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National Seminar on Corporate Valuation Valuation of Early Stage Companies
April 30, 2014
Leading / Thinking / Performing
Valuation
Transaction
Consulting
Real Estate
Advisory
Fixed Asset
Management
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1. Key characteristics of early stage companies
2. Challenges in valuing early stage companies
3. How does a venture capitalist value early stage companies?
4. Dealing with challenges in Valuation
5. Case Studies
Agenda
Leading / Thinking / Performing 3
No history, nascent operations - not yet at the stage of commercial production
Small or no revenues, operating losses; can consume vast amounts of cash
High level of dependence on external sources of funding
Complex shareholding structure with multiple claims on equity
Illiquid investments
1. Key characteristics of early stage companies
Leading / Thinking / Performing 4
1. Key characteristics of early stage companies
2. Challenges in valuing early stage companies
3. How does a venture capitalist value early stage companies?
4. Dealing with challenges in Valuation
5. Case Studies
Agenda
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2. Challenges in valuing early stage companies
Mostly future
growth
More from
existing assets
than growth
Entirely from
existing assets
Comparable firms None Some, but in
same stage of
growth
Large number of
comparables, at
different stages
Declining number of
comparables, mostly
mature
Revenues/
Earnings
Non-existent or low
revenues/ negative
operating income
Revenues
increasing/
income still
low or negative
Revenue growth
slows/ operating
income still
growing
Operating History
Revenues and
operating income
growth drops off
More comparable
at different stages
Portion from
existing assets/
Growth still
dominates
None Very
limited
Some operating
history
Operating history
can be used in
valuation
Substantial operating
history
Source of Value
$ R
eve
nu
es/ E
arn
ings
Time
Revenues in high
growth/ operating
income also
growing
Entirely future
growth
Start-up or Idea
companies
Rapid Expansion
High Growth
Mature Growth Decline
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Ea
rnin
gs
Time
Valley of Death
Angels/
Founders
Venture Capital /
Private Equity
Public Markets
Seed Capital
A
B
C
Early
Stage
Late
Stage
IPO
Secondary
Offerings
PIPE
Distressed Asset funds
2. Who invests in early stage companies? Funding Life Cycle
Strategic Investors
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1. Key characteristics of early stage companies
2. Challenges in valuing early stage companies
3. How does a venture capitalist value early stage companies?
4. Dealing with challenges in Valuation
5. Case Studies
Agenda
Leading / Thinking / Performing 8
Detailed Assumptions
Forecast P&L, Balance
Sheet and Cash flows
Computation of
FCFF / FCFE
Estimation of WACC /
Cost of Equity
Valuation
Summary Sensitivity Analysis
Equity
Requirement
Promoter
Dilution
Investor IRR
Requirement
Expected Exit
Valuations
3. How does a venture capitalist value early stage companies? Reviewing business plan and valuation process
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Example: Basic VC Formula (1/2)
Consider a VC contemplating an investment of $1.0 mn in a technology company. Assume no further capital requirement through year 5. The company is expected to earn $1.5 mn in year 5, and should be comparable to companies commanding P/E ratio of about 10x.
Further, the VC requires a 25% projected rate of return on a project of this risk. How much equity stake should the VC seek?
3. How does a venture capitalist value early stage companies? Method 1: Basic VC Formula
Fact Summary
Investment
Required IRR
Term
Revenues
Year 5 Net Income
Year 5 P/E Ratio Exit Multiple
$1.0 million
25%
5 years
$0.5 million
$1.5 million
10x
FY
14
FY
15
FY
16
FY
17
FY
18
PE
Investment
PE
exit
Equity
Requirement
$1.0 mn
Promoter
Dilution ? Exit Valuations
10x Net Income
Investor IRR
25%
FY
19
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Example: Basic VC Formula (2/2)
The VC must own enough of company in year 5 to realize a 25% annual return on the investment. Thus, at that time his shares must be worth:
Required Future Value of Investment = (Investment) X (1+IRR)^years
= ($1.0 mn) X (1+25%)^5
= $3.05 mn
Now, at that point the company must be worth:
Exit Value of Company = Exit Year Net Income X P/E Ratio
= $1.5 mn X 10
= $15.0 mn
Hence, VC must own: $3.05 / $15.0 = 20.3 percent
3. How does a venture capitalist value early stage companies? Method 1: Basic VC Formula
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3. How does a venture capitalist value early stage companies? Method 2: First Chicago Method
Overview
First Chicago approach simply does three different projections: Success, Failure and Survival cases and assigns probability estimates to each
When utilized, the First Chicago method results in a separate valuation and pricing for each of the three outcomes
These are then averaged and the weighted average valuation is determined (weights being the probability assigned to each case)
Let us continue with the same example and see how the analysis differs in this case.
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First Chicago Method Example (1/2)
Variables Success Sideways Survival Failure
Base year revenue: $ 0.5 mn $ 0.5 mn $ 0.5 mn
Revenue growth rate from base: 100.0% 50.0% 5.0%
After Tax Profit Margin: 20.0% 10.0% Negative
PE Ratio at Liquidity: *From Comparables etc. (P/E of 10
is long term historical average) 10x 10x N.A.
Projected Liquidation Value @ Year 5 in Failure Scenario: $ 1.0 mn
Discount Rate: 25.0% 25.0% 25.0%
Probability of Each Scenario: 33.3% 33.3% 33.3%
3. How does a venture capitalist value early stage companies? Method 2: First Chicago Method
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First Chicago Method Example (2/2)
Calculations Success Sideways Survival Failure
Revenue Growth Rate 100% 50% 5%
Revenue Level After 5 Years 16.0 3.8 0.6
Net Income at Liquidity 3.2 0.4 0.0
Value of Company At Liquidity 32.0 4.0 1.0
PV of Company Using Discount 12.0 1.6 0.3
Rate of 25%
33.3% 33.3% 33.3%
Expected PV Of The Company 4.0 0.5 0.1
Under Each Separate Scenario
Expected PV Of The Company 4.6
% Ownership Required in order 1.0 / 4.6 = 21.6%
to Invest $ 1.0mn
3. How does a venture capitalist value early stage companies? Method 2: First Chicago Method
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3. How does a venture capitalist value early stage companies? Method 3: Scorecard Method
Overview (1/2)
The first step in using the Scorecard Method is to determine the average pre-money valuation of early stage companies in the region and business sector of the subject company.
As one would expect, pre-money valuation varies with the state of the economy and the competitive environment for startup ventures within a region. However, the variation has been remarkably subdued, ranging between $2 million and $ 3 million from 1998 till 2008.
0
1
2
3
4
5
6
7
8
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Me
dia
n P
re-M
on
ey
Va
lua
tio
ns (
$M
n)
Source: Dow Jones VentureSource
Median Pre-Money Valuations by Round Class
First Round
Seed Round
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3. How does a venture capitalist value early stage companies? Method 3: Scorecard Method
Overview (2/2)
Since our subject company is revenue generating, we will assume that the average pre-money valuation for comparable firms is $3.5 million.
In the next step, the VC compares the subject company to his perception of similar deals, considering factors such as
Strength of the Management Team; Size of the Opportunity; Product/ technology risk, among others.
The subjective rating of factors is typical for investor appraisal of startup ventures.
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Continuing with the same example
Multiplying the Sum of Factors (1.080) times the average pre-money valuation of $3.5 million, we arrive at a pre-money valuation for the subject company of about $3.8 million.
Hence, the fund must own: $1 / ($3.8 + $1) = 20.9 percent
3. How does a venture capitalist value early stage companies? Method 3: Scorecard Method
Comparison factor Range Weights Company
Rating
Factor
Team/ Management 0-40% 30% 1.25 0.375
Size of Opportunity 0-30% 25% 1.50 0.375
Product/ Technology 0-20% 15% 1.00 0.150
Competition 0-15% 10% 0.80 0.080
Sales partnerships 0-15% 10% 0.80 0.080
Additional investment 0-10% 5% 1.00 0.050
Other factors 0-10% 5% 1.00 0.050
Total 100% 1.080
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1. Key characteristics of early stage companies
2. Challenges in valuing early stage companies
3. How does a venture capitalist value early stage companies?
4. Dealing with challenges in Valuation
5. Case Studies
Agenda
Leading / Thinking / Performing 18
Due to the challenges in applying the typical valuation approaches, we need to consider some modified approaches such as:
4. Dealing with challenges in Valuation
Method 1:
In-phase Valuation
Method 2:
Real Options
Method 3:
Backsolve Method
For Valuing Businesses For Valuing Shares
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Valuation of early stage companies should not be done by valuing the cash flows of the venture all in one step.
Valuation analysis should break down the cash flow forecasts into different development phases and evaluate each phase separately.
As the project/ firm progresses successfully from one phase to the next, the risk (and therefore the return expectation) should decline.
4. Dealing with challenges in Valuation Method 1: In-phase Valuation
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Example (1/3)
A startup is launching an ecommerce business which will proceed in two phases Phase 1 Setting up a website - for 3 years with: Initial Investment of $ 50,000 For the first three years, the project will produce $ 10,000 per year
Phase 2 Launch of ecommerce business* after 3 years Investment required $ 800,000 Expected cash flows $ 100,000 growing at 6% till perpetuity
There is a 40% chance that the killer application will be discovered All equity financed
* Contingent on discovery of killer application
4. Dealing with challenges in Valuation Method 1: In-phase Valuation
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Example (2/3): Valuation using traditional DCF method
Risk free rate = 6.0% Total Risk Premium = 16.0% Cost of Equity = 22%
4. Dealing with challenges in Valuation Method 1: In-phase Valuation
100,000*(1+6%)
10,000 Cash flows 10,000 10,000 100,000 Grow at 6% till
perpetuity
NPV of the Project at the end of 3 years - 800,000 + (22% - 6%)
Present Value of the Overall Project
= -- 137,500
40% * - 137,500 (1+22%)^3
= - 7,210
+ 10,000
(1+22%)^t
= 23,078 +
=
=
40% * - 75,722
Development of
killer application for
$800,000
Net Present Value of the Project = -- $ 57,210 - 7,210 -- 50,000 =
t = 1
3
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Example (3/3): Valuation using In-phase method
Risk free rate = 6% Total Risk Premium Phase 1 = 16% Total Risk Premium Phase 2 = 8% Cost of Equity Phase 1 = 22% Cost of Equity Phase 2 = 14%
4. Dealing with challenges in Valuation Method 1: In-phase Valuation
100,000*(1+6%)
10,000 Cash flows 10,000 10,000 100,000 Grow at 6% till
perpetuity
NPV of the Project at the end of 3 years - 800,000 + (14%-6%)
Present Value of the Project
= 525,000
40% * 525,000 (1+ 22%)^3
= 138,727
+ 10,000
(1+22%)^t
= 23,078 +
=
=
40% * 289,121
Net Present Value of the Project = $ 88,727 = 138,727 -- 50,000
t = 1
3
Development of
killer application for
$800,000
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Valuation using Real Options Traditional DCF approach understates the value of early stage companies because: It doesnt take into account the changes in risk over time Doesn't put value to the flexibility provided in investment decision at various phases of an early
stage firm
Looking these companies as a project with embedded real options, removes these drawbacks
The underlying asset in this approach is the present value of the project cash flows and the exercise price is the expected investment to be made, if first phase is successful
Identifying the underlying asset and exercise price are critical to the real options valuation
4. Dealing with challenges in Valuation Method 2: Real Options
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Continuing with our earlier example: The Company has an option to make an investment of $ 800,000 for phase 2 project at
the end of phase 1
The required investment of $ 800,000 will be incurred only if one shows that the project phase 1 turns out to be favourable, but will not be incurred otherwise
This flexibility with the management can be valued as a call option with exercise price of $ 800,000
The parameters of this call option are: Strike Price - $ 800,000 Time period 3 years Risk free rate 6% Dividend rate 0% Volatility 60% Value of underlying - $ 730,000 (present value of $ 1,325,000 @ 22% discount rate)
A simple application of the black scholes model suggests that this options value is $266,000
4. Dealing with challenges in Valuation Method 2: Real Options
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4. Dealing with challenges in Valuation Method 2: Real Options
50,000 (1) NPV of Phase 1 10,000 -- =
(1+22%)^t
(2) Option Value at present
Total NPV of the project
= 266,000
=
=
(1) + (2)
$ 239,708
Total Value of the Project:
50,000 23,708 -- = -26,292 =
t = 1
3
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Name of the
company
Amount Invested
($mn)
Stake Acquired
(%)
Implied Equity
Value ($mn)?
BabyOye 12 25 48
BankBazaar 13 35 37
FirstCry 15 26 58
TaxiForSure 2.55 31 8
The Beer Cafe 4.6 36 13
Yebhi.com 10 29 34
4. Dealing with challenges in Valuation Some recent VC investments
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The Backsolve Method derives the implied equity value for the company from a transaction involving the companys own securities, typically, the preferred stock.
It indicates an equity value that is consistent with the rate of return the investors in the most recent round expected given the degree of marketability of their investment as well as any special rights (e.g., liquidation preferences) accorded to them.
Option Pricing Model
The most common method to apply Backsolve is through the Option Pricing model. This model treats common and preferred stock as call options on the value of the business.
Common stock only has value if the funds available, at the time of a liquidity event (e.g., merger or sale), exceed the preferred liquidation value
In other words common shareholders have the option to buy the underlying asset (the company) at an exercise price equal to the liquidation preference amount.
4. Dealing with challenges in Valuation Method 3: Backsolve Method
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Example (1/8)
Company X receives $ 1 mn investment in the form of 100,000 Series A convertible preferred shares. It has 400,000 outstanding common shares. Series A preferred shares are issued with the following terms:
It would appear that the value of the Common Equity is $ 4 mn and overall Equity value is $ 5 mn
Let us assume that the value of the Company is $ 5 mn and apply the Backsolve model to see if this is indeed the case.
Key Facts
No. of shares 100,000
Issued price $10
Liquidation preference $10
Common shares 400,000
Conversion ratio 1, convertible into common at the ratio of one
4. Dealing with challenges in Valuation Method 3: Backsolve Method
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Example (2/8)
Series A preference share holders (Preferred A) will convert their shares into common shares once the enterprise value is above $5 million.
Before Conversion After Conversion
No. of shares No. of shares
Preferred A 100,000
Common 400,000 500,000
Liquidation Preference $10
Liquidation Preference Value $1,000,000
Preferred A Equity stake 20%
Required Enterprise Value $5,000,000
4. Dealing with challenges in Valuation Method 3: Backsolve Method
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Example (3/8)
To illustrate graphically, payoff to preferred and common shareholders is shown as below.
Enterprise Value
Payoff to
shareholders
Preferred
Common
Value Allocation
$5,000,000
$5,000,000
$1,000,000
$1,000,000
1st payoff :
100% to
Preferred
2nd payoff :
100% to
Common
3rd payoff : 80%
to Common
And 20% to
Preferred
4. Dealing with challenges in Valuation Method 3: Backsolve Method
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Example (4/8)
1st option 2nd option 3rd option
Underlying value $5,000,000 $5,000,000 $5,000,000
Exercise Price $0 $1,000,000 $5,000,000
Risk Free Rate 6% 6% 6%
Volatility 50% 50% 50%
Time to liquidity 5 years 5 years 5 years
Results $5,000,000 $4,400,000 $2,700,000
EV EV EV $ 1 m Ex. Price :$ 1 m Ex. Price :$ 5 m Ex. Price :$ 0
Option value Option value Option value
Diagram
4. Dealing with challenges in Valuation Method 3: Backsolve Method
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Example (5/8)
Based on the option results, value of preferred shares and common share values can be derived.
Enterprise Value
Payoff to
shareholders
$5,000,000
$5,000,000
$1,000,000
$1,000,000
1st payoff : 100% to
Preferred
2nd payoff : 100% to
Common
3rd payoff : 80% to
Common, and 20% to
Preferred
1st option 2nd option 3rd option
Results $5,000,000 $4,400,000 $2,700,000
4. Dealing with challenges in Valuation Method 3: Backsolve Method
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Example (6/8)
Preferred shares value is:
= Value of 1st option Value of 2nd option + (Value of 3rd option x 20%)
= $5,000,000 4,400,000 + (2,700,000 * 20%)
= $1,140,000
Since the Preferred shares value is not equal to the amount invested ($ 1 mn), it implies that the value of company is not $ 5 mn.
Using goal seek, we can find out the value of company at which value of Preferred Shares will be $ 1 mn. That value is about $ 3.93 mn.
1st option 2nd option 3rd option
Results $5,000,000 $4,400,000 $2,700,000
4. Dealing with challenges in Valuation Method 3: Backsolve Method
Leading / Thinking / Performing 34
Example (7/8)
Preferred shares value is:
= Value of 1st option Value of 2nd option + (Value of 3rd option x 20%)
= $3,930,000 3,300,000 + 1,850,000 x 20%
= $1,000,000
1st option 2nd option 3rd option
Underlying Assets $3,930,000 $3,930,000 $3,930,000
Exercise Price $0 $1,000,000 $3,930,000
Risk Free Rate 8% 8% 8%
Volatility 50% 50% 50%
Time to liquidity 5 years 5 years 5 years
Results $3,930,000 $3,300,000 $1,850,000
4. Dealing with challenges in Valuation Method 3: Backsolve Method
Leading / Thinking / Performing 35
Example (8/8)
Common shares value is:
Common Stock
= Value of 2nd option Value of 3nd option + (Value of 3rd option x 80%)
= $ 3,300,000 1,850,000 + (1,850,000 x 80%)
= $ 2,930,000
Note that the Common shares value is much lower than the $ 4 mn anticipated earlier.
1st option 2nd option 3rd option
Results $3,930,000 $3,300,000 $1,850,000
4. Dealing with challenges in Valuation Method 3: Backsolve Method
Leading / Thinking / Performing 36
1. Key characteristics of early stage companies
2. Challenges in valuing early stage companies
3. How does a venture capitalist value early stage companies?
4. Dealing with challenges in Valuation
5. Case Studies
Agenda
Leading / Thinking / Performing 37
Overview
Facebook acquired WhatsApp in $19bn deal.
Facebook is making the purchase in a mix of cash and stock. WhatsApp will receive:
$4bn in cash
$12bn in Facebook shares and an additional $3bn in restricted shares that will be paid out to executives at a later date > Large consideration is in form of stock!
5. Case Studies Facebook buys WhatsApp (1/2)
Key numbers WhatsApp
450 Mn Number of people using the service each month
70% Proportion of those users active on a given day
1 Mn New registered users per day
19 Bn Messages sent via WhatsApp each day
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Comparison
Considerations
Is the market over estimating the value of users at social media companies across the board? As social media companies move up the life cycle, the variable(s) that traders user to price
companies will change from number of users/ user intensity to revenues, earnings and cash flows.
The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another.
5. Case Studies Facebook buys WhatsApp (2/2)
Market Cap $160 Bn Deal Value $ 19 Bn $ 4 Bn (cash paid)
Daily Active Users 802 Mn Daily Active Users 315 Mn 315 Mn
Value/ Active User $ 200 Value/ Active User $ 60 $ 12 (cash paid/ user)
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5. Case Studies A renewable energy company
Overview
Dispute between two promoters. One promoter decided to exit and demanded USD 12.5 per share for his stake (latest round of funding had taken place at USD
12.5 per share).
Dispute went to court and American Appraisal was appointed to determine fair value of exiting promoters shares.
Solution
American Appraisal reasoned that since recent round of funding was in the form of preference shares, it could not be used as a benchmark for valuing common
equity
Instead, valuation of the equity shares was carried out using the Backsolve method, which indicated a fair value of ~ USD 5 per share for common equity.
The Court ruled in favor of our client, with the final concluded share price being very close to the value implied by the Backsolve method.
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Valuation / Transaction Consulting / Strategy
American Appraisal
B-204, Citipoint,
Andheri-Kurla Road
J.B. Nagar
Mumbai, India
www.american-appraisal.co.in
Varun Gupta Managing Director American Appraisal India
Mobile: +91 9967664231
Office: +91 (0) 22 6623 1000