Valuation and Financing for Entrepreneurs:A One-Hour Crash Course

Ilya Strebulaev

Stanford GSB

It requires a very unusual mind to undertake the analysis of the obvious

Alfred North Whitehead

Our Objectives

Four questions we will concentrate on:

◮ How to come up with an estimate of the value of your project/firm?

◮ How to finance your idea to make it into a successful project into a

successful company?

◮ How to write financial contracts with your money providers?

◮ How to optimize your exit strategy?

c© Ilya Strebulaev Valuation and Financing 2

c© Ilya Strebulaev Valuation and Financing 2

Valuation

What information do you need

◮ Your free cash flows this year and in the future

• free: not re-invested in the firm

◮ Your discount rate

• Reflects riskiness of the project

• Reflects general level of interest rates in the economy

• Also called: required rate of return; cost of capital

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Valuation example

Ilya Inc.

◮ The project costs $15,000 now (2005) to invest

◮ The project will bring $10,000 each year in 2006, 2007 and 2008

◮ The project has the discount rate of 20%

Net Present Value = −$15,000+10,000

1.2+

10,000

1.22+

10,000

1.23∼ $6,000

◮ What happens if the discount rate is 50%?

Net Present Value = −$15,000+10,000

1.5+

10,000

1.52+

10,000

1.53∼ −$1,000

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Main valuation rule

Invest in projects that have positive NPV

◮ How to estimate cash flows and discount rates for your project/firm?

◮ General case: much more difficult to estimate at an earlier stage

◮ Look at comparables

• Projects/firms/divisions of firms in a similar industry

• Valuation of recently sold businesses in your industry/region

◮ Look at industry practices/venture capitalist required rate of return

◮ Look at your competitive advantage

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Stages of financing

Seed stage investment

◮ Idea

◮ Business plan (often a confidential piece)

• The proposed product

• The potential market

• The underlying technology

• The needed resources (money, human capital, equipment, time)

• The resources currently in place

◮ What is crucially important at this stage for money providers

• Faith in the entrepreneurial team

• Faith in the product

◮ Who finances at this stage?

• Relatives, friends

• Venture capitalists (VC)

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Seed financing: Cont’d

◮ What are standard contracts between VC and the product team?

• Equity: VC becomes a partial owner of the company

∗ Often: preferred equity convertible into common stock

· Preferred equity has the first-right advantage over common equity

∗ Use it to your advantage, do NOT be afraid of that!

• VC gets a place on the board of directors

∗ Monitoring and control function

∗ Use VC’s expertise

◮ How to maximize VC’s faith in your project?

• Put your money where your mouth is

◮ What you need to be aware of that:

• Control function of VC

• Example: equity dilution

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Second-stage financing

◮ Common purposes:

• Pilot production

• Test marketing

• Further/larger experiments

◮ Who finances at this stage?

• The original VC [may have the first priority]

• Other VCs, wealthy individuals

◮ What form does new financing take?

• Preferred/common equity

• Convertible debt

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Deviation

Difference between equity and debt

◮ Common equity entitles to ownership of business

• “Ownership” means ”Residual cash”

• Cash is not promised

◮ Debt entitles to pre-specified income

• Cash is promised

• If not paid, the firm defaults and in the hands of creditors

◮ Preferred equity and convertible debt are between equity and debt

• Convertible debt is debt that can be converted into equity

• Preferred equity is equity with promised dividends

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Equity vs Debt

Continued

◮ Priority in distribution of profit/assets

1. Senior secured debt [bank debt, some VC debt]

2. Other debt

3. Junior [usually convertible] debt

4. Preferred equity

5. Common equity [owners of the firm: the production team]

◮ How to compare various financial securities/contracts:

• Differences in cash flow risks

• Differences in incentives

• Differences in control

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Mezzanine stage financing

◮ Purposes:

• Full-scale production

• Serious marketing

◮ Mezzanine investors are different from VC

• Lower appetite for risk ...

• ... but ready to accept lower returns

• Stock/Convertible debt/Debt

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Exit strategies

◮ Don’t count your chicken until they are hatched

◮ But ...

• A stitch in time saves nine!

◮ Plan your exit strategy in advance

◮ Possible outcomes

• Sale to a private equity firm, loss of ownership

• Merger/acquisition/takover within industry

• Initial public offer

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Initial public offer

◮ Many successful start-ups in the US/UK eventually go public

• Continental Europe: most companies remain private

◮ Primary vs secondary offering: raising new capital vs cashing in

◮ Selecting the market

◮ Selecting underwriters

• Underwriters: legal/procedural/financial advice, buy the issue and resell

◮ Important: any IPO will change the distribution of control in the firm

• Public markets have different attitude towards risk than VCs

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Financing and valuation:

Last word

There are three sorts of economists.

Those who can count and those who can’t.

attributed to John Maynard Keynes