Introduction to basic issues in entrepreneurial valuation

High Technology EntrepreneurshipProf. Scott Jones

Thanks to David J. Freschman, CPA, Delaware Innovation Fund andMark J. Gundersen, Esq., McCarter & English for contributingSome material used in this presentation.

Disclaimer

DO NOT CONSIDER THIS PRESENTATION TO BE LEGAL OR BUSINESS ADVICE. YOU SHOULD CONSULT A QUALIFIED ATTORNEY AND CPA WHEN MAKING IMPORTANT BUSINESS DECISIONS.

Selecting a Business Entity (what is the legal structure of the Owner’s

Equity?)

• Sole Proprietorship

• General Partnership

• Limited Partnership

• Limited Liability Company *

• Subchapter S Corporation*

• Subchapter C Corporation*

Factors to Consider

• Start-up Economics (Net Operating Losses)– Flow through type (income passed fully to owners)– C Corp. type (income passed as dividends)

• Projected Growth• Source of capital (founders, VCs, etc.)• Exit Strategy• Limited Liability• Employee Incentives• Tax Issues

Prepare Documents

• Business Plan

• Executive Summary

• Brief Venture Pitch

• Elevator speech

• PPM

Wrap-up legal issues

• IP (patents, copyrights, trademarks) & assignments

• NDAs, non-compete in place w/ employees

• Board members- add value

• Consulting agreements (work for hire)

• Web-site, name trademarked

How Do Entrepreneurs Raise Money?

• Sweat Equity (Bootleg)

• SBIR

• Friends, Family, Fools

• Banks

• Savings, 2nd Mortgage, etc.

• Angels

• Venture Capitalists

Small Business Innovation Research

• Federal Agency (DOD, EPA, NSF, NASA, etc.)• Phase I- Evaluate Scientific & Technical merit ($100k)• Phase II- R&D activity- prototype, clinical trials, etc.

($750k)• Phase III- Commercialize- no money but expedited

procurement• Topics vary by agency• For profit company, <500 employee, 51% US owned, PI

must be employee, not employed FT elsewhere• Gov’t gets use royalty free, but recipient gets worldwide

patent rights• 6-18 month funding gap• Can’t hire marketing/sales staff- scientific/R&D only

Angels

• Wealthy individuals

• May be, but not necessarily “accredited investors”

• Typically interested in- some return, philanthropic interest, want to be active

Venture Capital

• Most businesses do not use VC money• Many successful technology startups eventually

use VC money• Typical “Fund”

– 10 year limited partnership– May make 10 to 15 investments– LPs provide capital– VC professionals do the investing– Both share in the carried interest (profit after return of

investment capital to LPs)

The Venture Capital IndustryA Typical Fund

General Partner(VC Firm)

1% of Capital2.5% Mgmt. Fee

20% Carry

Newco A

Newco B

Newco C

Newco N

Megaco A

Bigco B

Hanginginco C

Loserco N

Limited Partners99% of Capital80% Carry

$

$$

Expertise

X

$ $ $

Trading Securities

• Public traded: NYSE, AMEX, NASDAQ– Requires SEC registration– Fees– Must comply w/ Act of ’34 &

requirements of Regulation S-X (17 CFR 210).

– SEC report filing (10Q/K, 8K)– Follow GAAP– Audited Financial Statements

• Private placements– No SEC registration– Generally want to follow

GAAP, no SEC filings– Be careful to follow rules

Private Placement Memorandum

• Mission/objective

• Capitalization & shareholders

• Company & Management (mini Bus plan)

• Financial

• Legal

• Exhibits

Legal issues & Investment Capital

• Impractical for small company to register (cost)• Comply to avoid contingent liability (Right of

rescission)– Section 4(2) exemption

• Sophisticated investors have access to information (i.e., like prospectus), no solicitation- VC fund

– Regulation D- Rules 501-508 Provide “Safe Harbor” • Size of offering, limits to unaccredited investor group size• Accredited Investors• Can’t “advertise” the offering• Provide Information

– Rule 701- Benefit plans or written compensation agreement

Basic Accounting Equation

ASSETS = LIABILITIES + OWNERS EQUITY

Stuff that has future economic benefit: cash, receivables, inventory, patents, equipment, etc. Things I owe to

to other people:payables, tax liabilities,loans, mortgages, etc.

What’s left over is mine.

Like the basic laws of physics, this equation cannot be out of balance.

Valuation Problem

• A = L + OE• Founders put in $100,000 of savings to buy

computer equipment to start company.• 100,000 = 0 + 100,000• Founders get $1,000,000 of venture money to

hire employees & expand sales effort• 1,100,000 = 0 + 1,100,000• How much of the company do the founders

own? The VCs own?

Depends on “valuation”

• It is all subject to negotiation, but a starting point is the “theoretical” VC valuation model:

Ownership % needed =

Required future value of investment

Total terminal value of the investment

VALUATION is NOT the same thing as ASSETS

Required future value of investment = (1 + IRR)n (Io)

Total terminal value of the investment = (P/E)(En)

IRR = VCs required internal rate of returnI0 = Investment at t=0P/E = Price to Earnings ratio for companies in that industryEn = Earnings in terminal year (n) of investment (exit point)

Ownership % needed =

(1 + IRR)n (Io)

(P/E)(En)

(at exit)

Ownership % needed =

Io

Vo + Io

Solve this for “Vo”, to get the pre-money valuation- this is the “value” that the VC gives the founders.

Io

Vo + Io

=(1 + IRR)n (Io)

(P/E)(En)

The following relationship must also hold true:

Number of new shares = To give investors

% ownership required

(1-% ownership required)

Price per Share =

No. of new shares

Amount Invested

* (number of old shares)

Example (continued)

• Assume technology company (P/E around 10.3), early stage investment requiring 35% IRR, expected exit 5 years, projected earnings at 750,000 in 5th year

% = (1 + 0.35)5(1,000,000)

10.3(750,000)

= 58%

Example (continued)

• Founders issued themselves 50,000 shares for the initial investment of $100k, or $2 per share. The new share price is:

No. new shares =.58

(1-.58)

= 69048*50000

Share price = 1,000,000/69048 = $14.48

THIS WAS AN “UP ROUND” FOR THE FOUNDERS!

Other issues

• Type of stock VC’s take is often “convertible preferred stock”- class of stock that has the preferences of debt, but the ownership rights of common stock– Preference in liquidation (perhaps even a multiple)– Dividends accrue if unpaid– Converts to common in an IPO– Has anti-dilution protection

• Usually get board seats

“B” round financing

Suppose that the example company needs $2,000,000 one year later. A second VC fund now joins the first, they each put in half. But the Pre-money value is set at $500,000.

Ownership % needed =

Io

Vo + Io

=

$2,000,000

$500,000+$2,000,000

Ownership % needed = 80%

The VCs will now want 80% of the stock.

Number of new shares = To give investors

% ownership required

(1-% ownership required)

Price per Share =

No. of new shares

Amount Invested

* (number of old shares)

Number of new shares = To give investors

Price per Share =

(.8/.2) * (119048) = 476,192

2,000,000/476,192 = 4.20

This is a “down round” for the original investors.

VCs protect their ownership percentages with Anti-dilution provisions

Preemptive rights: investors maintain their percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds.

Anti-dilution protection: adjusts the investors’ ownership percentages if the company effects a stock split, stock dividend, or recapitalization.

Price protection: adjusts the conversion price at which the preferred stock can be converted into common stock if the company issues stock at a price below the current conversion price of the preferred stock to protect from the risk that the pre-money valuation turns out to be too high.

• A full ratchet adjusts the conversion price to the lowest price at which the company subsequently sells its common stock regardless of the number of shares of common stock the company issues at that price.

• A weighted average ratchet adjusts the conversion price according to a formula that takes into account the lower issue price and the number of shares that the company issues at that price.

(Source: Hutchison and Mason PLLC, Structuring Venture Capital Investment)

VC Ratchet: Receives rights to convert stock based on lowest

subsequent issue priceOriginal capitalization table, or “CAP” Table:

# Shares%Founders 50,000 42Investor A 69,048 58

Suppose 3 months later there is a cash crunch and Grandma comes in for 10,000 shares at $5.00. Obviously A is unhappy because he or she paid $14.48 per share. If this is a VC with a full ratchet clause, A would receive rights to convert based on the lowest subsequent issue price. This is done to protect A’s rights for having taken the initial risk providing the bulk of the capital, and to avoid management from diluting VC’s ownership.

VC RatchetThe ratchet factor is $14.48/$5.00= 2.9 . So A gets rights to

69048*2.9=199,963 shares of common stock (130,915 additional for no additional investment.).

New CAP Table:Before Ratchet After Ratchet# Shares% #Shares %

Founder 50,000 39 50,000 19Investor A 69,048 54 199,963 77Grandma 10,000 7 10,000 4Total 129,048 259,963

Note the ownership dilution came out of the Founder’s share. (Figures shown are fully diluted)