Investing in Young and Start-up Firms: Using the Fermi Estimate

Early stage venture capital investment is more strategic and legal than financial analysis-the reverse of traditional investments. This reflects the lack of not only firm but also market history. What is needed is structure to help improve our estimates from a wild ass to reasoned guess. A modified Fermi Estimate provides such a structure. It involves starting with some defendable assumptions, updating the assumptions with observations, forming revised assumptions and repeating the process. This requires learning from facts as the investment unfolds using a Bayesian Inference approach. A key is to take small (baby) steps as the start-up evolves beyond the idea stage (no revenue) to stage one growth (revenue validation) and finally to stage two growth (profit validation). A lack of hard data does not mean anything goes. Instead, substitute reasonable assumptions which are updated as the process unfolds.

A useful framework is as follows:

1)     Industry: Porter 5 Forces

a)     Customer: who are the customers and how much bargaining power do they have?

b)     Suppliers: who are the suppliers and how much bargaining power do they have?

c)     Competitors: existing competitors and their relative positions.

d)     Substitutes: what substitutes exist?

e)     Entrants: what entry barriers exist?

2)     Strategy: what is our strategy regarding the 4 Ps

a)     Pricing

b)     Place-market segments and geography

c)     Promotion

d)     Products

3)     What is our business model for revenues and ultimately profits? Can we identify any sustainable competitive advantages? Is there enough built-in flexibility to allow for mid course corrections?

4)     Value realization plan

a)     Liquidity event: IPO;M&A

b)     Timing of liquidity event

c)     Realistic pricing expectations

Now we can turn to a DAR (Decisions at Risk) analysis:

1)     Asymmetric information

a)     Adverse selection-selecting the wrong firm, team or idea

b)     Moral hazard-failing to monitor the investment

2)     Bias: either the VC firm or the team suffers from over confidence, excessive optimism, the illusion of control, confirmation bias

3)     Control Mechanism: get a good lawyer and conduct appropriate due diligence to make sure you get the deal you thought you were getting. Consider:

a)     Monitoring: Board representation

b)     Incentives: Alignment of interests; make sure the founders are financially committed

c)     Governance: VC investor veto rights over compensation, management, vesting rights, redemptions and strategy.

d)     Investment Allocation and Timing: Stage investments based on milestones being obtained. Purse string control over the burn rate is needed to avoid incremental over committing. Balance against any first mover advantages requiring a fast rollout.

e)     Control: tight control over cash flow, assets, voting rights and dilution. Reflected in complex capital structures involving multiple instruments with different features.

The above helps avoid undue reliance on comps which can wildly overvalue start-ups when firms in the same industry are overvalued during bull markets.

J

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail."  I don't believe it and the statistical evidence doesn't support that claim.  True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid.   The combined returns to bidders and targets, appropriately weighted for size, are positive.  The typical deal creates value.   What I might believe is that 70 percent (or more) of mergers fail to realize their potential.  But that is typically a problem of integration and the subject of other posts. 

So what do we make of the continuing story that bidders tend to lose or break even?  After all, bidding activity continues to be quite popular (even if currently dampened).   There are many explanations in the literature to explain bidder returns.  Today, I will mention two.

The first is the possibility that we, as researchers, are not measuring returns correctly.  In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation.   When returns are measured correctly bidder returns are positive.  See (Anticipation, Acquisitions and Bidder Returns.)  

But let's return to the fact that some deals, however measured, do result in the loss of value to the acquiring firm.  Even in our sample this occurs as much as 40% of the time.  Why? A good place to start looking for the answer is in the price paid for the target.  As we have noted, Every deal is a bad deal at some price.  Not every deal is a good deal at some price.

In an efficient market, the value of a firm's shares are priced correctly.  Why would bidders typically add 20-40% to the market price in their bids?  Why would bidders pay more than this? The obvious, and always cited reason is synergies.  Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies.  Why are they available to your firm and to no one else?  

Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature.  

Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids.  We get caught up in deal fever or a desire to 'win' regardless of price.  The same behavior must certainly be true of at least some acquiring managments.  One can imagine the psychological pressures on management in certain bidding wars.  Multiple sides express multiple views with many unkind words and suggestions.  If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose.  As we have noted, some of the best deals are those not attempted or in this case, not completed.  

One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently, they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

We'll continue this discussion in two ways in the future.  One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns.  A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.

All the best,

Ralph 

Beware the Winner's Curse

Many acquisitions fail to create value for the acquirer and in most deals, the benefits go largely to the seller. This reflects the highly competitive nature of the M&A market. It also reflects the large concentrated investment bet at premium prices of M&A transactions. Buyers, in effect, are pre paying for uncertain future revenue and cost synergies. Frequently, buyers over pay for the expected synergies based on managerial optimism, overconfidence and the urge to beat competing bidders.  So it is understandable that the buyer’s shareholders react negatively to acquisition announcements. Many studies indicate that, on average, the acquirer’s share price falls once the transaction becomes public. (For alternative evidence see Ralph's blog on Anticipation). This overpaying is known as the winner’s curse or hubris-when the winning bid in an auction exceeds the target’s value. The absolute dollar loss of acquisition can be huge.  The loss can be estimated by looking at the level of goodwill paid and its subsequent write-off. Goodwill, the amount of the purchase price exceeding the target’s book value, represents a crude measure of over payment. Duff & Phelps estimates the amount of goodwill write offs, a proxy for overpayments which failed to materialize, for the 2007-2011 period to exceed $325B.

The key to avoiding this problem is to make an accurate assessment of the target’s value and to have the discipline not to bid more than that value. This requires establishing a walk-away, or reservation price, before making a bid.  The opening bid should be set at a fraction of that price based on competitive considerations. Ultimately, it is not just what you buy, but what you pay that determines an acquisition’s success. Overpaying for benefits received destroys acquirer shareholder value.

Distinguishing between cheap and frugal is needed when pricing an acquisition. Cheap refers to low value. Frugal, however, represents efficiency. You usually get what you pay for. Equally important is to avoid over paying for what you get. Complicating this matter is that price is fact, representing what the buyer gives up immediately. Value is an opinion concerning what you expect to receive in the future.

A target’s price has two components.  The first is the stand-alone, pre-bid minority ownership price.  It reflects the status quo value of its cash flow under the current strategy and management.  The second is the premium required to persuade the target’s shareholders to sell a control position.  The premium can be estimated from comparable transactions and can vary widely over time, reflecting the economic cycle.

Expected value includes the target’s status quo value plus potential synergy improvements. Value varies by owner depending on strategies pursued and execution of that strategy.  The acquirer’s net value added equals the difference between the expected synergies less the premium paid to acquire them. Buyers lose when the transaction premium exceeds the expected synergies. Thus, the buyer’s maximum price should be less than the seller’s status quo value plus expected synergies.

Projected synergies can represent a form of valuation Viagra used to justify excessive premiums.  As Warren Buffett notes, while deals often fail in practice, they never fail in projections. Buffett continues by noting that any business craving of the leader, however foolish, will be quickly supported by detailed rate of return and strategic studies. Avoiding this trap requires strong board of director oversight. Firms with weak governance and dominated by forceful CEOs are prone to the winner’s curse.

The board needs to consider the risk of an acquisition represented by the shareholder value at risk (SVAR), which represents the premium offered relative to the buyer’s market capitalization.  It measures the impact of failing to achieve the projected synergies. Larger, more competitively priced transaction with high SVAR should receive additional oversight.

Value additive acquisitions are difficult. Growth is not free. Furthermore, acquisitions are subject to behavioral biases like the winner’s curse that frequently override good analysis. Buyers need to exercise pricing discipline based on strong board oversight. There is no right way to do the wrong thing. Overpaying for synergies with an excessive premium is the wrong thing.  Bid wisely to avoid the winner’s curse. Keep in mind that bad bidders make good targets.

Joe

It is What You Pay- Not Just What You Buy-That Matters

Corporate profits are strong. Macro uncertainty is high and reinvestment rates are muted. Consequently firms are holding record levels of cash. Managers cannot wait for the last black swan to land before deploying their cash. Nonetheless, organic growth is difficult in the current environment. Acquisitions can be a valuable supplemental growth option. Acquisitions, however, are risky. Much research indicates that the typical acquisition fails to create value for the buyer's shareholders. Buyers can succeed despite the odds if they are disciplined-especially about price.

Pricing-over paying for an acquisition- is the single biggest risk. Even the prefect target becomes bad at some price. The key is to avoid paying more than the value received. Price is a fact. It is what you give up immediately. It reflects the target's standalone value plus a premium. Value is an opinion of what you hope to receive over time represented by the standalone value plus synergies. Therefore, the target's net value added is the premium less expected synergies. The iron law of acquisitions is the buyer's shareholders lose whenever the premium exceeds synergies. Sounds simple, but is complicated by two factors.

The first is the winner's curse. In a competitive market, and the M&A market is highly competitive, the winning bidder tends to over estimate the target's value. The second is what Warren Buffett calls the institutional imperative. Essentially, whatever the CEO wants will be supported by extensive projections and numerous strategic studies. That is why it is critical to establish a reservation or walk away price before the bidding begins to avoid getting carried away during the heat of the battle. This reservation price should be set below the target's estimated net value added. Keep in mind there is no one true intrinsic value. It depends on the buyer's strategy and ability to execute on that strategy. Certain acquirers employing higher value added strategies can extract higher values from an acquisition. They will- in effect- be the natural owner of the targets, and can successfully out bid other interested parties. You need to identify those unique factors allowing you to "win" the bidding and still create value for your shareholders to avoid the winner's curse.

Successful acquisitions are difficult-not hopeless. You need to recognize this fact, and maintain a strong sense of humility. This means keeping your confidence to competence ratio below one. Remember there is no right way to do the wrong thing. If you over pay relative to the target's reasonable expected synergies, then you become a bad bidder. Bad bidders become good targets. So let the buyers beware.