The Deal: Valuation, Structure & Negotiation Venture Planning Chapter 14 Dowling Fall 2006.

The Deal:The Deal:Valuation, Structure & Valuation, Structure &

NegotiationNegotiationVenture Planning Venture Planning

Chapter 14Chapter 14Dowling Dowling Fall 2006Fall 2006

Valuation, Structure & Valuation, Structure & NegotiationNegotiation

Ingredients to the Ingredients to the entrepreneurial entrepreneurial valuationvaluation CashCash TimeTime RiskRisk


The core mission … is to build the The core mission … is to build the best company possible. This is the best company possible. This is the single surest way of generating long-single surest way of generating long-term value for all the stakeholders term value for all the stakeholders and society.and society.

-Timmons-Timmons

““

””


Determining Value: At least a dozen waysDetermining Value: At least a dozen ways A Key Consideration:A Key Consideration:

Investor’s Required Rate of Return (ROR) (IRR)Investor’s Required Rate of Return (ROR) (IRR)


Inherent conflicts between users and Inherent conflicts between users and suppliers of capitalsuppliers of capital Entrepreneur WantsEntrepreneur Wants: As much time as possible : As much time as possible

for financingfor financing Investor WantsInvestor Wants: To supply capital just in time: To supply capital just in time Entrepreneur WantsEntrepreneur Wants: As much $$$ as possible: As much $$$ as possible Investor WantsInvestor Wants: To invest just enough $$$: To invest just enough $$$ Entrepreneur WantsEntrepreneur Wants : Control of Board-of- : Control of Board-of-

DirectorsDirectors Investor WantsInvestor Wants: Control of Board-of-Directors: Control of Board-of-Directors


Staged Capital Staged Capital CommitmentsCommitments Delivers funding in Delivers funding in

stages, rather than stages, rather than in lump sumin lump sum

Allows investors to Allows investors to evaluate company evaluate company as time passesas time passes


Conservation of capitalConservation of capital To “encourage” managers to conserve, VCs To “encourage” managers to conserve, VCs

apply strong sanctions if capital is misused, by:apply strong sanctions if capital is misused, by: Diluting management’s equity share at Diluting management’s equity share at

punitive ratepunitive rate Shutting down operations completelyShutting down operations completely


Structuring the dealStructuring the deal Deals involve allocation of Deals involve allocation of

cash flow streams, allocation cash flow streams, allocation of risk, and allocation of of risk, and allocation of value between different value between different groupsgroups


Characteristics of Successful DealsCharacteristics of Successful Deals SimplicitySimplicity They are robust and organicThey are robust and organic They take into account incentives of all They take into account incentives of all

involved under a variety of circumstancesinvolved under a variety of circumstances They provide mechanisms for communications They provide mechanisms for communications

and interpretationand interpretation They are based primarily on trust rather than They are based primarily on trust rather than

legaleselegalese They do not make it too hard to raise more They do not make it too hard to raise more

capitalcapital


Characteristics of Successful DealsCharacteristics of Successful Deals They match the needs of the user of capital with They match the needs of the user of capital with

the needs of the supplierthe needs of the supplier They reveal information about each partyThey reveal information about each party They are not patently unfairThey are not patently unfair


Lessons Learned:Lessons Learned: Raise money when you don’t need Raise money when you don’t need

itit Learn about the process and how Learn about the process and how

to manage itto manage it Know your relative bargaining Know your relative bargaining

positionposition If all you get is money, you’re not If all you get is money, you’re not

getting muchgetting much Assume the deal will never closeAssume the deal will never close


Lessons Learned:Lessons Learned: Always have a backup source of capitalAlways have a backup source of capital The experts can blow it – sweat the The experts can blow it – sweat the

details yourselfdetails yourself Users of capital are at a disadvantage Users of capital are at a disadvantage

when dealing with suppliers of capitalwhen dealing with suppliers of capital If you are out of cash when looking for If you are out of cash when looking for

capital, suppliers of capital will eat capital, suppliers of capital will eat your lunchyour lunch

Startup entrepreneurs are raising Startup entrepreneurs are raising capital for the first time; suppliers do capital for the first time; suppliers do it for a living.it for a living.


Sand trapsSand trapsLegal Legal

circumferencecircumference


Sand trapsSand traps Attraction to Status Attraction to Status

and Sizeand Size


Sand trapsSand traps Unknown territoryUnknown territory


Sand trapsSand traps Opportunity CostOpportunity Cost Underestimation of other costsUnderestimation of other costs GreedGreed


Sand trapsSand traps Being too anxiousBeing too anxious ImpatienceImpatience Take-the-money-and-run myopiaTake-the-money-and-run myopia

Valuation MethodsValuation Methods

The Venture Capital MethodThe Venture Capital Method Appropriate for investments in a company with Appropriate for investments in a company with

negative cash flow at the time of the investment, negative cash flow at the time of the investment, but which in a number of years is projected to but which in a number of years is projected to generate significant earningsgenerate significant earnings

The Fundamental MethodThe Fundamental Method Simply the present value of the future earnings Simply the present value of the future earnings

streamstream

Valuation MethodsValuation Methods

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

expected cash flowexpected cash flow Discounted Cash FlowDiscounted Cash Flow

Three time periods are defined (1) Years 1-5, (2) Three time periods are defined (1) Years 1-5, (2) Years 6-10, (3) Year 11 to infinityYears 6-10, (3) Year 11 to infinity

Operating assumptions include initial sales, growth Operating assumptions include initial sales, growth rates, EBIAT/sales, and (net fixed assets + rates, EBIAT/sales, and (net fixed assets + operating working capital)/sales; also note operating working capital)/sales; also note relationships and trade-offsrelationships and trade-offs

Exhibit 14.1Exhibit 14.1










Beyond “Just the Money”Beyond “Just the Money”

Critical aspects of the dealCritical aspects of the deal Number, type, and mix of stocks and various features that Number, type, and mix of stocks and various features that

may go with them that affect the investor’s rate of returnmay go with them that affect the investor’s rate of return The amounts and timing of takedowns, conversions, and The amounts and timing of takedowns, conversions, and

the likethe like Interest rate in debt or preferred sharesInterest rate in debt or preferred shares The number of seats, and who actually will represent The number of seats, and who actually will represent

investors, on the board of directorsinvestors, on the board of directors Possible changes in the management team and in the Possible changes in the management team and in the

composition of the board of directorscomposition of the board of directors

Beyond “Just the Money”Beyond “Just the Money”

Critical aspects of the dealCritical aspects of the deal Registration rights for investor’s stockRegistration rights for investor’s stock Right of first refusal granted to the investor on Right of first refusal granted to the investor on

subsequent private or initial public stock offeringssubsequent private or initial public stock offerings Stock vesting schedule and agreementsStock vesting schedule and agreements The payment of legal, accounting, consulting, or The payment of legal, accounting, consulting, or

other fees connected with putting the deal togetherother fees connected with putting the deal together

Burdensome Issues for Burdensome Issues for EntrepreneursEntrepreneurs

Co-sale provisionsCo-sale provisions Ratchet anti-dilution protectionRatchet anti-dilution protection Washout financingWashout financing Forced buyoutForced buyout Demand registration rightsDemand registration rights Piggyback registration rightsPiggyback registration rights Key-person insuranceKey-person insurance

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The Deal: Valuation, Structure & Negotiation Venture Planning Chapter 14 Dowling Fall 2006.

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