How Much is my Company Worth?

This is the most common question we receive at Kosch Capital. Whether someone is raising venture capital, establishing a strike price for warrant coverage in a private company, selling to a strategic buyer, or negotiating with a private equity sponsor, every deal starts and ends with this question. I do not need to add to the voluminous tombs of textbooks on securities analysis, valuation theories, and capital structures. Moreover, you can Google the terms WACC, Terminal Value, Discount Rate, Cost of Capital, Cap Rate, etc., and hopefully Wikipedia will have an accurate entry and useful references. Instead, I would like to explain some common misperceptions and pitfalls in practical terms.

First, you should expect that others will never view your company’s future prospects and, thus, value in a more positive light than you do. Whether this is because you know better how to mitigate these risks or you are simply less risk averse, expect that others will always haircut your projections and apply a higher discount rate to your projected cash flow. You should always openly explain to an investor or an acquirer how you manage risk, but at the end of the day they can walk away from a deal; you’re stuck with it, so you are likely to be more optimistic.

Second, when looking at public comparable company valuations, your smaller private company probably cannot command the same multiple. There is a liquidity premium. Those companies are efficiently priced by the market, and their investors can get out at any time; whereas, your company’s stock has no certainty of value or liquidity until you find a buyer.

Third, growth is extremely valuable—but hard to predict—and even harder to agree on. If you built a discounted cash flow (DCF) model for your company, you know that most of your valuation was contributed by the terminal value. You applied a discount rate to your free cash flow projections for the next 2, 3, or 5 years, but then there was a big fat number for everything after you gave up making predictions, and your growth rate assumptions had a huge impact on that final number. When so much value is determined by what happens five or more years from now, good luck on finding agreement between buyer and seller with this method. Thus, expect to compromise.

Fourth, your company is worth more or less to different people. I am not talking about differing perceptions of growth and risk, like I have described above. For a strategic buyer or investor, your company may provide new customers, new distribution or new products, and efficiencies of scale might be gained by combining like businesses. Some strategic buyers may also be interested in eliminating a competitor. All of these value propositions bring something to the table that you are less likely to find with a financial buyer, such as a private equity fund. On the other hand, a private equity fund may be more aggressive about applying leverage or might be acquiring your company as a strategic add-on to one of their other portfolio companies. Therefore, sometimes you may find that a financial buyer can pay a higher price than a strategic buyer.

Fifth, the cost of capital for potential acquirers and the IRR expectations of potential investors dictate what valuation they can accept. Private equity funds typically use leverage when they acquire companies. If the amount of debt they can raise against your company’s assets and cash flow decreases and the cost of that debt increases, then that acquirer will not offer you as high a valuation for your company. We originate these loans at Kosch Capital, often referred to as leveraged loans, and the coupon rates have gone up and debt coverage ratios have gone down since the Credit Crunch began last summer. Similarly, a venture capitalist is looking at the current economy and thinking that it might take you longer to grow your business and execute a successful exit; therefore, in order to meet their IRR expectations, they will not give you as high a pre-money valuation as they would have two years ago when the economy was booming.

Each of the five points above share a basis notion: when you step into the other party’s shoes, you get a different perspective. We all want to negotiate the best price and “not leave money on the table,” but if the buyer or investor does not feel that they are getting a good deal, they will not close. I prefer to shift the expression a little… “leave something on the table for the next guy.” Valuation is an art, not a science, and the only thing we can all be certain of is that projections are usually wrong; therefore, if you really want someone else to provide you liquidity or capital for growth, understand that the deal has to benefit everyone.

Ok, Then… Where are They Hiding all of the Cheese?

Congress has been busy grandstanding about how they are going to solve the high price of oil by cracking down on speculation in the oil markets. In fact, not less than nine bills have been introduced by our elected officials, who clearly have no idea how futures markets actually work or why they even exist. Of course it is very convenient to blame hedge funds and other speculators for today’s oil prices, instead of looking at the structural problems of our petroleum based culture and the lack of leadership and political willpower to support significant investment in technology development or encourage conservation since the first oil crisis began in 1973.

Interestingly enough, the Federal government purchased and warehoused cheese during the 1970’s in an effort to support cheese prices. Prices are driven by supply and demand, so if you want to raise price levels in the short term, you must limit supply. Congress apparently believes that hedge funds are hoarding barrels of oil in their office suites in New York and Connecticut today. In truth, the futures markets and speculators are all that stands between $140 a barrel and $250 a barrel. Let me explain…

When oil prices are going up, oil refineries and end-users are more likely to hoard oil at today’s prices, because they expect that if they wait to purchase supply later, the price will be higher. Instead of hoarding, they can hedge this market risk through trading in the futures markets, and speculators support this hedging strategy by taking the other side of the trade. Similarly, producers are less inclined to pump and ship as much product today if prices are expected to rise tomorrow. Again, hoarding the cheese is prevented by the liquidity of a robust futures market, which allows producers to hedge instead of to hoard. Finally, if an oil company is considering whether to invest capital in new production, they must consider whether it will still be economically viable if current oil prices were to drop. Again, the futures market provides a trading strategy to minimize these risks to producers and their lenders.

The fact is that more trading and more participants—including speculators—in futures market drives more efficient pricing for hedging strategies that prevent price bubbles from developing. Moreover, a seemingly thoughtful proposal in Congress to limit speculation by raising margin requirements from approximately 10% today to 50% would do more than just discourage some high stakes speculators; it would have the unintended consequence of raising financing costs for fuel distributors, forcing them either not to hedge—thus increasing risk of bankruptcies and supply disruption—or to raise prices to end users to compensate.

Congress needs to look elsewhere for solutions to high oil prices. If they succeed at driving speculators from the futures market, it will have the same effect as Congress hiding the cheese.