Valuation: Evaluating the Deal Greg Endicott Silicon Forest Forum November 16, 2002

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ValuationEvaluating the DealGreg
EndicottSilicon Forest ForumNovember 16, 2002

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Overview of Presentation

• Defining Valuation
• Valuation Methodologies
• Evaluating the Deal

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Who Performs Valuations

• Business appraisers
• Venture capitalists
• Investment banks
• Company executives
• Analysts
• Investors
• Others such as financial intermediaries
  consultants, etc.

Defining Valuation
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Reasons For Valuation
Legal Disputes
Accounting Compliance Purposes


FAS 141, 142
Divorce
Business Interruption
Option Pricing (FAS 123, etc.)
Shareholder Disputes
Tax Elections (Section 83b, etc.)
Cheap Stock
Employee Stock Ownership Plans
Restructuring
Defining Valuation
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Definitions of Value
Fair Market Value
InvestmentValue
Intrinsic Value
Defining Valuation
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What is Being Valued
Levels of Value
Tangible
ControllingInterest
Assets
Intangible
Control Premium
Minority Interest Discount
Common
MarketableMinority Interest
Equity
Preferred
Marketability Discount
Options, Warrants, etc.
Nonmarketable Minority Interest
Other
Defining Valuation
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What Has Value?
Working Capital
Tangible Assets
Intangible Assets
Defining Valuation
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Theoretical Valuation Methodologies
Income Approach
Market Approach
Cost Approach

• These methodologies are based upon numerous
  assumptions,
• most notably, efficient markets and informed and
  rational investors.

Valuation Methodologies
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Characteristics of Emerging Companies

• Short history with new, often innovative products
  / services
• Steep growth curve and high risk
• Months / years to first revenue or profit
• Securing adequate capital critical to success
• Complex ambiguous capital structures
• Rules of thumb are typically not available or
  relevant
• High risk / growth potential complicates the
  valuation process and can cause apparent market
  irrationality

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Understand Companys Stage of Development
Stage
Early Stage
Mid-Stage
Late Stage
Initial Public Offering
Qualitative Quantitative Analysis Analysis
Valuation Methodologies
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Applied Valuation Methodologies
Venture Capitalists
Investment Bankers
Potential Acquirers
Business Appraisers

• Income approach
• Market approach
• Cost approach

• Qualitative analysis at earlier stages with DCF/
  Market approaches typically applied at later
  stages

• Market Guideline (IPO)
• Market transaction and income approach (for MA)

• Income approach almost always
• Market approach and cost approach less often

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Qualitative Valuation Metrics (Internal)

• Management team
• The story or value proposition
• Underlying technology and state of development
• RD pipeline
• Patents/licenses
• Strategic alliances
• Market leadership
• Sales and earnings capabilities (time to )
• Sustainable competitive advantages
• Achievement of milestones

Valuation Methodologies
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Qualitative Valuation Metrics (External)

• Size of the market and first mover advantage
• Competitive environment
• Product demand
• Barriers to entry
• Market mindset (.com, B2C, B2B, P2P, etc.)
• MA market activity
• Public market activity (IPO)

Valuation Methodologies
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Income Approach

• Capitalization of earnings is not usually
  relevant
• Discounted cash flow is needed
• Starting point is business plan projections (must
  be credible)
• Projections are often optimistic and may require
  a haircut
• Discount rate is based upon venture capital type
  rates of return and should be consistent with the
  projections
• Terminal value is critical
• Often use an exit multiple to estimate terminal
  value

Valuation Methodologies
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Value and Risk Change Over Time
businessplan prototypes
full-scale operations, initial sales
break even (maybe!)
expansion, new products, new markets
increasing market share
goingpublic
KeyEvents
Valuation Methodologies
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Market Approach
Transaction method
Guideline method

• Usually minority value
• Select appropriate comparables
• Projected income streams
• Move up the P/L to find profitability
• Find IPO for similar company to derive a
  projected value and adjust backwards for risk (at
  VC rates) and time
• Non-Financial Benchmarks

• Usually control value
• Look for prior funding
• Transaction multiples are hard to find
• Non-Financial Benchmarks

Valuation Methodologies
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Cost Approach

• Not usually relevant for emerging companies
  but might be relevant in the following
  situations
• Situations where there is not yet significant
  intangible value.
• Distressed companies
• Buy vs. build analysis

Valuation Methodologies
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Applied Valuation Methodologies Acquisition
Analysis

• DCF
• Target specific
• Quantification of synergies
• Cash vs. stock deal
• Assets vs. Equity
• Accounting issues (EPS dilution, IPRD, etc.)
• Other structuring issues (earn outs, etc.)
• Transaction environment (pool of buyers, auction,
  etc.)

Valuation Methodologies
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Investment Bank IPO Valuation Methodology

• Focus is on market guideline multiples
• DCF as a reality check
• Key valuation considerations
• Overall market conditions
• Sector definition and position
• How to value off-line business segments
• Focus on forward revenue/earnings
• Industry metrics
• Historical performance validates projections
  (momentum)
• Credibility
• Barriers to entry
• Size of market
• Business model/projections assumptions

Valuation Methodologies
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Common Valuation Errors

• Ambiguous definition of what is being valued
• Poor understanding of the underlying business
  model, technology and/or market
• Internal Inconsistencies
• Improper use of comparable data (market
  approaches)
• Application of earnings multiples or rates of
  return to incorrect earnings streams
• Failure to properly consider the applicability of
  discounts
• Lack of consideration of appropriate milestones
• Discount Rate not consistent with level of risk
  in the projections
• Improper use of non-financial benchmarks

Evaluating the Deal
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Evaluating the Deal

• Define what you are valuing and the purpose
• Consider the current market conditions
• Strategic vs. Financial Buyers
• Buyer/seller motivations negotiating position
  what do they think they are buying? What do they
  think has value?
• Recognize differences in valuation techniques
• Beware of rules of thumb and non-financial
  metrics
• Consider premiums/discounts depending on the
  methodology
• Understand the components of value - do a sanity
  check
• Consider the terms
• Arm yourself with good information and present
  your case as convincingly as possible

Evaluating the Deal