Lecture 8Lecture 8

The Deal:The Deal:Valuation, Structure & NegotiationValuation, Structure & Negotiation

Timmons - Chapter 14Timmons - Chapter 14

Entrepreneurial capital Entrepreneurial capital marketsmarkets

More volatileMore volatile More imperfectMore imperfect Less accessibleLess accessible Affected by psychological factorsAffected by psychological factors

Chain of Capital ProvidersChain of Capital Providers

Deal SequenceDeal Sequence

Ingredients for valuationIngredients for valuation

CashCash How much How much To whom it flowsTo whom it flows

TimeTime When it flowsWhen it flows

RiskRisk The likelihood that it will flowThe likelihood that it will flow

Some tips for valuationSome tips for valuation

Art and scienceArt and science Multiple methods Multiple methods Ranges and boundaries rather than Ranges and boundaries rather than

specific valuesspecific values Sensitivity analysis based on assumptionsSensitivity analysis based on assumptions Shop the deal wiselyShop the deal wisely Know the other side of the tableKnow the other side of the table

Index of expected ratesIndex of expected rates

Core PrincipleCore Principle

The core principle for an entrepreneur … The core principle for an entrepreneur … is to build the best company possible. This is to build the best company possible. This is the single surest way of generating long-is the single surest way of generating long-term value for all the stakeholders and term value for all the stakeholders and society.society.

-Timmons-Timmons

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Determining ValueDetermining Value At least a dozen waysAt least a dozen ways A Key Consideration:A Key Consideration:

Investor’s Required Rate of Return (ROR) (IRR)Investor’s Required Rate of Return (ROR) (IRR) An indicator of the efficiency or quality of an investment, as opposed to An indicator of the efficiency or quality of an investment, as opposed to

Net Present Value (NPV), which indicates value or magnitude given the Net Present Value (NPV), which indicates value or magnitude given the current interest rate (or cost of capital)current interest rate (or cost of capital)

A project is a good investment proposition to an investor if its IRR is A project is a good investment proposition to an investor if its IRR is greater than the rate of return that could be earned by alternate greater than the rate of return that could be earned by alternate investments of equal risk (investing in other projects, buying bonds, investments of equal risk (investing in other projects, buying bonds, even putting the money in a bank account). Thus, the IRR should be even putting the money in a bank account). Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk compared to any alternate costs of capital including an appropriate risk premium.premium.

Inherent conflicts between Inherent conflicts between users and suppliers of capitalusers and suppliers of capital

Capital User Wants:Capital User Wants: As much time as possible As much time as possible

for financingfor financing As much $$$ as possibleAs much $$$ as possible IndependenceIndependence Control of Board-of-Control of Board-of-

Directors for freedomDirectors for freedom Any SuccessAny Success Flexibility to change, adapt Flexibility to change, adapt

or decommitor decommit OperateOperate

Capital Provider Wants:Capital Provider Wants: To supply capital just in To supply capital just in

timetime To invest just enough $$$To invest just enough $$$ AccountabilityAccountability Control of Board-of-Control of Board-of-

Directors for controlDirectors for control Big SuccessBig Success Clear, steady adherence Clear, steady adherence

to plansto plans Cash outCash out

Valuation, Structure & Valuation, Structure & NegotiationNegotiation

Staged Capital Staged Capital CommitmentsCommitments Delivers funding in Delivers funding in

stages, rather than in stages, rather than in lump sumlump sum

Allows investors to Allows investors to evaluate company as evaluate company as time passestime passes

Conservation of capitalConservation of capital

To “encourage” managers to conserve, VCs To “encourage” managers to conserve, VCs apply strong sanctions if capital is misused, by:apply strong sanctions if capital is misused, by: Diluting management’s equity share at punitive rateDiluting management’s equity share at punitive rate Shutting down operations completelyShutting down operations completely

Structuring the dealStructuring the deal

Deals involve Deals involve allocation of cash flow allocation of cash flow

streams streams allocation of riskallocation of risk allocation of value between allocation of value between

different groupsdifferent groups Suppliers versus users of Suppliers versus users of

capitalcapital Owners versus managersOwners versus managers

Characteristics of Successful Characteristics of Successful DealsDeals

SimplicitySimplicity They are robust (resistant to unexpected shocksThey are robust (resistant to unexpected shocks They are organic (evolve to meet circumstances)They are organic (evolve to meet circumstances) They take into account incentives of all involved in a They take into account incentives of all involved in a

variety of circumstancesvariety of circumstances They provide mechanisms for communications and They provide mechanisms for communications and

interpretationinterpretation They are based primarily on trust rather than legal They are based primarily on trust rather than legal

languagelanguage They do not make it too hard to raise more capitalThey do not make it too hard to raise more capital

Characteristics of Successful Characteristics of Successful Deals (cont.)Deals (cont.)

They match the needs of the user of capital They match the needs of the user of capital with the needs of the supplierwith the needs of the supplier

They reveal information about each partyThey reveal information about each party They allow for the arrival of new information They allow for the arrival of new information

before the deal is signedbefore the deal is signed They are considerate of the fact that it takes They are considerate of the fact that it takes

time to raise moneytime to raise money They improve the chances of venture successThey improve the chances of venture success They are not patently unfairThey are not patently unfair

Questions to identify agendasQuestions to identify agendas What is the bet ?What is the bet ? Who is it for ?Who is it for ? Who is taking the risk ?Who is taking the risk ? Who receives the rewards ?Who receives the rewards ? Who should be making the bets ?Who should be making the bets ? What happens if the venture exceeds investor expectations ?What happens if the venture exceeds investor expectations ? What happens if the venture falls short of investor expectations ?What happens if the venture falls short of investor expectations ? What are the incentives for the money managers ?What are the incentives for the money managers ? What are the consequences of the failure to perform by the money What are the consequences of the failure to perform by the money

managers ?managers ? How will the money managers behave ?How will the money managers behave ? What will be the investment strategy of the money managers?What will be the investment strategy of the money managers?

Critical Guides:Critical Guides: Raise money when you don’t need itRaise money when you don’t need it Learn about the process and how to Learn about the process and how to

manage itmanage it Know your relative bargaining positionKnow your relative bargaining position If all you get is money, you’re not getting If all you get is money, you’re not getting

muchmuch Assume the deal will never closeAssume the deal will never close Always have a backup source of capitalAlways have a backup source of capital The experts can blow it – sweat the details The experts can blow it – sweat the details

yourselfyourself

Critical Guides:Critical Guides: Assume the deal won’t closeAssume the deal won’t close Always have a backup source of capitalAlways have a backup source of capital Legal, financial and consulting sources Legal, financial and consulting sources

can make mistakes, too; check their workcan make mistakes, too; check their work Users of capital are at a disadvantage Users of capital are at a disadvantage

when dealing with suppliers of capitalwhen dealing with suppliers of capital If you are out of cash when looking for If you are out of cash when looking for

capital, suppliers of capital will eat your capital, suppliers of capital will eat your lunchlunch

Startup entrepreneurs are raising capital Startup entrepreneurs are raising capital for the first time; suppliers do it for a living.for the first time; suppliers do it for a living.

Potential PitfallsPotential Pitfalls

Strategic circumferenceStrategic circumference Legal circumferenceLegal circumference Attraction to Status and SizeAttraction to Status and Size Unknown territoryUnknown territory Opportunity CostOpportunity Cost Underestimation of other costsUnderestimation of other costs GreedGreed Being too anxiousBeing too anxious ImpatienceImpatience Take-the-money-and-run myopiaTake-the-money-and-run myopia

Methods of ValuationMethods of Valuation

Venture Capital MethodVenture Capital Method Fundamental MethodFundamental Method First Chicago MethodFirst Chicago Method Discounted Cash FlowDiscounted Cash Flow

Venture Capital MethodVenture Capital Method

Estimate Net Income for a number of yearsEstimate Net Income for a number of years Determine appropriate Price-to-Earnings (P/E) ratioDetermine appropriate Price-to-Earnings (P/E) ratio

Use comparables or industry dataUse comparables or industry data

Calculate terminal value (= Estimated Income x P/E)Calculate terminal value (= Estimated Income x P/E) Discount terminal value to present value (r=.35 to .80)Discount terminal value to present value (r=.35 to .80) Determine investor’s required percentage of ownershipDetermine investor’s required percentage of ownership

Final ownership = Final ownership = Required future value (investment)Required future value (investment) Total Terminal ValueTotal Terminal Value = = 1+(IRR) 1+(IRR) yearsyears x (investment) x (investment) P/E Ratio (Total Terminal Income)P/E Ratio (Total Terminal Income)

Calculate number of shares Calculate number of shares New Shares = New Shares = % ownership required by investor . % ownership required by investor . 1- % ownership required by investor x old shares1- % ownership required by investor x old shares

Fundamental MethodFundamental Method

First Chicago MethodFirst Chicago Method

Discounted Cash Flow Discounted Cash Flow MethodMethod

Three time periods are defined Three time periods are defined (1) Years 1-5, (1) Years 1-5, (2) Years 6-10, (2) Years 6-10, (3) Year 11 to infinity(3) Year 11 to infinity

Operating assumptions include Operating assumptions include initial salesinitial sales growth ratesgrowth rates EBIAT/salesEBIAT/sales (net fixed assets + operating working (net fixed assets + operating working

capital)/sales; capital)/sales; Also note relationships and trade-offsAlso note relationships and trade-offs

Staged InvestmentStaged Investment

Investor Expectations for Investor Expectations for Multiple Round FinancingMultiple Round Financing

Cram Down or Down RoundCram Down or Down Round

Beyond “Just the Money”Beyond “Just the Money”

Critical issues in the dealCritical issues in the deal Number, type, and mix of stocks and various features Number, type, and mix of stocks and various features

that may go with them that affect the investor’s rate of that may go with them that affect the investor’s rate of returnreturn

The amounts and timing of takedowns, conversions, The amounts and timing of takedowns, conversions, and the likeand the like

Interest rate in debt or preferred sharesInterest rate in debt or preferred shares The number of seats, and who actually will represent The number of seats, and who actually will represent

investors, on the board of directorsinvestors, on the board of directors Possible changes in the management team and in the Possible changes in the management team and in the

composition of the board of directorscomposition of the board of directors

Beyond “Just the Money”Beyond “Just the Money”

Critical issues in the deal (cont.)Critical issues in the deal (cont.) Registration rights for investor’s stockRegistration rights for investor’s stock Right of first refusal granted to the investor on Right of first refusal granted to the investor on

subsequent private or initial public stock subsequent private or initial public stock offeringsofferings

Stock vesting schedule and agreementsStock vesting schedule and agreements The payment of legal, accounting, consulting, The payment of legal, accounting, consulting,

or other fees connected with putting the deal or other fees connected with putting the deal togethertogether

More Burdensome IssuesMore Burdensome Issues

Co-sale provisionsCo-sale provisions Ratchet anti-dilution protectionRatchet anti-dilution protection Washout financingWashout financing Forced buyoutForced buyout Demand registration rightsDemand registration rights Piggyback registration rightsPiggyback registration rights Key-person insuranceKey-person insurance