What is Valuation?
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The process of determining what an asset is worth today and at some
later date
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Buyer Dependent
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Stage Dependent
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Market Driven
Subject to the Risks Associated with the Firm
Basis for negotiating private equity investments
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1
Is this one of a series of capital raises or the final one?
An estimate of the future cash flows or proceeds from the sale of assets
held by a business
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Thriving vs. struggling investments, expected or unexpected round
Capital Requirements Dependent
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Early vs. late-stage investments
Company Evolution/Track Record Dependent
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Financial buyers vs. strategic buyers
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Pre-money/post-money analysis
LBO purchase price
Valuation Overview
Valuation
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The Importance of Cash, Cash Flow
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Cash is the lifeblood of any business
Financial reports can misrepresent cash flow
Every modeling assumption impacts cash flow and
projected return on investment
Ultimately a company is worth only as much
as you want to pay for it, though someone
else may want or be able to pay more
Valuation Overview
Deal Analysis Framework
• Market/Industry Analysis
– Secular Trends, Size, Value, Competitors, Five Forces, Strategy,
Technology, Product Quality, Distribution Channels
• Revenue/Growth
• COGS
• Gross Profit
Margin
Trends
Margin
Trends
• Operating Expenses
• EBITDA
• Debt Required, Capital Structure
• Working Capital
Potential Improvements
• CapEx
Projected Needs
• Free Cash Flow
• Ratio Analysis
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Management
Valuation Overview
Pre-Money and Post-Money Value
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Pre-Money/Post Money Valuation
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Lexicon for determining common equity ownership for investors
Establishes a value for the a business
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4
“Value” can either be derived or set prior to a fundraising
Post-Money Valuation
V/(1+r)t
Pre-Money Valuation
Post-Money - Investment
Ownership Fraction
Investment / Post-Money
Many entrepreneurs focus on valuation too much and lose value
because of liquidation preference provisions
Pre-Money / Post-Money Valuation
Early-Stage Investment Scenario
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Early stage investment in a software company
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New investor owns 62.5% of the common stock while founders and/or
original investors own 37.5%
If new stock is redeemable preferred equity plus warrants for 62.5% of
the common stock, then new investors would be able to receive their
principal plus any accrued dividends as well as any multiple of capital
paid from a liquidation preference
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5
Pre-money valuation of $3.0 million
Capital raised of $5.0 million
Post-money valuation of $8.0 million (pre-money + invested capital)
Despite the preferred stock and the fact that the bulk of the proceeds at exit
go to the investors, the post-money valuation is still $8.0 million
Example: Early-Stage Investment
Structure, Valuation and Risk
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Why a $3.0 million pre-money valuation?
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Why use preferred equity?
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Company is expected to run losses for the foreseeable future so value will most likely
be created at some point in the future via an M&A or IPO process
Why would a founder accept such a high level of dilution?
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These securities allow the investor to recover all of the invested capital before
management receives any consideration and the investor earns any meaningful upside
What will drive value at exit?
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Early stage companies tend to lack well defined products, multiple customers,
revenues and profits. Firms tend to be more about ideas and management
Risks include competitive risk, product development risk, market acceptance/customer
adoption risk, execution risk, financing risk
Venture capitalist wants to own a large percentage of the equity because there is a
high risk of dilution in future rounds
Venture capitalist may bring skills, experience and network that will facilitate the
company’s success
May have been the best offer on the table
Example: Early-Stage Investment
Late-Stage Investment Scenario
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Series D investment in a software company
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Pre-money valuation of $48.0 million
Capital raised of $12.0 million
Capital raised in Series A-C: $18.0 million
Post-money valuation of $60.0 million (pre-money + invested capital)
While the Series D represents 40% of the capital raised, the new
investor only has a claim on 20.0% of the common stock while founders
and/or original investors retain a 80.0% interest
The new stock is convertible preferred equity.
Series D Preferred Equity is pari passu with all other preferred stock.
So it will take 40% of the proceeds paid out in a liquidation event that
does not result in a conversion by all investors of their preferred equity
into common stock
Example: Late-Stage Investment
Structure, Valuation and Risk
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Why a $48.0 million pre-money valuation?
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Why would the new investors make this investment without the protection of a
liquidation preference?
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The company has attained a modicum of success. It has a viable product and
customer list. It also expects to become cash-flow positive next year.
The new equity is being used to open up three new sales offices
Management expects to take the company public in 12-18 months
The company’s performance appears to be solid and the likelihood of exiting in the
near future at a favorable valuation is likely. In order to get in the deal, the new
investors had to forgo certain protections
Example: Late-Stage Investment
Valuation Approaches
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Comparables
Venture Capital Method
Net Present Value Method
Adjusted Present Value Method
Real Options Analysis
Valuation Approaches
Comparables
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Look for data on firms with similar value characteristics and
benchmark accordingly
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Investment data, purchase price data
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Look for data on publicly traded firms with the same value
characteristics
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Investment data, purchase price data
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May need to normalize data according to factors such as general
business risk profile, size of business or market, market, revenue or
profitability growth rate, capital structure, stage of company evolution,
etc.
The use of public company “comps” also needs to be viewed with
caution. In addition to the need to normalize according to the factors
listed above, public company valuation are subject to swings in the
capital markets that may be firm specific, but are equally likely to be
sector driven, market driven or caused by some exogenous shock
Comparables
Comparables
Pro’s
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Quick to use
Easy to understand
Commonly used
Market based
Con’s
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Private company
comparables may be
difficult to find
When using public firm
comparables, one
must discount result
because private firms
are illiquid
Easy to fall prey to
mania, market forces
Comparables
Weakness of Comparables
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Based on accounting adjustments and
interpretations, which may not accurately reflect
cash flow
Based on a static result which may not accurately
reflect the past or projected performance
Relying on multiples can shift focus from fair
market value to strategic value
Comparables may be of different scope
Historical transaction multiples may not reflect
current market conditions
Source: Valuation for M&A
Comparables
Venture Capital Method
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Simplified NPV method
Venture deals have negative cash flow for years, then emerge
with substantial earnings
High degree of uncertainty
Value is imbedded in the terminal value
Based on a targeted rate of return
Valuations are based on percentage ownership of common stock
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If the investment is done with a preferred security (which is the norm)
or has a liquidation preference, this will not impact the pre-/postmoney valuation despite the fact that the economics of the deal are
skewed in the VC’s favor
Venture Capital Method
Venture Capital Method
Value = Terminal Value / (1+Target IRR) ^ TYears
Required Final Ownership = Investment Commitment /
Discounted Terminal Value
Required Current Ownership = Required Final Ownership/
((1-Dilution x+1)*(1-Dilution x+2)*(1-Dilution x+3)
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Venture Capital Method
Venture Capital Method
Pro’s
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Simple to understand
Quick to use
Commonly used
Con’s
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Relies on terminal
values derived from
other methods
Terminal value
assumes success
Very rudimentary
Almost no visibility
Subject to market
forces, swings
Venture Capital Method
Net Present Value Method
Cash flow based methodology
CF1 = EBIT1*(1-t) + Dep1 – CapEx1 – DNWC1 + Other
TVT = [CFT*(1+g)]/(r-g)
NPV = [CF1/(1+r)] + [CF2/(1+r)2]+…+[(CFT + TVT)/(1+r)T]
r = (D/(D+E))* rd * (1-t) + (E/(D+E))*re
re = rf + B*(rm - rf)
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NPV Methodology
Net Present Value Method
Pro’s
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Easy to run different
investment scenarios
By assigning probabilities
to each scenario you can
generate E(EV)
Not impacted by distorted
market metrics
Technically sound and
well known within the
investment community
Con’s
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With so many estimates
and assumptions it is
hard to arrive at a
definitive result(s)
Capital structures can
change over the lifetime
of a firm, WACC
assumes it does not
In many instances most
of the value is in driven
by the terminal value
NPV Methodology
Adjusted Present Value Method
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Useful if a firm’s capital structure is changing or
if NOLs can be used to offset taxable income
Useful in LBO transactions where firms seek to
reduce leverage going forward
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NPV method assumes constant effective tax rate
APV looks at cash flows generated by assets and
values the interest based, tax savings separately
APV values NOLs separately
Adjusted NPV
Adjusted Present Value Method
1.
2.
Value cash flows (like NPV) using an unlevered beta
(i.e., all-equity beta)
Estimate tax savings from interest costs
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3.
Value NOLs available to the firm
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Use an NPV calculation
Discount rate is the debt’s nominal interest rate
Discount rate is the debt’s nominal interest rate
If NOLs are certain to be used (over time), discount rate
should be the risk-free rate
Adjusted NPV
Adjusted Present Value Method
Pro’s
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Theoretically sound
Useful in situations
where capital structure
changes (i.e., a typical
leveraged buyout)
Effective when a firm’s
effective tax rate
changes over time
Con’s
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More complicated than
NPV method
Not well known
Hard to arrive at a true
value estimate since
many estimates and
assumptions are used
Bulk of the firm’s value
may be generated by
the terminal value
Adjusted NPV
Real Options Analysis
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NPV and APV don’t work when a manager or
investor has “flexibility”
Private equity deals require multiple rounds
Helps you delay the investment decision, or at
least hold back on putting additional money in
Real Options Analysis
Real Options Analysis
Pro’s
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Theoretically sound
More useful than NPV
and APV methods if
managers or investors
have options
Con’s
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Not well understood or
commonly used
Hard to turn
investment decision
into an option problem
Subject to limitations
of Black-Scholes
Real Options Analysis
Monte Carlo Simulation
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Considers all possible combinations of input variables
so it generates a probability distribution of outcomes
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User set ranges for each assumption, not discrete
observations
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Can determine probability of a “total loss”
Software supports a range of statistical distributions
Output ranges can be defined
Some outcomes can be spurious
Not widely used or well known within private equity
community
Monte Carlo Simulation
Drivers of Value in DCF-based Analysis
• Revenue/Growth
• COGS
• Gross Profit
• Operating Expenses
• EBITDA
• Working Capital
• Capital Expenditures
EBITDA
Chg. In WC
CapEx
Other
FCF
Exit Mult.
Exit Value
Tot. FCF
Discount Rate
Enterprise Value
12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004
$
(600) $
50 $
250 $
650 $
1,000
(100)
(125)
(125)
(150)
(150)
(150)
(250)
(300)
(500)
(800)
$
(850) $
(325) $
(175) $
- $
50
$
$
(850) $
(325) $
(175) $
-
$
$
5.0x
5,000
5,050
15.0%
1,411
• Free Cash Flow
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Valuation Drivers
Valuation
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What is IRR?
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The discount rate at which a project would have zero NPV
A tool for evaluating the performance of a PE transaction
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Companies (and investors) should accept any investment
with any IRR in excess of the opportunity cost of capital
Can get spurious results when there are several sign
changes within the stream of cash flows
The highest IRR’s are usually found in short-lived projects
that require little upfront investment. Unfortunately, few of
these projects (and investment opportunities) exist
Any result can be manipulated, so be careful
Drivers of Returns
Impact of Good Timing and Execution
Returns Assuming $1.25 Million Investment
12/31/1999
12/31/2000 12/31/2001 12/31/2002 12/31/2003
$
(1,250) $
(850) $
(325) $
(175) $
IRR
12/31/2004
$
5,050
16.8%
Returns Assuming Improved Operating Performance
12/31/1999
12/31/2000 12/31/2001 12/31/2002 12/31/2003
$
(1,250) $
(638) $
(244) $
(131) $
250
IRR
12/31/2004
$
5,050
21.6%
Returns Assuming Lower Pre-Money Valuation
12/31/1999
12/31/2000 12/31/2001 12/31/2002 12/31/2003
$
(1,000) $
(638) $
(244) $
(131) $
250
IRR
12/31/2004
$
5,050
25.4%
Returns Assuming Faster Exit at Lower Value
12/31/1999
12/31/2000 12/31/2001 12/31/2002
$
(1,000) $
(638) $
(244) $
4,000
IRR
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12/31/2003
$
-
12/31/2004
$
-
35.6%
Drivers of Returns
What Drives Valuation?
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Historical and Projected Financial Results
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Growth Rate of Underlying Market
Strength of Business Model, Perceived Value of Product or
Underlying Technology
Quality of Management Team
Methodology Employed
Competitive Environment
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Past and future performance are both subject to interpretation
Expectations about future capital requirements
Is lots of money chasing a few “hot deals”
Market Dynamics (particularly with respect to exits)
Monte Carlo Simulation
What Drives Returns?
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Successful Execution of Plan
Continued Growth of Underlying Market, Perceived
Attractiveness of Business Opportunity
Proof of a Defensible Business Model
Timing of Exit (at least for IRR calculation)
Presence of Strategic Buyers, Open Capital Markets
Good Fortune/Luck
Monte Carlo Simulation
Valuation Wrap-Up: Deal Analysis Framework
• Market/Industry Analysis
– Secular Trends, Size, Value, Competitors, Five Forces, Strategy,
Technology, Product Quality, Distribution Channels
• Revenue/Growth
• COGS
• Gross Profit
Margin
Trends
Margin
Trends
• Operating Expenses
• EBITDA
• Debt Required, Capital Structure
• Working Capital
Potential Improvements
• CapEx
Projected Needs
• Free Cash Flow
• Ratio Analysis
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Management
Valuation Wrap-Up