Building and Valuing the Business Model Chapter 8

Steps in Developing a Business Model Identify the value chain Who pays you? And how much? Are you dealing with radical innovation? Can you create multiple revenue streams?

Business Models with Radical Innovation How do you prevent cannibalization of current products? How do you overcome customer resistance when switching costs are high? How do you avoid the inertia of a current business model?

Sources of Opportunity for New Business Models

Sudden Presence Business Model

Centurian School

Create Multiple Revenue Streams Expose the technology to people in different industries Understand and protect the value of the core technology so it can be licensed for a variety of applications. Go beyond the original invention team to find new applications. License applications outside the company’s core competency to gain critical mass and become a standard

Most Effective Model Based on your understanding of the value chain and how it works. Based on your positioning in the chain Based on your ability to experiment, learn and evaluate. Based on your ability to defend what you’re doing.

Drivers of Value Size of the market and its readiness to adopt Competitive advantage of the firm and its ability to sustain that advantage Skills, experience, and track record of management team Upside potential of the venture Downside potential of the venture An appropriate exit time for the investors Current state of the economy and the industry

Financial Models for Assessing Value

Increasing Risk from Things Company Can’t Own Labor Technologies Business models

Greatest Challenge: Understanding the difference between balance sheet and market valuation, which is intellectual capital

The Highest Valuations Require Options. Options are greatest when growth is possible, when there’s high volatility and high risk

Valuation with Real Options

Total Value Economic Value Strategic Value Diminishing Returns Innovation Risk

Calculating Total Value Value of the underlying security Strike or exercise price The time period of the option The volatility The risk-free rate Step 1: Calculate the Economic Value Step 2: Frame the Options Step 3: Determine the Option Premium Step 4: Determine the value Of the business plan Step 5: Calculate the option value Step 6: Calculate total

Valuing Early-Stage Technology

Stages and Values for New Ventures IPO Mezzanine First Round/ Second Round Seed Capital

+ Stage 1: Seed Capital Trojan Haptics $3 M Early Investors 3/7 of stock + Founders = $1 M Value (Cum R&D$ X Step-up ratio) + Financing = Postmoney Valuation ($1M X 4) + $3 M = $7 million

Stage 2: Private Placement, Round 1 Trojan Haptics $4M in R&D Business Plan $7M VC Post Money Valuation = ($4M x 2.5) + $7 M = $17

Stage 3: Private Placement, Second or Mezzanine round Trojan Haptics PreMoney $30 Million 2.8 SU Ratio $11M in R&D $17M VC Post Money Valuation = ($11M x 2.8) + $17 M = $47.8M

Stage 4: Initial Public Offering Trojan Haptics PreMoney $70 Million 2.5 SU Ratio $28M in R&D $40M IPO Post Money Valuation = ($28M x 2.5) + $40 M = $110M

Licensing Value

Valuing Via License Agreement Proven technologies Unproven or partially proven technologies Patent rights only – no technology applications

Proven Technology Question of balancing technology gains with market forces Licensor is the sole inventor For licensee, little risk of non-application since plant design and operating procedures part of licensing package.

Unproven or Partially Proven Licensee Higher risk Lower royalty Licensor (Capital investment + R&D investment) x ROIC – WACC) + License fees (licensee assumes role of inventor of application)

Valuing the Royalty Stream Appropriate discount rate = licensor’s cost of capital Evaluation fees: get rid of tire kickers- refundable Minimum Royalties/ Running Royalties Up-Front Fees Sign of commitment

Discounted Cash Flow Analysis Essential when part of return is in the future. Need combination of analytical tools and critical judgment. DCF says a dollar received tomorrow worth less than one received today. NPV: present value of future stream of cash flows less any investment

PV/NPV PV =  Pn/(1+M)n NPV = -I0 +  Pn/(1+M)n

Discount Rate Corporation’s cost of money absent any risk. Impact of DCF increases as discount rate is higher and time span between present and receipt of rewards increases.

Cost of Money Debt: short & long-term – comparable risk Weighted Average Cost of Capital (WACC) = (% debt) x (after-tax cost of debt) + (% equity) x (cost of equity) Equity: risk-free return + risk premium (beta x market premium) Rule of Thumb: cost of equity is double prime rate.

Terminal Value Liquidation Value: multiple of net income, pretax operating earnings (EBIT) or EBITDA. TV as a perpetuity. Assumes no growth & constant earnings. Value = Annual payment/Cost of money Growth in perpetuity Estimates future growth + degree of profitability. Use only when growth rate is several % less than discount rate.

Build a Revenue Model Estimate target revenues in a medium-term time horizon from time of commercial launch. Look for natural limits of size of market or your market share. Determine the nature of the end game Software – 2 years Computers – 3-4 years Pharmaceuticals – 10 years Assume that growth will decline

Take-Aways Add students’ comments here