Start Up Valuation
Start Up Valuation
Table of Contents
Table of Contents .................................................................................................................................. 2 OVERVIEW ................................................................................................................................................. 3 VALUATION METHODS .......................................................................................................................... 3 NET PRESENT VALUE ................................................................................................................................. 3 Step 3: Calculate NPV .......................................................................................................................... 4 ADJUSTED PRESENT VALUE ....................................................................................................................... 5 COMPARABLES ........................................................................................................................................... 5 VENTURE CAPITAL METHOD ...................................................................................................................... 6
Pre-money and post-money valuation............................................................................................................... 6
FIRST CHICAGO METHOD ........................................................................................................................... 6 REAL OPTIONS ........................................................................................................................................... 7 COMPARISON OF VALUATION METHODS .................................................................................................... 8 NON-FINANCIAL CONSIDERATIONS ........................................................................................................... 10 STAGES OF INVESTMENT .......................................................................................................................... 10 PROVISIONS OF TERMS SHEETS ....................................................................................................... 11 THE NEGOTIATION PROCESS .................................................................................................................... 11 INVESTMENT INSTRUMENTS ..................................................................................................................... 12 Preferred Stock ................................................................................................................................... 12 Liquidation Preference ....................................................................................................................... 12 Conversion Rights............................................................................................................................... 13 Conversion Rate Adjustments Anti-dilution ..................................................................................... 13 Redemption ......................................................................................................................................... 14 Common Stock .................................................................................................................................... 14 Convertible Debt................................................................................................................................. 14 PARTICIPATION IN MANAGEMENT OF COMPANY....................................................................................... 15 STOCK PURCHASE AGREEMENT ................................................................................................................ 16 REFERENCES ........................................................................................................................................... 16
Overview
Valuation of startup and emerging companies with most having negative cash flow in early stages with significant projected rewards later is very difficult task. Yet investors are confronted frequently with investments whose current value must be estimated in spite of the fact that much of the reward lies in future. This paper will discuss various methods used by investors to value such startups and emerging businesses. The latter half of the paper will discuss negotiation of term sheets and various different terms that are used by investors to ensure a successful investment, maintain value and control of the invested company as much as possible, share some risk with other investors and obtain maximum financial reward if the venture turns out to be a success.
Valuation Methods
Following are some of the most commonly used methods for valuation of startup and emerging companies followed by a comparative analysis of the strengths and weaknesses of each method. There are various different approaches to estimating the value of a startup company. Income Approach: Estimating future cash flow that could be taken out of the business without impairing future operations. Most common methods in this approach are: Net Present Value, Equity Cash Flow and Capital Cash Flow (Adjusted Cash Flow being a variation of this method). Market Approach: Estimates the value of a going concern business by comparing to similar firms whose stock is publicly traded. In many cases Market Approach is used as a secondary valuation method to verify the estimates derived from the Income Approach. Asset Approach: valuation based on the firm as a financial option.
Comparables
The comparables method is often used to arrive at a ballpark valuation of a firm. First firms that display similar value characteristics are selected. These value characteristics include risk, growth rate, capital structure, and the size and timing of cash flows. Often, these value characteristics are driven by other underlying attributes of the company which can be incorporated in a multiple. This valuation method is most useful when all the chosen comparable firms are publicly traded and their capital structure, revenue, profit margins, net profit figures are known. The most common measures used while valuation using this method are: P-E Ratio (share price divided by the earnings per share) Market value of the firm divided by total revenue Market-to-book ration (Market value of the firm divided by the shareholders equity) Market Value divided by EBITDA (earnings before interest, taxes, depreciation and amortization)
An average of these ratios for the chosen comparable firms is calculated and based on that the value of the firm is calculated for each measure. This gives a range of values for the firm based on these measures.
that subsequent performance of individual companies does not always match the projections contained in the original plans. This valuation method developed by First Chicago Corps venture capital group employs a lower discount rate but applies to an expected cash flow, which is calculated as an average of three possible scenarios, with each scenario weighted according to its perceived probability. Following three scenarios are considered: The success scenario: Under this scenario, the VCs assume that the company will successfully reach IPO stage in 4 to 5 years. In this case the last year (IPO year) cash flow can be calculated as: (accrued dividends) + ((final ownership %) x (terminal value)) Where, accrued dividends are total dividends received on preferred stock in prior years. The Sideways Scenario: In this case the company survives with enough profitability to pay dividends for first few years but never reaches the IPO stage. The Failure Scenario: The company is unsuccessful and the VCs have to recover capital by liquidating the assets of the company. Therefore cash flows under this scenario can vary greatly depending on how the funds were utilized. Once the scenarios are laid out, probability of each scenario is determined. The projected cash flows for each year are multiplied by the probability and a weighted average cash flow for each year is calculated. The expected cash-flow is broken down into expected cash flow from IPO and rest of the expected cashflow. Thus: (p x (final ownership) x TV) + FV(non-IPO cash flow) = FV(investment) Where, p = IPO probability TV = forecast terminal value Therefore the required final ownership is calculated as: Final ownership = ( FV(investment) FV(non-IPO cash-flow))/(p x TV)
Real Options
Discounted cash flow methods like NPV and APV can be deficient in situations where a manager or investor has flexibility in terms of changing rate of production, defer deployment or abandon a project. These changes affect the value of the firm which can not be measured accurately using discounted cash flow methods. Private equity-backed companies are often characterized by multiple rounds of funding. Venture capitalists use this multi-stage approach to motivate the entrepreneur to perform better and limit their exposure to a particular company. Options analysis in valuing firms as options is a developing area in finance. In this method firms are analyzed like a financial option. There are five variable commonly used in a financial option:
X = exercise price S = stock price T = time to expiration = standard deviation of returns on the stock r = time value of money In the firm option, they are interpreted as: X = Present value of expenditures required to undertake a project S = Present value of the expected cash flows generated by the project T = The length of time that the investment decision can be deferred = riskiness of the underlying assets r = risk free rate of return Once these variables are know the value of the option can be calculated using Black-Scholes computer model or a call option valuation table. The Black-Scholes formula calculates the price of a call option to be: C = S N(d1) - X e-rT N(d2) where C = price of the call option S = price of the underlying stock X = option exercise price r = risk-free interest rate T = current time until expiration N() = area under the normal curve d1 = [ ln(S/X) + (r + 2/2) T ] / T1/2 d2 = d1 - T1/2 Valuation of firms as a financial option is a very new concept and is not yet widely used.
NPV
Theoretically Sound
Cash flows may be difficult to estimate Private company comparables can be difficult to find and evaluate WACC assumes a constant capital structure and constant effective tax rate Typical cash flow profile of startups (negative cash flow in the beginning and uncertain inflows later) is very sensitive to discount and terminal growth rate assumptions More complicated than NPV Some of the same disadvantages as NPV except WACC assumptions
APV
VC Method
Theoretically Sound Suitable in situations where the capital structure is changing Suitable in situations where effective tax rate is changing Simple to understand Quick Commonly used Theoretically sound Overcomes drawbacks of NPV and APV methods where managers
Asset Option
Relies on terminal values derived from other methods Oversimplified Not in common use Real world situations may be difficult to reduce to a solvable
have flexibility
Non-financial considerations
Along with the above valuation methods that mainly rely on financial data, investors also consider following factors while valuing a company: Quality of management team Current state of technology Current state of companies in similar market Current market conditions Size of the market and companys potential to acquire market share Track record of entrepreneur; repeat entrepreneurs get better valuation Distribution of bargaining power between VC and entrepreneur Investors often include above considerations when they decide on the discount rate when using the venture capital method.
Stages of Investment
Seed Financing: is the earliest stage of funding. Investment is small (typically low tens of thousands of dollars) to support an entrepreneurs exploration of idea. No formal business plan exists, management team may not yet be formed, no feasibility of the project established. In case of an established technology, seed money is used to finance recruitment of key management and writing business plan. Seed investors provide basic business advice, office facilities etc. Discount rates of over 80% are typical. Startup Financing: Commitment of more significant funds to an organization that is prepared to commence operations. The start-up is able to demonstrate a competitive advantage, a prototype product is available in case of a high-tech venture, impressive research staff recruitment in case of a biotech firm, in case of low-tech firms established powerful concept of pre-emption advantages and a superior management. First-Stage Financing: On-going businesses. Not profitable yet but has an established organization, a working product, and some revenues. First-stage funds are usually used to establish first major marketing efforts, and to hire sales and support staff. Sometimes funds are also applied to product enhancements, customizations etc. First stage investors often monitor the staffing levels to make sure they are in line with projected revenues. Discount rates are typically in the range of 40% to 60%. Second-Stage Financing: Typically provided for working capital, fixed asset needs to support the growth of company with active production, sustainable sales
and some profits. Mainly aimed at expansion of a tested contender. In most cased capital invested is used to acquire assets, hence more readily recoverable in event of liquidation. Lower risk than earlier rounds. Typical discount rate range 30% to 50%. Bridge Financing: Intended to carry a company until its IPO. IPO is generally expected in short-term (typically within a year from financing event). Main purpose is to satisfy on-going capital needs. Sometimes bridge investors may apply some or all of the funds to buy out early-stage investors who are anxious to liquidate their holding. Typical discount rate of 20% to 35%. Restart Financing: also known as emergency or sustaining financing, is raised for a troubled firm, at a price significantly below that of previous round. Although the venture is performing well below expectations, the round is priced low enough to offer a high expected rate of return, which may result in substantial dilution of previous investors.
o Covenants of the issuer and its founders o Registration rights of the investor o Limitations on dilution o Investors right to participate in future financing o Issuers obligation to pay investors cousel 3. Negotiate and execute required legal documents
Investment Instruments
Principal instruments used in venture capital financing are: Preferred stock Convertible debt Warrants Common stock Dividend rights: Though most investors have no interest in ordinary income or distributions from the company, the dividend clauses for preferred stock are simply designed to guarantee that the preferred stock is not disfavored by comparison with the common stock. Liquidation Preference: Liquidation preferences are designed to protect the investors economic interests. Liquidation preference protects the investors originally invested capital against dilution. Hence liquidation preference provides that on liquidation or change-in-control transactions the preferred investors get money back before anyone else.
Preferred Stock
Preferred stock gets higher preference over common stock in the event of a liquidation. Purpose of preferred stock is to: Prevent founders from being able to pull out money before they create any real value Redemption of preferred stock does not attract capital gain tax as it is just a return of capital Limits returns to the founder for modest outcomes incentives to reach high payoffs The extent to which VC wants to encourage the entrepreneur to go for the big payoffs can be controlled by specific choice of security.
Liquidation Preference
Nonparticipating or Participating Preferred stock: Nonparticipating preferred stock is preferred stock whose liquidation preference defines the total of what the holder will receive on liquidation (or sale). Participating preferred stock is entitled both to receive its liquidation preference and to receive same thing as common stockholders on an as if converted basis. Fully Participating Preferred: Participating preferred stock whose right to get both its preference and a common equivalent share have no upper limit. In most
cases participating preferred stocks have an upper limit. In this system, the investor first receives its liquidation preference, and then gets to share with the common stock until the investor has received, in total, some multiple of the investors original investment. Liquidation Preference Multiple: When the stock market sees a sharp drop in valuations, demand rises for liquidation preferences that are a multiple of the original investment. The investor gets back not only its original investment, but also a multiple of its original investment, before the common stock holders get anything.
Conversion Rights
Venture investors convertible preferred stock typically carries both rights and obligations to convert into common stock. For optional conversion, the investor typically retains the option to convert the preferred stock to common stock at will, except that it is conventional to bar conversion after an investor has demanded redemption of the stock. In case of mandatory conversion, the issuer insists on the right to compel conversion of preferred stock at specified point in time. Typical mandatory conversion points are as follows: On IPO at above-price targets: The requisite per-share price is typically 35 times On Majority conversion: compel conversion of any remaining shares when a majority of originally issued shares of the series has converted On merger above price targets: in the event of a merger or sale of the company at or above an agreed-on per-share price.
company grows, option issuances that the board, including the investors representative, view as desirable do not inadvertently trigger adjustment in conversion ration. Basic Weighted Average Anti-dilution formula: Weighted average antidilution provision realizes that the actual economic dilution experienced by an investor is a function of how many shares are issued at the dilutive price. New price = ((old value) + (new money))/((old shares) + (new shares)) Old value is a dollar figure derived by valuing the entire company at the old conversion price. Broad-based and Narrow-based weighted averages: broad-based and narrow-based refer to the number of shares included in old shares in the fraction. A broad-based weighted average antidilution adjustment typically counts old shares as all outstanding shares, and all shares issuable on exercise of granted options, warrants, and convertible debt. A narrow-based weighted average antidilution adjustment typically counts only issued common shares and issued preferred shares.
Redemption
Some preferred stock include either a mandatory or an optional right to cause the preferred stock to be redeemed. Redemption rights are a last resort for an investor because they cannot be exercised unless there is sufficient net worth to do so, after allowance for all debts and all liquidation preferences of any remaining preferred stock. Investors insist on mandatory redemption as a means of rescuing their capital if no other exit path is available.
Common Stock
The use of common stock in venture financing is relatively infrequent because it creates problems for both parties. The principal drawback to the investor is that all shares of common stock are identical so the investor has no liquidation preferences, antidilution protections, or governance rights built into the definition of the investors equity. The principal drawback to the company is that sale of common stock to investors establishes a market value for the stock that carries over to stock sales or grants to the issuers employees. Thus the sale price to employees may be higher than employees can afford to pay or if the stock is sold at a reduced price, employees may be forced to recognize taxable income to the extent of bargain.
Convertible Debt
Convertible debt is similar to convertible preferred stock but provides the investor with the security of a debt instrument and more options in managing its investment. Convertible debt is less desirable to the company because: 1. It appears as debt on companys financial statement
2. absent a subordination agreement the convertible debt is treated as debt by the companys lenders, suppliers, and creditors and may thereby limit the companys ability to obtain credit or additional financing 3. it generally requires periodic payments of interest 4. the holder of convertible debt generally retains the right to accelerate the debt if the issuer defaults in performing specified covenants. The investors ability to participate in the companys management is limited.
cash on a form of registration statement that permits inclusion of the investors securities. Right to maintain percentage investment: Some investors request the right to participate in the purchase of any future shares offered for sale by the issuer to the extent necessary to maintain their percentage interest in the company. First refusal right: Investors may request a right of first refusal with respect to the purchase of any stock subsequently offered for sale by the issuer. Key-Employee Insurance: Investors may require the company to carry keyemployee insurance on its principal managers. In some cases investors may insist on the right to require the issuer to repurchase the investors shares at fair market value on the death of a key employee, to the extent that insurance provides funds for repurchase. Employee Agreement: In most venture investments, the company must compel its present and future employees to execute a series of agreements designed to protect the companys interests. The include proprietary rights and confidentiality agreements, and, for employees holding shares of the company, employee stock repurchase agreement.
References
1. A Method for Valuing High-Risk, Long-Term Investments: The Venture Capital Method. William A Sahlman. HBS Article 9-288-006. Aug 12, 2003. 2. A Note on Valuation in Private Equity Settings. Josh Lerner, John Willinge. HBS Article 9-297-050. April 8, 2002.
3. The Basic Venture Capital Formula. William A Sahlman. HBS Article 9804-042. 4. A Note on Pre-Money and Post-Money Valuation. Linda A Cyr. HBS Article 9-801-446 April 16, 2002. 5. Does the Market Know Your Companys Real Worth? James McNeill Stamcill. Hardward Business Review Article 82509. Sept 1982. 6. Valuation: Understanding How Analysts Value Your Stock. John J. Lewis. 7. Term Sheet Negotiation for Trendsetter, Inc. Walter Kuemmerle. HBS Article 9-801-358. April 22, 2004. 8. Venture Capital Contracts Part I & II. MIT Sloan 15.431 Entrepreneurial Finance Class Notes. Antoinette Schoar. Spring 2002. 9. New Venture Valuation. MIT Sloan 15.431 Entrepreneurial Finance Class Notes. Antoinette Schoar. Spring 2002. 10. Advising Oregon Business Volume 2. 2001 Edition. William C. Campbell.