The National Securities Market Commission (CNMV), which is the body responsible for the supervision and inspection of Spanish securities markets, reflects on its website in January 2022 the existence of 124 closed-end fund managers (SGEICs), out of which 60 are Venture Capital and 64 are Private Equity
They all aim to invest in the capital of companies that can revalue their investment within 5 years, for at least 2 or 3 times the money invested. It is an ideal source of financing for business development.
The managers of these firms, in addition to assuming a commitment of complete dedication, contributing with their knowledge, contacts and experience, have to invest personally, so their involvement is absolute, as if the investment fails, their reputation will be damaged, and they will lose money
Obviously, to reduce the risk of the investments they make, they use a diversification coefficient which, as a guideline, may involve allocating a maximum of 10% of the size of the Fund they manage to each company in which they invest.
In order to obtain these capital gains, they have to carry out an exhaustive search, analysis and negotiation of terms and conditions that allow them to visualise the target revaluation.
Therefore, in order to value an unlisted company, in addition to using market references that allow them to establish a range of value by comparable multiples of recent transactions, they must estimate the future of their investment, for which they will carry out detailed work in which they will identify risks and value drivers that allow them to quantify the cash flows that a company can generate, according to the business plan to be developed with the investment that is disbursed.
How to value a company from a Private Equity perspective
Venture Capital investing at early stages, generally uses valuation metrics that are often not based on rigorous financial parameters, but more related to market benchmarks that are understood to be applicable due to the comparability of the target company and the recent transactions identified. The possibilities of error are really high.
In Private Equity, the aim is to value companies with a track record that can support projections based on recent results, the stability of the company and the fundamental business variables that, according to experience, are more predictable.
Logically, the identification of key variables in the development of the business, its reasonably foreseeable evolution based on recent history, requires experience, procedure and a thorough study that incorporates the Investment Case, i.e. the business plan to be developed: the necessary investments, the resources required, the professional training and leadership of its management, among others.
The result of this study must be compared with applicable market parameters of recent transactions to conclude with a value range on which to make an offer to buy or take a stake.
The chart below provides an outline of Private Equity’s exercise and vision when performing a corporate valuation:
In the graph above we highlight several aspects:
- The attributed value does not necessarily match the purchase price.
- Attributed value is closely linked to the company’s ability to generate money.
- The value of a company is greater to the extent that there are sustainable and differential competitive advantages.
- Finally, the qualification and involvement of managers and entrepreneurs is a determining factor in accepting the value obtained from the econometric models used.
Difficulties in the valuation process.
Often, either due to the uniqueness of the company to be valued, the size of the company, or the absence of audit reports of the company from previous years, among others, it is really difficult to (1) identify market references applicable to the company concerned, especially in the field of Venture Capital, (2) correctly apply the identified metrics (whose parameters are often unclear, as the calculation bases are not reliably known) and (3) the absence of analytical accounting and an adequate accounting practice to make a correctly based forecast.
Logically, if the company to be valued has been advised by competent professionals, the process is greatly facilitated, especially for investment analysts from Private Equity firms.
At Delicias Capital we have a team of qualified professionals who carry out an analysis that is supported by documentation and is coherent in all its aspects, although this is not an easy task and requires time.