valuation methodologies for pe fund managers - presentation

Private and Confidential

Private Equity Workshop

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1Private and Confidential Not for Circulation

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Corporate Bridge Academy

Discussion Topics

Valuations

Pre-Money Valuation

Post-Money Valuation

Factors that impact valuation

Valuation Approach

Recent Transactions

Public Comparables

Discounted Cash Flow

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Private and Confidential Not for Circulation 2

Investor-Return

Valuation Triangulation

Summary

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Valuations

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3Private and Confidential Not for CirculationPrivate and Confidential Not for Circulation

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Valuations

Pre-Money Valuation

Value of company before equity investment is made. This figure is determined via a negotiation between investors and the company

Post-Money Valuation

Value of company after the equity investment has been made. Equal to pre-money value + the amount of equity invested

Valuation Approach

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Recent transactions

Publicly traded comparable companies

Discounted cash flow analysis

Investorreturn analysis

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All four methods should be used to arrive at a middle ground

Factors that impact valuation

Size of opportunity

Large growing markets are most attractive

Ability to generate large gross margins is a key driver

Near term opportunities will be valued higher

Stage of company

How complete and strong is the team

How complete and feasible is the product/technology

Has the company achieved traction (i.e. revenues)?

Market/Environment

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Market/Environment

Competitiveness in the target market

Public/private market fluctuations

Competition to get into the deal

Other

Lawsuits?

Regulatory/government

Capital Structure (prior financings)

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Recent Transactions

Review recent venture transactions that are comparable (market sector, stage of company, etc.)

Clearly depicts a quantitative state of the market and helps determine the current market clearing price

Difficult to identify pure comparables (often venture investments deal with new markets and technologies). Also, valuation is rarely disclosed for early stage deals

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Company Type Closing DatePre Money Value ($mn)

Capital Raised ($mn)

Post Money Value ($mn)

Share of company sold


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Date Value ($mn) ($mn) Value ($mn) company soldABC Company Apparels 8/1/2007 10.5 9.76 20.26 48.2%DEF Company High end fashion garments 3/3/2006 13.2 9.00 22.20 40.5%GHI Company Children clothing 8/13/2007 14.3 4.60 18.85 24.4%KRR Company General fashion garments 5/22/2007 9.8 8.86 18.61 47.6%JKL Company Ladies Apparel 2/11/2006 22.8 11.96 34.76 34.4%MNO Company Gents Apparel 4/15/2007 6.9 2.22 9.12 24.4%PQR Company Gents Apparel 7/17/2007 15.5 5.86 21.31 27.5%

Mean 13.3 7.5 20.7 35.3%Median 13.2 8.9 20.3 34.4%

Public Comparables

Review multiples & valuations of publicly traded companies

Provides a quantitative view, on key metrics, as to what values the public market gives to a certain level of revenue, profit, etc.

Results of this analysis must be discounted for:

self-selection of public companies (what about the 30 that failed?)

illiquidity

Discount for IPO timing

Public market multiples fluctuate rapidly (e.g., early April 00)

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Public market multiples fluctuate rapidly (e.g., early April 00)

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Company Description Terminal Value ($mn)

2008 Revenue Estimate ($mn)

Terminal Value / Sales Ratio

RZ Retail Apparels 36.0 13.0 2.8 Ink Fashion High end fashion garments 140.0 45.0 3.1 BKZ Children clothing 26.0 7.0 3.7 Blaze Clothings General fashion garments 1,708.0 285.0 6.0 MK Jimmy Ladies Apparel 2,983.0 345.0 8.6 KXY Gents Apparel 7,290.0 710.0 10.3

Mean 2,030.5 234.2 5.8 Median 924.0 165.0 4.9

Discounted Cash Flow

Developing a forecast of the companys revenues and costs to calculate a net present value (NPV) of its future cash flows

Can be extremely robust if done properly

A thorough knowledge of the business/market must be developed to determine the appropriate assumptions (revenue, ramp, penetration, costs, etc.) Selecting an appropriate discount

Steps in DCF

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Step 1: Estimate the VCs exit date

Step 2: Forecast free cash flows to equity until the exit date

Step 3: Estimate the exit price, use it as TV

Step 4: Choose a high discount rate (VC discount rate)

Step 5: Discount FCF and TV using this discount rate

Step 6: Calculate VCs Stake

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Steps in DCF

Step 1: Estimate the VCs exit date

VC money is not long-term money: Typically, the VC plans to exit after a few years

Estimate the likely time at which the VC will exit the investment

This determines your forecasting period

The VC usually will have a specific exit strategy in mind:

IPO

Sale to a strategic buyer (e.g., a larger firm in the industry)

Restructuring

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Step 2: FCF to (Levered) Equity

Forecast FCF to (levered) equity (or Equity FCF) until exit

These are cash flows received by equity-holders (VC included)

EFCF=Net Income + Dep. - CAPX DNWC

Principal Repayment + New Borrowing

Need to forecast the firms operations. May be very uncertain

Cash flow forecasts are the key to sound valuation

Oftentimes, these cash flows are zero or negative

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Steps in DCF

Step 3: Exit Value

Forecast the companys value at the exit date (i.e., forecast the companys value at the IPO or in a sale).

Use this value as the Terminal Value

Typically, this value is calculated by estimating the companys

earnings, EBIT, EBITDA, sales or customers (or other valuation-relevant figure)

and applying an appropriate multiple

The multiple is typically based on comparable publicly traded companies or comparable transactions

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transactions

Step 4: VC Discount Rate

Determine a rate for discounting the FCF to leveraged equity and the exit or terminal value back to the present

Typically, discount rates range from 25% to 80%:

lower for investments in later stage or more mature businesses

higher for seed investments

These discount rates are typically higher, and oftentimes much higher, than those calculated using a CAPM-based type model

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Steps in DCF

Step 5: Valuation (Pre-Money)

Use the discount rate to estimate:

the PV of all FCF to levered equity

the PV of the Exit Value

This gives the Pre-Money Value of the company.

This is the value of the firm before the investment is made

Go ahead only if this is positive

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Go ahead only if this is positive

Step 6: VCs Stake

Post-Money Value: Firm value after the VC has injected funds.

Post-money value = Pre-money value + VC Inv

It is what an investor would pay for the firm up and running

Post-funding, VCs stake is worth a fraction of the post-money value for an equity stake the VC should be willing to pay:

VC % Stake * Post-money value

This implies:

VC % Stake = VC Investment / Post-money value

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Discounted Cash Flow: Example of Super Fashion

Step 1: Exit Date

The idea is for Oz.com to go public in 5 years.

Step 2: Forecast FCF to (Levered) Equity

Five-year forecast of FCF:

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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Free Cash Flows (7.0) 1.0 3.0 5.0 10.0 15.0


Super Fashion will not have any debt, will not require additional equity investments.

Step 3: Exit Value

In five years, VC forecasts Super Fashion Net income to be $5M.

Today, publicly traded companies in the same business as Super Fashion trade at price-earnings (P/E) ratios of about 20x times.

Estimate an exit value of 20 * 5 = $150M.

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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Free Cash Flows (7.0) 1.0 3.0 5.0 10.0 15.0 Terminal Value 100.0

Discounted Cash Flow: Example of Super Fashion

Step 4: VC Discount Rate

The VCs target rate of return for this investment is 50%

Step 5: Valuation

Five-year forecast of FCF:

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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Free Cash Flows (7.0) 1.0 3.0 5.0 10.0 15.0 Terminal Value 100.0


Step 6: VCs Equity Stake

Super Fashion pre-money value = $13.6M.

If the VC injects $7M, Super Fashion post-money value = 13.6+7 = $20.6M,

To invest $4M, the VC will ask for 7M/20.6M = 34% equity stake.

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Total Cash Flows (7.0) 1.0 3.0 5.0 10.0 115.0 Discount rate 1.00 0.67 0.44 0.30 0.20 0.13 PV each year (7.0) 0.7 1.3 1.5 2.0 15.1 PV @ 50% 13.6 PV excluding initial investment 20.6

Investor-Return

The value of the business must be set so that both management and investors generate an appropriate return

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75

100

Series B investor requires 5x = $25MM

Management

$


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0

25

50

Seed investor requires 20x = $20MM

Series A investor requires 10x = $30MM

Seed Investor$1MM

Series A$3MM

Total Value

Required

$ Millions

Series B$5MM

Valuation Triangulation

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$15MM to

Appropriate private company multiple = 2-2.5x revenue


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Must be discounted for: illiquidity selection bias timing

revenue track record

market share

Public multiples are 4-5x NTM revenue

$15MM to $20MM Pre-

Money requirements?investors return

Does the range match the match the

Recent VC TransactionsDevelopmental stage

retail companies selling 35% - 40% of company

for round

Cash Flow DCF Model Valuation RangeRange: $15MM to Range: $15MM to $20MM, depending upon discounting

assumptions

Multiples Analysis

5x to 6x Revenue Multiple for Terminal Value

Valuation

While triangulation is an effective means to compute value, a number of other factors play a role

The negotiated valuation must result in sufficient incentive for current and future management team members

Competition, amongst venture capital firms, drives up the clearing price

Current investor sentiment with a sector (e.g., biotech / life sciences right now)

Structure of the deal (ratchets tied to milestones, etc.)

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Private and Confidential Not for Circulation

At the end of the day, investors and management are on the same team

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valuation methodologies for pe fund managers - presentation

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