Early Valuation for Entrepreneurs by John Shumate

John ShumateChief Executive Officer

Equity Valuation PrimerFocus on Early-Stage Companies

Roadmap

Introduction

Context

Early-Stage Funding “Rules of Thumb”

Fundamental Valuation Methodologies

Environment

Historical & Projected Financials

Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts

Final Calculation of Value

Trend Towards Convertible Debt

Seminar Introduction

• Purpose:

• Practical equity funding “rules of thumb”

• Fundamental valuation methodologies

• Current trends in funding

• Context of early-stage companies

• Perspective:

• Early-stage valuation and analytics specialists

• “Real world” perspective with practical focus

Profile

John Shumate – CEO, ValuLogik

ValuLogik (financial services; early-stage)BellaNovus (medical device)Blue Equity (private equity)bCatalyst (incubator)Ethicon – Johnson & Johnson (medical device)

Wharton; B.S. FinanceUniversity of Pennsylvania

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Context: Why Are We Here?

Entrepreneurs

Competitors

Investors

Customers

Next Big Thing

Analyze Value

Focus: Equity Valuation• Variety of different property to value

• Focus on Equity Valuation or deriving the valuation of a company (or some interest in that company)

Security Type ExampleEquity CompanyFixed Income Bonds, Annuities, etc.Derivatives Stock OptionsReal Estate WarehouseCurrencies HKD vs. USD

Take a Step Back: Valuation Purpose• Valuation: Process to establish value for an entire or partial

interest in a company, considering both quantitative and qualitative, tangible and intangible factors

• Context is extremely important

Context ObjectiveSelling Company Maximize ValueIPO Float Successful “Pop”Buy-Side Analysis Minimize PriceSpin Out Fair Market ValueStock Option Strikes Min (Mgmt); Mixed (Shareholders)Litigation Biased ArgumentMediation Fairness Opinion

Real World Use• Many real world applications of core valuation concepts

• Just a few include:

Venture Investment

Stock Options

Initial Public

Offering

Buy-Side Acquisition Merger Sell-Side

Acquisition

Debt Offering

Defense Analysis

Fairness Opinion

“Recap”Divestiture Research

Standards of Value

Fair Market Value

• Standard for most transactions

• Willing buyer, willing seller

Fair Value

• Multiple definitions

• Not as widely used

Strategic/Investment Value

• Value to a specific investor

• Based upon individual needs

• Three core standards of value• Fair Market Value (FMV) is most common standard

• FMV Definition: “The price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

Distribution of Value Perspectives

• Different parties view value of the same entity differently:

Levels of Value

• Resulting levels of value occur• Various discounts/premiums

Keep in Mind• Two key valuation questions:

1. What is the company worth?2. What can/will someone pay?

• Art as well as science• Highly subjective in nature• Purpose, context, and surrounding conditions are key

• Based upon future performance• Past performance is indicator of future performance for

later stage companies• Early-stage, high-growth, and more speculative companies

are forward-looking

Not Always the same

Understanding Future Potential & Risk

• Risk/Return Trade-Off• Risker investments require a higher rate of return• “What percentage return would and investor require?”

If expected return doesn’t justify added risk of moving from A to B, not worth the risk

Core Types of Equity Investments

Common Stock

Preferred Stock

Participating Preferred

Options

Warrants

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



High-Level Drivers• The longer it takes your forecast to get to profitability, the less

you are worth now• Use comparable companies as a guide: what was a

comparable company’s value at profitability?• In some instances, you are worth as much as your potential

(Instagram)• Reputation is important: Jeff Bezos would get a high valuation

for any startup

Early-Stage “Rules of Thumb”• How much money do you need?

• 6 months of runway / 3 experiments/studies• Investors want to see progress/growth in 18 months

• Average early-stage investments/valuations by investor type:

Micro-VC Super Angel Angel Incubator

$2,600,000

$1,500,000

$1,000,000

$400,000 $640,000

$300,000 $100,000 $20,000

Pre-Money Investment

Average Funding by Round• Venture Deal data from January 2013 to May 2014 shows

average funding by round:

Seed Series A Series B Series C Series D

$575,869

$6,488,214

$13,787,932

$21,508,156

$27,486,720

$50,000

$4,490,251

$10,000,000

$16,000,000

$20,000,000

Mean Median

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Environmental Factors

• Variety of external factors set the landscape for valuation

• Each can have considerable impact

IndustryEconomy Structure Other

Economic Impact

• Numerous economic forces can influence value• Example: Increased volatility results in decreased equity values

Industry Impact• Overall industry conditions or competitor performance can

directly influence value• Example: Even when an individual company is performing well,

negative industry trends can have a “drag” effect on value

Structural Impact

• Imposing capital structure can have dramatic effect on a particular class of equity

• Example: Participating preferred can increase “hurdle” for common shares

Preferred Investment

Available for Distribution

Preferred Dividends

Preferred Participation

Common

Sale Price

Impact of Other External Factors

• Countless other qualitative factors can relate directly to a company’s value

• Example: Perceived political risk can increase market uncertainty and decrease values of companies operating in that domain

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Historical Financials• Mature companies focus on past results to predict future

performance• Historical Income Statements (P&L) and Balance Sheets (BS)

are key for this analysis

• Review:• P&L is a flow statement summarizing revenues and

expenses over a period of time (perhaps a year); arriving at net income

• BS is a stock statement summarizing assets and liabilities at a single point in time (perhaps at year-end); arriving at an equity differential

Financial Projections• Problem with historical financial analysis is that it is often

less meaningful for early-stage companies• Early-stage companies are often targeting dramatic future

growth• Valuations must be based on future performance• Critical to have detailed projections• Many early-stage valuations will be based upon a blend of forward-looking projections and market-based comps

Sample Income Statement

Sample Balance Sheet

Financial Ratios• Use financial ratios to examine past and future years• Ideally, key financial ratios should be compared over a period

of several years in order to identify trends• Common Types• Internal Liquidity Ratios• Operating Efficiency Ratios• Operating Profitability Ratios• Business Risk (Operating) Analysis• Financial Risk (Leverage) Analysis• Capital Efficiency Ratios

• Compare with comparable companies

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



• Three core methods for equity valuation:

• Must select the right method(s) of valuation for specific company and purpose

• Not all valuations can be done using the same method

Asset Approach

Income Approach

Market Approach

Valuation Methodologies

Asset Approach

• Considerations:• Difficulty in appraising value of intangible assets like

trademarks, patents, goodwill, etc.• Assets are recorded at historical costs; GAAP principles

were not intended to reflect current value • Only effective for liquidation scenarios• Does not value future potential

TotalAssets

Total Liabilities

Liquidation Value

• Asset Approach examines static value of a company’s assets and liabilities

When to Use Asset Approach• Use Asset Approach when:• A company is distressed and facing liquidation• A company has developed some IP, but has no way to

value it in a contextual manner; there is no business plan or “story to tell” of how it might generate future value

• Asset Approach is not an appropriate approach for most early-stage companies

• Example:

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Market Method Approaches• Market Approach examines other similar companies (“peer

group”) and derives value based upon comparison• Two core sources of comparables:

• Publicly-Traded companies have transactions every day on global stock exchanges

• Private Transactions include larger deals (M&A, PE, etc.)

Publicly-Traded

Companies

Private Market

Transactions

Market Method Sources• Result is relative value based upon key multiples• Most commonly used multiples:• Enterprise Value/Revenue• Enterprise Value/EBITDA

• Both publicly-trade and transaction “comps” rely on publicly available information

• Public companies provide daily trading info via exchanges• Yahoo/Google Finance, Bloomberg, 10k filings

• Transactional data is more difficult to come by• Subscription databases are the best way to get

transactional data (Zephyr, Dealogic, Capital IQ, Factset)

Public Guideline Companies Example

Goo

gle

(GO

OG

) • Market Cap: $379.54B• Enterprise: 332.85B• Revenue: 62.29B• EBITDA: 18.58B• EV/Revenue 5.34x• EV/EBITDA 17.91x• Shares Out. 674.49M• Share Price $562• Beta

1.14 Yaho

o (Y

HO

O) • Market Cap: $34.88B

• Enterprise: 33.59B• Revenue: 4.67B• EBITDA: 887.3M• EV/Revenue 7.19x• EV/EBITDA 37.85x• Shares Out. 1.01B• Share Price $35• Beta

1.12

Transaction Comparisons Example

Medical Devices

Mobile Applications

Market Method Subjectivity• Difficult to find pure comps• Large degree of subjectivity• Must “Know the Story”• Early-stage companies often don’t fit into neat buckets• Similar as possible in terms of operations, stage, and

financials• Must often use a proxy mix for more complex situations

• Example: New mobile app that interacts with surgical equipment to improve efficiency

Selecting Comparables• Merger and Acquisition (M&A) Comps:• Determining the list• Similar in operations and financial aspects (use ratios)• Timing (within the last 2 years is optimal)• Similar size (preferable); can use regression as well• Circumstances around the deal• Market conditions

• Public Company Comps• Similar to M&A criteria• Relevant trading multiples at a point in time

Selecting Comparables• Typically use weighted average of selected comps• Multiply the company’s revenue or EBITDA by the appropriate

comparison multiple

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Income Method• For most early-stage companies, the value is in the future• Income Method used when the earning capacity of the

company is a factor for consideration• Determines value by converting anticipated economic benefit

into a single present value• Three main approaches:

Capitalization Method

Excess Earnings Method

Discounted Cash Flow Method

• Core concept: “A dollar today is worth more than a dollar tomorrow”

• Present value captures value today of future cash flows:

PV = where CF1, CF2, … CFn equals the cash flows in period 1, 2, … n

• This concept is central to all income method calculations

Present Value

Discount Rate Development• Calculating the appropriate discount rate is one of the most

important steps• Two Primary Methods• Build-Up Model• Capital Assets Pricing Model (CAPM)

• Build-Up Method is most intuitive

Build-Up Method

Risk-Free Rate

Equity Risk

Premium

Industry Risk

Premium

Size Risk Premium

Specific Company

Risk Premium

Spec.

Size Risk Premium

Industry Risk Premium

Equity Risk Premium

Risk-Free Rate (U.S. Treasuries)

Build-Up Components• Risk-Free Rate: The rate for U.S. Treasuries; the “safest

investment there is”… at least conventionally• Equity Risk Premium: Premium that common stockholders

require in the public marketplace over investors in long-term government bonds

• Industry Risk Premium: Premium (or discount) measuring the risk of companies in a particular industry to the baseline risk of the overall market

• Size Premium: Premium associated with investing in a company of a similar size (smaller companies have higher premiums)

• Specific Company Risk Premium: Premium for specific company conditions (financial condition, management, ability to raise capital, etc.)

Build-Up Method• Example:

Average Discount Rates

• Typical discount rates by stage:

Capital Asset Pricing Model• Rarely used since you have to know the Beta, which implies

the stock price is known• Can use a modified version by calculating the beta based on

return on equity

Expected Return

Risk Free Rate Beta

Expected Market Return

Risk-Free Rate

• Converts the company’s estimated future income into a single, present value

• Assumes the critical component to the value of the business is its ability to generate future earnings or cash flows

• Assumes steady growth in the future• Capitalization of Earnings

PV =

Capitalization Rate = Discount Rate – Long-Term Growth Rate

Capitalization Method

• Example:

PV =

Capitalization Method Example

Discounted Cash Flow Method (DCF)

• Examines the present value of projected future cash flows, as well as the terminal value at the end of that stream

• Based on unlevered cash flows• Present value is calculated by using a discount rate

PV = where CF1, CF2, … CFn equals the cash flows in period 1, 2, … n

DCF Example

• Discounted Cash Flow Example:

Terminal Value• Value of the business beyond the projections• Two Methods:• Exit Multiple• Values a business as a multiple of a relevant operating

statistic (most common for early-stage company)• Perpetuity Growth• Assumes growth of free cash flow at a constant rate

DCF Considerations• Advantages• Flexible, adaptable analysis• Objective conclusion• Requires scrutiny of key drivers of value• Always obtainable

• Disadvantages• Relies on forecast information• Based on numerous assumptions• Highly sensitive to changes in assumptions

Excess Earning Method• Used as a last resort when no other methods are applicable• Hybrid of the asset and income approaches as it involves the

determination of the portion of the earnings that may be attributed separately to the tangible and intangible assets of the company

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Calculating Enterprise Value• Example EV Calculation:

• Adjustments for cash and long-term debt

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Value Allocation• Once the value of the company has been established, must

allocate value to various classes of shares• Three Methods:

Current Value Method

Probability Weighted Expected Returns

Method

Option Pricing Method

Current Value Method• Waterfall analysis, which allocates a company’s enterprise

value to each cascading level of stock, based upon liquidation preference or conversion value

• Best used when:• Liquidity event is imminent• One class of equity outstanding• Inception-stage of development with no material progress

on business plan; no reasonable basis for projections

Probability Weighted Expected Returns Method• Probability Weighted Expected Returns Method (PWERM)

considers multiple exit scenarios• Weighs the respective values based upon their probability of

occurrence • Difficulty to apply due to the significant level of subjectivity• Example:

Option Pricing Method• Option Pricing Method (OPM) is a method for allocating

equity value between common and preferred shares• Most commonly used allocation method• Relies on Black-Scholes Model, a methodology for

determining the contingent future value of stock and options• Five assumptions required

1. Underlying company value at the time of valuation2. Strike price or the price at which the underlying stock will

be purchased in the future3. Risk free rate for the period4. Time to expiration/likely liquidity horizon5. The volatility of the shares

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Discounts to Common Shares• Discount for Lack of Control (DLOC)• Individual share is worth less if it is not part of a

majority block with voting control• Both historical and industry-specific data is

available• Typical DLOC is 25%-30%

• Discount for Lack of Marketability (DLOM)• Individual share in private company is worth

less if you cannot sell it on an exchange• Restricted stock studies and pre-IPO studies

available• Typical DLOM is 30%-35%

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Final Calculation of Value• After the discounts have been applied, you are left with the

final calculation of value for a single share of common stock• FMV is typically 30%-50% of the valuation of the preliminary

common share price

Roadmap

Introduction

Context



Environment


Asset Approach

Market Approach

Income Approach

Enterprise Value

Value Allocation

Discounts



Convertible Debt• Start-ups have changed to a lean business model; investors

are following suit• Traditional financing is cumbersome, time consuming, and

dated for early raises• Convertible debt model allow cash inflows without having

valuation negotiations • Solves many of the problems with traditional financing

How Does Convertible Debt Work?• Short-term• Converts into equity in the future• Automatically converts into shares of preferred stock at next

equity round • Often converts at a discount to the price of the next round• 15% - 20% is typical discount• Typically used prior to the Series A

Advantages to Convertible Debt• Cheap and fast due to simplified term sheets• Delays formal valuation until later round• Keeps control with the founders• Empowers angel investors in states that require

lender licenses

Next Steps• Contact Information• John’s email: [email protected]

• Find Us on the Web• www.valulogik.com

Early Valuation for Entrepreneurs by John Shumate

Economy & Finance

Transcript of Early Valuation for Entrepreneurs by John Shumate