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More commonly, investors use the approach involving market multiples
288 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


discussed briefly in the previous section. This calculation entails obtaining
the observed market value of a comparable company relative to earnings.
Herein lies the rub: What constitutes “comparable”? Some analysts use sim-
ilar industry, products, customers, ownership structure, or other factors.
Investors are also aware that entrepreneurs have many ways available to in-
fluence pro forma earnings forecasts (e.g., EBITDA) and still be within the
guidelines of generally accepted accounting principles (GAAP). EBITDA is
often used in earnings-based valuation calculations.
The discounted cash flow method of valuation is a derivation of the free
cash flows valuation method. Free cash flow valuation defines the value of
the company as the present value of the expected future cash flows in excess
of those needed to operate the company. The company™s value is a function
of the present value of its free cash flow discounted with the company™s cost
of capital, plus the value of the company™s nonoperating assets (e.g., any in-
vestments insecurities). The discount rate is a measure of the company™s cost
of capital.
The venture capital method of discounted cash flow is a concept based
on estimates and assumptions. Also, the calculations of net present value can
be effected in the venture capital method by qualitative, nonnumerical fac-
tors. The venture capital method is just another version of the discounted
cash flows valuation calculation, basically adapting the method to make it
more appropriate for start-up and early-stage ventures.
Central to the venture capital method is determining the future potential
of the venture. This is called the terminal value, the projected net earnings in
the terminal year or year of projected exit, multiplied by an appropriate mul-
tiple of earnings. For instance, the multiple might be the P/E ratio of a com-
parable company, appropriate for a company that has successfully achieved
the projected forecasts. The P/E ratio becomes the current market price of a
public company™s publicly traded stock divided by current annual earnings
per share amount.
Terminal value can be expressed as:

TV = PNI at TY — PER

where TV = terminal value
PNI = projected net income from projections for year of exit
PER = price-earnings ratio of comparable company
TY = terminal year”future year when investor™s shares are sold

As the reader can see, terminal value is measured as a ratio of financial
performance for a comparable company. The P/E ratio is applied to net earn-
ings to estimate a future value at the terminal year, usually estimated at three
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Valuation of the Early-Stage Company


to five years out. Also, it is apparent that forecasts and assumptions will
drive the accuracy of the calculation.
For investors attempting to determine how much of the company they
need to receive for their capital to attain their targeted return, the investors
need to now calculate the present value of the company. Whereas terminal
value reflects potential, present value equals the terminal value of the future
company minus the capital to get the company to that stage. Calculating
present value becomes a way to quantify risk to the investor, the time the in-
vestor puts into the company, the loss of the use of capital during the term of
the hold, and to some extent to compensate the investor for losses in other
deals. To capture this, the investor uses a discount rate obtaining present
value of future income streams. We have witnessed discount rates ranging
from 20 percent to 70 percent.
To calculate present value, the investor discounts the terminal value cal-
culated above. The discount terminal value is a function of the investor™s re-
quired rate of return. Converting terminal value to present value necessarily
involves the investor in determining his or her target ROI, for example, a five
times return in three years yields a 70 percent ROI, whereas a ten times re-
turn in five years yields a 58 percent ROI.
As we mentioned earlier, investors give projections a haircut. High-risk,
illiquid companies, requiring involvement for an average of up to eight years,
plus time, energy, and entrepreneurial optimism”all are reasons why in-
vestors indulge in this precaution.
Present value (PV) can be expressed as:

TV
PV =
(1 + ROI)Y

where TV = terminal value or annual net earnings projected for the
terminal year multiplied by the P/E ratio of a comparable
company
ROI = required or targeted rate of return
Y = number of years to exit

Once terminal value and discounted or present value has been com-
puted, a calculation can be made to determine the required ownership per-
centage of equity the investors will need to reach their investment return
objective. The minimum equity stake that investors will request can be ex-
pressed as:
A
=E
PV
290 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


where A = investment amount
E = minimum percentage share of company equity required
PV = present value

We point out “minimum” equity stake required because most investors
will further correct this third calculation to compensate for potential dilu-
tion from future financing rounds, both expected and unforeseen. We will
discuss dilution factors in the next section. As you can see from these for-
mulae, the higher the ROI that the investor expects and demands, the lower
the company valuation will be. However, the high discount rate becomes the
primary means to compensate the investor for the loss of the use of his or her
capital, risk, or entrepreneurial errors, and still allow him or her a reason-
able return.


DILUTION
The next element that the prospective angel investor will consider during
valuation”in addition to desired returns and time to liquidity, discounting
of projections, and clarifying multiples”is an assessment of how much ad-
ditional capital a company will need to get to the point that the envisioned
liquidity event can or will occur. More often than not investors are skeptical
about an entrepreneur™s claims of what it will take to get to break even and
to the point that operations and growth can be funded from internal cash
flows and traditional credit lines. So the prudent investor will create a dilu-
tion factor to compute into the valuation process.
While dilution may not be at the forefront of every valuation calcula-
tion, many angel investors have learned from painful experience that entre-
preneurs rarely, if ever, perceive that the company will need a lot more
capital than anyone had estimated. Just a little calculation will help investors
understand that for their investment to obtain their targeted and justified
rate of return, they need X percent of the company. If the entrepreneur has
miscalculated, and significantly more money is needed than has been pro-
jected, investors will suffer significant dilution and fail to make their targeted
rate of return. That is why dilution is rarely separated from negotiation of
deal structure by investors to protect the individual investor™s share, should
more money be needed later.
Less experienced angel investors commit a relatively common oversight
in their failure to recognize the difference between premoney and postmoney
valuations. Valuation of the company is called “premoney” because the
value was established before taking into account new investment. In other
words, the value is based on a view of the current climate for the company in
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Valuation of the Early-Stage Company


a specific industry or based on current revenue and some multiple of pro-
jected revenue for the year. For instance, if a company has a premoney valu-
ation of $10 million, the angel investing $1 million would purchase 10
percent of the shares of the company outstanding before it issues shares
to the investor. When the $1 million investment is added to the $10 million
premoney valuation, on a postmoney basis, the investor will hold approxi-
mately 9 percent of the outstanding shares of the company, with a post-
money valuation of $11 million.
Though no statistically valid research is currently available, our anec-
dotal research gleaned in speaking with almost 4,000 entrepreneurial com-
panies suggests that 90 percent of the deals worked out will need more
money than originally projected. The result is dilution, best explained this
way: If a deal calls for $1 million, 12 months later it will need more money.
An investor with a 40 percent ownership for the first million dollars is faced
with three options, if, say, another $500,000 is necessary. The investor can
put in $500,000, or he can put in a portion of it, or he can choose not to put
in any more money at all, in which case, to survive, the company has to raise
the $500,000 from somewhere else.
With all three options, the investor suffers dilution. He has to put more
money in to maintain his 40 percent ownership, or his stake will shrink.
Come liquidity, how much of the company will the investor own? The an-
swer is that the investor will own less than when he started out. This illus-
trates the dilemma a company creates when it needs additional money. This
scenario dramatizes dilution”something else that investors seriously ponder
during the valuation process.
How can the investor arrive at a dilution factor? As an example, let™s
say that the investor and entrepreneur agree that the company can achieve
$2 million in earnings in three years. They also agree that in three years buy-
ers can be found who will pay 20 times earnings for the company. Therefore,
based on these assumptions, in three years the company would be worth $40
million (that is, 20 — $2 million = $40 million). Let™s also assume that the in-
vestor has offered to invest $1 million, and he has decided to seek a 30 per-
cent return compounded annually over the time period. What percentage of
equity in the company does the investor require in order to obtain the tar-
geted ROI? Using his handy calculator, he determines that the present value
of the company is $18,206,645”$40 million/(1 + 0.30)3”and that the $1
million investment requires a 5.5% equity stake in the company ($1 mil-
lion/$18,206,645).
However, the investor not only needs 5.5 percent equity in the company
today, he needs 5.5 percent in equity three years from now as well to ensure
the return. Here the dilution factor comes into play. If the investor is uncom-
fortable with management™s forecasts and determines that more capital may
292 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


be needed than is projected, he can incorporate a dilution factor into the eq-
uity share calculation.
Let™s assume that the investor estimates 20 percent more capital will be
required than management projects. To protect himself, the investor must in-
crease his equity ownership percentage to ensure that in three years he will
attain the targeted return. The investor must therefore correct the 5.5 percent
equity percentage figure to account for the increased capital that will be re-
quired. This is accomplished as follows: 5.5 percent = 80 percent X (where
X = equity share, corrected for dilution). The 80 percent figure is derived by
subtracting the 20 percent additional capital required from the original 100
percent of value. Therefore, the investor will seek a 6.9 percent equity share
(5.5 percent/0.8 = 6.875) to ensure his 30 percent return in three years. The
dilution factor accounts for unanticipated needed capital.


TRUISMS IN THE VALUATION PROCESS
Entrepreneurs must grasp some truisms regarding their position with in-
vestors. Be convinced of the merits of the opportunity before discussing val-
uation. Also recognize that demand for capital greatly exceeds supply;
embrace this leverage in favor of investors during valuation negotiations.
Furthermore, understand that investors always discount projections, so run
your own cash flow forecasts, paying particular attention to unforeseen
follow-up financing requirements. And remember, in the past five years,
fewer than two percent of venture-backed exit transactions have been
through IPOs.
It is worth taking a closer look at some of these truisms.
First, prospective investors will not necessarily share the entrepreneurs™
level of enthusiasm for the project. Investors must be thoroughly convinced
of the merits of the opportunity before any discussion of valuation or terms.
Entrepreneurs have to understand that sophisticated investors are besieged
with projects. Investors could look at business plans seven days a week. A
project may soak up 100 percent of an entrepreneur™s life, but it constitutes
only one more business plan on an already prodigious stack of business plans
as far as the investor is concerned. So entrepreneurs have to adjust their
mind-sets; they have to concentrate on selling the investor on why this ven-
ture is a great deal. Also, entrepreneurs sometimes become upset because an
investor fails to jump at a project; they fail to realize that the investor may
have invested in three similar projects, each of which turned sour. As we
mentioned earlier, for most early-stage enterprises, the demand for equity
capital largely exceeds supply. Consequently, investors have substantial
leverage in valuation negotiations.
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Valuation of the Early-Stage Company


Second, entrepreneurs must allow for the high degree to which investors
are risk-averse. Some entrepreneurs think that venture capitalists love risk.
But investors who do are not investors for long. No investor, especially no
professional venture capitalist or sophisticated angel investor, is in the busi-
ness of jauntily taking a flyer. No investor is interested in floating out there
on gossamer wings. To the wise investor, a venture must be built on tresses
and struts. The way investors stay alive is by minimizing their mistakes. So
entrepreneurs, along with everyone else, need to cast off the misconception
that early-stage investors love taking risks. Investors try to manage risk
against return. But the popular notion of investors lovingly embracing risk is
hogwash.
A third truism is that investors will always discount projections in re-
viewing a proposal. The management principals of early-stage enterprises
rarely forecast cash requirements accurately, not because they are bad man-
agers, but because the situation is fraught with circumstances beyond their
control. As we have suggested, nearly all new deals need more money than
their management team had thought. Such discrepancies between hope and
reality are woven into the fabric of building dreams. The fictional Willie
Loman, Arthur Miller™s failed salesman in Death of a Salesman, is eulogized
this way by Charley, his sympathetic next-door neighbor: “A man has got to
dream, boy; it comes with the territory.” But Willie failed to realize that some
dreams must come to earth. Unforeseen follow-on financings are a fact of life
in early-stage investing. Follow-on financing weighs heavily in the valuation
process. When entrepreneurs say $1 million and no more will do the job, so-
phisticated investors are thinking otherwise”and with good reason.
Another truism: Acquisition or buyout is the predominant method for
achieving liquidity for small company shareholders. We have already pointed
out that the primary method of achieving liquidity is not IPO”far from it.
But the misconception remains. Too often, entrepreneurs and their business
plans say they will take their company public in five years. Given the current
IPO market and its prospects for recovery, odds are that such an event will
not occur. So entrepreneurs need to consider how that investor is going to
achieve liquidity.
Axiomatic is the truism that any valuation becomes irrelevant if the ven-
ture does not survive. Survival, survival, survival”in private investing the
word rings like a Buddhist mantra. As we have reiterated, smart investors are
risk-averse. The foremost thing they want to know is not what their ROI will
be in five years, but whether the company will survive at all. Entrepreneurs
can talk glory, displaying the infamous hockey stick projection extending

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