1 Confidential - for classroom use only Financing New Technologies.

1 Confidential - for classroom use only Financing New Technologies

2 Confidential - for classroom use only Introduction Key Financing Issues: 1. Value creation ─ for all stakeholders ─ positive cash flow ─ harvest options 2. Allocating risks and return 3. Obtaining capital ─ how much ─ when ─ from whom ─ in what form 4. Determining ─ Who gets what and when ─ Who gives what and when Financing Requirements Driven By: 1. Business strategy ─ product development ─ marketing ─ harvest ─ burn rate ─ OOC, TTC ─ working capital ─ asset needs ─ option creation ─ personal needs 2. Sources ─ equity ─ debt ─ earnings 3. Control ─ founders ─ investors

3 Confidential - for classroom use only Critical Variables for Investors Risk and return ─ Nature of technology and market ─ Stage in the life cycle ─ Accomplishments and performance to date ─ Growth rate ─ Amount of capital required, and for what ─ Prior valuations ─ Relative bargaining positions and strength ─ Founder and investor goal convergence ─ Anticipated timing of exit

4 Confidential - for classroom use only Reducing Risk to Stakeholders The extent of risk depends on the irreversibility of the investment ─ Do not own resources; just control them ─ Use standard fungible inputs ─ Use irreversible inputs only where they can lead to competitive advantage ─ Select stakeholders most willing and able to bear the risk  diversified  experienced in the type of risk they are expected to bear  have excess capacity  are risk seekers ─ Use other people’s resources to the extent possible The kinds of milestones that stakeholders look for can include: ─ product or service concept ─ prototype ─ pilot and market testing ─ initial sales ─ initial financing ─ market development ─ redesign and repricing of initial product or service

5 Confidential - for classroom use only Sources of Financing

6 Confidential - for classroom use only Questions for Screening Investors 1. At what stage does the individual or firm usually invest? 2. What is the typical investment level over the life of a company? 3. What is the typical amount invested in each round? 4. For VCs, when was the current fund started? (If > 5 years ago, then there may not be adequate funds remaining for additional financing rounds.) 5. For individuals, how did the investor earn his/her money? How many other companies is s/he involved in? 6. How much time will be spent with the company? What expectations does the investor or firm have regarding involvement? 7. What prior deals has the individual or firm done in the industry? 8. Does the company have references (other entrepreneurs with whom it has worked) who can be contacted? Stanford casebook

7 Confidential - for classroom use only Sources and Forms of Financing Sources of Capital: 1. Bootstrapping ─ personal funds ─ friends and family ─ credit cards ─ retained earnings 2. Debt capital ─ banks ─ government 3. Private placement ─ angels ─ venture capital 4. Suppliers and customers ─ collect early, pay late Forms of Financing: Debt financing  short-term debt  longer-term borrowings Equity financing  investment  earnings Combination of debt and equity financing

8 Confidential - for classroom use only Bootstrapping Financing from ─ founder’s personal savings, credit cards, current employment, family ─ extended terms from vendors and customer advances ─ loans from banks, insurance companies, pension funds, SBA ─ leases for property and equipment Per Amar Bhide, small entrepreneurs need to ─ get operational quickly ─ look for fast break-even, cash generating projects ─ offer high-value products or services that can sustain direct personal selling ─ not over hire ─ keep growth in check ─ focus on cash ─ cultivate financing sources early

9 Confidential - for classroom use only Debt Capital: Private Sources Main sources of debt capital: ─ Trade credit ─ Commercial banks ─ Finance companies ─ Factors ─ Leasing companies SecurityCredit Capacity Accounts receivable70-80% of those less than 90 days Inventory40-60% depending on obsolescence risk Equipment70-80% of market value (less if specialized) Chattel mortgage100-150% or more of auction appraisal value Conditional sales contract60-70% or more of purchase price Plant improvement loan60-80% of appraised value or cost

10 Confidential - for classroom use only Debt Capital: Government Sources (e.g. SBA Loans) The U.S. Small Business Administration (SBA) was created in 1953 as an independent agency of the federal government to aid, counsel, assist and protect the interests of small business concerns, to preserve free competitive enterprise and to maintain and strengthen the overall economy of our nation. General Information on SBA Loans All SBA loan programs lend to small businesses unable to secure financing on reasonable terms through normal lending channels. The loan programs are operated through private-sector lenders that provide loans which are, in turn, guaranteed by the SBA -- the Agency has no funds for direct lending or grants. Most private lenders (banks, credit unions, etc.) are familiar with SBA loan programs so interested applicants should contact their local lender for further information and assistance in the SBA loan application process. 7(a) Loan Guaranty Program One of the SBA's primary loan programs, 7(a) offers loans of up to $2,000,000. (The maximum dollar amount the SBA can guaranty is generally $1 million.) Certified Development Company (CDC), a 504 Loan Program Provides long-term, fixed-rate financing to small businesses to acquire real estate or machinery or equipment for expansion or modernization. Typically a 504 project includes a loan secured from a private-sector lender with a senior lien, a loan secured from a CDC (funded by a 100 percent SBA-guaranteed debenture) with a junior lien covering up to 40 percent of the total cost, and a contribution of at least 10 percent equity from the borrower. Microloan Program This new program offers loans of up to $35,000 to qualified start-up, newly established, or growing small business concerns. Loans are arranged through nonprofit community based lenders (intermediaries) which, in turn, make loans to eligible borrowers. The entire Microloan process is handled on the local level, but you must go to one of the local intermediaries to apply. http://www.sba.gov/aboutsba/index.html http://usgovinfo.about.com/library/weekly/blsbaloans.htm

11 Confidential - for classroom use only Small Business Innovation Research Program (SBIR) SBIR is a highly competitive program that encourages small business to explore their technological potential and provides the incentive to profit from its commercialization. By including qualified small businesses in the nation's R&D arena, high-tech innovation is stimulated and the United States gains entrepreneurial spirit as it meets its specific research and development needs. SBIR targets the entrepreneurial sector because that is where most innovation and innovators thrive. However, the risk and expense of conducting serious R&D efforts are often beyond the means of many small businesses. By reserving a specific percentage of federal R&D funds for small business, SBIR protects the small business and enables it to compete on the same level as larger businesses. SBIR funds the critical startup and development stages and it encourages the commercialization of the technology, product, or service, which, in turn, stimulates the U.S. economy. Since its enactment in 1982, as part of the Small Business Innovation Development Act, SBIR has helped thousands of small businesses to compete for federal research and development awards. Their contributions have enhanced the nation's defense, protected our environment, advanced health care, and improved our ability to manage information and manipulate data. Small businesses must meet certain eligibility criteria to participate in the SBIR program. ─ American-owned and independently operated ─ For-profit ─ Principal researcher employed by business ─ Company size limited to 500 employees Each year, eleven federal departments and agencies are required by SBIR to reserve a portion of their R&D funds for award to small business. ─ Departments of Agriculture, Commerce, Defense, Education, Energy, Health and Human Services, Homeland Security, Transportation ─ Environmental Protection Agency, National Aeronautics and Space Administration, National Science Foundation ─ These agencies designate R&D topics and accept proposals. Three-Phase Program: Following submission of proposals, agencies make SBIR awards based on small business qualification, degree of innovation, technical merit, and future market potential. Small businesses that receive awards then begin a three-phase program. ─ Phase I is the startup phase. Awards of up to $100,000 for approximately 6 months support exploration of the technical merit or feasibility of an idea or technology. ─ Phase II awards of up to $750,000, for as many as 2 years, expand Phase I results. During this time, the R&D work is performed and the developer evaluates commercialization potential. Only Phase I award winners are considered for Phase II. ─ Phase III is the period during which Phase II innovation moves from the laboratory into the marketplace. No SBIR funds support this phase. The small business must find funding in the private sector or other non-SBIR federal agency funding. http://www.sba.gov/SBIR/indexsbir-sttr.html#sbir

12 Confidential - for classroom use only Small Business Technology Transfer Program (STTR) The Small Business Technology Transfer (STTR) program is similar to the SBIR program in that it fosters R&D by small businesses. The major difference between the programs was that funding was provided to joint ventures or partnerships between nonprofit research institutions and small businesses. Like the SBIR, the STTR program has three phases. An award of $100,000 is made during the year- long Phase I. Phase II awards are of up to $500,000 in a two-year expansion of Phase I results. Funds for Phase III of STTR must be found outside the STTR program. By this time, however, the research project should be ready for commercialization. The STTR Pilot program began making awards in fiscal year 1994. In that year it made 198 awards for almost $19 million to small high-technology businesses that collaborated with nonprofit research institutions to undertake R & D projects. In fiscal year 1995, 238 Phase I and 22 Phase II awards were made for a total of over $34 million. The Departments of Defense, Energy, and Health and Human Services, and the federal agencies of NASA and the National Science Foundation are required to set aside a percentage of their R&D funds for small business/nonprofit research institution partnerships annually. As with the SBIR program, STTR is a highly competitive application procedure. Small businesses have similar eligibility limits in STTR and SBIR. The nonprofit institution must also meet certain criteria; namely, it has to be located in the United States and must meet one of the following definitions: that it be a nonprofit college or university, a domestic nonprofit research organization, or a federally funded R&D center. Description of the Small Business Technology Transfer Program (STTR): STTR is an important small business program that expands funding opportunities in the federal innovation research and development arena. Central to the program is expansion of the public/private sector partnership to include the joint venture opportunities for small business and the nation's premier nonprofit research institutions. STTR's most important role is to foster the innovation necessary to meet the nation's scientific and technological challenges in the 21st century. Three-Phase Program: Following submission of proposals, agencies make STTR awards based on small business/nonprofit research institution qualification, degree of innovation, and future market potential. Small businesses that receive awards then begin a three-phase program. ─ Phase I is the startup phase. Awards of up to $100,000 for approximately one year fund the exploration of the scientific, technical, and commercial feasibility of an idea or technology. ─ Phase II awards of up to $750,000, for as long as two years, expand Phase I results. During this period, the R&D work is performed and the developer begins to consider commercial potential. Only Phase I award winners are considered for Phase II. ─ Phase III is the period during which Phase II innovation moves from the laboratory into the marketplace. No STTR funds support this phase. The small business must find funding in the private sector or other non-STTR federal agency funding. http://www.sba.gov/aboutsba/sbaprograms/sbi r/sbirstir/SBIR_STTR_DESCRIPTION.html Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

13 Confidential - for classroom use only Government Sources: TEDCO Funding Maryland Technology Transfer Fund The goal of the Maryland Technology Transfer Fund (MTTF) is to provide funding for Maryland companies who wish to develop technology-based products and/or services in collaboration with the Universities and/or Federal Laboratories in Maryland. To be eligible for the program, a company must be collaborating with a Federal Laboratory or university in Maryland and meet the following two criteria: fewer than 16 employees OR the company is a university spin-off in business less than 5 years AND Pre-revenue OR pre-venture investment. The focus of the program is support of company technology development projects that transfer technology to the commercial sector from any university or federal laboratory in Maryland. A secondary focus is on development of technology-based products and/or services for future government procurements. University Technology Development Fund (UTDF) The goal of the Maryland Technology Development Corporation's (TEDCO) University Technology Development Fund (UTDF) is to provide resources to Maryland universities to support pre-commercial research on university intellectual property to increase the likelihood of commercializing that intellectual property. The program helps universities to license early stage technologies more effectively and serves as a source of technology development projects for Maryland companies that are eligible for additional TEDCO and other State financing programs. Johnson & Johnson Collaboration The joint TEDCO-J&J seed stage investment program is a component of the Maryland Technology Transfer Fund (MTTF). The joint program provides J&J with valuable insight into the most promising technologies being licensed by the universities and federal labs in Maryland to the private sector, which could provide pipeline product opportunities. It would provide MTTF awardees with the valuable commercial input and funding required to build a sustainable company that would meet Johnson & Johnson’s requirement for eventual equity investment though its venture capital group (JJDC) or licensing of products and technologies to one of its operating companies. The program provides TEDCO supplemental funding for the MTTF program and valuable connections for its portfolio companies. TechStart Program The TechStart Program will fund university-based teams to determine whether specific technologies proposed by the universities would have the potential to be commercialized through a startup company. A university having decided through its standard invention evaluation process whether a disclosed technology may have the potential to be a startup company submits a proposal to TEDCO for further evaluating the opportunity. An award would defray those costs of evaluating the feasibility of the startup opportunity approved by TEDCO. Proposals would initially be capped at $15,000 per technology. The Working Capital Fund The Working Capital Loan Fund provides loans to early stage technology-oriented companies located in the state of Maryland. Loans of between $15,000 and $50,000 are available to be used for working capital in order to assist a company with expansion, market entry, or other initiatives. Business Incubation TEDCO has long since supported the now 17 technology incubators in the State of Maryland with funding for feasibility studies for new and expanded incubator facilities, acting as the custodian of the State’s capital funding for incubators, providing modest resources to the incubators for intensive business assistance and market assessments, and recognizing the achievements of the incubator tenants and graduates through an annual Incubator Company of the Year Award competition. http://www.marylandtedco.org/tedcoprograms/fundingopp ortunities.cfm

14 Confidential - for classroom use only ProjectCapitalFunds $ $ $ BasicResearch Proof of Concept Feasibility Testing ProductDesign Product/ServiceDevelopmentProject Public Laboratory Company PublicFunding Angel Investors Venture CapitalSBIR $

15 Confidential - for classroom use only ProjectCapitalFunds $ University Technology Development Fund $ Maryland Technology Transfer Fund FDTTI FDTTIJ&J Maryland Industrial Partnerships DBED ChallengeSBIR $ $ BasicResearch Proof of Concept Feasibility Testing ProductDesign Product/ServiceDevelopmentProject Public Laboratory Company PublicFunding WCLF Angels Venture Capital DBED EnterpriseMDBio TechStart $ Techbridge $ $ $ $ Maryland Stem Cell Research Fund

16 Confidential - for classroom use only Angel Funding High net-worth individuals: ─ Usually knowledgeable about the industry or product ─ Criteria for investing is not well established ─ Can provide expertise, but are usually just meddlesome ─ Excellent source of seed money ─ Focus on smaller deals Angel networks ─ act like informal venture capitalists ─ need to be approached through an intermediary Informal, business angel investment is the most significant source of external equity finance for young companies. Business angels are more likely to act on a hunch rather than relying on complex appraisal ('due diligence' in the trade), they strike straightforward deals, usually in straight equity, and they tend to stay with their investments for longer. This makes angels an attractive prospect for businesses requiring a relatively substantial injection of equity finance to get going. Angel investors are simply wealthy people who operate in a similar manner as VCs, but independently rather than with a firm. They usually invest less than $200,000 and stick to new businesses within their own geographical region. They are called "angels" because they usually aren't interested in controlling your company, but simply acting as a mentor. It is speculated that angels account for the largest source of start-up capital for new business, but their ventures are more informal and private. Most business angels like to be actively involved in the companies they support, so the relationship between investors and their companies is usually close. When seeking a private investor, you are looking for an investment partner with whom you can work and create a successful business. http://cpd.ogi.edu/MST/CapstoneSPR2005/Options.htm

17 Confidential - for classroom use only Characteristics of the Angel Market It is difficult to get accurate data on the angel market in the United States because it is so fragmented and informal. Much of the research that has been done has been survey-oriented research, which can be notoriously troublesome. Freear, Sohl, and Wetzel (1996) estimate that between 5 and 10% of start-ups (around 50,000 firms) and 300,000 growing small firms require equity capital each year. If the average required investment /as $250,000, the required amount of equity capital would be $87 billion, far more than venture capital industry currently invests. Estimates by these researchers have placed the annual amount invested by angel investors at between $20 and $30 billion, although these numbers should be regarded with a great deal of suspicion. Other, potentially more reasonable estimates, place the amount of angel capital at around $3 billion per year (1993 National Survey of Small Business Finance). In addition, Freear, Sohl, and Wetzel (1996) also utilize surveys to draw inferences about the characteristics of angel investors. 1. Angels typically invest in technologies that they understand. 2. They tend to invest close to where the\ live. 3. They tend to invest in very early-stage companies. 4. Typical angel financing rounds are less than $1 million. 5. Angels tend to use investment terms and conditions that are briefer and more informal than venture capitalists. 6. Angels tend to take bigger risks and accept lower returns if they feel that the entrepreneurs idea is attractive for “nonfinancial” reasons; that is, the idea has the right “bells and whistles.” What is clear from anecdotal evidence, however, is that angels are also a diverse group. Many angel investors may be nothing more than wealthy local doctors, dentists, or businesspeople who have strong desires to “make a fortune.” Many are also naïve about the potential conflicts that can arise and are easy prey for unscrupulous entrepreneurs. On the other hand, some angel investors can provide value to the firm and are critical to its success. Recent work by Fenn, Liang, and Prowse (1997) examines the characteristics of successful high-technology start-ups that had been financed by angels and similar firms that had been financed by professional venture capital firms. Although both angel investors and venture capitalists had invested in a large proportion of successful firms, venture capitalists tended to invest more money, the venture-backed firms had significantly higher sales and significantly more assets, and the venture- backed companies had more patents. It appears that the venture-backed companies are more developed and more productive than similar angel-financed firms. Brav and Gompers (1997) find that venture-backed firms perform significantly better than similar non-venture capital-backed companies after they go public. Venture capitalists potentially add greater value to their companies, or they select better companies at the beginning. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

18 Confidential - for classroom use only Defining Venture Capital “The venture capital industry supplies capital and other resources to entrepreneurs in business with high growth potential in hopes of achieving a high rate of return on invested funds.” From HBS case (1981).

19 Confidential - for classroom use only Venture Capital Venture capital firms ─ are for new, emerging, and middle market companies ─ include both private and public funds ─ use well established stringent criteria for investing ─ take business plans seriously ─ spend considerable time conducting due diligence ─ expect board seats and strategic control ─ are generally risk averse, and are often best approached through an intermediary ─ accept very few deals, and are thus often a better source for first-round financing VC investments are characterized by ─ early stage equity financing ─ high risk ─ “homerun” returns ─ returns primarily from capital gains ─ lack of liquidity in equity holdings ─ mid-term perspective ─ ability to provide value-added advice

20 Confidential - for classroom use only How VCs Think Valuation of early stage companies is certainly much more an art than a science William R. Lonergan of Oxford Partners stated that there were three major factors his firm looked at in evaluating deals: 1. the management 2. the market 3. the technology Though venture capitalists vary, to some extent, in the weighting they apply to each of these factors, most of them would weigh management the heaviest, perhaps with as much as 40 or 50%. Perfection to a venture capitalist is a company ─ with a management team that has done it before, successfully ─ which has a unique and protectable technology ─ that is in a large and/or rapidly growing market segment

21 Confidential - for classroom use only http://techcrunch.com/2013/01/17/vcs-invested-26-5b-in-3698- companies-in-2012-total-dollars-and-deal-volume-both-down/

25 Confidential - for classroom use only By Comparison – VC Deals in 2003 $(millions)Sector#deals$/deal $5,104.60Healthcare, biotech, medical device571$8.90 $2,675.50Communication, radio, TV375$7.10 $4,353.90Software, business products866$5.00 $1,296.10Retail, consumer & business services234$5.50 $3,915.60Computer & electronics488$8.00 $841.10other181$4.60 $18,186.80Total2,715$6.70 http://cpd.ogi.edu/MST/CapstoneSPR2005/Options.htm

26 Confidential - for classroom use only Venture Capital Process Preliminary screening Valuation Basic agreement on terms Due diligence Renegotiation of terms Final approval VCs add value by ─ developing strategy ─ active board membership ─ attracting outside expertise ─ attracting later round investors ─ attracting other stakeholders ─ providing contacts, access to people and institutions ─ crafting and executing exit strategies

27 Confidential - for classroom use only Summary of Investor Types Investor Type ProsCons Angel Most angels are established business people, they bring valuable experience to your business and their involvement may make it easier for the company to attract other funders. Business angels can be hard to find because they're often busy with their own businesses. Venture Capital Deep pockets: Above table shows VC invested on average $6.7M per deal. Expensive $$$: VCs ask for a significant share of ownership. For example, seed funding VC ask for 40-60% of the company ownership. Professional expertise: VC brings management expertise to the firm Objective is to make quick money: VC focus more on building the company that can be either acquired or goes IPO in 3-5 years. Focused effort: VC helps company to focus on next milestone. Generally in a particular round, money is raised to reach next milestone. VC makes sure that company reaches that milestone. In-depth due diligence: VC selection requires due diligence from the firm. It is important that firm raise money from the VC that helps in building the business and also help to raise next round of funding Rich network: VC brings a strong network of other investors. Generally in a particular round, multiple investors are involved due to this strong network Corporate Investors Less expensive $$: Corporate investments are generally for strategic fit of their business. They are not looking for higher return rates from the venture itself. Little value added for business-building: Corporate investors are not interested in management of the venture Can add angle of leverage (i.e. distribution technology access): Hidden agendas: Corporate investors Can add credibility: New venture gets exposure to industry because of the brand image of the corporate investor Susceptible to economy: Little follow-on $$: Corporate investors are not interested in reinvesting in the company Cheapest $$Little value added for business-building Customers Enhances credibilityCompetitive issues http://cpd.ogi.edu/MST/CapstoneSPR2005/Options.htm

28 Confidential - for classroom use only Understanding What Investors Want

29 Confidential - for classroom use only Introduction In an ideal world, what most investors are seeking is an attractively valued company with a strong, experienced management team that can implement a well thought out business model to sell a proprietary technology or service in a large, worthwhile market, and grow a substantial. Profitable company over a short time frame with a clear exit strategy for the investors. In other words, they are seeking huge rewards with little risk. While specific investment criteria vary from investor to investor, most will have questions in five key areas: (1) technology or service concept, (2) market size and dynamics, (3) management team, (4) business model and financial requirements, and (5) valuation/deal structure. It is important for entrepreneurs to recognize that, even though all investors may be interested in the answers to these kinds of questions, different types of investors may have different expectations about what the answers should be to attract their investment. The following table compares and contrasts what angel investors, corporate investors, and VCs are often looking for when they evaluate a business plan: Stanford casebook

30 Confidential - for classroom use only Common Questions Asked by Professional Investors 1. Technology or Service Concept a. Is the product/service concept clear? Does it make sense? b. Is there sufficient proof of principle or evidence of feasibility? c. Are there adequate proprietary aspects—patents, trade secrets, or other barriers to entry? d. Is it manufacturable at a reasonable expense? e. Are there regulatory issues? 2. Market Size and Dynamics a. How large is the market, realistically? What is the actual addressable population? b. Does the company have realistic potential to obtain substantial revenues in the market? i.Are there reasonable marketing and sales costs? Sales cycles? Distribution systems? ii.Is the decision making of purchasers and users well understood? iii.Are the business relationships between referral sources, purchasers, providers, and consumers well understood? c. Does the company have a strong competitive position? d. Is the technology/service consistent with market, regulation, and reimbursement trends? Stanford casebook

31 Confidential - for classroom use only Common Questions Asked by Professional Investors 3. Management Team a. Is the management team smart? Are they knowledgeable about this business? b. Does the management team have a proven record, particularly in this business? c. They have high levels of honesty and integrity? Can they be trusted? Do they have reasonable expectations for the business, particularly for the difficulties of product/service development, rate of company growth, capital requirements, ultimate d. Business size and profitability? How do their investment expectations and interests fit with investor interests? e. What additions to the management team are needed? 4. Business Model and Financial Requirements a. What are realistic revenue and expense projections for the company? b. How much capital will be required to reach positive cash flow? c. What are realistic expectations for the timing and sources of this cash? d. Are the realistic exit opportunities for investors in this deal? 5. Valuation and Deal Structure a. Will the valuation of the investment in this deal afford a high probability of a substantial return (40 percent or greater internal rate of return)? b. Will the deal allow for enough capital to be put to work to make the investment worth the time and effort? c. Who will be the co-investors? Are these parties good to work with? How can this investment be structured to minimize the technological and financial risk? Stanford casebook

32 Confidential - for classroom use only Investor Types Stanford casebook AngelsCorporate InvestorsVCs Market SizeSmaller, emerging marketsSame as VCs but with an emphasis on markets in which they m already operate Large, established markets with $500 million or more in sales Investment Size$50,000 to $250,000$1 to $20 million$5 to $20 million minimum Expected ReturnMay accept lower returns if investment is aligned with mission Same as VCs4 to 10 times initial capital invested Capital IntensitySmaller markets with lower requirements; often look for markets untapped by VCs Same as VCsMarket with intense competition if potential reward is large enough Strategic FitMore likely to be mission- driven Looking for opportunities that complement their existing portfolio Seeking next blockbuster device, often regardless of specific field Investment TimelineSometimes flexible; could be longer than 8 years Same as VCs but sometimes may be shorter for corporate investors 4 to 8 years; tend to Prefer devices on 510(k) versus PMA regulatory pathway Ownership TargetSmall but will eventually want the start-up to seek funding from VCs or corporate investors Ultimately may seek to acquire technology 30 to 80 percent in early rounds, rising as high as 95 percent of company by the time of exit Board RepresentationOftenRarelyAlmost always

33 Confidential - for classroom use only Summary of Funding Rounds and Types of Investors Financial RoundFunding RangeInvestor Type Angel$25,000 - $500,000 Individual Angels Govt Funds (SBIR etc.) Seed$500,000 - $3,000,000 Early stage Venture Capitalists and Angel Groups Corporate funds Customers Series A$1,500,000 - $5,000,000Corporate funds Venture Capitalists Series B$3,000,000 - $10,000,000Corporate funds Venture Capitalists Private placement firms Series C$5,000,000 - $30,000,000Corporate funds Venture Capitalists Private placement firms http://cpd.ogi.edu/MST/CapstoneSPR2005/Options.htm

34 Confidential - for classroom use only Seed Funding Seed funding is provided by early stage VCs, corporate investors and customers. The funding is provided mainly to do some initial stage product development. Early stage VCs invest when they see a big opportunity in the business whereas big corporations are more strategic and invest in the seed companies for future products and technologies without impacting their own brand image. For example, Intel Capital is Intel's strategic investment program. With an overall strategy to stimulate advances in computing and communications, the Intel Capital team seeks out and invests in promising companies worldwide working together to establish new and innovative technologies, develop industry standard solutions, drive Internet growth and advance the computing platform. Similarly, customer investors also provide seed funding generally target to specific product development. http://cpd.ogi.edu/MST/CapstoneSPR2005/Options.htm

35 Confidential - for classroom use only Series Funding There are generally three rounds of funding before a startup reaches IPO stage namely series A, B and C rounds. As such, a company could go IPO either before three rounds or may undergo some more rounds. The number of rounds directly impacts the preference of the previous round stocks. The previous round preferred stocks become subordinated stocks as company goes thru the next round of funding. Seed and Series A rounds are generally fulfilled by early stage investors. Also, in series rounds mostly more than one VC firms are involved. Some VC firms acts as lead venture capitalists that helps a firm to arrange money from other VC firms. After series C round, series 1, 2 rounds are more dilution rounds. For example, if company offers series 1 round then most probably series A, B, C round investor’s preferred stocks will be converted into common stocks. http://cpd.ogi.edu/MST/CapstoneSPR2005/Options.htm

36 Confidential - for classroom use only Investor Due Diligence The process investors go through to find out the answers to these questions is referred to as due diligence. Due diligence is an iterative process that requires ongoing investigation and discovery. Each due diligence exercise is different, with the approach and required time varying from situation to situation and company to company. However, the steps outlined below are generally followed: 1. Triage Due Diligence ─ Direct or indirect contact between the investor and entrepreneur, often resulting in I he business plan being shared. ─ Review of the business plan and/or initial meeting between the investor and the entrepreneur or management team. 2. Initial Due Diligence ─ Initial discussion of concept by investor with some of his/her partners (if appropriate); investor makes initial calls to contacts in the technology/service area to get a general opinion on the concept and identify issues that need to be addressed. ─ One or more meetings with entrepreneur/management team to discuss technology/service concept, market, management experience, business/financial model, and valuation expectations. 3. Heavy Due Diligence ─ Calls to or meetings with company references on technology/service concept, market, management experience, etc. ─ Calls to or meetings with independent experts or knowledgeable individuals amongst the technology/service area’s actual or potential customers, and independent references on management. Investors may hire independent consultants to evaluate aspects of the business, particularly technical, market. Regulatory, reimbursement, or IP issues. ─ Independent analysis of financial projections and valuation scenarios. ─ Further discussion with entrepreneur/management team around specific business issues and company valuation. 4. Investment Decision – Based on due diligence. If positive, a term sheet is generated. 5. Investment Closing – If agreement is achieved on the investment terms, legal and patent due diligence is often done during the7rocess of closing’the”investoen7to there are no “hidden” issues about which the investors are unaware (e.g., lawsuits, problems in company capitalization, problems in contracts with employees, suppliers, or others that may impede the growth of the company or cause problems at exit). Information collected via this process is continually reviewed. If negative information comes to light at any point, an investor may decide to abandon the due diligence process (and abstain from investing in the company). When dealing with VCs, this process can take from as little as four weeks in rare cases to as long as three years. The typical range is three to nine months. Other types of investors will also conduct due diligence, but they may not spend quite as much time completing the process. However, fund raising, regardless of investor type, usually takes much longer and requires more effort than most entrepreneurs estimate. Stanford casebook

Confidential – For Classroom Use Only Greycroft Partners Due Diligence List Entrepreneurs feel it’s important to get to know the individual that’s sponsoring their deal, but that’s only half the story. By agreeing to sell equity to a venture capital firm an entrepreneur is no more partnering with one individual than that individual is partnering only with the entrepreneur. We meet with every member of a company’s executive team, call three to five references on each and also vet every employment agreement, stock option agreement, corporate formation document, and contract that the company has ever signed. Nothing is left un- reviewed. It’s not just the sponsor of the deal. At Greycroft, and at most well-run firms, every single person on the investment team is expected to have a high level of knowledge and exposure to every deal. Here is Greycroft’s standard due diligence data request: 1.Customer references 2.Management references 3.Company financials (historic) 4.Financial model (projections) 5.Usage and traffic stats 6.Cohort and churn analysis 7.Capitalization table 8.Previous term sheets and stock purchase agreements 9.Sales pipeline 10.Sales deck and other sales materials 11.Product roadmap 12.All substantial contracts 13.All company formation documents 14.Executive team biographies (all key players) 15.Hiring plan 16.Full team turnover data http://techcrunch.com/2014/ 09/27/the-open-vc/

38 Confidential - for classroom use only Milestones As noted, funding is typically provided to a new venture in a staged manner. Rather than committing too much funding up-front, investors provide financing as the business demonstrates Its ability to accomplish the milestones laid out in its business plan. This process enables investors to periodically update their information about the firm, monitor its progress, review its prospects, and evaluate whether to provide additional funding or abandon the project. It also enables them to exercise greater control over the direction of the company. It is important for entrepreneurs to seek funding in stages, since the attainment of significant milestones in between funding rounds may strengthen their position from a valuation and ownership standpoint during the next round of financing negotiations. Funding milestones represent significant events in the life of a start-up and should be selected with great care. The operating milestones chosen when creating the operating plan can serve as the starting point for selecting funding milestones. From an investor perspective, funding milestones represent points when a sizable amount of technical, clinical, or market risk has been eliminated from the company. Often these points will coincide with milestones in the operating plan, such as proof of concept, clinical trial initiation, regulatory approval, etc. Ultimately, the final funding milestone for investors is the exit event, be it an initial public offering (IPO) or acquisition (which is commonly known as the “harvesting event”). Stanford casebook

39 Confidential - for classroom use only Term Sheets

40 Confidential - for classroom use only Common Sections of Terms Sheets Summary of Financing This opening section summarizes the contents of the term sheet and provides an overview of the transaction being proposed. It usually includes: 1. The name of the investors 2. The name of the company 3. The amount of financing being offered 4. The number of newly issued shares 5. The purchase price per share 6. The post-financing capitalization structure (which enables the reader to calculate the pre-money and post-money valuation). Any milestones that must be met for the release of funds will also be outlined in this section. Linking funding to milestones set by investors allows investors to more closely monitor company progress and manage their downside risk. However, such milestones may be perceived as a red flag to a company wary of relinquishing too much control and/or forfeiting its flexibility to adjust the operating plan as new information becomes available. Dividend Provisions Dividend provisions outline the conditions for when/if dividends will be paid. They also address issues such as whether dividends will be cumulative or non-cumulative, and the priority order in which dividends will be paid to shareholders. As with most sections of the term sheet, dividend provisions can be considered investor favorable, neutral, or company favorable, depending on how they address these issues. Stanford casebook

41 Confidential - for classroom use only Common Sections of Terms Sheets (contd.) Liquidation Preference The liquidation preference outlines the terms governing the transaction if a company is closed down. While preferred shareholders will be given priority over common shareholders, the term sheet often takes this one step further by defining a multiple on the value of their initial investment that preferred and common shareholders will receive. According to these terms, the multiple promised to the preferred shareholders would be paid before any proceeds would be given to other shareholders. Redemption A redemption clause is used to associate a finite number of years (usually five to eight) with an investment. In essence, it forces an exit for investors at a defined point in time if a liquidity event has yet to occur. The terms outlined within a redemption clause specify the time frame associated with the exit, as well as the specific terms governing the rate and price at which shares will be repurchased from investors. Registration Rights Registration rights outline the rights of preferred investors in forcing the company to register its stock for public offering under SEC rules. Essentially, they give investors another mechanism for creating an exit, if market conditions are perceived as favorable. The issues addressed in this section include the number of registrations that the company is obligated to complete, the period of time in which these registrations are required, and the economic cost of going through the registration. Stanford casebook

42 Confidential - for classroom use only Common Sections of Terms Sheets (contd.) Conversion and Automatic Conversion When a conversion happens at the time of an IPO or acquisition, it is generally accepted that preferred shares will convert to common shares on 1:1 basis. The reasons for including this clause in the term sheet is to give preferred shareholders a mechanism for converting to common shares if the IPO is likely to generate a return higher than the one stipulated in the liquidity preference section. The automatic conversion clause describes other variables in the event of an IPO, such as the amount of money that will qualify the IPO as acceptable to the preferred shareholders. Its purpose is to ensure that any automatic conversion price (or amount raised hurdle) is set high enough to make forced conversion attractive. Dilution One of the single most important issues to investors, as a company grows, is how new rounds of financing will affect the value of their investment on a per share basis. Dilution clauses stipulate how conversion prices calculated if future rounds of financing are dilutive to preferred shareholders. If future stock is issued at a price lower than the current )und, an anti-dilution clause helps ensure that preferred investors continue to hold an equal (or near equal) percentage of ownership in a company without committing more capital. There are two primary approaches for structuring anti-dilution clauses: full-ratchet and weighted average. Full-ratchet provisions are the most favorable anti-dilution clauses to investors. Under this approach, the conversion price is adjusted to ensure that the new price factors in the total amount of capital invested and preserves the full percentage ownership of the preferred shareholders, typically at the expense of common shareholders and/or individuals holding stock options in the company. With the weighted-average approach, the conversion price is calculated on a weighted-average basis, therefore only partially offsetting the effect of dilution. As a result, it is considered more favorable to the company and common stock holders. Stanford casebook

43 Confidential - for classroom use only Common Sections of Terms Sheets (contd.) Right of First Refusal The right of first refusal gives preferred investors the right to exercise influence over the sale of any shares (preferred or common) within the company. Typically, investors use this clause to retain the ability to purchase shares or restrict their sale. Voting Rights Voting rights are included in term sheets to ensure that all shares are treated equally in the event that a shareholder vote is called. Typically, one vote per share is granted for both preferred and common stock. Protective Provisions Protective provisions outline the percentage of preferred shareholder approval needed for a company to take certain actions. The purpose of this clause is to help prevent common shareholders from diluting the power of preferred shareholders or “selling the company out from under them. Actions potentially covered under protective provisions include the issuance of new stock, major financial transactions (merger, sale, payment of dividend), or other events affecting the course of a company’s business (reorganization, amendments to the company’s certificates of incorporation, increase or decrease in the size of the board). Information Rights Information rights define what and how much information about the company is shared with investors. Under the terms most favorable to system (audited or system (audited or unaudited, financial or otherwise) as part of the standard inspection and visitation rights afforded to preferred shareholders. In more neutral scenarios, investors are regularly provided with, for example, audited annual financial statements and unaudited quarterly financial statements. Access to monthly financials and the company’s operating plan are other items that may or may not be included in the term sheet. Stanford casebook

44 Confidential - for classroom use only Common Sections of Term Sheets (contd.) Board Composition The board composition clause outlines the number of board seats and how they will be filled. Typically, companies seek to build a board with favorable composition would give the preferred shareholders majority control. A more neutral arrangement might give preferred shareholders (investor) and common shareholders (company management) an equal number of seats, with one additional seat granted to a mutually agreed upon independent participant. Employee Matters From an investor’s perspective, the conditions outlined in this section are designed to help retain important managers and employees while limiting the amount of power they exercise over the stock of the company. Issues typically addressed under employee matters include the number of shares of common stock reserved for option pools and other employee programs, vesting periods for common shares, restrictions on the sales of common stock by employees, the determination of whether life insurance policies will be taken out for key executives, and directors’ insurance. Conditions Precedent This section outlines what steps must be taken before the financing deal proposed in the term sheet can be finalized. For example, it may specify that due diligence must be completed, including a review of the company’s operating plan, IP strategy, regulatory strategy, clinical trials and other relevant documentation. It may also require the completion of IP, confidentiality, and non-compete agreements with employees; review of the company’s compensation, stock allocation, and vesting programs; and board approval. This section may also contain an exclusivity (or “no shop”) provision, which bans discussions between the company and other investors for a defined period of time. Expenses This section outlines which expenses, for due diligence and legal counsel. Are to be paid for by the company upon closing. Stanford casebook

45 Confidential - for classroom use only Dividing up the Equity

46 Confidential - for classroom use only Dividing Equity Between Founders and Investors Founders receive equity for what they bring to the table. How much of the company they own as a result of their contribution is purely up to the group to decide. There are several factors that need to be considered, however. Timing, size and duration of contribution: The earlier, bigger or longer the contribution to the company, the more equity a founder should receive. Power: Equity conveys voting power and control over the business. Generally, founders who intend to stay with the business long-term should retain the most control. I have heard it recommended that one individual own at least a 51 percent of the company, to provide consistent decision-making when resolution is needed. Equal partners, while great in theory, can destroy a company when the partners don't agree and have no way to resolve fundamental disagreements. Money: Early money is a contribution for equity. Money has the side effect of valuing the company. If you give 10 percent of the company for someone contributing $50,000, it implies a company value of $500,000. If you try to raise money immediately thereafter, that valuation could hurt your negotiating ability. But if substantial infrastructure has been built in the meantime--if customers have been acquired or if more of a team has been built--then a higher angel/VC valuation is justified. Kind of contribution: A founder may contribute in many ways. Some bring patents or product ideas. Some bring business expertise and ongoing work to build the business. Some bring capital. Some bring connections. Some may bring big names or reputations which convey credibility with VCs and/or clients. One big name that provides instant credibility may, in fact, be worth more to the company than a founder who actually puts in the work to build the business. Make sure to understand what each founder's contribution is and value it appropriately. According to Ann Bilyew of Advent International, a typical first round is: 1. Founders: 20 to 30 percent 2. Angel investors: 20 to 30 percent 3. Option pool: 20 percent 4. Venture capitalists: 30 to 40 percent http://www.entrepreneur.com/article/65028

47 Confidential - for classroom use only

48 Equity for Employees It’s important to figure out how much equity you give to your employees. David Crow writes in his article “Founders versus Early Employees“, “Remember the goal is to incent early employees to have an emotional ownership of the product and company they are building. Equally said, potential employees need to understand what they are getting into”. http://thinkspace.com/how-to-divide-equity-to-startup-founders-advisors-and-employees/

49 Confidential - for classroom use only Employee Equity: How Much? For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be granting them in terms of points of equity (i.e. 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Co-founders are an entirely different discussion…. The first thing you do is you figure out how valuable your company is (we call this "best value"). This "best value" can be the valuation on the last round of financing. Or it can be a recent offer to buy your company that you turned down. Or it can be the discounted value of future cash flows. Or it can be a public market comp analysis. Whatever approach you use, it should be the value of your company that you would sell or finance your business at right now. Let's say the number is $25mm. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let's say that is 10mm shares outstanding. The second thing you do is break up your org chart into brackets. There is no bracket for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board. 1. The first bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Eng, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team. 2. The second bracket is Director level managers and key people (engineering and design superstars for sure). 3. The third bracket are employees who are in the key functions like engineering, product, marketing, etc. 4. And the fourth bracket are employees who are not in key functions. This could include reception, clerical employees, etc. http://avc.com/2010/11/employee-equity-how-much/

50 Confidential - for classroom use only Employee Equity: How Much? When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets: 1. Senior Team: 0.5x 2. Director Level: 0.25x 3. Key Functions: 0.1x 4. All Others: 0.05x Then you multiply the employee's base salary by the multiplier to get to a dollar value of equity. Let's say your VP Product is making $175k per year. Then the dollar value of equity you offer them is 0.5 x $175k, which is equal to $87.5k. Let's say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125k which is equal to $31.25k. Then you divide the dollar value of equity by the "best value" of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25mm and there are 10mm shares outstanding. So the VP Product gets an equity grant of ((87.5k/25mm) * 10mm) which is 35k shares. And the the director level product person gets an equity grant of ((31.25k/25mm) *10mm) which is 12.5k shares. http://avc.com/2010/11/employee-equity-how-much/

51 Confidential - for classroom use only Dilution Example Stanford casebook

52 Confidential - for classroom use only Pre and Post-Money Mechanics Pre-money Valuation: $20m + Investment:$10m Post-money Valuation:$30m Terms matter! ─ Preference/seniority: who gets money first ─ “Participation” Assume entrepreneur owns 100% pre. Now owns 67% post. New investor owns 33% post. Note: You, the entrepreneur, start with 100% of the equity… More money raised = more dilution… Maximizing the opportunity on the least money is optimal Note: You, the entrepreneur, start with 100% of the equity… More money raised = more dilution… Maximizing the opportunity on the least money is optimal Courtesy of Questmark Partners

Confidential – For Classroom Use Only 53 Valuation

54 Confidential - for classroom use only The Importance of Valuation Valuation is the central concept in finance. Although many entrepreneurs believe that the process of valuation is a meaningless exercise, the tools and techniques discussed in this note are arguably far more important to a young, entrepreneurial firm than they are to a large established one. Without methods to assess value, capital budgeting becomes impossible. While elements of valuation remain an “art,” finance theory and its implementation through valuation methodologies have important implications for practice. When reasonable assumptions are made, the techniques discussed in this note can lead to better decision making in whatever setting you work. The margin for error in an entrepreneurial firm, however, is much smaller than it is in a large firm with considerable resources. Maximizing the probability that the “right” decision is made is the goal of proper valuation methodologies. Valuation methodologies can be widely applied to analyze many of the decisions that a firm faces. Anything that might affect the size or timing of a firm’s cash flow or changes its riskiness affects the firm’s value. Whether it is a new research project, a new production facility, an acquisition target, or a new product launch, value is the fundamental currency that compares all the firm’s potential decisions. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

55 Confidential - for classroom use only Cash Flows and Valuation Both the capital cash flows (CCF) and weighted average cost of capital (WACC) methods of valuation start by determining cash flows from operations. These cash flows are pre-financing; that is, they are independent of the capital structure of the firm. One common mistake that students make when calculating ash flows for CCF or WACC is to take out interest payments from the cash flows and call that number cash flow to equity-holders. While this approach has merit (it is referred to as equity cash flow valuation), it does not easily allow an individual to calculate the value of the firm independent of financing and under various financing scenarios. The equation below gives a quick refresher on how to calculate cash flows. Subscripts denote time periods. CF = EBIT * (1 – t) + DEPR – CAPEX – ∆WK + other Where CF= Cash Flow EBIT = Earnings Before Interest and Taxes t = Corporate Tax Rate DEPR = Depreciation CAPEX = Capital Expenditures ∆WK = Increases in Working Capital other = Increases in Taxes Payable, Wages Payable, etc. These cash flows are what are economically significant to the firm and to an investor. As will be discussed below, estimating cash flows is far more important than determining the discount rate. People valuing risky projects tend to increase the discount rate if they feel that the project s returns are uncertain. This “fudge” factor addition to the discount rate should always be avoided. The critical element of CCF and WACC analysis is to have unbiased estimates of free cash flows. One way to approach this estimation is scenario analysis, which will be discussed below. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only 56 Importance of Free Cash Flow Burn rate (projected or actual time) Time to OOC (when will the company be out of cash) TTC (time required to close the financing) Cash flow = EBIT – tax exposure + depreciation and other noncash charges – increase in working capital – capital expenditures

Confidential – For Classroom Use Only 57 Introduction: Valuing an Opportunity There is no certain way to value an opportunity –the true value is the perceived value to a buyer who is ready, willing, and able to buy –however, there are a number of approaches that can be used to reach an estimate The key problem: you have to try to determine the future The key question: is it a meaningful activity when trying to commercialize an opportunity, technology, or idea with an uncertain market

Confidential – For Classroom Use Only 58 Valuing a Technology Per F. Peter Boer, licensing scenarios fall into two broad scenarios –Proven technologies –Unproven or partially proven technologies –The difference is in the amount of risk absorbed by the licensee and the amount of investment required to further develop the technology and prepare it for market Terms and conditions: –Fields of use –Exclusive or non-exclusive –Milestones –Up-front fees and royalties –Base of royalties –Other factors that affect the fees and royalties Nature and scope of IP protection Nature and size of the market Stage of development of the technology Significance of the technology Scope of applications for the technology Lag time for substantial adoption Existence and nature of competing technologies Amount of investment required to commercialize the technology Kathleen Allen, Bringing New Technology to Market, (Prentice Hall: 2003).

Confidential – For Classroom Use Only 59 Factors Affecting Valuation Risk –Technology –Market –Management team Size of the market and its readiness to adopt the technology The competitive advantage of the firm and its ability to sustain that advantage The skills, experience, and track record of the management team The upside potential of the venture The downside potential of the venture An appropriate exit time for the investors The current state of the economy and the industry in which the venture will operate Kathleen Allen, Bringing New Technology to Market, (Prentice Hall: 2003).

Confidential – For Classroom Use Only 60 Limits to the Value of a Technology to a Company According to Michael Porter these five competitive forces determine industry attractiveness: –Threat of new entrants –Threat of substitute products or services –Bargaining power of suppliers –Bargaining power of buyers –Rivalry among competitors The interdependence among these factors prevents one competitor from earning above-average returns –It is only through competitive advantage that a firm can earn above- average profits for a time –These above-average profits are a function of strategically erected entry barriers

Confidential – For Classroom Use Only 61 Reminder: Assumptions in Developing a Valuation Revenue –sources –market penetration –amount sold and to whom –pricing Costs –production –order fulfillment –people - who will be hired and at what rate –marketing and sales –overhead Investment –fixed assets –working capital Sources of investment –equity –debt –repayment terms –cost of financing Timing –ramp-up –seasonality

62 Confidential - for classroom use only Reminder: Revenue Drivers Revenue is a function of 1.Number of units sold 2.Price per unit Number of units sold is a function of 1.Market size 2.Market share Price per unit is a function of 1.Total cost per unit 2.Competitor offerings 3.The value proposition 4.Market entry strategy Market size is a function of 1.The number of current customers 2.The number of potential customers 3.Quantity purchased by customer Market share is a function of 1.The value proposition 2.The business model 3.The rate and cost of customer acquisition 4.The pace and cost of ramping up operations 5.The marketing plan and market entry strategy

63 Confidential - for classroom use only Reminder: Cost Drivers Cost is a function of 1.Units sold 2.Cost per unit 3.Overhead 4.Financing 5.Seasonality Units sold is a function of 1.Market size 2.Market share Cost per unit is a function of 1.Variable Costs: expenses that change in proportion to the activity of a business; in other words, variable cost is the sum of marginal costs 2.Fixed Costs: business expenses that are not dependent on the level of production or sales; they tend to be time-related, such as salaries or rents being paid per year or month 3.Discretionary Costs: fixed costs changed easily by management decision such as advertising, repairs and maintenance, and research and development; also called managed costs 4.Step Costs: costs that are approximately fixed over a small volume range, but are variable over a large volume range 5.Committed Costs: sunk costs, i.e. past outlays or losses that cannot be altered by current or future actions Overhead is a function of 1.Fixed Costs 2.Discretionary Costs 3.Step Costs 4.Committed Costs 5.The cost of ramping up operations Financing is a function of 1.The scale of investment in fixed assets and working capital 2.The degree and terms of equity financing 3.The degree and terms of debt financing Seasonality is a function of 1.The sales cycle 2.Demand elasticity

Confidential – For Classroom Use Only Different Ways to Value an Opportunity All valuation is a function of cash, timing and risk –Analysts usually use more than one approach/method Valuation approaches: 1.discounted cash flow 2.VC model (e.g., investment must return three times its value in three years (100% ROI) or ten times in five years (58% ROI) 3.First Chicago method 4.comparables and multiples of earnings 5.fair value of assets 6.capitalized earnings 7.cash flow method 8.cost to create method 9.industry rules of thumb 10.Economic Value Added (EVA) 11.real options and decision trees Analysis must a.identify critical assumptions b.develop realistic scenarios c.clarify potential outcomes and consequences d.account for risk factors e.clarify how ROI is being carved up among all providers of resources f.explain competitive advantage Question: How can an opportunity for a market that does not yet exist be valued? 64

Confidential – For Classroom Use Only 65 1. Discounted Cash Flows Steps in doing a DCF analysis: 1.Forecast future business cash flows period by period (i.e. cash and timing) –Revenues and savings are positive numbers –Investments and increases in costs are negative numbers 2.Discount the forecasted cash flows to present value using the opportunity cost of funds (i.e. risk) –Opportunity cost consists of time value and a risk premium 3.Exclude cash flows associated with the financing program, e.g. interest, principal, dividends Adjusted present value –Basic idea is value additivity, where a problem can be broken into pieces, separating out cash flows driven by different dynamics and different opportunity costs (i.e. costs of capital) Timothy Luehrman, “What’s It Worth?” in Harvard Business Review, May-June 1997.

Confidential – For Classroom Use Only 66 Time Value of Money Future value –The amount that a current sum of money earning a stated rate of interest will accumulate to at the end of a future period Present value –The current worth of a specified amount of money to be received at some future date at some interest rate Discount rate –The interest rate used in determining the present value of future cash flows; also called the capitalization rate Weighted average cost of capital –Often used as the discount rate –A calculation of a firm's cost of capital that weights each category of capital proportionately. Included in the WACC calculation are all capital sources, including common stock, preferred stock, bonds, and any other long-term debt –WACC is calculated by multiplying the cost of each capital component by its proportional weighting and then summing Annuities –Periodic cash flows rather than a single sum Net present value (NPV) –The present value of a project’s net cash inflows from operations and disinvestment less the amount of the initial investment Internal rate of return (IRR) –The interest rate that makes net present value of all cash flows equal zero

Confidential – For Classroom Use Only 67 Net Present Value

Confidential – For Classroom Use Only 68 NPV and IRR Calculations

Confidential – For Classroom Use Only 69 2. Venture Capital Method Typical methods use discounted cash flows and market comparables, usually in terms of price/earnings of similar publicly held companies IRR reflects the VC’s cost of capital A general valuation methods for relating the VC investment to the percent of the company that the VC will own are below: William Sahlman, A Method for Valuing High-Risk Long-Term Investments, Harvard Business School Press, 9-288-006.

Confidential – For Classroom Use Only 70 Example Adapted from William Sahlman, A Method for Valuing High-Risk Long-Term Investments, Harvard Business School Press, 9-288-006.

Confidential – For Classroom Use Only 71 Examples: Financing Rounds Financing RoundExpected Annual Return (IRR) Seed financing80% Startup60% First-round financing50% Expansion financing (or second-round)40% Mezzanine financing (or third-round)30% Bridge25% William Bygrave and Andrew Zacharakis, Entrepreneurship, (John Wiley & Sons, Inc.: 2008).

72 Confidential - for classroom use only Expected Return Model for New Medical Technology Stanford casebook Risk LevelExpected Return Risk-Free Project: Build a new plant to make more of an existing product when there is a surge in demand 10 to 15 percent Low-Risk Project: Make incremental improvement in existing! Products5 to 20 percent (above corporation’s goals for return to shareholder) Low to Medium-Risk Project: Develop next generation of existing product 20 to 30 percent [Medium-Risk Project: Develop new product using existing| technology to address markets served by other products of the corporation 25 to 35 percent Medium to High-Risk Project: Build new product using existing technology to address new markets 30 to 40 percent High-Risk Project: Build new product using new technology to dress a new market 35 to 45 percent Extremely High-Risk Project: Build new product using new technology to address a new market when there is an unusually high level of risk associated with one or more of these factors 50 to 70 percent

Confidential – For Classroom Use Only 73 Another VC Valuation Method 1.Company’s income is projected for some terminal year, e.g. five years form the present –The estimate is usually based on a success scenario, one in which the company achieves its sales and margin projections 2.Then a price-to-earnings ratio (PER) is determined that is deemed appropriate for a company that has achieved the measure of success implied in the forecasts ─ The PER is usually determined by studying current multiples for companies with similar economic characteristics (e.g. size, profitability, growth rate, capital intensity, risk) 3.Company’s projected terminal value = projected net income X PER 4.Terminal value is then converted to a present value by applying a very high discount rate, typically between 35% and 80% per year ─ The resulting figure is the estimated current value as of today ─ For example, if the resulting figure is $4 million and the VC is being asked to invest $2 million, then the VC will demand 50% of the company 5.A typical version is below: William D. Bygrave and Andrew Zacharakis, Entrepreneurship (John Wiley & Sons: 2007).

Confidential – For Classroom Use Only 74 Example Adapted from William D. Bygrave and Andrew Zacharakis, Entrepreneurship (John Wiley & Sons: 2007).

Confidential – For Classroom Use Only 75 3. Expected Cash Flows: First Chicago Method The First Chicago method of valuation is another approach that is commonly used by appraisers. Under this methodology, a small number of discrete scenarios are valued using a discount rate that reflects the cost of capital for the venture. The objective is to select and weight the scenarios in a manner that provides unbiased estimates of expected cash flows and is of those cash flows. The venture capital group of First Chicago Corporation developed the First Chicago method. Scherlis and Sahlman (1987) describe it as a methodology developed to address valuation biases inherent in the Venture Capital method. Valuation using this methodology is made in the context of an outside individual investing in the venture as part of a well-diversified portfolio. A typical First Chicago method approach: 1.Select a terminal year for the valuation. 2.Estimate the cash flows during the explicit value period based on a small number of discrete scenarios. Normally, the valuation is based on a "optimistic scenario" for the venture, a "most likely scenario" and a "pessimistic scenario". 3.Compute the continuing value of the venture by applying a multiplier to the financial projection. The multiplier for the optimistic scenario should reflect the expected capitalization for a company that has achieved the level of success reflected in the scenario. The multiplier for the most likely scenario may be different from the optimistic scenario. 4.Compute the expected cash flows of the venture by discounting the expected cash flows, including the expected continuing value at their opportunity cost of capital. 5.Based on the present value, compute the fraction of ownership the investor should require in exchange for contributed capital. Advantages of the First Chicago method include: 1.Use of discrete scenarios is a simple and easy to apply method of determining both the risk and expected return of a venture. 2.The intent is to value expected cash flows. 3.The technique reduces the uncertainty associated with a single fair market value determination by allowing for several scenarios representing differing levels of success of the company. 4.Because information about total risk is derived, the method provides a basis for valuing complex financial claims. Disadvantages of the First Chicago method include: 1.Use of discrete scenarios discards information about the risk of the venture that could be useful, especially for valuing complex claims. 2.No guidance is provided about how to determine the discount rate(s) to be used in the valuation. Here I use my own methodology that includes standard components along with some widely accepted subjective components. http://www.charlesthardyphdmba.com/Valuation

Confidential – For Classroom Use Only 76 Example of First Chicago Method Jeffrey Timmons and Stephen Spinelli, New Venture Creation, (McGraw-Hill Irwin: 2007).

Confidential – For Classroom Use Only 77 4. Valuation by Comparison In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relative valuation then, 1.we need to identify comparable assets and obtain market values for these assets 2.convert these market values into standardized values, since the absolute prices cannot be compared; this process of standardizing creates price multiples. 3.compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or over valued Prices can be standardized using a common variable such as earnings, cash flows, book value or revenues. Earnings Multiples: 1.Price/Earnings Ratio (PE) and variants (PEG and Relative PE) 2.Value/EBIT 3.Value/EBITDA 4.Value/Cash Flow Book Value Multiples: 1.Price/Book Value(of Equity) (PBV) 2.Value/ Book Value of Assets 3.Value/Replacement Cost (Tobin’s Q) Revenues: 1.Price/Sales per Share (PS) 2.Value/Sales Industry Specific Variable, e.g.: 1.Price/kwh 2.Price per ton of steel http://pages.stern.nyu.edu/~adamodar/pdfiles/multintr.pdf

Confidential – For Classroom Use Only 78 Comparable Multiples Steps: 1.Select a set of comparable firms 2.Pick an activity measure, e.g., Sales, Operating income, EBITDA 3.Calculate the value of each comparable company as a multiple of activity measure, i.e. choose representative value or range 4.Apply multiple to activity measure at target company Equity vs. operating multiples: Net income after interest payments is an equity measure Operating multiples are any activity measure (e.g., sales, operating profit) prior to subtracting interest Pitfalls of multiples: Totally rests on comparability: Assumes comparable companies are comparable in every possible dimension, especially in risk and growth Seems to require fewer assumptions: illusory --- you just don’t know what assumptions you are making! Usually lack information about strategy, expectations, etc. Comparable industry not the same as comparable value, e.g. –investment needs –fixed/variable cost ratio differences –different accounting standards Accounting numbers are backward looking while value is forward looking www.kellogg.northwestern.edu/faculty/thompsnt/htm/emp/valuation_comps.ppt

Confidential – For Classroom Use Only 79 Example: NI Multiple (P/E ratio) Want to value Crazy Car Wash (CCW) Private firm, has $50M in debt Question: What is equity of CCW worth? CCW Net Income, last 12 Months (LTM) = $20M, Expected (next year) = $22M One comparable: Kooky Kar Wash Publicly traded, 10M shares @ $5/share Net Income, LTM, $5M, Expected next year, $5.5M NI multiple = Equity/NI(LTM) = $50M/$5M = 10X NI multiple (forward) = E/NI (next year) = $50M/5.5M = 9.1X Apply the multiple to CCW: 1.Last twelve month’s multiple Equity of CCW = 10 x (20M) = 200M 2.Expected next year’s multiple Equity of CCW = 9.1 x (22M) = 200M 3.Answer’s the same: why? Because it’s rigged But, on average they should be the same What is the total value of CCW? –Equity of $200M (estimated by multiples) plus Debt of $50M = $250M www.kellogg.northwestern.edu/faculty/thompsnt/htm/emp/valuation_comps.ppt

Confidential – For Classroom Use Only 80 Same Example: EBITDA multiples Additional information on Kooky Kar Wash They are unlevered (no debt) EBITDA (LTM) = $10.5M, Next Year $11.5M Additional information on CCW EBITDA (LTM) = $48M, Next Year $52M KKW multiple, (Equity + Debt)/EBITDA LTM, (50M+0)/10.5M = 4.76X Next year = 50M/11.5 = 4.35X Apply EBITDA multiple to CCW 1.Value of CCW based on LTM = ($48M) x (4.76) = $229M 2.Value of CCW based Next Year = ($52M) x (4.35) = $226M 3.Value of equity? = V – D = E = $227.5M – $50M = $177.5M (where average value less outstanding debt = value of equity) Which is better: equity multiple or operating multiple?

Confidential – For Classroom Use Only 81 5. Tangible Assets (Balance Sheet) Method In some instances, a business is worth no more than the value of its tangible assets. This would be the case for some (not all) businesses that are losing money or paying the owner(s) less in total than a fair market compensation. Selling such a business is often a matter of getting the best possible price for the equipment, inventory, and other assets of the business. It is generally best to approach other firms in the same business that would have direct use for such assets. Also, a company in the same business might be interested in taking over your facility. This would mean your leasehold improvements (modifications to space, etc.) would have value and the equipment would have value as "in place" plant and equipment. In place value is higher than the value on a piece by piece basis such as at a sale by auction. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 82 Value of Specific Intangible Asset Method This is an often overlooked approach to valuation. Yet in some cases it is the only appropriate approach that will result in a sale. The approach is based upon the buyer's buying a wanted intangible asset versus creating it. Many times buying can be a cost efficient and time saving alternative. For example, we recently sold a temporary employment agency. This agency specialized in placing health care assistants (such as nurses aids) in hospitals and nursing homes. Because there is a shortage of these workers in the area where the selling company did business, placing workers was not difficult. However, finding qualified workers was very difficult. We approached firms in the same and related businesses. Through our research, we calculated that recruiting a qualified worker cost at least $200 for an agency. Therefore, we were able to obtain a price of $170.00 for each worker in the pool of available employees by showing a competitor that this would save them money. In fact, this not only saved $30.00 per worker, but it also cut down on recruiting time to recruit. The overhead of the selling company was not an issue because the buying company already had the system in place that the overhead expense was paying for (offices, computer system, phones, etc.). In fact, whether the seller was making or losing money was of little consequence to the buyer. The value to the buyer was the value of buying a qualified worker versus recruiting a worker through the more traditional method of advertising, interviewing, etc. A common application of this method is the acquisition of a customer base. Customers with a high likelihood of being retained are valuable in most industries. Examples of industries where companies are bought and sold based upon the value of the customer base include insurance agencies, advertising agencies, payroll services, and bookkeeping services. In practice the buyer will often ask for a credit for each customer that is not retained for a stated period of time. For example, a firm may offer $100 per customer, with a pro-rated credit for each customer lost during the twelve months following the closing of the sale. Pro-rating is based upon the time the customer is lost-- if the customer is lost after 6 months, for example, half of the $100 would be returned to the seller. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 83 6. Capitalized Earnings Method A common method of valuing a business is called the Capitalization of Earnings (or Capitalized Earnings) method. Capitalization refers to the return on investment that is expected by an investor. There are many variations in how this method is applied. However, the basic logic is the same. To demonstrate the capitalization method of valuation, let's look at a mythical and highly oversimplified business. Pretend the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about $10,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely. The only expense for this business is $100 per year rent charged by the post office. So the business earns $10,000 per year ($10,100-$100). –Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back. –A buyer would look at this "minimum risk" business earning $10,000 and compare it to other ways of investing his or her money to earn $10,000 per year. –Let's assume a near no risk investment like a savings account or government treasury bills currently pays about 8% a year. At the 8% rate, for someone to earn the same $10,000 per year that the magic PO box earns, an investment of $125,000 (125,000*8%= $10,000) would be required. Therefore, the PO box value is in the area of $125,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill. Now the real world of business has no magic PO boxes and no "no risk" situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. –Rates of 20% to 25% are common for small business capitalization calculations. That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. –However, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning. –Finally, it is important to point out that the above example does not include a fair salary for the new business owner. If the owner must devote time working to realize a profit, he or she must, in theory, be paid a fair value for that work. The owner's fair and reasonable salary must be separated from the return on investment computations. For example, if the magic PO box produced $30,000 per year but required a manager with a fair market salary of $20,000, the income for valuation purposes is $10,000, not $30,000. The fair market value for salary is the important number to use, not the actual salary to the current owner. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 84 Excess Earnings Method This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let's suppose Mr. Owner runs a business that manufactures novelty products. His company has Tangible Assets of $300,000. Further let's suppose that Mr. Owner pays himself a very reasonable market value salary-- the same amount that he would have to pay a competent manager to do his job. After paying the salary Mr. Owner's business has earnings of $120,000. The financially rational reason for owning business assets is to produce a financial return. Let's say that a reasonable return on Mr. Owner's Tangible Assets is 15% per year. A reasonable number here should be based on industry averages for return on assets adjusted to current economic conditions. For example, Mr. Owner or his advisors may have looked up industry standards for novelty manufacturing shops and found that the current average return on assets was 14%. (An alternative approach to finding an industry appropriate return on asset figure is to use a rate 2 to 3 points above the current bank rate for a small business loan, or about 5 points above the current prime rate). So $45,000 of Mr. Owner's profits are derived from the tangible assets of the business ($300,000 x 15%= $45,000) The other $75,000 ($120,000-$45,000=$75,000) in earnings are the excess earnings). This $75,000 excess earning number is typically multiplied by a factor of 2 to 5 based on such factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. A typical number is 3 for a solid, profitable company. That is, a good business that is judged to be average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential would use three as a multiplier. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook. Let's suppose that Mr. Owner's business is a bit better than average in these factors and assign a multiplier of 3.6. Therefore, the value of this business can be determined as follows: A. Fair market value of tangible equipment $300,000 B. Total Earnings $120,000 C. Earnings attributed to Tangible Assets ($300,000 x 15%=$45,000) -$45,000 D. Excess Earnings ($120,000 - $45,000=$75,000) $75,000 E. Value of excess earnings ($75,000 x 3.6=$270,000) $270,000 F. Estimated Total Value (A+E) $570,000 The capitalization methods work for businesses that derive their income primarily from tangible assets such as a utility (such as gas or electric companies). In the case of most small businesses that earn only a small part of their revenues from tangible assets, the excess earning method is probably a better method to use. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 85 7. Cash Flow Method Buyers often look at a business and evaluate it by determining how much of a loan the cash flow will support. That is, they will look at the profits and add back to profits any expense for depreciation and amortization but also subtract from cash flow an estimated annual amount for equipment replacement. They will also adjust owner's salary to a fair salary or at least an acceptable salary for the new owner. The adjusted cash flow number is used as a benchmark to measure the firm's ability to service debt. If the adjusted cash flow is, for example, $100,000, and prevailing interest rates are 10%, and the buyer wants to amortize the loan over 5 years, the maximum a buyer is willing to pay for the firm would be $392,211. This is the amount that $100,000 per year would support over 5 years. Therefore, when using this method, the value of a company changes with interest rate conditions. It also changes with the terms a buyer can obtain on a business loan. From a buyer's perspective this may make sense, but from a seller's perspective it introduces a sort of arbitrariness into the process. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 86 8. Cost to Create (Start-Up) Method Sometimes companies or individuals will purchase a company just to avoid the difficulties of starting from scratch. The buyer will calculate his or her start up needs in terms of dollars and time. Next he or she will look at your business and analyze what it has and what it may be missing relative to the buyer's start up plan. The buyer will calculate value based on his or her projected costs to organize personnel, obtain leases, obtain fixed assets, and cost to develop intangibles such as licenses, copyrights, contracts, etc.). A reasonable premium of above the sum of projected start up costs may be offered because of the effort and time being saved by the buyer. The more difficult, expensive, and/or time consuming startup is likely to be, the higher the value would be based upon this method. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 87 9. Industry Rules of Thumb Method One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place, which we believe to be as adjuncts to other methods. One industry rule of thumb says an Internet Service Provider company is worth $75 to $125 per subscriber plus equipment at fair market value. Another says that small weekly newspapers are worth 100% of one year's gross income. The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 100 small weekly newspapers that were sold over a two year period. They will then average all the selling prices and calculate that the average paper sold for 100% of one year's gross income. The rule of thumb is thus created. However, some newspapers may have sold for twice one year's gross while other may have sold for half of one year's gross. The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary. To apply the rule of thumb to a business that varies significantly from the average is not appropriate. http://www.mergers-acquisitions.com/

Confidential – For Classroom Use Only 88 10. Economic Value Added (EVA) Economic Value Added or EVA® is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. GAAP is estimated to ignore US$300 billion in shareholder opportunity costs. EVA can be measured as Net Operating Profit After Taxes(or NOPAT) less the money cost of capital. Money cost of capital refers to the amount of money rather than the proportional rate (cost of capital). The amortization of goodwill or capitalization of brand advertising and other similar adjustments are the translations that occur to Economic Profit to make it EVA. The EVA is a registered trademark by its developer, Stern Stewart & Co. Features include: –Unlike Market-based measures, such as MVA, EVA can be calculated at divisional (Strategic Business Unit) level –Unlike Stock measures, EVA is a flow and can be used for performance evaluation over time –Unlike accounting profit, such as EBIT, Net Income and EPS, EVA is Economic and is based on the idea that a business must cover both the operating costs AND the capital costs. In the field of corporate finance, economic value added is a way to determine the value created, above the required return, for the shareholders of a company. The basic formula is: where r is the firm's return on capital, also called the Return on Invested Capital (ROIC); NOPAT is the Net Operating Profit After Tax; c is the Weighted Average Cost of Capital (WACC); and K is capital employed. Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital. Any value obtained by employees of the company or by product users is not included in the calculations. http://en.wikipedia.org/wiki/Economic_Value_Added

Confidential – For Classroom Use Only 89 Calculating EVA

Confidential – For Classroom Use Only 90 Conclusions About EVA Economic profit - otherwise known as "Economic Value Added" (EVA™) is based on classic financial theory, and, for this reason, is not entirely different from traditional free cash flow measures. Three conceptual pillars support economic profit: 1.Cash flows are more reliable than accruals. 2.Some period expenses are - in economic reality - actually long-term investments. 3.The company does not create value until a threshold level of return is generated for shareholders. As you perform your own economic profit calculations, keep the following in mind: Economic profit boils down to a set of adjustments that translate an accrual-based earnings before interest and taxes (EBIT) into a cash-based net operating profit after taxes (NOPAT). Although the list of potential adjustments is long, it is important not to be seduced into an almost-impossible quest for absolute precision. From an investor's perspective, consistency is more important. That is, an income statement adjustment should always be matched by a balance sheet adjustment. For example, if we add back minority interest to earnings, then we need to add the minority interest balance sheet account to invested capital. We can add neither or both, but there is no truly right answer. In this example, it comes down to whether we prefer our economic profit to have an operational perspective (add both) or a financial perspective (add neither). Avoid seeking precision in the calculation of weighted average cost of capital (WACC), a dubious academic exercise. It is far better to charge the company with an approximate but consistent estimate of WACC than to try to chase down the elusive cost of equity. (Several companies, after trying to explain a precise WACC to employees, have come to abandon a precise WACC in favor of a round number like 10%; e.g. "cost of capital is 10%".) Finally, to help you consider whether economic profit is an appropriate performance metric for the company you are evaluating, we have discussed the following strengths and weaknesses: Strengths: If you had to rely on only one single performance number, economic profit is probably the best because it contains so much information (mathematicians would call it "elegant"): economic profit incorporates balance sheet data into an adjusted income statement metric. Economic profit works best for companies whose tangible assets (assets on the balance sheet) correlate with the market value of assets - as is often the case with mature industrial companies. Weaknesses: Although some proponents argue economic profit is "all you need", it is very risky to depend on an single metric. The companies least suited for economic profit are high-growth, new-economy and high-technology companies, for whom assets are 'off balance sheet' or intangible. http://www.investopedia.com/university/EVA/EVA6.asp

Confidential – For Classroom Use Only 11. Real Options Why treat a corporate investment proposal as a call option, as suggested here, rather than as a bond or an unlevered equity? The latter are easier to understand and value and the associated analyses are easier to communicate and defend within a large corporation. However, many corporate investment proposals, particularly “strategic” ones a stronger resemblance to a call option than to a stock or a bond. Ignoring the option-like features of such projects can lead to poor decisions. The most likely mistakes are failing to invest in a valuable project because embedded options are overlooked— this will make the corporation appear shortsighted; and not getting the timing right, that is, committing funds earlier or later than would be ideal. Standard DCF valuation methodologies treat projects as follows: managers make a decision to invest (or not) and then wait to see what happens. For some projects this is an adequate representation of reality, but for others it is backwards. Sometimes managers get to wait and see what happens (at least some uncertainty is resolved) and then make a decision to invest or not. These two are obviously quite different. The latter is an option and the former is not. An efficient capital market would not place the same value on both, and neither should a corporation. A great many corporate investment proposals are complex and fit neither of these pure archetypes exactly. More often they contain elements of both. An R&D program, for example, may create both a cash-producing new product and opportunities for further R&D aimed at yet more new products. Investing in a new market may lead to both immediate cash flow and future expansion opportunities. Creating a brand may simultaneously create future brand-extension possibilities. Replacing a first-generation technology with a second makes it possible to eventually replace the second with a third, and so forth. All of these examples contain both assets-in-place (cash-producing assets that can be evaluated with DCF methodologies) and growth options (opportunities to make future investments, which require an option-pricing methodology). Growth options and a few other decision opportunities are known, collectively, as “real” options to distinguish them from “financial” options such as exchange-traded puts and calls. Projects with high option content are likely to be misevaluated by DCF techniques: either the options will be ignored (resulting in undervaluation and underinvestment), or they will be poorly approximated (resulting in either under- or overinvestment in addition to poor timing and management). A sensible solution is to separate a project s assets-in-place from its growth options and to analyze each part accordingly. Unfortunately, this is often difficult, first because a neat separation may not be possible and second because executing the option valuation for a capital project is usually a difficult analytical chore. This note is aimed at the second problem. It explains how to set up a mapping between the simplified project and a call option; how to perform an option valuation and relate it to a DCF valuation; and how to extract some managerial insights from the option-pricing framework. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Projects as Call Options An opportunity to invest in a corporate project bears an obvious similarity to an option o invest in a corporations stock. Both involve the right, but not the obligation, to acquire an asset by paying a certain sum of money on or before a certain time. The right buy the stock is known as a call option. European calls are exercisable only at expiration, whereas an American call may be exercised at any time prior to expiration. Oban American call must be at least as valuable as an otherwise-identical European call. The Black-Scholes option pricing model gives the value of a European call on a tradable stock that pays no dividends as a function of five variables: the stock price, S; the exercise price, X; the time to expiration, t; the risk-free rate of return, r; and the standard deviation of returns on the stock, σ. By establishing a mapping between project characteristics and the determinants of ill-option value, a corporate project can be valued in the same way. Most projects involve making an expenditure to buy or build a productive asset. This is analogous to exercising an option: the amount expended is the exercise price (X) and tie value of the asset built or acquired is the stock price (S). The length of time the company can wait without losing the opportunity is the time to expiration (t), and the riskiness of the project is reflected in the standard deviation of returns on the asset (σ). Time value is still given by the risk-free rate (r). Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002). ProjectVariableCall Option Expenditures required to acquire the assetsXExercise price Value of the operating assets to be acquiredSStock price Length of time decision may be deferredtTime to expiration Riskiness of the underlying operating assetsσ2σ2 Variance of returns on stock Time value of moneyrRisk-free rate of return

Confidential – For Classroom Use Only Example To illustrate, consider a simple project that requires an investment of $100, in return for which the company would receive an asset that is currently worth $90. However, the asset is risky, and its value is likely to change: returns on the asset have a standard deviation of about 40% per year. Moreover, the company can wait for up to three years before deciding to invest. Finally, suppose the risk-free rate is 5%. Viewed conventionally, this projects NPV is $90 - $100 = -$10. Clearly, however, having the opportunity to wait three years and see what happens is valuable. In effect, the company owns a three-year European call with an exercise price of $100 on underlying assets worth $90. NPV q for this option is $90 ÷ [$100/(1.05) 3 ] = 1.04. Cumulative variance is 0.40 times √3, or 0.69. An option with these characteristics is worth 28.4% of the value of the underlying asset, or.284($90) = $25.56. The simple project just examined had an NPV of —$10 but an option value of more than $25. Are these contradictory? What should the company do? In fact, the NPV and the option value do not contradict one another. The company should not invest in the project now. If it does, it will both forfeit the option and waste $10. But neither should it discard the project. It should wait, watch, and actively cultivate the project over the next three years. Although NPV 1. That is to say, although X > S, these two variables are relatively close to one another because S > PV(X). They are separated only by time value. Over time, we expect the market value of the asset, S, to increase at some rate greater than r. (No one would be willing to hold the asset otherwise.) By the end of three years, there is a good chance that the NPV will exceed zero and the option will be exercised. In any event, at expiration, the option will be worth the greater of zero or S — X. In the meantime, the option on the project really is worth $25, not —$10, provided the company does not (suboptimally) exercise it now. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Example (contd.) The difference between NPV and NPV q contains a useful managerial insight. As time runs out, these two must converge to some agreement: at expiration they will be either greater than 0 and 1, respectively, or less than these values. But prior to expiration, NPV q may be positive even when NPV is negative (just as in the preceding example). Figure 13-6 shows this diagrammatically. All options that fall in the right half of Figure 13-6 have NPV q > 1. But not all of these are in the money; that is, the NPV of an “exercise-now” strategy is positive for some and negative for others. The locus of points that corresponds to NPV(exercise now) = 0 is a curve that starts at the top, where cumulative variance is zero and NPV q = 1, and runs down and to the right. Options that fall above this curve have both NPV > 0 and NPV q > 1; they are in the money. Those below the curve have NPV q > 1 but NPV < 0; they are out of the money. We can now generate three different managerial prescriptions for options with NPV q > 1, each corresponding to a different region in the right half of Figure 13-6. At the very top are options with no cumulative variance—either time has run out or there is no variance. These options are in the money (NPV > 0) and should be exercised immediately—there is no value in waiting. Just below these are options that are in the money, but for which there is still some cumulative variance. The company should wait, if possible, to exercise these options. Early exercise may be desirable when the underlying asset is “wasting.” If, for example, its value is subject to erosion due to competitors’ actions, or if it is already paying out cash, then it is analogous to a dividend-paying stock. Holders of American call options )n a dividend-paying stock sometimes will find it optimal to exercise early, prior to expiration. This is a way to capture the cash being paid out or prevent the value erosion. However, by exercising early, the holder of an American call option foregoes the interest on the exercise price. Hence, a tradeoff must be evaluated in order to determine the better course of action. The distinction between American and European calls is very important for real options. Real options typically can be exercised early, and often the value of the underlying asset is subject to erosion by competitors’ actions or technical or demographic changes. Finally, at the bottom of the right half of Figure 13-6 are options like the simple example presented above: they are very promising because NPV q > 1 even though NPV < 0. If, as time runs out, neither S nor X changes, then NPV q will fall and these options will expire unexercised. But among a large sample of such projects, we should expect many to end up in the money, especially if they receive active attention and management. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Figure 13-6. Mapping projects into call-option space. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Real Options: Practical Issues Simplifying Complex Projects Real corporate projects, especially long-horizon ones, are complex. They are most often combinations of assets-in- place and options. Furthermore, the options are nested; that is, managers face a sequence of serially dependent choices. It helps to simplify such problems, not only for formal analytical purposes, but also to make them understandable and discussible within the group of responsible managers. Moreover, an un-simplified problem may be unique (and practically insoluble), whereas a simplified problem may fit in a larger class of problems which will provide hints or boundaries for a solution. Most real option problems can either be abstracted as fairly simple call options or broken into pieces, each one of which is a fairly simple call option. A useful guide in simplifying is to search for the primary uncertainty against which managers select. That is, by waiting and watching, what is the main thing a manager learns, and how will he she exploit the learning? Some projects have option-like characteristics (e.g., the project is risky and managers clearly have a choice about whether to undertake it); yet as long as the company does nothing, it learns nothing. For such projects, a DCF approach may be appropriate; in effect, the company has to make the investment in order to resolve the uncertainty. However, for many other projects, the resolution of a small set of uncertainties determines the outcome, and at least some can be resolved without making the entire investment. Identifying the key uncertainties is the first step toward a useful simplification. Another useful approach is to construct simplifications such that the simplified project is both priceable and either dominating or dominated, compared to the real project. A dominated project is one that is clearly less valuable than the real project. If it also can be priced, then its value provides a lower bound for the project value. For example, a simple European call is clearly dominated by a (more realistic) American call on an asset exposed to erosion by competitors’ investments. Dominating simplifications similarly provide an upper bound for project value. Sometimes it is possible to construct and compute both upper and lower bounds. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Real Options: Practical Issues (contd.) Estimating Volatility The option-pricing input managers are least accustomed to estimating its variance, or standard deviation. For a real option, σ cannot be looked up in a table or newspaper, and most people do not have highly developed intuition about, for example, the annual variance of returns on assets associated with entering a new market. Nevertheless, estimating σ is not a completely hopeless task. There are at least three reasonable approaches: 1.Take a guess. Systematic risk (β) and total risk (σ) are positively correlated in large samples of operating assets: those with high asset betas are likelier to have higher standard deviations. What is a high standard deviation? Returns broad-based U.S. stock market indices had a standard deviation of about 20% per year for much of 1986-1994, with exceptions (upward spikes) associated with events like the 1987 market crash and the 1990-1991 Persian Gulf crisis. Individual projects will have higher volatilities than a diversified portfolio of the same projects. Volatility of 20 to 30% per year is not remarkably high for a single project. 2.Gather some data. Volatility can be estimated for some businesses using historical data on investment returns in certain industries. Alternatively, implied volatilities can be computed from quoted option prices for a very large number of traded equities. The length, breadth, and quality of such data have improved greatly in recent years and should continue to do so. These data do require some adjustment, however. Equity returns are levered and therefore more volatile than underlying asset returns. 3.Simulate σ. Spreadsheet-based projections of a projects future cash flows, together with Monte Carlo simulation techniques can be used to synthesize a probability distribution for project returns. Inputs include estimated volatilities for specific items, such as commodity prices or exchange rates. Using these inputs, a computer simulates the project and, in the process, synthesizes a probability distribution for desired output variables, such as project returns. From the synthesized probability distribution, σ can be estimated. Simulation software for desktop computers is commercially available and designed to work as an add-in with popular spreadsheet applications. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Real Options: Practical Issues (contd.) Checking Models and Distributions All formal option-pricing models, including Black-Scnoles, assume that the riskiness of an asset can be expressed as a probability distribution for returns (or prices or payouts) for the asset. Some of the assumed distributions are elegantly simple, such as the lognormal distribution assumed by Black- Scholes. But corporate data for some real projects are inelegant and may be inconsistent with, for example, a lognormal distribution. One approach to this problem is to figure out in which direction a simplified distribution biases the analysis and then interpret the output accordingly, as an upper or lower bound for the actual project s value. Another is to choose a model, if one exists, based on a more appropriate distribution Many models have been constructed and solved, though most are mathematically sophisticated and unwieldy for use with real options. The type of world being modeled. The Black-Scholes world, for example, is one in which underlying assets are securities that are traded continuously. Many real options involve underlying assets that are not traded continuously or, in some cases, not traded at all. For such assets, the five variables (six, if dividends are allowed) of the Black-Scholes model are not sufficient to characterize and price a call option. Whether one model or another remains useful as a way to price a simplified version of the project is a judgment the analyst must make. One alternative to such modeling is brute force, in the form of computing power. High-speed computers and advanced spreadsheet software make it possible to simulate some projects as a complicated decision tree. Decision-tree analysis is not, formally speaking, option pricing, but if well-executed, it provides a better treatment of uncertainty and of managers’ scope for decision making than conventional DCF analysis alone. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Decision Tree Analysis Many entrepreneurial ventures are staged investments in which the entrepreneur or investors have multiple points to reevaluate the project and choose whether or not to continue the project. These sorts of projects often entail many decision points along the way. An entrepreneur can gather more information and decide what is the best course of action. These types of projects are difficult to value using simple discounted cash flow techniques. We will discuss two approaches to addressing the valuation of these multistage projects. The first is decision tree analysis, which uses discounted cash flow analysis matched with an explicit consideration of various decisions that are made along the way and the various probabilities of certain events occurring along the way. Multistage investments present problems that are difficult to assess with simple discounted cash flow valuation models. It is often the case that a firm can invest only a fraction of the capital required to complete the project but can gather information after a certain amount of time. This information may be helpful in determining if subsequent investment is profitable. Venture capitalists utilize multistage investments for just that reason. Simple CCF or WACC ignores this multistage decision process and may lead to wrong investment decisions. Projects may have a negative NPV but still be attractive opportunities. One way to assess the value of investment is to use decision trees to estimate the value of the project. If the project can be well parameterized, the analysis may be amenable to decision tree and real options approaches. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Decision Tree Analysis Example Exhibit 9-2 shows a simple decision tree example. The values at the end of the decision tree represent the present value of cash flows under each scenario. At point A a decision about investment in a test plant needs to be taken. The test plant requires an investment of $1 million today. Assume that we choose to invest in a full-scale plant :ext year, the present value of the cost of the investment is $3 million. With 50% probability, the test plant will be successful. If the test plant fails, the investment returns 0 for sure. If the test plant succeeds (i.e., we reach point B) and a full-scale plant is constructed, then the investment “succeeds” with 50% probability. The investment is worthless in the other 50% of the cases. The proper strategy to begin valuation is to proceed backwards from the end. At point B, would it be worth investing $3 million in present value terms to have a 50% probability of returning $16 million and 50% probability of returning 0? Clearly, the answer is yes. The net present value of that investment is $5 million, that is, 0.5*16 + 0.5*0 = 5. Now start at point A. Is it worth investing $1 million today to have a 50% probability of a $5 million return and a 50% probability of 0? Again the answer is yes. The net present value of that investment is $1.5 million. Another way to see the same result is to realize that with 25% probability, the net present value of the project will be $12 million. With 25% probability the investment will be worth -$4 million. In 50% of the cases, the projects NPV will be -$1 million. Weighting these outcomes by their respective probabilities yields an expected NPV of $1.5 million. As in the case of scenario analysis, the decision trees can be as complicated or as simple as you want them to be. The probabilities and explicit branches of the tree may like an oversimplification of the real investment opportunity, but standard CCF or WACC do not capture the state contingent nature of investment and lead to inappropriate valuations. Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only Exhibit 9.2 Decision Tree Analysis Example Paul A. Gompers and William A. Sahlman, Entrepreneurial Finance (John Wiley & Sons: 2002).

Confidential – For Classroom Use Only 102 Appendix: Real Options and Uncertainty

Confidential – For Classroom Use Only Valuing Real Options The value of a financial call option is essentially its expected value, which is a function of the probability of the price of the underlying asset, the stock, being at or above the strike price at some point in the future. A European call option is exercisable only at expiration, while an American call option can be exercised at any point up to expiration. The terms of the option contract specify the strike price and expiration. Either way the purchaser of the contract can estimate its worth by observing the price of the underlying asset and then estimating the distribution of possible future values for that stock. For example, if the stock has a price today of $10, and an option is being offered with a strike price of $15, the critical estimate is the likelihood that the stock will be worth $15 or more sometime between now and the expiration of the option. This distribution of future values is typically estimated using historical price distributions. Stocks with historically wide distributions are felt to have much more unpredictable future values and so a greater probability of extreme future values. In other words, a stock that has moved 10 percent per month over the last year, even if the net gain has been 0 percent, is, all else equal, likelier to achieve a 50 percent gain over the next year than a stock that has achieved the same 0 percent annual return and has moved only 1 to 2 percent per month. Different historical volatilities lead to different estimates of the underlying distributions of possible future values. The machinery of financial option valuation, including the widely promulgated Black-Scholes model, consists of different ways of estimating the probabilities of different future stock price values and the implications of those collective probabilities on the value of an option at different specific future prices. The field of real options valuation is firmly rooted in the same tradition. There is a well-established and highly elaborate body of work that uses the same tools and techniques created to value financial options to value real options (see next slide). Michael E. Raynor, The Strategy Paradox (Currency Doubleday: 2007). 103

Confidential – For Classroom Use Only Valuing Real Options (contd.) There are a number of conceptual and technical problems associated with applying this putative equivalence. The parameters required to value a financial call option are typically observable. The stock on which the option contract is written has a market price. The exercise price is stipulated in the option contract, as is the time to expiration. The risk-free rate is almost by definition the ninety-day Treasury bill interest rate, and the historical volatility of a stock provides a meaningful estimate of the range of future possible prices. The carrying cost is simply the opportunity cost of any dividends declared before the option is exercised, which can be estimated by observing the stock’s historical dividend rate and payout schedule and mapping that to the time period over which the option runs. It is for this reason that sophisticated mathematical tools can provide useful estimates of value. If option valuation required primarily keen strategic insight, it is not clear what statistical simulation techniques would have to offer. Michael E. Raynor, The Strategy Paradox (Currency Doubleday: 2007). 104 Financial Call OptionReal Option on an asset that is a contingent element of an alternative strategy Stock pricePresent value of the asset as a stand-alone enterprise Exercise or strike priceIncremental investment required to incorporate the asset into the alternative strategy Time to expirationTime until the asset is no longer required to implement the alternative strategy, or scenario demanding the alternative strategy is no longer plausible Risk-free rate Carrying costOpportunity cost of strategic constraints required option value Estimated range of stock’s future price Range of possible future values of the asset’s contribution to the alternative strategy of which it is part

Confidential – For Classroom Use Only Valuing Real Options (contd.) In contrast, the real option analogs typically are not observable. When making an acquisition, taking a partial equity stake, or investing in a joint venture, the price of the option is the premium paid above whatever the present value of cash generated by that investment would be if the option it represented were never exercised. Neither can the strike price be observed. Exercising a real option can require some combination of acquiring additional equity or outright ownership plus the additional investment necessary to integrate a particular asset and implement a new strategy. In other words, exercising a real option is a form of post- merger integration challenge, something that is often fraught with difficulty and uncertainty. The time to expiration and carrying costs are similarly unclear. The strategic option is valuable for as long as the alternative strategy requiring it remains viable within a scenario deemed sufficiently plausible. In other words, the option is valuable until it is no longer valuable, and who knows that will be? Carrying costs amount to the cramp on profitability, if any, imposed by the strategic constraints required to preserve the option. Preserving option value, recall, means keeping the asset with option value “integratable” into the alternative strategy of which it is a part and keeping it viable as a stand-alone entity should the option need to be abandoned. This means that the carrying cost is the sum of any possible reductions in profits generated by the asset as a consequence of strategic constraints required to preserve the exercisability of the option plus reductions in the success of the strategy, should it be implemented, as a result of the autonomy maintained prior to exercising the option that was needed to preserve the ability to abandon the option. That was complicated to say. Imagine how tough it is to figure out. Michael E. Raynor, The Strategy Paradox (Currency Doubleday: 2007). 105

Confidential – For Classroom Use Only Valuing Real Options (contd.) But the task is difficult only if the comparison is the relative precision of financial option valuation. This comparison is entirely inappropriate. The purpose of real options, in the context of Strategic Flexibility, is to reduce strategic risk and increase exposure to strategic opportunity. These are outcomes that cannot be measured ex ante, and for which suitable proxies in the financial markets simply do not exist. After all, the strategic uncertainty that is relevant to scenarios, alternative optimal strategies, and strategic options plays out over years and possibly decades. Few markets for financial options have time horizons much beyond a year. Strategic options create value by allowing subsequent investments to be based on better information….In the end, however, the value of strategic options is determined by the value the organization places on a particular risk/return profile. This is not something that can be priced with direct reference to close capital market proxies. The valuation of real options therefore necessarily relies more on common sense than on analytical rigor. The components of valuation are only conceptually the same for financial and real options, but this conceptual equivalence is helpful. It allows a senior team to build up the value to their organization of a given asset and trade off the contribution that asset makes to the management of strategic uncertainty against other uses of capital. As a result, no valuation technique, no matter how sophisticated, will replace human judgment. Management must determine what kind of Strategic Flexibility can be created at what cost, while the board must determine what kind of Strategic Flexibility is worth having at that price. Michael E. Raynor, The Strategy Paradox (Currency Doubleday: 2007). 106

Confidential – For Classroom Use Only Real Option Values and Uncertainty To understand how real option value (ROV) works in Level 3 situations, consider an oil company that wants to value a five-year license for exploration and production on a particular block of land. Suppose there is Level 3 uncertainty around the profitability of the block, driven by underlying uncertainty over the block’s oil reserves and future oil prices. This uncertainty allows one to bound the range of future revenues from the block, but the range is so wide that the choice of whether to acquire and develop the block is not obvious. These oil licenses pass our criteria for real options: They provide the purchaser with a privileged position (only the license owner can explore or produce on that block of land), they are highly leveraged (licenses cost little relative to full exploration and production costs), and they provide flexibility (companies have the right, but not the obligation, to explore and produce on the block). Buying a license and postponing block development may be more valuable than an immediate full-scale commitment to exploration and production, if time will help resolve uncertainty over the price of oil and the block’s reserves. The Black-Scholes option-pricing model was designed to value financial options under Level 3 uncertainty. It defines six drivers of option value, four of which we highlighted in the previous section. These six drivers also determine real option value under Level 3 uncertainty. The six drivers as applied to the oil example are the following: 1.Stock price. This is the current price of the stock for which the option is bought. According to finance theory, this price should reflect the present value of all expected future cash flows associated with owning the stock. The higher the stock price, all else being equal, the higher the value of a call option to purchase the stock at a given exercise price. The equivalent measure in real option valuation is the present value of cash flows expected from the investment opportunity on which the option is purchased. For example, if the block is expected to yield 50 million barrels of oil to be sold at a cash margin of $10/barrel (in present value terms), the “stock price” in this case is $500 million. The value of the license obviously rises as these expected cash flows rise. 2.Exercise price. This is the predetermined price at which the option can be exercised. The higher the exercise price, all else equal, the lower the value of a call option to purchase the stock at this price. The real option equivalent is the present value of all sunk costs that will be necessary to capture the cash flows expected from the investment opportunity. In valuing oil block licenses, this is the present value of the costs necessary to develop the field for production, assumed to be $600 million in this case. The value of the license falls as these costs rise. Hugh Courtney, 20/20 Foresight (Harvard Business School Press: 2001). 107

Confidential – For Classroom Use Only Real Option Values and Uncertainty (contd.) 3.Uncertainty. This is captured by the standard deviation of the per-period growth rate of expected future cash flows from owning the stock. While the stock price reflects the expected value of these cash flows, this standard deviation measure reflects the degree of uncertainty around this expected value. As noted previously, higher uncertainty increases option value. For real options, uncertainty is measured by the growth rate of cash flows from the investment opportunity. There are two main sources of uncertainty around cash flows from the oil bIock: the quantity of oil it will produce and the cash margin on that oil. In this case, these uncertainties implied a 30 percent standard deviation on the annual growth rate of cash flows. The license would be worth even more, however, with a 40 percent standard deviation. Since the company would never choose to exercise the option to develop the field unless cash flows were expected to cover the $600 million development costs, the greater downside is irrelevant. The greater upside, however, implies that there is a higher probability of earning large profits. 4.Option duration. This is the time remaining during which the option can be exercised. Option duration increases option value because it provides more time for the option to be “in the money.” For real options, the analog is the period for which the investment opportunity is available. In general, this will be determined by technology (length of a product life cycle), intensity of competition, and contract length, including patents, leases, and licenses. In this case, the option duration is five years, since the license provides proprietary access to the block for that time. The license would be worth more if it had a longer duration. 5.Dividends. Dividend payments lower option values since they drain cash from the company during the duration of the option. The real option equivalent is the cash that is lost during the duration of the real option. This includes costs that are necessary to keep the opportunity alive, and cash that is forfeited to competitors that make preemptive investments. In the license case, one doesn’t have to worry about competitive preemption on the block (the license is proprietary). However, a company does have to pay $15 million per year—or 3 percent of the expected value of future cash flows—to keep the reserve active and available for possible development. The license would be worth more if these annual upkeep expenses were lower. 6.Risk-free interest rate. In both real and financial options, this is the yield of a risk-less security with the same maturity as the duration of the option. A higher risk-free interest rate increases option value. With a high risk-free interest rate, there is a high opportunity cost associated with making full-scale commitments today relative to positioning or staging these commitments over time. In the oil block license case, the risk-free rate is 5 percent. Hugh Courtney, 20/20 Foresight (Harvard Business School Press: 2001). 108

Confidential – For Classroom Use Only Choosing Parameters for ROV Analysis The key to using the Black-Scholes to value real options versus big bets under Level 3 uncertainty lies in identifying the right parameters for the six value drivers. Of course, this is easier said than done. But it can be done, and the oil license case provides some hints on how to do it. Let’s take it one parameter at a time. 1.Stock price. History and geology are the best guides here. By studying blocks with similar geological characteristics that have already been explored and produced, the oil company can generate an expected oil production figure. Likewise, by consulting expert forecasts of future oil prices—as well as forward market prices—it can settle on an expected price path. Together, these forecasts determine the expected cash flows from full exploration and production of the block. 2.Exercise price. Experience is also the best guide here. By analyzing e costs to fully explore and produce similar blocks, the oil company can generate an estimate of the cost to exercise its option to develop this block. 3.Uncertainty. If history is the best guide for expected oil production from a given block, it can also tell you the standard deviation of such production. Likewise, historical oil price variance (and variance in expert forecasts) allows you to estimate the standard deviation around annual oil price forecasts. Together, these provide an estimate of the standard deviation around the growth rate of future cash flows from the block. In fact, the ability to make this estimate is what defines this license acquisition problem as a Level 3 issue. If such an estimate were impossible to obtain, this would be a level 4 issue instead. 4.Duration. In this case, it is easy: The license provides proprietary rights to develop the block for five years. When real options aren’t proprietary—and thus subject to competitive preemption—competitive intelligence will be necessary to determine how long the option will likely remain viable before being closed off by a more aggressive competitor. 5.Dividends. History again provides the necessary information. The oil company can study previous oil exploration and production projects to determine the annual expenses that were necessary to keep similar blocks viable for future development. 6.Risk-free interest rate. This parameter is easy. All the company has to do is find a U.S. government security (or similar “risk-free” corporate bond) with the same duration as the option to peg this discount rate. These first two parameters are the standard inputs into NPV analysis. What’s the expected NPV of a full-commitment strategy to develop the block right away? Expected future cash flows from the investment (stock price) minus up-front costs of the investment (exercise price). Since most companies attempt to complete some sort of NPV valuation of their strategies, estimates of these first two ROV parameters are often already on hand (even if they are difficult to obtain). Hugh Courtney, 20/20 Foresight (Harvard Business School Press: 2001). 109

Confidential – For Classroom Use Only ROV Analysis for a Biotech Company Rigorous Level 3 ROV analysis can also be applied to many drug development cases. Consider Biogen’s decision to commercially develop Avonex in the early 1990s. Biogen owned the patent on Avonex, a drug that had just been approved by the U.S. Food and Drug Administration to the progression of disability in relapsing forms of multiple sclerosis. Biogen faced Level 3 uncertainty over market demand for the drug, and thus it was considering whether to launch immediate commercial development of the drug (a big bet) or delay its launch until more precise demand forecasts were available (a real option). The solution lay in the six drivers of real option value: 1.Stock price. This was the expected present value of operating cash flows associated with selling Avonex in the market. Market research was used to size the market and estimate the price Biogen could charge. This research estimated that the expected value of bringing the drug to market, absent initial development costs, was $3,422 billion 2.Exercise price. This was the initial cost of developing the drug for commercial use. History and forward-looking expert analysis provided the estimate: $2.875billion in this case. 3.Uncertainty. There was no objective, project-specific estimate of uncertainty available for the Avonex launch. The average annual standard deviation of firm value for publicly traded biotechnology tocks, however, was considered a good proxy measure for this uncertainty—47 percent in this case. 4.Option duration. The option’s duration was assumed to be the Avonex patent life, or seventeen years. During this period, Biogen had the proprietary right to bring Avonex to market. Upon patent expiration, it was assumed that market competition would erase any excess returns Biogen could earn on Avonex. 5.Dividends. Every year that Biogen delayed commercialization of Avonex, it would lost a year of patent-protected cash flows. To delay one year, then, costs one-seventeenth, or 5.89 percent, of the $3,422 billion in total expected cash flows. As time goes on, this loss represents a higher percentage of total possible cash flows from the drug (the “dividend rate” would rise to one-sixteenth, or 6.25 percent, after a one-year delay, one-fifteenth, or 6.67 percent. After a two-year delay, and so on). This implies that even if it paid to delay commercialization in the first year, eventually it would make sense for Biogen to bring Avonex to market. 6.Risk-free interest rate. The current long-term Treasury bond rate was the right benchmark, 6.7 percent. Given these parameters, what was the right answer for Biogen? The of immediate commercial development was a healthy $547 million ($3,422 billion minus $2,875 billion). At the same time, the Black-Scholes formula showed that the value of the patent itself—including the option to defer development to future years—was $907 million. The implication? Biogen should defer commercial development of Avonex for at least one year even though the NPV of an immediate development strategy was positive. The intuition is clear. High uncertainty over future cash flows coupled with a reasonably low cost of delay (only forfeiting one-seventeenth of total potential cash flows, with no threat of competitive preemption) implies that it is worthwhile to delay development. The delay may allow for better information on the commercial prospects of the drug, and result in better decisions to develop the drug—or not—later. Hugh Courtney, 20/20 Foresight (Harvard Business School Press: 2001). 110

Confidential – For Classroom Use Only ROV Analysis and Level 2 Uncertainty The Black-Scholes model assumes continuous Level 3 uncertainty, and thus it is not directly applicable to real option versus big bet choices driven by Level 2 uncertainty. When faced with Level 2 uncertainty, decision-tree approaches can provide close approximations—if not exact calculations—of the value of big bet and real option strategy alternatives. Consider the following disguised case, based on observations taken from several different international retail markets. Acme (a fictitious name) was a diversified retailer with a leading position in its home geographic market. Globalco (also a fictitious name) was a highly innovative retailer that had developed a new store format in a different geographic market. This format was a hit with consumers in Globalco’s home market, and as a result Globalco was stealing significant market share from retailers with traditional store formats such as Acme’s. As Globalco’s position strengthened in its home market, however, market analysts believed that it would soon be seeking to enter international markets in order to sustain its rapid growth. This situation created a major Level 2 uncertainty for Acme: Would Globalco choose to invade Acme’s home market with its new store format? Given this uncertainty, Acme had three strategy options: (1) maintain its status quo strategy, (2) commit to and launch a new full-scale chain of retail stores modeled after Globalco’s store formats (a big bet) in its home market, or (3) build a few pilot stores modeled after Globalco’s Store formats with the option to launch a full-scale chain later if Globalco did indeed enter the market (a partial- commitment real option). These potential actions are summarized in the decision tree shown in figure 4-1 (see next slide). The partial-commitment pilot store strategy was obviously the best choice or Acme. While the strategy still had a negative expected value, its value was much higher than the other two alternatives. The pilot store program made it less likely that Globalco would enter the market, and it avoided (or at least postponed) major capital investments and significant cannibalization of Acme’s existing stores. The Acme case also illustrates a key difference between NPV and approaches. NPV mechanically discounts back expected cash flows, while ROV starts at the end of the decision tree and works back one decision at a time, always asking “What would an intelligent manager choose to do at this point given the flexibility to reoptimize?” When managers do have the option to reoptimize, anl when they will in fact exercise that option, then ROV provides a more accurate valuation of any investment or other strategic decision. NPV is appropriate for valuations of Level 2 strategies that have limited or no flexibility. However, any strategy built on managerial flexibility to reoptimize as Level 2 uncertainty unfolds should be valued with decision-tree techniques. Otherwise, strategies with flexibility will be systematically undervalued relative to full-commitment strategies, biasing decision makers away from real options and toward big bets. Hugh Courtney, 20/20 Foresight (Harvard Business School Press: 2001). 111

Confidential – For Classroom Use Only 2. Now or Later: Example of Decision Tree Hugh Courtney, 20/20 Foresight (Harvard Business School Press: 2001). 112

Confidential – For Classroom Use Only 113 More on Real Options and Decision Trees

Confidential – For Classroom Use Only 114 Options Pricing The idea is that spending now creates not just cash flow from operations but the opportunity to invest again later, depending on how things look –The crucial decision to invest or not will be made after some uncertainty is resolved or when time runs out Valuation factors –Two types of cash flow Cash from the business Cash required to enter the business should we choose to –Time matters in two ways The timing of the eventual cash flows How long the decision to invest may be deferred –Risk matters in two ways The riskiness of the business assuming we invest in it The risk that circumstances will change for better or worse before we have to decide Timothy Luehrman, “What’s It Worth?” in Harvard Business Review, May-June 1997.

Confidential – For Classroom Use Only 115 The Black-Scholes Model Assumptions of the Black and Scholes Model: 1) The stock pays no dividends during the option's life Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price. 2) European exercise terms are used European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same. 3) Markets are efficient This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itô process. To understand what a continuous Itô process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An Itô process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper. 4) No commissions are charged Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model. 5) Interest rates remain constant and known The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model. 6) Returns are lognormally distributed This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options. http://bradley.bradley.edu/~arr/bsm/pg04.html

Confidential – For Classroom Use Only 116 Terms in the Black-Scholes Model C is the current call option value. This is the cost to purchase one European-type call option of a certain stock. S is the current stock price. This is the price that the stock underlying the call option is currently trading at. N(d1) is a fraction (whose value is between 0 and 1) determined by the price of the stock; the exercise price; the risk-free interest rate (the annualized continuously compounded rate on a safe asset with the same maturity as the option); the time to maturity of the call option, and the volatility of the underlying stock price. –N(d) is the probability that a random draw from a standard normal distribution will be less than d. K is the exercise price, the price at which you have the right to buy the stock when the call option expires. e-rT is a term that adjusts the exercise price, K, by taking into account the time value of money. Here, "e" is 2.718, the base for the natural logarithm, used for continuous compounding; "r" is the risk-free interest rate; and "T" is the time until expiration of the call option. is a fraction (whose value is between 0 and 1) determined by the price of the stock; the exercise price; the risk-free interest rate (the annualized continuously compounded rate on a safe asset with the same maturity as the call otpion), the time to maturity of the option, and the volatility of the underlying stock price. It differs from N(d1) in that one subtracts (the volatility of the stock times the square root of the time till the call option expires) from d1 before the N function is performed. –N(d) is the probability that a random draw from a standard normal distribution will be less than d. http://www.investopedia.com/offsite.asp?URL=http://www.pbs.org/wgbh/nova/stockmarket/formula.html

Confidential – For Classroom Use Only 117 Calculating the Black-Scholes Formula http://www.erieri.com/scripts23/blackscholes/blackscholes.exe/Main

Confidential – For Classroom Use Only 118 An Example Stock Asset Price based on DCF calculation Option Strike Price is the amount necessary to bring the technology to market Maturity is the time remaining to decide whether to invest or not Risk Free Interest Rate is determined in the market Volatility is a measure of how risky (i.e. volatile, standard deviation) the cash flows are

Confidential – For Classroom Use Only 119 Real Options Method Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments. Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project. Traditional methods (e.g. net present value) fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change. The real options method represents the new state-of-the-art technique for the valuation and management of strategic investments. The real option method enables corporate decision-makers to leverage uncertainty and limit downside risk. http://www.real-options.com/overview_about.htm

Confidential – For Classroom Use Only 120 Real Options Method (contd.) There are a number of good introductions to real options (see the web resources for a full listing). Here is the starter from Expectations Investing: Reading Stock Prices for Better Returns by Alfred Rappaport and Michael Mauboussin. (HBS Press, 2001, Chapter 8) Mauboussin is the Chief Investment Strategist at Credit Suisse First Boston, and you can read a thought piece on real options he wrote for money managers called Get Real. –"The real-options approach applies financial options theory to real investments, such as manufacturing plants, product line extensions, and research and development. A financial option gives the owner the right, but not the obligation, to buy or sell a security at a given price. Analogously, companies that make strategic investments have the right, but not the obligation, to exploit these opportunities in the future.” Real options take a number of forms, including the following: If an initial investment works out well, then management can exercise the option to expand its commitment to the strategy. For example, a company that enters a new geographic market may build a distribution center that it can expand easily if market demand materializes. An initial investment can serve as a platform to extend a company's scope into related market opportunities. For example, Amazon.com's substantial investment to develop its customer base, brand name and information infrastructure for its core book business created a portfolio of real options to extend its operations into a variety of new businesses. Management may begin with a relatively small trial investment and create an option to abandon the project if results are unsatisfactory. Research and development spending is a good example. A company's future investment in product development often depends on specific performance targets achieved in the lab. The option to abandon research projects is valuable because the company can make investments in stages rather than all up-front. Each of these options - expand, extend, and abandon - owes its value to the flexibility it gives the company. Flexibility adds value in two ways. –First, management can defer an investment. Because of the time value of money, managers are better off paying the investment cost later rather than sooner. –Second, the value of the project can change before the option expires. If the value goes up, we're better off. If the value goes down, we're no worse off because we don't have to invest in the project. http://www.real-options.com/overview_about.htm

Confidential – For Classroom Use Only 121 Uncovering Real Options 1 Taking an options-based approach is not simply a matter of using a new set of valuation equations and models. It requires a new way of framing strategic decisions. The questions become less, What will we gain by moving from point A to point B? and more, If we begin down the path from point A to point B, what options will open for us and where will we gain by having those options? The first step in reorienting strategic thinking, then, is to identify the real options that exist in investment decisions. Uncovering real options can be tough. Unlike financial options, real options are not precisely defined or neatly packaged. But they do exist in almost every business decision, and they tend to take a limited number of forms. By understanding these forms, managers can become better able to spot the options in their own decisions. The following are hypothetical examples of the most common types of real options: Timing Options. Sales of low-fat ice cream are surging. Operating at full capacity, the Healthy Cow Creamery is considering whether to expand its plant. Launching the expansion would require a big up-front investment, and the company's managers can't be sure that the sales boom will persist. They have the option of delaying the investment until they learn more about the strength of demand. It may be that the risk avoided by waiting to invest has a greater value than the sales that might be forfeited by postponing construction. Growth Options. Friend-to-Friend, a company that sells cosmetics through a network of independent salespeople, is trying to decide whether to enter the vast Chinese market. The initial investment to build a manufacturing and sales organization would be large, but it may lead to the opportunity to sell a whole range of products through an established sales network. The investment would thus create growth options that have value above and beyond the returns generated by the initial operations. Staging Options. The top management team at International Widget is reviewing a proposal from the senior vice president of operations to install a new manufacturing system. The proposal calls for a full, multimillion-dollar rollout at all factories over the next two years. But the business benefits of the project remain uncertain. The company has the option to invest in the new system in stages rather than all at once. The conclusion of each stage ill in turn provide further options -- for continuing, for delaying, or for abandoning the effort. All these options add value to the proposed project. http://www.real-options.com/overview_about.htm

Confidential – For Classroom Use Only 122 Uncovering Real Options 2 Exit Options. Molecular Sciences has a patent for a promising new chemical product, but it's worried about the size of the market opportunity, and it's unsure whether the manufacturing process will meet government regulations regarding toxic chemicals. If the company does begin an effort to commercialize the product, though, it will have the option to abandon the project if demand doesn't materialize or if the environmental liability appears too large. The exit option increases the value of the project because it reduces the size of the investment at risk. Flexibility options. Cell, Incorporated needs to decide how to best manufacture its latest cellular telephone. Demand for the new product is uncertain, although forecasts indicate that sales will be spread across two continents. A traditional manufacturing analysis indicates that a single plant would be much cheaper to build and operate than two plants on two continents. But the analysis fails to take into account the flexibility of option that would be created by building two plants - the option to shift production from continent to continent in response to shifts in demand, exchange rates, or production costs. If the value of the option outweighs the cost saved by building just one plant, then Cell should invest in two plants and carry the excess capacity. Operating options. Bright Light Software has long contracted with other companies to produce and package its CD- ROMs Its sales have grown rapidly in recent years, however, and now the company is trying to decide whether it makes sense to build its own plant. If it goes ahead, it would gain a number of operating options. It would, for example, have the option to shut down the operations during times of weak demand and the option to run additional shifts during times of high demand. The value of these options adds to the value of the plant. Learning Options. Hollywood Partners is planning to release three movies in the midst of the Christmas season. Before the films actually open, the studio's executives can't tell which one will be the biggest hit, so they can't be sure how to best allocate their marketing and advertising dollars. But they have an important learning option. They can release each movie on a limited number of screens in selected cities and then refine their marketing plans based on what they learn. They can, for example, roll out the most popular movie nationwide and give it a large advertising budget while putting the other films into more limited release. From: "Disciplined Decisions: Aligning Strategy with the Financial Markets", Martha Amram and Nalin Kulatilaka, Harvard Business Review, January-February, 1999. www.hbsp.harvard.eduwww.hbsp.harvard.edu http://www.real-options.com/overview_about.htm

Confidential – For Classroom Use Only 123 Real Options and Strategy The goal of strategy is clear - to make investment decisions that lead to greater shareholder value. But when it comes to actually achieving that goal, things get fuzzy. In volatile markets, where prices and demand are always in flux, it's hard to predict how a particular investment will ultimately influence a company's value. Senior executives spend a lot of time structuring their decisions, tracing out possible implications, assigning probabilities, and assessing risk. Rarely, though, does everyone agree about how an investment will play out. Different managers draw on different experiences and have different perspectives, which lead them to different conclusions. It's hard to sort out whose answers are the right answers. In fact, there is only one right answer: the answer of the financial markets. The markets are the final arbiters of an investment's value, and the markets are adept at calculating uncertainty on value. By applying the discipline of the markets, managers can avoid basing important decisions on subjective judgments about the future. They can incorporate the market's objective measure of value under uncertainty into their own strategic choices. When does a decision become disciplined? Discipline, in our view, has three components: –The decision is structured, or framed, in terms of the options it creates. –All the relevant information value and risk available in the financial markets is taken into account. –Financial-market transactions are used to acquire options or otherwise mitigate risk whenever that's economically justified. Applying market discipline changes the way managers make decisions, and it changes the decisions themselves. All kinds of companies have the opportunity to draw on financial markets' techniques, benchmarks and information. They can discipline their decisions and align them with the investment decisions of the markets. They can close the gap between strategy and shareholder value. From: "Disciplined Decisions: Aligning Strategy with the Financial Markets", Martha Amram and Nalin Kulatilaka, Harvard Business Review, January-February, 1999. www.hbsp.harvard.eduwww.hbsp.harvard.edu http://www.real-options.com/overview_about.htm

Confidential – For Classroom Use Only 124 Framing Real Options in the Real World: Four Examples Framing is the act of setting up the application, of drawing out the analogy at the level of inputs and decision between the expansion option and the financial option. As these quick examples illustrate, there is a bit of a craft to the application of real options in the real world. The value of the payoff at Yahoo! During the turmoil of 2000 and 2001, Yahoo! significantly revised expectations. Its advertising-based business model was not working in the downturn of 2001, and a new business model was not yet in sight. Yahoo!'s stock price fell more quickly and more deeply than did Amazon's, because without a clear business model, Yahoo! lost the value of both its steady business (captured by a discounted cash flow analysis) and its upside potential (the payoff to any expansion options.) The blended volatility at Omni Media. Omni Media (Martha Stewart's company) wants to be a mature, nationwide content company. The firm creates content for Internet, print, and television. What determines the volatility of the payoff to an expansion option for Omni Media? A mix of Internet, content, and traditional publishing business models. The appropriate volatility captures the mix of risks from the online and offline worlds. Using volatility estimates from traditional publishing may omit the Internet components. Conversely, using volatility estimates from Internet-only companies neglects that mature business will have relatively low volatility. Judgment, and a sensitivity analysis, will be required. The option trigger in cable companies. In April 1999 Laura Martin, cable and media equity analyst at Credit Suisse First Boston, issued a report using real options to value the assets of cable companies. At the time, cable companies across the United States were upgrading the connection to customers' homes to a 750 MHz capacity. Only 650 MHz had identified uses, and the remainder was "dark fiber." Using a DCF model, Martin valued the projected free cash flow of the cable companies she covered. After adjusting for debt, the DCF estimate of stock price equaled the trading price. In a pioneering analysis, she went on to value the dark fiber as an expansion option: When the right deal came along, the cable companies would open up another channel. The expansion option simply increased the business-as-usual possibilities. The driver of the exercise decision is the arrival of an attractive deal for the channel, which is largely unrelated to the value of the payoff. The real options analogy is only an approximation. But when Martin's report was released, cable company stock prices increased 10 percent to 15 percent, and market values of cable companies exceeded DCF values for the remainder of 1999. As this example shows, while the analogy was not airtight, the equity report made the expansion option visible, and its value was capitalized into cable company value thereafter. The value decay in online pet stores. In 1999 venture capitalists funded six very similar companies with hundreds of millions of dollars, each racing for market share in the online pet store market.15 The pet companies felt the pressure-it seemed that with each passing month, potential market share slipped away to competitors. Viewed from an options angle, the payoff value was decaying. It is straightforward to quantify the effect of value decay on the expansion option. A sixth variable, the rate of value decay, is added to the input list. With the adjustment, the future outcome of S remains uncertain, but the new variable introduces a downward drift to the fluctuations, gently lowering the range of future outcomes. Value decay is very costly to option value. The implication was that investors grossly overestimated the value in online pet stores at the time of their funding. The implication for the management teams was that there was a reason to rush for market share. With value decay, waiting leads to a lower and lower payoff. From Chapter 4 of Value Sweep: Mapping Corporate Growth Opportunities, by Martha Amram (HBS Press, 2002). www.valuesweep.comwww.valuesweep.com http://www.real-options.com/overview_about.htm

Confidential – For Classroom Use Only 125 Decision Tree Basics Decision trees are used to select the best course of action in situations where you face uncertainty. Many business decisions fall into this category. For example, a manufacturer must decide how much inventory to build before knowing precisely what demand will be. A litigant must choose between accepting an out-of-court settlement or risking a trial. A speculator must decide to buy an asset before knowing if it can be sold for a profit. In all of these cases, the decision-maker faces an unknown that seems to make it impossible to choose the right option with any certainty. Although the decision-maker does not know what the outcome of the unknown will be, he or she generally has some knowledge about what the possible outcomes are and how likely each is to occur. This information can be used to select the option that is most likely to yield favorable results. Decision trees make this type of analysis easy to apply. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 126 Expected Monetary Value If you could somehow determine precisely what would happen as a result of choosing each option in a decision, making business decisions would be easy. You could simply calculate the value of each competing option and select the one with the highest value. In the real world, decisions are not quite this simple. However, the process of decision-making still requires choosing the most valuable option--most valuable being, in this case, the option that has the highest Expected Monetary Value (EMV), a measure of probabilistic value. Suppose you are given the opportunity to play a simple game. A friend flips a coin. If it comes up heads, you win $100. If it comes up tails, you win nothing. What is the value of this game to you? Stated another way, how much would you pay to play this game? Each time you play the game you have a 50% chance of winning $100 and a 50% chance of winning nothing. If you were to play the game many times, on average you would win $50 for every time you played. Therefore, $50 is the EMV for this game. Graphically, this game can be illustrated as follows: This diagram shows that there is an uncertain event with two possible outcomes. Win, which has a value of $100, and Lose, which has a value of $0. Furthermore, there is a 50% chance of each outcome. Finally, the EMV of this event is $50. This simple diagram does an excellent job of communicating all essential details of the situation you face. The EMV is calculated by multiplying each outcome value by its probability and adding all of the results together. In the diagram above, the EMV was calculated using the equation EMV = $100 * 0.50 + $0 * 0.50 = $50 The value shown under each node name is the expected value of reaching that point in the tree. Before playing the game, you are at the Play Game node and the combined value of all events following this node is $50. Similarly, if you win, you move to the Win node with a value of $100. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 127 Decision Diagrams Now, suppose your friend offered you the opportunity to play the game presented in the previous section or simply accept $40 cash. What should you do? Playing the game is worth $50, which is more valuable than $40, so you should play the game. This decision can be illustrated as follows: This diagram contains two new nodes: Root and Accept Cash. Note that Root is presented slightly differently from Play Game. Root is followed by a square, rather than a circle, and there are no outcome probabilities on the branches leading from Root. Furthermore, the value of the node Root is not a weighted average of option values, but is exactly equal to the value of only one of the options. Root is called a decision node. Play Game is called an event node. All other nodes are called end nodes. At a decision node, you get to pick which path you want to take. Being a rational decision-maker, you would choose the path with the highest value. Therefore, the value of a decision node is equal to the value of the best option branching from the node. In the example above, the best option is to play the game, which has a value of $50, so the value of the decision node is also $50. The branch labeled Accept Cash is marked with a double slash to indicate that you would not choose this option; it has been pruned from the tree. The diagram above is called a decision tree. Decision trees map all options and potential consequences in a manner that makes it easy to understand and communicate the situation you face. As you move from left to right in the tree, you generally move forward in time. The root node is where you are now and immediately branches off into all options from which you can choose. What might happen as a result of choosing each option is illustrated as additional branches. Note that this tree has five nodes, not two. Because the tree is displayed without node boxes, it is a common mistake to refer to the junction points (square or circle) as nodes. In fact, these are just symbols that are appended to the back of each node. Keep in mind that Win, Lose, and Accept Cash are also nodes. They are end nodes and include a triangle symbol. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 128 Incremental Values Now, let us complicate the coin toss game a little. Just as before, you will win $100 if heads comes up, and nothing for tails. However, your options are to pay $40 to play this game or don’t play at all. This game is illustrated using the following tree. The first thing you might notice is that each node has three lines instead of two. Just as before, the top line contains the node name and the bottom line contains the calculated EMV. The middle line is new. This line contains the amount of cash you will pay or receive as a result of jumping to that node from its parent--the incremental value. For example, if you decide to play the game, you will pay $40. This means that the Play Game node has an incremental value of -40. The value is negative because it is a cash outflow. Similarly, if you win the coin toss, you will receive $100. Therefore, Win has an incremental value of 100 (positive). Note that if you win the coin toss, you will not have earned $100. Instead, you will have a net profit of $60 ($100 winnings minus $40 to play). The net profit is shown in the EMV line. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 129 Inventory Example Assume you own a sporting goods store in a small community whose local college basketball team has made it into the finals of the national championships. You are sure that if the local team wins you will be able to sell a significant number of T- shirts proclaiming the school as the national champion. Unfortunately, to have the shirts ready the day after the championship game, you will have to order the shirts at least a week in advance--before you know if the local team will win. You expect to sell between 2,000 and 10,000 shirts at $20 each. You can order the shirts for $7 each. Any shirts you do not sell you can sell as scrap for $2 each. In addition, you estimate that there is a 60% chance of the local team winning. You must decide today if you will order any shirts, and if so, how many. In this problem you face two uncertain events, you don't know who will win the championship game, and you don't know how many shirts you can sell even if the local team does win. Here is a decision tree constructed to solve the T-shirt problem: In the first node you face a decision. You must decide how many shirts to order. This example has been simplified by assuming you can only order in quantities of 5,000. This means you must order 5,000, 10,000, or none at all. Once you have made a decision about how many shirts to order, you next come to an event node--the local team either wins or loses the championship. If the team loses, you must sell all of the shirts as scrap losing either $25,000 if you order 5,000 shirts ($2*5,000-$7*5,000) or $50,000 if you order 10,000 shirts ($2*10,000- $7*10,000). If the team wins, you face another uncertainty--the demand for shirts. The problem states that you expect demand to be between 2,000 and 10,000 shirts. A continuous, uncertain quantity, like forecast sales, can be modeled using several techniques. The simplest technique is to use three to five scenarios and assign a probability to each. In the T-shirt example the range of expected demand was divided into four bands (2-4K, 4-6K, 6-8K, and 8-10K) and the midpoint in each band (3K,5K,7K,9K) is chosen as the scenario's demand. Of course, you cannot sell more shirts than you have. Therefore, if you order only 5,000 shirts, you will make the same profit if demand is 5,000, 7,000 or 9,000. All shirts you have in excess of demand can be sold as scrap. The solution indicated by this tree is that you should order 5,000 shirts because this option yields the highest expected value. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 130 Real Estate Example 1 You have the opportunity to purchase a piece of property for $200,000. If it can be rezoned for business use, you will be able to resell the property for $250,000. You estimate that there is a 60% chance that your rezone request will succeed. If it fails, you can dump the property for $170,000 or you can choose to appeal the zoning board’s decision, which has only about a 10% chance of success. Applying for the zoning change and appealing an unfavorable ruling will each cost $5,000. Should you purchase the property? The values at the end nodes are the actual profit or loss that you will experience if you wind up at each node. For example, if you choose to buy the property, request a rezone, the request is approved, and you sell the property, you will earn $45000 (-200000 + -5000 + 0 + 250000). DecisionPro calculates the end node values by accumulating all incremental values between Root and each end node. After calculating the end node values, DecisionPro folds-back the tree to calculate EMVs for each node. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 131 Real Estate Example 2 Interpret Your Results The final step is to interpret the results of the decision tree analysis. Buying the property has an expected value of $14,200 vs. $0 for doing nothing. Therefore, if you are not adverse to risk, you should purchase the property. Furthermore, if your rezone request is denied, you should appeal. Keep in mind that you can never earn $14,200 on this investment; you will either earn $45,000, $40,000, or lose $40,000. The expected value calculation implicitly assumes that you are not adverse to risk. That is, individual gains or losses on investments like this are of no consequence to you. This is true if you have a large amount of money and many investment opportunities. In other cases, though, you should consider the range of outcomes as well as the expected values when interpreting your results. Techniques for applying risk aversion are presented later in this chapter. Choosing Event Probabilities One important difference between the real estate and the coin toss examples is in where the event probabilities came from. When you flip a coin, you know precisely what the possible outcome probabilities are--50% heads and 50% tails. In the real estate example, however, the probabilities are only estimates. We have assumed that there is a 60% chance that the rezone request will be approved. Another person constructing the same model might come up with a different estimate. Flipping a coin is truly a random event. That is, each time you repeat the event, you might get a different outcome. However, no matter how many times you issue the rezone request, you should get the same result (in theory). The probabilities you assign to this event represent your confidence in predicting an outcome rather than the probability of the outcome occurring. This distinction is not something you should be concerned about. Decision trees help you choose the best option given whatever information you have. It is perfectly valid to use estimated outcome probabilities as was done in this example. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 132 Real Estate Example with DCF Usually, when you build a decision tree you assume that all events take place close enough together that time value of money is not important. However, to be precise, you should replace each incremental value with a present value. The easiest way to do this is to create your own discounting function and use it in each incremental value entry. Let’s modify the real estate tree to discount all cash flows by 7% per year. Furthermore, let’s assume you purchase the property in year zero, and each rezone request takes a year. This means you can sell the property in year one or two depending on if you appeal the zoning board’s decision. One interesting thing to note is that applying time value of money to the real estate example changed the outcome values enough that now the best option is to do nothing. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 133 Risk Profile A decision tree conveys a great deal of information about your decision. It presents all of your options, the potential consequences of each option, contingent actions, and outcome values. However, if your tree is large, it is often difficult to appreciate the level of risk you are assuming by choosing a particular option. Keep in mind that the decision trees illustrated so far assume you are completely indifferent to risk. Generating a risk profile graph helps you to understand and communicate the risks involved. In the real estate example, you know that going ahead with the project has an expected value of $14,200 vs. $0 if you do nothing. However, going ahead also means that you could lose as much as $40,000 if things don't go well. A risk profile graph shows all of the possible outcomes and their probabilities so that these factors are understood. http://www.vanguardsw.com/dphelp4/dph00075.htm

Confidential – For Classroom Use Only 134 More on Decision Trees 1 Decision Trees are excellent tools for helping you to choose between several courses of action. They provide a highly effective structure within which you can lay out options and investigate the possible outcomes of choosing those options. They also help you to form a balanced picture of the risks and rewards associated with each possible course of action. Drawing a Decision Tree You start a Decision Tree with a decision that you need to make. Draw a small square to represent this towards the left of a large piece of paper. From this box draw out lines towards the right for each possible solution, and write that solution along the line. Keep the lines apart as far as possible so that you can expand your thoughts. At the end of each line, consider the results. If the result of taking that decision is uncertain, draw a small circle. If the result is another decision that you need to make, draw another square. Squares represent decisions, and circles represent uncertain outcomes. Write the decision or factor above the square or circle. If you have completed the solution at the end of the line, just leave it blank. Starting from the new decision squares on your diagram, draw out lines representing the options that you could select. From the circles draw lines representing possible outcomes. Again make a brief note on the line saying what it means. Keep on doing this until you have drawn out as many of the possible outcomes and decisions as you can see leading on from the original decisions. An example of the sort of thing you will end up with is shown in Figure 1: http://www.mindtools.com/dectree.html

Confidential – For Classroom Use Only 135 More on Decision Trees 2 Once you have done this, review your tree diagram. Challenge each square and circle to see if there are any solutions or outcomes you have not considered. If there are, draw them in. If necessary, redraft your tree if parts of it are too congested or untidy. You should now have a good understanding of the range of possible outcomes of your decisions. Evaluating Your Decision Tree Now you are ready to evaluate the decision tree. This is where you can work out which option has the greatest worth to you. Start by assigning a cash value or score to each possible outcome. Estimate how much you think it would be worth to you if that outcome came about. Next look at each circle (representing an uncertainty point) and estimate the probability of each outcome. If you use percentages, the total must come to 100% at each circle. If you use fractions, these must add up to 1. If you have data on past events you may be able to make rigorous estimates of the probabilities. Otherwise write down your best guess. This will give you a tree like the one shown in Figure 2: http://www.mindtools.com/dectree.html

Confidential – For Classroom Use Only 136 More on Decision Trees 3 Calculating Tree Values Once you have worked out the value of the outcomes, and have assessed the probability of the outcomes of uncertainty, it is time to start calculating the values that will help you make your decision. Start on the right hand side of the decision tree, and work back towards the left. As you complete a set of calculations on a node (decision square or uncertainty circle), all you need to do is to record the result. You can ignore all the calculations that lead to that result from then on. Calculating The Value of Uncertain Outcome Nodes Where you are calculating the value of uncertain outcomes (circles on the diagram), do this by multiplying the value of the outcomes by their probability. The total for that node of the tree is the total of these values. In the example in Figure 2, the value for 'new product, thorough development' is: 0.4 (probability good outcome) x £500,000 (value) = £200,000 0.4 (probability moderate outcome) x £25,000 (value) =£10,000 0.2 (probability poor outcome) x £1,000 (value) = £200 Sum Total = +£210,200 Note that the values calculated for each node are shown in the boxes. http://www.mindtools.com/dectree.html

Confidential – For Classroom Use Only 137 More on Decision Trees 4 Calculating The Value of Decision Nodes When you are evaluating a decision node, write down the cost of each option along each decision line. Then subtract the cost from the outcome value that you have already calculated. This will give you a value that represents the benefit of that decision. Note that amounts already spent do not count for this analysis - these are 'sunk costs' and (despite emotional counter-arguments) should not be factored into the decision. When you have calculated these decision benefits, choose the option that has the largest benefit, and take that as the decision made. This is the value of that decision node. Figure 4 shows this calculation of decision nodes in our example: In this example, the benefit we previously calculated for 'new product, thorough development' was £210,000. We estimate the future cost of this approach as £75,000. This gives a net benefit of £135,000. The net benefit of 'new product, rapid development' was £15,700. On this branch we therefore choose the most valuable option, 'new product, thorough development', and allocate this value to the decision node. http://www.mindtools.com/dectree.html

Confidential – For Classroom Use Only 138 More on Decision Trees 5 Result By applying this technique we can see that the best option is to develop a new product. It is worth much more to us to take our time and get the product right, than to rush the product to market. It is better just to improve our existing products than to botch a new product, even though it costs us less. Key points: Decision trees provide an effective method of Decision Making because they: –Clearly lay out the problem so that all options can be challenged –Allow us to analyze fully the possible consequences of a decision –Provide a framework to quantify the values of outcomes and the probabilities of achieving them –Help us to make the best decisions on the basis of existing information and best guesses. As with all Decision Making methods, decision tree analysis should be used in conjunction with common sense - decision trees are just one important part of your Decision Making tool kit. http://www.mindtools.com/dectree.html

139 Confidential - for classroom use only Appendix: Sources of Financing for MedTech

140 Confidential - for classroom use only Series Funding for Medtech Seed Funding – Defining early-stage prototypes and proof of concept can require extensive mentoring, depending on the experience of the team. Typically, this round is funded by friends and families and/or angels due to low capital requirements (i.e., $50,000 to $1,000,000). Government grants are another option. Many entrepreneurs also turn to bootstrapping (financing a small firm without raising equity from traditional sources or borrowing money from a bank; e.g., using internally generated retained earnings, credit cards, second mortgages, and customer advances). Start-Up Funding – In this stage, start-ups often look for sources of capital that can make investments in future rounds, as well as add value to completing the management team (e.g., angels, VCs). Common milestones during this stage are related to product development, animal testing, potential registration with the FDA, and the initiation of early-stage (small) clinical trials. This type of funding often requires capital in the millions to tens of millions of dollars. Expansion Funding – When the innovation is in early-stage clinical trials, expansion funding is needed to ensure the completion of clinical trials, the initiation of additional trials, and an initial product launch in limited markets. Such funding can often be acquired through VCs and/or corporate investors. Mezzanine Funding – Mezzanine funding is used when the company has either secured regulatory approval for its product or has already launched it in the market. This form of funding may be required to build distribution channels, fund sales efforts and marketing ‘Campaigns, and expand/develop product lines. Entrepreneurs may sometimes look for more debt-like forms of funding rather than equity financing at this stage in the company’s development. However, the risk profile of the company is the main factor that determines the availability of these alternative forms of financing. In some cases, VC funding and corporate investment may continue to be the best source of funding for e company. Stanford casebook

141 Confidential - for classroom use only Sources of Funding for Medtech Friends and Family – Members of an entrepreneur’s personal network with adequate means to make an investment in the company. Generally, this is one of the least expensive forms of financing since friends and family are usually more flexible than professional investors in terms of their timeline and expected level of return. However, entrepreneurs sometimes worry that goodwill investors may not truly understand the level of risk involved in a new enterprise, and fear negatively affecting these personal relationships. Angels – Experienced investors using their own wealth. Typically, angel funding is less expensive than other funding alternatives, with investors sometimes willing to take on more risk. However, angels with a good understanding of the company’s specific medical field can be difficult to find. Since money may need to be raised from several angels to meet the capital needs of the company, managing the expectations of numerous may also be daunting. Venture Capitalists (VCs) – Professional investment managers who specialize in investing in companies with the potential for high returns. VCs typically raise money from institutional investors (e.g., pension-fund managers, charitable foundations, wealthy individuals) or private and public equities. The money raised is put into a fund. Funds vary in size, but can range from $100 million to $2 billion and beyond. Each fund has a specific investment profile (e.g. medical devices, biotech, information technology) and an investment horizon from three to seven years. The capital in the fund is invested in startups that fit the fund’s profile with the expectation of reaching a liquidity event (i.e., the company will be acquired or will go public) within the fund’s defined investment horizon. VCs are known for having “deep pockets” when it comes to qualified investments. They usually collaborate with the companies they invest in such that the companies benefit from substantial start-up and industry experience. VCs also have the ability to provide multiple rounds of funding and have extensive networks of contacts (including other potential investors) that can be leveraged to assist the company. However, VC funding is expensive since entrepreneurs must be willing to give away significant equity to attract investment, and the due-diligence associated with the funding process can be time and labor intensive. VCs also have a clear objective for their involvement in a company—a strong financial return on investment—which may be based upon an exit strategy that may or may not be aligned with the company’s long-term objectives. Stanford casebook

142 Confidential - for classroom use only Sources of Funding for Medtech (contd.) Corporate Investment – Investment of corporate funds directly in external start-up Companies either through support investments (the purchase of equity in support of a research and development (R&D) or a licensing agreement) or traditional venture investments. Corporate investments are often made by large companies (e.g., Johnson «& Johnson) for strategic as well as financial reasons, since corporations seek to exploit synergies between projects in their internal portfolios and innovation occurring in the synergies between projects in their internal portfolios and innovation occurring in the external environment. This type of funding can be less expensive to an entrepreneur and can bring with it unique forms of leverage (e.g., access to established distribution channels and new technology). The association with a major corporation can also lend credibility to a young company. However, an entrepreneur involved in this type of relationship may receive limited value in return for building the business. Conflicting agendas may arise as the corporate investor looks out for the corporation’s best interests. There also may be issues surrounding the ownership of new intellectual property (IT) that is generated, which may be beneficial to both the start-up and the corporation. Corporate investments also may be susceptible to changes in the economy and provide entrepreneurs with limited opportunities for follow-on funding. Exiting from a corporate investment also may become complicated if there is more than one bidder but the corporate investor has been granted first rights to an acquisition. On the other hand, in many cases a strong, mutually beneficial relationship with a corporate investor provides an entrepreneur with a smooth and valuable exit strategy. Customers – Direct investment in the development of new products or services by customers. Sometimes physicians invest in devices in their field of expertise. For I instance, a cardiologist may invest in the development of a cardiac device that meets a specific clinical need that s/he has helped to identify. Other times, a manufacturing company may strategically invest in a technology company that supplies a key future component. Customer funding transforms the traditional customer value chain from design=>manufacture=>sell to sell=>design=>manufacture. This funding approach is usually one of the least expensive options. Up-front investment by customers can also dramatically increase an innovation’s credibility. However, customer funding can sometimes lead to conflicts when the company seeks to sell the innovation to other companies or promote the innovation in ways that may not be what the customer, who invested in the innovation’s development, had in mind. Stanford casebook

143 Confidential - for classroom use only Sources of Funding for Medtech (contd.) Government Grants – The U.S. Department of Defense (DoD) funds a billion dollars each year in early-stage R&D projects at small technology companies. These projects must serve a DoD need and have commercial applications. Through its Small Business Innovation Research (SBIR) program, small technology companies (or individual entrepreneurs who form a company) can receive up to $850,000 in early-stage R&D funding. The Small Business Technology Transfer (STTR) program provides up to $850,000 in early-stage R&D funding directly to small companies working cooperatively with researchers at universities and other research institutions. Recipients of these grants retain the IP rights to the technologies they develop. Funding is awarded competitively, but the process is relatively user-friendly. The primary advantage of government funding is that the financial interests of the company’s founders do not get diluted. Being the recipient of such a grant can also be a source of credibility for a start-up. On the other hand, the DoD expects grant recipients to perform diligent research (comparable to what would be required by the most demanding academic institution). In addition, competition for funds can be fierce, and the review cycles for awarding funds can be lengthy. With a cap at $850,000 per project, the amount of funding granted through the programs also may not be sufficient to meet a company’s needs. Other sources for SBIR and STTR funds include the National Science Foundation and National Institutes of Health. Banks – Commercial or state institutions that provide financial services, including loans, to individuals and businesses. Debt is the most typical form of financing that banks provide to companies. One of the key differences between funding a high-risk start-up versus a more stable, established company is that, with the start- up, the capital is more expensive (i.e., the founders give up more equity for the same amount of funding) due to the increased risk and uncertainty. As a result. This capital often comes with “faces” attached to it (individuals with specific expectations and requirements about how the company should conduct business). This is generally true, regardless of whether the young company is funded by angels, VCs, corporate money, or customers, but not if it is funded by government grants. Whereas a bank would traditionally give a loan to an established business contingent on the use of its business assets as collateral, investors in a medical device start-up are handing over millions of dollars in return for a stock certificate and the entrepreneur’s promise to build a successful company. For taking on the increased risk, investors in start-ups typically anticipate higher returns, seek to exercise more control, and expect to own more of the company. Not only can the capital carry with it an expected return five times greater than a bank loan, but it may be granted on the condition that the representatives of large investors become board members of the company and have input and voting control over the company’s future. For this reason, it is critical to select investors that can add value to the company and ensure that their goals are aligned with those of the company’s management team. Stanford casebook

144 Confidential - for classroom use only Funding at Different Stages of the Company’s Evolution Stanford casebook

Confidential – For Classroom Use Only 145 Appendix: Valuation for Medtech

Confidential – For Classroom Use Only Introduction to Valuation for Medtech As milestones are achieved, the company has the potential to reduce its cost of capital. Initially, at the earliest stage of investment, the company’s worth is low and the cost of raising money is high, because the business has no proven track record and thus poses significant risk for the investors. Yet, as the company begins to meet its milestones, it is able to raise increasingly large amounts of money at more competitive rates as the risks to investors decline. Three of the most important hurdles for a company to overcome in demonstrating increased value include: 1.Technical Feasibility – Relies heavily on engineering, science, and clinical interactions and is accomplished when the company has proven data regarding in vitro (seed funding), animal use (some seed funding and start-up funding), and human use (start-up funding and expansion funding). 2.Product Feasibility – Depends primarily on R&D and clinical and regulatory expertise. Product feasibility demonstrates commercial viability and is proven through the completion of pivotal trials, regulatory approvals, support from key opinion leaders, and first commercial sales (some start-up funding and expansion funding). 3.Company Feasibility – Relies on continued R&D, sales and marketing, and manufacturing to demonstrate sustainable profitability. Company feasibility can be shown through revenue and profit growth, a full product/technology pipeline with multiple generations of devices being developed, strong brand identification in the market, and defect-free quality (expansion funding, mezzanine funding, and IPO). Each of these milestones is achieved, the company essentially increases its value. To get from milestone to the next, the entrepreneur must evaluate how much capital is required. Much of this information will be laid out in the company’s operating plan. Plans should be revisited and reviewed with a funding perspective in mind to ensure that the link between capital needs and funding rounds makes sense given the current investment environment. Specifically, there are times when capital resources are ubiquitous, and other times when funding is virtually unavailable due to macro-economic trends outside the control of a start-up. When deciding on funding milestones, entrepreneurs should select milestones that the market views as significant barriers to the success of a company. This will yield the greatest increase in company value and, thus, the lowest dilution for entrepreneurs and previous round investors when each subsequent round of funding is sought. Stanford casebook 146

Confidential – For Classroom Use Only Pre-Money and Post-Money Valuation A company’s valuation, or the worth assigned to the business, is directly affected by the funding that the company receives, as is the company’s ownership. Other factors affecting a valuation include: –The current and expected future valuations of comparable companies in the public and, when available, private marketplace. –The supply and demand for capital at the time of financing. –Intangibles unique to a specific company, including the quality of the management team, a company’s competitive advantage, and its likely pace of revenue growth and profitability. –The nature and timing of an expected exit for the investor. –The implications of future capital raises, as well as needs to expand a company’s option pool on the company’s capital structure going forward. Investors often refer to pre-money and post-money valuations. Pre-money refers to a company’s value before it receives outside financing (or the latest round of financing), while post-money refers to its value after it gets outside funds. The post-money valuation is always equal to the pre-money valuation plus the capital raised. Stanford casebook 147

Confidential – For Classroom Use Only Dilution Pre-money and post-money valuation demonstrate the effect of dilution—as more investors provide money in exchange for shares in the company, the increased number of shares outstanding reduces the value of the holdings of existing shareholders. This is illustrated below: Many investors worry about the effect of dilution as each subsequent round of funding is raised, and seek anti-dilution clauses in their contracts to prevent their equity investments from losing value. Warrants can also be issued to all existing shareholders, giving them the option to invest more money in the company or else face the dilution of their ownership percentage. To calculate the percentage of the company owned by investors in the first round of funding, simply divide the amount of funding raised by the post-money valuation. For example, after the completion of the first round of funding, the investors provided $325,000 to acquire shares in Conor Medsystems. With a post-money valuation of $3,000,000 this means that the investors $325,000/$3,000,000 = approximately 11 percent of the company. The remaining percentage (89 percent) stays with the founders/management. In each round, the same initial calculation is performed (e.g., $1,500,000/$ 10,000,000 = 15 percent in the second round) to determine the percentage of the company sold to the new investors. However, an additional calculation is needed to compute the effect of each subsequent round of funding on the ownership percentages from previous rounds. For example, in the second round, the ownership )f the original investors and founders is reduced by 15 percent (the ownership share of the new investors.) The new investors’ share comes from the fraction owned by the original investors and founders. For instance, if the founders originally owned 89 percent of the company, after the new round of funding they will own 89 percent of the fraction of the company retained by the original investors and founder (which is 85 percent). So the founders’ diluted share of the company is 89 percent multiplied by 85 percent, which leads to the diluted share of 75.65 percent. Similar calculations apply for investors in series A (their new ownership is 11 percent of 85 percent which is 9.54 percent). When the company eventually reaches the liquidity event such as the time when the firm goes public, the terminal value for each investor is simply the value of their shares at the time of IPO (calculated as the number of shares multiplied by the price per share). Then, the ROI for each shareholder is the ratio of the terminal value over the initial investor (e.g., for A round investors it is $9,301/$325 = 28.6—the original investment made by A round investors grew 28.6 times). The compound annual growth rate (CAGR) is the annual growth that the initial investment of each investor experienced (e.g., for the funds provided by round A investors to grow 28.6 times from 2/1/2000 to 12/14/2004, this means that the compounded annual growth rate was 110 percent [Initial Investment (1+ CAGR)^(Time between Original Investment and Exit) = Terminal Value; expressed differently CAGR = I/Time between Original Investment and Exit In(Terminal Value/ Initial Investment)]). Stanford casebook 148

Confidential – For Classroom Use Only Dilution Example Stanford casebook 149

Confidential – For Classroom Use Only Strategic Considerations As outlined previously, the amount of funding a company needs to raise can be determined based on how much is required to complete critical milestones between rounds of fundraising. The achievement of each major milestone should be linked to the retirement of a major risk, such that it becomes easier to attract funding in each subsequent round. For example, as a company prepares to move from bench tests into animals, it should calculate how much money is needed to complete successful animal trials before it has to fundraise again. The capital and time required to reach each funding milestone should come from two sources. First, they come from the operating plan (and should be validated relative to a proxy company or companies). Second, incremental capital may be needed due to deviations from the plan. Each und must include a “cushion” to address these deviations, since running out of cash between valuation points can be incredibly costly and potentially jeopardize the business. However, keep in mind that raising too much capital needlessly dilutes the ownership of the entrepreneur and the previous investors. Determining the value of the company at each round of funding is both an art and a science. Importantly, these calculations must be market- based (who else is willing to get in?). A company can get started by doing simple modeling to develop “back of the envelope” valuations based on expected returns and potential exit valuations. Two common methods of valuing the start-up at each round are (1) discounting terminal value and (2) a comparables analysis. The premise behind discounting the terminal value is that investor require a certain return on their invested capital. While not a definitive valuation method, this approach represents a good exercise to understand the drivers of valuation. During earlier rounds of funding when the venture is more risky, investors expect higher returns than in later-stage rounds when risk has decreased. The critical components in determining the company value at each round are listed below: 1.Terminal Value – With the current exit strategy, what amount can investors expect the company to be worth? As an example, a start- up may determine that it could be acquired by a large medical device company for $400 million. The terminal value is often based on what comparable companies received at their exit event but can also be based on the future cash flows that the product may generate after the exit event. 2.Duration – The time frame between the specified round and the exit event. 3.Discount Rate – The discount rate is the expected return that investors expect to be compensated for putting their capital at risk. As a rule of thumb, the discount rates may get smaller with each subsequent round of funding. C 4.Calculation – For each round of funding, discount the terminal value back by the expected duration between that round and the exit using the discount rate. The general form of this equation is: Post-Money Valuation = Terminal Value/(1+Discount Rate)^(Duration). For example, a rough “back of the envelope” calculation for Conor’s valuation on 2/1/2000 could be as follows: Assume a terminal valuation of 100 million, a discount rate of 70 percent, and a duration of 5 years (time to IPO). 100/(1+0.70)^5 = $7 million. The actual realized valuation at that point was $3 million, which implies that the investors assumed either a longer duration, a lower exit, or required a discount rate in excess of 70 percent. Stanford casebook 150

Confidential – For Classroom Use Only Strategic Considerations (contd.) In addition to using the terminal value, a comparables analysis will help a company target a realistic valuation. This analysis starts by selecting a comparable company based on at least the following criteria: stage of funding, field and application, and founders experience. Post-money valuations for the entrepreneur’s company should be based on pre-money valuations of comparable companies, plus the estimated operating expenses to achieve the next major funding milestone from the company’s financial model. The best way to secure a favorable valuation is to have multiple interested investors with multiple deal sheets. While these analyses can help a company target a reasonable valuation, many other factors can influence the final numbers. The experience of the team, competitive threats, investor interest in the specific space, and macroeconomic market conditions can all play roles in determining the final valuation, Entrepreneurs should keep in mind that the company’s valuation will determine their ownership percentage. As the company progresses and more capital is raised, owners should expect their ownership percentage to shrink. However, in parallel, the valuation of the company is expected to increase, which can lead to a higher total value for the owners. In some cases, it is not uncommon for the valuation of a company to decrease between rounds of funding. While this may be disappointing, it usually reflects a temporary setback that may be reversed in the future. Yet, start- ups are risky investment, with some of them never generating a return on the capital and time invested. Investors are aware of these risks and seek to mitigate them by requiring high ownership stakes in the companies they fund (such that the returns on successful ventures help counterbalance investments in failed start-ups). Entrepreneurs can help retain ownership in the company by carefully and proactively evaluating and managing key risks. Stanford casebook 151

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