The investment appraisal and valuation process of venture capitalists .... is used, which combines the elements of risk, return, and profits or cash flows in order to.
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Venture Capitalists' Appraisal of Investment Projects: An Empirical European Study Sophie Manigart Mike Wright Ken Robbie Philippe Desbrieres Koen De Waele The investment appraisal and valuation process of venture capitalists includes information gathering, the assessment of risk and required return, and the choice of a valuation method. This process is empirically studied in the United Kingdom, the Netherlands, Belgium, and France. The importance of different information sources is equal in the four countries, except that the French venture capitalists place more emphasis on personal references and the track record of the entrepreneur. The required return is lowest in the Netherlands and Belgium for every development stage of a company, and highest in the UK. The most widely used valuation method in the UK is the multiplication of past or future earnings with some price-earnings ratio. In the Netherlands and Belgium it is the discounting of future cash flows, and in France it is the book value of the net worth.
enture capitalists perform an extensive due diligence process before investing in a company. In this way. they want to minimize their investment risk by getting to know the entrepreneur or the management team, the product, and the market potential presented in the investment proposal. Due to possible agency problems, caused by information asymmetry and moral hazard issues, the screening of deals is extremely important. This has received extensive attention in the academic literature (for a recent overview, see Muzyka, Leleux, & Birley, 1996). Recent research (Fried & Hisrich, 1994; Steier & Greenwood, 1995) has shown that the due diligence process is an iterative one, where the first step is to assess whether a proposal meets the investment criteria of the venture fund (e.g., with respect to the investment stage, sector, or magnitude of the investment proposal) and whether the proposal is viable at first sight. A formal valuation of a company will only be performed when the proposal passes this initial test (Wright & Robbie, 1996). This paper focuses on the information and valuation methods used in this stage of screening of an investment proposal. Other economic agents have to value companies in other settings; e.g., investment bankers have to determine the introduction price of a new company on a stock market or they have to appraise a take-over candidate. Financial analysts have to assess whether the stock market value of a company is significantly higher or lower than its 'true' economic value, in order to decide when to sell or buy stocks (Arnold and Moizer, 1984 ; Moizer & Arnold, 1984; Pike, Meerjanssen, & Chadwick, 1993). The venture capitalist's valuation process, however, is likely to differ from the ones used for these purposes, because of the very differSummer 1997
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ent nature of the companies they have to value. Investment proposals, received by venture capital funds, are often very risky, due to the early stage of development of the company, the lack of track record of the company, or the degree of innovation of products or markets. Moreover, the companies are not quoted on a stock market, so publicly available information is limited. The present study sheds light on this neglected area through an examination of how European venture capitalists proceed in this difficult task. The valuation of investment proposals is important for venture capitalists because the value of the company determines the proportion of shares they receive in return for their investment and thus their ultimate return. It is important for entrepreneurs, too, because a valuation that is too low will lead to an excessive dilution of their share in the company. Moreover, when entrepreneurs know how venture capitalists value investment proposals, they are better prepared to adapt their business plan to the needs of investors. They will be able to produce the required information and to understand the way venture capitalists use the infomiation. Despite the establishment of general corporate finance principles, differences may arise in their application between countries. Previous cross-country studies on the behaviour of investment analysts has shown differences between markets. Pike et al. (1993) show that German investment analysts make significantly more use of technical analysis than do their UK counterparts who place more emphasis on net assets per share and dividend growth models. Similarly, cross-country studies of venture capitalists (e.g. Sapienza, Manigart, & Vemieir, 1996; Manigart, 1994) have demonstrated that they behave differently in different geographical markets: the European venture capital market is not homogeneous. It is important, therefore, to investigate the differences and commonalities between countries and to try to explain them. The present study is an extension of Wright and Robbie (1996), where the authors investigated the valuation process of British venture capitalists. Here, the scope of the study is broadened to include three important Continental venture capital markets: France, the Netherlands, and Belgium.
THEORETICAL FRAMEWORK The valuation process consists of three sequential steps. First, information is gathered on the venture, its management team, and its future prospects. Second, this information is used to appraise the risk of the venture and hence the required return on the investment, and to estimate the (future) cash flows and profit potential. Finally, one or more valuation method is used, which combines the elements of risk, return, and profits or cash flows in order to compute the value of the company. Because non-public companies have few legal information requirements, the gathering of information is more difficult than with public companies. Due to adverse selection and information asymmetry problems (Amit, Glosten, & Muller, 1993), this is nonetheless one of the most crucial phases in coming to a decision. One of the most important sources of information is the business plan, which projects the future of the company (MacMillan, Siegel, & Subbanarasimha, 1985; MacMillan, Zamann, & Subbanarasimha, 1987), together with historic accounting data (especially the balance sheet and profit and loss statement), and future accounting data (especially cash flow forecasts). Amit et al. (1993) point to the fact that the managerial track record of the entrepreneur and his or her familiarity with the product and the sector may provide some hints as to the future success of the venture. However, venture capitalists face important information asymmetries with respect to company-specific data, since the entrepreneurs may disclose only what they deem necessary in order to get the funding. They may deliberately or inadvertently withhold important information or give a biased view of important facts (Sahlman, 1990 ; Amit et al., 1993). Therefore, we expect that venture capitalists will rely heavily on reports, issued by indepen30
ENTREPRENEURSHIP THEORY and PRACTICE
dent accountants or auditors, to supplement the (accounting) numbers and information produced by the management team itself. Moreover, due to the innovative nature of most ventures, market data and the future prospects of a sector are hard to estimate. Assessing the profit potential of new products and markets is essential to the valuation process; therefore, we expect that venture capitalists will also rely heavily on external reports. The information is used to evaluate the degree of risk of the project and, hence, the required rate of return on the investment. Financial theory states that the return that an investor should require on an investment is a function of the non-diversifiable risk of the investment (Brealey & Myers, 1996): the higher the risk, the higher the required return should be. Apart from the individual risk characteristics of the project, the general economic conditions should also affect the required return. More specifically, according to the Capital Asset Pricing Model, the required return should be positively related to the long-term, risk-free interest rate and to the difference between the expected return of the stock markets and the long-term, risk-free interest rate (Brealey & Myers, 1996). Until now, there has been little research on how the different risk factors influence the required return (Wright & Robbie, 1996); this will be investigated here. Practitioners and theorists offer several, sometimes conflicting, methods to compute the value of a company from the information gathered. There are, broadly, three categories of valuation methods; methods based on expected future cash income; methods based on accounting numbers; and methods based on rules of thumb. Accounting-based valuation methods include all types of accounting valuations of the firm's assets, such as historic cost, replacement or liquidation value of the assets, or the book value of the equity. Rules-of-thumb methods may include, for example, multiplying the sales of the company by some factor, where the factor should be influenced by the profit-generating potential of that type of business, or recent transaction prices for comparable companies. Rules of thumb are often sector specific. Sometimes attempts to sell the company are used to provide a benchmark valuation, thereby moving the valuation problem to another player in the market. The above-mentioned methods are very easy to use, but they lack theoretical rationale. Moreover, they mostly require historic information, which is not available for start-up companies. The discounted free cash flow (Copeland & Weston, 1983) and the discounted dividend yield methods (Damodaran, 1994) are theoretically correct valuation methods, because the current investment is compared with the expected future cash inflows gained by the investment. It is, however, expected that the dividend yield method will rarely be used for valuing potential venture capital investments, since this type of company hardly ever pays out (significant) dividends, especially in the early stages. Indeed, most companies are cash constrained when they require venture capital in order to fund their future expansion. The expected increase in value of the venture is thus not reflected in a dividend stream in the short term, but it is hoped that a significantly higher value will be placed on the company at the time of the exit of the venture capitalist. Discounted free cash flow methods have the advantage that they do not rely on the past in order to make predictions about the value of companies. This makes them very useful valuation methods for new ventures, since such firms evidently do not yet have a track record. A problem associated with the discounted free cash flow approach is the fact that it is not easy to forecast future cash flows in a highly uncertain environment, so that the expected error of the forecast will increase (Waldron & Hubbard, 1991). Sensitivity analyses may be an answer to this problem. A further drawback of this method is that, when the time horizon used in the projections is relatively short, e.g. five to eight years, an important part of the value of the company is captured by the residual value or the exit value (Copeland & Weston, 1983). This value is very sensitive to the expected growth percentage after the projected time horizon, when the company is assumed to be in a steady state. A slight change in the growth percentage thus has Summer 1997
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a very big impact on the estimated value of the company. Recently, it has been shown that the "real option" approach (Dixit & Pindyck, 1995) may be better adapted to valuing young and highly uncertain companies, where much value evolves from the fact that options are created on the future growth based on the development of new business opportunities (Keeley & Turki, 1992, 1993: Brophy & Shulman, 1992). In the venture capital environment, there are two important types of options embedded in investment projects. First, investing now in a company creates the opportunity to invest further (if needed) and to benefit from the future growth. As with financial call options, one is not obliged to invest further. The investor can wait until new information reveals the true nature of the potential benefits. Depending on the future outlook, which has been (partly) revealed by the new information and developments, he or she can decide at that time whether or not to invest further. The fact that a further investment is a right of the investor and not an obligation gives the investor a valuable option on the value of the company. The second type of option lies in the very nature of the companies themselves. Investments in R&D or company-specific knowledge may result in future cash fiows that far exceed the initial capital outlay, but these are very difficult, if not impossible, to predict. As with financial options, a small investment may lead to a very large profit, or a total loss. Standard discounted cash fiow techniques are inappropriate to value these types of expected cash fiows, because they are deterministic in nature, while entrepreneurs are able to make valuable choices depending on the development of the company, its technology, and its markets. Although very promising in theory, the real option approach has the drawbacks of first, not being well-known as yet among practitioners, and second, being very difficult to compute, due to the assumptions that have to be made. Therefore, this approach will not be further taken into consideration here.
RESEARCH METHOD AND SAMPLE In order to empirically study the above research questions, postal questionnaires was developed. A draft questionnaire was developed in the UK and pretested with venture capitalists, advisors, and academics (Wright & Robbie, 1996). The questionnaires were translated into French and Dutch, in order to be of use in France, Belgium, and the Netherlands. They were sent to all the full members of the British Venture Capital Association in early 1994 and to all the full members of the Association Fran^aise des Investisseurs en Capital, the Belgian Venturing Association, the Nederlandse Vereniging voor Participatiemaatschapppijen and to the French, Dutch, and Belgian members of the European Venture Capital Association in late 1995 or early 1996. Follow-up reminders were sent after two to three months. The questionnaires were sent to (senior) investment managers. The response rates are as follows: 66 completed and usable replies out of 114 questionnaires sent in the UK (58% response rate); 32 out of 133 in France (24% response rate): 24 out of 58 in the Netherlands (41% response rate); and 14 out of 28 in Belgium (50% response rate). The venture managers who filled out the questionnaires were very senior: the median number of years the respondents have worked in the venture sector varies from 9.5 years in Belgium to 14 years in the Netherlands. Almost half (49%) of the responses come from independent venture firms and 29% from venture firms dependent upon a financial institution or an industrial company (captive funds). The remainder are government agencies or semi-captive funds. The Netherlands have the highest proportion of independent companies (60%), while more French companies are dependent upon financial institutions (44%). This distribution matches the sector descriptions given by the European Venture Capital Association (1996). Table 1 gives an overview of the investment preference of the respondents with respect 32
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ENTREPRENEURSfflP THEORY and PRACTICE
to the investment stage (on a scale from 1 "definitely not" to 5 "definitely must be") and the effective percentage of the number of investments during the last three years in each of the investment stages (seed and early stage; expansion and development; management buy-out (MBO); management buy-in (MBI); secondary purchase and replacement; other). There is a statistically significant correlation at the 0.001 level between investment preference and investment behavior. The correlation between investment preference and investment behavior (number of investments) was MBOs: 0.45; for MBIs: 0.46; for seed/start-up/early stage: 0.79; for expansion/development: 0.31; for secondary purchase/replacement ; 0.38 . Each of these correlations is statistically significant (p < 0.001). The Continental venture capital companies prefer investments in the development stage, in which they invest heavily. The second most important category of investments is in MBOs, except in Belgium. The British venture capitalists have a significantly stronger preference for early-stage companies than the other
Table 1 Investment Preferences of the Companies in the Sample UK (N = 66)
France (N = 32)
Netherlands (N = 24)
Belgium (N = 14)
Seed/start-up/early stage investment preference*** effective % investtnent** expected time horizon*
3.3(1.16) 17.3 (22.74) 6.0(2.02)
2.1 (1.62) 11.8 (27.37) 4.5 (2.05)
1.9(1.32) 21.0(33.01)
2.3
Expansion/development investment preference*** effective % investment** exnected time horizon***
2.0 (0.89) 29.6(22.21) 4.8(1.33)
3.5 (1.14) 31.6 (28.59) 4.9 (1.24)
3.7(1.00) 26.3 (24.7) 6.6(3.85)
42.8 (12.10) 6.4 (1.67)
investment preference** effective % investment expected time horizon
3.3(1.05) 31.2(25.76) 4.2(1.49)
4.3(1.33) 30.2(28.22) 4.6(1.20)
3.0(1.43) 27.6(19.91) 5.9(3.54)
2.9(1.61) 8.2(7.35) 5.9(1.59)
MBI investment preference** effective % investment expected time horizon***
3.1(0.97) 11.4(11.36) 4.3(1.54)
3.9(1.37) 15.3(20.97) 4.7(1.15)
2.5(1.18) 5.7(6.86) 6.1(3.62)
2.7(1.49) 9.8(9.40) 6.4(1.38)
2.6(1.17) 9.7 (13.47) 3.9(1.07)
1.6(0.77) 3.1 (6.82) 5.0(2.31)
2.6(1.45) 16.2 (14.87) 5.3(1.19)
Average (standard deviation)
6.9 (3.84)
(1.38) 17.8 (18.97) 6.1 (1.53)
4.0 (1.18)
MBO
Secondaiy pwchasel replacement investment preference*** 2.6(0.94) effective % investment ** 3.9 (5.93) expected time horizon** 3.9(1.74)
Investment preference: 1 "definitely not" to 5 "definitely must be" Effective % investment: proportion of the investments for the last three years in each of the categories Expected time horizon: number of years Significant difference between countries: *p
