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The Deal: Valuation, Structure, and

Negotiation

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Exhibit 14.1

Factors underlying the required ROR include a premium for systemic risk, illiquidity, and value added.

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Exhibit 14.2

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Exhibit 14.3

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The “Ideal” Startup

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Exhibit 14.6

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Valuation Methods

• The Venture Capital Method• Appropriate for investments in a company with negative cash

flow at the time of the investment, but which in a number of years is projected to generate significant earnings• Need RRR, Time Period

• Termination Value=Earnings x Expected P/E ratio

• The Fundamental Method• Simply the present value of the future earnings stream

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Valuation Methods

• The First Chicago Method• Employs a lower discount rate, but applies it to an expected

cash flow

• Discounted Cash Flow• 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, and (net fixed assets + operating working capital)/sales; also note relationships and trade-offs

• Three stage financing method

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Exhibit 14.7

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Exhibit 14.8

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Exhibit 14.9

Calculate how much of the company must be sold at each stage if exit P/E=15!

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What is a Deal in Entrepreneurial Finance?

• Deals—economic agreements between at least two parties that involves the allocation of cash flow streams (with respect to both amount and timing), the allocation of risk, and hence the allocation of value between different groups• The deal includes value distribution, basic

definitions, assumptions, performance incentives, rights, and obligations.

• It also involves mechanisms for transmitting timely, credible information, plus negative and positive covenants, default clauses, and remedial action clauses.

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Tools

•Tools available are common stock, partnerships, preferred stock, convertible debt, performance conditional pricing, put/call options, warrants, and cash.

•Nonmonetary tools include:• Number, type, and mix of stocks.• The number of seats on the board of directors.• Possible changes in the management team

and in the composition of the board.• Specific performance targets for revenues,

expenses, market penetration, and the like.

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Deal Characteristics

• Characteristics of successful deals• They are simple• They are robust• They are organic• They take into account the incentives of each party to the deal

under a variety of circumstances• They provide mechanisms for communications and

interpretation

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Deal Characteristics

• Characteristics of successful deals• They are based primarily on trust rather than on legalese• They are not patently unfair• They do not make it too difficult to raise additional capital• They match the needs of the user of capital with the needs of

the supplier• They reveal information about each party

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Deal Characteristics

• Characteristics of successful deals• They allow for the arrival of new information before

financing is required• They do not preserve discontinuities• They consider the fact that it takes time to raise money• They improve the chances of success for the venture

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Tips

•Raise money when you do not need it.•If all you get is money, you are not

getting much.

•Learn as much about the process and how to manage it as you can.•Know your relative bargaining position.

•Assume the deal will never close.•Always have a backup source of capital.

•Legal and other experts can blow it.

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Exhibit 14.10

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Minimizing Surprises

• Tips to consider when raising capital:• Raise money when you do not need it• Learn as much about the process and how to manage it as you

can• Know your relative bargaining position• If all you get is money, you are not getting much• Assume the deal will never close• Always have a backup source of capital• The legal and other experts can blow it -- sweat the details

yourself

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Negotiation

• Steps of principled negotiation• Separate the people from the problem• Focus on interests, not positions• Generate a variety of possibilities before deciding what to do• Insist that the result be based on some objective standard

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Beyond “Just the Money”

• Critical aspects of 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

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Beyond “Just the Money”

• Critical aspects of the deal• 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

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Burdensome Issues for Entrepreneurs

• Co-sale provisions• investors can tender their shares of their stock

before an initial public offering.

• Ratchet anti-dilution protection• investors get free additional common stock if

subsequent shares are ever sold at a price lower than originally paid.

• Washout financing• wipes out all previously issued stock when

existing preferred shareholders will not commit additional funds.

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More Burdens

• Forced buyout• allowing the investor to find a buyer if

management cannot

• Demand registration rights• for at least one IPO in three to five years

• Piggyback registration rights• grant rights to sell stock at the IPO

• Key-person insurance• requiring the company to obtain life insurance on

key people

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Case

• Walnut Associates (B, C, D)

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