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Valuation

Valuation. April 12, 2005. First Principles. Value is a function of cash, time and risk Cash and risk are a function of Rules of the game Choices Incentives Information is costly Players have different information. Techniques. Discounted cash flow Scenario analysis (multi DCF)

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Valuation

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  1. Valuation • April 12, 2005

  2. First Principles • Value is a function of cash, time and risk • Cash and risk are a function of • Rules of the game • Choices • Incentives • Information is costly • Players have different information

  3. Techniques • Discounted cash flow • Scenario analysis (multi DCF) • Multistage analysis (decision tree or real options analysis) • “Venture Capital” method

  4. Discounted Cash Flows • Cash flow forecasts • Terminal values • Discount rate • Tax

  5. Cash Flow Forecasts • Earnings before interest but after tax (EBIAT) • plus: Depreciation (non-cash expenses) • less: increases in working capital • less: capital expenditures

  6. Terminal Value • Higher sensitivity in shorter-term models • Lower sensitivity with high discount rates • Watch terminal growth rate assumptions relative to inflation • Comparables

  7. Discount Rates • No right answer • “Range” of discount rates • Comparables • CAPM • Leverage

  8. Venture Capital Method Steps: • Forecast future results (”success”) • Determine likely value at that point (e.g. P/E ratio for comparable) • Determine likely dilution from: (a) capital and (b) employee stock • Determine share of value “pie” demanded given required rates of return • Convert future values to present to derive share prices, ownership percentages

  9. Step 1: Forecast Results • What’s a reasonable forecast? • Upside case--what can go right? • Over what period of time?

  10. Step 2: Future Value • What’s comparable? • Markets • Growth rates • Business model • Asset intensity • Cash flow characteristics • Metrics • P/E ratio • Price-per-subscriber • Price-to-cash-flow • Cap rate

  11. Step 3: Dilution • How much capital? When? • New shares for employees? When? • Other potential issuances of stock (e.g. acquisition)

  12. Step 4: Value “Pie” • Required rate of return for investors, dependent on: • Risk free rate • Premium for market risk • Premium for illiquidity • Premium for value-added (compensation) • Premium for “fudge factor” (past experience)

  13. VC Discount Rates • Seed stage: 80% + • Startup: 50-70% • First-Stage: 40-60% • Second-Stage: 30-50% • Bridge/Mezzanine: 20-35% • Public Expectations: 15-25%

  14. Venture Capital Method Steps: • Forecast future results (”success”) • Determine likely value at that point (e.g. P/E ratio for comparable) • Determine likely dilution from: (a) capital and (b) employee stock • Determine share of value “pie” demanded given required rates of return • Convert future values to present to derive share prices, ownership percentages

  15. Step 6: THINK! • Am I buying? • Am I selling? • Am I making an investment decision? • Am I negotiating value? • Does it make sense???

  16. Common Patterns • Achieve plan, but two years later • Achieve plan, but requires twice as much money • More shares required for management • Lower margins due to competition • Exit windows

  17. Typical VC Questions • What if we use a different discount rate? • What if terminal value is different? • What if performance varies from plan? (timing? magnitude and financial need?) • What if more shares are issued for management or other reasons? • What if we’re confronted with a different asking valuation or share price?

  18. Different Questions • What are the logical implications of a given value level • What level of net income is required in year 5 for investor to receive target return? • What level of sales is required? • Questions re: • industry structure • sustainability • exit multiples and options

  19. When to Use What? • How good are forecasts? • How good are comparables? • Highly risky investments/no substantive operating results for significant periods of time: VC METHOD • Less explosive growth/predictable flows: DCF

  20. Part ART • Part SCIENCE!

  21. Also Remember... • Venture capitalists don’t get rich by cutting tough deals • Entrepreneurs don’t get rich by taking highest offers • Don’t miss the forest for the trees! (sensitivity analysis)

  22. Equity Concepts

  23. Capitalization (”Cap Tables”) • Preferred shares (various series) • Common shares • Employee stock options • Warrants

  24. Important Concepts • “Fully diluted” ownership • Authorizing new series of preferred • Authorized vs issued/granted vs vested • “Printing stock” (new stock) for employees • Vested vs unvested stock • “Treasury method” for share accounting • Stock option expensing debate

  25. Equity Compensation

  26. Ranges of Grants

  27. Stock Comp Philosophy • Skew to key performers • Egalitarian • Replacement cost • Vesting policies • “Outsider” stock holdings

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