EMF uses many of the ideas presented by Spinelli and Adams in creating and financing new ventures. See below for an outline of how we approach Deal Valuation.
I. The Art and Craft of Valuation.
A. The entrepreneur’s world of finance in private markets is very different from corporate finance of public companies.
II. What Is a Company Worth?
A. In the case of private markets, where start-up companies are priced and financed, there is no equivalent of a public market for the company to know its worth or readily access capital.
B. Determinants of Value.
1. Value is determined by its risk in relationship to the potential return.
2. The ingredients to the entrepreneurial valuation are cash, time, and risk.
C. A Theoretical Perspective
1. Establishing Boundaries and Ranges Rather Than Calculating a Number.
2. There are dozens of different ways of estimating the value of a private company but the only value that matters is the price at which investors are willing to invest.
D. Investor’s Required Rate of Return (IRR).
1. Various investors will require a different rate of return (ROR) for investments in different stages of development.
2. IRR provides a benchmark to compare different returns across different time frames.
E. Investor’s Required Share of Ownership.
1. The rate of return required by the investor determines the investor’s required share of the ownership.
2. By changing any of the key variables, the results will change accordingly.
III. The Theory of Company Pricing.
A. The capital market food chain depicts the evolution of a company from its idea stage through an initial public offering (IPO).
1. The appetite of the various sources of capital vary by company size, stage, and amount of money invested.
2. Capital may be from family, friends, and angels, to venture capitalists, strategic partners, and the public market.
B. The Theory of Company Pricing
1. A venture capital investor envisions two to three rounds of financing.
2. The per share equivalent increases with each round: 4 to 5 times markup to Series B, followed by a double markup to Series B, then again by double markup to Series C.
3. The generic pattern would characterize the majority of deals that make it to an IPO.
IV. The Reality.
A. The venture capital industry has exploded in the past 25 years.
1. Current market conditions, deal flow, and relative bargaining power influence the actual deal struck.
2. The dot-com explosion led to much lower values for private companies.
B. The Down Round or Cram Down circa 2003.
1. In this environment, entrepreneurs face rude shocks in the second or third round of financing.
2. Instead of a four or even five times increase in the valuation from Series A to B, or B to C, entrepreneurs encounter a “cram down” round.
3. The price is typically one-fourth to two-thirds of the last round, severely diluting the founders’ ownership.
C. Improved Valuations by 2008
1. Both the flows of venture capital and the IPO market continued their strong rebound in 2007.
2. Overall, looking ahead to 2013 and beyond, the capital climate and valuations were showing signs of recovery.
V. Valuation Methods.
A. The Venture Capital Method.
1. Is appropriate for investments in a company with negative cash flows at the time of the investment, but has the potential to generate significant earnings.
2. Venture capitalists are the most likely investors to participate in this type of investment.
3. The steps involved are:
a. Estimate the company’s net income in a number of years.
b. Determine the appropriate price-to-earnings ratio, or P/E ratio.
c. Calculate the projected terminal value by multiplying net income and the P/E ratio.
d. The terminal value can then be discounted to find the present value of the investment.
e. To determine the investor’s required percentage of ownership, the initial investment is divided by the estimated present value.
f. Finally, the number of shares and the share price must be calculated.
B. The Fundamental Method is simply the present value of the future earnings stream.
C. The First Chicago Method.
1. The method, developed at First Chicago Corporation’s venture capital group, employs a lower discount rate, but applies it to an expected cash flow.
D. Ownership Dilution.
1. The final ownership that each investor must be left with, given a terminal price/earnings ratio, can be calculated using the formula’s basic valuation.
E. Discounted Cash Flow.
1. In a simple discounted cash flow method, three periods are defined:
a. Years 1-5.
b. Years 6-10.
c. Year 11 to infinity.
2. The necessary operating assumptions are initial sales, growth rates, EBIAT/sales, and (net fixed assets + operating working capital)/sales.
3. The discount rate can be applied to the weighted average cost of capital (WACC.)
4. Then the value for free cash flow (Years 1-10) is added to the terminal value.
F. Other Rule-of-Thumb Valuation Methods.
1. Other valuation methods are based on similar, most recent transactions of similar firms.
2. Venture capitalists know the activity in the current marketplace for private capital.
VI. Tar Pits Facing Entrepreneurs.
A. There are several inherent conflicts between entrepreneurs and investors.
1. Entrepreneurs want all the investment up front, while the investors want to supply just enough capital in staged commitments.
B. Staged Capital Commitments
1. Venture capitalists rarely invest all the external capital that a company will require.
a. Instead, they invest in companies at distinct stages in their development.
b. By staging capital, the venture capitalists preserve the right to abandon a project whose prospects look dim.
2. Staging the capital also provides incentives to the entrepreneurial team.
a. To encourage managers to conserve capital, venture capital firms apply strong sanctions if capital is misused.
i. Increased capital requirements invariably dilute management’s equity share.
ii. The staged investment process enables venture capital firms to shut down operations.
b. The threat by investors to abandon a venture is a key incentive for entrepreneurs.
VII. Structuring the Deal.
A. What Is a Deal?
1. Deals are economic agreements between at least two parties.
2. A Way Of Thinking About Deals Over Time: Asking a series of questions of the stakeholders is important for deal makers in structuring and in understanding how deals evolve.
3. The Characteristics of Successful Deals include:
a. They are simple, robust, and organic.
b. They take into account the incentives of each party to the deal and provide mechanisms for communication and interpretation.
c. They are based on trust rather than legalese and are not patently unfair.
d. They do not make it too difficult to raise additional capital and they match the needs of the user of capital with the supplier.
e. They reveal information about each party and allow for the arrival of new information before financing is requires.
f. They do not preserve discontinuities, consider the fact that it takes time to raise money, and improve the chances of success for the venture.
4. The Generic Elements of Deals.
a. The deal includes value distribution, basic definitions, assumptions, performance incentives, rights, and obligations.
b. Representations and warranties and covenants are all parts of the deal structure.
5. Tools for Managing Risk/Reward.
a. The claims on cash and equity are prioritized by the players.
b. Tools available are common stock, partnerships, preferred stock, debt, performance conditional pricing, puts and calls, warrants, and cash.
c. Nonmonetary tools include:
• Number, type, and mix of stocks.
• The number of seats on the board of directors.
• Possible changes in the management team and in the composition of the board.
• Specific performance targets for revenues, expenses, market penetration, and the like.
B. Understanding the Bets.
1. Deals are based on cash, risk, and time, and are subject to interpretation.
2. Various valuation methods contribute to the complexity of deals.
3. The text presents examples of term sheets for review and consideration.
4. The entrepreneur needs to identify the underlying assumptions, motivations, and beliefs of the individuals proposing the deals.
C. The Specific Issues Entrepreneurs Typically Face.
1. The primary focus is likely to be on how much the entrepreneur’s equity is worth and how much is to be purchased by the investor’s investment.
a. Other issues involving legal and financial control of the company and the rights and obligations of investors and entrepreneurs.
b. Another issue is the value behind the money that a particular investor can bring to the venture.
2. There are critical aspects of the deal that go beyond “just the money.”
3. Subtle but significant issues may be negotiated;
a. Co-sale provision, by which investors can tender their shares of their stock before an initial public offering.
b. Ratchet anti-dilution protection, which enables the lead investors to get free additional common stock if subsequent shares are ever sold at a price lower than originally paid.
c. Washout financing, which wipes out all previously issued stock when existing preferred shareholders will not commit additional funds.
d. Forced buyout, allowing the investor to find a buyer if management cannot.
e. Demand registration rights for at least one IPO in three to five years.
f. Piggyback registration rights grant rights to sell stock at the IPO.
g. Key-person insurance, requiring the company to obtain life insurance on key people.
D. The Term Sheet.
1. Regardless of the source of capital, the entrepreneur will want to be informed about the terms and conditions that govern the deal signed.
2. For example, there are four common instruments:
a. Fully participating preferred stock.
b. Partially participating preferred stock.
c. Common preference.
d. Nonparticipating preferred stock.
VIII. Sand Traps.
A. Strategic Circumference.
1. Each fund-raising strategy causes actions and commitments that will eventually scribe a strategic circumference around the company.
2. The entrepreneur needs to think through the consequences of each fund-raising strategy.
3. Creating a strategic circumference may be intentional, or may be unintended and unexpected.
B. Legal Circumference.
1. Legal documentation spells out the terms, conditions, responsibilities, and rights of the parties to a transaction.
2. Because these details come at the end of the fund-raising process, an entrepreneur may arrive at a point of no return.
C. Unknown Territory.
1. Entrepreneurs need to know the terrain, particularly the requirements and alternatives of various equity sources.
2. A venture that is not a “mainstream venture capital deal” may be overvalued and directed to investors who are not a realistic match.