Professional Documents
Culture Documents
companies?
Special Study
Amit Bapat
Summer 2004
Table of Contents
Table of Contents .................................................................................................................................. 2
OVERVIEW ................................................................................................................................................. 3
VALUATION METHODS .......................................................................................................................... 3
NET PRESENT VALUE ................................................................................................................................. 3
Step 3: Calculate NPV .......................................................................................................................... 4
ADJUSTED PRESENT VALUE ....................................................................................................................... 5
COMPARABLES ........................................................................................................................................... 5
VENTURE CAPITAL METHOD ...................................................................................................................... 6
Pre-money and post-money valuation............................................................................................................... 6
FIRST CHICAGO METHOD ........................................................................................................................... 6
REAL OPTIONS ........................................................................................................................................... 7
COMPARISON OF VALUATION METHODS .................................................................................................... 8
NON-FINANCIAL CONSIDERATIONS ........................................................................................................... 10
STAGES OF INVESTMENT .......................................................................................................................... 10
PROVISIONS OF TERMS SHEETS ....................................................................................................... 11
THE NEGOTIATION PROCESS .................................................................................................................... 11
INVESTMENT INSTRUMENTS ..................................................................................................................... 12
Preferred Stock ................................................................................................................................... 12
Liquidation Preference ....................................................................................................................... 12
Conversion Rights............................................................................................................................... 13
Conversion Rate Adjustments – Anti-dilution ..................................................................................... 13
Redemption ......................................................................................................................................... 14
Common Stock .................................................................................................................................... 14
Convertible Debt................................................................................................................................. 14
PARTICIPATION IN MANAGEMENT OF COMPANY....................................................................................... 15
STOCK PURCHASE AGREEMENT ................................................................................................................ 16
REFERENCES ........................................................................................................................................... 16
Overview
Valuation of startup and emerging companies with most having negative cash
flow in early stages with significant projected rewards later is very difficult task.
Yet investors are confronted frequently with investments whose current value
must be estimated in spite of the fact that much of the reward lies in future. This
paper will discuss various methods used by investors to value such startups and
emerging businesses. The latter half of the paper will discuss negotiation of term
sheets and various different terms that are used by investors to ensure a
successful investment, maintain value and control of the invested company as
much as possible, share some risk with other investors and obtain maximum
financial reward if the venture turns out to be a success.
Valuation Methods
Following are some of the most commonly used methods for valuation of startup
and emerging companies followed by a comparative analysis of the strengths
and weaknesses of each method. There are various different approaches to
estimating the value of a startup company.
Income Approach: Estimating future cash flow that could be taken out of the
business without impairing future operations. Most common methods in this
approach are: Net Present Value, Equity Cash Flow and Capital Cash Flow
(Adjusted Cash Flow being a variation of this method).
Market Approach: Estimates the value of a going concern business by comparing
to similar firms whose stock is publicly traded. In many cases Market Approach is
used as a secondary valuation method to verify the estimates derived from the
Income Approach.
Asset Approach: valuation based on the firm as a financial option.
The cash flow and discount rate are nominal values and are not adjusted for
inflation. Other common methods calculating terminal value include price-
earnings ration, market-to-book value multiples.
r = (D/V) * rd * (1 – t) + (E/V) * re
Where:
rd = discount rate for debt
re = discount rate for equity
t = corporate tax rate
D = market value of debt
E = market value of equity
V=D+E
If the firm is not at its target capital structure, it is necessary to unlever and
relever the beta:
Bu = Bt * (E/V) = Bt ( E / (E + D))
Where:
Bu = unlevered beta
Bt = levered beta
E = market value of equity
D = market value of debt
Adjusted Present Value
Adjusted Present Value (APV) method is a variation of the NPV method. When a
firm’s capital structure is changing or it has net operating losses (NOL) that can
be used to offset taxable income, APV method is used. If a firm has NOLs then
its effective tax rate changes over time, as NOLs are carried forward for tax
purposes and netted against taxable income. APV accounts for the effect of the
firm’s changing tax status by valuing NOLs separately.
Thus under APV method, first cash flow are valued ignoring the capital structure.
The discount rate used is different than in NPV method as it is assumed that the
company is financed totally by equity. This implies that the discount rate should
be calculated using unlevered beta.
The tax benefits associated with the capital structure are then estimated. The net
present value of the tax savings from tax-deductible interest payments is
quantified. The interest payments will change over time as debt levels change.
By convention the discount rate for this calculation is pre-tax rate of return on
debt. This will be lower than cost of equity.
Finally NOLs available to the company are quantified. The discount rate used to
value NOLs is often pre-tax rate on debt. If it is almost certain that NOLs will
result in tax benefits risk free rate can also be used as the discount rate. The
formula for this calculation is similar to the one presented above for NPV of tax
deductible interest payment.
Comparables
The comparables method is often used to arrive at a ‘ballpark’ valuation of a firm.
First firms that display similar ‘value characteristics’ are selected. These value
characteristics include risk, growth rate, capital structure, and the size and timing
of cash flows. Often, these value characteristics are driven by other underlying
attributes of the company which can be incorporated in a multiple. This valuation
method is most useful when all the chosen comparable firms are publicly traded
and their capital structure, revenue, profit margins, net profit figures are known.
The most common measures used while valuation using this method are:
• P-E Ratio (share price divided by the earnings per share)
• Market value of the firm divided by total revenue
• Market-to-book ration (Market value of the firm divided by the
shareholder’s equity)
• Market Value divided by EBITDA (earnings before interest, taxes,
depreciation and amortization)
An average of these ratios for the chosen comparable firms is calculated and
based on that the value of the firm is calculated for each measure. This gives a
range of values for the firm based on these measures.
Following formulas are used to calculate the value of the firm and shares issued:
Apart from the basic venture capital formula presented here, there are several
other variations that take into account various stages of funding like seed
funding, startup financing, first-stage financing, second-stage financing, bridge
financing and restart financing. The differences in valuation in these different
rounds of funding are discussed briefly in a later section.
Where, accrued dividends are total dividends received on preferred stock in prior
years.
The Sideways Scenario: In this case the company survives with enough
profitability to pay dividends for first few years but never reaches the IPO stage.
The Failure Scenario: The company is unsuccessful and the VCs have to
recover capital by liquidating the assets of the company. Therefore cash flows
under this scenario can vary greatly depending on how the funds were utilized.
Once the scenarios are laid out, probability of each scenario is determined. The
projected cash flows for each year are multiplied by the probability and a
weighted average cash flow for each year is calculated. The expected cash-flow
is broken down into expected cash flow from IPO and rest of the expected cash-
flow. Thus:
(p x (final ownership) x TV) + FV(non-IPO cash flow) = FV(investment)
Where,
p = IPO probability
TV = forecast terminal value
Real Options
Discounted cash flow methods like NPV and APV can be deficient in situations
where a manager or investor has flexibility in terms of changing rate of
production, defer deployment or abandon a project. These changes affect the
value of the firm which can not be measured accurately using discounted cash
flow methods. Private equity-backed companies are often characterized by
multiple rounds of funding. Venture capitalists use this multi-stage approach to
motivate the entrepreneur to perform better and limit their exposure to a
particular company. Options analysis in valuing firms as options is a developing
area in finance. In this method firms are analyzed like a financial option. There
are five variable commonly used in a financial option:
X = exercise price
S = stock price
T = time to expiration
σ = standard deviation of returns on the stock
r = time value of money
Once these variables are know the value of the option can be calculated using
Black-Scholes computer model or a call option valuation table.
where
C = price of the call option
S = price of the underlying stock
X = option exercise price
r = risk-free interest rate
T = current time until expiration
N() = area under the normal curve
d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2
d2 = d1 - σ T1/2
Valuation of firms as a financial option is a very new concept and is not yet
widely used.
Non-financial considerations
Along with the above valuation methods that mainly rely on financial data,
investors also consider following factors while valuing a company:
• Quality of management team
• Current state of technology
• Current state of companies in similar market
• Current market conditions
• Size of the market and company’s potential to acquire market share
• Track record of entrepreneur; repeat entrepreneurs get better valuation
• Distribution of bargaining power between VC and entrepreneur
Investors often include above considerations when they decide on the discount
rate when using the venture capital method.
Stages of Investment
Seed Financing: is the earliest stage of funding. Investment is small (typically
low tens of thousands of dollars) to support an entrepreneur’s exploration of idea.
No formal business plan exists, management team may not yet be formed, no
feasibility of the project established. In case of an established technology, seed
money is used to finance recruitment of key management and writing business
plan. Seed investors provide basic business advice, office facilities etc. Discount
rates of over 80% are typical.
Bridge Financing: Intended to carry a company until its IPO. IPO is generally
expected in short-term (typically within a year from financing event). Main
purpose is to satisfy on-going capital needs. Sometimes bridge investors may
apply some or all of the funds to buy out early-stage investors who are anxious to
liquidate their holding. Typical discount rate of 20% to 35%.
Investment Instruments
Principal instruments used in venture capital financing are:
• Preferred stock
• Convertible debt
• Warrants
• Common stock
Dividend rights: Though most investors have no interest in ordinary income or
distributions from the company, the dividend clauses for preferred stock are
simply designed to guarantee that the preferred stock is not disfavored by
comparison with the common stock.
Preferred Stock
Preferred stock gets higher preference over common stock in the event of a
liquidation.
Purpose of preferred stock is to:
• Prevent founders from being able to pull out money before they create any
real value
• Redemption of preferred stock does not attract capital gain tax as it is just
a return of capital
• Limits returns to the founder for modest outcomes – incentives to reach
high payoffs
• The extent to which VC wants to encourage the entrepreneur to go for the
big payoffs can be controlled by specific choice of security.
Liquidation Preference
Nonparticipating or Participating Preferred stock: Nonparticipating preferred
stock is preferred stock whose liquidation preference defines the total of what the
holder will receive on liquidation (or sale). Participating preferred stock is entitled
both to receive its liquidation preference and to receive same thing as common
stockholders on an ‘as if converted’ basis.
Fully Participating Preferred: Participating preferred stock whose right to get
both its preference and a common equivalent share have no upper limit. In most
cases participating preferred stocks have an upper limit. In this system, the
investor first receives its liquidation preference, and then gets to share with the
common stock until the investor has received, in total, some multiple of the
investor’s original investment.
Liquidation Preference Multiple: When the stock market sees a sharp drop in
valuations, demand rises for liquidation preferences that are a multiple of the
original investment. The investor gets back not only its original investment, but
also a multiple of its original investment, before the common stock holders get
anything.
Conversion Rights
Venture investor’s convertible preferred stock typically carries both rights and
obligations to convert into common stock. For optional conversion, the investor
typically retains the option to convert the preferred stock to common stock at will,
except that it is conventional to bar conversion after an investor has demanded
redemption of the stock.
In case of mandatory conversion, the issuer insists on the right to compel
conversion of preferred stock at specified point in time.
Typical mandatory conversion points are as follows:
• On IPO at above-price targets: The requisite per-share price is typically 3-
5 times
• On Majority conversion: compel conversion of any remaining shares when
a majority of originally issued shares of the series has converted
• On merger above price targets: in the event of a merger or sale of the
company at or above an agreed-on per-share price.
Redemption
Some preferred stock include either a mandatory or an optional right to cause the
preferred stock to be redeemed. Redemption rights are a last resort for an
investor because they cannot be exercised unless there is sufficient net worth to
do so, after allowance for all debts and all liquidation preferences of any
remaining preferred stock. Investors insist on mandatory redemption as a means
of rescuing their capital if no other exit path is available.
Common Stock
The use of common stock in venture financing is relatively infrequent because it
creates problems for both parties. The principal drawback to the investor is that
all shares of common stock are identical so the investor has no liquidation
preferences, antidilution protections, or governance rights built into the definition
of the investor’s equity. The principal drawback to the company is that sale of
common stock to investors establishes a market value for the stock that carries
over to stock sales or grants to the issuer’s employees. Thus the sale price to
employees may be higher than employees can afford to pay or if the stock is sold
at a reduced price, employees may be forced to recognize taxable income to the
extent of bargain.
Convertible Debt
Convertible debt is similar to convertible preferred stock but provides the investor
with the security of a debt instrument and more options in managing its
investment. Convertible debt is less desirable to the company because:
1. It appears as debt on company’s financial statement
2. absent a subordination agreement the convertible debt is treated as debt
by the company’s lenders, suppliers, and creditors and may thereby limit
the company’s ability to obtain credit or additional financing
3. it generally requires periodic payments of interest
4. the holder of convertible debt generally retains the right to accelerate the
debt if the issuer defaults in performing specified covenants.
The investor’s ability to participate in the company’s management is limited.
First refusal right: Investors may request a right of first refusal with respect to
the purchase of any stock subsequently offered for sale by the issuer.
References
1. A Method for Valuing High-Risk, Long-Term Investments: The Venture
Capital Method. William A Sahlman. HBS Article 9-288-006. Aug 12, 2003.
2. A Note on Valuation in Private Equity Settings. Josh Lerner, John Willinge.
HBS Article 9-297-050. April 8, 2002.
3. The Basic Venture Capital Formula. William A Sahlman. HBS Article 9-
804-042.
4. A Note on Pre-Money and Post-Money Valuation. Linda A Cyr. HBS
Article 9-801-446 April 16, 2002.
5. Does the Market Know Your Company’s Real Worth? James McNeill
Stamcill. Hardward Business Review Article 82509. Sept 1982.
6. Valuation: Understanding How Analysts Value Your Stock. John J. Lewis.
7. Term Sheet Negotiation for Trendsetter, Inc. Walter Kuemmerle. HBS
Article 9-801-358. April 22, 2004.
8. Venture Capital Contracts Part I & II. MIT Sloan 15.431 Entrepreneurial
Finance Class Notes. Antoinette Schoar. Spring 2002.
9. New Venture Valuation. MIT Sloan 15.431 Entrepreneurial Finance Class
Notes. Antoinette Schoar. Spring 2002.
10. Advising Oregon Business Volume 2. 2001 Edition. William C. Campbell.