By guest authors Irina Patterson and Candice Arnold
Alan: In our valuation, we generally ignore almost all the analytical things like discounted cash flows and those types of approaches and simply look at exit – and our expectation of exit is never accurate, of course – to try and figure what kind of internal rate of return we would likely get under given scenarios.
And we want to be in some place that’s in the 20%-plus range of internal rate of return. Looking at it with those metrics known and a pretty solid-looking pro forma, you can come into range of where the valuation ought to be and if it’s there and we like the company, we’re going to invest.
If it turns out it’s a high valuation or a low valuation, we don’t very much care as long as the company is, in our opinion, properly valued.
Irina: Do you think in terms of x number of returns in, say, five years?
Alan: We think in terms of IRR. What you’re saying, the proverbial ten times in five years, that really is a little over 50% internal rate of return because IRR is sensitive to both the multiple and the time. So, we’re looking at it in IRR because that takes into account the time frame of when we think there might be an exit.
We’re not as sensitive to valuation . . . because being in early-stage companies, the variables are so great that, frankly, you don’t know if you’re going to be at $15 million in annual run rate in the third year or $2 million. These are huge variables in the equation, so the highly precise valuation isn’t so important to us. It’s an important factor but it’s not the overarching factor.
One more comment on valuations – still today, despite the recession and all that’s been written, entrepreneurs are, in a general statement, are woefully ill-prepared to understand valuations. It is just such a common problem. Somebody will come in and drop a business plan on your desk, he or she has no customers, has not launched, it’s all pre-revenue and that person will sit there and tell it’s a $20 million company. It’s just crazy.
Irina: How do you feel about their unrealistic expectations?
Alan: I think it just comes with the territory. What appears to be naïveté or lack of realism comes with the territory. By that I mean, in a startup enterprise, you may have one, two, maybe three people on the management team. You just can’t be expert, on a very small team like that, in every aspect of the business enterprise, whether it be from finance to human resources to insurance to accounting to marketing to sales to product development. There are so many scales that are there that coalesce in a business that it’s very difficult when you only have like one or two people, to not have some very significant knowledge holes, to not have some very significant skill sets that are not being covered.