raiton slides with great khosla slide

OGI School of Science and Engineering1

VALUATIONReal World Entrepreneurship – 2006

byJack Raiton


Valuation: Magic or Myth?

• “It is a sign of an educated mind not to expect more certainty from a subject than it can possibly provide.”(Aristotle)

• “Valuation requires an intermediate perspective between ignorance and certainty, involving the exercise of skill, experience and judgment” (Razgatis)


An Icon’s Perspective

“At a presentation I gave recently, the audience’s questions were all along the same lines: “How do I get in touch with venture capitalists?”“What percentage of equity do I have to give them?” No one asked me how to build a business!”

Arthur Rock was a founder of Intel, an early investor in Apple,Teledyne, Scientific Data Systems, Air Touch Communications, …


THE REAL DEFINITION OF THE VALUE OF AN EARLY STAGE COMPANY IS:

“That point at which an investor’s fear is in equilibrium with his greed.”


What is a Company Worth?

• It’s worth what someone is willing to pay for it

• It doesn’t matter what they paid for it…

• Once you’ve paid for it, it’s yours!


Macro Valuation Factors

What drives valuations?

• Liquidity, aka the “Exit”• The Economy• Public Markets – market multiples and the strength of

the IPO market• M&A Activity


U.S. Private Equity Performance (thru 2Q05)

Early-stage VC historically beats all other asset classes


2004 VC Valuations by Company Industry

Valuations Vary by Industry


Valuation Shortcuts

• “Small business owners often like to use the “MMM”method of business valuation.MMM, or Make Me a Millionaire, determinesthe asking price of a business by multiplyingthe number of owners by $1.0 million.”

-Bryan Jamison, SMU BBA ’78 Wall Street Journal (circa 1985)


Valuation Methods

• DCF (Discounted Cash Flow)

• Comparable transactions (M&A)

• Public market multiples

• Gut!• Low single digits• Rules of Thumb• Convertible debt

SeedSeedStartup Later

Stage

SeedEarlyStage

• P/E Analysis• EBITDA multiples• Public market shares

• VC Method• Modified DCF• Market comparables

MaturePublic


Valuation Methodologies

• “Current Market Valuations”- More “art” than “science”- Comparable private market transactions- Usually correlates to changes in public market valuations

• Discounted Cash Flow Analysis- Build financial model for 3 to 5 yr time frame- Project cash flows to the investors over investment time- Discount cash flows based on discount rate and time

• Comparable Company Analysis- Select representative group of public companies- Sort by sector, size and growth rate- Determine appropriate valuation metrics: Revenue,

Earnings, EBITDA


The Art of the Deal –The “VC Method”


VC Valuation Perspective

Difficult to use established (late-stage/public market)valuation techniques for early-stage companies due to:

• Volatility• Illiquidity• Long investment cycle• Complex/new technologies• Lack of transparency of private company data

Last-stage valuation techniques more quantitative

• Discounted cash flows• Public market comparables


VC Returns

• VC discount rates high to support portfolio losses(e.g. losses must be “baked into” VC models)

• Game of “home runs”(Average portfolio: 10% - 10x or better returns

60% - low to average returns; 1x-4x30% - fire-sales or written off

• High risk/high reward game- Early-stage highest risk/reward ratio


Funding to Milestones: aka “Old-Fashioned Venture Capital”

Source: Vinod Khosla, Kleiner Perkins


VC Model – Managing Risk


Terminology 101

• IRR• Pre- and Post-money valuation


Internal Rate of Return (“IRR”)

• Internal Rate of Return– The discount rate that equates the net present value

(NPV) of an investment’s cash inflows with its cash outflows

– IRR measures the discount rate that sets NVP = 0– Different from rate of return on investment

(measure of market performance)


IRR Example

Example• 1st Year investment $1.0M• 2nd Year investment $2.0M• 4th Year investment $3.5M• Exit 5th Year return $20.0M

• Total investment $6.5M IRR = 59%• Cash return $13.5M Multiple = 3x

Excluding time weighting, produces a rate of return of 208%


Pre- and Post-money Valuation

• Post-money– Value of equity AFTER the new money goes in– Share price X fully-diluted shares outstanding

AFTER new investment– Investment/POA (% ownership acquired)

• Pre-money– Value of equity BEFORE the new money goes in– Share price X fully-diluted shares outstanding

BEFORE new investment– Post-money - Investment


Pre- & Post-Money

Shares & Options 1.0M

Price per Share X $7.00 (negotiated btwn co. and VC)

Pre-Money $7.0M

Pre-Money $7.0M (negotiated) 70%

New Investment $3.0M 30%

Post-Money $10.0M (value after new $) 100%


Simple Model I

How much do I need to own?

• Solve for the required future value of my $3.5M investment to achieve 50% IRR– VC Required IRR 50%– Amount I’m investing $3.5M– Expected term to exit 5 yrs– Expected Net Inc in yr 5 $4M– Yr 5 Market Comp P/E 20– Implied FV of Co in yr 5 $80M


Simple ModelHow much do I need to own?

1 2 3 4 6

$5.2 $7.8 $1.8 $17.7 $26.6

● Solve for the required future value of my $3.5M investmentto achieve 50% IRR– RFV = ((1+IRR)^Periods) X Investment– RFV = ((1+0.5)^5) X $3.5M– RFV = $26.6M

● Therefore, I need to own $26.6M/$80M– 33%

● My investment offer to company might be $3.5M investment at $7M pre-money ($10.5M post-money)


Simple Model II-APE – 20xExit = 5 yearsEarnings (Y5) = $10MVC required IRR = 50%VC investments = $10M

Exit Value (Post-Money)

Pre-Money = $26.4M - $10M = $16.4M

$10M x (1.5)5 = $10M x 7.59 = $75.9M

38%=$10M26.4M

38%=75.9M$200M

=75.9M

20 x $10M

OR

$26.4M=$200M

7.59=

20 x $10M(1.5)5


Rules of Thumb

• $5M Limit

• Berkus Method– For a sound idea $1M– For a prototype +1M– For a quality management team +1M-2M– For a quality board +1M– For any roll-out, sales +1M

$1M-6M• Role of Thirds

– 1/3 to Founders– 1/3 to Management– 1/3 to Investors

• $2.5M Angel Standard

• $2-10M Internet Standard


Some Take Aways

• Entrepreneur should consider the following…– how much money will it take to really fly?– what milestones exist between push back and take off?– how much is required to achieve each milestone?– work backwards…

• Valuations are negotiable particularly when…– you are a serial entrepreneur– there are numerous bidders– performance against milestones can be tangibly measured

• Guy Kawasaki’s Law of PreMoney Valuation…– for every full time engineer (+$500,000)– for every full time MBA (-$250,000)


Also Remember…

• Venture capitalists don’t get rich by cutting tough deals

• Entrepreneurs don’t get rich by taking highest offers

• Don’t miss the forest for the trees!(sensitivity analysis)

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