The Deal: Valuation, Structure

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Lecture 8

• The DealValuation, Structure Negotiation
• Timmons - Chapter 14

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Entrepreneurial capital markets

• More volatile
• More imperfect
• Less accessible
• Affected by psychological factors

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Chain of Capital Providers
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Deal Sequence
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Ingredients for valuation

• Cash
• How much
• To whom it flows
• Time
• When it flows
• Risk
• The likelihood that it will flow

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Some tips for valuation

• Art and science
• Multiple methods
• Ranges and boundaries rather than specific values
• Sensitivity analysis based on assumptions
• Shop the deal wisely
• Know the other side of the table

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Index of expected rates
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Core Principle

• The core principle for an entrepreneur is to
  build the best company possible. This is the
  single surest way of generating long-term value
  for all the stakeholders and society.
• -Timmons

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Determining Value

• At least a dozen ways
• A Key Consideration
• Investors Required Rate of Return (ROR) (IRR)
• An indicator of the efficiency or quality of an
  investment, as opposed to Net Present Value
  (NPV), which indicates value or magnitude given
  the current interest rate (or cost of capital)
• A project is a good investment proposition to an
  investor if its IRR is greater than the rate of
  return that could be earned by alternate
  investments of equal risk (investing in other
  projects, buying bonds, even putting the money in
  a bank account). Thus, the IRR should be compared
  to any alternate costs of capital including an
  appropriate risk premium.

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Inherent conflicts between users and suppliers of
capital

• Capital User Wants

• Capital Provider Wants

• As much time as possible for financing
• As much as possible
• Independence
• Control of Board-of-Directors for freedom
• Any Success
• Flexibility to change, adapt or decommit
• Operate

• To supply capital just in time
• To invest just enough
• Accountability
• Control of Board-of-Directors for control
• Big Success
• Clear, steady adherence to plans
• Cash out

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Valuation, Structure Negotiation

• Staged Capital Commitments
• Delivers funding in stages, rather than in lump
  sum
• Allows investors to evaluate company as time
  passes

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Conservation of capital

• To encourage managers to conserve, VCs apply
  strong sanctions if capital is misused, by
• Diluting managements equity share at punitive
  rate
• Shutting down operations completely

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Structuring the deal

• Deals involve
• allocation of cash flow streams
• allocation of risk
• allocation of value between different groups
• Suppliers versus users of capital
• Owners versus managers

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Characteristics of Successful Deals

• Simplicity
• They are robust (resistant to unexpected shocks
• They are organic (evolve to meet circumstances)
• They take into account incentives of all involved
  in a variety of circumstances
• They provide mechanisms for communications and
  interpretation
• They are based primarily on trust rather than
  legal language
• They do not make it too hard to raise more capital

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Characteristics of Successful Deals (cont.)

• They match the needs of the user of capital with
  the needs of the supplier
• They reveal information about each party
• They allow for the arrival of new information
  before the deal is signed
• They are considerate of the fact that it takes
  time to raise money
• They improve the chances of venture success
• They are not patently unfair

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Questions to identify agendas

• What is the bet ?
• Who is it for ?
• Who is taking the risk ?
• Who receives the rewards ?
• Who should be making the bets ?
• What happens if the venture exceeds investor
  expectations ?
• What happens if the venture falls short of
  investor expectations ?
• What are the incentives for the money managers ?
• What are the consequences of the failure to
  perform by the money managers ?
• How will the money managers behave ?
• What will be the investment strategy of the money
  managers?

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Critical Guides

• Raise money when you dont need it
• Learn about the process and how to manage it
• Know your relative bargaining position
• If all you get is money, youre not getting much
• Assume the deal will never close
• Always have a backup source of capital
• The experts can blow it sweat the details
  yourself

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Critical Guides

• Assume the deal wont close
• Always have a backup source of capital
• Legal, financial and consulting sources can make
  mistakes, too check their work
• Users of capital are at a disadvantage when
  dealing with suppliers of capital
• If you are out of cash when looking for capital,
  suppliers of capital will eat your lunch
• Startup entrepreneurs are raising capital for the
  first time suppliers do it for a living.

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Potential Pitfalls

• Strategic circumference
• Legal circumference
• Attraction to Status and Size
• Unknown territory
• Opportunity Cost
• Underestimation of other costs
• Greed
• Being too anxious
• Impatience
• Take-the-money-and-run myopia

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Methods of Valuation

• Venture Capital Method
• Fundamental Method
• First Chicago Method
• Discounted Cash Flow

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Venture Capital Method

• Estimate Net Income for a number of years
• Determine appropriate Price-to-Earnings (P/E)
  ratio
• Use comparables or industry data
• Calculate terminal value ( Estimated Income x
  P/E)
• Discount terminal value to present value (r.35
  to .80)
• Determine investors required percentage of
  ownership
• Final ownership Required future value
  (investment)
• Total
  Terminal Value
• 1(IRR) years x
  (investment)
• P/E Ratio (Total
  Terminal Income)
• Calculate number of shares
• New Shares ownership required
  by investor .
• 1- ownership required
  by investor x old shares

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Fundamental Method
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First Chicago Method
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Discounted Cash Flow Method

• Three time periods are defined
• (1) Years 1-5,
• (2) Years 6-10,
• (3) Year 11 to infinity
• Operating assumptions include
• initial sales
• growth rates
• EBIAT/sales
• (net fixed assets operating working
  capital)/sales
• Also note relationships and trade-offs

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Staged Investment
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Investor Expectations for Multiple Round Financing
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Cram Down or Down Round
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Beyond Just the Money

• Critical issues in the deal
• Number, type, and mix of stocks and various
  features that may go with them that affect the
  investors rate of return
• The amounts and timing of takedowns, conversions,
  and the like
• Interest rate in debt or preferred shares
• The number of seats, and who actually will
  represent investors, on the board of directors
• Possible changes in the management team and in
  the composition of the board of directors

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Beyond Just the Money

• Critical issues in the deal (cont.)
• Registration rights for investors stock
• Right of first refusal granted to the investor on
  subsequent private or initial public stock
  offerings
• Stock vesting schedule and agreements
• The payment of legal, accounting, consulting, or
  other fees connected with putting the deal
  together

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More Burdensome Issues

• Co-sale provisions
• Ratchet anti-dilution protection
• Washout financing
• Forced buyout
• Demand registration rights
• Piggyback registration rights
• Key-person insurance