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Thursday, January 17, 2008

Valuations

Value versus Price
There is an important distinction between value and price. The sale of shares to an Angel or venture capital investor seldom reflects “value” and normally reflects “price.”
Fair Market Value (FMV):
“the highest price available in an open and unrestricted market between informed and prudent parties, acting at arm's length, and under no compulsion to act, expressed in terms of money or money's worth.”
Price:
“the consideration paid in a negotiated open market transaction involving the purchase and sale of an asset.”
More casually, “value” is what something is worth and “price” is what you get for it. Here are some of the reasons why the two results may be materially different:
Fair Market Value is calculated in a “notional” market, while Price reflects the real world;
Fair Market Value assumes equal negotiating ability between the parties, while Price is affected by different negotiating strengths;
Fair Market Value assumes both parties have equal knowledge, while Price reflects differences in information or assumptions;
Fair Market Value assumes there are no “special purchasers”, while Price may reflect the influence of a purchaser that has a unique incentive;
Fair Market Value assumes neither party is under compulsion to transact while, in reality, vendors are usually under some financial pressure to sell, and one or both parties are acting on emotion; and,
Fair Market Value assumes there are many buyers in the “notional market”, whereas in reality there are often only a few that often confer.
Notwithstanding this important distinction between “value” and “price,” most discussions on the topic inherently use the term “value” to refer to “price.” This whitepaper will follow that same practice. Just remember though, all discussions on value really refer to price – i.e. what you can get for your company, not what it is worth.
With the higher risks inherent with earlier stage companies, the valuation methodologies are much more subjective than the methodologies used for Later Stage companies.

Trends in Pre-Money Valuation
Overall ObservationsVentureOne Corporation has been tracking the US VC industry since the 1980s. Figure 1 presents their findings respecting quarterly changes to pre-money valuations across the major venture capital investment classes (i.e. investee company maturity stages) during the period between Q1 1998 and Q3 2001. The NASDAQ performance is overlaid across the VentureOne research for comparative purposes. A few observations can be made:
The further distanced company maturity is from IPO status, the less dependency there seems to be on changes to NASDAQ values. Seed Stage pre-money values seem to be influenced by NASDAQ activity very little. Valuation methods for early stage companies are different from traditional methods used for public companies.
As compared to Series B and Later Stage pre-money valuation trends, the pre-money valuations for Seed Stage and Series A Stage are relatively flat. Valuation methods for these very early stage companies result in a narrow band of valuation possibilities.


The choice of valuation methodology should reflect the maturity stage of the company. Classical private company valuation methodologies are well suited to more mature companies that have sales, profits, and material assets. Seed Stage companies have none of that. Instead, they offer potential, balanced by considerable risk. Valuation assessments at this stage ought to reflect these challenges

Seed Stage Pre-Money Valuations
A longer period of pre-money valuations is shown in Figure 2. The data indicates that Seed Stage pre-money valuations have fluctuated within a narrow band of between, US$2 million and US$5 million across more than ten years. This seeming stability contrasts some meaningful external market forces, such as a major recession, the “dot com” cycle, the “telecom meltdown”, and a few major market “corrections.”
This data indicates that Seed Stage pre-money valuations are normally between US$2 million and US$5 million. That same research also includes data on typical issue sizes, indicating that Seed Stage investors typically own 20% to 30% of the company's post-money fully diluted equity. The issue sizes are normally between US$500,000 and US$2 million.
Given the relatively few possible outcomes, Seed Stage investors typically use very simple valuation methodologies. Some of the reasons for a more simple approach include:
The final pre-money valuations will be within a narrow band and will be more affected by negotiating strengths than “mathematical” determinations
Many Seed Stage investors recognize that much of the company's business plan and product concept will likely change over the next few years
With so much “uncertainty” and perceived risk, Seed Stage investors typically rely on more “intuitive” or subjective valuation models and support their subjective views with reality checks (i.e. due diligence) in a few key areas
Seed Stage investors also recognize that, without a lot of substance in the companies upon which to do meaningful due diligence, they should be able to reach an intuitive assessment relatively quickly.
Many Seed Stage investors recognize the “subjective” nature of their Seed Stage investment decisions and expect a high “mortality rate.” To offset this exposure, most Seed Stage investors are prepared to invest in one or two more financing rounds for the more promising investees.
Here are a few “data points” supporting the above summary observations:
MIT Entrepreneurship Center
Research Findings February 2000: Seed stage technology ventures were typically US$500,000 to US$3 million. Pre-money valuations greater than US$5 million required an extraordinarily compelling story.
The Tech Coast Angels:
Website: “we look for pre-money valuations below US$5 million”
Presentation March 2002: "sweet spot" for investing is a pre-money valuation of US$1.5 million to US$3 million.
Sand Hill Angels:
Website: invest US$250,000 to US$2 million at a valuation of less than US$5 million.
New Jersey Entrepreneurial Network Angels:
Presentation: Valuation of US$1 million to US$5 million, for 20% to 30%
Winning Angels, Amos/Stevenson (Noted Book):
Most Angel investors want pre-money valuations between US$2 million and US$5 million, with US$2.5 million as the “sweet spot”
Rule of “Development Milestone”
The more diligent investors will attempt to provide more “quantification” to their assessment of pre-money value. As one such attempt, some Seed Stage investors estimate the amount of cash required to achieve a major development milestone and, often without regard to how much that is, equate that amount to 50% to 60% of the company (post-money, full dilution).
Rule of “Thirds”
The Rule of “Thirds” simply implies that 1/3 of a new company's equity should go to the Founders, 1/3 to management (i.e. an Option Pool), and 1/3 to the Seed Stage investors. This methodology is used most often as a “sanity check” to other valuation methodologies.

Valuations Basics

An important component of the venture capital investment process is the valuation of the business enterprise seeking financing. Valuation is an important input to the negotiation process relative to the percentage of ownership that will be given to the venture capital investor in return for the funds invested.
There are a number of commonly used valuation methods, each with their strengths and weaknesses. The most commonly used valuation methods are:
Comparables
The Net Present Value Method
The Venture Capital Method
Comparables
Similar to real estate valuations, the value of a company can be estimated through comparisons with similar companies. There are many factors to consider in selecting comparable companies such as size, growth rate, risk profile, capital structure, etc.
Hence great caution must be exercised when using this method to avoid an “apples and oranges” comparison. Another important consideration is that it may be difficult to get data for comparable companies unless the comparable is a public company. Another caveat when comparing a public company with a private company is that, all other things being equal, the public company is likely to enjoy a higher valuation because of its greater liquidity due to being publicly traded.
Net Present Value Method
The Net Present Value Method involves calculating the net present value of the projected cash flows expected to be generated by a business over a specified time horizon or study period and the estimation of the net present value of a terminal value of the company at the end of the study period. The net present value of the projected cash flows is calculated using the Weighted Average Cost of Capital (WACC) of the firm at its optimal capital structure.
Step 1: Calculate Net Present Value of Annual Cash Flows
Cash Flow for each future period in the time horizon or study period of the analysis is defined as follows:
CFn = EBITn*(1-t) + DEPRn – CAPEXn – .CNWCn
Where:
CF = cash flow or “free cash flow”n = the specified future time period in the study periodEBITn = earnings before interest and taxest = the corporate tax rateDEPRn = depreciation expenses for the periodCAPEXn = capital expenditures for the period.NWCn = increase in net working capital for the period
It should be noted that interest expense is factored out of the cash flow formula by using EBIT (earnings before interest and taxes). This is because the discount rate that is used to find the net present value of the cash flows is the WACC. The WACC uses the after tax cost of debt, which takes into account the tax shields that result from the tax deductibility of interest. By using EBIT in the cash flow calculation, double counting of the tax shields is avoided.
Step 2: Calculate the Net Present Value of the Terminal Value
The terminal value is normally calculated by what is often referred to as “the perpetuity method.” This method assumes a growth rate “g” of a perpetual series of cash flows beyond the end of the study period. The formula for calculating the terminal value of the company at the end of the study period is:
TVt = [CFt*(1 + g)]/(r – g)
Where:
TVt = the terminal value at time period t, i.e. the end of the study periodCFt = the projected cash flow in period tg = the estimated future growth rate of the cash flows beyond t
The Venture Capital Method
Most venture capital investment scenarios involve investment in an early stage company that is showing great promise, but typically does not have a long track record and its earnings prospects are perhaps volatile and highly uncertain. The initial years following the venture capital investment could well involve projected losses.
The venture capital method of valuation recognizes these realities and focuses on the projected value of the company at the planned exit date of the venture capitalist.
The steps involved in a typical valuation analysis involving the venture capital method follow.
Step 1: Estimate the Terminal Value
The terminal value of the company is estimated at a specified future point in time. That future point in time is the planned exit date of the venture capital investor, typically 4-7 years after the investment is made in the company. The terminal value is normally estimated by using a multiple such as a price-earnings ratio applied to the projected net income of the company in the projected exit year.
Step 2: Discount the Terminal Value to Present Value
In the net present value method, the firm's weighted average cost of capital (WACC) is used to calculate the net present value of annual cash flows and the terminal value.
In the venture capital method, the venture capital investor uses the target rate of return to calculate the present value of the projected terminal value. The target rate of return is typically very high (30-70%) in relation to conventional financing alternatives.
Step 3: Calculate the Required Ownership Percentage
The required ownership percentage to meet the target rate of return is the amount to be invested by the venture capitalist divided by the present value of the terminal value of the company. In this example, $5 million is being invested. Dividing by the $17.5 million present value of the terminal value yields a required ownership percentage of 28.5%.
The venture capital investment can be translated into a price per share as follows.
The company currently has 500,000 shares outstanding, which are owned by the current owners. If the venture capitalist will own 28.5% of the shares after the investment (i.e. 71.5% owned by the existing owners), the total number of shares outstanding after the investment will be 500,000/0.715 = 700,000 shares. Therefore the venture capitalist will own 200,000 of the 700,000 shares.
Since the venture capitalist is investing $5.0 million to acquire 200,000 shares the price per share is $5.0/200,000 or $25 per share.
Under these assumptions the pre-investment or pre-money valuation is 500,000 shares x $25 per share or $12.5 million and the post-investment or post-money valuation is 700,000 shares x $25 per share or $17.5 million.
Step 4: Calculate Required Current Ownership % Given Expected Dilution due to Future Share Issues
The calculation in Step 3 assumes that no additional shares will be issued to other parties before the exit of venture capitalist. Many venture companies experience multiple rounds of financing and shares are also often issued to key managers as a means of building an effective, motivated management team. The venture capitalist will often factor future share issues into the investment analysis. Given a projected terminal value at exit and the target rate of return, the venture capitalist must increase the ownership percentage going into the deal in order to compensate for the expected dilution of equity in the future.
The required current ownership percentage given expected dilution is calculated as follows:
Required Current Ownership = Required Final Ownership divided by the Retention Ratio