Early Valuation for Entrepreneurs by John Shumate
John Shumate is CEO of ValuLogik and has focused his career on working closely with venture-backed companies. He has worked with hundreds of early- and growth-stage companies across many industries, many of them dealing with highly-technical products or business models. He believes strongly in the use of carefully-applied rigor to rationalize financial models, business plans, valuations, and other quantification tools. He has over a decade of financial experience, including buy-side and sell-side mergers and acquisitions; debt and equity capital raises; strategic consulting; complex financial modeling; business plan development; equity and derivative valuation; and venture incubation. John recently served as Vice President at Blue Equity, a growth-stage private equity firm, and Chief Financial Officer at BellaNovus, an early-stage medical device development company. He was a Senior Associate at bCatalyst, a business incubator and financial services provider to early-stage companies. He has also held analytical roles for Ethicon-Endo Surgery, a division of Johnson & Johnson, and Hilliard-Lyons, a regional brokerage house. John attended the Wharton School at the University of Pennsylvania, where he received a B.S. in Economics and dual concentrations in Finance and Management
2. Roadmap
Page 2
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
3. Seminar Introduction
Page 3
• Purpose:
• Practical equity funding “rules of thumb”
• Fundamental valuation methodologies
• Current trends in funding
• Context of early-stage companies
• Perspective:
• Early-stage valuation and analytics specialists
• “Real world” perspective with practical focus
4. Profile
Page 4
John Shumate – CEO, ValuLogik
ValuLogik (financial services; early-stage)
BellaNovus (medical device)
Blue Equity (private equity)
bCatalyst (incubator)
Ethicon – Johnson & Johnson (medical device)
Wharton; B.S. Finance
University of Pennsylvania
5. Roadmap
Page 5
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
6. Context: Why Are We Here?
Page 6
Entrepreneurs
Competitors
Investors
Customers
Next Big Thing
Analyze Value
7. Focus: Equity Valuation
• Variety of different property to value
• Focus on Equity Valuation or deriving the valuation of a
company (or some interest in that company)
Page 7
Security Type Example
Equity Company
Fixed Income Bonds, Annuities, etc.
Derivatives Stock Options
Real Estate Warehouse
Currencies HKD vs. USD
8. Take a Step Back: Valuation Purpose
• Valuation: Process to establish value for an entire or partial
interest in a company, considering both quantitative and
qualitative, tangible and intangible factors
• Context is extremely important
Page 8
Context Objective
Selling Company Maximize Value
IPO Float Successful “Pop”
Buy-Side Analysis Minimize Price
Spin Out Fair Market Value
Stock Option Strikes Min (Mgmt); Mixed (Shareholders)
Litigation Biased Argument
Mediation Fairness Opinion
9. Real World Use
• Many real world applications of core valuation concepts
• Just a few include:
Page 9
Venture
Investment
Stock
Options
Initial
Public
Offering
Buy-Side
Acquisition
Merger
Sell-Side
Acquisition
Debt
Offering
Defense
Analysis
Fairness
Opinion
“Recap”Divestiture Research
10. Standards of Value
Page 10
Fair Market Value
• Standard for most
transactions
• Willing buyer,
willing seller
Fair Value
• Multiple
definitions
• Not as widely used
Strategic/Investment
Value
• Value to a specific
investor
• Based upon
individual needs
• Three core standards of value
• Fair Market Value (FMV) is most common standard
• FMV Definition: “The price at which the property would
change hands between a willing buyer and a willing seller,
neither being under a compulsion to buy or sell and both
having reasonable knowledge of relevant facts.”
11. Distribution of Value Perspectives
Page 11
• Different parties view value of the same entity differently:
12. Levels of Value
Page 12
• Resulting levels of value occur
• Various discounts/premiums
13. Keep in Mind
• Two key valuation questions:
1. What is the company worth?
2. What can/will someone pay?
• Art as well as science
• Highly subjective in nature
• Purpose, context, and surrounding conditions are key
• Based upon future performance
• Past performance is indicator of future performance for
later stage companies
• Early-stage, high-growth, and more speculative companies
are forward-looking
Page 13
Not Always the same
14. Understanding Future Potential & Risk
• Risk/Return Trade-Off
• Risker investments require a higher rate of return
• “What percentage return would and investor require?”
Page 14
If expected return
doesn’t justify added
risk of moving from A
to B, not worth the risk
15. Core Types of Equity Investments
Page 15
Common Stock
Preferred Stock
Participating Preferred
Options
Warrants
16. Roadmap
Page 16
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
17. High-Level Drivers
• The longer it takes your forecast to get to profitability, the less
you are worth now
• Use comparable companies as a guide: what was a
comparable company’s value at profitability?
• In some instances, you are worth as much as your potential
(Instagram)
• Reputation is important: Jeff Bezos would get a high valuation
for any startup
Page 17
18. Early-Stage “Rules of Thumb”
• How much money do you need?
• 6 months of runway / 3 experiments/studies
• Investors want to see progress/growth in 18 months
• Average early-stage investments/valuations by investor type:
Page 18
$2,600,000
$1,500,000
$1,000,000
$400,000
$640,000
$300,000
$100,000 $20,000
Micro-VC Super Angel Angel Incubator
Pre-Money Investment
19. Average Funding by Round
• Venture Deal data from January 2013 to May 2014 shows
average funding by round:
Page 19
$575,869
$6,488,214
$13,787,932
$21,508,156
$27,486,720
$50,000
$4,490,251
$10,000,000
$16,000,000
$20,000,000
Seed Series A Series B Series C Series D
Mean Median
20. Roadmap
Page 20
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
21. Roadmap
Page 21
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
22. Environmental Factors
• Variety of external factors set the landscape for valuation
• Each can have considerable impact
Page 22
IndustryEconomy Structure Other
23. Economic Impact
• Numerous economic forces can influence value
• Example: Increased volatility results in decreased equity values
Page 23
24. Industry Impact
• Overall industry conditions or competitor performance can
directly influence value
• Example: Even when an individual company is performing well,
negative industry trends can have a “drag” effect on value
Page 24
25. Structural Impact
• Imposing capital structure can have dramatic effect on a
particular class of equity
• Example: Participating preferred can increase “hurdle” for
common shares
Page 25
Preferred
Investment
Available for
Distribution
Preferred Dividends
Preferred
Participation
Common
Sale Price
26. Impact of Other External Factors
• Countless other qualitative factors can relate directly to a
company’s value
• Example: Perceived political risk can increase market
uncertainty and decrease values of companies operating in
that domain
Page 26
27. Roadmap
Page 27
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
28. Page 28
Historical Financials
• Mature companies focus on past results to predict future
performance
• Historical Income Statements (P&L) and Balance Sheets (BS)
are key for this analysis
• Review:
• P&L is a flow statement summarizing revenues and
expenses over a period of time (perhaps a year); arriving at
net income
• BS is a stock statement summarizing assets and liabilities at
a single point in time (perhaps at year-end); arriving at an
equity differential
29. Financial Projections
• Problem with historical financial analysis is that it is often
less meaningful for early-stage companies
• Early-stage companies are often targeting dramatic future
growth
• Valuations must be based on future performance
• Critical to have detailed projections
• Many early-stage valuations will be based
upon a blend of forward-looking
projections and market-based comps
Page 29
32. Financial Ratios
• Use financial ratios to examine past and future years
• Ideally, key financial ratios should be compared over a period
of several years in order to identify trends
• Common Types
• Internal Liquidity Ratios
• Operating Efficiency Ratios
• Operating Profitability Ratios
• Business Risk (Operating) Analysis
• Financial Risk (Leverage) Analysis
• Capital Efficiency Ratios
• Compare with comparable companies
Page 32
33. Roadmap
Page 33
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
34. • Three core methods for equity valuation:
• Must select the right method(s) of valuation for specific
company and purpose
• Not all valuations can be done using the same method
Asset
Approach
Income
Approach
Market
Approach
Valuation Methodologies
Page 34
35. Page 35
Asset Approach
• Considerations:
• Difficulty in appraising value of intangible assets like
trademarks, patents, goodwill, etc.
• Assets are recorded at historical costs; GAAP principles
were not intended to reflect current value
• Only effective for liquidation scenarios
• Does not value future potential
Total
Assets
Total
Liabilities
Liquidation
Value
• Asset Approach examines static value of a company’s assets
and liabilities
36. Page 36
When to Use Asset Approach
• Use Asset Approach when:
• A company is distressed and facing liquidation
• A company has developed some IP, but has no way to
value it in a contextual manner; there is no business plan
or “story to tell” of how it might generate future value
• Asset Approach is not an appropriate approach for most
early-stage companies
• Example:
37. Roadmap
Page 37
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
38. Market Method Approaches
• Market Approach examines other similar companies (“peer
group”) and derives value based upon comparison
• Two core sources of comparables:
• Publicly-Traded companies have transactions every day on
global stock exchanges
• Private Transactions include larger deals (M&A, PE, etc.)
Page 38
Publicly-
Traded
Companies
Private
Market
Transactions
39. Market Method Sources
• Result is relative value based upon key multiples
• Most commonly used multiples:
• Enterprise Value/Revenue
• Enterprise Value/EBITDA
• Both publicly-trade and transaction “comps” rely on publicly
available information
• Public companies provide daily trading info via exchanges
• Yahoo/Google Finance, Bloomberg, 10k filings
• Transactional data is more difficult to come by
• Subscription databases are the best way to get
transactional data (Zephyr, Dealogic, Capital IQ, Factset)
Page 39
42. Medical
Devices
Mobile
Applications
Market Method Subjectivity
• Difficult to find pure comps
• Large degree of subjectivity
• Must “Know the Story”
• Early-stage companies often don’t fit into neat buckets
• Similar as possible in terms of operations, stage, and financials
• Must often use a proxy mix for more complex situations
• Example: New mobile app
that interacts with surgical
equipment to improve
efficiency
Page 42
43. Selecting Comparables
• Merger and Acquisition (M&A) Comps:
• Determining the list
• Similar in operations and financial aspects (use ratios)
• Timing (within the last 2 years is optimal)
• Similar size (preferable); can use regression as well
• Circumstances around the deal
• Market conditions
• Public Company Comps
• Similar to M&A criteria
• Relevant trading multiples at a point in time
Page 43
44. Selecting Comparables
• Typically use weighted average of selected comps
• Multiply the company’s revenue or EBITDA by the appropriate
comparison multiple
Page 44
45. Roadmap
Page 45
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
46. Income Method
• For most early-stage companies, the value is in the future
• Income Method used when the earning capacity of the
company is a factor for consideration
• Determines value by converting anticipated economic benefit
into a single present value
• Three main approaches:
Page 46
Capitalization
Method
Excess Earnings
Method
Discounted Cash
Flow Method
47. • Core concept: “A dollar today is worth more than a dollar
tomorrow”
• Present value captures value today of future cash flows:
PV =
𝐶𝐹1
(1+𝑅)
+
𝐶𝐹2
(1+𝑅)2 +
𝐶𝐹3
(1+𝑅)3 + … +
𝐶𝐹 𝑛
(1+𝑅) 𝑛
where CF1, CF2, … CFn equals the cash flows in period 1, 2, … n
• This concept is central to all income method calculations
Present Value
Page 47
48. Discount Rate Development
• Calculating the appropriate discount rate is one of the most
important steps
• Two Primary Methods
• Build-Up Model
• Capital Assets Pricing Model (CAPM)
• Build-Up Method is most intuitive
Page 48
50. Build-Up Components
• Risk-Free Rate: The rate for U.S. Treasuries; the “safest
investment there is”… at least conventionally
• Equity Risk Premium: Premium that common stockholders
require in the public marketplace over investors in long-term
government bonds
• Industry Risk Premium: Premium (or discount) measuring the
risk of companies in a particular industry to the baseline risk
of the overall market
• Size Premium: Premium associated with investing in a
company of a similar size (smaller companies have higher
premiums)
• Specific Company Risk Premium: Premium for specific
company conditions (financial condition, management, ability
to raise capital, etc.)
Page 50
53. Capital Asset Pricing Model
• Rarely used since you have to know the Beta, which implies
the stock price is known
• Can use a modified version by calculating the beta based on
return on equity
Page 53
Expected
Return
Risk Free
Rate
Beta
Expected
Market
Return
Risk-Free
Rate
54. • Converts the company’s estimated future income into a
single, present value
• Assumes the critical component to the value of the business is
its ability to generate future earnings or cash flows
• Assumes steady growth in the future
• Capitalization of Earnings
PV =
Net Income
Capitalization Rate
Capitalization Rate = Discount Rate – Long-Term Growth Rate
Capitalization Method
Page 54
56. Discounted Cash Flow Method (DCF)
• Examines the present value of projected future cash flows, as
well as the terminal value at the end of that stream
• Based on unlevered cash flows
• Present value is calculated by using a discount rate
PV =
𝐶𝐹1
(1+𝑅)
+
𝐶𝐹2
(1+𝑅)2 +
𝐶𝐹3
(1+𝑅)3 + … +
𝐶𝐹 𝑛
(1+𝑅) 𝑛
where CF1, CF2, … CFn equals the cash flows in period 1, 2, … n
Page 56
58. Terminal Value
• Value of the business beyond the projections
• Two Methods:
• Exit Multiple
• Values a business as a multiple of a relevant operating
statistic (most common for early-stage company)
• Perpetuity Growth
• Assumes growth of free cash flow at a constant rate
Page 58
59. DCF Considerations
• Advantages
• Flexible, adaptable analysis
• Objective conclusion
• Requires scrutiny of key drivers of value
• Always obtainable
• Disadvantages
• Relies on forecast information
• Based on numerous assumptions
• Highly sensitive to changes in assumptions
Page 59
60. Excess Earning Method
• Used as a last resort when no other methods are applicable
• Hybrid of the asset and income approaches as it involves the
determination of the portion of the earnings that may be
attributed separately to the tangible and intangible assets of
the company
Page 60
61. Roadmap
Page 61
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
63. Roadmap
Page 63
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
64. Value Allocation
• Once the value of the company has been established, must
allocate value to various classes of shares
• Three Methods:
Page 64
Current Value
Method
Probability Weighted
Expected Returns
Method
Option Pricing
Method
65. Current Value Method
• Waterfall analysis, which allocates a company’s enterprise
value to each cascading level of stock, based upon liquidation
preference or conversion value
• Best used when:
• Liquidity event is imminent
• One class of equity outstanding
• Inception-stage of development with no material progress
on business plan; no reasonable basis for projections
Page 65
66. Probability Weighted Expected Returns Method
• Probability Weighted Expected Returns Method (PWERM)
considers multiple exit scenarios
• Weighs the respective values based upon their probability of
occurrence
• Difficulty to apply due to the significant level of subjectivity
• Example:
Page 66
67. Option Pricing Method
• Option Pricing Method (OPM) is a method for allocating
equity value between common and preferred shares
• Most commonly used allocation method
• Relies on Black-Scholes Model, a methodology for
determining the contingent future value of stock and options
• Five assumptions required
1. Underlying company value at the time of valuation
2. Strike price or the price at which the underlying stock will
be purchased in the future
3. Risk free rate for the period
4. Time to expiration/likely liquidity horizon
5. The volatility of the shares
Page 67
68. Roadmap
Page 68
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
69. Discounts to Common Shares
• Discount for Lack of Control (DLOC)
• Individual share is worth less if it is not part of a
majority block with voting control
• Both historical and industry-specific data is
available
• Typical DLOC is 25%-30%
• Discount for Lack of Marketability (DLOM)
• Individual share in private company is worth
less if you cannot sell it on an exchange
• Restricted stock studies and pre-IPO studies
available
• Typical DLOM is 30%-35%
Page 69
70. Roadmap
Page 70
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
71. Final Calculation of Value
• After the discounts have been applied, you are left with the
final calculation of value for a single share of common stock
• FMV is typically 30%-50% of the valuation of the preliminary
common share price
Page 71
72. Roadmap
Page 72
Introduction
Context
Early-Stage Funding “Rules of Thumb”
Fundamental Valuation Methodologies
Environment
Historical & Projected Financials
Asset Approach
Market Approach
Income Approach
Enterprise Value
Value Allocation
Discounts
Final Calculation of Value
Trend Towards Convertible Debt
73. Convertible Debt
• Start-ups have changed to a lean business model; investors
are following suit
• Traditional financing is cumbersome, time consuming, and
dated for early raises
• Convertible debt model allow cash inflows without having
valuation negotiations
• Solves many of the problems with traditional financing
Page 73
74. How Does Convertible Debt Work?
• Short-term
• Converts into equity in the future
• Automatically converts into shares of preferred stock at next
equity round
• Often converts at a discount to the price of the next round
• 15% - 20% is typical discount
• Typically used prior to the Series A
Page 74
75. Advantages to Convertible Debt
• Cheap and fast due to simplified term sheets
• Delays formal valuation until later round
• Keeps control with the founders
• Empowers angel investors in states that require
lender licenses
Page 75
76. Next Steps
• Contact Information
• John’s email: jshumate@valulogik.com
• Find Us on the Web
• www.valulogik.com
Page 76