Price, Value, Market Economy and Regulations

By definition, Price of a product is the money paid for it in an arm’s length transaction, whereas, Value of an asset is the intrinsic cash generation power of that asset or the value of intrinsic utility it provides to the one consuming it.

Theoretically, Price should be same as the Value and it is Prices that determine allocation of resources in an Economy. Objective is to utilize limited available resources in such a combination so as to produce maximum Value in total.

For example, if cars are priced higher than corn, it is but prudent that resources that can produce cars should be allocated there, and not misallocated to produce corn. So, in a country, based on its available resources and Prices of different products it produces, we can get a particular combination of resource allocation that maximizes its GDP.

Now, if Prices are distinctly away from intrinsic Values of their respective products, resources in the society will be misallocated and society will not be able to achieve its full Value Creation Potential. So, it is important to understand that there is a huge implication if Prices and Values are out of sync.

There are 2 systems that economies pursue for determining product Prices.

1. Command System
2. Market System.

In a Command System, Prices are determined by the State. It is assumed that Prices determined by them are accurate and close to their respective intrinsic values. But historically, as in case of former USSR and Eastern European countries, this system did not work and their economies collapsed.

In a Market System, Prices are left to be determined in the market, based on Demand and Supply principles. Theoretically, this looks like an ideal system, where Equilibrium Prices could be close to their intrinsic Values and could also keep current with any changes in conditions. But recent financial crisis has exposed two major vulnerabilities of this system.

1. Information Gap: One big assumption of Demand Supply Principle to determine Prices is that both parties in a transaction have the same level of information. If this assumption does not hold then Prices will be distinctly away from their respective intrinsic Values. For example, if selling party has more information than the buying party, Prices will be higher than what they should be. And if this information gap remains for a critical period, it may result in formation of Bubbles.

2. Price Volatility: Since Prices are determined by market Demand and Supply, they are bound to fluctuate in keeping up with ever changing conditions. This results in additional costs to businesses in form of Hedging Costs and an added Cost of Production in the economy.

This is where in a Market Economy; State must play a role by putting in Regulations. Regulations must ensure that no Information Gap exists and irrespective of complexities of financial instruments used, information should be available to all transacting parties in complete and full.

Evaluation of Firm for Venture Capital Financing

Once a Venture Capital Firm has looked into the firm seeking finance and is also willing to finance an agreed sum, the next issue is how much of ownership should the Venture Capital Firm seek in lieu of its funding?

This is generally a negotiable process between Entrepreneurs and the Venture Capital firm. However, the evaluation process described below is only used as a baseline for these negotiations. The term given to this mostly used evaluation method is known as ‘Venture Capital Method’.

Objective of the Venture Capital firm is to finance an upcoming firm, for a Limited Period, in return for an Equity Ownership in that firm. It will seek to sell out its stake at the end of that period thru an IPO or a Private sale. Length of this period is very important to the Venture Capital Firm, as its capital will be tied up into Entrepreneur Firm for such expected period.

Evaluation Process begins by having Forecasted Statements of Earnings, prepared by Entrepreneur Firm for the period of Venture Capital Investment. Now, based on Final Period forecasted Earnings from this statement, Value of the Firm is determined using a comparable market P/E multiple. For example, if final period earnings are $1m and average P/E multiple of listed firms in the same industry as the Entrepreneur Firm is 10x, then the Value of the Entrepreneur Firm at the end of Financing Period is 1 X 10 = $10m.

Next, the terminal value of $10m is discounted to today’s value using an appropriate Discount Rate (say 30%). That would give us the Value of the Firm as of today.

Knowing the value of the firm as of today (say $2m) and knowing the funding asked for (say $1m), ownership percentage of Venture Capital Firm would be $1m/$2m = 50%.

As we see, there are several assumptions used in this process.

· Earnings Forecast is a big assumption and is expected to be overly optimistic as it is prepared by Entrepreneurs.
· Comparable P/E is another assumption. Usually, it will be difficult to find existing listed firms of the similar size and industry as the Entrepreneur Firm.
· Discount Rate is another assumption.

Venture Capital firm will negotiate on Earnings Forecast for them to be consistent with appropriate risks it sees. Another way to reduce value would be to reflect those risks in the Discount Rate used. If Cash flows are overly optimistic, Discount Rate could be higher to subdue them.

So, during negotiations, Projected Earnings/Cash Flows is where Entrepreneurs could be optimistic and Discount Rate is where Venture Capital firm can be pessimistic. So, both have their negotiation tools in the valuation process.

Another issue for Venture Capital Firm is to know, if Entrepreneurs are planning any future Venture Capital financing in that firm. If they are, then, any such future funding will dilute their existing ownership. But, if these future fundings are known at the time of first financing, Venture Capital firm would increase their ownership proportionately, so as to get its expected ownership after any future dilution/s.

To summarize, objective of this evaluation is not to project an accurate value for that firm, but rather to provide a good basis for any negotiated value.

Cash, Liquidity and Working Capital Management

Quite often the terms, Cash Management, Liquidity Management and Working Capital Management seem to be used interchangeably. These functions may be related and may provide effective inputs to each other, but, their scope under management is distinctly different.

Working Capital Management involves your current assets in Inventory and Receivables and your current liabilities under Payables. The scope under this function is to manage the amount required as Working Capital, its duration and different ways of financing it. Please see my earlier blog for more details in managing this function.

Cash Management involves management of your Cash Flows. Under its scope there are three categories of Cash Flows to be managed:
· Cash Inflows
· Cash Concentrations
· Cash Disbursements
The objective is to establish and manage cost effective processes that will speed up your Collections and Concentration and optimally delay your Disbursements.

Liquidity Management function is to manage availability of Cash to make payments on your obligations as and when they become due. Need for Liquidity Management arises from the fact that businesses have uncertain and asynchronous timings between their Cash Receipts (from Sales) and their various other payment obligations. Decisions on when, how much and how to finance for any gaps and decisions on how to invest excess liquidity are core parts of this functionality.