understanding how much the company will be worth if it doesn’t hit its plan, and how easy it will be to raise new capital when the business is under stress. Our valuations are therefore geared toward reasonable expectations rather than best cases.
Valuing businesses with confidence
Estimating the value of fast-growing private companies is difficult but important. Since many of the approaches and tools used to value public enterprises don’t work in a private setting, venture lenders must use other ways to gauge how much businesses are worth.
These rely on a combination of data analysis and human judgment, and yield outputs that are robust enough to rely on. To the extent that our valuations might be off in one direction or the other, it’s important for us that we err on the side of conservatism, such that we underwrite a loan on the basis of valuations that are lower than our clients are actually able to achieve.