Entrepreneurial Finance: New Venture Valuation Flashcards
What are the three approaches to valuation in the go-to order?
- Income approach
- Market approach
- Cost approach
Describe the income approach
This is based on the assumption that the value of a business equals the sum of the present values of any expected future benefits (by income stream and/or liquidity event)
Describe the market approach
This value is determined based on comparisons to similar companies for which values are known, and using “market multiples” (eg. if the value of your business is 2x your sales, or 1.5x, etc.). It’s like selling homes; you look at what similar homes in the neighbourhood sold for so that you get an idea of what your home would be worth
Describe the cost approach
When the value is determined as a measure of net cost of assets, the original amount invested, or the “cost-to-duplicate?”
When you ask:
How much would it cost me to get to the point where you’re at right now? How much would we come up with if we had to liquidate the assets you have right now?
What three things are required to value any asset?
- Income stream (based on guesswork and assumptions)
- Growth rate (based on guesswork of the product life cycle: you want to value the venture at its peak)
- Discount rate (usually 40-70%): how we get the present value
Describe the income approach
The income approach is the sketchiest of the three approaches because it is mostly guesswork: you have to do multiple sales forecasts. It is much more certain that there will be losses than that there will be successes/profits. The valuations are more subjective and qualitative because the numbers are fairly iffy. The qualitative aspects may have more to do with whether you get ideal or not than the quantitative aspects
Are there hard and fast rules for valuing early stage companies?
NO: there are too many unknowns
How many of the three valuation requirements are uncertain in valuing early stage companies?
2 of the three are subject to substantial uncertainty
What are four considerations in applying the income approach?
- One scenario of cash flow is inadequate (because the development of projects depends on specific outcomes and milestones)
- The risk of failure is likely higher than the present value discount rate
- If losses are forecast in the first few years, it is likely that they will occur and even greater ones
- Valuations are driven by subjective factors
What are the three subjective factors (3M’s) that drive valuation?
- Market
- Moat
- Management
Name and describe each of the two components of the “market” subjective factor
- Value proposition: does it make sense? Is it compelling? Is it unique? Does it demonstrate strong problem-solution fit?
- Industry sector: is it volatile? Is it stable? Is the industry growing or shrinking? What market are you entering? How attractive is the industry?
What are the four components of the “moat” subjective factor?
- Intellectual property
2: Time to market
3: Path to profitability
4: Deal structure
Describe the “intellectual property” segment of the “moat” subjective factor
Can you get a patent? Have you applied? How promising is that patent?
Describe the “time to market” segment of the “moat” subjective factor
How long until you get to market / make sales? How long will it take you to get to a position where you are selling consistently?
Describe the “path to profitability” segment of the “moat” subjective factor
When do you breakeven? What are the roadblocks (eg. approving a food product can take a long time)? Could the investor help with any of those barriers?
Describe the “deal structure” segment of the “moat” subjective factor
Valuation, equity exchanged; the nature of the deal
What are the three components of the “management” subjective factor?
- Experience and quality
- Add value?
- Social capital - trust
Describe the “experience and quality” segment of the “management” subjective factor
Does the investor have experience? Can you see yourself working with them?
Describe the “add value?” segment of the “management” subjective factor
Can the investor add value? Can they open doors in the industry? Can they be a good mentor? Do they have the right industry experience?
Describe the “social capital” segment of the “management” subjective factor
Do I want to work with this/these investor(s)? Do I feel that I can work well with them? Do I trust them?
Describe the concept of “real life valuation”
In real life, the result of a mutually accepted valuation between the company and its investors incorporates:
- The entrepreneur’s determination of the acceptable amount of ownership that may be given in return for the capital and/or expertise
- The investor’s assessment of risks and rewards
How are most deals negotiated?
They are an exchange of equity and capital
How are more deals now being negotiated? Why is this good for investors and entrepreneurs?
More deals are being negotiated using royalties. This arrangement is good because entrepreneurs only have to pay the investor after they have earned money, so they are guaranteed some cash before payments. It is also good for the investors because they earn more immediate return on their investment. The investors may also be more motivated to help the entrepreneur make more sales
How is most external capital raised?
Most external capital is raised through the issuance of preferred stock with provisions to provide protection for the investor
What eight provisions are provided for the investor?
- Preference in liquidation
- Preferred dividends
- Redemption rights
- Conversion rights
- Anti-dilution rights
- Voting rights
- Representation on Board
- Veto rights
Describe preference in liquidation
Investors get their money back first (before the entrepreneur) in liquidation
Describe preferred dividends
Investors get their money back first (before the entrepreneur) in dividends
Describe redemption rights
The investors can also force the entrepreneur to buy back their shares at a certain time or at a certain price (this would be in their contract)
Describe conversion rights
Investors can convert their preferred shares to common shares
Describe anti-dilution rights
The entrepreneur can’t issue more shares without consulting the investors (therefore diluting their power in the business)
Describe voting rights
Because the investor often owns equity of the company, they have some control over the actions the company takes* (not in notes)
Describe representation on the board
- (not in notes)
Describe veto rights
- (not in notes)
