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	Business Valuation Techniques and Negotiation
	The Venture Capital Funding Process and Documentation
	Tax and Legal Issues in Structuring Mergers & Acquisitions

Business Valuation Techniques and Negotiation
by Mark Cameron White of White & Lee LLP

The most important consideration in any private or public financing, merger or acquisition, or private resale of securities, is the purchase price of the securities to be issued, transferred or exchanged. Company value sets the purchase price, both at the time that investors first purchase securities in the Company, and again when these securities are sold in a liquidating event such as an IPO or acquisition. 

Valuation for newly-formed emerging growth companies is far more speculative than setting the value of more established, mature private companies. Unlike newly-formed companies, established companies that are about to go public can more easily be compared to similar companies that are already trading on the public markets. Earnings can then be multiplied by price/earnings ratios prevalent in the market at that time to determine company value based on known variables which are not subject to the speculation of future earnings and P/E ratios that must be applied to younger companies. Similarly, mature target companies in acquisitions that will not go public can be accurately valued by acquiring companies based on the known product lines, markets, revenues and profits of the target company (the "Company") - and how the established business of the target might fit with the business of the acquirer (taking operational synergies into effect). 

*Note: The concepts and several examples of valuation techniques described in this paper come from other materials, including (1) Coopers & Lybrand, Business Acquisitions and Leveraged Buyouts; (2) Venture Capital, A. David Silver, John Wiley & Sons, Inc., 1985; (3) The Venture Magazine Complete Guide to Venture Capital, Clinton Richardson, 1987; and (4) QED Report on Venture Capital Financial Analysis, QED Research, Inc.

The valuation of newly-formed companies is far more speculative. Notwithstanding the best of plans, the risks of successful technology and product development, market penetration, cost control and profit generation can be substantial. This paper will discuss the valuation techniques employed by sophisticated venture-capital investors in newly-formed companies that are intended to account for these risks. These principles are universal, and can be applied to both technology-based and non-technology companies. 

At the outset, Company founders and managers should understand that the valuation process is a negotiation between buyer and seller. Value is not set by plugging numbers into a formula (though, admittedly, this is part of the process). The techniques described below are used by investors as tools for setting a range of valuations that, from their perspective, make sense. For venture investors, this perspective is formed by limits placed on the investor's ability to invest based on available funds and limits imposed under the firm's partnership agreement, and limits which are determined by the rates of return, industry focus, and Company maturity. Within these investment parameters, however, most investors are willing to negotiate Company valuation for attractive early-stage investments.

Accordingly, management should consider each of the variables in these techniques to determine how their Company should be considered. All of these techniques are based on analysis of the Company and the markets and industry in which it will compete. Management and investors must question the assumptions each are making - in order to finally agree on a rational, realistic price. 

One: Future Focus and What Doesn't Work

First, management must realize that virtually all valuation is based on an analysis of the future market for the company's products. Except in asset purchase transactions, valuation typically assumes that the Company is a "going concern". Given this, it is inappropriate to value a company based on its book or liquidation value, except for the purpose of establishing a floor price, setting a "residual value" under the Discounted Cash Flow technique (described below), or determining the investor's return in the event of insolvency. But even for these purposes, inasmuch as technology companies do not have tangible assets that can be readily valued, valuation based strictly on book value does not make sense.

One caveat to the discussion of book value above. Book value is an appropriate valuation technique for acquirers of more established companies with tangible assets (and perhaps some intangible assets) that can be readily valued. The "market value" of these assets should be used to set a floor price for the acquisition, rather than the "book value", assuming that these assets would be sold in the event of insolvency. But again, this may not be a valid assumption if the target's business will be merged into the existing business of the acquirer. 

It might further be argued that for very early-stage companies, valuation based on multiples of P/E ratios should not apply. The reason for this is that finding comparable public companies to determine a range of appropriate P/E ratios is speculative, and projecting earnings to apply against these ratios on an assumed IPO date of from, typically, 3 to 5 years is totally hypothetical. Notwithstanding these risks, market multiples techniques are applied to early-stage company valuation, again, simply as a tool to project possible returns on investment based on successful public companies in the same industry. In fact, market multiple techniques appear to be critical to company valuation conducted by venture capitalists ("VCs") - as further described below. 

Two: The Discounted Cash Flow Technique and Underlying Assumptions

The Discounted Cash Flow ("DCF") technique is the most commonly used valuation method that accounts for the "going-concern" value of the Company as indicated by the present value of the Company's projected pre-interest cash flows for a determined period of 3 to 5 years (corresponding to the expected date of an IPO or acquisition). These cash flow projections are derived from (a) assumed revenue generation on product sales, less (b) operating costs and debt repayment on capital investments (not including interest payments), plus (c) an estimate of the Company's residual value at the end of the 3 to 5 year period. These projections are then discounted back to the present by the risk-adjusted, weighted-average cost of capital. This cost of capital accounts for interest payments and/or equity returns expected by investors in the Company over the projection period. 

Critical to DCF analysis is a determination of 4 key areas, including (a) the assumptions underlying the projections, (b) the length of the projection period, (c) the Company's residual value at the end of the projection period, and (d) the discount rate (cost of capital) - each of which are further described below: 

1. Underlying Assumptions. Management should have a model for conducting the Company's business. This model, typically employed by other successful companies in the same industry, should be the basis for assumptions on operating the business. If no model exists for what management would like to do, then distinctions must be made from other successful companies, and the reasons for these distinctions must be adequately explained to the investors. 

Management's assumptions must take into account the historical growth of similar companies and products (if any); prevailing economic and industry-specific business conditions; competitive pressures; the costs of technology development and continuing innovation; anticipated working capital needs based on operational requirements; market penetration and expected revenue generation and profitability. Specific attention should be directed to the following categories: 

1. Sales. Sales must anticipate buyer demand, growth of specific product categories, the need and timing of new product introduction, product pricing relative to competitive products (requiring an analysis of competitive strategy and product positioning), production capacity, seasonal demand (if any) and market penetration in view of access to distribution channels, product differentiation and the like. Investors like to see these factors determined based on formulas followed by other comparable companies - if possible. Numbers should be broken down by targeted markets, specific products and product lines and market introduction dates. 
2. Technology Development and Manufacturing Costs. Continuing technology and new product development is critical to adjust to anticipated market shifts - or simply to take advantage of established distribution pipelines to the market. Consequently, projections should provide for ongoing development costs - both for acquired technology and internal development costs. Further, the costs of applying new technology to commercially viable products - and the costs of manufacture, packaging and distribution to customers must be addressed in the projections. These costs translate into staffing requirements, capital purchases to support R&D, and the costs of internal or sub-contract manufacture of products - all of which must be thoroughly considered and anticipated.
3. Selling, General and Administrative Expenses. Administrative and selling expenses must be tied to the development of new technology and products - and generation of sales. Investors will not support a company that builds G&A staff too far in advance of development and operational requirements - or lags too far behind these requirements (indicating that these requirements might never be met). Further, management will want to minimize non-revenue generating staff in order to preserve resources for staff needed to create, manufacture and sell products. Investors want to see working capital being spent on functions necessary to generate profits, not merely to create jobs. It is also important for these projections to reflect salary levels which are beneath market rates established by more mature companies. Investors will expect that staff will accept non-cash incentive compensation in promising early-stage companies, particularly management staff, in order to minimize cash requirements prior to the Company becoming self-sufficient. 

2. Projection Period. For venture investors, the projection period should be from 3 to 5 years, reflecting that period of time that VCs expect to hold the Company's securities before the Company goes public or is acquired. In addition, beyond the 3 to 5 year period, the accuracy of projected cash flows is increasingly speculative. Inasmuch as these cash flows are inherently speculative, and the effect of discounting these cash flows to the present minimizes their impact on current valuation - it does not make sense to project cash flow beyond 5 years.

3. Residual Value. Residual value is the "going-concern" value given to the Company at the end of the projection period. Given that projections through the projection period assume that the Company will be a going concern, it is inappropriate to determine the terminal value based on the Company's liquidation or book value. Two techniques that are frequently applied include the "income capitalization" and the "market multiple" techniques. 

Under the income capitalization technique, the Company's final year earnings are divided by the discount rate (or cost of capital). This method sets value at the established earnings of the Company at that time in consideration of the cost of capital required to sustain earnings. The market multiple technique is a more appropriate method of setting terminal value if the assumption is that the Company will be an IPO or acquisition candidate at the end of the projection period (this assumption is always made!). As described above, under the market multiple technique, the Company's earnings are multiplied by an appropriate P/E ratio of comparable publicly-traded companies. Keep in mind that both the income capitalization and the market multiple techniques are somewhat speculative. The accuracy of the income capitalization technique rests on the accuracy of projected earnings - while the market multiple technique is subject to this uncertainty, as well as to the uncertainty of the public market for stock in companies such as the Company 3 or 5 years from the date that the valuation is set.

4. Discount Rate. This rate is critical to the analysis, as it determines the present value of all of the Company's projected cash flows. The higher the discount rate, the lower the present value of the Company.

Quite simply, the discount rate is the expected rate of return of the investor - also known as the cost of capital. The most favorable rate that can generally be applied by the Company is the rate generated under the "Capital Asset Pricing Model" (CAPM), which sets the rate at (a) the cost to the Company of risk-free debt, plus (b) an additional risk premium relating to the Company's particular line of business. The CAPM is commonly used for the preparation of internal capital budgets, and this method has historically generated discount rates from 10% to 20%. This method of determining the cost of capital is rarely used, however, by VCs.

Venture investors typically determine their required compounded rate of return based on commitments the VCs have made to their limited partners in the venture funds that the VCs manage. The yardstick followed by many venture capital firms is that they are looking for investments in companies in which they will multiply their investment (a) by 3 times in 5 years (resulting in a compounded annual ROI of 71%), or (b) by 10 times in 5 years (resulting in a compounded annual ROI of 58%). Examples of discount rates resulting from different payoff requirements include the following:
 

TABLE ONE: SAMPLE VC DISCOUNT RATES FROM EXPECTED PAYOFFS
Payoff	Compounded Annual ROI
3 times investment in 3 years	44%
5 times investment in 3 years	71%
7 times investment in 3 years	91%
4 times investment in 4 years	41%
3 times investment in 5 years	25%
5 times investment in 5 years	38%
7 times investment in 5 years	48%
10 times investment in 5 years	58%

Management should also consider that VC payoff requirements, and their corresponding ROI expectations, lessen with the maturity of the Company in which they invest. Examples of the ranges of ROIs that VCs typically expect for maturing private companies include the following (see The Venture Magazine Complete Guide to Venture Capital, Clinton Richardson, 1987, pps 183-184):

TABLE TWO: SAMPLE VC ROI EXPECTATIONS
Company Stage	Compounded Annual ROI *
Seed or Startup	40% and up
First and Second Stage	30% to 50%
Third Stage and Mezzanine	20% to 30%

*Note: These are ranges of ROIs typically required by VC investors for the indicated stage of investment - and not the percentage ownership sought in the Company. Percentage ownership is a separate analysis described in Section Three below.

With these general guidelines, management should generate several valuations for the Company under a variety of best-case, worst-case and expected-case scenarios. This sensitivity analysis is useful in determining changes in valuation based on differences in management and investor assumptions on cash flow. A sample DCF analysis assuming a 5-year projection period and 15% ROI is provided below:

*Note: This example is taken from Coopers Lybrand, Business Acquisitions and Leveraged Buyouts, p. 15)

** Residual value using the market multiple technique. EBIT from Year 5 times the market multiple selected of eight (5856 x 8).

Three: Venture Capital Valuation Techniques

Sophisticated investors such as VCs, institutional investors and corporate investors generally begin the valuation analysis by examining management's cash flow projections to test the underlying assumptions and business model. Once the investor has developed a certain comfort level in the projections, a variety of techniques are used to determine the percentage ownership the investor will require. Each of these methods start with the management's projections under the DCF technique, but ignore management's application of its assumed discount rate to the present in order to value the Company. Instead, the VC investor imposes its own ROI, as indicated in each of the methods described below - to meet its own investment parameters irrespective of management's analysis of the cost of capital. By applying its own ROI, the investor can then determine the percentage ownership it will require to reach this ROI assuming a certain market valuation for the Company.

Where these VC valuation methods differ from the DCF method is in (a) the difference in the discount rate, or ROI applied by the Company and by the investor, and (b) the use all VC methods employ of P/E ratios to determine market valuation of the Company at the end of the projection period (equivalent to the methods used under the DCF technique to determine the terminal or residue value of the Company). The following VC valuation methods are commonly used.

1. The Hockey Stick Method. Simply stated, in the "Hockey Stick" method the investor (a) first decides what return on investment it seeks through the projection period, (b) applies a price/earnings ratio to earnings at the end of the projection period to determine the market valuation of the Company, and (c) then determines percentage ownership as the ratio of the investor's expected return on investment to the market valuation for the Company as a whole. The formula for the Hockey Stick Method consists of the following:
 

(initial investment) x (expected payoff)	=	Percent investor ownership
(after tax earnings) x (comparable P/E)

To apply this method, assume (a) the Company requires an investment of $800,000, (b) the projection/liquidity period is 3 years, (c) the investor expects to earn 5 times its investment over the 3-year liquidity period, (d) the Company's 3rd year after-tax earnings are expected to be $1 million, and (e) an appropriate P/E ratio based on a composite of comparable stocks is 12. By applying the formula above, the investor will ask for approximately 33% of the Company - or whatever higher percentage the investor is able to coax out of management, as follows:

($800,000 investment) x (payoff of 5 times)	=	33% investor ownership

The hockey stick analogy for this method comes from the graphical depiction of typically no earnings for the early months or years of the Company, followed by steadily rising earnings growth as follows:

Depiction of Hockey Stick Valuation Method
Net Profit
$2mm
$1mm
$0.5mm
$0mm
Startup Years	Yr.1	Yr.2	Yr.3

2. The Conventional VC Method. This method is identical to the Hockey Stick Method, with the exception that the future market valuation of the Company is discounted to the presented before the investor percentage of ownership is determined. To illustrate how the Conventional Method works, consider the example of the Company described under the Hockey Stick Method above. Under the Conventional Method, the following steps would be followed:

Step One: The 3rd year after tax earnings of $1 million is multiplied by the accepted P/E ratio of 12 for a market valuation of $12 million.

Step Two: The market valuation of $12 million achieved over 3 years is then discounted to its present value of $2,400,000, using a discount rate of 71% (which is the rate resulting from a desired payoff of 5 times investment over 3 years). 

Step Three: The investor's ownership in the Company is determined by taking the initial investment of $800,000 as a percentage of the $2,400,000 present value of the Company - which equal 33%. This is the same equity ownership derived under the Hockey Stick Method.

3. The First Chicago Method. Similar to "decision-tree analysis" where decisions are analyzed based on the probability of certain events occurring - the First Chicago Method values the Company based on the cumulative impact of the probability of different earnings scenarios. While different scenarios can be generated under the either the DCF, Hockey Stick or Conventional Methods - the First Chicago Method requires management and the investors to consider the likelihood of earnings scenarios, thereby accounting for a range of possible outcomes in a single analysis.

To illustrate the First Chicago Method, consider the following example (assuming initial revenue is $2.0mm):
 

Revenue Growth	60%	15%	0%
Revenue over 5 yrs.	$20.97mm	$4.02	$2.0mm
Earnings	$3.15mm @ 15%	$0.28mm @ 7%	$0.14mm @ 7%
P/E Ratio	17	7	N/A
Mkt Value	$53.55mm	$1.96	$0.5mm (liq)
Present Value @ 40% Discount Rate	$9.96mm	$0.364mm	$0.092mm
Probability	40%	40%	20%
Expected Pres. Value	$3.98mm	$0.146mm	$0.0184mm
Cumulative Pres. Value	-	$4.144mm	-
Percentage Ownership w/ $2.0mm initial investment	-	approx. 48% ownership	-

*Note: In this example the earnings margins and the P/E ratio both decrease from the high revenue growth scenario of 60% to the revenue growth scenario of 15%. This change in assumptions from one scenario to the next is necessary to accurately reflect the full impact of lower revenue growth. 

Four: Negotiating the Purchase Price

Typically the investor will review management's business plan for the Company, conduct its own due diligence investigation on the business model and assumptions presented in the plan, and, if the investor is still interested, will present a pricing proposal to management. In the absence of a competitive situation where investors are bidding against each other to fund the Company (which is a very rare event) - management must evaluate the investor's proposal to determine if it is fair to the Company. How is this done? 

Essentially, management must question the investor on its assumptions in valuing the Company. After understanding these assumptions, management should then be in a position to argue for better valuation. The critical pricing assumptions to examine include the following (taken from the Venture Magazine Complete Guide to Venture Capital, Clinton Richardson, 1987, pps 163-164): 

1. The Price/Earnings Ratio Applied to the Company. A higher ratio will reduce the cost of the Company's funding. Management should question how the investor arrived at the ratio he chose. Have higher P/Es dominated the industry? Is the investor's P/E based on current P/Es in a sluggish market? Does the investor really believe that the low P/E it has chosen will prevail when the Company goes public? 

1. The Expected ROI. Question if the ROI used by the investor is the return he or she generally expects of similar investments, or if it is significantly higher. Is the ROI in line with returns typically expected or received in the venture capital industry, or are the returns used by the investor inflated? If so, why? 

1. Earnings Projections. While management should expect that the investor's projections for the Company will be lower than management's, management should question a large disparity between numbers that may indicate fundamental differences in the view of the Company's prospects between management and the investor. 

1. The Projection Period; When the Investor Expects to Cash Out. Inasmuch as the future value of earnings is less with each year that passes, the Company will have a higher valuation with a shorter cash-out period. Management should expect that the investor will assume a longer cash-out period than management in order to take account of unforeseen contingencies. Well thought out projections may anticipate these contingencies, and cause the investor to agree with a smoother and quicker maturity of the Company. 

1. The Downside Risk. Question and anticipate the investor's evaluation of the downside risk to the venture. Attempt to mitigate the investor's concern for losses in the terms of the offering itself. For example, a portion of the investment can be made for secured debt instruments that are convertible into equity at the investor's election once the risk inherent in the venture has diminished. Further, the Company may offer redemption or co-sale rights to the investor as a means of allowing the investor to liquidate his or her stock holdings in the Company should things not go well, and risk increase. 

Management should remember that investors will not even begin to address valuation unless and until they feel comfortable with the Company. Only after investor inquiry into market demand, product development and management capabilities have been completed will these valuation methods be considered. Notwithstanding this, management should also expect that investors will almost immediately inquire how much management hopes to raise, for what purposes, and what management is willing to give up for this investment. For this reason, no business plan should be distributed before management has set its own valuation for the Company based on the principles discussed in this paper.