Great 2006 presentation on business valuations including a brilliant summary slide by the Guru Khosla

1. VALUATION
Real World Entrepreneurship – 2006
by
Jack Raiton
1 OGI School of Science and Engineering

2. Valuation: Magic or Myth?
• “It is a sign of an educated mind not to expect more
certainty from a subject than it can possibly provide.”
(Aristotle)
• “Valuation requires an intermediate perspective
between ignorance and certainty, involving the
exercise of skill, experience and judgment” (Razgatis)
2 OGI School of Science and Engineering

3. An Icon’s Perspective
“At a presentation I gave recently, the audience’s
questions were all along the same lines: “How
do I get in touch with venture capitalists?”
“What percentage of equity do I have to give
them?” No one asked me how to build a
business!”
Arthur Rock was a founder of Intel, an early investor in Apple,
Teledyne, Scientific Data Systems, Air Touch Communications, …
3 OGI School of Science and Engineering

4. THE REAL DEFINITION OF THE VALUE
OF AN EARLY STAGE COMPANY IS:
“That point at which an investor’s fear is in
equilibrium with his greed.”
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5. What is a Company Worth?
• It’s worth what someone is willing to pay for it
• It doesn’t matter what they paid for it…
• Once you’ve paid for it, it’s yours!
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6. Macro Valuation Factors
What drives valuations?
• Liquidity, aka the “Exit”
• The Economy
• Public Markets – market multiples and the strength of
the IPO market
• M&A Activity
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7. U.S. Private Equity Performance (thru 2Q05)
Early-stage VC historically beats all other asset classes
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8. 2004 VC Valuations by Company Industry
Valuations Vary by Industry
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9. Valuation Shortcuts
• “Small business owners often like to use the “MMM”
method of business valuation.
MMM, or Make Me a Millionaire, determines
the asking price of a business by multiplying
the number of owners by $1.0 million.”
-Bryan Jamison, SMU BBA ’78 Wall Street Journal (circa 1985)
9 OGI School of Science and Engineering

10. Valuation Methods
• Gut! • DCF (Discounted
Seed
Seedup Cash Flow)
Start
• Low single digits Later
Stage • Comparable
• Rules of Thumb transactions (M&A)
• Convertible debt • Public market
multiples
• VC Method • P/E Analysis
Early
Seed e Maturce
• EBITDA multiples
Stag • Modified DCF Publi
• Market comparables • Public market shares
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11. Valuation Methodologies
• “Current Market Valuations”
- More “art” than “science”
- Comparable private market transactions
- Usually correlates to changes in public market valuations
• Discounted Cash Flow Analysis
- Build financial model for 3 to 5 yr time frame
- Project cash flows to the investors over investment time
- Discount cash flows based on discount rate and time
• Comparable Company Analysis
- Select representative group of public companies
- Sort by sector, size and growth rate
- Determine appropriate valuation metrics: Revenue,
Earnings, EBITDA
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12. The Art of the Deal –
The “VC Method”
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13. VC Valuation Perspective
Difficult to use established (late-stage/public market)
valuation techniques for early-stage companies due to:
• Volatility
• Illiquidity
• Long investment cycle
• Complex/new technologies
• Lack of transparency of private company data
Last-stage valuation techniques more quantitative
• Discounted cash flows
• Public market comparables
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14. VC Returns
• VC discount rates high to support portfolio losses
(e.g. losses must be “baked into” VC models)
• Game of “home runs”
(Average portfolio: 10% - 10x or better returns
60% - low to average returns; 1x-4x
30% - fire-sales or written off
• High risk/high reward game
- Early-stage highest risk/reward ratio
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15. Funding to Milestones: aka “Old-Fashioned Venture Capital”
Source: Vinod Khosla, Kleiner Perkins
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16. VC Model – Managing Risk
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17. Terminology 101
• IRR
• Pre- and Post-money valuation
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18. Internal Rate of Return (“IRR”)
• Internal Rate of Return
– The discount rate that equates the net present value
(NPV) of an investment’s cash inflows with its
cash outflows
– IRR measures the discount rate that sets NVP = 0
– Different from rate of return on investment
(measure of market performance)
18 OGI School of Science and Engineering

19. IRR Example
Example
• 1st Year investment $1.0M
• 2nd Year investment $2.0M
• 4th Year investment $3.5M
• Exit 5th Year return $20.0M
• Total investment $6.5M IRR = 59%
• Cash return $13.5M Multiple = 3x
Excluding time weighting, produces a rate of return of 208%
19 OGI School of Science and Engineering

20. Pre- and Post-money Valuation
• Post-money
– Value of equity AFTER the new money goes in
– Share price X fully-diluted shares outstanding
AFTER new investment
– Investment/POA (% ownership acquired)
• Pre-money
– Value of equity BEFORE the new money goes in
– Share price X fully-diluted shares outstanding
BEFORE new investment
– Post-money - Investment
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21. Pre- & Post-Money
Shares & Options 1.0M
Price per Share X $7.00 (negotiated btwn co. and VC)
Pre-Money $7.0M
Pre-Money $7.0M (negotiated) 70%
New Investment $3.0M 30%
Post-Money $10.0M (value after new $) 100%
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22. Simple Model I
How much do I need to own?
• Solve for the required future value of my $3.5M
investment to achieve 50% IRR
– VC Required IRR 50%
– Amount I’m investing $3.5M
– Expected term to exit 5 yrs
– Expected Net Inc in yr 5 $4M
– Yr 5 Market Comp P/E 20
– Implied FV of Co in yr 5 $80M
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23. Simple Model
How much do I need to own?
● Solve for the required future value of my $3.5M investment
to achieve 50% IRR 1 2 3 4 6
– RFV = ((1+IRR)^Periods) X Investment
– RFV = ((1+0.5)^5) X $3.5M $5.2 $7.8 $1.8 $17.7 $26.6
– RFV = $26.6M
● Therefore, I need to own $26.6M/$80M
– 33%
● My investment offer to company might be $3.5M
investment at $7M pre-money ($10.5M post-money)
23 OGI School of Science and Engineering

24. Simple Model II-A
PE – 20x
Exit = 5 years
Earnings (Y5) = $10M
VC required IRR = 50%
VC investments = $10M
Exit Value (Post-Money)
20 x $10M $200M
= = $26.4M
(1.5)5 7.59
Pre-Money = $26.4M - $10M = $16.4M
$10M
= 38%
26.4M
OR
75.9M 75.9M
= = 38%
20 x $10M $200M
$10M x (1.5)5 = $10M x 7.59 = $75.9M
24 OGI School of Science and Engineering

25. Rules of Thumb
• $5M Limit
• Berkus Method
– For a sound idea $1M
– For a prototype +1M
– For a quality management team +1M-2M
– For a quality board +1M
– For any roll-out, sales +1M
$1M-6M
• Role of Thirds
– 1/3 to Founders
– 1/3 to Management
– 1/3 to Investors
• $2.5M Angel Standard
• $2-10M Internet Standard
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26. Some Take Aways
• Entrepreneur should consider the following…
– how much money will it take to really fly?
– what milestones exist between push back and take off?
– how much is required to achieve each milestone?
– work backwards…
• Valuations are negotiable particularly when…
– you are a serial entrepreneur
– there are numerous bidders
– performance against milestones can be tangibly measured
• Guy Kawasaki’s Law of PreMoney Valuation…
– for every full time engineer (+$500,000)
– for every full time MBA (-$250,000)
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27. Also Remember…
• Venture capitalists don’t get rich by cutting
tough deals
• Entrepreneurs don’t get rich by taking highest
offers
• Don’t miss the forest for the trees!
(sensitivity analysis)
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