Venture Capital Valuation
Contents
Cover
Series
Title Page
Copyright
Acknowledgments
INTRODUCTION: What You Don't Know About Valuation Will Cost You Money
WHAT THIS BOOK IS ABOUT AND WHOM IT IS FOR
MY PERSPECTIVE ON VALUATION AND THIS BOOK'S SETUP
DID YOU KNOW EMPLOYEES LOSE $1 BILLION EACH MONTH DUE TO OVERVALUED (UNDERWATER) OPTIONS?
ABOUT THE COMPANION WEB SITE
CHAPTER 1: Using Facebook, Twitter, and LinkedIn to Explain VC Valuation Gains and Losses
DID VALUATION IGNORANCE COST CONNECTU (AND THE WINKLEVOSSES) $50MM?
AN EXPERT DOESN'T NEED A 409A VALUATION WHEN HE OR SHE HAS A CERTIFICATE AND BASIC MATH
VALUING FACEBOOK'S COMMON STOCK COMPARED TO PREFERRED STOCK IN MINUTES
WHAT THE WINKLEVOSSES WOULD HAVE SEEN IN ANY 409A VALUATION REPORT
DERIVING A DISCOUNT FOR LACK OF MARKETABILITY FOR VALUATIONS
FACEBOOK AT $80 BILLION VALUATION VERSUS ENRON AT $80 BILLION VALUATION
DEAL TERMS, WATERFALLS, AND THE PRE-MONEY MYTH
THE PRE-MONEY MYTH
SUMMARY
CHAPTER 2: Should Venture-Backed Companies Even Consider a DCF Model?
ZOGENIX: COMPANY BACKGROUND SUMMARY AND HIGHLIGHTS
LEAPING FORWARD JUST 20 MONTHS, THE COMPANY FILES FOR AN IPO
ORDER OF VALUATIONS PRESENTED IN THIS CASE
CHAPTER 3: Valuation Methods versus Allocation Methods Regarding Zogenix
SEPARATING ENTERPRISE VALUE FROM THE ALLOCATION OF THAT VALUE
VALUING TOTAL EQUITY
USING FUTURE VALUE (FV) AND PRESENT VALUE (PV) TO VALUE FUTURE CASH FLOWS TODAY
SUMMARY
CHAPTER 4: Applying the Typical DCF Model to a Venture-Backed Company Hardly Ever Works
THE GORDON GROWTH MODEL
HIGH GROWTH LIMITS THE GORDON GROWTH MODEL
DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE IRRELEVANCE
USING COMPARABLES (GENERALLY MARKET MULTIPLES) TO GENERATE A TERMINAL VALUE
ACTUAL DIFFERENCES BETWEEN ANGELS AND VCS VERSUS PERCEIVED DIFFERENCES
APPLYING VALUATION METHODS AND ALLOCATION METHODS AT INCEPTION
SUMMARY
CHAPTER 5: “Enterprise Value” + “Allocation Methods” = Value Destruction
MOST 409A VALUATIONS UNDERVALUE THE COMPANY AND SIMULTANEOUSLY OVERVALUE EMPLOYEE STOCK OPTIONS
DID AUDITORS DRIVE VALUATORS TO OVERVALUE EMPLOYEE STOCK OPTIONS?
MOST 409A ENTERPRISE VALUE CALCULATIONS IGNORE THE “TAKEOVER” VALUE OF PREFERRED
THE REALISTIC RANGE OF POSSIBILITIES DEPENDS ON WHO THE INVESTORS ARE
OVERSTATING RETURNS AND UNDERSTATING RETURNS ON THE SAME ASSET (SIMULTANEOUSLY)
WHAT HAPPENS TO FUND IRRS WHEN YOU ASSUME BOOK VALUE EQUALS MARKET VALUE?
THE REAL COST OF FAIR VALUE, FAIR MARKET VALUE, AND ENTERPRISE VALUE
YAHOO! CASE
CHAPTER 6: Why You Should D.O.W.T. (Doubt) Venture Capital Returns—Option Pool Reserve
UNISSUED OPTION POOLS
VALUE CONCLUSION ELEMENTS IMPACTED BY OPTION POOL RESERVE ASSUMPTIONS
IMPACT ON PARTIES RELYING ON ASSUMPTIONS OF VC INVESTMENTS
CHAPTER 7: If Valuation Can't Make You Money, Do You Really Need It?
APPLYING STUDIES TO REAL-WORLD CASES
IMPORTANT QUESTIONS TO ASK
SUMMARY
CHAPTER 8: Don't Hate the Appraiser (Blame the Auditor Instead)
INTERVIEW WITH JEFF FAUST, AVA
SUMMARY
CHAPTER 9: Don't Blame the Auditors (Blame the Practice Aid Instead)
INTRODUCTION TO THE EXPERT PANELISTS
THE AUDITOR'S VALUATION “BIBLE”
SAS101 TESTS, PWERMS, AND OPMS
PWERMS AND RNPV/ENPV MODELS
SUBJECTIVITY AND THE PWERM (OR “power”) METHOD
FINDING INPUTS FOR THE OPM MODEL
ENTERPRISE VALUES VERSUS ALLOCATIONS
NEXT ROUND PRICING AND TOPIC 820
DIFFERENT WAYS OF TREATING GRANTED, UNVESTED, AND RESERVED OPTIONS
VALUING WARRANTS IN VENTURE-BACKED COMPANIES
QUANTIFYING QUALITATIVE INPUTS TO VALUE CONCLUSIONS FOR VC-FUNDED COMPANIES
DISCOUNTS FOR LACK OF MARKETABILITY (DLOM) AND VENTURE-FUND PORTFOLIOS
SHARESPOST, SECONDMARKET AS MARKET INPUTS
SUMMARY
CHAPTER 10: Now That You Understand Venture Capital Valuation, Share It
About the Author
Index
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.
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For a list of available titles, visit our Web site at www.WileyFinance.com.
Copyright 2012 by Lorenzo Carver. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
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Library of Congress Cataloging-in-Publication Data:
Carver, Lorenzo, 1968–
Venture capital valuation : case studies and methodology / Lorenzo Carver. — 1
p. cm. — (Wiley finance series)
Includes index.
ISBN 978-0-470-90828-0 (hardback); ISBN 978-1-118-18232-1 (ebk);
ISBN 978-
1-118-18233-8 (ebk); ISBN 978-1-118-18234-5 (ebk)
1. Venture capital—Case studies. 2. Valuation—Case studies. I. Title.
HG4751.C367 2012
658.15—dc23
2011037186
Acknowledgments
I'd like to thank God for giving me the time and wherewithal to write this book, John DeRemigis of John Wiley and Sons for suggesting I write it and making that happen, and my friends, family, clients, customers, and partners who put up with my efforts to get it done. Also, I'm grateful for Jennifer MacDonald’s, of John Wiley and Sons, patience as I tested ways to communicate a complex topic to a broader pool of beneficiaries than just valuation professionals.
Thanks to my immediate family, Sandra Carver, Lorenzo Carver Sr., Lester and Vanessa Carver, and Sandra and Todd Welch, Kaila, Jasmine, Victor, Veronica, Charity, Aaron, Avery, and Rachel.
Many of my friends, and all of my business partners, helped me with these efforts just by being themselves and having a passion for entrepreneurs and entrepreneurial finance as much as I do. But some of those were particularly instrumental in keeping me focused on this task or otherwise allowing me to focus on it by picking up the slack elsewhere. This list includes, but is not limited to, my friend and valuation partner Connie Yi, Esq. of Carver Yi, LLP, all my friends, partners, and shareholders at Liquid Scenarios, Inc., but especially Sacha Millstone, Alan Kaplan, Chris Svarczkopf, Michael Edwards, David Jilke, Tony Jones, Henry Wright, Alexey Gavrilov, Alexander Vinogradov, Eugene Mymrin, Manoj Biswas, Susan Jarvis, Sue Perrault, Tim Barlow, Claudine Schneider, KG Charles-Harris, Manish Jindal and Peter Fusaro, and my friends and fellow shareholders at Free409A/TapMyBooks, David Berkus and Eric Woo.
I also wish to thank my customers and clients, who have effectively subsidized my continuous education in this area over the past 20 years, especially my friends Mark Freedle, Frank Maresca, Sina Simantob, Jason Mendelson of Foundry Group, Jeff Donnan and Stephen Pouge of First Round Capital, Jack Genest, Sarah Reed and the finance team at Charles River Ventures, Harry D’Andrea of Valhalla Partners, Matt Potter of Delphi, and all other Liquid Scenarios Users, the thousands of small companies that have purchased BallPark Business Valuation and the millions that visited BulletProof Business Plans over the years.
INTRODUCTION
What You Don't Know About Valuation Will Cost You Money
How would you feel if you sold $2 million “worth” of Google stock and received $50 in cash instead of $2 million? This happens to venture-backed companies everyday and that's why understanding valuation is critical.
The terms “value” and “valuation” are used a lot for high-growth private companies and that's a bad thing. It's bad because when founders, VCs, angels, attorneys, CFOs, CEOs, and employees use these words and don't truly understand what they mean, those same people end up losing lots of money as a result.
Imagine you log in to your brokerage account. You see your 2,000 shares of Google valued at $2,000,000, place a market order to sell all 2,000 shares, and wait for it to clear. A few minutes later you get a confirmation that you sold 2,000 shares, received $0 in proceeds, and owe the brokerage firm $50.00 in commissions. A transaction you expected to put $2,000,000 in your pocket has instead effectively taken $2,000,050 out of your pocket. How would that make you feel? What would your spouse's reaction be? Most of us would experience a rapid increase in heart rate and an unpleasant feeling in our stomachs. The culmination of this fight-or-flight response would at least be a call to our broker to find out what happened to the other $2,000,000 (yours) and get it back.
Yet this same scenario plays out for real every day for VCs, founders, angels, limited partners, strategic investors, CEOs, CFOs and employees of high-growth companies and most people don't panic and don't feel the need to make a phone call. Why? Because they don't know what's happening to them until it's too late to do anything about it. This book represents an opportunity for those parties to stop losing money before it's too late to do anything about it, by understanding how “value” changes their rights to cash flow at every stage of a company's evolution.
WHAT THIS BOOK IS ABOUT AND WHOM IT IS FOR
In a broad sense, this book is for anyone who's involved with a venture capital- or angel-backed private company who wants to maximize his or her investment by controlling one of the few things you can when dealing with high-velocity, risky investments after you've committed: your understanding of valuation.
In many ways, valuing an early-stage venture-backed company (one that's received financing) is a lot easier than valuing a traditional privately held company. You would never know that by reading a 409A valuation report, looking at a certificate of incorporation, or viewing an investor rights agreement for a venture-funded company, though. While those venture deal complexities, which relate to rights and preferences for various securities and holders, are absent in the vast majority of traditional private companies, access to capital, networks, and long runways to the first meaningful customer are also absent in most traditional businesses. The result is that venture capital- and angel-backed company value is better measured in terms of volatility, as opposed to traditional private companies, which are generally more easily valued in terms of cash flow, or operating income benefit streams, in their early lives.
From a valuation perspective, this allows you to focus on the existing investors and capital structure (the known variables) more so than you could ever do with a traditional business. As these angel- and venture-backed companies evolve, faster and often more dramatically than would ever be acceptable for a traditional business, the one constant, in most cases, is the investors and, ideally, parts of the founding management team. These elements, and this pattern, can be reduced to simple math, and that simple math can produce useful indications and conclusions of value.
However, none of those conclusions, or indications of value, are of any use unless you understand how they were arrived at and what the limiting conditions and assumptions are. This book uses real-life cases where stakeholders in a given startup or high-growth company could have made out better simply by having better information about valuation. In other words, if the company had performed exactly as it did using misunderstood valuation inputs, parties in the know would have increased their profits without changing how the company operated in any way.
MY PERSPECTIVE ON VALUATION AND THIS BOOK'S SETUP
I've spent the better part of my adult life making it easier for those who want to understand high-growth company valuation to do so, primarily by creating software. But before I released my first valuation software in the late 1990s, I had spoken with hundreds of entrepreneurs, attorneys, investors, and other parties, who would always ask questions like:
“What's this company worth?”
“Is this a fair valuation?”
“Are we leaving too much money on the table?”
The entrepreneurs I had the conversations with were some of the smartest people I've ever known, including award-winning PhDs, with patents to their name for products that have literally either saved or vastly improved the lives of millions around the world. Yet, explaining valuation to these sophisticated parties verbally or even with an interactive spreadsheet still didn't make it intuitive enough that they felt comfortable when the ink dried on their deals. That's when I decided to take six months off from consulting and write a software application that made it intuitive for almost anyone. I realized that software allowed people to get instant satisfaction and experiment with “what if” inputs that were hard to do on a scratch pad or on a spreadsheet. That software application, BallPark Business Valuation, focused on the discounted cash flow (DCF) and capitalization of earnings methods, which are both methods within the income approach to valuation mentioned in Chapters 3 and 4.
In the late 1990s, I created several hundred valuations as part of strategic planning for high-growth companies. These valuations were used to explain to management what a reasonable range of returns would be based on the
capital they were seeking, the types of businesses they were starting (IT, Internet related, biotech, medical device, and so forth), and the time horizon to a liquidity event. In 1996 and 1997, the value indications I generated, both with respect to pre-money/post-money values and in terms of true “enterprise” values, tended to be close to what clients actually ended up realizing when raising funds. But when 1998 rolled around, almost all founders I built a valuation analysis for in conjunction with their finance strategy were quick to let me know that they were getting twice, or even four times, the “pre-money” valuations I suggested would be reasonable before they closed their financing. This trend increased, month after month, and by the time Red Herring had written an article on my strategic planning services, half the entrepreneurs I worked with would balk at the valuation estimates as being way too low. So who was right, me or my clients?
As you will see in the very first chapter of this book, “Using Facebook, Twitter, and LinkedIn to Explain VC Valuation Gains and Losses,” my clients could be right with their higher assumed “valuations,” and I could be right with my lower assumed “value indications,” depending on what “standard” of value was used. Financial buyers, as discussed in Chapters 1, 3, 5, 6, 7, 8, and 9, are willing to pay for the cash flow, or benefits, a business is capable of producing as of the date of the transaction. If VCs and angels priced deals this way, they would effectively own almost 100% of each company they invested in, not including options reserved for future issuance. Instead, the expectation is that a series of subsequent financing rounds, ideally at increasing prices, should bring a venture-backed company closer to the point where financial buyers could foreseeably participate in either a financing of the company or an acquisition of the company.
Early in the process of building a valuation analysis as part of strategy engagements, I used to begin by trying to solve for the value of a client company to a financial buyer. I knew both experientially and from auditing VC funds before starting my consulting practice, BulletProof Business Plans, that most VCs, angels, and early-stage investors in general were not financial buyers. However, I also believed that once investment values and speculative values became “market values,” there would be an opportunity to acquire any residual intellectual property once it was clear that little or no future cash flows would ever be realized for the vast majority of “overvalued” Internet companies, in the absence of restructuring. Based on that hypothesis, BulletProof Business Plans founded a publicly traded company to value and “harvest” the intellectual property from these companies as they went out of business. In exchange for investor rights to the IP, which a lot of parties were more or less walking away from at the time, investors in overpriced private companies about to fail would receive interests in a publicly traded, but restricted, stock, and the publicly traded company would redeploy the IP in new ventures or otherwise sell it.