The Deal: Valuation, Structure & Negotiation Timmons - Chapter 14 Lecture 8 The Deal: Valuation, Structure & Negotiation Timmons - Chapter 14

Entrepreneurial capital markets More volatile More imperfect Less accessible Affected by psychological factors

Chain of Capital Providers

Deal Sequence

Ingredients for valuation Cash How much To whom it flows Time When it flows Risk The likelihood that it will flow

Some tips for valuation Art and science Multiple methods Ranges and boundaries rather than specific values Sensitivity analysis based on assumptions Shop the deal wisely Know the other side of the table

Index of expected rates

Core Principle “ The core principle for an entrepreneur … is to build the best company possible. This is the single surest way of generating long-term value for all the stakeholders and society. -Timmons ”

Determining Value A Key Consideration: At least a dozen ways Investor’s Required Rate of Return (ROR) (IRR) An indicator of the efficiency or quality of an investment, as opposed to Net Present Value (NPV), which indicates value or magnitude given the current interest rate (or cost of capital) A project is a good investment proposition to an investor if its IRR is greater than the rate of return that could be earned by alternate investments of equal risk (investing in other projects, buying bonds, even putting the money in a bank account). Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk premium.

Inherent conflicts between users and suppliers of capital Capital User Wants: Capital Provider Wants: As much time as possible for financing As much $$$ as possible Independence Control of Board-of-Directors for freedom Any Success Flexibility to change, adapt or decommit Operate To supply capital just in time To invest just enough $$$ Accountability Control of Board-of-Directors for control Big Success Clear, steady adherence to plans Cash out

Valuation, Structure & Negotiation Staged Capital Commitments Delivers funding in stages, rather than in lump sum Allows investors to evaluate company as time passes

Conservation of capital To “encourage” managers to conserve, VCs apply strong sanctions if capital is misused, by: Diluting management’s equity share at punitive rate Shutting down operations completely

Structuring the deal Deals involve allocation of cash flow streams allocation of risk allocation of value between different groups Suppliers versus users of capital Owners versus managers

Characteristics of Successful Deals Simplicity They are robust (resistant to unexpected shocks They are organic (evolve to meet circumstances) They take into account incentives of all involved in a variety of circumstances They provide mechanisms for communications and interpretation They are based primarily on trust rather than legal language They do not make it too hard to raise more capital

Characteristics of Successful Deals (cont.) They match the needs of the user of capital with the needs of the supplier They reveal information about each party They allow for the arrival of new information before the deal is signed They are considerate of the fact that it takes time to raise money They improve the chances of venture success They are not patently unfair

Questions to identify agendas What is the bet ? Who is it for ? Who is taking the risk ? Who receives the rewards ? Who should be making the bets ? What happens if the venture exceeds investor expectations ? What happens if the venture falls short of investor expectations ? What are the incentives for the money managers ? What are the consequences of the failure to perform by the money managers ? How will the money managers behave ? What will be the investment strategy of the money managers?

Critical Guides: Raise money when you don’t need it Learn about the process and how to manage it Know your relative bargaining position If all you get is money, you’re not getting much Assume the deal will never close Always have a backup source of capital The experts can blow it – sweat the details yourself

Critical Guides: Assume the deal won’t close Always have a backup source of capital Legal, financial and consulting sources can make mistakes, too; check their work Users of capital are at a disadvantage when dealing with suppliers of capital If you are out of cash when looking for capital, suppliers of capital will eat your lunch Startup entrepreneurs are raising capital for the first time; suppliers do it for a living.

Potential Pitfalls Strategic circumference Legal circumference Attraction to Status and Size Unknown territory Opportunity Cost Underestimation of other costs Greed Being too anxious Impatience Take-the-money-and-run myopia

Methods of Valuation Venture Capital Method Fundamental Method First Chicago Method Discounted Cash Flow

Venture Capital Method Estimate Net Income for a number of years Determine appropriate Price-to-Earnings (P/E) ratio Use comparables or industry data Calculate terminal value (= Estimated Income x P/E) Discount terminal value to present value (r=.35 to .80) Determine investor’s required percentage of ownership Final ownership = Required future value (investment) Total Terminal Value = 1+(IRR) years x (investment) P/E Ratio (Total Terminal Income) Calculate number of shares New Shares = % ownership required by investor . 1- % ownership required by investor x old shares

Fundamental Method

First Chicago Method

Discounted Cash Flow Method Three time periods are defined (1) Years 1-5, (2) Years 6-10, (3) Year 11 to infinity Operating assumptions include initial sales growth rates EBIAT/sales (net fixed assets + operating working capital)/sales; Also note relationships and trade-offs

Staged Investment

Investor Expectations for Multiple Round Financing

Cram Down or Down Round

Beyond “Just the Money” Critical issues in the deal Number, type, and mix of stocks and various features that may go with them that affect the investor’s rate of return The amounts and timing of takedowns, conversions, and the like Interest rate in debt or preferred shares The number of seats, and who actually will represent investors, on the board of directors Possible changes in the management team and in the composition of the board of directors

Beyond “Just the Money” Critical issues in the deal (cont.) Registration rights for investor’s stock Right of first refusal granted to the investor on subsequent private or initial public stock offerings Stock vesting schedule and agreements The payment of legal, accounting, consulting, or other fees connected with putting the deal together

More Burdensome Issues Co-sale provisions Ratchet anti-dilution protection Washout financing Forced buyout Demand registration rights Piggyback registration rights Key-person insurance