more benefits, in the form of profits or cash flow, are preferred
to less; (2) near-term benefits are preferred to more distant
benefits; and (3) safe investments are preferred to risky ones.
Although it’s easy to fall into the trap that somehow the basic
principles of investment are different in start-up ventures than
in large, mature companies, these principles apply to all investments,
in all markets, and for all investors. As we show in the
next chapter, however, the ways in which the essential features
of this framework are applied will vary according to the stage
of a firm’s development as well as other factors.
When someone invests capital in a business, any business,
that investment invariably takes the form of cash, or at least
something that is convertible into cash. To illustrate, suppose a
company’s share price is $50, and that a particular investor
owns 1,000 shares. By phoning his (or her) stockbroker, the investor
could convert those shares into $50,000 of cash. Why
doesn’t he? The logical answer is that he believes, rightly or
wrongly, that by holding on to the shares he will receive cash
from the investment in the future that has a present value equivalent
greater than $50,000. If he didn’t believe this, the only
logical course of action would be to bail out of the company
and put the cash somewhere else.
This simple example points out several important lessons
about capital markets and how customers in capital markets
(i.e., investors) go about the business of deciding where to invest
their resources. First, it shows that the value of any investment
is based on the future and not the past. If investors have
cash tied up in the company today, which must be true because
their investments can be converted into cash in the present
simply by issuing sell orders to their brokers, they do so because
of expectations that they will receive more cash in the
future by hanging on to their shares. The past still matters because
it helps investors to form expectations of the future, but
ultimately it is only expectations of the future and not realizations
of the past that determine the value of any company.
The second key lesson is that value is based on capital market
expectations of performance. The practical consequence of
this lesson is that value is driven by the beliefs of investors and
potential investors. A company can be blessed with the world’s
best managers and value-creating strategies, but unless the capital
markets believe it there is no value creation. When it comes
to valuation, if the capital markets don’t believe it, it’s not true.
This fundamental reality points out the central role of communications
in affecting market perceptions of value and risk.
Third, because investors tie up cash in the present, it is the
prospect of getting even more cash in the future that gives
companies any value at all in the capital markets. This is why
finance professionals place so much emphasis on cash flows.
Companies have value precisely because they can deliver cash
flows to investors in the future. Those companies that are not
perceived as having that ability are unable to raise capital.
More specifically, the cash flow investors care about is
called “free cash flow.” It’s normally defined as a company’s
operating cash flows (i.e., the cash generated from its day-today
business activities), net of whatever investment is required
to sustain and grow these cash flows. The remainder, or free
cash flow, represents the amount of cash that the company will
then be able to give to its shareholders, bankers, and bondholders.
In other words, it is the cash flow left over, after investment,
for distribution to capital providers. Because capital
providers invest in companies precisely because of the prospect
of future cash rewards, and free cash flow represents the cash
the company will be able to give back, the value of any business
must be a function of its perceived ability to generate free
cash flows in the future. This does not mean that free cash
flows have to be positive this year, or even next, for a company
to have value now. It only means that investors must believe in
the company’s ability to generate positive free cash flows in the
future. If investors do not believe this is possible, to them the
company has no value now.
The fourth, and final, lesson this example teaches us is that
because any cash flows that a company might provide its investors
will appear in the future, all such cash flows must be
discounted. The discounting process, which reflects both the
time value of money and the risk that the expected cash flows
might not materialize, allows investors to convert a stream of
expected benefits (to be received at different points in the future)
into a common point of reference called the present value
equivalent. In short, future free cash flows are discounted by a
cost of capital, or interest rate, that reflects the rate of return
that investors would expect if they invested in another company
of similar risk.
As we show in the following chapter, while the basic aim
of investing is the same for any investor, namely the highest
risk-adjusted returns on capital, the cast of characters changes
dramatically as companies make the transition from private
to public ownership. Logically, therefore, publicly traded
companies market themselves differently than start-ups or
growth companies that have not yet gone public. For example,
the market for venture capital or angel investing is of little
or no interest to Cola-Cola or Intel. Instead, their sales
efforts in the capital markets are targeted mainly at large institutional
investors in the mutual fund, pension fund, and
insurance industries.
While the dominant motive for investing is the desire to
earn competitive returns, there can be other motives, too. For
example, some investors in start-up or early-stage investments
are attracted by the opportunity to play a role in the entrepreneurial
process. They may have been successful entrepreneurs
themselves, and welcome the chance to play that role again.
The free time and financial security provided by earlier successes
gives them the means to do this. Altruism can play a
part, too, especially for investors who want to “give something
back” to their local communities or hometowns. They may
hope to stimulate investment or entrepreneurial activity in the
region by offering capital and expertise to budding entrepreneurs.
But while these motives can sometimes play a role in the
allocation of capital, their importance is overwhelmed by the
desire of capital providers to earn the highest risk-adjusted returns
possible on their capital.
Although the world’s capital markets are bigger than ever,
the competition for capital has never been greater than it is
now. With so many businesses competing for this capital, the
process of raising capital has become as much of a marketing
function as a finance function. Logically, therefore, the key elements
of marketing come into play. For example, “know your
market.” This means understanding who your best prospective
investors (buyers) are, what they want to know, and what sort
of investment opportunities they look for. Trying to sell a security
to the wrong prospective buyer is expensive and wasteful,
particularly when the range of tastes for securities covers virtually
every kind of company and every kind of industry.
Another tenet of marketing is to “know your product.”
This means knowing every aspect of what your business has to
offer investors. What can you offer them, in terms of riskadjusted
returns, that other investment opportunities cannot?
In order to compete successfully for capital, any company
must be prepared to demonstrate—clearly, forcefully, and honestly—
those factors about itself that indicate why it would be
such a good investment.
Another tenet of marketing is to “know how to communicate
effectively.” One of the authors attended an investor forum
where would-be entrepreneurs had 10 minutes each to explain
their business concepts and risk-return prospects. Half of the
presentations were so poorly done that they didn’t stand a
chance, however good their business concept might have been.
Today, managers talk about creating a value proposition
for their customers. They must do likewise for their capital
providers. In short, they must convince investors that their
business offers a superior risk-return profile (i.e., a superior
value proposition) to alternative investment opportunities
(i.e., competitors).
Read More: What Investors Want?
