Startup Financial Engineering
Tutorial
B.W.Stuck
B
WS k
Managing Director
Si l LLake
Signal
k
Outline
Public Markets vs Private Markets
y Valuation Methodologies
y Staging Financing in Tranches
y Equity vs Debt
y Preferred
P f
d SStockk vs Common
C
Stock
S k
y
©2008, Signal Lake Management LLC
2
Public vs Private Markets
Characteristic
Public Market
Private Market
Number
N
b off buyers
b
and
d
sellers
Milli
Millions
T
Tens
Information available
Large amount of publicly Relatively small amount
available information
of privately held
information
Investor characteristics
Small number of very
sophisticated
p
investors;;
large number of
relatively
unsophisticated
i
investors
t
Small number of very
sophisticated
p
investors
Investment Valuation
Highly efficient and
systematic
Highly inefficient and
subjective
©2008, Signal Lake Management LLC
3
Private Equity/Debt Markets
by Stage of Investment
y Friends and family/angel investors
y Venture capital
y Expansion capital
y Working capital
y Mezzanine
y Buyout
y Secondaryy markets
y Cross over funds
©2008, Signal Lake Management LLC
4
Historical Prolog
Prolog—
—Asset Classes
y
Markowitz (1952)
◦ Diversify
Di
if across assett classes
l
◦ Achieve Lower Risk but Lower Reward
y
Illustrative Asset Classes
◦
◦
◦
◦
◦
◦
◦
◦
Public equities
Bonds
Foreign exchange currencies
Real estate
Commodities
Energy
Private equities
Derived Asset Classes (Derivatives)
(
)
©2008, Signal Lake Management LLC
5
Historical Prolog Continued
y
1965-2000
◦
◦
◦
◦
Angel investors—returns
investors returns unknown
Early stage venture capital—60%+ IRR
S&P 500-15% CAGR
All other
h private
i
equity
i returns in
i between
b
venture and
d
S&P 500
◦ Roughly 50 out of 700+ early stage funds returned 50%+
of returns for all funds: 1965-1995
◦ Explosion to 1500 venture funds in 1995-200
y
◦
◦
◦
◦
2000-2008
Angell investors-returns
A
i
unknown
k
Early stage venture capital-0% IRR
S&P 500-15% CAGR
Late stage private equity/buyouts 50%+ IRR
©2008, Signal Lake Management LLC
6
Alternative Investment Choices
Historical 20 year returns for Other Investments
Source:Venture Economics HFRI Equity Hedge index
25.0%
20.0%
22.4%
18.7%
18.7%
16.5%
15.0%
14.9%
13.2%
10.0%
5.0%
0.0%
Seed Funds All Venture
Hedge
F d
Funds
Buyouts
S&P 500
7
NASDAQ
Benchmark VC Returns
300%
250%
200%
150%
100%
50%
0%
1999
1999
1999
Matrix (3.3-5 Battery (3
Average VC Average VC Average VC
Years)
Years)
5 Year
2 Year
1 Year
1999 Early
Stage VC 1
Year
Source: Venture Economics,
Boston Globe, Signal Lake Analysis
©2008, Signal Lake Management LLC
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Long Return Superior Returns for Early
S
Stage
Funds
F d
Average Annualized 5 Year VC Return
Average Annualized 10 Year VC Return
60%
40%
35%
50%
+38%
+124%
+22%
30%
+36%
40%
25%
30%
20%
55.1%
20%
15%
40.0%
24.6%
34.5%
10%
28.4%
25.4%
10%
5%
0%
0%
Average
Early Stage
Average
Late Stage
Early Stage
Late Stage
Average Annualized 20 Year VC Return
25%
+20%
20%
+29%
15%
10%
22.4%
5%
18.7%
17.4%
0%
Average
source: Venture Economics 10/16/01
Early Stage
Late Stage
©2008, Signal Lake Management LLC
9
Share of GDP:
Rising over the long term
Telephone and Communications Sectors Share of GDP
3.50%
3.00%
2.50%
2.00%
Communications
(Telephone, Telegraph, Radio, TV) as
% of GDP
1.50%
Telephone and telegraph as % of
GDP
1.00%
0.50%
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
1959
1956
1953
1950
1947
0.00%
©2008, Signal Lake Management LLC
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Fueled By Increasing GDP Per
Capita
Telecommunications Revenues as % of GDP (PPP), 1999
4.50%
4.00%
3.50%
3.00%
2 50%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
-
5 000
5,000
10 000
10,000
15 000
15,000
20 000
20,000
25 000
25,000
30 000
30,000
35 000
35,000
40 000
40,000
GDP Per Capita (purchasing power parity
©2008, Signal Lake Management LLC
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Telecom As Asset Class
y
Demand for telecom grows at 8.5%
◦ Not
N bad,
b d but
b not mid-double
id d bl digits
di i
◦ Of course, new areas will grow much faster
y
Demand
D
d ffor telecom
t l
capital
it l equipment
i
t grows att
14.8%
◦ Overall, this is much higher than for most industries
◦ However, 15% growth versus 50% growth is consistent with
observed 90% public equity decline
◦ Next-generation areas will grow much faster (50%)
y
Internet based services growing at 25%+
◦ Advertising based revenue models—free is the right price point
p
y content priced
p
on pperceived value
◦ Proprietary
y
If so, there’s still opportunity for superior returns
©2008, Signal Lake Management LLC
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Valuation Methodologies
y
Public and private market norms
◦A
Any thing
h out off norm is a flag
fl to a potentiall
investor
y
Discounted cash flows/net ppresent value
◦ Cash flows in each year, discounted to present
◦ Terminal value: 90% of total net present value
y
R i
Ratios
◦ Market cap/revenue: 2X-10X
3X-20X
20X
◦ Market cap/EBITDA: 3X
y
y
Private market valuation norms
Public market surrogates
g
©2008, Signal Lake Management LLC
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Staged Financing
y
Key metric
Total capital required to reach positive cash flow, on a risk adjusted basis
Positive cash flow businesses can raise money on far more favorable terms than negative cash flow
businesses!
Seed or friends/family
y
y
y
Angel/seed funding and/or venture capital
y
y
Series A: launch product/service
◦
◦
y
Series B
y
y
Working capital: components, infrastructure, staffing
Series D
y
y
expansion capital: staff for marketing, sales, support
Series C
y
y
Smallest amount of monies
Lowest price/share-> greatest dilution
Mezzanine financing: within one year of exit
exit, pump up balance sheet
Exit
◦
◦
◦
Merger/acquisition
Initial Public Offering
Shut down/bankruptcy
©2008, Signal Lake Management LLC
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Equity vs Debt
y
Debt: p
principal
p and interest be repaid
p
◦
◦
◦
◦
y
Requires an income stream to repay!
g to a subsequent
q
financingg event
Bridges
Interest/dividend on preferred stock
yp
y senior to equity:
q y control!
Typically
Equity is sunk cost
◦ Control
◦ Fiduciary oversight and responsibility
©2008, Signal Lake Management LLC
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Preferred vs Common Equity
y
Preferred Equity:
q y Typical
yp
Preferences
◦ Liquidation preference: 1X, 2X et al, paid off
before common stock
◦ Dividends
◦ Participating preferred: converts to common
and then participates in returns
◦ Conversion to common
y
Common Equity
◦ Chance to be independently
p
y wealthyy
©2008, Signal Lake Management LLC
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