Ilya Strebulaev,Stanford GSB, presentation at Deep Dive seminar(http://www.tecglobal.org/tec_20101129)

1. Valuation and Financing for Entrepreneurs:
A One-Hour Crash Course
Ilya Strebulaev
Stanford GSB
It requires a very unusual mind to undertake the analysis of the obvious
Alfred North Whitehead

2. Our Objectives
Four questions we will concentrate on:
◮ How to come up with an estimate of the value of your project/firm?
◮ How to finance your idea to make it into a successful project into a
successful company?
◮ How to write financial contracts with your money providers?
◮ How to optimize your exit strategy?
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3. c Ilya Strebulaev Valuation and Financing 2

4. Valuation
What information do you need
◮ Your free cash flows this year and in the future
• free: not re-invested in the firm
◮ Your discount rate
• Reflects riskiness of the project
• Reflects general level of interest rates in the economy
• Also called: required rate of return; cost of capital
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5. Valuation example
Ilya Inc.
◮ The project costs $15,000 now (2005) to invest
◮ The project will bring $10,000 each year in 2006, 2007 and 2008
◮ The project has the discount rate of 20%
10, 000 10, 000 10, 000
Net Present Value = −$15, 000+ + 2
+ 3
∼ $6, 000
1.2 1.2 1.2
◮ What happens if the discount rate is 50%?
10, 000 10, 000 10, 000
Net Present Value = −$15, 000+ + + ∼ −$1, 000
1.5 1.52 1.53
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6. Main valuation rule
Invest in projects that have positive NPV
◮ How to estimate cash flows and discount rates for your project/firm?
◮ General case: much more difficult to estimate at an earlier stage
◮ Look at comparables
• Projects/firms/divisions of firms in a similar industry
• Valuation of recently sold businesses in your industry/region
◮ Look at industry practices/venture capitalist required rate of return
◮ Look at your competitive advantage
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7. Stages of financing
Seed stage investment
◮ Idea
◮ Business plan (often a confidential piece)
• The proposed product
• The potential market
• The underlying technology
• The needed resources (money, human capital, equipment, time)
• The resources currently in place
◮ What is crucially important at this stage for money providers
• Faith in the entrepreneurial team
• Faith in the product
◮ Who finances at this stage?
• Relatives, friends
• Venture capitalists (VC)
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8. Seed financing: Cont’d
◮ What are standard contracts between VC and the product team?
• Equity: VC becomes a partial owner of the company
∗ Often: preferred equity convertible into common stock
· Preferred equity has the first-right advantage over common equity
∗ Use it to your advantage, do NOT be afraid of that!
• VC gets a place on the board of directors
∗ Monitoring and control function
∗ Use VC’s expertise
◮ How to maximize VC’s faith in your project?
• Put your money where your mouth is
◮ What you need to be aware of that:
• Control function of VC
• Example: equity dilution
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10. Second-stage financing
◮ Common purposes:
• Pilot production
• Test marketing
• Further/larger experiments
◮ Who finances at this stage?
• The original VC [may have the first priority]
• Other VCs, wealthy individuals
◮ What form does new financing take?
• Preferred/common equity
• Convertible debt
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11. Deviation
Difference between equity and debt
◮ Common equity entitles to ownership of business
• “Ownership” means ”Residual cash”
• Cash is not promised
◮ Debt entitles to pre-specified income
• Cash is promised
• If not paid, the firm defaults and in the hands of creditors
◮ Preferred equity and convertible debt are between equity and debt
• Convertible debt is debt that can be converted into equity
• Preferred equity is equity with promised dividends
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12. Equity vs Debt
Continued
◮ Priority in distribution of profit/assets
1. Senior secured debt [bank debt, some VC debt]
2. Other debt
3. Junior [usually convertible] debt
4. Preferred equity
5. Common equity [owners of the firm: the production team]
◮ How to compare various financial securities/contracts:
• Differences in cash flow risks
• Differences in incentives
• Differences in control
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13. Mezzanine stage financing
◮ Purposes:
• Full-scale production
• Serious marketing
◮ Mezzanine investors are different from VC
• Lower appetite for risk ...
• ... but ready to accept lower returns
• Stock/Convertible debt/Debt
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14. Exit strategies
◮ Don’t count your chicken until they are hatched
◮ But ...
• A stitch in time saves nine!
◮ Plan your exit strategy in advance
◮ Possible outcomes
• Sale to a private equity firm, loss of ownership
• Merger/acquisition/takover within industry
• Initial public offer
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15. Initial public offer
◮ Many successful start-ups in the US/UK eventually go public
• Continental Europe: most companies remain private
◮ Primary vs secondary offering: raising new capital vs cashing in
◮ Selecting the market
◮ Selecting underwriters
• Underwriters: legal/procedural/financial advice, buy the issue and resell
◮ Important: any IPO will change the distribution of control in the firm
• Public markets have different attitude towards risk than VCs
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16. Financing and valuation:
Last word
There are three sorts of economists.
Those who can count and those who can’t.
attributed to John Maynard Keynes