New Way to Value Tech Firms (Wharton to make it easier for VCs to measure the value of startups)

Red Herring ^ | Michael Cohn

[nickcarraway]

Venture capitalists could start relying on a new way to measure the potential value of tech startups they might decide to fund if a Wharton professor has his way.

Andrew Metrick, an associate professor of finance at the University of Pennsylvania’s Wharton School of Business in Philadelphia, believes he has found a simpler way to value tech companies using Microsoft Excel spreadsheets and some common-sense advice.

Establishing the value of a startup company has never been an easy task for either entrepreneurs or VC firms looking for promising technology to finance. While VC funding can help a company develop its technology as well as its sales and marketing muscle, the initial value of a company might be low, especially when it’s still in its early stages.

Mr. Metrick has written a textbook, Venture Capital and the Finance of Innovation, which he hopes will become a standard in the field, much the same way an earlier Penn professor, Edwin Mansfield, wrote a seminal textbook on managerial economics that also became a standard for business students for many years.

But in today’s world of the Internet, Mr. Metrick has also provided downloadable tools in the form of Excel spreadsheets that VCs and finance students can apply right away from his web site.

“The idea of the book is to provide a unified framework for thinking about the valuation of high-tech, high-growth investments,” he said in an interview last week.

Mr. Metrick is examining a variety of scenarios, including ways that a large company like Intel or Merck could evaluate a licensing deal or investment in a startup, or how a VC could decide on an investment in a small company, as well as how bankers might look at different pieces of the capital structure in a company.

“If someone is thinking about how to value, say, an IPO, how can I do this in a quick and dirty way that is anchored to reality, instead of having to look at all the companies selling at 10 times revenue to decide what they’re worth?” he said.

He includes a “reality check model” in the book to help investors make such determinations.

Anchoring to Reality

Mr. Metrick uses venture capitalization and startup valuation as a way to teach finance to the MBA students in his classes. But he also thinks his approach could help VCs ground themselves to more of a “finance reality” so they can avoid another potential dot-com bust in the future like the one that sunk so many tech companies a few years ago.

He believes VCs need to follow more of a cash flow-based method of thinking about the valuation of VC-backed high-growth companies.

“Most people will do some kind of a comparables method, some multiple,” Mr. Metrick pointed out. “They’ll say this company is doing 10 times revenue, this one is at five times revenue, so we’re going to be somewhere in between those two. There’s no anchor there. You’re never really asking whether the company is generating cash flows that could support that valuation.”

The other element he emphasizes is providing enough detail to evaluate different types of structures. In Silicon Valley, he noted, most VCs don’t just buy plain old common stock when they make their investments. Instead, they acquire very complicated structures, such as participating convertible preferred stock with a 2X liquidation preference.

“That’s not just a nice proportional fraction of a company,” said Mr. Metrick.

He wants to make it easier for VCs to be able to boil down complicated structures like these to their component elements to properly decide how a promising tech startup would be valued.

But even though he is in favor of realistic valuations of companies, he said he agrees with some of the better known recent high-flying valuations, such as Google’s $1.65-billion buy of YouTube and News Corp.’s $580-million acquisition of Intermix Media and its social network MySpace. For those properties and the potential they are bringing to their parent companies, they’re worth the price tag.

[martin_fierro]

Too many Sillycon Valley startups rely on this guy for their financial advice.

[nickcarraway]

These days companies are a lot more reasonable than they were back in the "good old days."