Business valuation throughout a business's life cycle, march 11, 2010 (1)
1. Which Lady Do You See?
“Value, like
beauty, is in
the eye of the
beholder”
2. Discussion Outline
Basic Business Valuation Principles
Company Life Cycle Analysis
Early-Stage Company Valuation
Venture Capital Method
PWERM
Later-Stage Company Valuation
Questions
3. Basic Business Valuation Principles
Principle of Substitution
“The value of an item tends to be determined
by the cost of acquiring an equally desirable
substitute.”
Basis for the asset-based approach –
assumes that an equally desirable substitute
for the business is to replicate all of the
underlying assets and liabilities of the
business.
4. Basic Business Valuation Principles
Principle of Substitution
Basis for the market approach – assumes
that an equally desirable substitute for the
business is to buy a business with similar
investment characteristics.
Basis for the earnings approach – assumes
that an equally desirable substitute for the
business is a business that has similar
earnings capacity.
5. Basic Business Valuation Principles
Principle of Alternatives
“In any contemplated transaction, each party
has alternatives to consummating the
transaction.”
Buyer = buy, not buy, buy something else.
Seller = sell, not sell, sell to someone else.
6. Basic Business Valuation Principles
Principle of Future Benefits
“Economic value reflects anticipated future
benefits.”
A buyer would not pay more for a business
than the present value of the future benefits
the business is expected to generate.
7. Basic Business Valuation Principles
Definition of Value
Fair Market Value:
“The price at which the property would change hands between
a willing buyer and a willing seller when the former is not under
any compulsion to buy and the latter is not under any
compulsion to sell, both parties having reasonable knowledge
of relevant facts. Court decisions frequently state in addition
that the hypothetical buyer and seller are assumed to be able,
as well as willing, to trade and to be well informed about the
property and concerning the market for such property.”
Revenue Ruling 59-60
8. Basic Business Valuation Principles
Definition of Value
Market Value
“The most probable price that a property should bring in a
competitive and open market under all conditions requisite to a
fair sale, the buyer and seller each acting prudently and
knowledgeably, and assuming the price is not affected by
undue stimulus.”
Uniform Standards of Professional Appraisal Practice
9. Basic Business Valuation Principles
Market Value assumes the consummation of
a sale as of a specified date and the passing
of title from seller to buyer under conditions
whereby:
• Buyer and seller are typically motivated;
• Both parties are well informed or well advised and acting in
what they consider their best interests;
• A reasonable time is allowed for exposure in the open
market;
• Payment is made in terms of cash in United States dollars or
in terms of financial arrangements comparable thereto; and
• The price represents the normal consideration for the
property sold unaffected by special or creative financing or
sales concessions granted by anyone associated with the
sale.
10. Company Life Cycle Analysis
Company Life Cycle
Enterprise Value
Seed Start-up Growth Established Expansion Mature Decline
11. Company Life Cycle Analysis
Stage Focus Financing
Seed Proof of concept, prototype, business planning Personal finances, friends, family, customers, grants
Start-up Production, establish customer base Angels, venture capital
Growth Infrastructure - systems, processes, effectiveness Venture capital, mezzanine, private equity
Established Improvement, productivity, efficiency Profits, banks, private equity
Expansion New markets and distribution channels Profits, banks , private equity, IPO
Mature Declining sales and profitability, sustain cash Profits, banks
Exit Valuation, transition planning ESOP, MBO, IPO, strategic sale, bankruptcy
12. Company Life Cycle Analysis
Methods
Stage Data Risk VC DFE CE GLC GPT AB Liq
Seed Soft data, value proposition Extremely high X X
Start-up Validation, time to market High X X
Growth Preliminary revenue, may not be profitable Moderate X X X X
Established Predictable revenue, profitability Low X X X X X
Expansion Historical data, EBITDA, cash flow Moderate X X X X X
Mature Historical data, EBITDA, cash flow High X X X X X X
Exit Historical data, EBITDA, cash flow NA X X X X X X
13. Early-Stage Company Valuation
Why are Early-Stage Companies Valued?
Financing
Financial and Tax Reporting
Gift and Estate Tax Planning
Management of Intangible Assets
• Internally developed or to-be-purchased intangible
assets for sale or acquisition.
• Royalty rates related to license of patents, etc.
• Purchase price allocation.
14. Financing - Venture Capital Method
Application of method will differ depending
on stage of development.
Steps:
Estimate future value (FV) of invested capital
of company at proposed exit date.
Seed usually based on a multiple of revenue
Start-up usually based on a multiple of revenue or earnings
Growth usually based on earnings
15. Financing - Venture Capital Method
Determine cost of capital based on risk
assessment (required rate of return).
Venture Economics conducts an annual
study of venture capital rates of return by
fund type over various investment horizons.
Cost of capital generally ranges from 30% to
100% depending on risk assessment.
16. Financing - Venture Capital Method
Factors that affect determination of required
rate of return:
• Management team
• Phase of product development
• Phase of market development
• Revenue phase
• Quality and quantity of data
• Probability of success
17. Financing - Venture Capital Method
Determine present value (PV) of invested
capital, this is the “post-money” value:
PV = FV / (1 + required rate of return)term
Determine the “pre-money” value:
Pre-money value = Post-money value minus
Investment
Determine the ownership fraction:
Ownership fraction = Investment / Post-money value
18. Financing - Venture Capital Method
Determine number of shares to be issued to
investor:
Total number of shares after issuance = Original
number shares outstanding / (1 minus ownership
fraction)
Number of shares to be issued = Total number of
shares after issuance minus original number of
shares outstanding
Determine price of shares:
Investment amount / Number of shares issued
19. Financing - Venture Capital Method
1. Estimate Future Value:
Expected revenue in year of exit $ 50,000,000
Times: Revenue multiple 0.6
Future value of invested capital $ 30,000,000
2. Determine Cost of Capital (Required Rate of Return):
Required rate of return 50%
Number of years until exit event 5
Discount factor 7.59
3. Determine Post-Money Value:
Future value of invested capital $ 30,000,000
Divided by: Discount factor 7.59
Present value of invested capital (Post-money value) $ 3,952,569
20. Venture Capital Method
4. Determine Pre-Money Value:
Present value of invested capital (Post-money value) $ 3,952,569
Investment (2,000,000)
Pre-money value $ 1,952,569
5. Calculate Ownership Fraction:
Investment $ 2,000,000
Divided by: Post-money value 3,952,569
Ownership fraction 50.6%
21. Financing - Venture Capital Method
6. Calculate Number of Share to be Issued:
Original number of shares 2,000,000
Divided by: 1 minus ownership fraction 49.4%
Total number of shares after issuance 4,048,583
Original number of shares (2,000,000)
Number of shares to be issued 2,048,583
7. Calculate Price per Share:
Investment $ 2,000,000
Divided by: Number of shares to be issued 2,048,583
Price per share $ 0.98
22. Financing - Venture Capital Method
Valuation Assuming Future Dilution
If new stock is issued to later-round investors
or to new key employees, the early-round
investors expect to suffer dilution.
The effect of the dilution can be built into the
method by modeling the effect of the dilution
and adjusting the number of shares issued in
each round.
23. Financing - Venture Capital Method
Valuation Assuming Future Dilution
The ratio of the percent ownership an
investor holds at the terminal year of a
project to its original percent ownership is
that investor’s retention percent.
In order to prevent dilution, the early
investor’s ownership percentage should be
increased by the ratio of the investor’s
original percent ownership times that
investor’s retention percent.
24. Financial/Tax Reporting - PWERM
Probability Weighted Expected Return
Method.
Also known as the scenario method.
Rooted in decision-tree analysis.
Future outcomes are modeled and
probability weighted.
25. Financial/Tax Reporting - PWERM
Along with Option Pricing Method (OPM)
and Current Value Method (CVM), PWERM
has become a generally accepted method
for financial and tax reporting purposes.
Accomplishes valuation and allocation of
enterprise value across multiple classes of
stock.
26. Financial/Tax Reporting - PWERM
Steps:
Identify possible future outcomes:
• Initial public offering
• Sale or merger
• Continuation as a private company
• Dissolution
Usually the method models both a liquidity
scenario (sale or merger or IPO or both) and
a going-out-of-business scenario
(dissolution).
27. Financial/Tax Reporting - PWERM
Estimate future value for each potential
outcome
• Best sources for revenue multiples on early-stage
companies are VentureOne and PitchBook.
• Analysis must consider the need for future
financing and the milestones the company must
pass to achieve various exit events.
28. Financial/Tax Reporting - PWERM
Allocate future values to each share class.
• Analysis should consider:
– Dates and types of future events
– Rights and preferences of each class
Discount future values to present value by
class.
• Use risk-adjusted required rate of return for each
class.
• Each class may have a different required rate of
return.
29. Financial/Tax Reporting - PWERM
Assign probability to each outcome
• The National Venture Capital Association (NCVA)
tracks statistics on venture capital deals and the
probability of achieving a positive liquidity event by
financing round.
• Based on this research, the probability of achieving
a positive liquidity event for a deal declined from
25% to 40% in 2002 to 2% to 10% in 2009,
depending on the round.
30. Financial/Tax Reporting - PWERM
• Based on this research, the probability of:
– Sale or merger - approximately 10%
– IPO - approximately 4%
• 85% of deals do not generate a positive liquidity
event.
31. Financial/Tax Reporting - PWERM
Determine enterprise value by summing the
probability-weighted outcomes.
Determine the value per share by dividing
the enterprise value by the number of shares
outstanding.
32. Financial/Tax Reporting - PWERM
Facts: Series A Series B Common Total
Valuation Date End of Year 4
Number of shares 3,405,405 1,317,735 2,000,000 6,723,140
Percentage ownership 50.6% 19.6% 29.8% 100.0%
1. Identify Possible Future Outcomes:
Initial Public Offering 5 years
Sell to Private Equity Firm 8 years
Continue as a Private Firm 8 years
Dissolution 8 years
33. Financial/Tax Reporting - PWERM
2. Estimated Future Value for Each Potential Outcome:
Initial Public Offering
Revenue of $50,000,000 x MVIC/revenue multiple of 0.60 $ 30,000,000
Sell to Private Equity Firm
EBITDA of $5,000,000 x MVIC/EBITDA multiple of 7 $ 35,000,000
Continue as a Private Firm
EBITDA of $5,000,000 x MVIC/EBITDA multiple of 4 $ 20,000,000
Dissolution $ 5,000,000
34. Financial/Tax Reporting - PWERM
3. Allocate Future Value to Each Share Class: Series A Series B Common Total
Percentage ownership 50.6% 19.6% 29.8% 100.0%
Future Value:
Initial Public Offering $ 15,180,000 $ 5,880,000 $ 8,940,000 $ 30,000,000
Sell to Private Equity Firm 17,710,000 6,860,000 10,430,000 35,000,000
Continue as a Private Firm 10,120,000 3,920,000 5,960,000 20,000,000
Dissolution 2,530,000 980,000 1,490,000 5,000,000
35. Financial/Tax Reporting - PWERM
4. Discount Future Value to Present Value: Series A Series B Common Total
Required rate of return 25% 25% 30%
Years until:
Initial Public Offering 1 1 1
All other events 3 3 3
Discount Factor:
Initial Public Offering 125% 125% 130%
All other events 195% 195% 220%
Present Value:
Initial Public Offering $ 12,144,000 $ 4,704,000 $ 6,877,000 $ 23,725,000
Sell to Private Equity Firm 9,068,000 3,512,000 4,747,000 17,327,000
Continue as a Private Firm 5,181,000 2,007,000 2,713,000 9,901,000
Dissolution 1,295,000 502,000 678,000 2,475,000
36. Financial/Tax Reporting - PWERM
5. Assign Probability to Each Outcome: Total
Initial Public Offering 10%
Sell to Private Equity Firm 20%
Continue as a Private Firm 65%
Disssolution 5%
6. Determine Enterprise Value and Value per Share: Series A Series B Common Total
Initial Public Offering $ 1,214,000 $ 470,000 $ 688,000 $ 2,372,000
Sell to Private Equity Firm 1,814,000 702,000 949,000 3,465,000
Continue as a Private Firm 3,368,000 1,305,000 1,763,000 6,436,000
Disssolution 65,000 25,000 34,000 124,000
Total enterprise value $ 6,461,000 $ 2,502,000 $ 3,434,000 $ 12,397,000
Divided by: Number of shares outstanding 3,405,405 1,317,735 2,000,000 6,723,140
Value per share outstanding $ 1.90 $ 1.90 $ 1.72 $ 1.84
37. Later-Stage Company Valuation
Why are Later-Stage Companies Valued?
Exit Planning
• Sale to employees (ESOP)
• Sale to management (MBO, stock options)
• Gift/bequest to family members (FLPs)
• Charitable contributions
Financial and Tax Reporting
• Purchase price allocation (FASB 141R)
• Goodwill impairment (FASB 142)
• Equity compensation (FASB 123R, 409A)
38. Later-Stage Company Valuation
Use Traditional Valuation Methods
Discounted Future Earnings
Capitalization of Earnings
Guideline Public Companies
Guideline Private Transactions
Adjusted Net Assets
• Going-Concern Mass Assemblage of Assets
• Orderly Disposition Forced Liquidation