THE DEAL

VALUATION, STRUCTURE, AND NEGOTIATION

'Always assume the deal will not close, and keep several alternatives alive."

- James Hindman, Founder, Chief Executive Officer, and Chair, Jiffy Lube International

The Art and Craft of Valuation

The small business owner's and private investor's world of finance is very different from the corporate finance arena, where public compa­nies jostle and compete in well-established capital markets. The private company and private capital world of entrepreneurial finance is more volatile and imperfect and less accessible. The sources of capital are very different. The companies are usually younger and more dynamic, and the environment more rapidly changing and uncertain. The conse­quences, for entrepreneurs and investors alike, of this markedly differ­ent context are profound. First, cash is king and beta coefficients and elegant corporate financial theories are irrelevant. Liquidity and timing are everything, and there are innumerable, unavoidable conflicts between users and suppliers of capital. Finally, the determination of a company's value is quite elusive, and more art than science.

What Is a Company Worth?

The answer: it all depends! Unlike the market for public companies, where millions of shares are traded daily and the firm's market capital­ization (total shares outstanding times the price per share) is readily determined, the market for private companies is very imperfect.

Determinants of Value

The message here is simple. The criteria and methods applied in cor­porate finance to value companies traded publicly in the capital markets, when cavalierly applied to entrepreneurial companies, have severe limitations. The ingredients of the entrepreneurial valuation are cash, time, and risk.

Long-Term Value Creation Versus Quarterly Earnings

The core mission of the entrepreneur is to build the best company pos­sible and, if possible, a great company. This is the single surest way of generating long-term value for all the stakeholders and society Such a mission has quite different strategic imperatives than one aimed solely at maximizing quarterly earnings in order to attain the highest share price possible given price/earnings ratios at the time. (More will be said about this in the last chapter of the book.)

Psychological Factors Determining Value

Time after time companies are valued at preposterous multiples of any sane price/earnings (P/E) or sales ratios. In the best years - for exam­ple, the 1982-1983 bull market - the New York Stock Exchange Index was trading at nearly twenty times earnings; it sank to around eight after the stock market crash of October 1987. Even twelve to fifteen times earnings would be considered good in many years. By 1998 to late 2 001, the S&P 500 was setting above a P/E of thirty. A late 1990s survey of the top one hundred public companies in Massachusetts showed these stocks were being traded at fifty or more times earnings; several were at ninety-five to one hundred times earnings and six to seven times saks\ Even more extreme valuations were seen during the peak of the so-called dot-com bubble from 1998 to early 2000. Some companies were valued at one hundred times revenue and more during this classic frenzy, echoing the tulip mania of centuries past. Most of the dot-coms that survived the dot-"bomb" phase lost 90 percent of their value!

Often what is behind extraordinarily high valuations is a psycholog­ical wave, a combination of euphoric enthusiasm for a fine company, exacerbated by greed and fear - of missing the run-up. The same psy­chology can also drive prices to undreamed-of heights in private com­panies. In the late 1960s, for instance, Xerox bought Scientific Data Systems, then at $100 million in sales and earning $10 million after taxes, for $1 billion: ten times sales and one hundred times earnings! The pattern of big companies paying huge sums for small firms con­tinually repeats. Between 1997 and 2000, telecom firms like Nortel and Lucent bought small firms that had minimal if any revenue, earning small business founders hundreds of millions. Value is also in the eye of the beholder.

A Broad Look at Valuation

Establishing Boundaries and Ranges, Rather than Calculating a Number. Valuation is much more than science, as can be seen from the examples just noted. As will be seen shortly, there are at least a dozen different ways of determining the value of a private company. A lot of assumptions and a lot of judgment calls are made in every valua­tion exercise. It can be a serious mistake, therefore, to approach the val­uation task in hopes of arriving at a single number or even a quite narrow range. All you can realistically expect is a range of values with boundaries driven by different methods and underlying assumptions. Within that range the buyer and the seller need to determine the com­fort zone of each. At what point are you basically indifferent to buying and selling? Determining your point of indifference can be an invalu­able aid in preparing you for negotiations to buy or sell.

Valuation is an important exercise for the growth-minded small busi­ness owner who is seeking capital. For you to make a deal to acquire an investment, the investor is likely to want a share of the company (in one form or another). We will discuss a number of valuation methods but first consider how and why you might want to make a deal.

What Is a Deal?1

Deals are defined as economic agreements between at least two parties. In the context of entrepreneurial finance, most deals involve the allo­cation of cash-flow streams (with respect to both amount and timing), the allocation of risk, and hence the allocation of value between differ­ent groups. For example, deals can be made between suppliers and users of capital, or between management and employees of a venture.

A Way of Thinking About Deals over Time. To assess and to design long-lived deals, Professor William A. Sahlman from Harvard Business School suggests the following series of questions as a guide for deal makers in structuring and in understanding how deals evolve over time:2

Who are the players?

What are their goals and objectives?

What risks do they perceive and how have these risks been managed?

What problems do they perceive?

How much do they have invested, both in absolute terms and relative terms, at cost and at market value?

What is the context surrounding the current decision?

What is the form of their current investment or claim on the company?

What power do they have to act? To precipitate change?

What real options do they have? How long does it take them to act?

What credible threats do they have?

How and from whom do they get information?

How credible is the source of information?

What will be the value of their claim under different scenarios?

How can they get value for their claims?

To what degree can they appropriate value from another party?

How much uncertainty characterizes the situation?

What are the rules of the game (e.g., tax, legislative)?

What is the context (e.g., state of economy, capital markets, industry specifics) at the current time? How is the context expected to change?

Investor's Required Rate of Return (IRR)

One of the first things you have to do when seeking investment is to understand the return requirements of the investor. Various investors will require a different rate of return (ROR) for investments in differ­ent stages of development and will expect holding periods of various lengths. For example, Exhibit 6.1 summarizes, as ranges, the annual RORs that venture capital investors seek on investments in firms by stage of development and how long they expect to hold these invest­ments. Several factors underlie the required ROR on a venture capital

Exhibit 6.1 Rate of Return by Venture Capital Investors

Typical Expected

Stage Annual ROR (%) Holding Period (years)

Seed and start-up 50-100% or more More than 10 years

First stage 40-60 5-10

Second stage 30-40 4-7

Expansion* 20-30 3-5

Bridge and mezzanine 20-30 1-3

LBOs 30-50 3-5

Turnarounds 50+ 3-5

investment, including premium for systemic risk,* a lack of liquidity, and value added. Of course, these can be expected to vary regionally and from time to time as market conditions change, because the invest­ments are in what are decidedly imperfect capital-market niches to begin with.

Valuation Methods

The Venture Capital Method

This method is appropriate for investments in a company with negative cash flows at the time of the investment, but that in a number of years is projected to generate significant earnings. The steps involved in this method are as follows:

1. Estimate the company's net income in a number of years, at which time the investor plans on harvesting. This estimate will be based on sales and margin projections presented by the entrepreneur in his or her business plan.

2. Determine the appropriate price-to-earning ratio, or P/E ratio. The appropriate P/E ratio can be determined by studying current multiples for companies with similar economic characteristics.

3. Calculate the projected terminal value by multiplying the expected net income at the point you expect to provide liquidity to your investors times the P/E ratio.

4. The terminal value can then be discounted to find the present value of the investment. Venture capitalists use discount rates ranging from 35 percent to 80 percent (these discount rates coincide with the expected RORs listed in Exhibit 6.1), because of the risk involved in these types of investments.

5. To determine the investor's required percentage of ownership, based on the initial investment, the initial investment is divided by the estimated present value.

To summarize the above steps, the following formula can be used:

Required future value (investment)

Final ownership required =------------------------------------------------------------

Total terminal value

(I + IRR)^1 (investment)

P/E ratio (terminal net income)

Finally, the number of shares and the share price must be calculated by using the following formula:

Percentage of ownership required by the investor

New shares = -------------------------------------------------------------------------------- X old shares

I - Percentage of ownership required by investor

By definition, the share price equals the price paid divided by the num­ber of shares.

This method is commonly used by venture capitalists, because they make equity investments in industries often requiring a large initial investment with significant projected revenues, in addition to the fact that in the negotiations, the percentage of ownership is a key issue.

The growth-minded small business can affect the variables in the cal­culation to their advantage. Because you have a proven market and a positive cash flow, the rate of return required by the investor is lowered from the start-up 40-70 percent to a growth company 25-40 percent return. This will effectively reduce the amount of equity you'll have to surrender for investment by as much as one-half!

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