AA Early Stage Company Valuation

National Seminar on Corporate Valuation Valuation of Early Stage Companies

April 30, 2014

Leading / Thinking / Performing

Valuation

Transaction

Consulting

Real Estate

Advisory

Fixed Asset

Management

Leading / Thinking / Performing 2

1. Key characteristics of early stage companies

2. Challenges in valuing early stage companies

3. How does a venture capitalist value early stage companies?

4. Dealing with challenges in Valuation

5. Case Studies

Agenda


No history, nascent operations - not yet at the stage of commercial production

Small or no revenues, operating losses; can consume vast amounts of cash

High level of dependence on external sources of funding

Complex shareholding structure with multiple claims on equity

Illiquid investments







5. Case Studies

Agenda



Mostly future

growth

More from

existing assets

than growth

Entirely from

existing assets

Comparable firms None Some, but in

same stage of

growth

Large number of

comparables, at

different stages

Declining number of

comparables, mostly

mature

Revenues/

Earnings

Non-existent or low

revenues/ negative

operating income

Revenues

increasing/

income still

low or negative

Revenue growth

slows/ operating

income still

growing

Operating History

Revenues and

operating income

growth drops off

More comparable

at different stages

Portion from

existing assets/

Growth still

dominates

None Very

limited

Some operating

history

Operating history

can be used in

valuation

Substantial operating

history

Source of Value

$ R

eve

nu

es/ E

arn

ings

Time

Revenues in high

growth/ operating

income also

growing

Entirely future

growth

Start-up or Idea

companies

Rapid Expansion

High Growth

Mature Growth Decline


Ea

rnin

gs

Time

Valley of Death

Angels/

Founders

Venture Capital /

Private Equity

Public Markets

Seed Capital

A

B

C

Early

Stage

Late

Stage

IPO

Secondary

Offerings

PIPE

Distressed Asset funds

2. Who invests in early stage companies? Funding Life Cycle

Strategic Investors






5. Case Studies

Agenda


Detailed Assumptions

Forecast P&L, Balance

Sheet and Cash flows

Computation of

FCFF / FCFE

Estimation of WACC /

Cost of Equity

Valuation

Summary Sensitivity Analysis

Equity

Requirement

Promoter

Dilution

Investor IRR

Requirement

Expected Exit

Valuations

3. How does a venture capitalist value early stage companies? Reviewing business plan and valuation process


Example: Basic VC Formula (1/2)

Consider a VC contemplating an investment of $1.0 mn in a technology company. Assume no further capital requirement through year 5. The company is expected to earn $1.5 mn in year 5, and should be comparable to companies commanding P/E ratio of about 10x.

Further, the VC requires a 25% projected rate of return on a project of this risk. How much equity stake should the VC seek?

3. How does a venture capitalist value early stage companies? Method 1: Basic VC Formula

Fact Summary

Investment

Required IRR

Term

Revenues

Year 5 Net Income

Year 5 P/E Ratio Exit Multiple

$1.0 million

25%

5 years

$0.5 million

$1.5 million

10x

FY

14

FY

15

FY

16

FY

17

FY

18

PE

Investment

PE

exit

Equity

Requirement

$1.0 mn

Promoter

Dilution ? Exit Valuations

10x Net Income

Investor IRR

25%

FY

19


Example: Basic VC Formula (2/2)

The VC must own enough of company in year 5 to realize a 25% annual return on the investment. Thus, at that time his shares must be worth:

Required Future Value of Investment = (Investment) X (1+IRR)^years

= ($1.0 mn) X (1+25%)^5

= $3.05 mn

Now, at that point the company must be worth:

Exit Value of Company = Exit Year Net Income X P/E Ratio

= $1.5 mn X 10

= $15.0 mn

Hence, VC must own: $3.05 / $15.0 = 20.3 percent

3. How does a venture capitalist value early stage companies? Method 1: Basic VC Formula


3. How does a venture capitalist value early stage companies? Method 2: First Chicago Method

Overview

First Chicago approach simply does three different projections: Success, Failure and Survival cases and assigns probability estimates to each

When utilized, the First Chicago method results in a separate valuation and pricing for each of the three outcomes

These are then averaged and the weighted average valuation is determined (weights being the probability assigned to each case)

Let us continue with the same example and see how the analysis differs in this case.


First Chicago Method Example (1/2)

Variables Success Sideways Survival Failure

Base year revenue: $ 0.5 mn $ 0.5 mn $ 0.5 mn

Revenue growth rate from base: 100.0% 50.0% 5.0%

After Tax Profit Margin: 20.0% 10.0% Negative

PE Ratio at Liquidity: *From Comparables etc. (P/E of 10

is long term historical average) 10x 10x N.A.

Projected Liquidation Value @ Year 5 in Failure Scenario: $ 1.0 mn

Discount Rate: 25.0% 25.0% 25.0%

Probability of Each Scenario: 33.3% 33.3% 33.3%



First Chicago Method Example (2/2)

Calculations Success Sideways Survival Failure

Revenue Growth Rate 100% 50% 5%

Revenue Level After 5 Years 16.0 3.8 0.6

Net Income at Liquidity 3.2 0.4 0.0

Value of Company At Liquidity 32.0 4.0 1.0

PV of Company Using Discount 12.0 1.6 0.3

Rate of 25%

33.3% 33.3% 33.3%

Expected PV Of The Company 4.0 0.5 0.1

Under Each Separate Scenario

Expected PV Of The Company 4.6

% Ownership Required in order 1.0 / 4.6 = 21.6%

to Invest $ 1.0mn



3. How does a venture capitalist value early stage companies? Method 3: Scorecard Method

Overview (1/2)

The first step in using the Scorecard Method is to determine the average pre-money valuation of early stage companies in the region and business sector of the subject company.

As one would expect, pre-money valuation varies with the state of the economy and the competitive environment for startup ventures within a region. However, the variation has been remarkably subdued, ranging between $2 million and $ 3 million from 1998 till 2008.

0

1

2

3

4

5

6

7

8

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Me

dia

n P

re-M

on

ey

Va

lua

tio

ns (

$M

n)

Source: Dow Jones VentureSource

Median Pre-Money Valuations by Round Class

First Round

Seed Round



Overview (2/2)

Since our subject company is revenue generating, we will assume that the average pre-money valuation for comparable firms is $3.5 million.

In the next step, the VC compares the subject company to his perception of similar deals, considering factors such as

Strength of the Management Team; Size of the Opportunity; Product/ technology risk, among others.

The subjective rating of factors is typical for investor appraisal of startup ventures.


Continuing with the same example

Multiplying the Sum of Factors (1.080) times the average pre-money valuation of $3.5 million, we arrive at a pre-money valuation for the subject company of about $3.8 million.

Hence, the fund must own: $1 / ($3.8 + $1) = 20.9 percent


Comparison factor Range Weights Company

Rating

Factor

Team/ Management 0-40% 30% 1.25 0.375

Size of Opportunity 0-30% 25% 1.50 0.375

Product/ Technology 0-20% 15% 1.00 0.150

Competition 0-15% 10% 0.80 0.080

Sales partnerships 0-15% 10% 0.80 0.080

Additional investment 0-10% 5% 1.00 0.050

Other factors 0-10% 5% 1.00 0.050

Total 100% 1.080






5. Case Studies

Agenda


Due to the challenges in applying the typical valuation approaches, we need to consider some modified approaches such as:


Method 1:

In-phase Valuation

Method 2:

Real Options

Method 3:

Backsolve Method

For Valuing Businesses For Valuing Shares


Valuation of early stage companies should not be done by valuing the cash flows of the venture all in one step.

Valuation analysis should break down the cash flow forecasts into different development phases and evaluate each phase separately.

As the project/ firm progresses successfully from one phase to the next, the risk (and therefore the return expectation) should decline.

4. Dealing with challenges in Valuation Method 1: In-phase Valuation


Example (1/3)

A startup is launching an ecommerce business which will proceed in two phases Phase 1 Setting up a website - for 3 years with: Initial Investment of $ 50,000 For the first three years, the project will produce $ 10,000 per year

Phase 2 Launch of ecommerce business* after 3 years Investment required $ 800,000 Expected cash flows $ 100,000 growing at 6% till perpetuity

There is a 40% chance that the killer application will be discovered All equity financed

* Contingent on discovery of killer application



Example (2/3): Valuation using traditional DCF method

Risk free rate = 6.0% Total Risk Premium = 16.0% Cost of Equity = 22%


100,000*(1+6%)

10,000 Cash flows 10,000 10,000 100,000 Grow at 6% till

perpetuity

NPV of the Project at the end of 3 years - 800,000 + (22% - 6%)

Present Value of the Overall Project

= -- 137,500

40% * - 137,500 (1+22%)^3

= - 7,210

+ 10,000

(1+22%)^t

= 23,078 +

=

=

40% * - 75,722

Development of

killer application for

$800,000

Net Present Value of the Project = -- $ 57,210 - 7,210 -- 50,000 =

t = 1

3


Example (3/3): Valuation using In-phase method

Risk free rate = 6% Total Risk Premium Phase 1 = 16% Total Risk Premium Phase 2 = 8% Cost of Equity Phase 1 = 22% Cost of Equity Phase 2 = 14%


100,000*(1+6%)

10,000 Cash flows 10,000 10,000 100,000 Grow at 6% till

perpetuity

NPV of the Project at the end of 3 years - 800,000 + (14%-6%)

Present Value of the Project

= 525,000

40% * 525,000 (1+ 22%)^3

= 138,727

+ 10,000

(1+22%)^t

= 23,078 +

=

=

40% * 289,121

Net Present Value of the Project = $ 88,727 = 138,727 -- 50,000

t = 1

3

Development of

killer application for

$800,000


Valuation using Real Options Traditional DCF approach understates the value of early stage companies because: It doesnt take into account the changes in risk over time Doesn't put value to the flexibility provided in investment decision at various phases of an early

stage firm

Looking these companies as a project with embedded real options, removes these drawbacks

The underlying asset in this approach is the present value of the project cash flows and the exercise price is the expected investment to be made, if first phase is successful

Identifying the underlying asset and exercise price are critical to the real options valuation

4. Dealing with challenges in Valuation Method 2: Real Options


Continuing with our earlier example: The Company has an option to make an investment of $ 800,000 for phase 2 project at

the end of phase 1

The required investment of $ 800,000 will be incurred only if one shows that the project phase 1 turns out to be favourable, but will not be incurred otherwise

This flexibility with the management can be valued as a call option with exercise price of $ 800,000

The parameters of this call option are: Strike Price - $ 800,000 Time period 3 years Risk free rate 6% Dividend rate 0% Volatility 60% Value of underlying - $ 730,000 (present value of $ 1,325,000 @ 22% discount rate)

A simple application of the black scholes model suggests that this options value is $266,000




50,000 (1) NPV of Phase 1 10,000 -- =

(1+22%)^t

(2) Option Value at present

Total NPV of the project

= 266,000

=

=

(1) + (2)

$ 239,708

Total Value of the Project:

50,000 23,708 -- = -26,292 =

t = 1

3


Name of the

company

Amount Invested

($mn)

Stake Acquired

(%)

Implied Equity

Value ($mn)?

BabyOye 12 25 48

BankBazaar 13 35 37

FirstCry 15 26 58

TaxiForSure 2.55 31 8

The Beer Cafe 4.6 36 13

Yebhi.com 10 29 34

4. Dealing with challenges in Valuation Some recent VC investments


The Backsolve Method derives the implied equity value for the company from a transaction involving the companys own securities, typically, the preferred stock.

It indicates an equity value that is consistent with the rate of return the investors in the most recent round expected given the degree of marketability of their investment as well as any special rights (e.g., liquidation preferences) accorded to them.

Option Pricing Model

The most common method to apply Backsolve is through the Option Pricing model. This model treats common and preferred stock as call options on the value of the business.

Common stock only has value if the funds available, at the time of a liquidity event (e.g., merger or sale), exceed the preferred liquidation value

In other words common shareholders have the option to buy the underlying asset (the company) at an exercise price equal to the liquidation preference amount.

4. Dealing with challenges in Valuation Method 3: Backsolve Method


Example (1/8)

Company X receives $ 1 mn investment in the form of 100,000 Series A convertible preferred shares. It has 400,000 outstanding common shares. Series A preferred shares are issued with the following terms:

It would appear that the value of the Common Equity is $ 4 mn and overall Equity value is $ 5 mn

Let us assume that the value of the Company is $ 5 mn and apply the Backsolve model to see if this is indeed the case.

Key Facts

No. of shares 100,000

Issued price $10

Liquidation preference $10

Common shares 400,000

Conversion ratio 1, convertible into common at the ratio of one



Example (2/8)

Series A preference share holders (Preferred A) will convert their shares into common shares once the enterprise value is above $5 million.

Before Conversion After Conversion

No. of shares No. of shares

Preferred A 100,000

Common 400,000 500,000

Liquidation Preference $10

Liquidation Preference Value $1,000,000

Preferred A Equity stake 20%

Required Enterprise Value $5,000,000



Example (3/8)

To illustrate graphically, payoff to preferred and common shareholders is shown as below.

Enterprise Value

Payoff to

shareholders

Preferred

Common

Value Allocation

$5,000,000

$5,000,000

$1,000,000

$1,000,000

1st payoff :

100% to

Preferred

2nd payoff :

100% to

Common

3rd payoff : 80%

to Common

And 20% to

Preferred



Example (4/8)

1st option 2nd option 3rd option

Underlying value $5,000,000 $5,000,000 $5,000,000

Exercise Price $0 $1,000,000 $5,000,000

Risk Free Rate 6% 6% 6%

Volatility 50% 50% 50%

Time to liquidity 5 years 5 years 5 years

Results $5,000,000 $4,400,000 $2,700,000

EV EV EV $ 1 m Ex. Price :$ 1 m Ex. Price :$ 5 m Ex. Price :$ 0

Option value Option value Option value

Diagram



Example (5/8)

Based on the option results, value of preferred shares and common share values can be derived.

Enterprise Value

Payoff to

shareholders

$5,000,000

$5,000,000

$1,000,000

$1,000,000

1st payoff : 100% to

Preferred

2nd payoff : 100% to

Common

3rd payoff : 80% to

Common, and 20% to

Preferred


Results $5,000,000 $4,400,000 $2,700,000



Example (6/8)

Preferred shares value is:

= Value of 1st option Value of 2nd option + (Value of 3rd option x 20%)

= $5,000,000 4,400,000 + (2,700,000 * 20%)

= $1,140,000

Since the Preferred shares value is not equal to the amount invested ($ 1 mn), it implies that the value of company is not $ 5 mn.

Using goal seek, we can find out the value of company at which value of Preferred Shares will be $ 1 mn. That value is about $ 3.93 mn.


Results $5,000,000 $4,400,000 $2,700,000



Example (7/8)

Preferred shares value is:

= Value of 1st option Value of 2nd option + (Value of 3rd option x 20%)

= $3,930,000 3,300,000 + 1,850,000 x 20%

= $1,000,000


Underlying Assets $3,930,000 $3,930,000 $3,930,000

Exercise Price $0 $1,000,000 $3,930,000

Risk Free Rate 8% 8% 8%

Volatility 50% 50% 50%

Time to liquidity 5 years 5 years 5 years

Results $3,930,000 $3,300,000 $1,850,000



Example (8/8)

Common shares value is:

Common Stock

= Value of 2nd option Value of 3nd option + (Value of 3rd option x 80%)

= $ 3,300,000 1,850,000 + (1,850,000 x 80%)

= $ 2,930,000

Note that the Common shares value is much lower than the $ 4 mn anticipated earlier.


Results $3,930,000 $3,300,000 $1,850,000







5. Case Studies

Agenda


Overview

Facebook acquired WhatsApp in $19bn deal.

Facebook is making the purchase in a mix of cash and stock. WhatsApp will receive:

$4bn in cash

$12bn in Facebook shares and an additional $3bn in restricted shares that will be paid out to executives at a later date > Large consideration is in form of stock!

5. Case Studies Facebook buys WhatsApp (1/2)

Key numbers WhatsApp

450 Mn Number of people using the service each month

70% Proportion of those users active on a given day

1 Mn New registered users per day

19 Bn Messages sent via WhatsApp each day


Comparison

Considerations

Is the market over estimating the value of users at social media companies across the board? As social media companies move up the life cycle, the variable(s) that traders user to price

companies will change from number of users/ user intensity to revenues, earnings and cash flows.

The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another.

5. Case Studies Facebook buys WhatsApp (2/2)

Market Cap $160 Bn Deal Value $ 19 Bn $ 4 Bn (cash paid)

Daily Active Users 802 Mn Daily Active Users 315 Mn 315 Mn

Value/ Active User $ 200 Value/ Active User $ 60 $ 12 (cash paid/ user)


5. Case Studies A renewable energy company

Overview

Dispute between two promoters. One promoter decided to exit and demanded USD 12.5 per share for his stake (latest round of funding had taken place at USD

12.5 per share).

Dispute went to court and American Appraisal was appointed to determine fair value of exiting promoters shares.

Solution

American Appraisal reasoned that since recent round of funding was in the form of preference shares, it could not be used as a benchmark for valuing common

equity

Instead, valuation of the equity shares was carried out using the Backsolve method, which indicated a fair value of ~ USD 5 per share for common equity.

The Court ruled in favor of our client, with the final concluded share price being very close to the value implied by the Backsolve method.


Valuation / Transaction Consulting / Strategy

American Appraisal

B-204, Citipoint,

Andheri-Kurla Road

J.B. Nagar

Mumbai, India

www.american-appraisal.co.in

Varun Gupta Managing Director American Appraisal India

Mobile: +91 9967664231

Office: +91 (0) 22 6623 1000

[email protected]

AA Early Stage Company Valuation

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