The Deal: Valuation, Structure & Negotiation Venture Planning Chapter 14 Dowling Fall 2006

Valuation, Structure & Negotiation Ingredients to the entrepreneurial valuation Ingredients to the entrepreneurial valuation Cash Cash Time Time Risk Risk

Valuation, Structure & Negotiation The core mission … is to build the best company possible. This is the single surest way of generating long-term value for all the stakeholders and society. -Timmons “ ”

Valuation, Structure & Negotiation Determining Value: At least a dozen ways Determining Value: At least a dozen ways A Key Consideration: A Key Consideration: Investor’s Required Rate of Return (ROR) (IRR) Investor’s Required Rate of Return (ROR) (IRR)

Valuation, Structure & Negotiation Inherent conflicts between users and suppliers of capital Inherent conflicts between users and suppliers of capital Entrepreneur Wants : As much time as possible for financing Entrepreneur Wants : As much time as possible for financing Investor Wants : To supply capital just in time Investor Wants : To supply capital just in time Entrepreneur Wants : As much $$$ as possible Entrepreneur Wants : As much $$$ as possible Investor Wants : To invest just enough $$$ Investor Wants : To invest just enough $$$ Entrepreneur Wants : Control of Board-of-Directors Entrepreneur Wants : Control of Board-of-Directors Investor Wants : Control of Board-of-Directors Investor Wants : Control of Board-of-Directors

Valuation, Structure & Negotiation Staged Capital Commitments Staged Capital Commitments Delivers funding in stages, rather than in lump sum Delivers funding in stages, rather than in lump sum Allows investors to evaluate company as time passes Allows investors to evaluate company as time passes

Valuation, Structure & Negotiation Conservation of capital Conservation of capital To “encourage” managers to conserve, VCs apply strong sanctions if capital is misused, by: To “encourage” managers to conserve, VCs apply strong sanctions if capital is misused, by: Diluting management’s equity share at punitive rate Diluting management’s equity share at punitive rate Shutting down operations completely Shutting down operations completely

Valuation, Structure & Negotiation Structuring the deal Structuring the deal Deals involve allocation of cash flow streams, allocation of risk, and allocation of value between different groups Deals involve allocation of cash flow streams, allocation of risk, and allocation of value between different groups

Valuation, Structure & Negotiation Characteristics of Successful Deals Characteristics of Successful Deals Simplicity Simplicity They are robust and organic They are robust and organic They take into account incentives of all involved under a variety of circumstances They take into account incentives of all involved under a variety of circumstances They provide mechanisms for communications and interpretation They provide mechanisms for communications and interpretation They are based primarily on trust rather than legalese They are based primarily on trust rather than legalese They do not make it too hard to raise more capital They do not make it too hard to raise more capital

Valuation, Structure & Negotiation Characteristics of Successful Deals Characteristics of Successful Deals They match the needs of the user of capital with the needs of the supplier They match the needs of the user of capital with the needs of the supplier They reveal information about each party They reveal information about each party They are not patently unfair They are not patently unfair

Valuation, Structure & Negotiation Lessons Learned: Lessons Learned: Raise money when you don’t need it Raise money when you don’t need it Learn about the process and how to manage it Learn about the process and how to manage it Know your relative bargaining position Know your relative bargaining position If all you get is money, you’re not getting much If all you get is money, you’re not getting much Assume the deal will never close Assume the deal will never close

Valuation, Structure & Negotiation Lessons Learned: Lessons Learned: Always have a backup source of capital Always have a backup source of capital The experts can blow it – sweat the details yourself The experts can blow it – sweat the details yourself Users of capital are at a disadvantage when dealing with suppliers of capital Users of capital are at a disadvantage when dealing with suppliers of capital If you are out of cash when looking for capital, suppliers of capital will eat your lunch If you are out of cash when looking for capital, suppliers of capital will eat your lunch Startup entrepreneurs are raising capital for the first time; suppliers do it for a living. Startup entrepreneurs are raising capital for the first time; suppliers do it for a living.

Valuation, Structure & Negotiation Sand traps Sand traps Legal circumference

Valuation, Structure & Negotiation Sand traps Sand traps Attraction to Status and Size Attraction to Status and Size

Valuation, Structure & Negotiation Sand traps Sand traps Unknown territory Unknown territory

Valuation, Structure & Negotiation Sand traps Sand traps Opportunity Cost Opportunity Cost Underestimation of other costs Underestimation of other costs Greed Greed

Valuation, Structure & Negotiation Sand traps Sand traps Being too anxious Being too anxious Impatience Impatience Take-the-money-and-run myopia Take-the-money-and-run myopia

Valuation Methods The Venture Capital Method The Venture Capital Method Appropriate for investments in a company with negative cash flow at the time of the investment, but which in a number of years is projected to generate significant earnings Appropriate for investments in a company with negative cash flow at the time of the investment, but which in a number of years is projected to generate significant earnings The Fundamental Method The Fundamental Method Simply the present value of the future earnings stream Simply the present value of the future earnings stream

Valuation Methods The First Chicago Method The First Chicago Method Employs a lower discount rate, but applies it to an expected cash flow Employs a lower discount rate, but applies it to an expected cash flow Discounted Cash Flow Discounted Cash Flow Three time periods are defined (1) Years 1-5, (2) Years 6-10, (3) Year 11 to infinity Three time periods are defined (1) Years 1-5, (2) Years 6-10, (3) Year 11 to infinity Operating assumptions include initial sales, growth rates, EBIAT/sales, and (net fixed assets + operating working capital)/sales; also note relationships and trade-offs Operating assumptions include initial sales, growth rates, EBIAT/sales, and (net fixed assets + operating working capital)/sales; also note relationships and trade-offs

Exhibit 14.1

Exhibit 14.2

Exhibit 14.3

Exhibit 14.4

Exhibit 14.5

Exhibit 14.6

Exhibit 14.7

Exhibit 14.8

Exhibit 14.9

Exhibit 14.10

Beyond “Just the Money” Critical aspects of the deal Critical aspects of the deal Number, type, and mix of stocks and various features that may go with them that affect the investor’s rate of return Number, type, and mix of stocks and various features that may go with them that affect the investor’s rate of return The amounts and timing of takedowns, conversions, and the like The amounts and timing of takedowns, conversions, and the like Interest rate in debt or preferred shares Interest rate in debt or preferred shares The number of seats, and who actually will represent investors, on the board of directors The number of seats, and who actually will represent investors, on the board of directors Possible changes in the management team and in the composition of the board of directors Possible changes in the management team and in the composition of the board of directors

Beyond “Just the Money” Critical aspects of the deal Critical aspects of the deal Registration rights for investor’s stock Registration rights for investor’s stock Right of first refusal granted to the investor on subsequent private or initial public stock offerings Right of first refusal granted to the investor on subsequent private or initial public stock offerings Stock vesting schedule and agreements Stock vesting schedule and agreements The payment of legal, accounting, consulting, or other fees connected with putting the deal together The payment of legal, accounting, consulting, or other fees connected with putting the deal together

Burdensome Issues for Entrepreneurs Co-sale provisions Co-sale provisions Ratchet anti-dilution protection Ratchet anti-dilution protection Washout financing Washout financing Forced buyout Forced buyout Demand registration rights Demand registration rights Piggyback registration rights Piggyback registration rights Key-person insurance Key-person insurance