Valuing Early-Stage, Knowledge-based/Tech Companies

September 18, 2014

Gregory Phipps – Managing Director, Investment

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The Challenge

• Valuation mix of (black) art & science• In start-up/early-stage, valuation exercise more art than science, with

heavy dose of negotiation thrown in by the investment source (VC’s, angels, etc.)

• Valuation may be used for both negotiated “price” for equity investment purposes, Founder/Partner buy-out scenarios (more common than you think), marital dissolutions, and third-party acquisitions

• Absence of historic, or (often) accurate means to predict future revenues and cash flow, makes it virtually impossible to use traditional models like DCF – used frequently by CBV’s

• How do we do it then?

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Alternative Methods

Venture Capital Method First Chicago Method Berkus Method Scorecard Method Comparables Negotiation WAG

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Venture Capital Method (Bill Sahlman, Harvard) If we know the value of something in the future and

we know what kind of ROI we need to induce us to make an investment, then we figure out its “present value” to us.

Present value = valuation Incorporates some elements of DCF insomuch that we

apply risk premium (expressed as return/discount/hurdle rate), and are determining PV, but it is based on future terminal value rather than cash flows

No time/value of money considered

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Venture Capital Method

1. Forecast future results (”success”) vs current situation (more optimistic?)

2. Determine likely value at that point (e.g. P/E ratio for comparable)

3. Determine likely dilution from: (a) equity capital issuance and (b) employee stock option grants

4. Determine share of value “pie” demanded given required rates of return

5. Convert future values to present to derive share prices, ownership percentages

Terminal (exit) value ÷ post-money valuation = return on investment

or,

Post-money valuation = terminal value ÷ anticipated ROI

CASE STUDY: VC looking at three companies. She is unwilling to invest unless she can obtain an annualized return of 30% from her investment

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Company AM&A

Company BIPO

Company CSaaS M&A

Revenue $100,000,000 $80,000,000 $10,000,000

Net Income $15,000,000 $9,000,000 $0

IPO/M&A Multiple

6X EBIT 15X Net Income

SaaS metric 40,000 subs X $1200 per

Terminal Value $90,000,000 $135,000,000 $48,000,000

Venture Capital Method

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Company A Company B Company C

Terminal Value $90,000,000 $135,000,000 $48,000,000

Post Money = Terminal

Value/30% (ROI)

$3,000,000 $4,500,000 $1,600,000

Subtract Investment

$1,000,000 $1,000,000 $1,000,000

Pre-Money $2,000,000 $3,500,000 $600,000

Venture Capital Method

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Venture Capital Method

  "Venture Capital Method" of Valuation     

     

    INPUT

  Amount to Invest $ 1,000,000

  Net Income $ 8,000,000

  Year 5

  Average P/E Ratio of Profitable Comparable Companies 10

  Shares Currently Outstanding 9,989,640

  Target Rate of Return 50%

     

     

    OUTPUT

  Discounted Terminal Value $ 10,534,979

  Required Percentage Ownership for the VC 9.49%

  Number of New Shares Required for the VC's Investment 1,047,683

  Price per New Share $ 0.95

  Implied Pre-money Valuation $ 9,534,979

  Implied Post-money Valuation $ 10,534,979

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First Chicago Method

First Chicago approach simply does three different projections: Best, Worst and Survival scenarios & assigns probability estimates to each

i.e. Success - 30% chance; Failure - 20% chance; and Survival - 50% chance

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

These are than added and the valuation and pricing is determined.

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First Chicago Method *Fill all Yellow Highlighted Areas

Variables Success Sideways Survival Failure

Base Revenue: 0.45 (Average of provided data)

Revenue growth rate from base: 120.0% 50.0% 5.0%

Projected Liquidation Value @ Year 5 With Failure: 1

After Tax Profit Margin: 20.0% 7.0%

PE Ratio at Liquidity: 15 7 *From Comparables etc. (P/E of 15 is long term historical average)

Discount Rate: 30.0% *Internal Hurdle

Probability of Each Scenario: 30.0% 50.0% 20.0%

Investment Amount: 0.5

Calculations Success Sideways Survival Failure

Revenue Growth Rate 1.2 0.5 0.05(From Base Of ???)

Revenue Level After 3 Years 4.79 1.52 0.52

Revenue Level After 5 Years 23.19 3.42 0.57

Net Income at Liquidity 4.64 0.24 0.00

Value of Company At Liquidity 69.57 1.67 1.00

PV of Company Using Discount 18.74 0.45 0.27Rate of ????

Expected PV Of The Company 5.62 0.23 0.05Under Each Separate Scenario

Expected PV Of The Company 5.90

Berkus Method

Dave Berkus – noted angel investor, speaker, author

Method only really used or accurate for pre-revenue companies

Still requires subject evaluation/assessment of key value metrics

I have renamed it the “Keg Steakhouse Method” or “A La Carte Menu Method”

Cast your vote for best name

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Berkus Method

Valuation Metric Value

Cool idea/concept/tech $.5 million

Experienced management $.5 million

Prototype/build $.25 million

Strategic relationships $.25 million

Board of Directors $.25 million

Paying customers/traction <> $.5 - $1 million

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Keg Fries (Management)

Mixed vegetables (Productized)

Rice Pilaf (Distribution partner)

Roasted garlic mashed (Board)

Sautéed mushrooms(Customers)

Twice-baked potato (Business plan)

The Keg Steakhouse Method

Not really a “valuation method” in itself Ranks various factors consider predictors of entrepreneurial

success Somewhat subjective but balanced on the whole Best for comparing a number of companies against each other, by

type, or by region Company with an avg. product/technology (100% of norm), a

strong team (125% of norm) and a large market opportunity (150% of norm). The company can get to positive cash flow with a single angel round of investment (100% of norm). Looking at the strength of the competition in the market, the target is weaker (75% of norm) but early customer feedback on the product is excellent (Other = 100%). The company needs some additional work on building sales channels and partnerships (80% of norm).

Using this data, we can complete the following calculation:

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Scorecard Method

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Scorecard Method

Comparison factor Range Company

Factor

Team/Management 30% max 125% 0.375

Size of Opportunity 25% max 150% 0.375

Product/Technology 15% max 100% 0.150

Competition 10% max 75% 0.075

Sales partnerships 10%max

80% 0.080

Additional investment

5% max 100% 0.050

Other factors 5% max 100% 0.050

SUM 100% 1.075

Comparables

Accurate, reasonable approach to valuation, in the absence of, or willingness, to apply other valuation methods

Court tested? Simply research valuations, of similar companies

who have raised equity capital, at same stage, in same region

Regional “pricing” applies. Valuations in Canada are NOT the same as Silicon Valley

We use DowJones “VentureSource” and “PitchBook” to research comparable valuations as reported in VC deals

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Negotiation

Used more often than not. Follows traditional, age-old premise of “value”:

“what a willing seller and a willing buyer agree upon”

Can be considered a reasonable foundation value (starting point), on which to apply future/next valuation exercises

Probably hard to argue against, retroactively, in legal/court-related testimony of valuation unless one can prove duress

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Wild Ass Guess

Bonus: Venture Capital Math $1 million at a $3 million pre-money valuation leading to a $4 million post

money valuation.  

The math works out that the investor owns 25% of the company post deal ($1 million invested / $4 million valuation) and assuming 1 million shares, each share would be valued at $3 / share ($3,000,000 pre-money / 1 million shares = $3/share).  

Investors own 25%, the founders own 75%. 

But…… ESOP complicates it, and impacts price/share

Assuming a 15% option pool post funding then you need a 20% option pool pre funding (because the pool gets diluted by 25% also when the VC invests their money).  So your 100% of the company is down to 80% even before VC funding.

The VC’s $1 million still buys them 25% of your company – it’s you who has diluted to 60% ownership rather than 75%.  

The price / share is actually $2.40 (not $3.00), which is $3,000,000 pre-money / 1,250,000 shares (because you had to create the 250,000 share options).   Thus the “true” pre-money is only $2.4 million (and not $3 million) because $2.40 per share * 1 million pre-money outstanding shards = $2.4 million

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