UVA-F-1471 Rev. Aug. 20, 2009

This note was originally prepared by Susan Chaplinsky, Professor of Business Administration. This version was revised in August 2009 with the assistance of Brendan Reed (JD ’09). Copyright © 2005 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 8/09. ◊

VALUING THE EARLY-STAGE COMPANY

Valuation in any context is a challenging task, one requiring careful consideration of both the risks and potential rewards of an investment opportunity. When valuing publicly traded assets, this task is aided by gathering available information on the firm’s business fundamentals and performance, benchmarking data on comparable companies, and arriving at some consensus on the relevant risks faced by investors and how to measure them. Unfortunately, when it comes to valuing privately held assets, both the available information and the consensus about how to measure risk disappear. Although the foregoing increases the challenge of obtaining plausible valuations for privately held assets, it by no means diminishes the need for such valuations. This note briefly discusses several frequently used valuation methods and some of the issues and difficulties encountered in valuing privately held assets. In addition, it attempts to provide some direction in making the appropriate tradeoffs between the guidance provided by financial theory and the practical limitations posed by an illiquid asset class.

Conceptually, the value of an asset is the present value of a future stream of benefits derived from the asset (e.g., interest, income, cash flow) discounted at a rate reflective of the risk inherent in the stream of benefits. Valuations can be obtained from market comparables (e.g., price–earnings or EBIT multiples) or more formally by projecting cash flows for an asset and discounting them to the present at an appropriate risk-adjusted rate. The fact that an asset is privately held does not change the conceptual underpinnings of valuation; however, it does require adjustment of basic valuation methods to reflect the greater uncertainty inherent in young companies. We begin with the venture capital method and then compare it to the discounted cash flow approach. For each we describe some of the adjustments necessary for the methods to be used in early-stage companies.1

1 Real options is another method that is conceptually appealing for valuing early-stage companies. The real

option method is compared with other valuation methods, such as the discounted cash flow method, in “Methods of Intellectual Property Valuation” (UVA-F-1401). Also R. Shockley, S. Curtis, J. Jafari, and K. Tibbs, “The Option Value of an Early Stage Biotechnology Investment,” Journal of Applied Corporate Finance 15, no. 2, (Fall 2002), and T. Luehrman, “Investment Opportunities as Real Options, Getting Started on the Numbers,” Harvard Business Review, reprint number 98404.

-2- UVA-F-1471 Venture Capital Method

The venture capital (VC) method is a widely used method of valuing early-stage companies. At its heart is a simplified net present value (NPV) framework stripped of many of the details associated with the more widely used discounted cash flow method. Practitioners will argue that these simplifications are justified by the large uncertainty associated with projecting many of the inputs required for valuation. Others, as we discuss later, argue that the simplifications go too far, leaving practitioners relying on the VC method open to serious omissions.

Venture capital investors frequently present their valuation in terms of a premoney and postmoney value. Premoney refers to the value of the company prior to the addition of an investor’s capital. Postmoney is the premoney value plus the amount of the investor’s capital commitment. More generally, the postmoney value is the current perception of the potential value the enterprise can achieve over its investment horizon with the provision of an investor’s funds. The postmoney value is often presented as the amount invested in the round (I) divided by the percentage of equity an investor obtains in the round (F). These basic two terms interact in a manner illustrated by the formula below.

Number of new shares purchased A Number of shares, warrants, options outstanding B Fully diluted shares FD=SUM(A+B) Percent of total shares investor purchased F=A/FD Amount invested in this round I Post-financing valuation POST=I/F Prefinancing valuation PREPOST- I

The VC method usually begins with investors estimating how much they plan to invest.

Of necessity, the amount invested must come from an analysis of the firm’s financial situation and an assessment of the funds necessary to take the firm to the “next stage.” Based on the formula above it appears that the postmoney value is derived from the funds going into the enterprise. This appears to belie the usual notion that value is derived from cash invested in the firm today (cash out) in relation to the cash received from the firm at some future point in time. Underlying the VC method, however, is a conceptual link between cash out and cash in. To see the link, investors must forecast an entity’s exit value over the planned investment horizon. As shown below, their percentage equity ownership determines their realizations of cash from the investment.

Today Exit (T years later) Amount invested Exit value of firm’s equity × investors’ equity stake %

= Cash received upon exit (– Cash out) (+ Cash in)

-3- UVA-F-1471

The foregoing leaves a key question remaining: How do investors determine what percentage ownership they seek in exchange for the funds they provide? To determine their equity stake, investors must also know what return they hope to achieve on their investment. This rate of return is known as the target rate.2 Exhibit 1 reports the common target rates and horizon periods of private equity investors by stage of investment. In general, the greater the target rate and horizon periods are, the less developed the enterprise. For the sake of argument, let’s assume a target rate of 50%. While the merits of this can be debated, the VC method generally disregards all interim cash flows, so that an investment is evaluated based on the money invested today in relation to the amount to be received t periods later, or its terminal value. Let’s assume an investor is contemplating investing $1.5 million today and foresees at exit the enterprise being worth $50 million five years from today.

Figure 1. Illustration of the VC method.

Target rate 50% Years 0 1 2 3 4 5

Investment cash flows (millions)

($1.5) 0 0 0 0 $50.0 PV of exit value (millions) $6.58 FV of amount invested (millions) $11.39 Ownership stake (%) 22.78% 22.78%

In Figure 1, the present value (PV) of the exit value is found by discounting $50 million

at 50% per period for five periods (i.e., $50 million ÷ 1.505 = $6.58 million). The ratio of $1.5 million invested today divided by the present value of the exit value gives the percentage ownership stake an investor must negotiate to achieve a 50% target return. The present value of the exit value is in actuality the postmoney value of the enterprise. In concept, this represents the value today of the potential value the enterprise can achieve given the infusion of funds. The premoney value is simply $6.58 million – $1.5 million = $5.08 million.

Alternatively, one can approach the problem by focusing on the future point of exit. In this case, we determine the future value (FV) of $1.5 million invested today at 50% per year for five years. This turns out to be $11.39 million (i.e., $1.5 million × 1.505 = $11.39 million). If we anticipate exiting at $50 million, then an investor needs to realize $11.39 million in order to achieve a 50% return. Therefore, he or she needs to own 22.78% of the firm’s equity at the time of exit (i.e., $50 million × 22.78% = $11.39 million). Given the symmetry between present and future values, one can view the problem from either perspective. Given the importance attached to the postmoney value in negotiations, however, one is more apt to encounter the VC method from the first perspective of present value.3

2 Be careful to distinguish the concept of a target rate from that of an expected or required rate of return. The

target rate is the return one hopes to achieve in the best outcome. The expected return is the return one is likely to achieve factoring in the probability that things do not always work as planned.

3 All else equal, it should make sense that if investors increase their investment to say $2 million that the required ownership stake will increase from 22.8% to 30.4%. It will take a higher percentage of the firm’s equity at exit to realize the 50% return.

-4- UVA-F-1471 Number of Shares and Price per Share

So far, we have not said anything about the number of shares or price of the equity shares. There is a reason for that—for the most part, the number of shares and the price per share are fungible. They are often determined after a postmoney value and a percentage equity stake are established. By analogy, one might think of the example of a stock split. The price and number of shares is of lesser importance than the overall value they equal. Nonetheless, it is useful to consider how the number of shares and price per share are determined because ultimately those values must be entered on the term sheet and stock purchase agreement for the round. Let’s assume in our example that the firm had 500,000 founders’ shares outstanding prior to this round’s investment.4 We know from our prior example that investors wished to achieve a 22.78% equity stake. Therefore, the number of new shares, N, can be found as follows:

2278.0 )000,500(

)( = +

= N

N NSharesNew

Solving for N yields 147,501 new shares, which, when added to the founders’ shares, results in 647,501 total shares outstanding following the round.5 The price per share can now be determined several ways.

• Based on the postmoney value, $6.58 million ÷ 647,501 = $10.17 per share.

• Based on the premoney value, $5.08 million ÷ 500,000 = $10.17 per share.

• Based on the amount invested, $1.50 million ÷ 147,501 = $10.17 per share.

It goes without saying that the per-share price must be the same in all three cases.

A $10 per-share price probably falls outside the norm that investors hold for a first-round investment. As we noted earlier, the number of shares and prices are fungible, and in this case, one can well imagine that the firm will undergo a “mini-recap” wherein the number of founder shares will be increased and the new shares adjusted accordingly to result in a lower per-share price for the round. From a valuation viewpoint, such adjustments are cosmetic. There are many examples, however, of norms or reference prices in practice, and this is an example that pertains to private equity. Option Pools

In negotiating other issues relevant to valuation, the parties should also consider a third constituency, the firm’s employees. The entrepreneur and investors will likely agree upon the importance of reserving a pool of shares for future use as an employee incentive, both to

4 Founders’ shares are shares of common equity as opposed to preferred shares 5 One can also find the number of new shares as the number of preexisting shares × [F ÷ (1 – F)]. (500,000 ×

(0.2278 ÷ (1 – 0.0.2278) = 147,501 new shares).

-5- UVA-F-1471 augment compensation or to hire and retain highly talented workers. Although the entrepreneur and investors will agree on the need to reserve shares for employees, they may not agree on the number of shares that should be reserved or how such shares should be incorporated into the company’s valuation.

Investors should discuss up front how the share reserve pool will be incorporated into the valuation with the entrepreneur. Using the above example, we can see the importance of this determination. Suppose the preclose valuation is set at $6.58 million, and 250,000 shares have been allocated to the share reserve pool. Investors will seek to include those reserved shares in the number of shares outstanding. Therefore, they will argue that a total of 750,000 shares rather than 500,000 shares are previously outstanding. Since investors are bargaining for 22.78% of the company, their share allocation should be 221,251 (versus 147,501) shares, which would result in a larger total of 971,251 (versus 647,501) shares outstanding after the close of the deal. Since more new shares are issued, the price per share falls from $10.17 to $6.78 ($6.58 million ÷ 971,251), but since investors own 221,251 shares, their investment is still worth $1.5 million (ignoring rounding).

It is in the entrepreneur’s interest, however, to try and exclude the reserve pool from the valuation. If the entrepreneur is successful, investors will still receive 147,501 shares as originally calculated. As the reserved shares are granted to employees, they will dilute the value of the investors’ shares. The fully diluted price per share is still $6.78, but investors would hold only 147,501 shares. Therefore, the value of their investment would be worth $1.0 million instead of $1.5 million. In this circumstance, investors actually purchase 15.2% of the company (147,501 ÷ 971,251 = 15.2%) rather than the 22.8% they originally sought.

The treatment of the share reserve pool not only affects the price per share and the value of the investment, but other aspects of the deal that have to do with control rights. One such example concerns the corporate governance provisions. Credible governance mechanisms help to maintain the value of an investment by providing the investor with monitoring capabilities that can be used to discourage misbehavior by the entrepreneur. The strength of those monitoring provisions often depends on the percentage of ownership and control investors’ possess. Therefore, for a number of reasons, investors should be mindful of the treatment of reserve pools in negotiating the terms of the deal. Discounted Cash Flow Method

The discounted cash flow (DCF) approach typically attempts to determine the value of the company (or enterprise) by establishing the NPV of cash flows over the life of the company.6 Since a corporation is assumed to have infinite life, the analysis is typically broken into two parts: a forecast period and a terminal value. In the forecast period, explicit projections of free

6 One can value the enterprise or the equity of the enterprise, but this note focuses on valuing the company as a

whole (the enterprise). When valuing the equity, residual cash flows are used, which are after-interest payments and debt repayments. One must discount residual cash flows at the cost of equity.

-6- UVA-F-1471 cash flow (FCF) that incorporate the economic benefits and costs of the firm must be developed. Ideally, the forecast period should equate with the interval in which the firm enjoys a competitive advantage (i.e., the circumstances where expected returns exceed required returns). More often than not, 5- or 10-year forecast periods are used in lieu of careful thinking about the subject. The value of the company derived from FCFs arising after the forecast period is captured by terminal value. Terminal value is usually placed in the last year of the forecast period and capitalizes the present value of all future cash flows beyond the forecast period. Often the terminal region cash flows are projected under a steady-state assumption that the firm enjoys no opportunities for abnormal growth in this interval or that the expected returns from the target equal the required returns. In summary, to capture the firm’s ongoing nature, we break the valuation of the firm into two regions:

VALUE (V) = PV(FCFs in Forecast Period) + PV(FCFs after Forecast Period)

Once a schedule of FCFs is developed for the enterprise, the weighted-average cost of

capital (WACC) is used to discount them and to find the present value. The present value of those cash flows provides an estimate of company value or enterprise value. Since few start-up firms make extensive use of debt financing, the WACC is usually based on the company’s equity cost of capital.

In contrast to the target rate used in the VC method, the WACC used in the DCF method represents the opportunity cost or expected return on investments of similar risk to the enterprise in question. Free Cash Flows

The free cash flows should be operating cash flows attributable to the company, but excluding financing charges. Generally, cash flow will be the sum of after-tax earnings, plus depreciation and noncash charges, less investment. From an enterprise valuation standpoint, earnings must be the earnings after taxes available to all providers of capital or NOPAT (net operating profits after taxes). Cash flows should include the expected synergies (cost savings, growth opportunities, etc.) of owning the firm in question. The cash flows must also be expected cash flows meaning they reflect the level of performance that is most likely for the firm and not the best or worst cases possible. By comparison, the VC method uses a success or best case scenario. That distinction is especially important for early-stage companies: Research suggests that 50% to 60% of all startups fail within four years of their founding.

-7- UVA-F-1471 The inputs to free cash flow (FCF) are as follows:

EBIT (1 – T) = Net operating profit after taxes + Depreciation = Noncash operating charges including depreciation, depletion, and

amortization recognized for tax purposes – Capital expenditures = Addition of long-lived capital assets during year (net of dispositions) – ΔNWC = Change in net working capital (NWC), defined as current assets less

non-interest-bearing current liabilities.

To determine the expected FCF, the best-case forecast of FCF must incorporate the high probability of enterprise failure for an early-stage company. The expected FCFt is given as:

E(FCFt) = Best-Case FCFt × (1 – Probability of Failure).

Enterprise or project failure is what is referred to in portfolio theory as diversifiable or unique risk. Across a portfolio containing several investments in early-stage companies, diversifiable risk is reduced until the risk of the portfolio comprises largely nondiversifiable or systematic risk. For diversified investors in private equity, which would include most categories of limited partners (e.g., pension funds, insurance companies, endowments, or high-net-worth individuals), the discount rate used in the DCF method is based on the systematic risk or beta of the enterprise. Note that this does not mean that unique risk is unimportant. Rather, under the DCF method, the cash flows are adjusted directly for the possibility of enterprise failure or unique risk rather than adjusting the discount rate, which captures systematic risk.7

Even the simplest income statement (Figure 2), which provides key inputs into the estimation of FCF, requires assumptions about the level and growth rate of revenues, production costs (COGS), and marketing expenses (SG&A). In addition, estimates of the amount of capital expenditures upon which depreciation depends, and the sustainability of operating margins are required. Such forecasts are difficult to make for mature companies, let alone for start-ups. Nonetheless, those projections are at the heart of any business plan, and their reasonableness is often the basis upon which investors make their judgment of an entrepreneur’s understanding of the business and marketplace realities.

7 The greater the percentage of an entrepreneur’s wealth that is invested in the company, the higher his or her

opportunity cost or discount rate will be in relation to that of investors. Leaving aside differences in future performance expectations for the firm, the difference in risk between entrepreneurs and investors is one reason why valuations can differ so markedly between the parties. One paper estimates the cost of capital for venture capital investors and entrepreneurs in high-tech initial public offerings (IPOs). It reports for the sample average a 16.7% cost of capital before management fees and carried interest for a well-diversified investor. By comparison, an entrepreneur with 25% of his or her wealth invested in the venture and 75% in a diversified market portfolio is estimated to have a cost of capital of 40%. See F. Kerins, J. K. Smith, and R. Smith, “Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs,” Journal of Financial and Quantitative Analysis 39, no. 2, (June 2004).

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Figure 2. Income statement.

Sales – Cost of goods sold (COGS) – Selling & administrative expenses (SG&A) Earnings before interest & taxes (EBIT) – Interest expense Taxable income – Taxes Net income (NI)

The DCF approach cannot eliminate the need to make difficult forecasts, but it can

handle several problems that occur frequently with early-stage companies. First, by including all FCFs in the forecast period, the method captures the value associated with the fact that early- stage companies frequently lose money in their first several years in business. Second, it includes capital expenditures and the purchase of other long-lived assets. These items are not included in COGS or operating expenses, which are annual or short-term expenses. These expenditures can have pronounced effects on both the funding requirements and ultimately the viability of early- stage enterprises. Third, it can address the problems of high (or varying) growth rates and uncertainty in a straightforward manner through the use of probability-weighted scenarios. The DCF method, if properly employed, allows an investor to account in a fuller sense than the VC method for the uniqueness of each company. After all, it is the uniqueness of the company and its particular circumstances upon which success in private equity depends.8 Terminal Value

To capture the longevity of the cash flows, the DCF method typically uses a terminal value (TV) at the end of the forecast period to value the cash flows beyond that point. As a base case, terminal value can be estimated using a constant-growth-rate DCF formula:

TVN = Terminal value in year N that values cash flows beyond year N FCFN = Free cash flow for year N Growth = Long-term sustainable growth rate of cash flows—normally equal to GNP growth or

inflation plus 1% to 2% real growth. WACC = The discount rate should reflect the risk of the cash flows. Since early-stage

companies are private, we find an appropriate rate based on the beta coefficients from publicly held companies that are comparable to the target.

8 For further discussion of the merits of the DCF method in this context, see D. Desmet, T. Francis, A. Hu, T.

Koller, and G. Riedel, “Valuing Dot-coms,” The McKinsey Quarterly 1 (2000).

FCFN × (1 + Growth)

WACC – Growth TVN =

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If carefully applied, a growing perpetuity can provide a reasonable estimate of TV for established companies, but determining one sustainable growth rate for an early-stage company can be problematic. For this reason, market comparables are often used to supplement the base- case TV estimate.

Some of the frequently used multiples in private equity are evaluated in Figure 3 for a typical company included in Standard and Poor’s (S&P) Small Cap 600 Index. The publicly traded companies that make up the index are generally larger in size, more transparent, and liquid than a privately held company. For those reasons, the public company valuation multiples are reduced by a 30% liquidity discount to reflect the fact that investors have been shown to pay more for more transparent and liquid companies.9 Assuming a five-year exit horizon and that the value of the firm is based only on the terminal value cash flow (something that violates the assumptions of the DCF method), the Figure 3 shows the comparative postmoney valuations derived using alternative valuations approaches. The growing perpetuity method provides the lowest valuation, most likely because the assumed growth rate of 5% is less than the embedded growth rates of the other multiples. The range in estimates underscores the importance of examining alternative estimators of terminal value.

9 Two studies attempt to more rigorously estimate the size of the liquidity discount by comparing publicly

traded firm valuation to private firm valuation for a sample of firms in the same industry over the same period of time. J. Koeplin, A. Sarin, and A. Shapiro, “The Private Company Discount,” Journal of Applied Corporate Finance 12, (Winter 2000): 94–101 reports a 30% liquidity discount for a sample of firms from 1984–98. S. Block, “The Liquidity Discount in Valuing Privately Owned Companies,” Journal of Applied Corporate Finance, (Fall/Winter 2007): 33–40 finds an average discount of 20% to 25% for a sample of firms between 1999 and 2006. His study also examines the discount by industry and finds that the discount is highest for manufacturing firms (30% to 40%) and lowest for financial firms (8% to 10%). Block attributes the lower discount in the latter period to the reduction in the length of holding period from two years to one year under Rule 144 before which private assets can be sold publicly. Because after 1997, Rule 144 requires investors to hold an investment for one year, these assets are more liquid than the typical early-stage investment, and we use 30% as a more representative discount in the absence of more detailed information about the assets being valued.

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Figure 3. Comparative postmoney valuations.

Valuation Multiples Growing

Perpetuity Price–Earnings

Ratio

Enterprise Value ÷

EBITDA10 Enterprise

Value ÷ Sales Inputs: Discount or target rate (%) 17% 50% 50% 50%

Numerator Free cash flow Market

capitalization Enterprise value Enterprise value11

Denominator (WACC – g) Net income EBITDA Sales Terminal year cash flow ($ mil.) $80 $91 $165 $960 Valuation multiples – 20.30 10.90 1.90 Less liquidity discount 30% – 30% 30% 30% Multiple applied – 14.21 7.63 1.33 Terminal value $7

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