business valuation throughout a business's life cycle, march 11, 2010 (1)

Which Lady Do You See?

“Value, like

beauty, is in

the eye of the

beholder”

Discussion Outline

Basic Business Valuation Principles

Company Life Cycle Analysis

Early-Stage Company Valuation

Venture Capital Method

PWERM

Later-Stage Company Valuation

Questions


Principle of Substitution

“The value of an item tends to be determined

by the cost of acquiring an equally desirable

substitute.”

Basis for the asset-based approach –

assumes that an equally desirable substitute

for the business is to replicate all of the

underlying assets and liabilities of the

business.


Principle of Substitution

Basis for the market approach – assumes

that an equally desirable substitute for the

business is to buy a business with similar

investment characteristics.

Basis for the earnings approach – assumes

that an equally desirable substitute for the

business is a business that has similar

earnings capacity.


Principle of Alternatives

“In any contemplated transaction, each party

has alternatives to consummating the

transaction.”

Buyer = buy, not buy, buy something else.

Seller = sell, not sell, sell to someone else.


Principle of Future Benefits

“Economic value reflects anticipated future

benefits.”

A buyer would not pay more for a business

than the present value of the future benefits

the business is expected to generate.


Definition of Value

Fair Market Value:

“The price at which the property would change hands between

a willing buyer and a willing seller when the former is not under

any compulsion to buy and the latter is not under any

compulsion to sell, both parties having reasonable knowledge

of relevant facts. Court decisions frequently state in addition

that the hypothetical buyer and seller are assumed to be able,

as well as willing, to trade and to be well informed about the

property and concerning the market for such property.”

Revenue Ruling 59-60


Definition of Value

Market Value

“The most probable price that a property should bring in a

competitive and open market under all conditions requisite to a

fair sale, the buyer and seller each acting prudently and

knowledgeably, and assuming the price is not affected by

undue stimulus.”

Uniform Standards of Professional Appraisal Practice


Market Value assumes the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: • Buyer and seller are typically motivated;

• Both parties are well informed or well advised and acting in what they consider their best interests;

• A reasonable time is allowed for exposure in the open market;

• Payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and

• The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.


Seed Start-up Growth Established Expansion Mature Decline

Ente

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se V

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Company Life Cycle


Stage Focus Financing

Seed Proof of concept, prototype, business planning Personal finances, friends, family, customers, grants

Start-up Production, establish customer base Angels, venture capital

Growth Infrastructure - systems, processes, effectiveness Venture capital, mezzanine, private equity

Established Improvement, productivity, efficiency Profits, banks, private equity

Expansion New markets and distribution channels Profits, banks , private equity, IPO

Mature Declining sales and profitability, sustain cash Profits, banks

Exit Valuation, transition planning ESOP, MBO, IPO, strategic sale, bankruptcy


Methods

Stage Data Risk VC DFE CE GLC GPT AB Liq

Seed Soft data, value proposition Extremely high X X

Start-up Validation, time to market High X X

Growth Preliminary revenue, may not be profitable Moderate X X X X

Established Predictable revenue, profitability Low X X X X X

Expansion Historical data, EBITDA, cash flow Moderate X X X X X

Mature Historical data, EBITDA, cash flow High X X X X X X

Exit Historical data, EBITDA, cash flow NA X X X X X X

Early-Stage Company Valuation

Why are Early-Stage Companies Valued?

Financing

Financial and Tax Reporting

Gift and Estate Tax Planning

Management of Intangible Assets

• Internally developed or to-be-purchased intangible

assets for sale or acquisition.

• Royalty rates related to license of patents, etc.

• Purchase price allocation.

Financing - Venture Capital Method

Application of method will differ depending

on stage of development.

Steps:

Estimate future value (FV) of invested capital

of company at proposed exit date.

Seed usually based on a multiple of revenue

Start-up usually based on a multiple of revenue or earnings

Growth usually based on earnings


Determine cost of capital based on risk

assessment (required rate of return).

Venture Economics conducts an annual

study of venture capital rates of return by

fund type over various investment horizons.

Cost of capital generally ranges from 30% to

100% depending on risk assessment.


Factors that affect determination of required

rate of return:

• Management team

• Phase of product development

• Phase of market development

• Revenue phase

• Quality and quantity of data

• Probability of success


Determine present value (PV) of invested

capital, this is the “post-money” value:

PV = FV / (1 + required rate of return)term

Determine the “pre-money” value:

Pre-money value = Post-money value minus

Investment

Determine the ownership fraction:

Ownership fraction = Investment / Post-money value


Determine number of shares to be issued to

investor:

Total number of shares after issuance = Original

number shares outstanding / (1 minus ownership

fraction)

Number of shares to be issued = Total number of

shares after issuance minus original number of

shares outstanding

Determine price of shares:

Investment amount / Number of shares issued


1. Estimate Future Value:

Expected revenue in year of exit 50,000,000$

Times: Revenue multiple 0.6

Future value of invested capital 30,000,000$

2. Determine Cost of Capital (Required Rate of Return):

Required rate of return 50%

Number of years until exit event 5

Discount factor 7.59

3. Determine Post-Money Value:

Future value of invested capital 30,000,000$

Divided by: Discount factor 7.59

Present value of invested capital (Post-money value) 3,952,569$

Venture Capital Method

4. Determine Pre-Money Value:

Present value of invested capital (Post-money value) 3,952,569$

Investment (2,000,000)

Pre-money value 1,952,569$

5. Calculate Ownership Fraction:

Investment 2,000,000$

Divided by: Post-money value 3,952,569

Ownership fraction 50.6%


6. Calculate Number of Share to be Issued:

Original number of shares 2,000,000

Divided by: 1 minus ownership fraction 49.4%

Total number of shares after issuance 4,048,583

Original number of shares (2,000,000)

Number of shares to be issued 2,048,583

7. Calculate Price per Share:

Investment 2,000,000$

Divided by: Number of shares to be issued 2,048,583

Price per share 0.98$


Valuation Assuming Future Dilution

If new stock is issued to later-round investors

or to new key employees, the early-round

investors expect to suffer dilution.

The effect of the dilution can be built into the

method by modeling the effect of the dilution

and adjusting the number of shares issued in

each round.


Valuation Assuming Future Dilution

The ratio of the percent ownership an investor holds at the terminal year of a project to its original percent ownership is that investor’s retention percent.

In order to prevent dilution, the early investor’s ownership percentage should be increased by the ratio of the investor’s original percent ownership times that investor’s retention percent.

Financial/Tax Reporting - PWERM

Probability Weighted Expected Return

Method.

Also known as the scenario method.

Rooted in decision-tree analysis.

Future outcomes are modeled and

probability weighted.


Along with Option Pricing Method (OPM)

and Current Value Method (CVM), PWERM

has become a generally accepted method

for financial and tax reporting purposes.

Accomplishes valuation and allocation of

enterprise value across multiple classes of

stock.


Steps:

Identify possible future outcomes:

• Initial public offering

• Sale or merger

• Continuation as a private company

• Dissolution

Usually the method models both a liquidity

scenario (sale or merger or IPO or both) and

a going-out-of-business scenario

(dissolution).


Estimate future value for each potential

outcome

• Best sources for revenue multiples on early-stage

companies are VentureOne and PitchBook.

• Analysis must consider the need for future

financing and the milestones the company must

pass to achieve various exit events.


Allocate future values to each share class.

• Analysis should consider:

– Dates and types of future events

– Rights and preferences of each class

Discount future values to present value by

class.

• Use risk-adjusted required rate of return for each

class.

• Each class may have a different required rate of

return.


Assign probability to each outcome

• The National Venture Capital Association (NCVA)

tracks statistics on venture capital deals and the

probability of achieving a positive liquidity event by

financing round.

• Based on this research, the probability of achieving

a positive liquidity event for a deal declined from

25% to 40% in 2002 to 2% to 10% in 2009,

depending on the round.


• Based on this research, the probability of:

– Sale or merger - approximately 10%

– IPO - approximately 4%

• 85% of deals do not generate a positive liquidity

event.


Determine enterprise value by summing the

probability-weighted outcomes.

Determine the value per share by dividing

the enterprise value by the number of shares

outstanding.


Facts: Series A Series B Common Total

Valuation Date End of Year 4

Number of shares 3,405,405 1,317,735 2,000,000 6,723,140

Percentage ownership 50.6% 19.6% 29.8% 100.0%

1. Identify Possible Future Outcomes:

Initial Public Offering 5 years

Sell to Private Equity Firm 8 years

Continue as a Private Firm 8 years

Dissolution 8 years


2. Estimated Future Value for Each Potential Outcome:

Initial Public Offering

Revenue of $50,000,000 x MVIC/revenue multiple of 0.60 30,000,000$

Sell to Private Equity Firm

EBITDA of $5,000,000 x MVIC/EBITDA multiple of 7 35,000,000$

Continue as a Private Firm

EBITDA of $5,000,000 x MVIC/EBITDA multiple of 4 20,000,000$

Dissolution 5,000,000$


3. Allocate Future Value to Each Share Class: Series A Series B Common Total

Percentage ownership 50.6% 19.6% 29.8% 100.0%

Future Value:

Initial Public Offering 15,180,000$ 5,880,000$ 8,940,000$ 30,000,000$

Sell to Private Equity Firm 17,710,000 6,860,000 10,430,000 35,000,000

Continue as a Private Firm 10,120,000 3,920,000 5,960,000 20,000,000

Dissolution 2,530,000 980,000 1,490,000 5,000,000


4. Discount Future Value to Present Value: Series A Series B Common Total

Required rate of return 25% 25% 30%

Years until:

Initial Public Offering 1 1 1

All other events 3 3 3

Discount Factor:

Initial Public Offering 125% 125% 130%

All other events 195% 195% 220%

Present Value:

Initial Public Offering 12,144,000$ 4,704,000$ 6,877,000$ 23,725,000$

Sell to Private Equity Firm 9,068,000 3,512,000 4,747,000 17,327,000


Dissolution 1,295,000 502,000 678,000 2,475,000


5. Assign Probability to Each Outcome: Total

Initial Public Offering 10%

Sell to Private Equity Firm 20%

Continue as a Private Firm 65%

Disssolution 5%

6. Determine Enterprise Value and Value per Share: Series A Series B Common Total

Initial Public Offering 1,214,000$ 470,000$ 688,000$ 2,372,000$

Sell to Private Equity Firm 1,814,000 702,000 949,000 3,465,000


Disssolution 65,000 25,000 34,000 124,000

Total enterprise value 6,461,000$ 2,502,000$ 3,434,000$ 12,397,000$

Divided by: Number of shares outstanding 3,405,405 1,317,735 2,000,000 6,723,140

Value per share outstanding 1.90$ 1.90$ 1.72$ 1.84$


Why are Later-Stage Companies Valued?

Exit Planning• Sale to employees (ESOP)

• Sale to management (MBO, stock options)

• Gift/bequest to family members (FLPs)

• Charitable contributions

Financial and Tax Reporting• Purchase price allocation (FASB 141R)

• Goodwill impairment (FASB 142)

• Equity compensation (FASB 123R, 409A)


Use Traditional Valuation Methods

Discounted Future Earnings

Capitalization of Earnings

Guideline Public Companies

Guideline Private Transactions

Adjusted Net Assets

• Going-Concern Mass Assemblage of Assets

• Orderly Disposition Forced Liquidation

business valuation throughout a business's life cycle, march 11, 2010 (1)

Economy & Finance

market approach

willing buyer

present value

willing seller

desirable substitute

hypothetical buyer

open market payment

fair sale