Valuation of start-ups

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1 Valuation of start-ups We ready to begin? Introduction Valuation is one of the biggest hurdles to overcome when taking on an equity investment. Nobody truly knows the value of a company without historical financials to better predict the future. i.e. Basketball players are often drafted based on future potential 1

2 Valuation an art, not a science Early-stage companies are often comprised of little more than an entrepreneur with an idea. Valuations are heavily influenced by: - Founding Team; - Novelty of the Idea; - Defensible Positions; - Time to market (runway); - Path to profitability; and - Estimated capital needs Liquidity/Funding Risk: The likelihood that a company will not be able to raise additional capital following the current round. Ex. Company A has $100,000 in cash and is spending $25,000 per month and has not yet generated revenue. The Company s burn rate is $25,000 per month and the company has 4 months left before it runs out of money. If it doesn t raise more capital, it will be insolvent. Market Risk: Timing the market plays a significant role in a start-up s success or failure. It s almost impossible to know exactly the right time to introduce a product or service. A company can fail from being too early or too late. 2

3 Management Risk: Starting a company is one of the hardest things to do in business and multiple mistakes will be made (even by seasoned entrepreneurs). The less experienced the team, the greater the odds mistakes will happen. Too many mistakes will crater a company. Macro Risks: Recessions, down-turns in the market force businesses and consumers to get defensive with their cash. Companies are forced to lower prices to attract business. But this will make the start-up less profitable. Competitive Risks: Goes back to how strong a start-up s defensible position is. Investors need to account for the chance that well-funded competitors can potentially take away the opportunity. 3

4 Based on the identified risks, investors will assign a probability to each of the risks to generate a Rate of Return for the investment. Ex: Funding / Liquidity Risk 15% Market Risk 15% Management Risk 10% Macro Risks 5% Competitive Risks 15% Required Rate of Return 60% Rate of Return example. Cowboy Ventures is interested in making a $3MM investment in a start-up called Time Capsule. Their Rate of Return is 35% and they estimate that it will take 4 years before the company has a liquidity event. Calculate the Future Value of Cowboy s investment: $3,000,000 * (1+.35)^4 = $9,964,518 Rate of Return example (cont d) Assuming $9,964,518 is Cowboy s Future Value of its investment in 4 years, what s the Exit Value of the company (assuming that Cowboy owns 35% at the exit)? $9,964,518 /.35 = $28,470,051 4

5 Rate of Return example (cont d) Assuming $28,470,051 is the exit value for Time Capsule in 4 years, using Cowboys 35% ROR, what is the present value of Time Capsule? $28,470,051 / (1+.35)^4 = $8,571,427 Present Value Before we move on: Any Questions on: Translating identified risks into a Rate of Return? Hold times also plays a large factor Investors put startups on the clock the minute the cash goes into the company. And, if an investor believes that it s going to take longer to get the money out, this will affect valuation. Typically, it takes 5-7 years from a company s commercialization launch (Series A) to an exit. 5

6 Hold times also plays a large factor Using the Cowboy/Time Capsule example again, look at the return expectations Cowboy would have based on holding times: Investment ROR Yrs. Held Est. Future Value Option 1 $3,000,000 35% 4 $9,964,518 Option 2 $3,000,000 35% 7 $24,516,453 Option 3 $3,000,000 35% 9 $44,681,235 Before we move on: Any Questions on: Hold times and how they affect valuation? Future dilution is another factor Dilution Occurs anytime a company issues more shares. Equity % ownership decreases in proportion to the percentage of new shares issued. When conducting a valuation, investors will try and forecast future dilutive events. 6

7 Future dilution is another factor Dilution Tom and Sara each own 1,000,000 shares in Company XYZ. They agree to let New Investor purchase 500,000 shares. Before Investment After investment Tom 1,000,000 50% 1,000,000 40% Sara 1,000,000 50% 1,000,000 40% New Investor - 0% 500,000 20% Total Shares 2,000, % 2,500, % Future dilution is another factor Good Dilution When the Value of an investors ownership increase at subsequent capital raises. % Ownership Value of Ownership Time Time Future dilution is another factor Good Dilution When the Value of an investors ownership increases at subsequent capital raises. Ownership Valuation Value of Ownership At Investment 25% $5,000,000 $1,250,000 Post Series A 15% $15,000,000 $2,250,000 Post Series B 10% $45,000,000 $4,500,000 Post Sereis C 5% $135,000,000 $6,750,000 7

8 Future dilution is another factor Bad Dilution When the Value of an investors ownership decreases at subsequent capital raises. % Ownership Value of Ownership Time Time Future dilution is another factor Bad Dilution When the Value of an investors ownership decreases at subsequent capital raises. Ownership Valuation Value of Ownership At Investment 25% $5,000,000 $1,250,000 Post Series A 15% $15,000,000 $2,250,000 Post Series B 10% $12,000,000 $1,200,000 Post Sereis C 5% $10,800,000 $540,000 Future dilution is another factor Dilution Example: Suppose Cowboy Ventures is seeking 35% for a $3,000,000 investment in Time Capsule. They believe that, two years after their investment, Investor B will acquire 30% of Time Capsule for a $5,000,000 investment. Cowboy doesn t want its shares diluted by this event. How does it bake this event into their valuation of Time Capsule? 8

9 Future dilution is another factor Dilution Example (Cont d) 35% / (1-.30) = 50% After applying the retention ratio formula, Cowboy is now projecting it needs 50% ownership in Time Capsule, not 35%. If/when Investor B comes in, Cowboy will be diluted back down to and estimated 35%. Before we move on: Any Questions on: Dilution and applying retention ratios? Pre-Money vs. Post Money Valuation Pre-money valuation is the estimated value of a company as it stands prior to any purchase of equity. Post-money valuation is the estimated value of the company + the new cash coming into the company. Pre-Money Valuation + Invested capital = Post Money Valuation 9

10 Pre-Money vs. Post Money Valuation Example: Cowboy wants to invest $3MM in Time Capsule. The Pre-Money Valuation agreed to by Cowboy and Time Capsule is $5,571,427. The Post Money Valuation = $8,571,427 Cowboy would receive 35% of Time Capsule for its investment. $3,000,000/$8,571,427 = 35% Pre-Money vs. Post Money Valuation Example: Cowboy agrees to invest $3,000,000 in Time Capsule in exchange for 35% of the company $3,000,000 / 35% = $8,571,427 Post Money Valuation $8,571,427 - $3,000,000 = $5,571,427 Pre Money Valuation Calculating Price Per Share Price per share = Pre-Money Valuation / Pre-Money Shares Ex. Based on previous example, if Pre- Money is $5,571,427 and there were a total of 1,000,000 shares outstanding in Time Capsule (before Cowboy s investment), the share price would be: $5,571,427 / 1,000,000 = $

11 Using share price to calculate shares Translating an investment into shares = Ex. Based on Cowboy/Time Capsule example, if the price per share is $5.5714, how many shares will Cowboy receive for its $3,000,000 investment? $3,000,000 / $ = 538,461 Shares How to create a new pool of equity Example. If Cowboy is investing $3,000,000 in Time Capsule for 35% ownership and Time Capsule has 1,000,000 shares outstanding, how many shares will need to be issued to Cowboy? 1,000,000 / (1-.35) = 1,538,461 1,538,461 1,000, ,461 Pre-Money vs. Post Money Valuation *Example*: Cowboy agrees to invest $3,000,000 in Time Capsule in exchange for 50% of the company (Because they factored in future dilution). Note how it always lowers the valuation. $3,000,000 / 50% = $6,000,000 Post Money Valuation $6,000,000 - $3,000,000 = $3,000,000 Pre Money Valuation 11

12 Before we move on: Any Questions on: Pre-Money vs. Post Money valuation, finding a share price, and creating a new pool of equity? Dealing with Option Pools Option Pools. Shares set aside for possible issuance to employees at a later date. Venture Funds will typically ask that a new option pool be created at the time they invest. The reason is to incentivize employees to stay with the company and work hard. But they don t want an option pool to dilute their ownership. Dealing with Option Pools Option Pools. Example: Company A 1,000,000 outstanding shares Suppose Cowboy Ventures agrees to invest $3,000,000 in Time Capsule in exchange for 35% of the company. They also want Time Capsule to create a 10% option pool. How can Cowboy ensure that it s investment doesn t dilute the option pool and vice versa? 12

13 Dealing with Option Pools Option Pools. Example: Time Capsule / 1,000,000 outstanding shares (Cont d) 1,000,000 / ( ) = 1,818,181 1,000,000 1,818, ,182 New Shares Dealing with Option Pools Option Pools. Example: Time Capsule / 1,000,000 outstanding shares (Cont d) Cowboy 35% 77.78% 636,364 Option Pool 10% 22.22% 181,818 45% % 818,182 Dealing with Option Pools Option Pools. Example: Time Capsule / 1,000,000 outstanding shares (Cont d) Existing TC owners 1,000,000 55% Cowboy Ventures 636,364 35% Option Pool 181,818 10% 1,818, % 13

14 Before we move on: Any Questions on: Creating an option pool alongside a pool of equity for the Venture Investor? The Venture Game Valuation Model The Valuation Model requires the following steps: Step 1: Project the Future/Exit Value of the start-up at the assumed exit year under three scenarios: Best Case, Middle Case, and Worse Case. The Venture Game Valuation Model The Valuation Model requires the following steps: Step 2: Discount the future values back to present values based on the investor s Rate of Return (ROR) 14

15 The Venture Game Valuation Model The Valuation Model requires the following steps: Step 3: Assign a probability of occurrence for each of the three scenarios. And multiply each of the present values against the assigned probability. Add each of the revised present values up and create a Estimated Present Value The Venture Game Valuation Model The Valuation Model requires the following steps: Step 4: Divide the Estimated Present Value by the anticipated Investment to come up with a targeted Ownership Requirement. And then, if the investor expects future dilution, apply a Retention Ratio. The Venture Game Valuation Model The Valuation Model requires the following steps: Step 5: Convert the targeted ownership into a Post-Money Valuation, Pre-Money Valuation, and a share price. 15

16 The Venture Game Valuation Model Please go through the Valuation Homework problems in advance of the next class using the EquityBible. We ll be spending the entire class working through the problems. Please be prepared to provide answers and how you go them. See you Wednesday 16