#6.     Poorly communicated value

Typically in a capital raising project we need to communicate the value of the proposition three times:

1.       Pique stage (previously “pitch” but that word has been devalued see mistake #5

2.       Presentation stage

3.       Pricing stage

First – what is value?

In pure, economic terms a business’s value is the “today value of the future cash flows”.

This means that, if you could be certain about all the future cash dividends which the business will produce, you could then simply discount those cash flows to allow for the diminishing time value of money, thus you would know the business’s value – simple!!

But – in the real world!

All commercial transactions involve some form of value exchange and require the parties to agree on “value”.

A good deal is when both parties think they got better value than the other. How can that be?

In each of these transactions, if the parties do not agree on “value”, the transaction does not proceed.

Value, therefore, is a matter of opinion:

It is simply a matter of “perception of future benefits”

tempered by “the risk that the benefits will not be achieved”

 

If value is a matter of opinion, then it follows that the party raising capital is obliged to encourage the investor to form the opinion that the value of the business is high enough, that a deal can be made that satisfies both parties.

 

In a capital raising context, value is whatever is agreed by the investor and the company. That’s it!

 

Communication

As in most important events, preparation is important – although consider Confucius’ “a diamond with a flaw is better than a pebble without”

Preparing?

Future Cash flows

As a founder, your challenge is to infect the investor with some of your passion and also to have all the bases covered in terms of anticipating their requirements for risk aversion.

 

Before engaging with potential investors you should have a comprehensive forecast of your business, with one output being a time series of (free) cash flows or dividends. There are ways of putting such forecasts into a spreadsheet model which automatically adjusts for changes in input parameters. This can be quite valuable during the price negotiation phase of the project. Many professional investors will need to find an exit within a fixed timeframe, so your forecast / model should include a value crystallisation event such as a trade sale or IPO within 4 or 5 years. The (discounted) cash flows from that event are included in the valuation calculation.

 

Once a realistic forecast and cash model has been created, the only other issue is dealing with perception of risk, because perception of risk determines the discount to apply to the forecast future cash flows.

Free Cash Flow - ??

Better, more experienced analysts will use Free Cash Flow (FCF) as the important forecast metric, not Profit nor EBIT nor value per user (so 1990s) or any other approximation. A technical discussion of FCF is beyond the scope of this article.

Discount factor – it’s all about perception of risk.

During dot com boom one 1998-2000?, an associate of mine had a simple diagram explaining the step process of creating value. His model showed the stages of risk mitigation:

This model is a great tool to “reality check” your assumptions.

It is a good idea to list all the potential risks to your business plan (timing of disclosure not withstanding), and carefully assess the likelihood of each risk being realised. Even if only to have covered them off in the material presented to investors, or to avoid embarrassment when surprises are raised during negotiation.   You can then aggregate all those risks and use the result as your discount factor in your valuation argument.

 

My experience of professional investors is that, for early stage businesses, they will generally want conservative forecasts and then discount them at an annual rate of around 40%.

Putting it into action

OK – now it’s time!

·         We have a solid business plan with comprehensive forecasts

·         We have a risk assessment document identifying risks and detailing how we are going to mitigate them.

What now?

In my article about engaging the wrong advisors I asked about experience preparing documents.

I have received “Information Memoranda” with numbers and risks detailed from page one, with no contextual discussion of any kind!

BZZZZZZZZZZZZZZZZ – wrong! You don’t want to put them to sleep.

First: Pique their interest

In Australia, we have a chain of big box DIY stores where people go for all sorts of hardware and garden supplies. As you get out of the car in the carpark you are assailed by the smell of fried onions so you automatically go to the charity BBQ at the entrance and buy a sausage in bread snack.

No one drives across town to Bunnings to buy a sausage in bread!   Everyone who goes to Bunnings buys a sausage in bread!

 

That smell of fried onion is the epitome of “Compelling”. Make sure you have a compelling piquing statement or “elevator pitch”. Think fried onions – don’t mention the sausage.

Second: Present

We are still not using the documents we prepared earlier. This time we are hitting the high points, smell of onion again; what’s the pain; how many people feel it, what would they pay to relieve it; how you are addressing the opportunity. NOW – high level numbers (the promise of future rewards)

Give some idea of price expectations but only summarily.

Finally: only after they have expressed interest in dealing

So, now they are a “buyer in principle” conditional only on terms.

Sit with them and go through the forecasts, adjust the levers to reflect their questions, address the risk concerns and come to an agreed range of values.

If there’s a will, you can use a structured instrument to address unbridgeable gaps in expectations.

 

In my forthcoming article #7 DIY Corporate Finance, I’ll explore things like convertible / converting preference shares, redeemable converting shares etc.

Feel free to message me for more info on this topic.