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Valuation Methods

Valuation Methodology

• There are numerous ways to value a company quantitatively and no one method is superior to all others

• Valuation is part science and part “gut”

• 3 categories: – Asset-based: rarely used now as mfg. shifts out of

the U.S.

– Cash flow capitalization, and

– Multiples, widely used for entrepreneurial co’s.

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Multiples

• Cash flow multiples – EBITDA X (3 to 10)

– Adjusted up and down for contextual factors.

– May adjust EBITDA for founder salaries.

• Free cash flow multiples. – EBITDA – CAPEX

– Yields more conservative valuation

– Used when company requires major CAPEX to sustain growth

Multiples

• Sales multiples – Widely used, varies by industry

– Food industry = 1 to 2 X revenues

– Professional services = 1 to 3 X revenues

– Software companies = 2 to 3 X revenues

• P/E ratio method – For publicly traded companies

– Private companies can be based on “comps”

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Free Cash Flow

• Most complicated and involved – AKA Discounted Cash Flow model

• Relies on many projections and assumptions

• Simply stated, projected future cash flows (generally 5 years), adjusted for taxes, depreciation, working capital and CAPEX, are discounted to PV using the weighted average cost of capital of the company PLUS residual value

Free Cash Flow Formula • Year 1 FCF/(1+DR)+Year 2 FCF/(1+DR)^2 +Year 3

FCF/(1+DR)^3 . . . + RV

• Many criticize model due to its complexity and uncertainties

• Bill Sutter (venture capitalist and Stanford Business School grad) says “I have not used any models since business school – valuation is remarkably unscientific”

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Valuing Technology/Internet Companies

• Valuation methods discussed thus far are not applicable for valuing tech companies

• Early companies like Netscape, Yahoo, and Amazon.com all went public with little to no revenues at very high valuations

• Current models now focus on users and ultimate revenues attached thereto

• Ultimately, financial fundamentals count

Summary

• Many valuation methods, none of which is particularly better than others

• Valuation, particularly for early stage companies, is highly subjective

• Valuation is “educated speculation”

• Internet/tech companies don’t fit traditional models

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Key Factors Influencing Valuation

Valuation Process • Valuation is not solely quantitative

• Qualitative factors also come into play

• A “contextual factor analysis”, which describes in what context a valuation is taking place, is needed to properly value a company

• Contextual factors include cash flow (current and historical), who’s involved, availability of capital, and the team

– Many other factors

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Contextual Factors

• Cash flow – historical, present, future – Current cash flow is most important

– Future cash flow is unknown and primarily the result of efforts of the new owner

– Amount of debt the cash flow can service

• Who’s doing the valuation? – If VC, wants to keep value low

– If entrepreneur, wants to push number up

Contextual Factors

• Public or private? – Public companies are valued higher due to

liquidity in the market and better information

– Private companies lack liquidity and provide limited information

• Availability of capital. – The greater capital available, the higher the

valuations

– Supply vs. demand – greater capital chasing, fixed number of opportunities will compete

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Contextual Factors

• Is it a strategic or financial buyer? – Generally, strategic buyers value companies

higher than financial buyers

– Availability of capital for private equity funds may swing the pendulum

• Speculation – Value based on projected future performance can

drive valuations up

– “Hype vs. Hope”

Contextual Factors • Company stage

– Early stage = lower valuation

– Less risk with later-stage companies

– Best advice, develop product and market traction as long as possible before seeking outside capital

• Auction – Buyers bidding on company drives valuation

– MSFT outbid Google/Yahoo for 1.6% of Facebook @ $240 million

• Valuation $15 billion! 300 X revenue multiple!

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Contextual Factors

• Economic conditions – Valuations increased 5 consecutive years to 2000

– Coincided with sustained U.S. economic growth

• Reason for selling – Personal or business pressures?

– Settle estate, owner death, etc.

• Tangible/intangible assets – Mfg. companies – tangible assets

– Technology companies – intangibles

Contextual Factors

• Industry – Similar companies in different industries can have

significantly differing valuations

– Internet/e-commerce vs. the field

• Quality of management team – Startup experience valued in early stage

companies

– If existing team is viewed as weak, valuation can be lower

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Summary

• Valuations of companies, particularly early stage valuations, are highly subjective

• Valuations are both quantitative and qualitative

• Contextual factors play a large role

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Valuation Basics

The Ambiguity of Valuation

• Valuation is not solely quantitative

• Entrepreneurs must learn valuation methods but be comfortable with ambiguity

• Valuation is “an illusion”, set more by market factors than by formulas

• What’s the price of your company?

• What someone is willing to pay for it?

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A Willing Buyer and Willing Seller

• Apple Computer and Be, Inc.

• Apple (Amelio) approached Be to acquire it

• Be had revenues of $3 million and 40 employees (financed with $20 million of venture money)

• Apple - $100 MM; Be’s counter - $250 MM.

• Never came to terms; Apple acquire NeXt

• 5 years later, Be acquired for $11 MM

Subjective Factors in Valuation

• Stage of business

• Management team

• Industry (or market)

• Reason for acquisition or sale

• Other factors

• Ultimately, cash flows drive valuation

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Pre-money and Post-money Values • Pre-money is the value placed on the company

prior to the investment

• Post-money is the value after the investment – Computed as pre-money + amount invested

• Post-money determines how much the investor owns (or the entrepreneur has given up) as a result of the investment

• Post-money is often pre-money of the next round

Why Value Your Company?

• To determine its selling price

• To determine how much to give up for partnering

• To determine how much to give up for an investment

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How Much Equity Should You Give Up? • Many entrepreneurs ‘unknowingly’ establish their

company’s value – I want to raise $100,000.

– I want to maintain ownership of 90%

– Implied post-money valuation is $1,000,000 • Entrepreneur retains 90%

• A $100,000 investor gets 10%

• $100,000 ÷ $1,000,000 = 10%

• Sophisticated investors may not agree on equity split or valuation

Summary

• Valuations of companies, particularly early stage companies, is highly subjective

• It’s a negotiation process

• Understanding of terms is essential

• Other factors have big impact on ultimate valuation