AA Early Stage Company Valuation

National Seminar on Corporate Valuation
Valuation of Early Stage Companies

April 30, 2014
Valuation
Transaction
Consulting
Real Estate
Advisory
Leading / Thinking / Performing
Fixed Asset
Management
Agenda
1. Key characteristics of early stage companies

2. Challenges in valuing early stage companies
3. How does a venture capitalist value early stage companies?
4. Dealing with challenges in Valuation

5. Case Studies
No history, nascent operations - not yet at the stage of commercial production

Small or no revenues, operating losses; can consume vast amounts of cash
High level of dependence on external sources of funding
Complex shareholding structure with multiple claims on equity
Illiquid investments
Agenda


5. Case Studies

Mature Growth
$ Revenues/ Earnings
High Growth
Decline
Rapid
Expansion
Start-up
or Idea
companies
Time
Revenues/
Earnings
Non-existent or low
revenues/ negative
operating income
Revenues
increasing/
income still
low or negative
Revenues in high
growth/ operating
income also
growing
Revenue growth
slows/ operating
income still
growing
Revenues and
operating income
growth drops off
Operating History
None
Very
limited
Some operating
history
Substantial operating
history
Comparable firms
None
Some, but in
same stage of
growth
More comparable
at different stages
Operating history
can be used in
valuation
Large number of
comparables, at
different stages
Source of Value
Entirely future
growth
Mostly future
growth
Portion from
existing assets/
Growth still
dominates
More from
existing assets
than growth
Entirely from
existing assets
Declining number of
comparables, mostly
mature
2. Who invests in early stage companies?

Funding Life Cycle
Earnings
Strategic Investors
Venture Capital /
Private Equity
Angels/
Founders
Public Markets
PIPE
IPO
Early
Stage
Seed Capital
Late
Stage
Secondary
Offerings
C
B
A
Distressed Asset funds
Time
Valley of Death
Agenda


5. Case Studies

Reviewing business plan and valuation process
Detailed Assumptions
Forecast P&L, Balance

Sheet and Cash flows
Computation of
Estimation of WACC /
FCFF / FCFE
Cost of Equity
Valuation
Summary
Equity
Requirement
Investor IRR
Requirement
Sensitivity Analysis
Expected Exit
Valuations
Promoter
Dilution

Method 1: Basic VC Formula
Example: Basic VC Formula (1/2)
Consider a VC contemplating an investment of $1.0 mn in a technology company. Assume
no further capital requirement through year 5. The company is expected to earn $1.5 mn in
year 5, and should be comparable to companies commanding P/E ratio of about 10x.
Further, the VC requires a 25% projected rate of return on a project of this risk.
equity stake should the VC seek?
Fact Summary
Investment
Required IRR
Term
$1.0 million
25%
5 years
Revenues
$0.5 million
Year 5 Net Income
$1.5 million
Year 5 P/E Ratio Exit Multiple
FY
15
PE
exit Exit Valuations
10x Net Income
Promoter
Dilution ?
Equity
Requirement
$1.0 mn
FY
14
How much
FY
16
FY
17
FY
18
FY
19
Investor IRR
25%
10x
PE
Investment

Method 1: Basic VC Formula
Example: Basic VC Formula (2/2)
The VC must own enough of company in year 5 to realize a 25% annual return on the
investment. Thus, at that time his shares must be worth:
Required Future Value of Investment = (Investment) X (1+IRR)^years

= ($1.0 mn) X (1+25%)^5
= $3.05 mn
Now, at that point the company must be worth:

Exit Value of Company = Exit Year Net Income X P/E Ratio
= $1.5 mn X 10
= $15.0 mn
Hence, VC must own: $3.05 / $15.0 = 20.3 percent
10

Method 2: First Chicago Method
Overview
First Chicago approach simply does three different projections: Success, Failure and
Survival cases and assigns probability estimates to each
When utilized, the First Chicago method results in a separate valuation and pricing for each
of the three outcomes
These are then averaged and the weighted average valuation is determined (weights being
the probability assigned to each case)
Let us continue with the same example and see how the analysis differs in this case.
11

First Chicago Method Example (1/2)
Variables
Success
Sideways Survival
Failure
Base year revenue:
$ 0.5 mn
$ 0.5 mn
$ 0.5 mn
Revenue growth rate from base:
100.0%
50.0%
5.0%
After Tax Profit Margin:
20.0%
10.0%
Negative
10x
10x
N.A.
PE Ratio at Liquidity:
*From Comparables etc. (P/E of 10
is long term historical average)
Projected Liquidation Value @ Year 5 in Failure Scenario:
$ 1.0 mn
Discount Rate:
25.0%
25.0%
25.0%
Probability of Each Scenario:
33.3%
33.3%
33.3%
12

First Chicago Method Example (2/2)
Calculations
Success
Sideways Survival
Failure
Revenue Growth Rate

Revenue Level After 5 Years
100%
16.0
50%
3.8
5%
0.6
Net Income at Liquidity

Value of Company At Liquidity
3.2
32.0
0.4
4.0
0.0
1.0
PV of Company Using Discount

Rate of 25%
12.0
1.6
0.3
33.3%
4.0
33.3%
0.5
33.3%
0.1
Expected PV Of The Company

Under Each Separate Scenario
Expected PV Of The Company

% Ownership Required in order
to Invest $ 1.0mn
4.6
1.0 / 4.6 = 21.6%
13

Method 3: Scorecard Method
Overview (1/2)
The first step in using the Scorecard Method is to determine the average pre-money valuation of early
stage companies in the region and business sector of the subject company.
As one would expect, pre-money valuation varies with the state of the economy and the competitive
environment for startup ventures within a region. However, the variation has been remarkably subdued,
ranging between $2 million and $ 3 million from 1998 till 2008.
Median Pre-Money Valuations ($Mn)
Median Pre-Money Valuations by Round Class

8
7
6
5
4
First Round
Seed Round
2
1
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Source: Dow Jones VentureSource

14

Overview (2/2)
Since our subject company is revenue generating, we will assume that the average premoney valuation for comparable firms is $3.5 million.
In the next step, the VC compares the subject company to his perception of similar deals,
considering factors such as
Strength of the Management Team;

Size of the Opportunity;
Product/ technology risk, among others.
The subjective rating of factors is typical for investor appraisal of startup ventures.
15

Continuing with the same example
Comparison factor
Range
Weights
Company
Rating
Factor
Team/ Management
0-40%
30%
1.25
0.375
Size of Opportunity
0-30%
25%
1.50
0.375
Product/ Technology
0-20%
15%
1.00
0.150
Competition
0-15%
10%
0.80
0.080
Sales partnerships
0-15%
10%
0.80
0.080
Additional investment
0-10%
5%
1.00
0.050
Other factors
0-10%
5%
1.00
0.050
Total
100%
1.080
Multiplying
the Sum of Factors (1.080) times the average pre-money valuation of $3.5
million, we arrive at a pre-money valuation for the subject company of about $3.8 million.
Hence, the fund must own: $1 / ($3.8 + $1) = 20.9 percent

16
Agenda


5. Case Studies
17
Due to the challenges in applying the typical valuation approaches, we need to consider
some modified approaches such as:
Method 1:
In-phase Valuation
For Valuing Businesses

Method 2:
Real Options
Method 3:
Backsolve Method
For Valuing Shares

18

Method 1: In-phase Valuation
Valuation of early stage companies should not be done by valuing the cash flows
of the venture all in one step.
Valuation analysis should break down the cash flow forecasts into different
development phases and evaluate each phase separately.
As the project/ firm progresses successfully from one phase to the next, the risk
(and therefore the return expectation) should decline.
19

Example (1/3)
A startup is launching an ecommerce business which will proceed in two phases

Phase 1 Setting up a website - for 3 years with:
Initial Investment of $ 50,000
For the first three years, the project will produce $ 10,000 per year
Phase 2 Launch of ecommerce business* after 3 years
Investment required $ 800,000

Expected cash flows $ 100,000 growing at 6% till perpetuity
There is a 40% chance that the killer application will be discovered

All equity financed
* Contingent on discovery of killer application

20

Example (2/3): Valuation using traditional DCF method

Cash flows
10,000
Risk free rate

Total Risk Premium
Cost of Equity
10,000
10,000
- 800,000
NPV of the Project at the end of 3 years =

3
100,000*(1+6%)
(22% - 6%)
-- 137,500
10,000
(1+22%)^t
40% * - 137,500
(1+22%)^3
23,078
40% * - 75,722
- 7,210
- 7,210
--
50,000
-- $ 57,210
t=1
Net Present Value of the Project
Grow at 6% till
perpetuity
Development of
killer application for
$800,000
= 6.0%
= 16.0%
= 22%
Present Value of the Overall Project
100,000
21

Example (3/3): Valuation using In-phase method

Cash flows
10,000
Risk free rate

Total Risk Premium Phase 1
Total Risk Premium Phase 2
Cost of Equity Phase 1
Cost of Equity Phase 2
10,000
10,000
100,000*(1+6%)
(14%-6%)
10,000
(1+22%)^t
40% * 525,000
(1+ 22%)^3
23,078
138,727
--
- 800,000
3
t=1
Net Present Value of the Project

Grow at 6% till
perpetuity
Development of
killer application for
$800,000
= 6%
= 16%
= 8%
= 22%
= 14%
NPV of the Project at the end of 3 years =

Present Value of the Project
100,000
525,000
40% * 289,121
138,727
50,000
$ 88,727
22

Method 2: Real Options
Valuation using Real Options

Traditional DCF approach understates the value of early stage companies because:
It doesnt take into account the changes in risk over time

Doesn't put value to the flexibility provided in investment decision at various phases of an early
stage firm
Looking
these companies as a project with embedded real options, removes these

drawbacks
The underlying asset in this approach is the present value of the project cash flows and
the exercise price is the expected investment to be made, if first phase is successful
Identifying
valuation
the underlying asset and exercise price are critical to the real options
23

Continuing with our earlier example:

The Company has an option to make an investment of $ 800,000 for phase 2 project at
the end of phase 1
The required investment of $ 800,000 will be incurred only if one shows that the project
phase 1 turns out to be favourable, but will not be incurred otherwise
This flexibility with the management can be valued as a call option with exercise price of
$ 800,000
The parameters of this call option are:
Strike Price - $ 800,000

Time period 3 years
Risk free rate 6%
Dividend rate 0%
Volatility 60%
Value of underlying - $ 730,000 (present value of $ 1,325,000 @ 22% discount rate)
A simple application of the black scholes model suggests that this options value is
$266,000
24

Total Value of the Project:

3
10,000
-(1+22%)^t
50,000
23,708
50,000
(2) Option Value at present
266,000
Total NPV of the project
(1) + (2)
$ 239,708
(1) NPV of Phase 1
t=1
--
-26,292
25

Some recent VC investments
Name of the
company
Amount Invested
($mn)
Stake Acquired
(%)
Implied Equity
Value ($mn)?
BabyOye
12
25
48
BankBazaar
13
35
37
FirstCry
15
26
58
TaxiForSure
2.55
31
The Beer Cafe
4.6
36
13
Yebhi.com
10
29
34
26

Method 3: Backsolve Method
The Backsolve Method derives the implied equity value for the company from a transaction
involving the companys own securities, typically, the preferred stock.
It indicates an equity value that is consistent with the rate of return the investors in the
most recent round expected given the degree of marketability of their investment as well as
any special rights (e.g., liquidation preferences) accorded to them.
Option Pricing Model
The most common method to apply Backsolve is through the Option Pricing model. This
model treats common and preferred stock as call options on the value of the business.
Common stock only has value if the funds available, at the time of a liquidity event (e.g.,
merger or sale), exceed the preferred liquidation value
In other words common shareholders have
the option to buy the underlying asset (the

company) at an exercise price equal to the liquidation preference amount.
27

Example (1/8)
Company X receives $ 1 mn investment in the form of 100,000 Series A convertible preferred
shares. It has 400,000 outstanding common shares. Series A preferred shares are issued with the
following terms:
Key Facts
No. of shares
100,000
Issued price
$10
Liquidation preference
$10
Common shares
400,000
Conversion ratio
1, convertible into common at the ratio of one
It would appear that the value of the Common Equity is $ 4 mn and overall Equity value is $ 5 mn
Let us assume that the value of the Company is $ 5 mn and apply the Backsolve model to see if
this is indeed the case.
28

Example (2/8)
Series A preference share holders (Preferred A) will convert their shares into common
shares once the enterprise value is above $5 million.
Before Conversion
After Conversion
No. of shares
No. of shares
Preferred A
100,000
Common
400,000
Liquidation Preference
Liquidation Preference Value
Preferred A Equity stake
Required Enterprise Value
500,000
$10
$1,000,000
20%
$5,000,000
29

Example (3/8)
To illustrate graphically, payoff to preferred and common shareholders is shown as below.

Payoff to
shareholders
Value Allocation
3rd payoff : 80%
to Common
And 20% to
Preferred
$5,000,000
Preferred
Common
2nd payoff :
100% to
Common
$1,000,000
1st payoff :
100% to
Preferred
$1,000,000
$5,000,000
Enterprise Value
30

Example (4/8)
1st option
2nd option
3rd option
$5,000,000
$5,000,000
$5,000,000
Exercise Price
$0
$1,000,000
$5,000,000
Risk Free Rate
6%
6%
6%
Volatility
50%
50%
50%
5 years
5 years
5 years
$5,000,000
$4,400,000
$2,700,000
Underlying value
Time to liquidity
Results
Option value
Option value
Option value
Diagram
EV
Ex. Price :$ 0
$1m
Ex. Price :$ 1 m
EV
Ex. Price :$ 5 m
EV
31

Example (5/8)
Based on the option results, value of preferred shares and common share values can be derived.
Payoff to
shareholders
3rd payoff : 80% to

Common, and 20% to
Preferred
$5,000,000
2nd payoff : 100% to
Common
$1,000,000
1st payoff : 100% to

Preferred
$1,000,000
Results
Enterprise Value
$5,000,000
1st option
2nd option
3rd option
$5,000,000
$4,400,000
$2,700,000
32

Example (6/8)
Preferred shares value is:
Results
1st option
2nd option
3rd option
$5,000,000
$4,400,000
$2,700,000
= Value of 1st option Value of 2nd option + (Value of 3rd option x 20%)
= $5,000,000 4,400,000 + (2,700,000 * 20%)
= $1,140,000
Since the Preferred shares value is not equal to the amount invested ($ 1 mn), it implies
that the value of company is not $ 5 mn.
Using goal seek, we can find out the value of company at which value of Preferred Shares
will be $ 1 mn. That value is about $ 3.93 mn.
33

Example (7/8)
1st option
2nd option
3rd option
$3,930,000
$3,930,000
$3,930,000
Exercise Price
$0
$1,000,000
$3,930,000
Risk Free Rate
8%
8%
8%
Volatility
50%
50%
50%
5 years
5 years
5 years
$3,930,000
$3,300,000
$1,850,000
Underlying Assets
Time to liquidity
Results
Preferred shares value is:

= Value of 1st option Value of 2nd option + (Value of 3rd option x 20%)
= $3,930,000 3,300,000 + 1,850,000 x 20%
= $1,000,000
34

Example (8/8)
Common shares value is:
Results
1st option
2nd option
3rd option
$3,930,000
$3,300,000
$1,850,000
Common Stock
= Value of 2nd option Value of 3nd option + (Value of 3rd option x 80%)
= $ 3,300,000 1,850,000 + (1,850,000 x 80%)
= $ 2,930,000
Note that the Common shares value is much lower than the $ 4 mn anticipated earlier.
35
Agenda


5. Case Studies
36
5. Case Studies
Facebook buys WhatsApp (1/2)
Overview
Facebook acquired WhatsApp in $19bn deal.

Facebook is making the purchase in a mix of cash and stock. WhatsApp will receive:
$4bn in cash
$12bn in Facebook shares and an additional $3bn in restricted shares that will be paid
out to executives at a later date > Large consideration is in form of stock!
Key numbers
WhatsApp
450 Mn
Number of people using the service each month
70%
Proportion of those users active on a given day
1 Mn
New registered users per day
19 Bn
Messages sent via WhatsApp each day
37
5. Case Studies
Facebook buys WhatsApp (2/2)
Comparison
Market Cap
$160 Bn
Deal Value
$ 19 Bn
$ 4 Bn
(cash paid)
Daily Active Users
802 Mn
Daily Active Users
315 Mn
315 Mn
Value/ Active User
$ 200
Value/ Active User
$ 60
$ 12 (cash
paid/ user)
Considerations
Is the market over estimating the value of users at social media companies across the board?
As social media companies move up the life cycle, the variable(s) that traders user to price
companies will change from number of users/ user intensity to revenues, earnings and cash
flows.
The problem for companies (and investors) is that these transitions happen unpredictably and
that markets can shift abruptly from focusing on one variable to another.
38
5. Case Studies
A renewable energy company
Overview
Dispute between two promoters. One promoter decided to exit and demanded
USD 12.5 per share for his stake (latest round of funding had taken place at USD
12.5 per share).
Dispute went to court and American Appraisal was appointed to determine fair
value of exiting promoters shares.
Solution
American Appraisal reasoned that since recent round of funding was in the form
of preference shares, it could not be used as a benchmark for valuing common
equity
Instead, valuation of the equity shares was carried out using the Backsolve
method, which indicated a fair value of ~ USD 5 per share for common equity.
The Court ruled in favor of our client, with the final concluded share price being
very close to the value implied by the Backsolve method.
39
Varun Gupta
Managing Director American Appraisal India
Mobile: +91 9967664231
Office: +91 (0) 22 6623 1000
vgupta@american-appraisal.com
Valuation / Transaction Consulting / Strategy

American Appraisal
B-204, Citipoint,
Andheri-Kurla Road
J.B. Nagar
Mumbai, India
www.american-appraisal.co.in
40

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National Seminar on Corporate Valuation

Valuation of Early Stage Companies

Leading / Thinking / Performing

1. Key characteristics of early stage companies

4. Dealing with challenges in Valuation

Leading / Thinking / Performing

1. Key characteristics of early stage companies

No history, nascent operations - not yet at the stage of commercial production

Leading / Thinking / Performing

1. Key characteristics of early stage companies

4. Dealing with challenges in Valuation

Leading / Thinking / Performing

2. Challenges in valuing early stage companies

Leading / Thinking / Performing

2. Who invests in early stage companies?

Leading / Thinking / Performing

1. Key characteristics of early stage companies

4. Dealing with challenges in Valuation

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Forecast P&L, Balance

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Consider a VC contemplating an investment of $1.0 mn in a technology company. Assume

Year 5 Net Income

Year 5 P/E Ratio Exit Multiple

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Required Future Value of Investment = (Investment) X (1+IRR)^years

Now, at that point the company must be worth:

Hence, VC must own: $3.05 / $15.0 = 20.3 percent

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Base year revenue:

Revenue growth rate from base:

After Tax Profit Margin:

Projected Liquidation Value @ Year 5 in Failure Scenario:

Probability of Each Scenario:

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Revenue Growth Rate

Net Income at Liquidity

PV of Company Using Discount

Expected PV Of The Company

Expected PV Of The Company

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Median Pre-Money Valuations ($Mn)

Median Pre-Money Valuations by Round Class

Source: Dow Jones VentureSource

3. How does a venture capitalist value early stage companies?

Strength of the Management Team;

Leading / Thinking / Performing

3. How does a venture capitalist value early stage companies?

Hence, the fund must own: $1 / ($3.8 + $1) = 20.9 percent

1. Key characteristics of early stage companies

4. Dealing with challenges in Valuation

Leading / Thinking / Performing

4. Dealing with challenges in Valuation

For Valuing Businesses

For Valuing Shares

4. Dealing with challenges in Valuation