Company valuation methods Cassino, May 2nd 2024 Lesson held by Antonio Zangrilli Short presentation of my profile • Antonio Zangrilli • CEO INVENT Srl a seed capital company based in Italy • The company invests in high-tech startups from R&D activities • 25+ investments closed so far • 200+ Business plans assessed with a go-phase rate of 12,5% • 14 startups in portfolio • 3 successful exits and 8 write-offs Definition - Valuation • When buying a company you need to give a value, so, in general, the company valuation is the value that someone pays for it. • If someone pays € 20,000 for 10% of a company the company is worth € 200,000 • The company valuation depends on several factors: The founder and team Intellectually Property Right Customers and current sales Future Revenues Market demand and competition Risks Why to valuate a company? Company valuation is the process of assessing the economic value of a business relating to a period The scope is to estimate the current worth of an organization (or department) The reasons are different but the most important is to provide investors with an initial value to guide the investment process Valuation opposite interests Founder Founder Investors Investors • Founders want to get the highest value Based on future expectations • Investors want the lowest valuation to get the largest gains Based on more current value Valuation is typically in between the two values The valuation method depends on the business development phase Characteristi cs Seed Start-up Early growth Expansion Growth Cash-Flow N.A. Only negative Negative (but decreasing) Positive (fast growing) Positive (Stable growing) Proof of concept (PC) / Product (P) Idea/PC MVP/P P P P Historical data ✗ ✗ Limited ✓ ✓ Forecast data ✗ Limited Limited ✓ ✓ Pre-money /Post-money value Pre-money valuation is the value of a company before receiving an investment Post-money valuation is the value of a company after the investment has been made If the company is worth $5 million after receiving $1 million in funding, then its pre-money worth is $4 million. Business Angels vs Venture Capitals Criteria Business Angels Venture Capitals Typology Persons (Money, Expertise, Etc.) Companies (Investment Funds) Investment phase Seed/Startup Startup/Early Growth Investment size Hundred-Thousands Millions Exit model Sale to VC/Industry IPO / Sale to Industry Valuation Methods Pre-Revenues Valuation Methods Berkus Post-Revenues Valuation Methods Discounted Cash Flow (DCF) Scorecard Comparables Risk Factor Summation Venture Capital Method First Chigago There is no substitute for Experience These methods are guidelines All methods are sensitive to the inputs and assumptions Garbage in and garbage out Most of these methods depend on the valuation for similar startups (in the region, in the sectors, etc.) All depend on market dynamics, demand analysis, supply offering (competition), etc. The Berkus method • Invented by Dave Berkus in 1990, a business angel in the Silicon Valley (California) Up to $0,5 mil. • To determine the pre-money valuation for seed / early-stage startups Up to $0,5 mil. • No need for financial forecasts • Base on 5 categories to which are given a value depending on the local situation and market conditions CRITERIA VA LUAT I ON Idea Value (Reducing product risk) Quality Management Team (Reducing execution risk) Prototype (Reducing tech risk) Up to $0,5 mil. Strategic Relationships (Reducing market risk) Up to $0,5 mil. Product roll-out or sales (reducing production risk) Up to $0,5 mil. Total pre-money valuation Up to $2,5 mil. (or your selected benchmark) The Berkus method: an example • A new startup developing an innovative solution for …… Criteria Comments • The pre-valuation starting point is : € 2.5 mil. Idea Value There is a clear vision of the business (Product, Market, Customer) € 0,20 mil./ € 0,5 Lab tests have been executed with mil. positive feedback The risk is high but there is a market vision Quality Management Team (execution risk) The team is made of people who knows each-other. However, they € 0,30 mil./ € 0,5 are at the first business experience mil. and lack marketing profiles Prototype (Reducing tech risk) The team has developed a prototype which demonstrates the feasibility to move on a final product Strategic Relationships (Reducing market risk) Product roll-out or sales (reducing production risk) Il team sets out strategic relationships which are sufficient in this phase to move on for a future deployment Sales are still missing however production tests has been made and it owns funds to continue the activities for the next period Total pre-money valuation Valuation € 0,30 mil./ €0,5 mil. € 0,40 mil./ €0,5 mil. € 0,10 mil./ €0,5 mil. € 1,30 mil. The Berkus method: Pros and Cons Pros • Quick and does not rely on forecasts Cons • All five areas are the same in terms of importance • Require skill and background to give the right value to each category • Dependent on choosing an appropriate benckmark startup valuation to set the minimum value (USA vs Europe) The scorecard method • The first step is to determine the premoney valuation of a similar business (same sector, same geographical area, same technology, etc.). It is an average value of the same startups in the area. CRITERIA WEIGHT Board, entrepreneur, the management team 25% • Determine the criteria and the weight for each of them Market Size/Opportunity 15% • Develop a scoring system considering the firms’ criteria quality vs other startup. E.g. it goes from 0% up to 150% Technology/Product 10% Marketing/Sales 10% Competition 20% Need for additional financing 10% Others 10% • Multiply the weight with the scores and make the sum • Calculate the company values multiplying the pre-money valuation with the result of the sum The scorecard method: an example • The pre-valuation of ABC Ltd (a similar company) is € 8 mil. • Criteria have been selected • The weight have been assigned • The score goes from 0% up to 150% • The company values is: 0,99 x € 8 mil = € 7,92 mil CRITERIA WEIGHT TARGET COMPANY The management team 25% 150% 0,30 Market Size/Opportunity 15% 100% 0,15 Technology/Produ ct 10% 100% 0,10 Marketing/Sales 10% 80% 0,08 Competition 20% 80% 0,16 Need for additional financing 10% 100% 0,10 Others 10% 100% 0,10 Total 0,99 The scorecard method: Pros and Cons Pros • More areas than the Berkus method • Still relatively easy • Method largely used from Angels investors Cons • Require to know of the area and/or sector • Require skill and background to give the right value to each category • Dependent on choosing an appropriate benchmark startup valuation to set the maximum value (€ 8 Mil. !!??) Risk factor summation method • Begin with an average company’s valuation formulated on similar companies in a region, sector, etc. • Analyse 12 different risk factors for the startup • Weight the risks giving from a very low to a very high range (-2 /+2) • Adjust the company value using the risk weight + 2 Extremely positive add K€ 500 +1 Positive add K€ 250 0 neutral add/minus nothing -1 Negative minus K€ 250 -2 Extremely negative minus K€ 500 R I S K FAC TO R S Risk of the Management Stage of the business Political risk Supply chain or manufacturing risk Sales and marketing risk Capital raising risk Competition risk Risk of Technology Risk of Litigation International risk Risk of Reputation Exit value risk Risk factor summation method: an example R I S K FAC TO R S R I S K R AT I N G A D J U S T M E N T TO P R E M O N E Y VA L U AT I O N Risk of the Management +2 + K€ 500 Stage of the business -1 - K€ 250 Political risk +1 + K€ 250 Supply chain or manufacturing risk 0 - Sales and marketing risk +1 + K€ 250 Capital raising risk 0 - Competition risk -2 - K€ 500 Risk of Technology -1 - K€ 250 Risk of Litigation 0 - International risk 0 - Risk of Reputation 0 - Exit value risk 1 + K€ 250 Total K€ 500 Pre-money valuation = € 2 Mil Pre-money adjusted value = € 1.75 Mil. Risk factor summation method : Pros and Cons Pros • Still relatively easy • Consider more areas Cons • Require skills to assign weights • Dependent on choosing an appropriate benchmark startup valuation to set the maximum value Venture Capital Method • It is used by venture capital investors to determine the ownership stake when investing an amount of capital • The venture capital (VC) method is comprised of six steps: 1. Estimate the exit (Terminal) value of the company 2. Estimate the business return (ROI – Return of Investment) 3. Calculate the Post-money and Pre-Money value 4. Determine the desired ownership value Venture Capital Method: an example 1. Estimate the exit (Terminal) value of the company This can be done considering the value of similar startups or using other method such as the DCF 2. Estimate the business return (ROI – Return of Investment). This is the required return of the VC usually it is 20x at least! 3. Calculate the Post-money and Pre-Money value TV = € 50 Mil. -> post-money -> €50/20X = € 2.5 mil. If the startup is raising € 500 K, the pre-money valuation is € 2.0 Mil. 4. Determine the desired ownership If the VC is investing € 500 K the ownership is 20% of the company (€ 500 K / € 2.5 Mil.) Risk factor summation method : Pros and Cons Pros • Useful for calculating required (or expected) valuations for pre-revenues business • Largely used by VCs Cons • It doesn’t look at aspects of the business (team, traction, technology, etc.) • Depending on choosing an accurate terminal value Discounted Cash Flows (DCF) Method The DCF is used to translate an investment’s value into today’s moneys The DCF-method is based on two main assumptions: 1. The valuation is based on the future performance of the firm measured by future cash-flow generated by the business 2. Cash-flows have a different value over a period of time. Due to uncertainty and risk, the same amount of money has a different value in time “t0” and time “t1” (for instance after 1 year), therefore you need to discount future amounts to compare them Discounted Cash Flow formula € 1.215,51 Discounted Cash Flow € 1.000 € 1.215,51/(1+0,05)4 € 1.000 € 1.157,63/(1+0,05)3 € 1.000 € 1.157,63 € 1.102,50 € 1.102,50/(1+0,05)2 € 1.000 € 1.050/(1+0,05) € 1.050 0 Year 1 (t1) (t0) 𝐷𝐶𝐹 = 𝐶𝐹 Year 2 (t2) Year 3 (t3) Year 4 (t4) € 1.050 € 1.102,50 € 1.157,63 + € 1.215,51 + + = € 4.000 (1 + 5%) 1 + 5% 2 1 + 5% 3 1 + 5% 4 𝐶𝐹 𝐶𝐹𝑛 1 𝐷𝐶𝐹 = (1+𝑟) + 1+𝑟2 2 + ⋯ … . + 1+𝑟 𝑛 = 𝐶𝐹𝑛 𝑛 𝑡=1 1+𝑟 𝑛 = 1 𝑛 𝐶𝐹 X 𝑡=1 𝑛 1+𝑟 𝑛 Where CF = Cash flow ; r= discount rate; discount factor =1/(1+ r)n ; n = time periods from 1 to n Step 1: Create financial projections How to apply the Discounted Cash Flow method? We need to forecast future cash-flows (usually for at least five years) Create a Free Cash flow statement Choose the discount factor (r) Use the DCF to calculate the enterprise value Step 2: Determine the future “free cash flows” Year 1 2 3 4 5 Earning Before Interest and Tax (EBIT) (+) Amortization (-) Taxes Cash Flow from Operations 1.000 € 20 € 50 € 970 € 1.500 € 20 € 75 € 1.445 € 2.000 € 20 € 100 € 1.920 € 2.500 € 20 € 125 € 2.395 € 3.000 € 20 € 150 € 2.870 € (-) Equipment (-) Building (+/-) Loans 200 € - € 100 € 100 € - - € - € 25 € 25 € - € - € 25 € 25 € -€ - € 25 € 120 € - € - € 25 € 25 € 870 € 1.420 € 1.895 € 2.370 € 2.845 € 2 0,76 1.074 € 3 0,66 1.246 € 4 0,57 1.355 € 5 0,50 1.414 € - Cash Flow from investments - Free Cash Flow Discount period Discount factor (r = 15%) Discounted Cash Flow (DCF) Enterprise value ( 5 𝑡=1 𝐷𝐶𝐹𝑛) 1 0,87 757€ - 5.846 € - - Profit & Loss statement INCOME STATEMENT Year 1 Year 2 Year 3 Year 4 Year 5 + Sales (net) Cost of goods sold (Material, direct Labor and - overhead) = GROSS PROFIT Operating Expenses - Selling, Advertising, delivery Expenses General & administrative (Utilities, rental, telephone, insurance, etc.) - R&D - Amortisation - Other = EARNING BEFORE INTEREST AND TAX (EBIT) - Income taxes = NET INCOME 27 Step 3: Determine the discount factor How to choose “r” WACC (Weighted Average Cost of Capital), is the average cost of capital (interest) the company has to pay when is seeking for an investment. WACC expresses, in a single number, the return that investors (bondholders and shareholders) demand to provide the company with capital. The higher is the company risk the higher is the WACC, because investors will want greater returns to compensate the risk. A personal indicator of an investor taking into account his/her expectations of returns Step 4: Consider the Terminal Value /1 • But what about the following years? The business does not terminate in the Y5! • You need to calculate the value for the Free Cash Flows generated in the years thereafter by projecting the one of the 1-5 year-period • You can use the CAGR formula: 1 𝑛 𝑋 𝑡𝑛 𝑋1 -1 Step 4: Consider the Terminal Value /2 Year Earning Before Interest and Tax (EBIT) (+) Amortization (-) Taxes Cash Flow from Operations 1 2 3 4 5 1.000 € 1.500 € 2.000 € 2.500 € 3.000 € 20 € 20 € 20 € 20 € 20 € 50 € - 75 € - 100 € - 125 € - 150 € 970 € 1.445 € 1.920 € 2.395 € 2.870 € 200 € - € - € -€ - € (-) Building - € - € - € - € - € (+/-) Loans 100 € - 25 € - 25 € - 25 € - 25 € 100 € - 25 € - 25 € - 120 € - 25 € (-) Equipment - Cash Flow from investments Free Cash Flow 870 € Discount period 6 7 8 9 10 3.826 € 5.145 € 9.918 € 9.303€ 12.511 € 1.420 € 1.895 € 2.370 € 2.845 € 1 2 3 4 5 5 Discount factor (r = 15%) 0,87 0,76 0,66 0,57 0,50 0,50 Discounted Cash Flow (DCF) 783 € 953 € 1.072 € 1.165 € 1.373 € 18.745 € Enterprise value ( 5 𝑡=1 𝐷𝐶𝐹𝑛 ) + TV 24.591 € DCF EXERCISE ASSUMPTIONS 1. Janus Pharma is a company producing a food supplement useful to fight some diseases (www.lycoprozen.com) 2. 2023 market sales in Italy is 5 billion euro/y and the company share is 0,005% 3. Sales growth rate in the period 2023-2027 is 20% each year 4. EBIT is 50% of sales and it is the same each year 5. Taxation is 10% of EBIT 6. Investment in equipment of 100.000 € in 2024. The amortisation period is of 5 years 7. A loan of 100.000 € is obtained in 2025, with a repayment period of 10 years starting from 2026 A. Calculate the company value using the DCF for the period 2023-2027 using a WACC of 25% B: Calculate the company value using the DCF for the period 2023-2028. For the period 2028-2032 estimate the Free Cash Flow using the CAGR relating to the Free Cash Flow period 2023-2027
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