Lecture 4:
Valuation of the Opportunity / Business
1
Financial Questions 1. Is this a financially viable business?
2. What will the likely returns be to the various stakeholders? 3. What is the probable value of the business? 4. What will the cash flows look like? 5. How much funding is required?
2
VC Discount Rates and Risk Reduction
Idea is Feasible Technology Works A Customer Buys
P(success) = 80% Req’d IRR = 30%
Valuation
P(success) = 50% Req’d IRR = 50%
P(success) = 30% Req’d IRR = 100%
P(success) = 40% Req’d IRR = 70%
Risk (ß) Capital
Seed Funding R&D Capital Go-to-Market Capital Expansion Capital
Source: Jim White (SHV)
3
Financial Valuation Methods
1. Comparables 2. NPV
3. Adjusted NPV
4. Venture Capital Method 5. Real Options
4
Comparables
• • Multiples – P/E, P/NAV, P/S etc. Problem: difficult to find info, especially on private deals.
•
•
• •
Fall-back: publicly traded equity.
When valuing a non-listed business, apply a discount for:
Liquidity. Corporate governance and underregulation. Skills and resource issues (inexperience).
5
•
Net Present Value (NPV)
• • • • Cash flows - scenarios and timing. Typically cash inflows distant – most value in terminal value (TV). TVs – tricky to estimate, scenarios and ranges. Discount rates – WACC, using CAPM for cost of equity (re).
•
•
Problem: need beta of comparable public firm.
Changing capital structures and effective tax rates – WACC (constant assumption) inappropriate.
6
Adjusted Present Value (APV)
Appropriate where:
• • • Hybrid securities (neither debt nor equity). Changing capital structure. Assessed tax losses and tax rates.
Sequence:
1. 2. Value cash flows at CAPM derived all-equity discount rate. Using (usually) pre-tax rate on debt, value (a) tax benefits of capital structure (interest payments), and (b) assessed tax losses. Subtract value of debt. 7
3.
Discount Rate and Beta
Discount Rate:
r = [(D/V) x re] + [(D/V) x rd x (1 – t)]
V=E+D
re = rf + β x (rm – rf)
8
The Venture Capital Method
Sequence:
1. Forecast cash flows to equity for period. 2. Predict exit point. 3. Value exit price using multiple (based on public company or comparable transaction multiple). 4. Discount cash flows at required RR.
5. Determine own share of this value.
6. Consider share option pools and follow-on funding rounds (dilutions) 9
PE vs. Public Numbers
Multiples:
• • • • • • 20-30% liquidity discount vs. market. Between 30% and 70% in SA. Liquidity risk. Compensation for value addition. Correcting for optimistic forecasts. Bargaining power of investor.
10
Discount rates:
Why so high?
Real Options
• • • • Flexibility i.t.o. follow-on investments (funding rounds). Right of first refusal = call option on equity in the business. Black-Scholes model. Not commonly known or used, complex in “real world”.
11
Black Scholes Variables
C SN (d1 ) Ke RT N (d 2 ) where
2 S T ln R 2 K d1 T and
d 2 d1 T
Variable definitions: S = current stock price K = option strike price e = base of natural logarithms R = riskless interest rate T = time until option expiration = standard deviation (sigma) of returns on underlying security ln = natural logarithm N(d1) and N(d2) = cumulative standard normal distribution functions 12
Black Scholes Variables
Variable Financial Option X S t Exercise price. Stock price. Firm Option
PV of expenditures to undertake project.
PV of expected project cash flows.
Length of time that inv. Time to expiration. decision can be deferred.
σ
rf
SD of returns.
Time value of money.
Riskiness of underlying assets.
Risk-free rate of return. 13
Source: Venture Capital and Private Equity, Lerner and Hardymon, J Wiley & Sons, 2002.
Valuing Ideas: Non-Financial Determinants • • • • • • • • The management team. Market opportunity. Value proposition. Intellectual capital. Skills, systems and structures. Competitors. Regulatory environment. Control, bargaining power and influence.
14
Assessing the Management Team • Motives and passion.
• Business experience. • Can skills gaps be bridged? • Personalities & conflict potential. • Governance issues.
15
Passion by itself is not enough…
16
The Essence of VC…
“Good ideas and good products are a dime a dozen. Good execution and good management - in a word, good people - are rare.”
- Arthur Rock
(78-Year old Venture Capitalist and Multi-Millionaire with NW of $1bn). 17
Investment Structure
•
•
Convertible Preferred Shares.
Downside protection: ranks above common equity in case of liquidation and pays dividends. Upside potential: convertibility.
•
•
•
Strategic influence.
Board representation.
18
Common Mistakes
Entrepreneur Unrealistic projections Weak analysis of market/competition Other Lacking clarity Mistakes and errors Incomplete Management weak Not realistic about challenges 15% 4% 27% 8% 16% 4% 16% Venture Capitalist 21% 18% 18% 17% 10% 8% 8%
Incorrect valuation and exit strategy
Source: Profit Dynamics, Inc, March, 2002
10%
19
Many VC Investments Fail
20
Phrases to avoid…
• • • • • • • We conservatively project… The project is 98% complete We have a 1 year lead… Customers are clamoring for our product… We are the low cost producer… Our team has a great deal of experience… If you invest on our terms you will earn a 68% IRR...
21
The Basis: Projected Sales
22
Cumulative Sales & Penetrations
23
Sales Converted to Revenue
24
Unit Production Costs
25
Total Cost of Sales
26
Gross Profit & Gross Margin
27
Capital Expenditures
28
Running Costs (1)
29
Running Costs (2)
30
Annual Cashflows
31
Monthly Cashflows
32
Valuation of Idea
33
The Negotiation: Different Objectives
Entrepreneur • Maximum capital/valuation. • Low cost of capital. • Dilution and control. Investor • Maximum return (lower valuation). • Minimise risk. • Control/ input into future.
34
The Negotiation: Common Objectives
• Growth in value of business. • Additional financing at more favorable valuations • Mutually beneficial exit strategy
35
Another take on Risk.
•
•
Entrepreneur cannot diversify away risk.
But PE Fund can and does across many investments.
Therefore: • Transferring part of risk to fund through equity investment reduces overall risk.
36
Management / Monitoring of Investments
• • • Strong, balanced team required. Across all areas of business sciences. Direct and active involvement.
In some ways: • PE investing is hybrid between business consulting and investment science.
37
Liquidity and Exit
• • • • The key risk. No public market. Over-the-counter markets (OTC). Secondary markets (PE portfolios, e.g. banks). • IPOs. • Third-party sales.
38
BJM OTC Market
http://www.bjmdirect.com
39
Initial Public Offerings (IPOs)
•
• •
Attractive if public valuations are high (e.g., high P/Es on listed equities).
Moves in cycles. V/C firm is insider – retains equity subject to lock-in period (usually 2 years). Thereafter, distributes equity to Limited Partners.
40
•
3rd Party Sale : Pleasure Foods
•
• •
The PE Fund:
Ethos PE Fund III. Part of RMB Group
•
• • • • • •
The Investment:
Date: 1996. Business: Pleasure Foods Seller: AngloVaal Industries. Reason: MBO / strategic refocusing. Cost: unknown Shareholding: 79% Ethos, 21% management 41
Pleasure Foods (2)
•
•
Restructuring:
1996 - 2003.
•
•
Exit (after 7 years):
Phase 1: • June 2003. • Sale of Juicy Lucy and Milky Lane to Ola (part of Unilever). Phase 2: • December 2003. • Sale of remainder to Steers Holding for R150.6 mn. 42
•
Assignment (1):
• Topic: A basic business plan of a novel business idea / concept / product.
•
• • •
• • • • • • •
Target Audience: A venture capitalist or VC firm.
Objective: To obtain funding from the venture capitalist to start the business. Format: MS Word format. Maximum length of text: 15 A4 pages of (minimum) font 11. Should include (at a minimum):
A description of the concept The need and how this idea will satisfy it The target market Why it would be a good investment for the venture capitalist (build an investment case). The financial case (attached financial projections as an Annexure) Competition issues. A clear indication of the amount of funding that will be required and why.
•
Annexures may be added to the above (e.g. supporting material, competing products etc., website info, additional research etc.).
43
Assignment: Practical Arrangements
• To be done in groups of between 3 and 5. You are expected to form your own groups timeously and will not be required to register your groups in advance.
Assignments handed in by groups of more than 5 or less than 3 members will automatically be marked down 25%.
• • • • The key will be to be original, comprehensive and concise within the space constraints Deadline for hand-in: 12:00 on 15 August 2006 to Nonnie Falala (LC 5.39) Grading will be on a relative basis – therefore there is no absolute right or wrong. Remember you will be graded on how well you achieve your objective, namely to convince the venture capitalist of the size of the opportunity, the novelty of the idea, the profits that can be made from it etc. Therefore, you have to achieve a fine balance between being creative and being realistic. The more realistic your assumptions, idea, financials etc,. the better your mark will be. This is an exercise in realism, not a license to dream or go on a flight of fancy. In short: You have to come up with an idea that can work and that can make money, and you have to be able to sell this idea as being realistic and profitable in order to get funding from a VC, which is your objective.
•
•
44
The Exam
• • • • •
• • • •
17 May, 15:00, Kramer 1 and 2, Class 2A Extra timers in Classroom 2A Essay / Case Study based. 1 Essay of 5 pages. Know / broadly understand:
Issues, challenges and financing issues facing entrepreneur. Functioning of the P/E and V/C industries Considerations of private equity investor. Etc. 45
Exam (2)
•
•
No correct answer.
Insight and lateral thinking will be rewarded.
•
• •
You may make some assumptions if needed, but do not invent your own story.
Correct application of material from other parts of the course can be useful. Slides and readings to form basis – do not need to know readings and specific info on VC and P/E industries.
46
Exam (3)
Slides and readings to form basis
What you do not need to know:
•
• •
Specific stats on VC and P/E industries (SA, US etc.)
The readings on areas of research in Entrepreneurial Finance. You will not be directly tested on specifics, but rather on application and understanding.
47
For the Exam, Remember…
48