Venture Capital Pricing Game

How do Venture Capitals (“VCs”) attach numbers to companies? Valuing companies at conventional DCF models often churns out values half or a third of what the VCs value them at. So why does the difference arise? The standard response is that VCs don’t value companies – they price them.

 

There’s a difference in the pricing process and the value process. Classrooms, books, and all educational media spend a lot of time explaining the factors that drive the value process such as cash flow, growth, and risk. We often use DCF as the tool to arrive at the value. The pricing process on the other hand is driven by demand and supply. The price and value may be the same in an efficient market. We understand from behavioural studies that the pricing game factors in mood, momentum, liquidity, small pieces of information, and other softer issues that drive markets. Pricing is often based on multiples and comparables rather than discounted cash flows. Going a step further, the pricing process can even be studied on charts and technical indicators.

 

So how do VCs price a company? There’re 3 fundamental ways

 

1.      Recent Pricing by another VC

VCs first establish a baseline price by the most recent investment by another VC in the same company. They might spend an amount higher or lower, but that becomes the benchmark of the price they pay for the company today. This is not just for new investors but for existing investors as well for marking up (or down) their investments. The dangers are manifold. They’re just looking at one company and one investment which means one bad investment can open a feedback loop and hijack transactions for the foreseeable future. A few people start (or stop) throwing money around and the pricing process can get out of control very quickly in either direction.

 

2.      Pricing of other private companies

This is an extension of the above where VCs look at similar companies. The problem with this approach is that the word “similar” is very subjective. VCs decide the “similarity” on the basis of size, sector, geography, macroeconomic cycles, etc. and scale the prices for some common metric. For example, in case of cab companies like Ola, Ubers, Meru, etc. the pricing is scaled relative to the number of riders or the number of drivers or geographical spread.

 

3.       Pricing of public companies

This is used for companies that already have substantive revenues and profits. Here you can compare the subject company with companies listed on the stock exchanges.

 

3.2. Pricing of public companies + Forecasting

Most young start-ups don’t have much revenues or profits today. So sometimes VCs forecast the earnings of these companies to 3-5 years or as many years as it takes to get profits, apply the current multiples of public companies to the subject company, and discount the price back to the present value using a target rate of return. The target rate of return is the reflection of the confidence in the company. Most young start-ups do not make it and this needs to be reflected in the target rate of return.

So VCs price companies just like public markets do. The difference is in statistics. There’re a thousand listed oil companies in the world but maybe ten cab companies, all unlisted. So the VCs have a much smaller sample size. Within that sample space there’s no 24/7 trading but 2-4 transactions a year so there’s infrequent updating of prices. In addition, the transactions themselves have options embedded in them which do not reflect in the numbers. Some options allow the VCs special prices on future capital raising. So ₹ 1 million for 10% of a company does not necessarily value it at ₹ 10 million if there’re enough options in the pricing, but that’s what the newspapers miss to report.

 

Another problem with VC pricing is that they generally lag the markets. It is a common observation that there’re lots of VC transactions when the economy is booming which can virtually dry up during recessions. When the transactions stop, so does the repricing and we see the VC returns lagging the market by 1-2 quarters if there’s not enough repricing being done.

 

There is a lot of value locked up in unrealized returns of VC investments. Unlike market investments like mutual funds where the returns are calculated by the realized returns (dividends and capital gains) and the market value of the investments, VC investments are more difficult to monetize. They aren’t based on market prices but rather on estimates. These estimates are often based on what other VCs are paying for similar companies. There’s also a lot of noise and bias in the data available while valuing VC funds. So, they cannot be measured like market investments.

 

Finally, VC investments are very difficult to liquidate. There’s a long time horizon involved. VCs take a position in an undeveloped company, build-up the company, and find someone who will be willing to take it off your hands at a much higher price.

 

All these issues might make VC investment look problematic. But across time, VCs have done much better than PE investors and index funds, which are a proxy for public market investors. So surely, VCs bring something to the table that public and private investors do not.

Professional Monopoly over the Practise of Law

 Under Section 29 of the Advocates Act, 1961,

“29. Advocates to be the only recognised class of persons entitled to practise law — Subject to the provisions of this Act and any rules made thereunder, there shall, as from the appointed day, be only one class of persons entitled to practise the profession of law, namely, advocates.”

 

Similar provisions in Chapter IV of the Act have entitled advocates alone to practice the profession of law. This includes practicing before all courts, tribunals, and arbitration panels including the Supreme Court. Further, Section 45 of the Act contemplates imprisonment of up to 6 months for a person who practices in a Court where he is not entitled to practice. The Act was promulgated with an intention to consolidate the different classes of professionals practising law in the country such as advocates, vakils, barrister etc. into a single roll of officers of the court. However, it remains to be seen if such distinction has resulted in new problems in the modern world.

 

Over time with the emergence of specialized services over time requiring particular knowledge, other forums like ITAT, NCLT, NCLAT, SEBI etc. began to allow other professionals like CA, CS, & CMAs to represent their clients. This offered three benefits

1. A professional with specialized knowledge in the domain could better represent clients;
2. It brought down the cost of the client from having to engage multiple professionals for the same matter;
3. A professional was able to offer comprehensive services to clients

However, this idea has not been extended to all courts of law. Once a case has to be appealed at higher levels, at some point, an advocate is required to be engaged. Especially in cases when parties are so aggrieved that they are required to knock at the doors of the Supreme Court. Even for an advocate to be eligible to qualify as an advocate-on-record in the apex court, one year training contract with an advocate-on-record needs to be completed, besides passing prescribed tests. There is no provision for other professionals to act as officers of the Supreme Court whatsoever. This has given the legal profession a stronghold in the courts of law, regardless of the requirement of the case.

 

Often in any commercial transaction or insolvency proceeding, one requires comprehensive knowledge of local laws, business acumen, market research, and liaison support, which may tantamount to the practice of law. One may even require filing and appearances before courts of law. In this new emerging world, there is a need to allow other professionals to represent before Courts of Law. This achieves the following objectives

1. In a world of emerging white-collar crimes with complex transactions, we need transaction auditors, engineers, Insolvency Professionals etc. to present the facts of the case in their entirety;
2. The Government of India aims to make India a hub of International Arbitration which is not possible till a diverse group of professionals are allowed to represent before Indian arbitrators;
3. It assists foreign investors looking for commercial transaction knowledge and business structuring which is usually a domain of financial consultants and company secretaries, but have to engage advocates for vetting legal documents;

This need has already been adopted into the more modern laws such as the Companies Act, 1991 wherein the Adjudicating Authority and the Appellate Tribunal allow for CA, CS, & CMAs, three pillars of professional services in the field of Corporate Governance, to represent before them. A majority of cases before the Income Tax Appellate Tribunal are represented by CAs. Insolvency Professionals have been authorized to represent the needs of their clients during Corporate Insolvency Resolution Process. Civil Engineers and Architects are required to interpret and apply municipal and building laws.

 

However, the Advocates Act, 1961, remains unchanged assuming advocates alone to have the specialization to pursue the same matters before higher courts including the Supreme Court. In fact, the Act prohibits any other professional to offer even non-litigious services to its clients if it falls in the domain of legal opinion.

 

Over the last 60 years, the Indian economy has transitioned into a new cycle of macroeconomic growth which fuelled by liberalization which was not anticipated in 1961. However, we continue to be governed by the provisions of an archaic law which was aimed to solve the problems of a different era. Maybe it’s time to review the 1961 Act so that it is in tune with the current times.

What the Rf

In Valuation, we often come across this term “risk-free rate” also known by its nickname - “R_f”. In general usage, most valuers use the 10-year G-Sec Yield published by FBIL as the risk-free rate. Which makes sense. The risk-free rate is supposed to be least risky investment one can find, and we add a risk premium on top of that for valuation. Right? No.

There’s a difference between a “risk-free” rate and the “least risky” rate. While Government Securities (G-Secs) may be the least risky rupee denominated investments in the world, they are certainly not “risk-free”. After all, we’re talking of R_f and not R_L. In fact, on 1 Apr 2020, the sovereign rating of India assessed by Moody’s was Baa2. The typical default spread for this rating was 2.82%. Further, the average credit default swap (CDS) rate for dollar denominated Indian bonds was 2.78% higher than the CDS of Swiss bonds.[1] Hence we see that the Indian G-Secs are far from risk free. There are two possible ways to adjust for the difference.

1. We can take the 10-year G-Sec rate and reduce the sovereign default spread to arrive at the risk-free rate. For example, on 1 Apr 2020, the default spread for India was 2.82% against a 10 year G-Sec yield of 6.73%[2]. Hence, the risk-free rate of return for India was 6.73% - 2.82% = 3.91%
   
   
2. We may start with a 10-year Government bond yield rate for a riskless economy, and add the CDS of the Indian economy to that. The inherent assumption here is that there exists a riskless economy, which is not true. However, we would rather base our judgement on an incorrect assumption rather than do away with the measurement altogether. Let us assume Switzerland to be a riskless economy with very little chance of sovereign default. The CDS spread of India over Switzerland comes to be 2.78%. Given that the yield of Swiss Government Bonds on 1 Apr 2020 was -0.37%[3], the risk free rate for India should be -0.37% + 2.78% = 2.41%

The two calculations give us very different numbers. However, we see that the “risk-free” rate is very different from the 10 year G-Sec yield which is not inherently riskless. Still it is common practice to assume the 10 year G-Sec yield. In fact, why use the 10 year G-Sec bond yield at all? Aren’t 90 day T-bills riskless by the same sovereign guarantee? In fact, since risk lies in an uncertain future, lower duration T-bills should be less risky and hence more “risk-free” than 10-year G-Secs. So why do we use the 10-year G-Sec yields?

Purist valuation practices suggest that the duration discount rates should be equal to the duration of the cash-flows. In the perfect sense of the definition, each cash-flow should have a unique risk-free rate equal to the duration of the cash-flows. In going concerns, the bulk of the value comes from the future terminal value of cash-flows. Hence, it is logical to assume that the longest duration G-Secs used for the discounting of all the cash-flows will result is very little error in calculations. However, we must not forget that in cases of SPVs with limited time-frame of operation, such as many real estate or infrastructure projects, the 10 year G-Sec rate may not be ideal for calculation of the risk-free rate.

An argument in favour of using the 10 year G-Sec rates is the R_f on its own is meaningless. What we intend to find is the cost of equity (K_e) which also incorporates a market risk premium. As long as we adjust the market risk premium correctly for our risk-free rate we calculated, our K_e will come out correctly. But that’s a different discussion.

For now we may change the way we use R_f, or we may stick to the conventional practice of using 10 year G-Sec rates as R_f, but we should remember the baggage that comes with it. The 10-year G-Sec yield is not risk-free, but is a good starting point to find the correct risk-free rate.

---

[1] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

[2] https://rbidocs.rbi.org.in/rdocs/Wss/PDFs/5T_1004202059CA110D786B4E64A3434C8CD4EF8877.PDF

[3] https://countryeconomy.com/bonds/switzerland?dr=2020-04

Fault Lines

“A working capital loan is a loan that is taken to finance a company’s everyday operations. These loans are not used to buy long-term assets or investments and are, instead, used to provide the working capital that covers a company’s short-term operational needs.” - Investopedia

The Indian financing sector is no stranger to Working Capital Loans. Any 1st year analyst is aware of the terms “inventory”, “book debts”, and “trade payables” while assessing the “working capital gap”, “DP”, and “margin requirement” for a manufacturing or trading company. In essence, lenders are willing to finance the amount secured against stock and book debts of a company. They reduce the trade payables to arrive at the working capital and reduce a “margin” requirement akin to “promoters’ contribution” and arrive at the “DP” or Drawing Power, i.e. the amount of funding the borrower is eligible for and can secure the bank against his working capital. This offers a dual benefit

1. Banks are secured against what are believed to be “liquid” securities, being inventories and book debts which are fast moving in usual business circumstances;
2. Businesses are able to draw funds at low rates with a tax shield thus enabling them to operate at higher capacities.

So it arrives from the discussion that a business having negative working capital is not eligible for working capital funding.

1. There is no security against the working capital debt;
2. If a business is able to hold off paying its creditors (0 interest) while being able to collect faster from its debtors, then there’s no need to draw any working capital;

So far so good. This is why we see most companies having negative working capital not having any working capital loans. While one may see substantial long-term loans on their books, the short-term working capital loans are almost non-existent. Such companies are also ones with good working capital management being able to collect-first and serve-later.

 That is why it is surprising when we find the adjacent financials in one of the largest companies in the country. It is clear that the massive amount of Trade Payables easily turns the working capital of the company negative. However, the company enjoys working capital facilities of ₹ 24 from banks and others.

As per the RBI’s Master Circular dt 2 Jul 2012 on “Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances”, it is stated that,

“Banks should ensure that drawings in the working capital accounts are covered by the adequacy of current assets, since current assets are first appropriated in times of distress… A working capital borrowal account will become NPA if such irregular drawings are permitted in the account for a continuous period of 90 days even though the unit may be working or the borrower's financial position is satisfactory.”

On the face of it, our company in question maintains a Current Asset base of ₹ 167. However, of these current assets, only ₹ 46 is a part of the working capital and ₹ 32 is liquid. The bulk of the current assets are unquoted investments which may or may not be marketable in times of distress. Further, the company also has a large Current Liability base of ₹ 310 eating into the security for working capital loans. It is also seen that this inadequate working capital is not a one-time delinquency in the company but more of a behavioural pattern.

So the question arises, if the working capital loans are neither deployed nor secured by current assets, then what has been their use? And which is this company that we are talking of?

The 1st question remains unanswered.

For the 2nd question, we’ll leave you with a few hints

1. All figures quoted have been in ‘000 Cr, i.e. the working capital loans are not ₹ 24, they are ₹ 24,000,00,00,000
2. This was the 1st Indian company to cross ₹ 10 lac Cr in market cap;
3. The company has been trying to bring down its debt levels since 2019, and has resulted in some of the largest FDI inflows in the country during the COVID-19 period