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

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

3. Chain of Capital Providers

4. Deal Sequence

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

6. 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

7. Index of expected rates

9. 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 ”

10. 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.

11. 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

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

13. 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

14. 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

15. 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

16. 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

17. 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?

18. 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

19. 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.

20. 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

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

22. 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
= (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

23. Fundamental Method

24. First Chicago Method

25. 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

26. Staged Investment

27. Investor Expectations for Multiple Round Financing

28. Cram Down or Down Round

29. 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

30. 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

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