Investment Appraisal Techniques - Research Paper Example

Investment pprisl techniques Venture cpitlists perform n extensive due diligence process before investing in compny. In this wy, they wnt to minimize their investment risk by getting to know the entrepreneur or the mngement tem, the product, nd the mrket potentil presented in the investment proposl. Due to possible gency problems, cused by informtion symmetry nd morl hzrd issues, the screening of dels is extremely importnt. This hs received extensive ttention in the cdemic literture. In the following pper I will be exmining investment pprsl techniques used by modern compnies. I will prticulrly provide literture review of few contemporry theoreticl pproches to the issue. Recent reserch (Steier & Greenwood, 2005) hs shown tht the due diligence process is n itertive one, where the first step is to ssess whether proposl meets the investment criteri of the venture fund (e.g., with respect to the investment stge, sector, or mgnitude of the investment proposl) nd whether the proposl is vible t first sight. forml vlution of compny will only be performed when the proposl psses this initil test. Other economic gents hve to vlue compnies in other settings; e.g., investment bnkers hve to determine the introduction price of new compny on stock mrket or they hve to pprise tke-over cndidte. Finncil nlysts hve to ssess whether the stock mrket vlue of compny is significntly higher or lower thn its 'true' economic vlue, in order to decide when to sell or buy stocks. The venture cpitlist's vlution process, however, is likely to differ from the ones used for these purposes, becuse of the very different nture of the compnies they hve to vlue. Investment proposls, received by venture cpitl funds, re often very risky, due to the erly stge of development of the compny, the lck of trck record of the compny, or the degree of innovtion of products or mrkets. Moreover, the compnies re not quoted on stock mrket, so publicly vilble informtion is limited. The present study sheds light on this neglected re through n exmintion of how Europen venture cpitlists proceed in this difficult tsk. The vlution of investment proposls is importnt for venture cpitlists becuse the vlue of the compny determines the proportion of shres they receive in return for their investment nd thus their ultimte return. It is importnt for entrepreneurs, too, becuse vlution tht is too low will led to n excessive dilution of their shre in the compny. Moreover, when entrepreneurs know how venture cpitlists vlue investment proposls, they re better prepred to dpt their business pln to the needs of investors. They will be ble to produce the required informtion nd to understnd the wy venture cpitlists use the informtion. The vlution process consists of three sequentil steps. First, informtion is gthered on the venture, its mngement tem, nd its future prospects. Second, this informtion is used to pprise the risk of the venture nd hence the required return on the investment, nd to estimte the (future) csh flows nd profit potentil. Finlly, one or more vlution method is used, which combines the elements of risk, return, nd profits or csh flows in order to compute the vlue of the compny. Becuse non-public compnies hve few legl informtion requirements, the gthering of informtion is more difficult thn with public compnies. Due to dverse selection nd informtion symmetry problems, this is nonetheless one of the most crucil phses in coming to decision. One of the most importnt sources of informtion is the business pln, which projects the future of the compny, together with historic ccounting dt (especilly the blnce sheet nd profit nd loss sttement), nd future ccounting dt (especilly csh flow forecsts). mit et l. (2003) point to the fct tht the mngeril trck record of the entrepreneur nd his or her fmilirity with the product nd the sector my provide some hints s to the future success of the venture. However, venture cpitlists fce importnt informtion symmetries with respect to compny-specific dt, since the entrepreneurs my disclose only wht they deem necessry in order to get the funding. They my delibertely or indvertently withhold importnt informtion or give bised view of importnt fcts. Therefore, we expect tht venture cpitlists will rely hevily on reports, issued by independent ccountnts or uditors, to supplement the (ccounting) numbers nd informtion produced by the mngement tem itself. Moreover, due to the innovtive nture of most ventures, mrket dt nd the future prospects of sector re hrd to estimte. ssessing the profit potentil of new products nd mrkets is essentil to the vlution process; therefore, we expect tht venture cpitlists will lso rely hevily on externl reports. The informtion is used to evlute the degree of risk of the project nd, hence, the required rte of return on the investment. Finncil theory sttes tht the return tht n investor should require on n investment is function of the non-diversifible risk of the investment (Breley & Myers, 2001): the higher the risk, the higher the required return should be. prt from the individul risk chrcteristics of the project, the generl economic conditions should lso ffect the required return. More specificlly, ccording to the Cpitl sset Pricing Model, the required return should be positively relted to the long-term, risk-free interest rte nd to the difference between the expected return of the stock mrkets nd the long-term, risk-free interest rte (Breley & Myers, 2001). Until now, there hs been little reserch on how the different risk fctors influence the required return; this will be investigted here. Prctitioners nd theorists offer severl, sometimes conflicting, methods to compute the vlue of compny from the informtion gthered. There re, brodly, three ctegories of vlution methods: methods bsed on expected future csh income; methods bsed on ccounting numbers; nd methods bsed on rules of thumb. ccounting-bsed vlution methods include ll types of ccounting vlutions of the firm's ssets, such s historic cost, replcement or liquidtion vlue of the ssets, or the book vlue of the equity. Rules-of-thumb methods my include, for exmple, multiplying the sles of the compny by some fctor, where the fctor should be influenced by the profit-generting potentil of tht type of business, or recent trnsction prices for comprble compnies. Rules of thumb re often sector specific. Sometimes ttempts to sell the compny re used to provide benchmrk vlution, thereby moving the vlution problem to nother plyer in the mrket. The bove-mentioned methods re very esy to use, but they lck theoreticl rtionle. Moreover, they mostly require historic informtion, which is not vilble for strt-up compnies. The discounted free csh flow nd the discounted dividend yield methods re theoreticlly correct vlution methods, becuse the current investment is compred with the expected future csh inflows gined by the investment. It is, however, expected tht the dividend yield method will rrely be used for vluing potentil venture cpitl investments, since this type of compny hrdly ever pys out (significnt) dividends, especilly in the erly stges. Indeed, most compnies re csh constrined when they require venture cpitl in order to fund their future expnsion. The expected increse in vlue of the venture is thus not reflected in dividend strem in the short term, but it is hoped tht significntly higher vlue will be plced on the compny t the time of the exit of the venture cpitlist. (Breley, Myers, 2001) Discounted free csh flow methods hve the dvntge tht they do not rely on the pst in order to mke predictions bout the vlue of compnies. This mkes them very useful vlution methods for new ventures, since such firms evidently do not yet hve trck record. problem ssocited with the discounted free csh flow pproch is the fct tht it is not esy to forecst future csh flows in highly uncertin environment, so tht the expected error of the forecst will increse. Sensitivity nlyses my be n nswer to this problem. further drwbck of this method is tht, when the time horizon used in the projections is reltively short, e.g. five to eight yers, n importnt prt of the vlue of the compny is cptured by the residul vlue or the exit vlue. This vlue is very sensitive to the expected growth percentge fter the projected time horizon, when the compny is ssumed to be in stedy stte. slight chnge in the growth percentge thus hs very big impct on the estimted vlue of the compny. Recently, it hs been shown tht the "rel option" pproch (Dixit & Pindyck, 2002) my be better dpted to vluing young nd highly uncertin compnies, where much vlue evolves from the fct tht options re creted on the future growth bsed on the development of new business opportunities. In the venture cpitl environment, there re two importnt types of options embedded in investment projects. First, investing now in compny cretes the opportunity to invest further (if needed) nd to benefit from the future growth. s with finncil cll options, one is not obliged to invest further. The investor cn wit until new informtion revels the true nture of the potentil benefits. Depending on the future outlook, which hs been (prtly) reveled by the new informtion nd developments, he or she cn decide t tht time whether or not to invest further. The fct tht further investment is right of the investor nd not n obligtion gives the investor vluble option on the vlue of the compny (Steier, Greenwood, 2005). The second type of option lies in the very nture of the compnies themselves. Investments in compny-specific knowledge my result in future csh flows tht fr exceed the initil cpitl outly, but these re very difficult, if not impossible, to predict. s with finncil options, smll investment my led to very lrge profit, or totl loss. Stndrd discounted csh flow techniques re inpproprite to vlue these types of expected csh flows, becuse they re deterministic in nture, while entrepreneurs re ble to mke vluble choices depending on the development of the compny, its technology, nd its mrkets (Dixit & Pindyck, 2002) lthough very promising in theory, the rel option pproch hs the drwbcks of first, not being well-known s yet mong prctitioners, nd second, being very difficult to compute, due to the ssumptions tht hve to be mde. Therefore, this pproch will not be further tken into considertion here. ccounting informtion is importnt for vlution purposes in Europe. This includes udited nd unudited reports nd both informtion from the pst nd projections of the future. This is probbly due to the fct tht investments in Europe re much less tilted towrds erly stge investments thn is the cse in the US. For erly stge investments there is n lmost complete lck of ccounting informtion. When investing in development-stge compnies or in MBOs, ccounting informtion is of course redily vilble, nd consequently importnt for vlution purposes. More intngible informtion, such s the qulity of the mngement tem nd the nture of the product nd the mrket, is not used directly in the vlution process, but this is not to sy tht it is unimportnt. It hs been shown tht the mngeril skills nd the nture of the product mrket re the most importnt risk fctors, prt from the investment stge of the compny. higher perceived risk leds to higher required rte of return nd consequently to lower compny vlue. To sum up, in this pper, there ws provided insights into the vlution process used by venture cpitl investors in contemporry word. The vlution process hs been studied with n emphsis on the informtion used, the ssessment of the risk nd the required return, nd the use of specific vlution methods. Bibliography: 1. Steier, L., & Greenwood, R. (2005). Venture capitalist relationships in the deal structuring and post-investment stages of new firm creation. Journal of Management Studies, 32(3), 337-357. 2. Dixit, A. K., & Pindyck, R. S. (2002). The options approach to capital investment. Harvard Business Review, May-June, 105-115. 3. Brealey, R., & Myers, S. (2001). Principles of corporate finance. 5th ed. New York: McGraw-Hill. 4. Amit, R., Glosten, L., & Muller, E. (2003). Challenges to theory development in entrepreneurship research. Journal of Management Studies, 30(5), 815-34. Read More