The fundamental method is simply the present value of the future earn­ings stream (see Exhibit 6.2). The fundamental method can be prob­lematic for you because earnings, in a growth company, are pushed into the future. Once a company decides on a high-potential growth strat­egy, there are no calculable earnings because all cash (and earnings) is applied to increasing the growth rate. The purpose of this strategy is to reap a huge increase in earnings in future years. But remember, the investors’ required rate of return is annualized. So each year the pay­back to the investor is delayed, the amount of money required to sat­isfy the investor is greatly increased (see also about safe investments).

Total present value of earnings in the super growth period Residual future value of earnings stream Total present value of company priate for year 0, it is estimated that investors in Hkech, Inc., will demand a 40 percent return in year 2 and a 25 percent return in year 4. The final ownership that each investor must be left with, given a ter­minal price/earnings ratio of 15, can be calculated using the basic val­uation formula:

Round I:

Future value (investment) 1.50s X $1.5 million

Final % =————— *————- = ———————— = 30.4% ownership

Terminal value (company) 15. X $2.5 million

Round 2: (I.403 X $1 million)/ (15 X $2.5 million) = 7.3%

Round 3: (I.251 X $1 million)/ (15 X $1.5 million) = 3.3%

Discounted Cash Flow

In a simple discounted cash-flow method, three time periods are defined: (1) years 1-5; (2) years 6-10; and (3) years 11-infinky. The necessary operating assumptions for each period are initial sales, growth rates, EBIAT/sales, and (net fixed assets + operating working capi-tal)/sales. While using this method, one should also note relationships and trade-offs. With these assumptions, the discount rate can be applied to the weighted average cost of capital (WACC).* Then the value for free cash flow (years 1-10) is added to the terminal value. This termi­nal value is the growth perpetuity.

Other Rule-of-Thumb Valuation Methods

Several other valuation methods are also employed to estimate the value of a company. Many of these are based on the most recent transactions of similar firms, established by a sale of the company or a prior invest­ment. Such comparables may look at several different multiples, such as earnings, free cash flow, revenue, EBIT, and book value. Knowledge­able investment bankers and venture capitalists make it their business to know the activity on the current market place for private capital and how deals are being priced. These methods are used most often to value an existing company, rather than a start-up, since there are so many more knowns about the company and its financial performance. The rate of return required by the investor determines the investor’s required share of the ownership (see also about money investment).

As a final note, one can readily see that if any key variable – the amount of investment, profit, required return, or industry price/earn­ings ratio – is changed, the percentage of ownership will change also.

If the venture capitalists require the RORs mentioned earlier, the ownership they also require is determined as follows: in the start-up stage, 25-75 percent for investing all of the required funds; beyond the start-up stage, 10-40 percent, depending on the amount invested, matu­rity, and track record of the venture; in a seasoned venture in the later rounds of investment, 10-30 percent to supply the additional funds needed to sustain its growth. Exhibit 6.4 reflects the relative return an investor will expect at each stage of a company’s life.

Exhibit 6.4 Investor’s Required Share Ownership Under Various ROR Objectives

Assumptions:

Amount of initial startup investment = $1 million Year 5 after-tax profit = $1 million

Holding period = 5 years Year 5 price/earnings ratio = 15

Required rate of return = 50%

Calculating the required share of ownership:

Investor’s Return Objective (Percent/Year Compounded)

Price/Earning Ratio__________ 30%__________ 40%__________ 50%_________ 60%

I0X

I5X 20 X 25 X

The Reality

The past two and a half decades have seen the venture capital industry explode from investing only $50-$ 100 million per year to nearly $ 100 billion in 2000. Exhibit 6.5 shows how the many realities of the market­place for capital are at work, and how current market conditions, deal flow, and relative bargaining power influence the actual deal struck. The dot-bomb explosion and the plummeting of the capital markets led to much lower values for private companies. The NASDAQ index fell from over 5000 to less than 1200, a 76 percent decline.

The Down Round or Cram Down Circa 2002

In this environment, which also existed after the October 1987 stock-market crash, entrepreneurs face rude shocks in the second or third round of financing. Instead of a substantial four or even five times increase in the valuation from series A to B, or B to C, they are jolted with what is called a “cram down” round: the price is typically one-fourth to two-thirds of the last round. This severely dilutes the found­ers’ ownership, as investors are normally protected against dilution. Founder dilution from a failure to perform is one thing, but dilution because the NASDAQ and IPO markets collapsed seems rudely unfair. But that is part of the reality of valuation.

In many financings in 2001, and into 2002, onerous additional con­ditions were imposed, such as a three to five times return to the series C investors before series A or B investors receive a single dime! One can readily see that both the founders and early-round investors are severely punished by such cram-down financings. The principle of the last money in governing the deal terms still prevails (see also about Capital Association).

One can sense just how vulnerable and volatile the valuation of a company can be in these imperfect markets when external events, such as the collapse of NASDAQ, trigger a downward spiral. One also gains a new perspective on how critically important timing is. Many strongly performing companies were crammed down. Imag­ine those companies that didn’t meet their plans: they were pum-meled, if financed at all. What a startling reversal from the dot-com boom in 1998-1999, when companies at concept stage (with no prod­ucts, no identifiable or defensible models of how they would make money or even break even, and no management teams with proven experience) raised $20 million, $50 million, $70 million, and more, and had IPOs with multibillion valuations. History asks: what is wrong with this picture? History also offers the answer: happiness is still a positive cash flow!

Thereafter most investors retreated to the sidelines and stopped investing. From 2000 into early 2003, funds rationalized their invest­ments with dramatic downward revaluations and reserved huge quanti­ties of cash. Then in the second quarter of 2003, venture money started going into existing, growth-oriented firms. Indeed, more than half of the biggest venture investments went to growth in the second quarter of that year/

Exhibit 6.5 The Reality

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