“It is not growth that you should be paying a premium for but “Quality Growth,” with quality defined as the excess returns you generate over and above the cost of capital” [Aswath Damodaran]
The quote above is taken from the celebrated NYU-Stern Professor Damodaran’s blog post (May 29, 2012). Professor Damodaran always stresses on ‘value’ and in fact in this particular blog post, he mentions that word a stunning 90 times!
I got a chance to interact with him at a lecture he delivered in Singapore a few months ago and his stance, views and understanding of valuation were logical, simple and laced with a healthy dose of common sense. While many may argue that he has multiple theories that are truly his, in my opinion it is a simple formula mentioned below and completely defines what ‘value’ really means. This formula should be one that all entrepreneurs looking for funding, must comprehend to add to their knowledge and in turn use the expertise gained while making business plan presentations.
(1) Reinvestment Rate = Expected Growth Rate / Cost of Capital
This may also be rearranged as:-
(2) Expected Growth Rate = Cost of Capital / Reinvestment Rate
Most start-ups are expected to reinvest all the money that is generated from operations back into the business and therefore the reinvestment rate will always be 100%, this essentially means that:-
(3) Expected Growth Rate = Cost of Capital
Based on the quote above:
(4) Value = Expected Growth Rate – Cost of Capital
(5) Expected Growth Rate = Cost of Capital + Value
As an entrepreneur and an investor, we create and expect the ‘value’ in a business to be the more than zero, for which a future investor will pay a premium. The formulae and simple expectation should be understood by all entrepreneurs that are out there looking for funding and are going to be promising “exit” opportunities to those they prospect to bring on board as investors.
There are 3 options before an entrepreneur when he/she is raising a round of funding:
- Customer Advances/Deposits/Subscriptions
- Bank Financing
Let’s look at option one: Customer Advances/ Deposits/ Subscriptions:
-This is the cheapest and best form of financing. A recent Harvard Business Review article Use Customer Cash to Finance Your Start-Up by John Mullins introduced me to this excellent form of finance, often overlooked by most start-ups.
First, it allows the entrepreneur to test the marketability of their product or service, because if the customer is willing to put down money upfront for what you have to offer – you know you are investing your time, sweat and efforts into something that your target audience really wants.
Secondly, this form of finance comes without any ROI expectations, except for the value your product or service will bring to the customer’s operations. Thirdly, and most importantly – there is ZERO dilution in equity!
Entrepreneurs have a warranted concern, that asking for a customer deposit will raise too many questions during the transaction closure, and that in turn may lead to longer sales cycles but it should also be noted that there have been businesses like Via.com (formerly Flight Raja) that have successfully marketed and benefited immensely by delivering a product that answered a pain point that customers were willing to pay upfront! Via.com is a start-up incorporated in 2006 and grew to $500 million in revenue by 2012 with VCs knocking on their door for a chance to invest into them!
Option three: Equity
This form of finance has been the most popular form of financing that start-ups want to raise. The boom in liquidity for Seed, Angel, VC and PE transactions (until 2012-13) was testament to the fact that this form of finance wasn’t just easy – it was almost reassuring. Young professionals armed with business plans and fancy degrees made business cases where investors (including yours truly) poured in billions and with high expectations of the number before the “x” just rolling up like the litre count at petrol pumps in the 1990s.
For some entrepreneurs just getting investment itself was considered to be a validation of their business model’s viability and while there are a good number of start-ups that did end up doing very well by adapting themselves and their businesses with the lessons that were learnt between making a PowerPoint & Financial Model to making Quarterly Calls and MIS reports. There also exists a group of entrepreneurs that have taken the funding they received and have either burned through all the cash and have not been able to perform to investor expectations. Overall from my personal and professional interactions with investors, fund managers and our own portfolio’s performance – we are not a happy bunch.
So what is investor’s expectation?
The investor expects the start-up to create value by growing above the cost of capital that the firm has attracted, which will create value that a future suitor will be willing to pay for. The amount of money investors have to invest is limited (yes that is true!) and there are a multitude of investment options available to an investor. Prudent investors are expected to allocate the funds in their portfolio in a manner which reflects their return expectations, moderated by how much risk they are comfortable with. So while the investor wants to be prudent – he also wants to achieve market beating performance!
So in a nutshell, an entrepreneur has to satisfy an investor by achieving the highest returns with the lowest possible risk and beat all comparable investment options that are available to the investor. So not only is the entrepreneur competing with other start-ups that are vying for the investor’s cash and attention – they are also competing with the entire universe of investment opportunities available to investors where they can put their money to work. So it’s easy then. Because we just need to know what the investor’s expected return on investment (ROI) will be.
To start, we have graphed the growth in investment (of Rs. 100) of some of the most popular investment opportunities that compete for investor cash from the last 10 years along with the CAGR achieved by these investments in brackets.
Almost all equity investments, as gleaned from the graph above, double in value in under four years. That is the parameter with which we will compare the publicly listed companies in our portfolio, and most entrepreneurs are fully aware (or should be) that an investment in a start-up is riskier than any of the publicly listed company investments – no matter how safe you consider your idea to be.
Now, investors are a competitive bunch and we always want to (or expect to) have our portfolio to out-perform the market, therefore we expect a Tata Motors or Reliance to provide us returns that are multiple percentage points above the 19% CAGR achieved by Nifty or Sensex. Therefore, when reviewing a start-up for investment the entrepreneur has to beat the returns that these established behemoths are expected to achieve, multiplied by a risk beta (that will include the multiple probabilities of failure of the business) which will then further inflate the growth expectations from the business.
Next, let’s add the favourable income tax benefits available to publicly listed entities of ZERO capital gains tax. So the growth rate you saw above is to be multiplied by 1 + the tax rate applicable for profits on unlisted shares which currently is 20% (with indexation). Just incase you are still up to the challenge – you should achieve these returns AFTER you have paid all taxes. I hope you know by now what we are expecting in terms of growth expectations from start-ups, and mind you this lesson was learnt just recently.
Recently, we have started looking and keeping conversations with only those start-ups that can convince us of growing the entire value of the company by over 35% per annum. If you think that this is excessive then it is important to understand that 90% of all start-ups are expected to fail in the first year and there is enough history to rely on to say that 95% of all businesses will fail in the first 5 years.
Now let me remind you, that we defined value as the incremental growth achieved above and beyond the Cost of Capital attracted by a firm. So then the proverbial question is – ‘Can you grow your venture at over 35% per year – that is double in value every 2 years and do that for 5 years?’
I would love to believe that all the start-ups in my portfolio meet that criteria but that would be hoping against hope. Not only would I have to put tonnes of pressure on the business to perform, some of these business models may not support such high growth and it could run them into the ground. The investing community’s over-exuberance during investment, misplaced trust in the ability of Indian entrepreneurs and turning a blind eye to the challenges of being a business in India, have collectively put the brakes on the liquidity to this sector. It also explains why not just AVP but a lot of LP’s are starting to freeze investments into the sector or are
- Requiring entrepreneurs to jump through multiple hoops before parting with the money
- Putting multiple caveats on the use of money
- Releasing money in multiple tranches
- Taking longer timelines for completing due diligence
I am sure the list can run in to multiple pages….
So what does an entrepreneur have to do to
- Create Value
- To attract equity from investors at favourable terms and valuation
That is where Option 2 will be handy and why it should be Plan A J.
[Guest article contributed by Anirudh Damani. Anirudh is a serial entrepreneur and Angel Investor. He is also the Managing Partner of Artha Venture Partners. Follow him on @showmedamani]