How to value startups and emerging companies?

Special Study Amit Bapat

Summer 2004

Table of Contents Table of Contents .................................................................................................................................. 2

OVERVIEW ................................................................................................................................................. 3 VALUATION METHODS .......................................................................................................................... 3

NET PRESENT VALUE ................................................................................................................................. 3 Step 3: Calculate NPV .......................................................................................................................... 4

ADJUSTED PRESENT VALUE ....................................................................................................................... 5 COMPARABLES ........................................................................................................................................... 5 VENTURE CAPITAL METHOD...................................................................................................................... 6

Pre-money and post-money valuation............................................................................................................... 6 FIRST CHICAGO METHOD ........................................................................................................................... 6 REAL OPTIONS ........................................................................................................................................... 7 COMPARISON OF VALUATION METHODS .................................................................................................... 8 NON-FINANCIAL CONSIDERATIONS........................................................................................................... 10 STAGES OF INVESTMENT .......................................................................................................................... 10

PROVISIONS OF TERMS SHEETS ....................................................................................................... 11 THE NEGOTIATION PROCESS .................................................................................................................... 11 INVESTMENT INSTRUMENTS ..................................................................................................................... 12

Preferred Stock ................................................................................................................................... 12 Liquidation Preference ....................................................................................................................... 12 Conversion Rights............................................................................................................................... 13 Conversion Rate Adjustments – Anti-dilution ..................................................................................... 13 Redemption ......................................................................................................................................... 14 Common Stock .................................................................................................................................... 14 Convertible Debt................................................................................................................................. 14

PARTICIPATION IN MANAGEMENT OF COMPANY....................................................................................... 15 STOCK PURCHASE AGREEMENT ................................................................................................................ 16

REFERENCES ........................................................................................................................................... 16

Overview Valuation of startup and emerging companies with most having negative cash flow in early stages with significant projected rewards later is very difficult task. Yet investors are confronted frequently with investments whose current value must be estimated in spite of the fact that much of the reward lies in future. This paper will discuss various methods used by investors to value such startups and emerging businesses. The latter half of the paper will discuss negotiation of term sheets and various different terms that are used by investors to ensure a successful investment, maintain value and control of the invested company as much as possible, share some risk with other investors and obtain maximum financial reward if the venture turns out to be a success.

Valuation Methods Following are some of the most commonly used methods for valuation of startup and emerging companies followed by a comparative analysis of the strengths and weaknesses of each method. There are various different approaches to estimating the value of a startup company. Income Approach: Estimating future cash flow that could be taken out of the business without impairing future operations. Most common methods in this approach are: Net Present Value, Equity Cash Flow and Capital Cash Flow (Adjusted Cash Flow being a variation of this method). Market Approach: Estimates the value of a going concern business by comparing to similar firms whose stock is publicly traded. In many cases Market Approach is used as a secondary valuation method to verify the estimates derived from the Income Approach. Asset Approach: valuation based on the firm as a financial option.

Net Present Value The Net Present Value (NPV) is one of the most common methods of cash flow valuation. Following are the steps to calculate NPV.

Step 1: Calculate Cash Flow CF = EBIT * (1-t) + DEPR – CAPEX – dNWC + other Where: CF = free cash flow EBIT = earnings before interest and taxes t = corporate tax rate DEPR = depreciation CAPEX = capital expenditure dNWC = change in net working capital, can be negative other = increase in taxes payable, wages payable etc.

Step 2: Calculate Terminal Value TV = [CF*(1+g)]/(r-g) Where: TV = terminal value CF = cash flow g = growth rate r = discount rate The cash flow and discount rate are nominal values and are not adjusted for inflation. Other common methods calculating terminal value include price-earnings ration, market-to-book value multiples.

Step 3: Calculate NPV NPV = [CF1/(1+r)] + [CF2/(1+r)2] + [CF3/(1+r)3] + … + [CFT/(1+r)T] Discount rate is calculated as: r = (D/V) * rd * (1 – t) + (E/V) * re Where: rd = discount rate for debt re = discount rate for equity t = corporate tax rate D = market value of debt E = market value of equity V = D + E The cost of equity (re) is calculated as: re = rf + B * (rm –rf) where: re = discount rate of equity rf = risk free rate B = beta, or degree of correlation with the market rm = market rate of return on common stock (rm – rf) = market risk premium If the firm is not at its target capital structure, it is necessary to unlever and relever the beta: Bu = Bt * (E/V) = Bt ( E / (E + D)) Where: Bu = unlevered beta Bt = levered beta E = market value of equity D = market value of debt

Adjusted Present Value Adjusted Present Value (APV) method is a variation of the NPV method. When a firm’s capital structure is changing or it has net operating losses (NOL) that can be used to offset taxable income, APV method is used. If a firm has NOLs then its effective tax rate changes over time, as NOLs are carried forward for tax purposes and netted against taxable income. APV accounts for the effect of the firm’s changing tax status by valuing NOLs separately. Thus under APV method, first cash flow are valued ignoring the capital structure. The discount rate used is different than in NPV method as it is assumed that the company is financed totally by equity. This implies that the discount rate should be calculated using unlevered beta. The tax benefits associated with the capital structure are then estimated. The net present value of the tax savings from tax-deductible interest payments is quantified. The interest payments will change over time as debt levels change. By convention the discount rate for this calculation is pre-tax rate of return on debt. This will be lower than cost of equity. NPV of tax deductible interest payment = [I1/(1+r)] + [I2/(1+r)2] + [I3/(1+r)3] + … + [IT/(1+r)T] Where: In = Interest payment in year n r = discount rate (pre-tax rate of return on debt) Finally NOLs available to the company are quantified. The discount rate used to value NOLs is often pre-tax rate on debt. If it is almost certain that NOLs will result in tax benefits risk free rate can also be used as the discount rate. The formula for this calculation is similar to the one presented above for NPV of tax deductible interest payment.

Comparables The comparables method is often used to arrive at a ‘ballpark’ valuation of a firm. First firms that display similar ‘value characteristics’ are selected. These value characteristics include risk, growth rate, capital structure, and the size and timing of cash flows. Often, these value characteristics are driven by other underlying attributes of the company which can be incorporated in a multiple. This valuation method is most useful when all the chosen comparable firms are publicly traded and their capital structure, revenue, profit margins, net profit figures are known. The most common measures used while valuation using this method are:

• P-E Ratio (share price divided by the earnings per share) • Market value of the firm divided by total revenue • Market-to-book ration (Market value of the firm divided by the

shareholder’s equity) • Market Value divided by EBITDA (earnings before interest, taxes,

depreciation and amortization)

An average of these ratios for the chosen comparable firms is calculated and based on that the value of the firm is calculated for each measure. This gives a range of values for the firm based on these measures.

Venture Capital Method This method is commonly applied in the private equity industry. Most private equity investments are characterized by negative cash flows and earnings in the early stages and highly uncertain but potentially substantial future rewards. The VC method accounts for this profile by valuing a company using a multiple, at a time in the future when it is projected to have achieved positive cash flows and earnings. This terminal value is then discounted back to the present value at a typically very high discount rate 40% to 75%. Following formulas are used to calculate the value of the firm and shares issued: Total Terminal Value = PER * Terminal Net Income Final Ownership Required = Required future ownership / Total terminal value = (( 1 + IRR ) years X Investment ) / (PER x Terminal Net Income) % ownership acquired = new shares / (old shares + new shares) Or, new shares issued = (% ownership / (1 - %ownership)) x old shares PER = price-earnings ratio IRR = internal rate of return aka discount rate

Pre-money and post-money valuation Pre-money valuation: The price paid per share in the financing round multiplied by the number of shares outstanding before the financing event Post-money valuation: The price paid per share in the financing round times the number of shares outstanding after the financing event Following formulae can be used to calculate the pre-money and post-money valuations: Post-money valuation = investment / % ownership acquired Pre-money valuation = post-money valuation – new investment Apart from the basic venture capital formula presented here, there are several other variations that take into account various stages of funding like seed funding, startup financing, first-stage financing, second-stage financing, bridge financing and restart financing. The differences in valuation in these different rounds of funding are discussed briefly in a later section.

First Chicago Method The venture capital presented above is successful in many cases, but the discount rate applied embodies many assumptions. Out of this need a variation on the basic venture capital method has evolved that compensates for the fact

that subsequent performance of individual companies does not always match the projections contained in the original plans. This valuation method developed by First Chicago Corp’s venture capital group employs a lower discount rate but applies to an expected cash flow, which is calculated as an average of three possible scenarios, with each scenario weighted according to its perceived probability. Following three scenarios are considered: The success scenario: Under this scenario, the VCs assume that the company will successfully reach IPO stage in 4 to 5 years. In this case the last year (IPO year) cash flow can be calculated as: (accrued dividends) + ((final ownership %) x (terminal value)) Where, accrued dividends are total dividends received on preferred stock in prior years. The Sideways Scenario: In this case the company survives with enough profitability to pay dividends for first few years but never reaches the IPO stage. The Failure Scenario: The company is unsuccessful and the VCs have to recover capital by liquidating the assets of the company. Therefore cash flows under this scenario can vary greatly depending on how the funds were utilized. Once the scenarios are laid out, probability of each scenario is determined. The projected cash flows for each year are multiplied by the probability and a weighted average cash flow for each year is calculated. The expected cash-flow is broken down into expected cash flow from IPO and rest of the expected cash-flow. Thus: (p x (final ownership) x TV) + FV(non-IPO cash flow) = FV(investment) Where, p = IPO probability TV = forecast terminal value Therefore the required final ownership is calculated as: Final ownership = ( FV(investment) – FV(non-IPO cash-flow))/(p x TV)

Real Options Discounted cash flow methods like NPV and APV can be deficient in situations where a manager or investor has flexibility in terms of changing rate of production, defer deployment or abandon a project. These changes affect the value of the firm which can not be measured accurately using discounted cash flow methods. Private equity-backed companies are often characterized by multiple rounds of funding. Venture capitalists use this multi-stage approach to motivate the entrepreneur to perform better and limit their exposure to a particular company. Options analysis in valuing firms as options is a developing area in finance. In this method firms are analyzed like a financial option. There are five variable commonly used in a financial option:

X = exercise price S = stock price T = time to expiration σ = standard deviation of returns on the stock r = time value of money In the firm option, they are interpreted as: X = Present value of expenditures required to undertake a project S = Present value of the expected cash flows generated by the project T = The length of time that the investment decision can be deferred σ = riskiness of the underlying assets r = risk free rate of return Once these variables are know the value of the option can be calculated using Black-Scholes computer model or a call option valuation table. The Black-Scholes formula calculates the price of a call option to be: C = S N(d1) - X e-rT N(d2) where C = price of the call option S = price of the underlying stock X = option exercise price r = risk-free interest rate T = current time until expiration N() = area under the normal curve d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2 d2 = d1 - σ T1/2 Valuation of firms as a financial option is a very new concept and is not yet widely used.

Comparison of Valuation Methods Method Strenghts Weaknesses Comparables • Quick to use

• Simple to understand

• Market based

• Private company comparables may be difficult

• Need to adjust resulting valuation to account for private company’s illiquidity when using public company comparables

NPV • Theoretically Sound

• Cash flows may be difficult to estimate

• Private company comparables can be difficult to find and evaluate

• WACC assumes a constant capital structure and constant effective tax rate

• Typical cash flow profile of startups (negative cash flow in the beginning and uncertain inflows later) is very sensitive to discount and terminal growth rate assumptions

APV • Theoretically

Sound • Suitable in

situations where the capital structure is changing

• Suitable in situations where effective tax rate is changing

• More complicated than NPV

• Some of the same disadvantages as NPV except WACC assumptions

VC Method • Simple to understand

• Quick • Commonly used

• Relies on terminal values derived from other methods

• Oversimplified Asset Option • Theoretically

sound • Overcomes

drawbacks of NPV and APV methods where managers

• Not in common use

• Real world situations may be difficult to reduce to a solvable

have flexibility equation • Limitations of

Black-Scholes model

Non-financial considerations Along with the above valuation methods that mainly rely on financial data, investors also consider following factors while valuing a company:

• Quality of management team • Current state of technology • Current state of companies in similar market • Current market conditions • Size of the market and company’s potential to acquire market share • Track record of entrepreneur; repeat entrepreneurs get better valuation • Distribution of bargaining power between VC and entrepreneur

Investors often include above considerations when they decide on the discount rate when using the venture capital method.

Stages of Investment Seed Financing: is the earliest stage of funding. Investment is small (typically low tens of thousands of dollars) to support an entrepreneur’s exploration of idea. No formal business plan exists, management team may not yet be formed, no feasibility of the project established. In case of an established technology, seed money is used to finance recruitment of key management and writing business plan. Seed investors provide basic business advice, office facilities etc. Discount rates of over 80% are typical. Startup Financing: Commitment of more significant funds to an organization that is prepared to commence operations. The start-up is able to demonstrate a competitive advantage, a prototype product is available in case of a high-tech venture, impressive research staff recruitment in case of a biotech firm, in case of low-tech firms established powerful concept of pre-emption advantages and a superior management. First-Stage Financing: On-going businesses. Not profitable yet but has an established organization, a working product, and some revenues. First-stage funds are usually used to establish first major marketing efforts, and to hire sales and support staff. Sometimes funds are also applied to product enhancements, customizations etc. First stage investors often monitor the staffing levels to make sure they are in line with projected revenues. Discount rates are typically in the range of 40% to 60%. Second-Stage Financing: Typically provided for working capital, fixed asset needs to support the growth of company with active production, sustainable sales

and some profits. Mainly aimed at expansion of a tested contender. In most cased capital invested is used to acquire assets, hence more readily recoverable in event of liquidation. Lower risk than earlier rounds. Typical discount rate range 30% to 50%. Bridge Financing: Intended to carry a company until its IPO. IPO is generally expected in short-term (typically within a year from financing event). Main purpose is to satisfy on-going capital needs. Sometimes bridge investors may apply some or all of the funds to buy out early-stage investors who are anxious to liquidate their holding. Typical discount rate of 20% to 35%. Restart Financing: also known as emergency or sustaining financing, is raised for a troubled firm, at a price significantly below that of previous round. Although the venture is performing well below expectations, the round is priced low enough to offer a high expected rate of return, which may result in substantial dilution of previous investors.

Provisions of terms sheets Purpose of terms sheets for entrepreneurs:

• Build a successful business • Raise enough money to fund the venture • Maintain as much value and control of the company as possible • Get expertise and contacts to grow the company • Share some of the risks with investors • Financial rewards if the venture turns out to be a good one

Purpose of term sheets for VCs: • Maximize financial returns to justify the risk and effort involved • Ensure the firm is using the capital in best possible way • Participate in later rounds of funding if the venture is a success • Eventually achieving liquidity • Building their own reputation

Simple financial instruments like common stock and debt are not designed for high-risk startup businesses to achieve the above purposes for both entrepreneurs and VCs.

The Negotiation Process Negotiation process takes place in three phases:

1. Issuer and investor examine if a sufficient basis exists for a business and financial relationship: business plan evaluation

2. Parties negotiate a term sheet outlining principal terms of investment o Amount of financing o Investment instrument o Timing of investment o Investor’s role in company’s management

o Covenants of the issuer and its founders o Registration rights of the investor o Limitations on dilution o Investor’s right to participate in future financing o Issuer’s obligation to pay investor’s cousel

3. Negotiate and execute required legal documents

Investment Instruments Principal instruments used in venture capital financing are:

• Preferred stock • Convertible debt • Warrants • Common stock

Dividend rights: Though most investors have no interest in ordinary income or distributions from the company, the dividend clauses for preferred stock are simply designed to guarantee that the preferred stock is not disfavored by comparison with the common stock. Liquidation Preference: Liquidation preferences are designed to protect the investor’s economic interests. Liquidation preference protects the investors’ originally invested capital against dilution. Hence liquidation preference provides that on liquidation or change-in-control transactions the preferred investors get money back before anyone else.

Preferred Stock Preferred stock gets higher preference over common stock in the event of a liquidation. Purpose of preferred stock is to:

• Prevent founders from being able to pull out money before they create any real value

• Redemption of preferred stock does not attract capital gain tax as it is just a return of capital

• Limits returns to the founder for modest outcomes – incentives to reach high payoffs

• The extent to which VC wants to encourage the entrepreneur to go for the big payoffs can be controlled by specific choice of security.

Liquidation Preference Nonparticipating or Participating Preferred stock: Nonparticipating preferred stock is preferred stock whose liquidation preference defines the total of what the holder will receive on liquidation (or sale). Participating preferred stock is entitled both to receive its liquidation preference and to receive same thing as common stockholders on an ‘as if converted’ basis. Fully Participating Preferred: Participating preferred stock whose right to get both its preference and a common equivalent share have no upper limit. In most

cases participating preferred stocks have an upper limit. In this system, the investor first receives its liquidation preference, and then gets to share with the common stock until the investor has received, in total, some multiple of the investor’s original investment. Liquidation Preference Multiple: When the stock market sees a sharp drop in valuations, demand rises for liquidation preferences that are a multiple of the original investment. The investor gets back not only its original investment, but also a multiple of its original investment, before the common stock holders get anything.

Conversion Rights Venture investor’s convertible preferred stock typically carries both rights and obligations to convert into common stock. For optional conversion, the investor typically retains the option to convert the preferred stock to common stock at will, except that it is conventional to bar conversion after an investor has demanded redemption of the stock. In case of mandatory conversion, the issuer insists on the right to compel conversion of preferred stock at specified point in time. Typical mandatory conversion points are as follows:

• On IPO at above-price targets: The requisite per-share price is typically 3-5 times

• On Majority conversion: compel conversion of any remaining shares when a majority of originally issued shares of the series has converted

• On merger above price targets: in the event of a merger or sale of the company at or above an agreed-on per-share price.

Conversion Rate Adjustments – Anti-dilution These provisions are included in term sheets to ensure that the economic effect of the conversion is preserved in case of changes in common stocks, such as splits, combinations, recapitalization, and subsequent sales of stock at prices below the price they paid. Typically, investors would like to issue themselves more shares; that is, if someone else is getting a better price than the investors paid, the investors would like to effectively reprice their investment to a new lower price thereby protecting from economic dilution of the later lower priced investment. Full ratchet or weighted average adjustment: Full ratchet anti-dilution provisions provide that the protected investment instrument will effectively be repriced to the same price as any later stock issued at a price below that of the original investment. Weighted average anti-dilution provisions change the conversion price for the instrument in a way that will have only minimal effects if only a few new shares are issued, and that will have progressively larger effects as more and more shares are issued. Adjustment of Option Pool by Board Action: It is common and useful to allow for the board of directors to have power to increase the size of the option pool from which issuances will not trigger dilution, provided the board acts with the affirmative vote of a director elected by the investors. This insures that as the

company grows, option issuances that the board, including the investor’s representative, view as desirable do not inadvertently trigger adjustment in conversion ration. Basic Weighted Average Anti-dilution formula: Weighted average antidilution provision realizes that the actual economic dilution experienced by an investor is a function of how many shares are issued at the dilutive price. New price = ((old value) + (new money))/((old shares) + (new shares)) Old value is a dollar figure derived by valuing the entire company at the old conversion price. Broad-based and Narrow-based weighted averages: broad-based and narrow-based refer to the number of shares included in ‘old shares’ in the fraction. A broad-based weighted average antidilution adjustment typically counts old shares as all outstanding shares, and all shares issuable on exercise of granted options, warrants, and convertible debt. A narrow-based weighted average antidilution adjustment typically counts only issued common shares and issued preferred shares.

Redemption Some preferred stock include either a mandatory or an optional right to cause the preferred stock to be redeemed. Redemption rights are a last resort for an investor because they cannot be exercised unless there is sufficient net worth to do so, after allowance for all debts and all liquidation preferences of any remaining preferred stock. Investors insist on mandatory redemption as a means of rescuing their capital if no other exit path is available.

Common Stock The use of common stock in venture financing is relatively infrequent because it creates problems for both parties. The principal drawback to the investor is that all shares of common stock are identical so the investor has no liquidation preferences, antidilution protections, or governance rights built into the definition of the investor’s equity. The principal drawback to the company is that sale of common stock to investors establishes a market value for the stock that carries over to stock sales or grants to the issuer’s employees. Thus the sale price to employees may be higher than employees can afford to pay or if the stock is sold at a reduced price, employees may be forced to recognize taxable income to the extent of bargain.

Convertible Debt Convertible debt is similar to convertible preferred stock but provides the investor with the security of a debt instrument and more options in managing its investment. Convertible debt is less desirable to the company because:

1. It appears as debt on company’s financial statement

2. absent a subordination agreement the convertible debt is treated as debt by the company’s lenders, suppliers, and creditors and may thereby limit the company’s ability to obtain credit or additional financing

3. it generally requires periodic payments of interest 4. the holder of convertible debt generally retains the right to accelerate the

debt if the issuer defaults in performing specified covenants. The investor’s ability to participate in the company’s management is limited.

Participation in Management of company Venture capital investors require the right to play a significant role in the management of company they are financing as the risk involved is very high. To hedge the high-risk nature of the investment, investors are anxious to monitor and participate in critical management decisions. The extent of investor’s participation varies with operating history of the issuer and the investor’s opinion of the company’s management team. Company’s are generally wary of giving the investors too much control over management issues but typically grant some participation in order to tap the additional skills and value that investors can add to the company. The primary mechanism of participation is representation on the company’s board of directors. It is prudent for the company founders to ensure that major investors are represented on the board. Along with participation in company’s management, investors require the company to abide by many other obligations to protect their investment. Some of the most important obligations are described below. Registration Rights The securities acquired by the investor are restricted securities and, as a consequence, have relatively limited liquidity. A registration right enables the investor to require the issuer to register the investor’s securities for sale to the public pursuant to the Securities Act of 1933. There are two kinds of registration rights: demand registration rights and piggyback registration rights. A demand registration right entitles the holder, on demand, to require the issuer to register the issuer’s securities held by the holder for sale to the public. Although demand registration rights are rarely exercised, the existence of those rights gives the holder significant leverage in dealing with company’s management with respect to the nature and timing of registrations initiated by the company. For that reason, investors in virtually all venture capital financing insist on demand registration rights. A piggyback registration right entitles the investors to require the issuer to use its best efforts to include the investors’ securities in any registration effected by the issuer for its own account or for other shareholders. Thus, the holder ‘piggybacks’ on issuer’s registration. These rights are exercised more frequently than demand rights and, because they arise only when the issuer is already committed to bearing the expense of registration, their exercise is not as expensive or disruptive to the company as the exercise of demand rights. Piggyback rights generally are restricted to proposals for a public offering for

cash on a form of registration statement that permits inclusion of the investors’ securities. Right to maintain percentage investment: Some investors request the right to participate in the purchase of any future shares offered for sale by the issuer to the extent necessary to maintain their percentage interest in the company. First refusal right: Investors may request a right of first refusal with respect to the purchase of any stock subsequently offered for sale by the issuer. Key-Employee Insurance: Investors may require the company to carry key-employee insurance on its principal managers. In some cases investors may insist on the right to require the issuer to repurchase the investors’ shares at fair market value on the death of a key employee, to the extent that insurance provides funds for repurchase. Employee Agreement: In most venture investments, the company must compel its present and future employees to execute a series of agreements designed to protect the company’s interests. The include proprietary rights and confidentiality agreements, and, for employees holding shares of the company, employee stock repurchase agreement.

Stock purchase agreement The principal document in any venture capital financing is the stock purchase agreement, which serves three functions:

1. int includes the basic terms of the venture capital investment 2. through a series of representations and warranties by the company, it

servers as a basic disclosure document 3. it imposes certain conditions on the continued operations of the company

The agreement is generally divided in eight sections: 1. purchase and sale of securities 2. the company’s representations and warranties 3. the investors representation and warranties 4. conditions precedent to the investor’s obligation to close 5. conditions precedent to the company’s obligation to close 6. registration rights accorded the investors 7. covenants of the company 8. miscellaneous general provisions

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