There is a staggering difference between the return on investment (ROI) that a venture capitalist seeks (some more than 50 percent per year) compared to the ROI that a large company may seek (some are at 7 percent per year) from a potential business acquisition. The difference often takes business sellers — and even business brokers — by surprise, but it makes perfect sense.
Although some acquirers speak in terms of multiple of earnings when they discuss pricing on a business, in the end it all comes down to future earnings, and how much of those earnings are available as a payback on the initial investment. Return on investment (or return on equity) is a method of measuring that payback, and it involves forecasting out the cash flow of the acquisition vs. the initial investment and calculating the rate of return.
We just finished estimating the value of a product line for which the most likely acquiring candidate would be a large company. Large companies typically have fairly low cost of capital. They can raise money by selling stock or they can raise money using debt. An average of these sources is called the weighted average cost of capital, or WACC. When a company looks at a project, they often compare the rate of return to their internal cost of raising money, their WACC. If the project such as an acquisition returns more than the WACC, it is considered a good deal, since they can make more money with the project than it costs to get the money. A typical WACC for a large, mature company in a low risk area can be 7 or 8 percent (for example, their debt cost is basically prime or even lower).
However, risk raises the required ROI by a significant amount. Private equity groups (PEGs) typically require 35 percent per year return on their investment. PEGs typically invest in mature, fairly stable profit generating companies, as compared to Venture Capitalists (VCs) that invest in early stage, often pre-revenue companies. VCs require 50 percent or even more per year.
The difference is the risk. In fact, trained business appraisers will “build up” the discount rate (essentially ROI) used for valuations. They’ll start with the low risk discount rate, very similar to what a large stable company uses, and then add risk premiums. There are significant risk premiums added just by the fact that a company is small. In some high risk tech areas they end up with 50 percent.
That discount rate is applied to future estimated cash flows. A high risk technology venture with huge future “potential” cash flows will be discounted fairly heavily because of the risk premium associated with that industry. And it makes sense, doesn’t it? Many technology ventures have a large payoff – IF they succeed. Many don’t. By requiring 50 percent ROI, the VCs acknowledge that they’ll make good money with the successes, but that for many of their investments there won’t be a big payoff.
By the way, private buyers that pay three times earnings for a business are, in effect, requiring 25 to 30 percent ROI, even if they don’t do the calculations.