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Understanding Valuation: Principles, Techniques, and Venture Capital Methodologies

This comprehensive overview of valuation explores its fundamental principles, including the relationship between cash, time, and risk. It highlights pivotal techniques such as discounted cash flow and scenario analysis, while also emphasizing the importance of understanding market dynamics and comparable metrics. The venture capital method is detailed, including the steps to forecast results, evaluate risks, and assess dilution. Moreover, it addresses the nuances of discount rates and the implications these have on investment decisions. Ideal for investors and entrepreneurs alike.

derek-mckinney
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Understanding Valuation: Principles, Techniques, and Venture Capital Methodologies

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Presentation Transcript

  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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