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VALUATION FOR STARTUP COMPANIES
Anthony Knobloch, CFA November 14, 2016
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EARLY STAGE COMPANIES Why?
Valuation matters to entrepreneurs because it determines the share of the company they have to give away to an investor in exchange for money. At the early stage the value of the company is close to zero, but the valuation has to be a lot higher than that. Why? Let’s say you are looking for a seed investment of around $50,000 in exchange for about 10% of your company. Typical deal. Your pre-money valuation will be $500,000. This however, does not mean that your company is worth $500k now. You probably could not sell it for that amount. Valuation at the early stages is a lot about the growth opportunity rather than a forecast of near term cash flow. When the company is just an idea or a process – but there may or may not be any tangible assets or intellectual property Recommend this article linked at the top of the slide – it gives a good, plain language overview of the framework of the dynamics at play for various stages in a companies lifecycle.
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VALUE AT THE EARLY STAGES OF A COMPANY
How much money do you need (and for what time period) to get to significant growth and raise the next round of investment. Let’s say that number is $100,000, to last you 18 months. So let’s say the amount of the investment is set. How much of the company to give to the investor. So you will probably give away 5-20% of the company, depending on your valuation. As you see, $100,000 is set and 5%-20% equity is also set. That puts the (pre- money) valuation somewhere between $500,000 (if you give away 20% of the company for $100,000) and $2 Million (if you give away 5% of the company for $100,000). Where will your company land in the range? Depends on how other investors value similar companies. How well you can convince the investor that you will grow fast. 2 – grow fast and have a large potential market.
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VALUATION APPROACHES Cost (Asset) Approach Every dollar you spend may or may not create an equal dollar of value Market Approach Are there comparable companies? Income Approach Are there current revenues or projections? General idea about how folks in my profession think about value. – Three approaches
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WHAT IS OF VALUE? Future Revenue Historical v Patents Trademarks
Process Equipment
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WHAT IS OF VALUE? (simplified)
Cash Flow Either current or
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COST (ASSET) APPROACH Cost to obtain or reproduce the asset
Historical or Future Costs Substitution Absolute Reproduction Cost to obtain or reproduce the asset Purchase the asset today Replacing the asset with a substitute of equal quality Create a reproduction of the asset Direct costs: materials, designs, marketing, legal fees, personnel, engineering Indirect costs: development time, overhead
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TECHNOLOGY, TRADEMARKS AND OTHER IP
No linear relationship between cost of creating IP and its value Risk of wasted investment is high, but there is upside potential with commercialization IP is commonly licensed - market-based royalty rates
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MARKET APPROACH Active Market Comparable Transactions
Most Direct Method – if there are comps available Often necessary to work with less than optimal comparable transactions Limited data for business owners Fairly costly databases Look at the context for the transaction (bankruptcy, divorce, litigation) Royalty rates
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PRIVATE COMPANY TRANSACTIONS - BIOTECH
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PUBLIC COMPANY TRANSACTIONS - BIOTECH
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PRIVATE COMPANY TRANSACTIONS – INTERNET/SOFTWARE
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PUBLIC COMPANY TRANSACTIONS – INTERNET/SOFTWARE
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INCOME APPROACH How reliable are the current projections?
Future Benefits How reliable are the current projections? Expert Judgment What can substantiate growth and customer acquisition rates? Outside Factors What other economic and industry factors are present?
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DISCOUNT RATE STUDIES (1) Plummer, James L., QED Report on Venture Capital Financial Analysis, Palo Alto: QED Research, Inc., 1987. (2) Sherlis, Daniel R. and Sahlam, William A., “A Method for Valuing High-Risk, Long Term, Investments: the Venture Capital Method,” Harvard Business School Teaching Note , Boston: Harvard Business School Publishing, 1989. (3) William A. Sahlman, Howard H. Stevenson, Amar V. Bhide, et al., “Financing Entrepreneurial Ventures,” Business Fundamental Series (Boston: Harvard Business School Publishing, 1998). (4) Babson College, William D. Bygrave, June 1997, "Classic Venture Capital in the Next Millennium". The data and supporting studies/reports above are somewhat dated but I still think hold water– another more recent source would we the Private Capital Markets Project at Pepperdine University. More current data may indicate lower rates due to the accommodative monetary environment we’ve been experiencing since 2008.
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DISCOUNT RATE STUDIES – cont.
Source: 2016 Pepperdine Capital Markets Project
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VALUE DRIVERS Founding Team Near-Term Revenues Growth Market Size Competition Business Plan What is the reputation and/or background of the founding members? How quickly can revenue start? What is the expected growth? How large is the potential market? Are there any current competitors? How are the competitors performing? Is there a solid business plan? What are you willing to give up in equity? Who are your available investors?
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ALTERNATIVE METHODS Venture Capital Method First Chicago Method
Berkus Method
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Venture Capital Method
Bill Sahlman, Harvard Predict Exit Result Backsolve For Entry Forecast future results Apply an exit multiple Estimate likely dilution to that point Determine share Convert future value to present using a required ROI or hurdle rate.
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First Chicago Method Best, Worst, and Survival
Three projection scenarios Assign Probabilities to each Expected Value Best, Worst, and Survival ie. 20% failure, 15% success, 65% survival. Major benefit of the approach is that you can perform some sensitivity analysis, which helps to articulate risk. Downside is that you have three projections which all require their own assumptions in addition to an estimate of probability for each
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Berkus Method Cool idea/concept/tech – 500k
Dave Berkus – investor, speaker, author Pre-Revenue companies Key Value Metrics Cool idea/concept/tech – 500k Experienced management – 500k Prototype/build – 250k Strategic relationships – 250k Board of Directors – 250k Paying customers/traction – 500k – 1m
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OTHER CONSIDERATIONS Capital Structure Complexity Equity Compensation
How do you allocate the total value to various preferred/convertible different classes of equity? Ensuring compliance with 409A when issuing equity as compensation. Ensuring GAAP compliance with the recognition of compensation expense with regard to equity and equity options grants.
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QUESTIONS?
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THANK YOU! Anthony L. Knobloch, CFA Tony@bridgevaluation.com
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