As a leading provider of valuation services to the energy industry, we spend most of our time focusing on the nuances around traditional valuation techniques and how to best apply them to the various subsectors of the energy sector. However, with the recent boom in alternative energy investments and the “energy transition”, our private equity clients are especially spending more time looking at earlier and earlier stage investments. Most early-stage energy investments fall into two categories: new technologies and early-stage project financings.
When most people think of traditional valuation techniques, they think of the “Big Three”:
- Discounted Cash Flow (DCF)
- Comparable Public Company Multiples (Public Comps)
- Comparable Transaction Multiples (Transaction Comps)
Valuation Of Early-Stage Investments: Assuming The Unknown
They say when you have a hammer, everything looks like a nail, but we often caution our clients against this kind of bias. For early-stage investments, these tools may not be the best as primary valuation techniques. For example, and for obvious reasons, these early-stage companies rarely have good comparables. Financially, one new technology can be very different from another, making comparisons difficult.
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Also, with early-stage companies, many are not yet at a stage where they are producing earnings, cash flow, EBITDA, or even sometimes revenue. Many people try to estimate what revenue and cash flow may look like in the future and try to compare that to other “similar” company or transaction multiples. However, as discussed in more detail below, these estimates are far too subjective and often, by necessity, based on layers of assumptions (i.e., market size, pricing, competitors, costs, timing, etc.). An honest range of projections at these early stages would yield implied valuation ranges that are far too wide to be useful.
Many investors or management teams are tempted to solve these issues by relying on DCF. However, in addition to the layers of assumptions involved in projections discussed above, the question of the appropriate discount rate can also be even more subjective. For example, a study by the Fed published the following results:
- 15% to 25% – Middle-market Private Equity (profitable, lower, but stable growth rates than later-stage ventures. Access to bank loans)
- 25% to 40% – Venture Capital Later-Stage (Commercially viable with customers, growing fast, and generating profits)
- 35% to 70% – Venture Capital Early-Stage (Concept stage, unprofitable and significant operational/technology risk – no customers)
Anyone who has worked with DCFs will tell you that even a 1% or 2% change in the discount rate can yield a big difference in net present value (NPV). We often find that combining ranges on assumptions (i.e., growth, price, cost, market penetration, etc.) with these discount rate ranges can result in valuation ranges from deeply negative to wildly positive. In cases involving venture and early-stage investing (both technology-based or project-based), we find that taking a step back and looking at the bigger picture is often more useful.
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Take the example of an equity investment in an early-stage technology-based venture. The initial investment is typically made by a venture firm based on an assessment of the technology and its potential applicability. In most cases, the initial investment gives the venture firm control of the venture and the founder and team with a material equity stake. The ownership reflects the fact that, especially at such an early stage, the capital provider is carrying virtually all the financial risk. The start-up venture capital is used for:
- Developing and proving the technology
- Administrative and legal start-up and patent costs
- Scaling the technology
- Assembling the appropriate team
- Building out infrastructure for a sustainable business model
Similarly, an early-stage energy project goes through a comparable set of steps before it can reach long-term financial fundability:
- Identify project and technology
- Site selection and market analysis
- Assemble the appropriate team
- Acquire land (purchase or lease)
- Obtain licenses/permits
Determining The Best Valuation Methodology Approach
Only until these initial hurdles are achieved can a reasonable set of projections be relied on, and traditional valuation techniques be utilized. For a technology-based venture, this milestone is somewhat unclear but with a project, it coincides with the “financial closing” of the project financing.
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Until that time, we recommend a cost-based approach (“Cost Approach”) to valuation. The Cost Approach entails looking at the amount of capital spent on a venture at a certain point in time. Obviously, there are nuances like: Should the investment be depreciated? Should an opportunity cost of that capital be considered? While valuation decisions regarding these nuances are evaluated on a case-by-case basis, the crux of the Cost Approach in the context of venture and early-stage energy investments is typically a two-pronged due diligence-based test:
- Has any new information come to light during the development process that calls into question whether the technology or project is still potentially economically viable? (Important to the Buyer)
- If a business plan is found not to be viable, it would suggest that the historical costs should be written off/down and that the value of that business is less than what the Cost Approach valuation would indicate.
- A contextual indicator is a current valuation based on the Cost Approach relative to the total future development costs. If costs spent to date are high relative to future development costs, it logically might imply that either (a) the business has been developed to the point that financial projections should be reviewed to determine the value or (b) the costs may not be fully justified relative to the future business and more evaluation could be needed.
If reasonable and specific financial projections are not available, the implicit assumption in the Cost Approach is that the venture will generate positive returns
- Could the Cost Approach underestimate the value of the venture? (Important to Seller)
- Need to determine if the development work to date has generated excess economic goodwill over and above the value suggested by the Cost Approach.
- If a business has progressed far enough that reasonable financial projections of cash flow exist and can be evaluated against projected reasonable estimates of future development capital and other costs, it would be possible to determine if the risk-adjusted range value of the venture exceeds the valuation suggested by the Cost Approach (potentially a wide range but above the Cost Approach value).
- Often this shift to more traditional valuation techniques (i.e., DCF) can occur at or near a literal (project-based) or figurative (technology-based) financial closing. Financial closing cannot occur without a good understanding of expected future cash flows relative to the required investment.
As alluded to above, this two-pronged test is based on objective, detailed and comprehensive due diligence:
- Focus on the specific nature of the commercial opportunity, the stage of development, identification of significant milestones passed or remaining, pro formas where available, and estimates of capital required to complete.
- Also focused on assessments of probability to complete as a high percentage of early-stage ventures terminate or are abandoned due to technical, financial, or regulatory reasons.
- Total invested to date and additional required for “financial closing”.
- Discussions with the management teams.
Lastly, as a reasonableness check, to the extent the projections are available, we recommend using them to calculate an internal rate of return (IRR). This IRR can then be compared to the very wide ranges highlighted in the Fed study referenced above. If the implied IRR falls outside of the range, it could be an indication that the two-pronged test needs to be revisited and scrutinized.