Outreach networks first venture round

Looking For Catherine Becks

Lecture 6

Valuing Entrepreneurial Ventures 2

Housekeeping:

This Tuesday we have an In-class exercise where you will apply the valuation techniques that you are currently learning. To complete this you will need to purchase the case. I have put together a Course Pack at Harvard Business Publishing that has the case you will need, and two other cases for later in the course. The cases will cost $12.75. I have also added some suggested reading that is optional and won't be directly tested on. These cost an additional $32.90. The link for theses purchases was sent by email and is posted on BlackBoard.

Cash, Build, Burn & Runway and Cash Conversion Cycle Homework - Still waiting for one more student to submit the assignment so I can't post the answer yet. Most of you did very well. Here are two common errors that you should fix so that you get it right for the test. For Cash Build, Burn and Runway, be careful with the Cash Burn from Balance Sheet. You are looking at the change in balances from one year to the next. Also, review the slides on whether in increase or decrease in a balance item is a cash inflow or outflow.

For Cash Conversion Cycle, there is no such thing a negative days. Use absolute values. Also, your answer is in days, not dollars. You are trying to understand how long it takes from the time that you first invest in Raw Materials to make your product to the date when you receive the cash from a completed sale.

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Adjusted Present Value Example

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APV formula steps

Estimate the value of the firm in three steps:

Calculate the value of the unlevered firm

Discount equity CF’s at unlevered re

Calculate interest tax savings generated from debt (tax shield), if any

Tax rate x Debt

Sum up steps 1 and 2 and add back starting cash

Step 1: Calculate the value of the unlevered firm

Calculate free-cash flows from operations:

FCF = EBIT (1 – t) + Depreciation – CAPEX – Δ NWC

Calculate the Terminal Value (future value of all steady state firm cash flows):

Terminal Value = FCF (1 + g) / (re – g)

where g is the steady state (stable) growth rate of the firm, and re is the unlevered cost of equity

Discount FCF and terminal value to present time using re

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APV Method Example – Crunch Co.

Facts:
Crunch Co. is a start-up fitness equipment company founded by Bob “Crunch” Borkowski. Crunch Co. received a $300,000 investment from Golden Venture Partners (GVP). After 3 years, Crunch Co. has finally begun to generate positive earnings and free cash flow.
GVP is now considering its exit options and asks you to help value Crunch Co. They have provided financial projections and other information below.
Value the company using the Adjusted Present Value Method.
Unlevered Cost of Equity 14%
Perpetual Growth Rate 4.50%
Debt (US$ 000’s) $200
Cost of Debt 10%
Tax Rate 22%
APV Method Example – Crunch Co.

Crunch Co. Selected Financial Projections (US$ 000’s)

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Year
Actual 1 2 3 4 5
Sales $220.0 $231.0 $242.6 $254.7 $267.4 $280.8
Cost of Goods Sold 132.0 138.6 145.5 152.8 160.4 168.5
General & Administrative Expenses 20.0 20.0 20.0 20.0 20.0 20.0
Depreciation 15.0 15.0 16.0 17.0 18.0 19.0
EBIT 53.0 57.4 61.0 64.9 69.0 73.3
Interest Expense 20.0 20.0 20.0 20.0 20.0 20.0
Pre-tax Income 33.0 37.4 41.0 44.9 49.0 53.3
Taxes 7.3 8.2 9.0 9.9 10.8 11.7
Net Income $25.7 $29.2 $32.0 $35.0 $38.2 $41.6
Selected Balance Sheet Information:
Cash & Marketable Securities 24.0 33.8 37.6 45.6 47.8 53.2
Gross Property Plant and Equipment 10.0 15.0 19.0 22.0 25.0 27.0
Net Working Capital 6.0 7.0 9.0 8.0 9.0 10.0
Time 0

Year
Unlevered Free Cash Flow Calculation: 1 2 3 4 5
NOPLAT (EBIT x (1 - tax rate)) 44.8 47.6 50.6 53.8 57.2
+ Depreciation 15.0 16.0 17.0 18.0 19.0
- Capital Expenditures 5.0 4.0 3.0 3.0 2.0
- Change in New Working Capital 1.0 2.0 (1.0) 1.0 1.0
Unlevered Free Cash Flow $53.8 $57.6 $65.6 $67.8 $73.2
Present Value @re of 14% 47.2 44.3 44.3 40.1 38.0
Cumulative PV of Forecast Period $213.9
Terminal Value Calculation $805.0
Present Value of Terminal Value 418.1
Crunch Co. Unlevered Value $632.0
Crunch Co. APV – Calculate Unlevered Value

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Step 1: Calculate Unlevered Value of Crunch Co.

Year
Unlevered Free Cash Flow Calculation: 1 2 3 4 5
NOPLAT (EBIT x (1 - tax rate)) 44.8 47.6 50.6 53.8 57.2
+ Depreciation 15.0 16.0 17.0 18.0 19.0
- Capital Expenditures 5.0 4.0 3.0 3.0 2.0
- Change in Net Working Capital 1.0 2.0 (1.0) 1.0 1.0
Unlevered Free Cash Flow $53.8 $57.6 $65.6 $67.8 $73.2
Present Value @re of 14% 47.2 44.3 44.3 40.1 38.0
Cumulative PV of Forecast Period $213.9
Terminal Value Calculation $805.0
Present Value of Terminal Value 418.1
Crunch Co. Unlevered Value $632.0
Crunch Co. APV – Calculate Unlevered Value

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Step 1: Calculate Unlevered Value of Crunch Co.

NOPLAT =

EBIT x (1 – tax rate

$57.4 x (1 – .22) = $44.8

CAPEX =

Gross PPE Yr. 1 – Gross PPE Yr. 0

$15 – $10 = $5

Change in NWC =

NWC Year 2 – NWC Year 1

$9.0 – $7 = $2

Present Value =

CF4 / (1 + re)4

$67.8 / (1 + .14)4 = $40.1

Terminal Value =

CF5 x (1 + g) / (r – g)

$73.2 x (1 + .045) / (.14 - .045) = $805.0

Present Value =

TV / (1 + re)5

$805.0 / (1 + .14)5 = $418.1

Keep this slide handy for the exam.

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Crunch Co. APV – Interest Tax Shield

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Interest Tax Shield Formula: Tax Rate x Debt

Tax Rate: 22%

Debt = $200

Interest Tax Shield = .22 x $200 = $44

Step 2: Calculate Interest Tax Shield

Crunch Co. APV Solution – Final Step

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Unlevered Firm Value $632.0
+ Interest Tax Shield 44.0
+ Starting Cash 24.0
Adjusted Present Value $700.0
Step 3: Add back starting cash

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The VC Method

40 years of valuation experience. This approach is the least satisfying.

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The VC Method of Valuation

How do investors (VCs) decide …

The ownership percentage for their investment?

The share price and number of shares they should receive?

VC Method created by William Sahlman (1987, updated 2009)

Method for Valuing High-Risk, Long-Term Investments: The "Venture Capital Method“, Harvard Business School Press

Begin with an exit value based on similar firms, discount this value to time zero using a “high” discount rate and adjust for dilution

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The VC Method of Valuation

Forecast results for some point in the future;

Determine a value that is likely to apply at that point, based on well-understood valuation methodologies (e.g., price earnings ratios for comparable publicly traded companies);

Determine how much capital will be required to attain the target metric as well as the likely timing of stock sales;

Estimate the amount of new shares that will have to be awarded to attract new managers required to attain the targets;

Calculate the share of the final value “pie” that each group will demand, given a set of required rates of return

Convert future shares back to the present in order to determine share prices and ownership percentages that make sense; and

Reflect on the result. Are the projections reasonable? What can go wrong and what can go right for the venture? Are valuation levels likely to hold between now and the exit event? Make adjustments based on your reflections.

Source: William Sahlman, Method for Valuing High-Risk, Long-Term Investments: The "Venture Capital Method“

The VC method

Time

T

Exit (IPO or M&A)

S

Steady state

Rapid growth period

Stable growth period

Venture growth period

0

Initial (VC) investment

Projected

“Successful” Exit Valuation

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Answer 3 questions

Will the firm make it to stable growth?

When will the firm become a stable growth firm?

What will the firm look like in stable growth?

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Basic VC Valuation Method

Begin with an exit value based on similar firms, discount this value to time zero using a “high” discount rate and adjust for dilution

Method:

Invest cash today

Receive cash at some future exit event

Discount the entire future value cash flow back using the VC’s target rate of return

Calculate the VC’s ownership percentage by dividing the cash invested today (step 1) by the present value of the business (step 3)

Calculate the number of shares that need to be issued to meet the VC’s required ownership percentage

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Basic VC Method Example – Series A

Facts:
Founder invests $10,000 and receives 2,000,000 shares of common stock in H Corporation (H Corp).
H Corp. now needs to raise $1,000,000 to execute its business plan.
Series A VC investor will invest $1,000,000, if the parties can agree on percentage ownership.
They agree that the time to exit should be 5 years at which point H Corp. should have Net Income of $1,000,000.
The VC requires a 50% compound rate of return.
A similar venture, M Corp., recently went public at a $20,000,000 valuation. In the last 12 months (LTM), its net income was $2,000,000
PROBLEM: Value the business based on a 5-year exit and determine the number of shares to issue to the VC for the $1,000,000 Series A investment.
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Step 1: Calculate the Exit Value for H Corp.

Use relative valuation provided by M Corp. IPO

Price/Earnings (PE ratio) = 20,000,000/2,000,000 = 10x

Apply the comp to H Corp’s exit year income

10x P/E x $1,000,000 = $10,000,000

Exit year valuation is $10 million

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Step 2: Calculate the Present Value of H Corp.

Discount $10 million exit value to today’s value

a. N = 5 years

b. Discount rate = 50% (VC’s required return)

c. Future Value = $10,000,000

PV = $10,000,000 / (1.5)5 = $1,316,872.43

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Step 3: Calculate VC’s required ownership percentage

Divide $1,000,000 by the present value of H Corp.

$1,000,000 / $1,316,872.43 = 75.9375%

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Step 4: Calculate number of new shares to be issued

Formula for new shares:

(Existing shares x Acquired %)

(1 – Acquired %)

n = (2,000,000 x .759375) / .240625 = 6,311,688 new shares

Total Shares outstanding after Series A financing:

n =

H Corp. Capitalization Table after Series A
Owner # of Shares % Ownership
Founder 2,000,000 24.0625%
Series A Investor 6,311,688 75.9375%
Total 8,311,688 100.0000%
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Series A Solution Summary

Solution Steps
1 Calculate Valuation metric from the M Corp. Initial Public Offering Price/Earnings (PE ratio) = 20,000,000 / 2,000,000 = 10x
2 Calculate H Corp’s value at exit. Apply comp PE ratio to H Corp’s projected year 5 earnings: 10 x $1,000,000 = $10,000,000
3 Calculate the PV of H Corp by discounting the year 5 value at the Series A VC’s 50% required rate of return: PV = $10,000,000 / (1.5)5 = $1,316,872.43
4 Calculate Series A VC’s required ownership percentage by dividing today’s cash investment by the present value: % = $1,000,000 / $1,316,872.43 = 75.9375%
5 Calculate required shares to be issued (n): n = (Existing shares x Acquired %) / (1 – Acquired %) (2,000,000 x .759375) / .240625 = 6,311,688 new shares
6 Total shares outstanding = 2,000,000 + 6,311,688 = 8,311,688 shares
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Could look to Future Value for Series A VC as an alternative

Invests 1,000,000 for 5 years expecting a 50% return. Future Value = 1,000,000 x (1.5)5 = $7,593,750

Formula: FV of A’s investment

FV of 100% of H Corp

= $ 7,593,750 / 10,000,000

= 75.9375%

Series A VC must own 18,000,000 shares after Series A closing to ensure that it owns 75.9375% at exit

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Target Exit Ownership % After Series A

H Corp. Capitalization Table after Series A
Owner # of Shares % Ownership
Founder 2,000,000 24.0625%
Series A Investor 6,311,688 75.9375%
Total 8,311,688 100.0000%
First Round Financing

Founder Series A Investor 0.24062499999999998 0.75937500000000002

Founder Full Ownership

Founder 1

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Additional rounds of financing

Venture financing is usually staged in rounds (Series A, B, C …)

Each financing round will dilute existing shareholders

The first round VC investor will demand dilution protection, because it needs to own a target percentage (75.9% in the prior example) at the time of exit

Therefore, the VC will need to own more than the end target % after the first round is closed

All of the dilution will be borne by the founder

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Basic VC Method with Series B

Facts:
Same facts as before except that the parties anticipate that another $1,000,000 will need to be raised at the end of year 3 from a Series B investor who will demand a 25% compound annual return.
Series A VC investor will invest $1,000,000, if they can agree on percentage ownership.
Based on our earlier analysis, we know that Series A investor needs to own 75.9% at the time of exit.
PROBLEM: What percentage ownership must Series A VC own at the closing of Series A to ensure that it will own 75.9% at the time of exit?
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Calculate Required Future Value of Series B VC’s investment

Series B VC will invest $1,000,000 and expects an exit after 2 years. B requires a rate of return of 25%.

Analysis should focus on ownership % at exit.

Calculate the required Future Value of Series B VC’s investment using the 25% required rate of return:

FV = $1,000,000 * (1.25)2 = $1,562,500

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Calculate Series B VC’s required ownership percentage

Formula: FV of B’s investment

FV of 100% of H Corp

= $1,562,500 / 10,000,000

= 15.625%

Required % =

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Calculate number of new shares to be issued

Formula for new shares:

Existing shares x (A + B Acquired %)

(1 – Acquired %)

n = (2,000,000 x (.759375 + .15652) / .084375 = 21,703,704 new shares

n =

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Calculate each investors’ shares at Exit

Total shares at exit: 2,000,000 + 21,703,704 = 23,703,704

Apply required ownership % to determine allocation of shares

Series A VC must own 18,000,000 shares after Series A closing to ensure that it owns 75.9375% at exit

Shares % Ownership
Founder 2,000,000 8.4375%
Series A VC 18,000,000 75.9375%
Series B VC 3,703,704 15.6250%
Total Shares 23,703,704 100.0000%
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Series B Solution Summary

Solution Steps
We need to calculate the share requirements of the Series B VC to solve this problem. Series B VC will invest $1,000,000 and expects an exit after 2 years.
1 Calculate the required Future Value of Series B VC’s investment using the 25% required rate of return: FV = $1,000,000 * (1.25)2 = $1,562,500
2 Calculate Series B investor’s required ownership percentage by dividing the future value in step 4 by the $10,000,000 exit value: % = $1,562,500 / $10,000,000 = 15.625%
3 Calculate required shares to be issued to Series A VC to ensure that it owns 75.9375% at exit (n): n = (Existing shares x Acquired %) / (1 – Acquired %) ((2,000,000 x (.759375 + .15625) / .084375) = 21,703,704 new shares
4 Series A VC must own 90% after Series A closing to keep ownership at 75.9375% at exit
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Target Exit Ownership % After Series B

H Corp. Capitalization Table after Series B
Shares % Ownership
Founder 2,000,000 8.4375%
Series A VC 18,000,000 75.9375%
Series B VC 3,703,704 15.6250%
Total Shares 23,703,704 100.0000%
Founder Full Ownership

Founder 1

Second Round Financing

Founder First Round Investor Second Round Investor 8.4374999999999978E-2 0.75937500000000002 0.15625

First Round Financing

Founder Series A Investor 0.24062499999999998 0.75937500000000002

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Incentive Compensation for Employees

Virtually all new ventures offer equity to attract and retain key employees

Keeps cash compensation low

Motivates key employees to make the business succeed

Typically comes in the form of options that vest over time or at the exit event.

Typical key employee plans grant between 6% to 12% to employees.

VC investors need to own their target percentage at exit, so dilution will come at the expense of the founder.

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Ownership at Exit after Each Event

Second Round Financing

Founder First Round Investor Second Round Investor 8.4374999999999978E-2 0.75937500000000002 0.15625

Founder Full Ownership

Founder 1

Incentive Ownership Round

Founder First Round Investor Second Round Investor Employees 2.437499999999998E-2 0.75937500000000002 0.15625 0.06

First Round Financing

Founder Series A Investor 0.24062499999999998 0.75937500000000002

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A few thoughts on The VC Method

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1. Applying Today’s Multiples to the Future

Markets go up and down over time

VC Method assumes this away by applying today’s comps to an exit metric that could be 5 years out.

2. Target return/Target multiple

Investor “discount rate” usually conflates the true discount rate and the probability of business failure

Examples:

Target Multiple: “We want 5X investment at exit”

Target Return: “I discount all investments at a 50% rate”

Discount rate and probability of successful exit: “We discount investments at r𝑣 c and assume a probability of success of 50%””

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Word of the Day - Conflate: To combine two or more ideas in a way that often results in confusion.

Why are VC discount rates so high?

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Stage of development Typical target rates of return
Start up 50% to 70%
First stage 40% to 60%
Second Stage 35% to 50%
Bridge/IPO 25% to 35%
Venture Capital Target Rates of Return – Stages in Life Cycle

Source: Valuing Young, Start-Up and Growth Companies: Estimation Issues and Valuation Challenges,

by Aswath Damodaran

Why are VC discount rates so high?

3 possible outcomes for a new venture

Utopia – everything goes well

Black Holes – 100% loss of investment

Living Dead – venture barely breaks even

Venture Portfolio returns reflect average of all 3 outcomes

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3 year 5 year 10 year 20 year
Early/Seed VC 4.9% 5.0% 32.9% 21.4%
Balanced VC 10.8% 11.9% 14.4% 14.7%
Later Stage VC 12.4% 11.1% 8.5% 14.5%
All VCs 8.5% 8.8% 16.6% 16.9%
NASDAQ 3.6% 7.0% 1.9% 9.2%
S&P 2.4% 2.5% 1.2% 8.0%
Returns earned by Venture Capitalists - 2007

Source: Valuing Young, Start-Up and Growth Companies: Estimation Issues and Valuation Challenges,

by Aswath Damodaran

Valuing Companies: Science or Art

With a science, if you get the inputs right, you should get the output right. The laws of physics and math are universal and there are no exceptions. Valuation is not a science.

In art, there are elements that can be taught, but there is also magic that you either have or you do not. Valuation is not an art.

A craft is something that you learn by doing. The more you do it, the better you get at it. Valuation is a craft.

- Aswath Damodoran

‹#›

‹#›

Valuation Price

Factors influencing final price paid:

Numbers, numbers, numbers

Stage of company

The investors natural entry point

Competition with other funding sources

Experience of the entrepreneurs and leadership team

Current economic climate

Negotiation skills

If price paid doesn’t equal value, then why calculate valuations?

A well-thought out valuation provides a solid starting point when negotiating a financing round AND signals competence

Additionally, a valuation gives founders a better understanding of the company and its value drivers

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Practice Problems

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Founders issued themselves 1M shares before VC financing (assume no other employees)

Series A investors expect an exit value of $25M for a successful exit in 4 years

Required investment amount: $3 million

Target annual return of VCs: 50% for Series A investors

Assume no future dilution, i.e., the company does not need to raise additional money before exit, therefore no need to issue additional shares.

Should the VC invest?

VC Method Practice Problem – Try This at Home

Facts:
Dragon Inc. founders issued themselves 1M shares before VC financing (assume no other employees)
Dragon now needs to raise $3,000,000 to execute its business plan.
Series A VC investor will invest $3,000,000, if the parties can agree on percentage ownership.
They agree that the time to exit should be 4 years at which point H Corp. should have Net Income of $2,500,000.
The VC requires a 50% compound rate of return.
A similar venture, Calisi Corp., recently went public at a $18,000,000 valuation. In the last 12 months (LTM), its net income was $2,000,000
QUESTIONS: Value the business based on a 4-year exit and determine the number of shares to issue to the VC for the $3,000,000 Series A investment. What is the price per share for the investment? Prepare a Capitalization Table.
VC Method Practice Problem 1

VC Method Practice Problem 2

Facts:
Same facts as before except that the parties anticipate that another $2,000,000 will need to be raised at the end of year 2 from a Series B investor who will demand a 25% compound annual return.
Series A VC investor will invest $3,000,000, if they can agree on percentage ownership.
QUESTIONS: What percentage ownership must Series A VC own at the closing of Series A to ensure that it will own the ownership determined in Practice Problem 1? What is the price per share for the investment? Prepare a Capitalization Table showing the ownership of the investors (Founder, Series A and Series B) If Dragon issues employee options equal to 6% of the company, what happens to the ownership percentage of the various parties?
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Additional Materials

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Characteristics of new ventures

No/little financial history

Small revenues or operating losses

Expenses are typically for establishing business, not for generating revenues

Dependent on private equity

Many don’t survive

Investments are illiquid

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Three pieces of DCF valuation

Cash flows

Discount rates

Terminal Value

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1. Cash flows

Standard approach: Use firm’s history of financial statements to estimate cash flows

PROBLEMS: Financial statements provide little relevant info for assessing value

Are revenues sustainable? Don’t know, no history

Expenses that young companies incur to generate future growth are often mixed in with the expenses associated with generating current revenues

How will earnings evolve as revenue changes?

How to estimate return on capital?

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2. Discount rates

Standard approach: Estimate the equity beta by regressing firm stock returns on market returns, debt beta by looking at current market prices of publicly traded bonds

PROBLEMS: Company not publicly traded and has no publicly traded bonds outstanding

Equity in a young company is often held by investors who are either completely invested in the company (founders) or only partially diversified (venture capitalists)  May require compensation for firm specific risk

Different equity claims may have different costs of capital. E.g., first claim to cash flow has lower cost etc.

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3. Terminal value

Terminal values account for a much larger proportion of firm value for new ventures than typical firms

Have to answer 3 questions

Will the firm make it to stable growth?

When will the firm become a stable growth firm?

What will the firm look like in stable growth?

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The Top Down Approach to Discounted Cash Flow Valuation

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Adapting DCF for young firms

The Top Down Approach

Forecast cash flows by starting with total market for the product and then work down to revenues and earnings

Use APV

Business life-cycle cash flows

Time

Cash flows

T

Exit (IPO or M&A)

S

Steady state

Rapid growth period

Stable growth period

Venture growth period

0

Initial (VC) investment

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WTFK?

The Top Down approach

Time

Cash flows

T

Exit (IPO or M&A)

S

Steady state

Rapid growth period

Stable growth period

Venture growth period

0

Initial (VC) investment

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A systematic method for estimating firm value for new ventures

Define the market for product/service

Determine market share

Determine operating expenses/margins

Determine necessary reinvestment

Compute tax effect

Check for internal consistency

Calculate expected free cash flows

Value the firm using APV

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1. Define the market for product/service

Define the product/service offered by the firm

Narrow definition  Smaller potential market

Broad definition  Larger potential market

Example: Amazon.com in 1999 – Was it a book retailer ($10B market) or a general retailer ($100B market)

Estimate the market size

Trade group publications: http://en.wikipedia.org/wiki/List_of_industry_trade_groups

_in_the_United_States

Professional forecasting services: E.g., Gartner group

Understand how the market is expected to evolve over time

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2. Determine market share

Start by listing largest players in market and try to estimate where firm will fall in that list

Guesstimate the market share path which will lead up to your steady state market share estimate

Function of the quality of the product, management skill, and competition

Remember that optimistic forecasts for market share  large investments in both capacity and marketing

Revenue estimate = Market size*Market share

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3. Determine operating margins

Estimate operating margin (EBIT/sales) in steady state

Primarily from looking at mature public firms

Estimate “pathway to profitability”

I.e., figure out how you expect the margin to evolve over time

DON’T estimate individual operating expenses such as labor, materials, SG&A, etc.

Detail in a forecast only leads to better estimates, if and only if the additional detail adds information

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4. Compute tax effect

Most new firms have never paid taxes, so not sure what effective tax rate, t, will be

Use marginal tax rate (conservative)

Use industry average effective tax rate

Calculate EBIT(1-t)

Past losses  future losses: Net operating losses (NOL) will be carried forward and used to offset tax burden in years of positive earnings

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5. Determine reinvestment

2. Calculate SS Reinvestment = SS growth rate/SS ROC

I.e., Determine how much firm needs to reinvest to maintain steady state growth rate

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6. Check for internal consistency

1. Compare implied steady state return on capital to industry average return on capital

Operating income (EBIT) and reinvestment are estimated separately  estimates may not be internally consistent

Implied ROC >> Industry ROC  Forecasted reinvestment is insufficient, given expected earnings (and vice versa)

7. Calculate expected FCFF

FCF = EBIT x (1 – t) + Depreciation – CAPEX +/- Change in Net Working Capital

Calculate the terminal value in three steps

Steady state EBIT(1-t)

Steady state reinvestment = SS growth rate/SS ROC

Terminal FCFF = (SS EBIT(1-t) – SS Reinvestment)/(r-g)

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8. Value the firm using APV

Calculate discount rates

Use APV to calculate firm value

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Top Down Approach Example: Secure Mail

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Secure Mail

Small software company that has developed a new computer virus screening program

Fully owned by founder, no debt

Has existed for 1 year

Software has been beta tested, but revenues are 0

During first year, the firm incurred $15M in expenses (operating loss)

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Top Down Approach

Define the market for product/service

Determine market share

Determine operating expenses/margins

Determine necessary reinvestment

Compute tax effect

Check for internal consistency

Calculate expected free cash flows

Value the firm using APV

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1. Define the market

Secure mail sells anti-virus software

Market = Security software market

Forecasted global market for security software (in million US $)

Source: Gartner group

2021-2025 growth rate: 5%

>2025 growth rate: 3%

Year Current (2015) 2016 2017 2018 2019 2020
Market growth rate NA 5.5% 5.5% 5.5% 5.5% 5.5%
Market size $10,500 $11,078 $11,687 $12,330 $13,008 $13,723
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2. Determine market share

Largest anti-virus software companies - 2015

Source: Gartner group

Strong management + great product = 10% market share in 10 years (steady state)

Company 2015 Revenues Market Share
Symantec $2,789M 26.6%
McAfee $1,226M 11.8%
Trend Micro $810M 7.8%
IBM $608M 5.8%
CA $419M 4.0%
EMC $415M 4.0%
Others $4,171M 40.0%
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3. Determine operating margins

Pre-tax profitability measures – Anti-virus software businesses

Assume Secure Mail operating margin will converge to 13% in steady state

“Pathway to profitability” – Probably rocky, with margins being negative for 3 years

Company Operating margin (Pre-tax)
Symantec 13.05%
McAfee 12.91%
Trend Micro 14.50%
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4. Compute the tax effect

Recall Secure Mail is starting 2016 with an accumulated net operating losses (NOL) of $15M

Use marginal tax rate of 40%

5. Determine reinvestment

Industry average Sales/Capital = 2.25

Assume one-year lag between reinvestment and growth

Calculate Reinvestmentt =

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∆ revenues𝑡

Sales / Capital

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6. Check for internal consistency

ROC = EBIT(1 - t)/(D+E-C)

Average ROC = 19.25%

Implied SS ROC = 15.62%

15.62% < 19.25%  Reinvestment may be a little high…estimates are conservative. Decrease reinvestment for more internally consistent results – E.g., bump up Sales/Capital ratio

Company ROC
Symantec 17.07%
McAfee 22.80%
Trend Micro 17.89%
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7. Calculate expected FCFF

FCFF = After-tax operating income – reinvestment

Note: Typically earnings become positive way before cash flows do

This is because cash flows are weighed down by the reinvestments needs to sustain future growth

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7. Calculate expected FCFF

Calculate the terminal value in three steps

Steady state EBIT(1-t)

Assume EBIT(1-t) in 2026 persists in perpetuity

Steady state reinvestment = SS growth rate/SS ROC

SS growth rate is assume – roughly equal to growth rate of economy

SS ROC is implied ROC in last projected year. In this case 2025.

Terminal FCFF = (SS EBIT(1-t) – SS Reinvestment)/(r-g)

8. Value the firm using APV

1. Calculate discount rates

No public equity returns  Can’t estimate 𝛽𝛽 directly

Use anti-virus software sector averages to estimate

𝛽𝛽𝑟𝑟𝑟𝑟𝑆𝑆𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑢𝑢 =

1

1 + (1 − 𝑅𝑅) 𝐷𝐷�

𝐸𝐸

𝛽𝛽

𝑆𝑆𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑢𝑢

Average beta = 1.24, Average D/E = 6%

𝛽𝛽𝑟𝑟𝑟𝑟𝑆𝑆𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑢𝑢 =

1

1 + 1 − 0.4 × 0.06

75

× 1.24 = 1.2

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8. Value the firm using APV

Add up discounted cash flows

(Optional) Make additional adjustments – See next slide

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Additional valuation adjustments!

Probability of failure can be assessed in one of three ways:

Sector averages

Probit models

Simulations

Calculate expected value of firm

Expected value = Value*(1 – Probability of failure) + Distress value*(Probability of failure)

Knaup/Piazza suggest that only 25% of software firms survive past year 5

We’ll adjust this upwards to 60% to reflect Secure Mail’s strong product/experienced manager

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Further reading

The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2009) – By Aswath Damodaran

Top Down Valuation of Tesla: http://aswathdamodaran.blogspot.com/2013/09/v aluation-of-week-1-tesla-test.html

Tesla valuation

Expected revenues in 2022

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Tesla valuation

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Tesla valuation

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Tesla valuation

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Tesla valuation – Sensitivity analysis

Replacing point estimates of revenue growth, target operating margin, sales/capital, cost of capital) with distributions

 Probability of price exceeding $170 is less than 10%

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Practice problem: Semico Inc.

EBV is considering an investment in Semico, an early-stage semiconductor company.

5 years until a successful exit

At exit the following is expected:

$50M in revenue

150 employees

10 percent operating margin (EBIT/Sales)

40 percent tax rate

$50M in assets

What companies can be used as comparables for Semico?

Using relative valuation, what is Semico’s value at exit?

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DCF vs. relative valuation?

Use both methods

If there is a significant difference, double check the your underlying assumptions

Are inputs used in DCF unrealistic?

Are comparable companies poorly chosen or non-existent?

Are multiple measures poorly chosen?

Is the industry as a whole over- or under-valued in the current market?

Estimates of p by industry

Source: BLS Quarterly Census of Employment and Wages, Knaup and Piazza (2005,2008)

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Practice problem 1

Sequoia is considering a Series A investment of

$5M for 30% ownership in FreshDirect, an online grocer. Sequoia expects FreshDirect to IPO at a

$200M valuation in 4 years with a probability of

25%. Sequoia’s discount rate is 10%.

Should Sequoia make this investment?

Partial valuation = (200*0.25*0.3*0.5)/(1.1^4) = 5.12

 Invest!

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Sensitivity analysis

The investment decision is highly sensitive to a variety of assumptions

In particular, the exit valuation and the probability of success

Thus, your decision to invest should never rely on a single set of assumptions

To get a feeling for the robustness of your investment decision, see if decision is invariant to changing key parameters