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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
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
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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
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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
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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)
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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
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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
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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?
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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.
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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?
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VC and the dot.com Boom
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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
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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
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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
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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
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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
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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?
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Typical 90+ Day VC Funding Process
Referral Contact
Review Business Plan
Term Sheet
Meet CEOVisit Company
Closing More Due Diligence, Documents
Start Due Diligence
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Pitching Deal
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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
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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
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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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• 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
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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?
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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
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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.
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• 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
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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?
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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
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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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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
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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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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?
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Race to the Top…
• Market attaches premium for early entrants before chances to succeed are sorted out– not necessarily irrational
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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
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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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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
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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
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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
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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 -- --
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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.
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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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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.
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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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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)
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Absolute Worst Outcome?
• Hidden information and/or hidden action– the charm of control
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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
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Firm Value and Real Options
• Explains a trade-off determining optimal degree of optionality
Optionality
Value
Agency CostsOption Value
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Throwing Good Money after Bad
• Stage financing levers optionalities in VC– commitment to pull the plug
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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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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
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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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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
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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).
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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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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
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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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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
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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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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
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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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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([*
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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.
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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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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
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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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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%
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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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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%