More than once a week at Spectrum there is a conversation that goes something like “Our view of the company’s valuation is….” and then the other side replies “But you are not considering the intrinsic value.” To which we would unfailingly reply, “That is correct.” All too often, founders and early stage investors get caught up in this idea of intrinsic value because they want it to be there so badly that they overlook the simple fact that intrinsic value has nothing to do with valuation from an investment standpoint.
What is Intrinsic Value?
Intrinsic Value is the value placed on a company based upon its “brand positioning” or “all the work that it took to build the company” or some other senseless metric. The theory is that because a company exists, and has a following, or was expensive to start or because the founders passed up on a lucrative job somewhere else, that somehow enterprise value has been created and therefore should be considered in the valuation of a company by a venture capitalist.
Valuing A Company and its Assets
The next question, often asked after the other party is relatively hurt by the sudden realization that there is no such thing for a venture capitalist as enterprise value, is “How DO you value a company”. Unfortunately, only really three ways of valuing any company and these are largely universal methods which apply both to the assets of the company as well as to the company itself.
Valuation Method #1: How Much Can You Sell It For
This should appear the most straightforward valuation method as it is about terminal value. This is the question of what someone is willing to pay, today, in the orderly disposition of a company or an asset. There is a great story of a company whose CEO insisted that their company’s intellectual property was worth AT LEAST $50 Million and the CEO spent a good ten minutes explaining why it was worth so much money having to do with all of the brilliant minds that worked on the intellectual property and how revolutionary it was. The response to this assertion was “Do you know of anyone today who would pay $50 Million today for the IP?” the CEO responded “Well, no but that’s because…” and listed more insane excuses.
When asked, “Well, if more people knew about the IP and knew it was for sale, do you think someone would pay $50 Million?” the CEO again responded in the negative and when asked how much someone would actually pay for the intellectual property the CEO indicated that the company had been offered about $8 Million for the intellectual property along with some other assets but that the CEO doubted that offer was still available.
Valuation Method #2: How Much Can You Rent It For
Not all companies or assets need to be sold in order to have value. For example, much of the real estate industry is based upon the idea that commercial real estate is best valued as a multiple of the income stream that the property can produce irrespective of the historical cost of the asset or even the replacement cost. Similarly, most companies exist to sell a product or service as opposed to sell their assets. The income generated from the sale of goods and services can be similarly adapted as though the company were renting out the method of production.
To arrive at a valuation based upon renting, leasing, licensing, or otherwise commercializing an asset one need only know the likely annual cash-flow stream (net of the expenses related to commercialization) and the multiple of the cash-flow stream investors would be willing to accept. The multiple of cash-flow streams can be derived through the calculation of a given investor’s target Internal Rate of Return (IRR) as the denominator and 1 as the numerator. The target IRR is also (rationally) based on a function of the risk-free interest rate and perceived volatility over the duration of the investment.
The risk-free rate can be calculated based upon the equivalent yield of the US Treasury matching the anticipated duration of commercialization and then the only variable left is volatility. As such, to value any asset based upon its commercialization, all an investor really needs to know is the expected cash-flow from commercialization, the duration of commercialization, and the volatility of that cash-flow stream over the duration.
Valuation Method #3: What is the Avoided Cost
Avoided cost becomes a tricky valuation metric because it is inherently linked to the metric of selling or renting an asset (as being able to avoid a cost only matters if you have an expense – otherwise there is nothing to avoid). That said, avoided cost is differentiated because it is something that may be otherwise worth more to another party than it is to the company itself.
For example, the value to Coca Cola of Pepsi being eliminated to the market is likely far more than the value of Pepsi’s assets or even the multiple on Pepsi’s income stream. This is because Pepsi would be able to avoid substantial costs in advertising and marketing and could theoretically significantly raise prices if it did not have Pepsi in the market. Similarly, a company may be sitting on an asset that could be utilized to reduce the expense of another company substantially more than its own value in generating income for its owner (the standard example of this being vertical integration).
Arriving At A Valuation
Given these three methods, in order to arrive at a singular valuation figure for an enterprise, one must consider the value of the constituent components (a sum of the parts method) as well as the value of the company as an operating system. In certain circumstances, buyers may be willing to pay more for the pieces as they may be split up among different buyers or they may be able to be divested from certain liabilities (such as in the case of a sale in bankruptcy) or conversely, a buyer may be willing to pay more for the operating company because the separation of any of the pieces might lessen the company’s ability to derive value from the above (selling the patents to Apple’s products and the Apple trademark separately would greatly diminish the value of both assets as the value in the trademark is based upon the recognition of the product – similarly the value of the products is based upon their association with the trademark).
Similarly, barriers to entry are all valued in avoided cost. Everything from the monopolistic value of a company to the cost of its licensing and the value of every one of its customers can be viewed in the context of avoided cost.
Is there was value beyond the sum of the assets and why is that not intrinsic value?
There is value beyond the sum of the assets, except to the extent that the value beyond the sum of the assets of a company is always reflected in the valuation method of commercialization as that is the amount the company itself was able to derive in cash-flow from commercializing the asset as an operating company. So while there is more value than the some of the assets in their discrete pieces, there is never more value than the sum of the assets, valued together.
Why people think there is intrinsic value
Despite having no place in valuation, founders and early stage investors cling to this idea of intrinsic value because they are frequently stuck with having to justify seeking a valuation that cannot be reconciled with any rational metrics. As such, intrinsic value has become a catch-all for inflating valuations in venture capital. Frequently the requirement to increase the valuation has something to do with either historic events of the company (such as raising a bunch of money that was squandered and not wanting to do a down round despite the fact that the company is inherently worth less than when the prior investors invested) or general avarice.
Again, just because the company raised a lot of funding previously at a higher valuation has really nothing to do with valuation as many companies make extremely poor use of their funding and actually put themselves in a worse position than before their prior funding as they now have large overhead obligations and increased expectations without any appreciable value creation to support it.
Similarly, issues such as the opportunity cost of the founders has nothing to do with venture capital valuation. Just because a founder left a job that was paying them a lot more money or they could have gone to work for Google or Pfizer or McKinsey has nothing to do with what the stock in the company is worth – that has do with how they value their internal basis in their stock.
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