. 87
( 100 .)


In this approach the appraiser estimates net earnings at cash-out time,
often at Year 5 or 6. He or she then estimates a P/E multiple and mul-
tiplies the two to estimate the cash out.
In Table 12-2 we use Fowler™s (Fowler 1989) numbers, with minor
changes in the presentation. Fowler assumed Year 5 net income of
$1,936,167 and multiplied it by a P/E multiple of 12 to calculate the Year
5 cash out at $23.2 million (B5), rounded.

T A B L E 12-2

VC Pricing Approach [1]


5 Assumed cash out-5 yrs @ 12 earnings $23,200,000
6 Present value factor-5 years @ 45% ROI 0.1560
7 Present value-rounded $ 3,619,000

[1] Source: Bradley Fowler, What Do Venture Capital ˜˜Pricing Methods Tell About Valuation of Closely Held Firms?™™ Business Valua-
tion Review, June 1989, page 77.

PART 5 Special Topics
He then used a 45% rate of return to discount cash ¬‚ows, based on
industry statistics he presented in the article, which we repeat below in
the next section. The present value factor at 45% for ¬ve years is 0.156,
and the present value of the Company is then $3,619,000 (B7, rounded).

Venture Capital Rates of Return
Fowler (1989) cited rates of return from two different studies. Plummer
(1990) found that the required rates of return (ROR), which included dis-
counts for lack of control (DLOC) and discounts for lack of marketability
(DLOM), were:

Stage of Development of Co. Required Rate of Return

Seed capital stage 50“75%
1st stage 40%“60%
2nd stage 35%“50%
3rd stage 30%“50%
4th stage 30%“40%

Morris (1988, p. 55) writes that VCs are looking for the following
rates of return:

Stage of Development of Co. Required Rate of Return

Seed capital stage 50%
2nd stage 30“40%

Summary of the VC Approach
The VC approach is a valid valuation approach, though certainly less
analytically precise than the First Chicago approach. Nevertheless, it is
used by venture capitalists, and it serves as a ˜˜quick-and-dirty™™ valuation
method, on the one hand, and as a useful alternative approach, on the
This concludes Part 1 of this chapter. Part 2 is a complex decision
tree analysis combined with multiscenario valuation.

Early-stage technology-based companies often ¬nd themselves in ¬nan-
cial hot water. They incur large expenses for years during the develop-
ment of a new product. Consequently, they run short of funds and often
require the infusion of venture capital, which may or may not occur. In
the following example”which is based on an actual assignment, with
names and numbers changed”the Subject Company has several possible
events that can impact the probability of obtaining venture capital as well
as surviving as a ¬rm without venture capital, i.e., bootstrapping to

CHAPTER 12 Valuing Startups 415
The Company and its former parent (˜˜the parent™™) share a nearly iden-
tical set of shareholders”well over 100. The president is the major share-
holder of the ¬rm, with effective, but not absolute control. The parent had
lent the Company $1 million to get started as a spinoff, but the debt
would be coming due in four years, and the Company has no way of
paying it off.
The parent proposed the following restructuring of the debt:
1. The parent would convert the debt into $400,000 of convertible
preferred stock”and part of the valuation exercise was to
determine how many shares of preferred stock that would be.
There would be no preferred dividends, but the parent would
have a liquidation preference.
2. The president would have to relinquish a certain number of his
shares in the parent back to the parent, which had a ready
buyer for the shares.
In return for relinquishing his shares to the parent, the president
wants the Company to issue 1.3 million new shares to him. The board of
directors wants an independent appraisal to determine whether the trans-
action is favorable to the other shareholders. This example, however, is
typical of the types of decisions faced by startup ¬rms in their quest for
adequate funding. More importantly, the statistical approach we use in
this valuation is applicable to the valuation of many startups, regardless
of industry.

Key Events
The company president, Mr. Smith, has identi¬ed a sequence of four key
events that could occur, and each one of them increases the Company™s
ability to obtain venture capital ¬nancing as well as to successfully boot-
strap the ¬rm without VC ¬nancing. The events are sequentially depen-
dent, i.e., event #1 is necessary, but not suf¬cient for event #2 to occur.
Events #1, #2, and #3 must occur in order for #4 to occur. These events
1. Event #1: The Company sells its product to company #1. The
conditional probability of this event occurring is 75% (Table
12-3, cell B11).
2. Event #2: The Company sells its product to company #2. The
conditional probability of this happening, assuming event #1
occurs, is 90% (B12).
3. Event #3: The Company sells its product to company #3, which
has a 60% (B13) conditional probability, i.e., assuming event #2
4. Event #4: The Company sells its product to company #4. If the
Company sells its product to company #3, then it has an 80%
(B14) probability of selling it to company #4.
While these four events are all potential sales, the statistical process
involved in this analysis is generic. The four events could just as easily

PART 5 Special Topics
be a mixture of technology milestones, rounds of ¬nancing, regulatory,
sales, and other events.

Decision Trees and Spreadsheet Calculations
Our analysis begins as decision trees, which appear in Figures 12-1 and
12-2. However, careful analysis leads to our being able to generalize the
decision tree calculations mathematically and transform them into ex-
pressions that we can calculate in a spreadsheet. This has tremendous
computational advantage, which is not very apparent in a four-milestone
analysis. Increase the number of milestones to 20, and the decision tree
becomes very unwieldy to present, let alone to calculate, while the
spreadsheet is easy. The discussions over the next few pages ultimately
culminate in the development of equations (12-3) through (12-6). The
equations provide the blueprint for the structure of the calculations in
Table 12-3.

Table 12-3: Statistical Calculation of FMV
Table 12-3 is a statistical calculation of the FMV of the common shares of
the Company owned by the existing minority shareholders, based on the
probabilities of the different events occurring and the results of DCF anal-
yses of several different scenario outcomes.

The table is divided into three sections. In the ¬rst two sections, 1A and
1B, the Company does restructure its debt with the parent. Section 1A is
the calculation of the probability-weighted contribution to the FMV of the
current shareholders™ shares when the Company is successful in obtaining
venture capital. Several possible combinations of events can lead to this
outcome, and we identify the probabilities and payoffs of each combi-
nation in order to calculate the FMV of the common stock owned by the
existing minority shareholders. Section 1B is the probability-weighted
equivalent of section 1A when the Company is not successful in obtaining
venture capital and instead attempts to bootstrap its way to success. The
total of sections 1A and 1B is the FMV of current shareholders™ shares,
assuming the Company restructures the debt.
Section 2 is an analysis of the combination of events in which the
Company does not restructure its debt with the parent. Section 3 is a
summary of the FMVs under the different scenarios and contains calcu-
lations of the per share values. This is the bottom line of the valuation

Section 1A: Venture Capital Scenario
In section 1A the primary task is to determine the probability of receiving
venture capital funding. Once we have accomplished that, it is simple to
determine the contribution to FMV from the VC scenario.
Figure 12-1 is a diagram of the decision tree for section 1A. We begin
by noting that there is a 75% probability of making sale #1 and a 25%
probability of not making sale #1, in which case the Company fails. We
denote the former as P(1) 75% and the latter as P( 1) 25%. We

CHAPTER 12 Valuing Startups 417

T A B L E 12-3

Statistical Calculation of Fair Market Value


4 Section 1A: Weighted Average Values Assuming Venture Capital Scenario & Debt Restructure With Parent

[C] [D] [G] B18
6 Cum. Product [B] [1 [D] Cumulative [Fn 1] 1 VC% [H] [1 Min] [I]
7 Product [E]

8 Event Conditional Cumulative Venture Prob No VC Current Current Current
9 Probability Joint Cap 1 VC Cond. Shareholders Shareholders Shareholders
10 of Sale Probability Conditional Probability Cum. no VC Prob of VC % Own FMV Control FMV Minor
of Sale Probability

11 #1: Company makes sale #1 75.000% 75.000% 50.000% 50.000% 50.000% 37.500% 50.000% $18,750,000 $14,062,500
12 #3: Company makes sale #2 90.000% 67.500% 60.000% 40.000% 20.000% 20.250% 60.000% $12,150,000 $9,112,500
13 #3: Company makes sale #3 60.000% 40.500% 70.000% 30.000% 6.000% 5.670% 70.000% $3,969,000 $2,976,750
14 #4: Company makes sale #4 80.000% 32.400% 100.000% 0.000% 0.000% 1.944% 85.000% $1,652,400 $1,239,300
15 Totals 63.364% $36,521,400 $27,391,050


18 FMV VC scenario $100,000,000
19 Minority interest discount 25%

21 Section 1B: Bootstrap Scenario Assuming Debt Restructuring With Parent

23 Cum. Product [B] 1 [D] Cum. Prod. P[Si i, [C] [F] Note [1] [H] [I] [1 Min] [J]
[E] (i 1)] {1 [Bt 1]}*[G]

Venture Wtd Avg
26 Cumulative Cap Prob No VC Bootstrap FMV Current
27 Conditional Joint Conditional 1 VC Cond. Conditional Prob of Survival/ Conditional FMV Shareholders
28 Event Probability Probability Probability Probability Cum. No VC Probability No VC FMV Control FMV Minor

29 #1: Company makes sale #1 75.000% 75.000% 50.000% 50.000% 50.000% 30.000% 1.125% 15,286,460 $171,973 $128,980
30 #3: Company makes sale #2 90.000% 67.500% 60.000% 40.000% 20.000% 35.000% 1.890% 15,464,845 292,286 219,214
31 #3: Company makes sale #3 60.000% 40.500% 70.000% 30.000% 6.000% 75.000% 0.365% 15,732,422 57,345 43,009
32 #4: Company makes sale #4 80.000% 32.400% 100.000% 0.000% 0.000% 90.000% 0.000% 16,000,000 0 0
33 Totals 3.380% $521,603 $391,202
35 Section 2: No Debt Restructure With Parent

37 #1: Company makes sale #1 75.000% 75.000% 0.000% 100.000% 100.000% 30.000% 2.250% 7,286,460 $163,945 $122,959
38 #3: Company makes sale #2 90.000% 67.500% 0.000% 100.000% 100.000% 35.000% 9.450% 7,464,845 705,428 529,071
39 #3: Company makes sale #3 60.000% 40.500% 0.000% 100.000% 100.000% 75.000% 6.075% 7,732,422 469,745 352,308
40 #4: Company makes sale #4 80.000% 32.400% 0.000% 100.000% 100.000% 90.000% 29.160% 8,000,000 2,332,800 1,749,600
41 Totals 46.935% $3,671,918 $2,753,938

43 No
Assumptions Restructure Restructure

44 Adjusted FMV $16,000,000 $8,000,000
45 Minority interest discount 25.0%

49 Section 3: Calculation of FMV per Share

50 Restructure No
51 Restructure:
Venture Investor %
52 Capital Bootstrap Total 33.33%

53 Sec 1: venture capital $27,391,050 $391,202 $27,782,252 $2,753,938


. 87
( 100 .)