Business valuation throughout a business's life cycle, march 11, 2010 (1)
Which Lady Do You See? “Value, like beauty, is in the eye of the beholder”
Discussion OutlineBasic Business Valuation PrinciplesCompany Life Cycle AnalysisEarly-Stage Company Valuation Venture Capital Method PWERMLater-Stage Company ValuationQuestions
Basic Business Valuation PrinciplesPrinciple 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.
Basic Business Valuation PrinciplesPrinciple 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.
Basic Business Valuation PrinciplesPrinciple 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.
Basic Business Valuation PrinciplesPrinciple 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.
Basic Business Valuation PrinciplesDefinition 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
Basic Business Valuation PrinciplesDefinition 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
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.
Company Life Cycle Analysis Company Life CycleEnterprise Value Seed Start-up Growth Established Expansion Mature Decline
Company Life Cycle Analysis Stage Focus FinancingSeed Proof of concept, prototype, business planning Personal finances, friends, family, customers, grantsStart-up Production, establish customer base Angels, venture capitalGrowth Infrastructure - systems, processes, effectiveness Venture capital, mezzanine, private equityEstablished Improvement, productivity, efficiency Profits, banks, private equityExpansion New markets and distribution channels Profits, banks , private equity, IPOMature Declining sales and profitability, sustain cash Profits, banksExit Valuation, transition planning ESOP, MBO, IPO, strategic sale, bankruptcy
Company Life Cycle Analysis Methods Stage Data Risk VC DFE CE GLC GPT AB LiqSeed Soft data, value proposition Extremely high X XStart-up Validation, time to market High X XGrowth Preliminary revenue, may not be profitable Moderate X X X XEstablished Predictable revenue, profitability Low X X X X XExpansion Historical data, EBITDA, cash flow Moderate X X X X XMature Historical data, EBITDA, cash flow High X X X X X XExit Historical data, EBITDA, cash flow NA X X X X X X
Early-Stage Company ValuationWhy 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.
Financing - Venture Capital MethodApplication of method will differ dependingon 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
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.
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
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
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
Financing - Venture Capital Method1. Estimate Future Value:Expected revenue in year of exit $ 50,000,000Times: Revenue multiple 0.6Future value of invested capital $ 30,000,0002. Determine Cost of Capital (Required Rate of Return):Required rate of return 50%Number of years until exit event 5Discount factor 7.593. Determine Post-Money Value:Future value of invested capital $ 30,000,000Divided by: Discount factor 7.59Present value of invested capital (Post-money value) $ 3,952,569
Venture Capital Method4. Determine Pre-Money Value:Present value of invested capital (Post-money value) $ 3,952,569Investment (2,000,000)Pre-money value $ 1,952,5695. Calculate Ownership Fraction:Investment $ 2,000,000Divided by: Post-money value 3,952,569Ownership fraction 50.6%
Financing - Venture Capital Method6. Calculate Number of Share to be Issued:Original number of shares 2,000,000Divided by: 1 minus ownership fraction 49.4%Total number of shares after issuance 4,048,583Original number of shares (2,000,000)Number of shares to be issued 2,048,5837. Calculate Price per Share:Investment $ 2,000,000Divided by: Number of shares to be issued 2,048,583Price per share $ 0.98
Financing - Venture Capital MethodValuation 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.
Financing - Venture Capital MethodValuation 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.
Financial/Tax Reporting - PWERMProbability Weighted Expected ReturnMethod.Also known as the scenario method.Rooted in decision-tree analysis.Future outcomes are modeled andprobability weighted.
Financial/Tax Reporting - PWERMAlong with Option Pricing Method (OPM)and Current Value Method (CVM), PWERMhas become a generally accepted methodfor financial and tax reporting purposes.Accomplishes valuation and allocation ofenterprise value across multiple classes ofstock.
Financial/Tax Reporting - PWERMSteps: 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).
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.
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.
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.
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.
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.
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
Financial/Tax Reporting - PWERM2. 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
Financial/Tax Reporting - PWERM3. 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
Financial/Tax Reporting - PWERM4. 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
Financial/Tax Reporting - PWERM5. Assign Probability to Each Outcome: TotalInitial 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 TotalInitial Public Offering $ 1,214,000 $ 470,000 $ 688,000 $ 2,372,000Sell to Private Equity Firm 1,814,000 702,000 949,000 3,465,000Continue as a Private Firm 3,368,000 1,305,000 1,763,000 6,436,000Disssolution 65,000 25,000 34,000 124,000Total enterprise value $ 6,461,000 $ 2,502,000 $ 3,434,000 $ 12,397,000Divided by: Number of shares outstanding 3,405,405 1,317,735 2,000,000 6,723,140Value per share outstanding $ 1.90 $ 1.90 $ 1.72 $ 1.84
Later-Stage Company ValuationWhy 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)
Later-Stage Company ValuationUse 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