equity in private - american university · • venture capital (vc) and private equity (pe) –...

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FIN 673 Private Equity, Network Economics, and Start-Up Valuation Professor Robert B.H. Hauswald Kogod School of Business, AU 2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 2 Equity in Private From start to end: the valuation challenge good project assessment makes for sound investments tools: moving beyond DCF techniques to options Venture capital (VC) and private equity (PE) industry overview and the art of start-up financing valuation techniques biggest sellers of assets: suppliers of M&A deals The brave new world of start-ups: key concepts network economics and network valuation private equity and optionality

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Page 1: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

FIN 673 Private Equity, Network

Economics, and Start-Up Valuation

Professor Robert B.H. Hauswald

Kogod School of Business, AU

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 2

Equity in Private

• From start to end: the valuation challenge– good project assessment makes for sound investments– tools: moving beyond DCF techniques to options

• Venture capital (VC) and private equity (PE)– industry overview and the art of start-up financing– valuation techniques– biggest sellers of assets: suppliers of M&A deals

• The brave new world of start-ups: key concepts– network economics and network valuation– private equity and optionality

Page 2: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 3

Would You Have Invested?

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 4

Private Equity: Synonyms and Definitions

• Private equity encompasses early finance cycles• From idea to inception: seed money

– the MCI crowd: friends&family– Angel investors: fairy queens or godfathers?

• From inception to viable business– Angel investors: private VCs with sidelines– Venture capital: investing other people’s money

• From survival to success:– Private equity proper: direct institutional investments– IPO – going public: the endgame

Page 3: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 5

Sources of Capital

Seed Start-Up Growth Expansion / Diversification

Family and Angel Investors

Venture Capital

Mezzanine Capital

Public Equity

Corporate Capital

Finance / Leasing Companies

Commercial Banks

Private Debt

Equity Sources Debt Sources

Firm and Capital Lifecycle

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 6

Defining Venture Capital

• All Types of VC’s & Growth Capital– Incubator, Tech Transfer, Seed– Early Stage, First Round– Late Stage, Mezzanine– LBO– Big, small and everything in-between– Specialists to generalists

• Very gray lines between various types of funds• Focus today is on early stage capital

Page 4: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 7

Venture Capital

“The very best job I can think of is a venture capitalist. Not only does it sound great at parties, but you are expected to fail 90% of the time. I mean no disrespect to venture capitalists when I say this, but a hamster could make those kinds of numbers. It’s good work if you can get it.”

Scott Adams (Dilbert Creator)

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 8

VC Investment Objectives

• Per annum compounded rates of returns (holding returns) significantly in excess of public markets

• Diversification: typically 20 independent holdings– various gestation and industries

• Long-term capital gains• Deal flow: 400 opportunities reviewed annually• 4-5 investments / year • Investments with liquidity expectations within 5 to

7 years

Page 5: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 9

Rates of Return (ROR) Sought by Venture Capital Investors

Stage Annual ROR% Typical Expected Holding Period (Years)

Seed and start-up 50 - 100% or more More than 10 First stage 40 - 60% 5 – 10

Second stage 30 - 40% 4 – 7 Expansion 20 - 30% 3 – 5

Bridge and mezzanine 20 - 30% 1 - 3 LBOs 30 - 50% 3 - 5

Turnarounds 50% + 3 - 5

Jeffrey A. Timmons, New Venture Creation, 4th ed., (Irwin: Chicago) 1994, p. 512.

Hurdle Rates for Venture Capital

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 10

Venture Capital Realized RoR

• Based on various studies:– 14% - 92 firms in ‘60s and ‘70s

– 23% - before fees, 100 firms in the ‘60s

– 16% - public fund stock returns from 1959 to 1985

– 27% - 11 firms from 1974 to 1979

– 13.5% - from 1974 to 1989

– 20.7% - from 1987 to 1996

• How are the hurdle rates reconciled with realized rates?

Page 6: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 11

US Private Equity Performance

Source: Venture Economics’ US Private Equity Performance Index (PEPI) 12/31/2004Venture Economics’ Private Equity Performance Index is calculated quarterly from Venture Economics’ Private Equity Performance Database (PEPD). The PEPD tracks the performance of over 1,400 US venture capital and buyout funds formed since 1969 and over 425 European private equity funds formed since 1980.

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 12

The Magic of Venture Capital Returns

• US Venture Capital returns in – 1960-1995 average: 45%

– 1999: 150% (of which 1/3 realized early 2000)

• Returns virtually uncorrelated with stock market– meaning what? how could this be?

• Interesting question: not “Why so much VC now?” but “Why so little VC before?”– what were 19th century’s start-up industries? VCs?

Page 7: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 13

VC and the dot.com Boom

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 14

Median Pre-Money Valuations

Source: Dow Jones VentureOne/Ernst &Young

$16.7

$13.0

$10.0$10.8

$16.0

$25.3

$21.1

$15.5

$12.9

$11.1

$9.3$10.0

$0

$5

$10

$15

$20

$25

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 YTD05

Page 8: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 15

Median Pre-Money Valuations by Round

Source: Dow Jones VentureOne/Ernst &Young

$36

$20

$17$14

$5$6

$2$2$0

$10

$20

$30

$40

3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05

Later Stage Second Round First Round Seed Round

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 16

Value Drivers: Exit Decision

Trade Sale: current target

Success

Failure

Sale, Buy-back, disposal

Write-off

IPO: future target

20-25% of projects generate

bulk of return

Page 9: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 17

Exit and Liquidity Events

Source: Dow Jones VentureOne/Ernst &Young

0% 20% 40% 60% 80% 100%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

IPOs M&As

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 18

M&A Transactions in VC

Source: Dow Jones VentureOne/Ernst &Young

$27.3$23.4

$13.1$10.8

$21.8

$98.1

$43.1

$14.8$12.7

$26.0

$10.1

356

407

338

380402

458

304

253232

197

162

$0

$20

$40

$60

$80

$100

$120

1995 1997 1999 2001 2003 2005

0

150

300

450

Amount Paid ($B) Number of Transactions

Page 10: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 19

Valuing Start-Ups

• What is a start-up entrepreneur?– a twenty-three year old with 12 interactive Java slides?– a fifty-six year old with 75 black&white slides?

• Valuing start-ups depends on the players– some VCs can pull it off, others not– private equity investors implicated: nurture or nature

• The biggest valuation challenge of them all– little information: ideas, promises and opportunities– most important decisions occur down the road– what to fall back on: common sense and intuition?

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 20

Typical 90+ Day VC Funding Process

Referral Contact

Review Business Plan

Term Sheet

Meet CEOVisit Company

Closing More Due Diligence, Documents

Start Due Diligence

Page 11: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 21

Pitching Deal

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 22

Valuation - a VC’s perspective

• Not a science for early stage companies• 51% is not important, covenants are • 3 or 4 companies out of a portfolio of 20 will

provide 75% plus of returns for a VC• Need to see a potential for fabulous upside (100%

+ per annum) • 4 to 5 rounds of capital will be raised prior to exit• Option pool 15% - 20% and must be considered• An average of $25MM will be required prior to

exit

Page 12: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 23

Start-Up Valuation Challenges

• New Technologies may not work– technological uncertainty

• Markets may not develop– demand, competition uncertainties

• The entrepreneur may know more about the idea than anyone else: agency conflicts– asymmetric information– conflicts of interest

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 24

The VC (and PE) Method

• How to value a project/firm with negative CFs?– terminal value calculation: directly related to IPO or

trade sale objective

• The four steps of private equity valuation1. terminal value (TV) estimation often as multiples (of

network penetration measure):

2. discount TV back at hefty target ROE:

3. required final % ownership:

4. retention ratio: subsequent financing and dilution

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 25

• Pre-Money Valuation = $2.5MM, initial investment $1.5MM = post money value = $4MM, therefore Original Investors (OI) own 38%

• Round A: done at $8MM pre money and $4MM is raised and OI’s put in $1MM. OI’s own $3MM based on pre-money value plus $1MM invested, or $4MM total (33%) of the new $12MM post money value.

• Round B: now assume $20MM pre money value and $8MM is raised with the IO’s putting in $1MM. The IO’s now own $6.7MM plus the $1MM invested or $7.7MM of the $28MM post money value, or 28% of the Company.

• Round C: now assume $30MM pre money value and $10MM is raised with the IO’s putting in another $1MM. The IO’s now own $8.4MM plus the $1MM invested or $9.4MM of the $40MM post money value, or 24% of the Company.

• Exit: assuming the best, the company is sold for $125MM, of which the OI’s get $30MM in return for $4.5MM invested over 5 + years. 6.7X cash on cash return or, depending on the exact exit timing, approximately a 30% IRR.

Venture Math

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 26

Private Equity Valuation: TV as Multiples

• Usual suspects fail with new product or industry– DCF techniques (APV and NPV): limited usefulness– real option techniques: plausibility/reality check

• New techniques based on key ratios and multiples: meant to measure network effects– Comparables: similar case used for ballpark valuation;

P/E, market cap/tot rev, market/book– Multiples: cash flow predicted as a multiple of some

underlying number (HMO and members enrolled)– problem: two firms are never completely comparable;

how to adjust for dissimilarities?

Page 14: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 27

Comparable Companies Method

• Group of companies comparable with respect to size, products, – Recent trends and future prospects

• Key ratios are calculated for each company

• Key ratios are averaged for group– Average ratios applied to absolute data for

company of interest

– Indicated market values obtained from each ratio

– Valuation judgments are made

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 28

Financial and High-Tech Comps

• Financial ratios of similar public firms:– Valuation/Sales, Valuation/profits, P/E

– Market value of equity / book value• High-tech ratios of similar public firms:

– Value / Patent

– Value / Customer exposure

– Value / employee

– Value / Ph.D.

Page 15: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 29

• Advantages: common sense approach– Used to value a company not publicly traded

– Marketplace transactions are used

– Widely used in legal cases, fairness evaluation, and opinions

• Limitations: comparability– hard to find companies that are actually comparable

by key criteria

– Ratios may differ widely for comparable companies

– Different ratios may give widely different results

Pros and Cons of Multiples

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 30

Justification for Multiples?

• How to explain quick and dirty multiples valuation: let’s look at start-ups

• Network effects: start-ups attempt to capture the pole position in a network– their value is then a given fraction of the network’s

• Value the network and, by extension, the start-up with respect to users, suppliers, etc.– network participants vs. financial ratios– however, what has to be true about the network for this

approach to work?

Page 16: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 31

Network Industries

• Network Industry = value of any transaction between two parties A and B affected by– size (number of users, lines) and state (“congestion”) of network– integration of A and B into the network: access, switching costs– classic examples: transportation, electricity grid

• Transaction between A and B feeds back into state of the network (market size, congestion)

• Network character of IT-technologies:– compatibility: hardware profiles (e.g. Wintel), – software standards (open and proprietary)– coordination effects, audience, market size (VOIP, email use, Kazaa)– economies of scale, pace of innovation

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 32

Start-ups as Network Industry Plays

• Many high-tech and internet developments imply a technological leadership or monopoly position: – browsers (Netscape), portals (Yahoo!); ISPs (AOL)

• Plumbing: the infrastructure of the goldrush– server markets, routers: (Cisco, Sun)– broadband access (UPC), wireless access (UMTS)

• B2C and B2B: amazon.com, chemx.com– platforms: auctions (ebay, QXL), travel and matching

services (lastminute.com)– financial services: online brokerage, payment systems,

data content

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 33

Cost Structure

• Expensive to produce, cheap to reproduce• High fixed cost (sunk!), low marginal cost• Particular market structures: monopoly

– cost leadership, product differentiation: versioning

• Lock-in and switching costs– Stereos and LPs: Costly switch to CDs

• Systems lock-in: durable complements– Hardware, software, and wetware

– Individual, organizational, and societal

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 34

Network Effects: Metcalfe’s Law

• Value depends on number of users

– a: independent value

– b: benefit from adopting standard

• Positive feedback– Fax (patented in 1843), Internet (1980s)

• Indirect network effects: software

• Research shows that Metcalfe’s Law overstates network value

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 35

Competition in Networks• Entrants’ business plan to capture network

monopoly position, dynamic competition for– speed: time to market, presence, fill out the segment– best solution: reach as many participants as possible

• Prize attributed by aggregate consumer decision– “Winner-takes-all” competition: how long a winner?

• Difference to patent races etc.– uncertainty about final product, market size, market

structure – determination of winner(s)

• What about incumbent/entrant advantages?

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 36

Race to the Top…

• Market attaches premium for early entrants before chances to succeed are sorted out– not necessarily irrational

Page 19: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 37

Valuation Challenges: Art and Science

• Network potential– potential size and growth potential implies total value– good proxies for these quantities?

• Business idea/plan within network– know the competition– how to attack, defend competitive advantage

• Network fallacy: e-conomy– competition is NOT like VHS vs. Betamax – internet is a network of networks: blurry boundary– pole position hard to gain, easy to lose

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 38

Warren Buffet

“If I were a business school professor in finance, I would assign the following final exam: How do you value Internet companies?

And I would fail everyone who did not leave the answer sheet blank.”

Quoted in Rayport, page 294

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 39

Better Tool: Option Analysis

• VC method: arbitrary discount rate selection– 30% to 75%: all risk lumped together– analyze and price the different risks separately

• Private equity and VC are staged investments– typically 2-4 rounds of VC and PE– milestones need to be met

• Price the optionalities directly: compound options– each financing round resolves uncertainty – follow-on investments: call option on firm’s stock– option to abandon, scale back, exit

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 40

The Value of Option to Abandon

• Growth and strategy: “GROW or else…”– perspective: no alternative to maturing quick (Netscape,

Geocities); so look at the converse to price growth!

• Idea: in each financing round, a company valuation is performed to fix VC’s equity stake– ex post, sequence of company valuations allows to back

out implied survival probabilities of project– estimate Present Value of Option to Abandon:

PV(Abandon Option) = Expanded NPV - Passive NPV = PVInv (Unconditional) - PVInv (Stage Fin.)= Expected Savings in Investment

Page 21: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 41

Rates of Return (ROR) Sought by Venture Capital Investors

Stage Annual ROR% Typical Expected Holding Period (Years)

Seed and start-up 50 - 100% or more More than 10 First stage 40 - 60% 5 – 10

Second stage 30 - 40% 4 – 7 Expansion 20 - 30% 3 – 5

Bridge and mezzanine 20 - 30% 1 - 3 LBOs 30 - 50% 3 - 5

Turnarounds 50% + 3 - 5

Jeffrey A. Timmons, New Venture Creation, 4th ed., (Irwin: Chicago) 1994, p. 512.

Hurdle Rates for Venture Capital

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 42

The Value of Option to Abandon:Growth and Survival Simulation

• IP Global Net: now quoted on EASDAQ– realized by U. Hege, HEC and J. van Rijen, Residentie

Investments

– successful start-up with three financing round, over 20 months in 1999/2000 Est. Firm Value Investment Discount rate Seed

V0 = 3.98 I 0 = 1.59 0.5

First round

V1 = 12.08 I 1 = 3.24 0.4

Second round

V2 = 27.43 I 2 = 2.0 0.3

IPO

V3 = 114.75 -- --

Page 22: Equity in Private - American University · • Venture capital (VC) and private equity (PE) – industry overview and the art of start-up financing ... – LBO – Big, small and

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 43

The Value of Option to Abandon

I1, V1

V3

I2, V2

I0, V0

p1

p3

p2

1 - p1

1 - p3

1 - p2

Stop

Stop

Stop

IPO

Recursive values: dt matters mostV1 = d2 p2 ( V2 – I2 ), etc.

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 44

Option to Abandon: Success

• Calculate implied survival probability pi as

Vi-1 = di pi ( Vi – Ii )

di = discount factor: contains all interesting information

• Assume salvage value Li = 0: if recapitalization fails, often very little value left in early rounds

– for IPO clearly unrealistic

• We get: p1 = 68 %, p2 = 66 %, p3 = 31 %

– ex ante success probability was only p1 ·p2 ·p3 = 13 %

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 45

Per Period Success Probabilities

I1, V1

V3

I2, V2

I0, V0

68%

31%

66%

32%

69%

34%

Stop

Stop

Stop

IPO

Recursive values: dt matters mostV1 = d2 p2 ( V2 - I2 ), etc.

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 46

Success: Survival Probabilities• Financial valuation (post money) implies ultimate

survival chance (total ex ante success probability)– t = 0: success probability p1 ·p2 ·p3 = 13 %– t = 1: success probability p2 ·p3 = 20 %– t = 2: success probability p3 = 31 %

• Roughly corresponds to PE/VC rules– increasing success probability p, decreasing r– the higher post money, the lower p: why?

• Final round: success probability understated– alternative would have been trade sale, not abandoning– V2 = d3 (p3 V3 + (1- p3) T3 ): solve for p3

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 47

Option to Abandon: Value

• Risk-neutral pricing: recovery of q from RA r– discount factor contains risk premium information– back out p: recall recovery of RNP in real options

• Value of the Option to Abandon RO = Expected savings in investment costs

RO = d1 ·(1 - p1) ·I1 + d1 ·d2 ·[(1 - p1) + p1 (1 - p2) ] ·I2

= 0.76 + 0.61 = 1.38

Passive NPV = V0 - RO = 3.98 - 1.38 = 2.6

RO / Passive NPV = 1.38 / 2.6 = 53 % (in million EUR)

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 48

Absolute Worst Outcome?

• Hidden information and/or hidden action– the charm of control

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 49

Agency Conflict and Real Options

• Keeping real options in start-up means– adding option value to firm value– but some of those real options are likely to reinforce the

discretion of entrepreneur: agency costs increase

• Trade-off determines optimal degree of optionality– most visible than in exercise of growth options

• The dynamic agency conflicts can be expressed as (real) options of entrepreneur– option to manipulate depth, scope– option to entrench = force continuation

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 50

Firm Value and Real Options

• Explains a trade-off determining optimal degree of optionality

Optionality

Value

Agency CostsOption Value

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 51

Throwing Good Money after Bad

• Stage financing levers optionalities in VC– commitment to pull the plug

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 52

Summary and Outlook

• PE valuation in the information economy– network economics drives rule of thumb methods; and– business plans: raise and spend USD 50m on ads in 4Q

• Return to PE valuation and financial strategy in the context of growth– real options in PE or VC setting: to grow, abandon, exit

• Capital structure: from economics to finance– principles: rooted in the economics of the firm– equity: the currency of the new economy – why?– the curious absence of debt – fact or fiction?

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 53

Appendix AExamples of Network Industries

• Almost by definition, most new industries and products exhibit network characteristics– a fortiori in an information intensive economy

• Examples: competition in technical standards– computers: IBM vs. Control Data, PC vs. Apple– software: languages, compilers, application suites– video: Betamax vs. VHS– mobile phones: technical standards as barrier to entry– network software: Novell, Linux, NT, Netscape– pharmaceuticals: race to the market

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 54

Two Kinds of Networks

• Physical network: direct connection and interaction– Existence of a physical network

• Virtual network– Community of demanders

– Actions affect each other indirectly

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 55

Networks

• Physical– Telegraph, telephone, fax– Trains, roads, airlines– Credit cards– ATMs– Cable TV– Broadcasting– Internet– Paging– Utilities: electric, gas

• Virtual• VHS video users

• Operating systems

• Software users

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 56

Virtual Networks

• No physical or electronic connection• Benefits of increase in size appear in

ancillary and supporting markets– Videotape users: Blockbusters– Recorded music: Hardware makers– Software: User base attracts developers– Operating system: Compatibility issue (This

one is complicated.)

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Network Topologies

Departure Point: A Non-network

Allison

Lesley

JuliannaElizabeth

No network benefits in this configuration (save for the trivial one – people like bigger communities).

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 58

Two Way Switching Network

Star Network with Switching

Allison

Lesley

JuliannaElizabeth AOL/IM

Abel to Baker is not the same as Baker to Abel. This is a two way network.

Bill

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 59

Characteristics of Switching Networks

• True positive network externality in consumption– Usually large economies of scale in production

• Natural monopoly?– Tipping

– Critical mass

– Winner take all?

• Two way communication to and from the switch

• Possible negative network externality: Congestion

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 60

Network Economics

• Analytic foundations: networks lead to – externalities: benefits (more wireless users) and costs

(traffic congestion) for other members– lock-in effects: it is costly to switch – implies what?– value of network depends on its state and members

• Metcalfe’s law (as attributed by George Gilder)– developer of Ethernet and founder of 3Com– if value of participating in a network is proportional to

number of users n, its total value is proportional to n(n – 1) and increases in the square of the number or users

• Valuation of networks by multiples of users!

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 61

Appendix BIP Global Net

• Pricing financial flexibility: the option to financially abandon a project

• Matching financial strategy with business strategy: spot the optionalities– staged development: compound options

– staged financing: why?

• Incentive effects for both parties

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 62

Project Valuation Method 1: Adjust Discount Rates

• The investment decision:– Today: Invest $100

– In one year: get $V (normal distribution, mean =$110)

– T-Bill (riskless) rate = 5%

• Method 1: risk-adjust the discount rate (NIRL)– Risk premium is 5%, so risk-adjusted rate is 10%

– E(V) is the expected value (mean) of V

10010.1

110)( ===r V

VEPV

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 63

Project Valuation Method 2: Adjust Expected Cash Flows

• CEV = Certainty Equivalent Value(indifferent between CEV for sure or V)

• E*(V) = Expected value using risk-adjusted probabilities (p*)

10005.1

105)(* ====−− rr BillTBillT

VECEVPV

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 64

Finding Risk-Adjusted Probabilities

• Go back to the case of the investment project without an option: we know that there are two ways to get the PV:

• So, if we know PV outright, or if we know what rV is, then we can back out the p*’s (basically, we have the same distribution as for V, but with a shift of the mean).

10005.1

105)(*

10.1

110)( =====−rr BillTV

VEVEPV

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 65

Options Valuation: Risk-adjusted Probabilities

• Option means contingency:– quantify uncertainty: probability theory

– adjust probabilities for riskiness: risk-neutral pricing

• An investment problem with an option:– today: Invest $100

– in one year: Max ($105, V) (i.e. can sell facility for $105, or use it)

• Take expected value using risk-adjusted probabilities:

r BillT

VMaxEPV

= )],105([*

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 66

Staged Financing and Discount Rate Selection: Experience?

• Start with risk-adjusted discount rate– “market determined:” private equity investors

determine appropriate r from experience

• Back out risk-adjusted probabilities– use post money valuations and risk-adjusted

discount rates to find implied probabilities

• Pricing the option to refuse funding– same risk-adjusted probabilities to be used

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Per Period Success Probabilities

I1, V1

V3

I2, V2

I0, V0

68%

31%

66%

32%

69%

34%

Stop

Stop

Stop

IPO

Recursive values: dt matters mostV1 = d2 p2 ( V2 - I2 ), etc.

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 68

Success: Survival Probabilities• Financial valuation (post money) implies ultimate

survival chance (total ex ante success probability)– t = 0: success probability p1 ·p2 ·p3 = 13 %– t = 1: success probability p2 ·p3 = 20 %– t = 2: success probability p3 = 31 %

• Roughly corresponds to PE/VC rules– increasing success probability p, decreasing r– the higher post money, the lower p: why?

• Final round: success probability understated– alternative would have been trade sale, not abandoning– V2 = d3 (p3 V3 + (1- p3) T3 ): solve for p3

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 69

Options Valuation: Risk-adjusted Probabilities

• Options means contingency:– quantify uncertainty: probability theory

– adjust probabilities for riskiness: risk-neutral pricing

• An investment problem with an option:– today: Invest $100

– in one year: Max ($105, V) (i.e. can sell facility for $105, or use it)

• Take expected value using risk-adjusted probabilities:

r BillT

VMaxEPV

= )],105([*

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 70

Option to Abandon: Value

• Not risk-neutral pricing but recovery of true p– discount factor contains risk premium information– back out p: recall recovery of RNP in real options

• Value of the Option to Abandon RO = Expected savings in investment costs

RO = d1 ·(1 - p1) ·I1 + d1 ·d2 ·[(1 - p1) + p1 (1 - p2) ] ·I2

= 0.76 + 0.61 = 1.38

Passive NPV = V1 - RO = 3.98 - 1.38 = 2.6

RO / Passive NPV = 1.38 / 2.6 = 53 % (in million EUR)

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Internet Related Start-ups

Red Herring

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 72

Deal Flow by Sector

Source: Dow Jones VentureOne/Ernst &Young

0%

20%

40%

60%

80%

100%

4Q02 2Q03 4Q03 2Q04 4Q04 2Q05 4Q05

Other

Products &Services

IT

Healthcare

24%

58%

16%

26%

16%

26%

54%

15%

64%

5%5%1%

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 73

Equity Investments by Sector

Source: Dow Jones VentureOne/Ernst &Young

0%

20%

40%

60%

80%

100%

4Q02 2Q03 4Q03 2Q04 4Q04 2Q05 4Q05

Other

Products &Services

IT

Healthcare

29%

58%

36%

51%

17%

3%

63%

5%

36%

11%

1%

11%

2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 74

Deal Flow by Round

0%

20%

40%

60%

80%

100%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Restart

Later

Second

First

Seed*32%

*35%

20%

33%

39% 37%

8%

*54%

20%

39%

9% 11%

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2/2/2011 Private Equity and Start-up Valuation © Robert B.H. Hauswald 75

Investment by Round

0%

20%

40%

60%

80%

100%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Restart

Later

Second

First

Seed*43%

25%

31%

9%

*22%

49%

20%

9%

45%

36%

*42%