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What is Valuation?

The process of determining what an asset is worth today and at some later date– Buyer Dependent

Financial buyers vs. strategic buyers– Stage Dependent

Early vs. late-stage investments– Company Evolution/Track Record Dependent

Thriving vs. struggling investments, expected or unexpected round– Capital Requirements Dependent

Is this one of a series of capital raises or the final one?– Market Driven

An estimate of the future cash flows or proceeds from the sale of assets held by a business

– Subject to the Risks Associated with the Firm Basis for negotiating private equity investments

– Pre-money/post-money analysis– LBO purchase price

Valuation Overview

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Valuation

The Importance of Cash, Cash Flow– Cash is the lifeblood of any business– Financial reports can misrepresent cash flow– Every modeling assumption impacts cash flow and

projected return on investment

Ultimately a company is worth only as much as you want to pay for it, though someone else may want or be able to pay more

Valuation Overview

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Deal Analysis Framework

• Market/Industry Analysis– Secular Trends, Size, Value, Competitors, Five Forces, Strategy,

Technology, Product Quality, Distribution Channels

• Revenue/Growth

• COGS

• Gross Profit Margin Trends

• Operating Expenses

• EBITDA Margin Trends

• Debt Required, Capital Structure

• Working Capital Potential Improvements

• CapEx Projected Needs

• Free Cash Flow

• Ratio Analysis Management

Valuat ion

Valuation Overview

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Pre-Money and Post-Money Value

Pre-Money/Post Money Valuation– Lexicon for determining common equity ownership for investors– Establishes a value for the a business

“Value” can either be derived or set prior to a fundraising

Many entrepreneurs focus on valuation too much and lose value because of liquidation preference provisions

Post-Money Valuation V/(1+r)t

Pre-Money Valuation Post-Money - Investment

Ownership Fraction Investment / Post-Money

Pre-Money / Post-Money Valuation

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Early-Stage Investment Scenario

Early stage investment in a software company– Pre-money valuation of $3.0 million– Capital raised of $5.0 million– Post-money valuation of $8.0 million (pre-money + invested capital)

New investor owns 62.5% of the common stock while founders and/or original investors own 37.5%

If new stock is redeemable preferred equity plus warrants for 62.5% of the common stock, then new investors would be able to receive their principal plus any accrued dividends as well as any multiple of capital paid from a liquidation preference

– Despite the preferred stock and the fact that the bulk of the proceeds at exit go to the investors, the post-money valuation is still $8.0 million

Example: Early-Stage Investment

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Structure, Valuation and Risk

Why a $3.0 million pre-money valuation?– Early stage companies tend to lack well defined products, multiple customers, revenues

and profits. Firms tend to be more about ideas and management– Risks include competitive risk, product development risk, market acceptance/customer

adoption risk, execution risk, financing risk– Venture capitalist wants to own a large percentage of the equity because there is a high

risk of dilution in future rounds Why use preferred equity?

– These securities allow the investor to recover all of the invested capital before management receives any consideration and the investor earns any meaningful upside

What will drive value at exit?– Company is expected to run losses for the foreseeable future so value will most likely be

created at some point in the future via an M&A or IPO process Why would a founder accept such a high level of dilution?

– Venture capitalist may bring skills, experience and network that will facilitate the company’s success

– May have been the best offer on the table

Example: Early-Stage Investment

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Late-Stage Investment Scenario

Series D investment in a software company– Pre-money valuation of $48.0 million– Capital raised of $12.0 million– Capital raised in Series A-C: $18.0 million– Post-money valuation of $60.0 million (pre-money + invested capital)

While the Series D represents 40% of the capital raised, the new investor only has a claim on 20.0% of the common stock while founders and/or original investors retain a 80.0% interest

The new stock is convertible preferred equity. Series D Preferred Equity is pari passu with all other preferred stock.

So it will take 40% of the proceeds paid out in a liquidation event that does not result in a conversion by all investors of their preferred equity into common stock

Example: Late-Stage Investment

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Structure, Valuation and Risk

Why a $48.0 million pre-money valuation?– The company has attained a modicum of success. It has a viable product and

customer list. It also expects to become cash-flow positive next year.– The new equity is being used to open up three new sales offices– Management expects to take the company public in 12-18 months

Why would the new investors make this investment without the protection of a liquidation preference?

– The company’s performance appears to be solid and the likelihood of exiting in the near future at a favorable valuation is likely. In order to get in the deal, the new investors had to forgo certain protections

Example: Late-Stage Investment

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Valuation Approaches

Comparables Venture Capital Method Net Present Value Method Adjusted Present Value Method Real Options Analysis

Valuation Approaches

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Comparables

Look for data on firms with similar value characteristics and benchmark accordingly

– Investment data, purchase price data May need to normalize data according to factors such as general

business risk profile, size of business or market, market, revenue or profitability growth rate, capital structure, stage of company evolution, etc.

Look for data on publicly traded firms with the same value characteristics

– Investment data, purchase price data The use of public company “comps” also needs to be viewed with

caution. In addition to the need to normalize according to the factors listed above, public company valuation are subject to swings in the capital markets that may be firm specific, but are equally likely to be sector driven, market driven or caused by some exogenous shock

Comparables

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Comparables

Pro’s Quick to use Easy to understand Commonly used Market based

Con’s Private company

comparables may be difficult to find

When using public firm comparables, one must discount result because private firms are illiquid

Easy to fall prey to mania, market forces

Comparables

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Weakness of Comparables

Based on accounting adjustments and interpretations, which may not accurately reflect cash flow

Based on a static result which may not accurately reflect the past or projected performance

Relying on multiples can shift focus from fair market value to strategic value

Comparables may be of different scope Historical transaction multiples may not reflect

current market conditions

Source: Valuation for M&A

Comparables

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Venture Capital Method

Simplified NPV method Venture deals have negative cash flow for years, then emerge

with substantial earnings High degree of uncertainty Value is imbedded in the terminal value Based on a targeted rate of return Valuations are based on percentage ownership of common stock

– If the investment is done with a preferred security (which is the norm) or has a liquidation preference, this will not impact the pre-/post-money valuation despite the fact that the economics of the deal are skewed in the VC’s favor

Venture Capital Method

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Venture Capital Method

Value = Terminal Value / (1+Target IRR) ^ TYears

Required Final Ownership = Investment Commitment /

Discounted Terminal Value

Required Current Ownership = Required Final Ownership/

((1-Dilution x+1)*(1-Dilution x+2)*(1-Dilution x+3)

Venture Capital Method

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Venture Capital Method

Pro’s Simple to understand Quick to use Commonly used

Con’s Relies on terminal

values derived from other methods

Terminal value assumes success

Very rudimentary Almost no visibility Subject to market

forces, swings

Venture Capital Method

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Net Present Value Method

Cash flow based methodology

CF1 = EBIT1*(1-t) + Dep1 – CapEx1 – NWC1 + Other

TVT = [CFT*(1+g)]/(r-g)

NPV = [CF1/(1+r)] + [CF2/(1+r)2]+…+[(CFT + TVT)/(1+r)T]

r = (D/(D+E))* rd * (1-t) + (E/(D+E))*re

re = rf + *(rm - rf)

NPV Methodology

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Net Present Value Method

Pro’s Easy to run different

investment scenarios By assigning probabilities

to each scenario you can generate E(EV)

Not impacted by distorted market metrics

Technically sound and well known within the investment community

Con’s With so many estimates

and assumptions it is hard to arrive at a definitive result(s)

Capital structures can change over the lifetime of a firm, WACC assumes it does not

In many instances most of the value is in driven by the terminal value

NPV Methodology

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Adjusted Present Value Method

Useful if a firm’s capital structure is changing or if NOLs can be used to offset taxable income

Useful in LBO transactions where firms seek to reduce leverage going forward– NPV method assumes constant effective tax rate– APV looks at cash flows generated by assets and

values the interest based, tax savings separately– APV values NOLs separately

Adjusted NPV

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Adjusted Present Value Method

1. Value cash flows (like NPV) using an unlevered beta (i.e., all-equity beta)

2. Estimate tax savings from interest costs Use an NPV calculation Discount rate is the debt’s nominal interest rate

3. Value NOLs available to the firm Discount rate is the debt’s nominal interest rate If NOLs are certain to be used (over time), discount rate

should be the risk-free rate

Adjusted NPV

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Adjusted Present Value Method

Pro’s Theoretically sound Useful in situations

where capital structure changes (i.e., a typical leveraged buyout)

Effective when a firm’s effective tax rate changes over time

Con’s More complicated than

NPV method Not well known Hard to arrive at a true

value estimate since many estimates and assumptions are used

Bulk of the firm’s value may be generated by the terminal value

Adjusted NPV

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Real Options Analysis

NPV and APV don’t work when a manager or investor has “flexibility”

Private equity deals require multiple rounds Helps you delay the investment decision, or at

least hold back on putting additional money in

Real Options Analysis

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Real Options Analysis

Pro’s Theoretically sound More useful than NPV

and APV methods if managers or investors have options

Con’s Not well understood or

commonly used Hard to turn

investment decision into an option problem

Subject to limitations of Black-Scholes

Real Options Analysis

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Monte Carlo Simulation

Considers all possible combinations of input variables so it generates a probability distribution of outcomes

– Can determine probability of a “total loss” User set ranges for each assumption, not discrete

observations– Software supports a range of statistical distributions– Output ranges can be defined

Some outcomes can be spurious Not widely used or well known within private equity

community

Monte Carlo Simulation

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Drivers of Value in DCF-based Analysis

• Revenue/Growth

• COGS

• Gross Profit

• Operating Expenses

• EBITDA

• Working Capital

• Capital Expenditures

• Free Cash Flow

12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004EBITDA (600)$ 50$ 250$ 650$ 1,000$ Chg. In WC (100) (125) (125) (150) (150) CapEx (150) (250) (300) (500) (800) Other - - - - -

FCF (850)$ (325)$ (175)$ -$ 50$

Exit Mult. 5.0xExit Value 5,000$

Tot. FCF (850)$ (325)$ (175)$ -$ 5,050$

Discount Rate 15.0%Enterprise Value 1,411$

Valuation Drivers

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Valuation

What is IRR?– The discount rate at which a project would have zero NPV– A tool for evaluating the performance of a PE transaction

Companies (and investors) should accept any investment with any IRR in excess of the opportunity cost of capital

Can get spurious results when there are several sign changes within the stream of cash flows

The highest IRR’s are usually found in short-lived projects that require little upfront investment. Unfortunately, few of these projects (and investment opportunities) exist

Any result can be manipulated, so be careful

Drivers of Returns

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Impact of Good Timing and Execution

Drivers of Returns

Returns Assuming $1.25 Million Investment

12/31/1999 12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004(1,250)$ (850)$ (325)$ (175)$ -$ 5,050$

IRR 16.8%

Returns Assuming Improved Operating Performance

12/31/1999 12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004(1,250)$ (638)$ (244)$ (131)$ 250$ 5,050$

IRR 21.6%

Returns Assuming Lower Pre-Money Valuation

12/31/1999 12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004(1,000)$ (638)$ (244)$ (131)$ 250$ 5,050$

IRR 25.4%

Returns Assuming Faster Exit at Lower Value

12/31/1999 12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004(1,000)$ (638)$ (244)$ 4,000$ -$ -$

IRR 35.6%

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What Drives Valuation?

Historical and Projected Financial Results– Past and future performance are both subject to interpretation– Expectations about future capital requirements

Growth Rate of Underlying Market Strength of Business Model, Perceived Value of Product or

Underlying Technology Quality of Management Team Methodology Employed Competitive Environment

– Is lots of money chasing a few “hot deals” Market Dynamics (particularly with respect to exits)

Monte Carlo Simulation

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What Drives Returns?

Successful Execution of Plan Continued Growth of Underlying Market, Perceived

Attractiveness of Business Opportunity Proof of a Defensible Business Model Timing of Exit (at least for IRR calculation) Presence of Strategic Buyers, Open Capital Markets Good Fortune/Luck

Monte Carlo Simulation

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Valuation Wrap-Up: Deal Analysis Framework

• Market/Industry Analysis– Secular Trends, Size, Value, Competitors, Five Forces, Strategy,

Technology, Product Quality, Distribution Channels

• Revenue/Growth

• COGS

• Gross Profit Margin Trends

• Operating Expenses

• EBITDA Margin Trends

• Debt Required, Capital Structure

• Working Capital Potential Improvements

• CapEx Projected Needs

• Free Cash Flow

• Ratio Analysis Management

Valuat ion

Valuation Wrap-Up