INTRODUCTION
Prior to engaging in negotiations
with interested investors, founders and their executive management team need to
have developed a keen understanding of how a new venture is valued and what is
a reasonable value for them to expect for their new venture.
In the prior article (Part II) the
key aspect of sales projection and their veracity was discussed. Combining
sales projections and revenue with operating expense and the costs of
manufacturing and delivery of product and services enables a complete set of
integrated financial statements to be developed. This article presumes that
these statements have been completed and are available. Furthermore, it is
understood at this point in the valuation analysis (Part III) that these
financials implicitly presume that execution is perfect and the team can
overcome all problems. Valuation in the face of imperfect situations and
developmental stage is considered in the subsequent article (Part IV).
NET
PRESENT VALUE AND DISCOUNTED CASH FLOW
When considering cash flows that
vary over time, perhaps even changing from negative to positive and back again,
the term net present value (NPV) is used to account for the variability
of cash flows.
A well-known expression for future
value, FV, and its relationship to present value, PV, and interest rate
(i), is:
FV
= PV × (1+ i)^n
where n is the number of periods corresponding to the interest or discount rate, i. As an example, for an interest rate of 10% per year for five years (n=5) and a PV of $100, then FV = $100 × 1.61, or $161.
When it is desired to determine the present value of a future cash flow the interest rate is referred to as the discount rate; thus for a future value of $161 and with a discount rate of 10% over five years, the present value is $100.
NPV is a perfectly fine method of
determining value in the present day provided all the underlying assumptions
are accurate. Established enterprises can depend on their record of sales and
thereby construct a reasonable financial extrapolation to the future. Less
established companies, however, have to make assumptions about sales and
expenses that become increasingly problematical as sales history decreases.
Pre-revenue companies have the most difficult task and secure the highest
discount rates as a result.
Discounted cash flow (DCF) analysis
is a concept used in financing to account for the value of future cash flows
derived from investments in equipment, business, mortgage contracts, bonds,
dividends, etc. DCF analysis is also used frequently to evaluate and
discriminate among different potential projects, each with its own set of
unique investments and returns. Its adaptation to the valuation of start-up
ventures, while straightforward, does have its limitations, as will be
explained. However, understanding DCF analysis is important to an entrepreneur
because it provides one method of new venture valuation that is quantitative
and based on logical financial principles.
AN
EXAMPLE OF DISCOUNTED CASH FLOW ANALYSIS
A further example of DCF analysis is
provided in 1. A series of free cash flows for Years one through five is shown.
The PV for each year of free cash flow is determined using the formula above
and then summed. The discount rate of 27% provides an NPV of zero. Other
choices of the discount rate, either lower or higher, would provide an NPV that
is either higher or lower. When the discount rate is chosen so as to produce an
NPV of zero, the discount rate is called the internal rate of return (IRR), a
common term used by professional investors to measure fund performance. The
rate of 27%, while an example[2], is a common goal for a portfolio of
investments by angels and venture capital firms; of course, some investee
companies may be successful, while many others may have failed in varying
degrees.
Table
1 Discounted Cash Flow and Net Present Value
TERMINAL
VALUE
Omitted from the analysis of Table 1
is the terminal value of the investment or enterprise. Terminal value, also
called residual value or continuing value, is the value of the enterprise in
the years subsequent to an end period of time (often an exit for professional
investors). The residual value recognizes that the enterprise will continue to
generate cash flow of benefit to other parties beyond investors.
As a new venture will experience the
largest amount of free cash flow in its “out-years,” the issue of terminal
value and how it is calculated is very important. Over a five-year time period
of interest[3] maintained by a professional investor, the fact that a funded
venture may also have rapidly increasing rates of growth during the out-years
also has a big influence on the terminal value of the enterprise.
Fortunately, there is a conceptually
easy way to compute the terminal value of an enterprise: by taking the free
cash flow (a.k.a. earnings) in the terminal year and multiplying by an assumed
price-to-earnings (P/E) ratio. The assumed P/E ratio is based on comparables
from public companies in the same or similar business and adjusted for various
competitive and economic factors. For instance, if the free-cash-flow earnings
of a new enterprise is projected at $800,000 per year in year five and the P/E
for the companies that compete in the market and/or industry was 12, then the
enterprise value is estimated at $9.6 million in year five. This scenario
presumes the new enterprise becomes public.
The terminal value is discounted to
the present day as shown in Table 2. The discount rate of 50% is more typically
applied by a venture capital firm to an individual investee company with
outstanding prospects. It is immediately obvious that determination of the
terminal value is a critical aspect for the pre-money valuation of a
pre-revenue opportunity.
As observed in Table 2, the NPV of
the new venture is $1.12 million. Given that an investment of $550,000[4] is
made, the investor ownership (in the absence of any dilution complexities from
subsequent rounds of investment) would be 33% ($550,000/$1,673,000)[5]. In this
example, the value of assets (e.g., equipment, facilities, and cash) is not
included in the valuation, though it would be in an actual situation,
especially if the cash component is large.
Table 2 Discounted Cash Flow and
Terminal Value
The presumed accuracy of the DCF
analysis is dependent upon the accuracy of the free-cash-flow assumptions that
drive the calculations (along with the discount rate, of course). In the case
of a new venture, inattention to the sensitivity of the calculation of NPV
(e.g., new venture pre-money value) can lead to misleading conclusions about
the pre-money value of the opportunity. It should also be remembered that the
terminal value of the enterprise is a major component of the NPV of the new
venture, notwithstanding the intermediate positive cash flows.
Opportunities that are slow to
develop positive cash flows are disadvantaged by the lower out-years of
positive cash flow. That is why “time-to-revenue” and revenue growth rate are
so important to both entrepreneurs and investors.
DCF
ANALYSIS AND VALUATION
DCF is often used to conduct
sensitivity analysis for various sales and expense scenarios. DCF is also used
in conjunction with other methods to guesstimate the value of a pre-revenue
company, as will be explained in the next article (Part IV). Financial analysis can be extremely complex
when issues of equipment, salvage value, good will, and other factors are
considered. These issues are not typically a part of new
venture valuation except in unusual situations. Furthermore, experienced
professional investors and experts in financial analysis and valuation
often rely upon sophisticated spreadsheets and tables to arrive at risk
adjusted conclusions. . For the new venture considered herein these
complexities are not pertinent.
There are critics among professional
investors in regard to using DCF methods for pre-revenue companies. This is
especially true with the entrepreneur has not taken account of the development
stage of the company. Professional investors also have many rules of thumb and
may examine a number of different valuation methods in an attempt to “range”
the new enterprise’s value in preparation for a final decision and offer.
SUMMARY
Entrepreneurs should understand the
important concepts of NPV, DCF, and terminal value so that subsequent and
eventual discussions with investors are adroitly managed.
The next article (Part IV) takes the
somewhat theoretical concepts of this article to the real world where a
particular new venture's developmental process and important risk factors are
incorporated into a realistic valuation at least from an entrepreneur's
perspective.
Footnotes
[1] Free cash flow is a
financial term that is generally determined by adding depreciation and
amortization to the earnings and subtracting changes to working capital and
capital expenditures.
[2] Implicit in this example is that
the investor not only makes an investment (not shown) to cover the negative
cash flows in years one and two, but receives all the subsequent positive cash
flows. In real situations, the positive cash flows would be used to expand the
business, provide dividends to investors, and other beneficial activities. The
investor is rewarded upon exit at a future date.
[3] A five-year time frame has been
chosen. Typical investor exits are five to eight years.
[4] Sum of negative free cash flows
in years one and two.
[5] In this example, the enterprise
retains the positive cash flows, and the investor who has waited five years for
a return garners 49% of the terminal value, which is assumed to occur from a
sale of the investors’ interest in the company.
***
Rocky Richard Arnold provides strategic corporate and capital acquisition advice
to early-stage companies founded by entrepreneurs wishing to successfully
commercialize high-value-creation opportunities, ideas, and/or technologies.
More information about Rocky can be found at www.rockyrichardarnold.com. His book, The Smart Entrepreneur: The book investors
don’t want you to read, is available for purchase on Amazon at http://tinyurl.com/pv248qq.
Financial software for use by startups can be purchased on Amazon at http://www.amazon.com/gp/product/B00K2KPSI2. He posts articles about entrepreneurship on his blog at http://thesmartentrepreneur.blogspot.com. Connect with Rocky on Twitter @Rocky_R_Arnold; Facebook at
www.facebook.com/rocky.r.arnold; Google+ at www.google.com/+RockyArnold01.
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