1 Confidential

Basics of valuation

3rd December 2010

R. Natarajan

Chief Operating Officer

Helion Advisors

Confidential2

Agenda

• Misconceptions about valuation

• Fair Value

• Fair value estimation

– Quoted Investments

– Unquoted Investments

• Price of recent investment

• Earnings multiple

• Net Assets

• Discounted Cash flows

• Industry valuation benchmarks

• SFAS 157

• Valuation at different stages

• Regulatory implications

– Startup

– Mid-stage

– Growth

• Valuation

– Linear growth and Non linear growth

• Convertibles is another negotiation tool

• Practical perceptions

• Alignment of interest

• Legal terms makes valuation complicated – Entrepreneurs don’t understand

• Methods of valuation

3 Confidential3

" One hundred thousand lemmings cannot be wrong"

Graffiti

4 Confidential

What is valuation?

Confidential

Its all about perception

5

Rs 1500

Rs 15,000

Rs 50,000

Rs 150,000

Rs 350,000

Confidential

A philosophical basis for Valuation

• Many investors believe that the pursuit of 'true value' based upon financial fundamentals is a fruitless one in markets where prices often seem to have little to do with value

• There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers, and not by anything as prosaic as cash flows or earnings

• Perceptions matter, but they cannot be all the matter.

• Asset prices cannot be justified by merely using the “bigger fool” theory

6

Confidential

Misconceptions about valuation

• Myth 1: A valuation is an objective search for “true” value– Truth 1.1: All valuations are biased. The only questions are how much and in

which direction– Truth 1.2: The direction and magnitude of the bias in your valuation is

directly proportional to who pays you and how much you are paid

• Myth 2.: A good valuation provides a precise estimate of value– Truth 2.1: There are no precise valuations– Truth 2.2: The payoff to valuation is greatest when valuation is least precise

• Myth 3: . The more quantitative a model, the better the valuation– Truth 3.1: One’s understanding of a valuation model is inversely proportional

to the number of inputs required for the model.– Truth 3.2: Simpler valuation models do much better than complex ones

7

Confidential

Fair value

“Valuation is nothing else than arriving at fair value for transacting parties”

“Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between at the measurement date”

– Independent– Knowledgeable about the asset/liability– Able– Willing to transact

8

Confidential

What?

• Business Valuation– Acquisition– Assessment of merger swap ratio– Valuation of business segments– Restructuring– Share purchase/ investment/ fund raising

• Valuation of Intangibles– Brand or trade names– Customer contracts and relationships– Non compete agreements– Software and technology– Intellectual property– Human resources

9

Confidential

Know what we are valuing

• Enterprise value (EV) – the market/ fair value of economic assets

• Equity value – the market/ fair value of the shareholders’ equity, i.e. the market/ fair value of the Enterprise value, once the debt has been reimbursed

• In some circumstances individual tangible (e.g. capital requirement) and/ or intangible (e.g. trademarks, parents, contracts) assets are independently valued

• Certain liabilities may also be required to be valued

10

Confidential

Fair value estimation

• Determine EV of Investee Company using the appropriate valuation methodologies

• Adjust EV for surplus assets, excess/ unrecorded liabilities and other relevant factors

• Make adjustments for any financial instrument ranking ahead of the highest ranking instrument of the Fund in a liquidation scenario that may dilute the Fund’s Investment to derive the Gross Adjusted EV

• Apply an appropriate Marketability Discount to the Gross adjusted EV to derive Net Adjusted EV which is apportioned between the company’s relevant financial instruments according to their ranking

• Allocate the amounts derived according to the Fund’s holding in each financial instrument, representing their FV

11

Confidential

Quoted investments

Estimating value of investments quoted on active stock markets

•At their bid prices on the reporting date

•When bid price is not most representative the most representative point estimate in the bid/ ask spread can be used

•Discount should not be applied to prices quoted on active markets unless there is some legal enforceable restriction which would impact the value realized at the reporting date

•The valuer may consider an option pricing model to value the impact of any restriction on realization

12

Confidential

Unquoted investments

Estimating the Fair value of Unquoted investments– Price of recent investment– Earnings multiple– Net Assets– Discounted Cash flows– Industry valuation benchmarks

•Valuation methods for each investment should be selected separately based on its appropriateness to that particular investment

•Preferred methods to derive FV would be those methods that are entirely based on observable market data rather than based on assumptions

•Where more than one method is appropriate for a specific investment, a combination of methods can be applied or value based on one particular method can be cross checked with values based on other methodologies

13

Confidential

Price of recent investment

• When the investment has been made recently, its cost provides a good indicator of its FV

• In case of recent investment by other investors, price of investment can be taken as the FV

• Also suitable for Start ups, seed stage situations – where there are no current assets, short term future earnings or positive cash flows

• Appropriate for all private equity investments, but only for a limited period post investments in the investee company

• The length of period for which PRI would remain appropriate will depend appropriate will depend on market conditions internal or external environment post investment till the reporting date

• The valuer attempts to assess whether changes or events have occurred subsequent to the date of investment impacting the FV

14

Confidential

Multiples method

• Preferred method of valuation

• Appropriate for an investment in an established business with identifiable stream of maintainable earnings

• Multiple method based on earnings can be used for valuing businesses with positive earnings – P/E ratio, EV/ EBIT and EV/ EBITDA

• However for businesses in development stage and prior to positive earnings being generated, revenue multiple can be used as a basis for valuation

• Similar transactions– Recent transactions involving the sale of similar companies are sometimes used as a frame

of reference to derive a reasonable multiple– Not very popular due to lack of reliable pricing information for the transactions, lack of

reported earnings of private companies

15

Confidential

Net Asset Value Method

• Business whose value derives mainly from the underlying fair value of its assets rather than its earnings, such as property holding companies and investment businesses (including Fund of Funds)

• In the context of private equity – for valuing investments in loss making companies and companies making only marginal level of profits

16

Confidential

Discounted cash flow

• DCF methodology uses the present value of future free cash flows of the underlying business of the investee company by using a appropriate discount factor to derive the FV of the investee company

• In PW context DCF methodology being flexible, can be applied in situations where other methodologies are incapable of addressing. E.g. cases where business is going though a period of great change, turnaround, strategic repositioning or is loss making or it is in its start up stage

• As DCF involves high level of subjectivity, DCF valuations are generally useful as a crosscheck for values estimated under market based methodologies

17

Confidential

Industry Valuation Benchmark

• Industry specific benchmarks are used in specific industries such as certain information technology and service sectors where long term contracts is a key feature

• This method assumes that investors are willing to pay for turnover or market share and the normal profitability of business of similar companies in the industry does not vary much

• Valuation benchmarks includes industry norms such as– ‘Price per subscriber’ – Cable and telecommunication industry– ‘Price per bed’ – Nursing homer operators

• This method is used to derive FV only in limited situations and can be generally used as a sense check for values derived using other methods

18

Confidential

Valuation guidelines and principles

• SFAS 157

• International Private Equity and Venture Capital Valuation guidelines (IPEVC)

• Private Equity Industry Guidelines Group (PEIGG)

“ It is not requirement of accounting principles that these guidelines are followed. However compliance with these accounting principles can be achieved by following the guidelines”

19

Confidential

SFAS 157…

20

Valuation techniques

Market approach - Uses prices and information generated by market transactions involving comparable assets/ liabilities

Income approach - Converts future amounts to a single present discounted amount

Cost approach - Amount currently required to replace service capacity of asset

Preference of approach depends upon relevant circumstances!!

Confidential

SFAS 157

21

Levels of inputs

Level 1: Observable marketprices

Level 2:Observable pricesother than quoted prices

Level 3: Unobservable inputs

Quoted prices for similar assets and liabilities in active markets

Quoted prices for similar assets and liabilities in inactive markets

Observable inputs other thanQuoted prices

Inputs derived from / that can becorroborated by observablemarket data

Entity’s reporting data

Unobservable interest rates in a specified currency (related to foreign currency swaps)

22 Confidential

Enough of theory and bookslet us move to some reality check

Confidential

Valuation at different stages of business

23

Start up Mid Stage Growth

Team Team Performance

Potential Performance Potential

Potential

Confidential

Valuation at different stages of business

24

Linear Growth Non Linear Growth

Confidential

Alignment of interest

• Rachet valuation Vs Fixed valuation• Promoter stake in the company• Skin in the game ??• Exits—alignment of interest between promoter and

Investor• ESOP, Salary issues,

25

26 Confidential

“Convertibles a win-win situation”

27 Confidential

“$50M valuation offered by investor can be expensive than $30M asked by

entrepreneur”

“Understanding the technicalities and other conditions of valuations is

equally important”

Confidential

Regulatory implications

• RBI guidelines – Change from CCI pricing to DCF

• Foreign investor cant buy lesser than Fair market Valuation

• Foreign investor cant sell higher than Fair marker Valuation

• Pricing of the capital instruments that the Indian companies can issue under the FEMA regulations, should be “… decided/determined upfront at the time of issue of such instruments” - Issues related to valuation mismatch?

• Secondary purchase/ sale between non residents is all full of ambiguity around withholding taxes

28

Confidential29

India FocusedTwin opportunity

•Growing domestic market•Global outsourcing

Multi-stage VentureInvestment range from $2 - 10M

Dual focus themes• Indian consumer-services businesses•Technology-powered businesses

Active

Capital

++

**

Helion Ventures … The Journey So Far

Started in June 2006 with $140M fund and raised another fund of $208M in

February 2008

30 Confidential

Thank You