Sophisticated investors are rightly skeptical about the projections made by private companies seeking capital.
Projected profits, and the potential benefits of owning stock in a private company, are confidently advanced by management as justification for risk. The investor’s natural skepticism is compounded when the business owner seeks a modest amount of funding in return for a significant percentage of equity, coupled with projections of substantial, fast-growing profitability.
If the company truly believed its own projections, why would it sell its equity at such a low price?
The root of this issue is found in the almost infinitely variable space between the top line and the bottom line of a balance sheet. A company’s bottom line — profit — is inherently more complex to project than its top line — revenue.
Each line in the balance sheet between top and bottom — operating costs, capital expense, marketing, general and administrative, depreciation, taxes and more — is challenging to predict. So by the time you sift down to the bottom line, the complexities have compounded in so many dimensions that a reliable risk assessment is difficult to make.
Yet investors are asked to accept this complex bottom-line earnings projection (in the form of common valuation metrics like EBITDA and EPS) to justify their capital contribution. Profitability is the bedrock on which valuation rests, and on which the investor’s calculation of potential return is based. The investor, understanding the labyrinth of complexity this represents, discounts heavily for risk, and often passes on great opportunities.
Many of today’s great companies were rejected at one time or another by sophisticated investors for exactly this reason. Amazon, Google, Facebook, Apple — all sought capital as private companies, and all were turned down at some point.
In many of those cases, there were too many unknowns at the time. We will never know how many great business opportunities expired in their infancy because of their inability to attract capital from skeptical investors. For every Amazon, Google, Facebook and Apple that made it through the venture capital gauntlet — how many did we miss?
This inefficiency is wasteful for all participants in a deal, and can be corrected. Great companies need capital to grow, and cautious investors need a better means of estimating their return on investment.