1. F317 – Venture Capital & Entrepreneurial Finance Principals of Valuation + Types of Securities

2. Valuation of start-ups is not science, it’s an art. The more you do it, the better you get at it. Today, we’re going to discuss the principals of early stage valuation + Types of Securities. 10,000 FT View

3. 4 Factors that affect Valuation Well, It all Depends Ingredients to the valuation of a start-up Time What ’ s a newly formed HPV worth? Risk Cash Dilution

4. A Fifth Factor Psychological + = Euphoric enthusiasm Fear of missing the boat Extraordinarily high valuations

5. 4 Factors that affect Valuation Ingredients to the valuation of a start-up Cash

6. Ex. Instagram raised $50MM from precisely a week before going into negotiations to be acquired by Facebook for $1 Billion. WHY?????

7. Cash Entrepreneur's bargaining power based on when Company is out of Cash (OOC) Now Nil Relative bargaining power (RBP) of the entrepreneur versus sources of capital Time in months to OOC 3 6 9 12+

8. Cash Burn Rate The rate at which a company uses its supply of cash over time before it breaks even Company A – Has $100,000 in cash is losing $30,000 per month on a cash basis Definition Example Investors’ Interpretation Burn Rate - $30,000 Per Month Company has 3 months before hitting the wall

9. Cash If have lots of cash and/or are generating positive cash flow, relative bargaining position with investors is high. Being in a position to say “NO” drive up valuations!

10. 4 Factors that affect Valuation Ingredients to the valuation of a start-up Risk

11. Risks associated with the business itself Private equity is non-marketable and dependent on major transactions for exit. Due to bad management, unsuccessful products, or services Future funding may not be available (unpredictability of the market) Start-ups dependent on lead management team with specific core competency Liquidity Risk Business Failure Risk Funding Risk Management Risk

12. Risk Macro Risks Recessions – difficult to grow business when customers are pessimistic Increases cost of capital, provide alternatives to potential investors Margins get squeezed, and wealth generated from product/service diminished Economic Risk Interest Rate Risk Inflation Risk

13. Risk Simply assess and add up the risks which will drive the Rate or Return (ROR) Requirement ex. Liquidity: 10% Failure: 10% Inflation: 5% Management:10% ----- Required ROR34%

14. Risk The higher the perceived risk, the higher the Rate of Return (ROR) Requirement. De-risk your deal as much as possible before going out for money

15. ROR (Based on Stage of Investor) INVESTMENT STAGERORHOLDING PERIOD Seed & Startup50-100%10+ years First Stage40-60%5-10 years Second Stage30-40%4-7 years Expansion20-30%3-5 years Bridge & Mezzanine20-30%1-3 years Leveraged Buyouts30-50%3-5 years Turnarounds50+%3-5 years

16. Time The amount of time an investor expects to hold the investment will impact valuation. Why??? (a ROR is a compounded annual return….

17. Ex. Suppose Ashton of Slane Ventures wants to invest $2MM in a company called Mobile Dynamics, a mobile commerce platform for IU students. Ashton believes that Mobile Dynamics will get acquired for $100,000,000 in 5-7 years. At this investment level, Slane typically is looking for a 40-50% ROR. Translating ROR and Time into percentage ownership

18. 5 Years6 Years7 Years 40% $18,593,443 $13,281,031 $9,486,451 45% $15,601,271 $10,759,497 $7,420,343 50% $13,168,724 $8,779,150 $5,852,766 Present Value Formula: Future Value / (1 + ROR)^Years Investment is Held Depending on the ROR and the estimated hold times, the valuation of Mobile Dynamics can vary widely.

19. Translating ROR and Time into percentage ownership $5,852,766 Formula: Investment / Present Value Let’s suppose Ashton believes that ROR should be 50% and the estimated hold time will be 7 Years. At a $2MM investment, here’s how much equity she’s seeking today: 34.17%

20. 4 Factors that affect Valuation Ingredients to the valuation of a start-up Dilution

21. Definition: Ownership % of existing shareholders decreases in proportion to the percent of the company the new investor purchases. % Ownership Time Time of Investment After more investors purchase equity

22. Dilution Good Dilution – When the value of an investors’ ownership increases at subsequent capital raises. OwnershipValuationValue of Ownership At Investment25%$5,000,000$1,250,000 Post Series A15%$15,000,000$2,250,000 Post Series B10%$45,000,000$4,500,000 Post Sereis C5%$135,000,000$6,750,000

23. Dilution Bad Dilution – When the value of an investors’ ownership decreases at subsequent capital raises OwnershipValuationValue of Ownership At Investment25%$5,000,000$1,250,000 Post Series A15%$15,000,000$2,250,000 Post Series B10%$12,000,000$1,200,000 Post Sereis C5%$10,800,000$540,000

24. Dilution For Venture Capital investors, however, their problem is that future dilution “lowers” the ROR they were seeking when they initially invested. Let’s go back to Ashton of Slane Ventures seeking 34.17% of Mobile Dynamics (based on a 50% ROR, held over 7 years).

25. Dilution EXIT $100,000,000 34.17% INVESTMENTRORYRS $2,000,00050%7$34,171,875 $2MM*(1+.5)^7 $100MM *.3417 If Mobile Dynamics is sold in year 7 (as expected) and without having to raise additional capital, then Slane Ventures will get its ROR.

26. Dilution EXIT $100,000,000 20.00% $20,000,000 INVESTMENTRORYRS $2,000,00050%7$34,171,875 Actual Outcome Expected Outcome But what happens if Slane Venture’s ownership has been diluted down to 20% (because of company raising additional equity capital)?

27. Dilution To bake “future dilution” into the valuation cake, Investors may apply a Retention Ratio prior to placing a final value on the company. It requires “forecasting” when dilution will occur + “estimating” how much dilution will occur. (Yep, more Assumptions).

28. Dilution Let’s suppose the Ashton estimates that, 3 years following Slane’s Investment, Mobile Dynamics will raise an additional $10MM and predicts the Post Money Valuation will be $40MM. $10,000,000 / $40,000,000 = 25% New Equity

29. Dilution This translates into Slane’s Investment being diluted down to 25.62%......(34.17% *.25). Thus, Slane would not achieve its ROR. EXIT $100,000,000 25.63% $25,628,906 INVESTMENTRORYRS $2,000,00050%7$34,171,875

30. Dilution Based on this information, Ashton can apply a retention ratio. It will artificially increase her equity today know that she’ll be diluted later. 34.17 / (1-.25) = 45.56% 34.17% Diluted down by subsequent investor in year 3 Ownership at Exit (Hits ROR of company sells for $100MM within 7 Years).

31. Predicting a Future Exit Trying to predict a future exit is almost impossible. It’s just another assumption. However, if the start-up reaches a point of generating meaningful revenue and profits, then an investor can look at “Market Comparables” to determine a potential future exit. In most cases, Investors will look at more simplistic metrics to assign a value.

32. Predicting a Future Exit Example: How to price a new monolithic social media site (Social Media Site #2)? Look at Facebook as a comparable. Ex. Facebook at 1.23 Billion Active Monthly Users. Market Capitalization is: $202 Billion. Could assign a value of $164 Per Monthly User in Market Cap. (Next Page)

33. Predicting a Future Exit If Social Media Site #2 reaches 10,000,000 active monthly users by Year 7, then, perhaps: $164 * 10 Million Monthly Users = $1.64 Billion The problem is that Social Media Site #2 is not Facebook and 10 Million Active users is much different than 1.23 Billion Active users. But you get the point.

34. The Venture Game Valuation Model Now that you have the fundamentals of Start- up Valuation, make sure you understand the Venture Game™ Valuation Model. You will be handed a set of facts at the beginning of class and your team will turn in a valuation. We’ll spend that last 10-15 Minutes going through the valuation.

35. Types of Securities

36. Secured Debt with Warrant Combination. Convertible Subordinated Debt with Warrant Combination. Participating Preferred Stock, Cumulative Dividends. Convertible Preferred Stock with Cumulative Dividends. Common Stock with Liquidation Rights. Common Stock (Straight Equity). Strongest position as an investor Weakest position as an investor

37. Next week, we’ll discuss how VCs value investments Any Questions?