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By Andrew Maxwell

Investors and entrepreneurs often ask me to shed some light on how to value pre-revenue companies – an issue often raised when entrepreneurs are looking for external investment.

Teaching courses on entrepreneurship and innovation, which include raising finance, suggests that I have a level of expertise in this area, which enables me to provide a definitive answer. Unfortunately, the opposite is true. The more I teach this issue and research different valuation techniques, the more I recognize that valuation of pre-revenue companies is more of an art than of science.

Essentially, the purpose of identifying a formula to provide a company valuation is simply to provide a base number from which both parties involved in a negotiation can start. This can be inhibiting, as most valuation techniques limit the potential upside of the venture – despite the fact that the entrepreneur is often optimistic. However, it is an approach that has merits, as the investor and entrepreneur have different knowledge and experience of the business and industry and the process of discussing the current status of the venture, the market opportunity and the long-term vision, creates an improved understanding that can enhance the relationship. That said, about 50% of the businesses that receive investment offers, turn them down as they cannot agree on company valuation.

The traditional way of calculating company value for pre-revenue companies is to rely on one of two approaches. The first is based on the calculation of equivalent value, whereby forecast profits (or revenues) are estimated in five years time, and current industry multipliers (such as price to earnings (P/E) ratio) are then applied to this forecast to calculate the future value. Armed with a valuation, post-investment, in the future, the current value of the venture can be calculated backwards. This simple approach has a number of benefits, but two fundamental limitations:  it’s very dependent on the accuracy of the forecast profit or sales and whether using a standard P/E ratio reflects the fact that a possible acquirer is likely to pay significantly more for the venture. Specifically, this approach assumes that the investor will exit from their investment through an Initial Public Offering (IPO) whereas a strategic acquisition is a much more likely option. In this case, the strategic acquirer will see value in their ability to leverage the acquired company with their existing business, and therefore be willing to pay much more for the business. Accurate forecasting of five-year profitability and the P/E ratio that might be offered by a strategic acquirer becomes quite a challenge.

The second valuation method, is one that is traditionally preferred in business schools and large companies, and uses the forecast cash flow of the business to calculate in the net present value. It is calculated by taking the forecast cash flow for each year and discounting that value back to today’s net present value, based upon assumptions about interest rates. While this is a reasonable way of looking at valuation in an ongoing business and an accurate method for making the decision to invest in a fixed asset, it is less useful when used to measure the value of a pre-revenue company.

This technique suffers from three fundamental problems when used to value a pre-revenue company. First, it is very dependent on the cash-flow that is forecast in the final years of the period chosen. Estimates of cash-flow in at some time in the future are likely to be inaccurate, and small changes to them can have a significant impact on the calculated value. Second, it is very dependent on assumptions about the interest rates used, and small changes in the interest rate can dramatically change the valuation. Third, this technique traditionally uses a standard interest rate for each year, despite the fact that interest rates are meant to reflect uncertainty, and that uncertainty about cash flows in future years are much greater – suggesting a standard interest rate for each year might not be appropriate.

Given this problem with using traditional calculation methods, two other methods might be more useful, but are much more subjective. First, there is the Berkus method (www.berkus.com), which calculates an estimated value based on the achievement of certain milestones. This is a much more useful technique, partly because it highlights the importance of certain factors (such as availability of a prototype, or the signing of a strategic alliance) that fundamentally changes the value of the business.  Also, this process tends to provide a framework for investment, which encourages the achievement of specific milestones before more investment is received.  Finally, the VC shortcut method is based on a simple estimation of how much someone will pay for the business in five years, and what that is worth in today’s terms, assuming that they make a required interest rate (usually around 35 % per annum) in the period.

At the end of the day, the valuation of a business is a function of a negotiation between an investor and entrepreneur that reflects the ability of the entrepreneur to share his or her vision with the investor.  Importantly, most pre-revenue valuation negotiations should focus on  identifying the amount of money needed by the company and how the entrepreneur and investor wish to divide control of the company. As a result, the convertibility of debentures issued and the inclusion of specific contract clauses in the shareholder agreement, become more important than the actual calculation of the company value, which underlie the shared vision of the entrepreneur and investor.

Join us for Business Valuation-Busting the Myths: How do Investors Value Your Business? Growing Your Business” breakfast event series 7:30 to 10 a.m., Thursday April 14th, at the University of Toronto Mississauga’s Faculty Club . To register, visit www.riccentre.com.

Andy is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.


The RIC blog is designed as a showcase for entrepreneurs and innovation. Our guest bloggers provide a wealth of information based on their personal experiences. Visit RIC Centre for more information on how RIC can accelerate your ideas to market.

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By  Joseph Wilson

What do cleantech investors want?Cleantech investment: Where is the money going?

Recently, we kicked off the MaRS Best Practices Special Valuation series with experts talking about investor interest in the biotech industry.

The message: the economy is pretty quiet these days, and cash is not flowing like it once was, especially for R&D companies in the biotech or life sciences fields.

Rupert Merer, a Director of Equity Research at National Bank Financial, will join Tim Babcock from the TSX Venture Exchange, where he will issue a similar warning for the cleantech field in Canada.

“It’s a tough market for IPOs these days, but there’s always money for good companies,” says Merer. “The market doesn’t have much patience for companies burning too much cash. They’re looking at companies that are better at bootstrapping.”

One of the things that cleantech start-ups want to know is how investors determine how much their company is worth. “Investors value a company based on its potential to generate cash,” says Merer. “There are lots of different metrics to evaluate.”

One of the key metrics to look at is the company’s potential for global competitiveness. “It’s really an international market these days,” he says. “We market Canadian equities to the global investment community.”

A bright side to the state of venture capital in Canada is that we don’t suffer from the same extremes of boom and bust as in cash-rich Silicon Valley. “There are a number of US companies that are moving to Canada,” he says. “They are attracted by the conservatism that fits Canada’s culture of investment. In this kind of economy the Silicon Valley model suffers more.”

Merer and his team at National Bank Financial have broadened the scope of their portfolio. Instead of just focusing on technology that generates clean power, they look carefully at anything that could be considered a “clean environmental technology.” Merer’s team is looking at water technologies, alternative fuels, waste management, recycling technologies and energy efficiency.

All this work has paid off. Recently, Merer was named by Brendan Wood International as the top analyst in the country in the alternative energy category. “It really is a group effort,” he says about the award. “We have a whole sales desk working in this space.”

Merer has worked both at start-ups and at large companies such as Enbridge, so is well placed to examine opportunities in the market of environmental entrepreneurship. “I track the industry and make recommendations to investors on where to put their money in the industry,” he says. Rupert Merer is the guy you want on your side.

Reposted from MaRS

JosephWilson is currently an education advisor at MaRS. He also writes on issues of technology and culture for NOW Magazine, the Globe and Mail, Spacing and Yonge Street. He is the Executive Director of the Treehouse Group, dedicated to fostering innovation by hosting cross-disciplinary events.

The RIC blog is designed as a showcase for entrepreneurs and innovation. Our guest bloggers pro vide a wealth of information based on their personal experiences. Visit RIC Centre for more information on how RIC can accelerate your ideas to market.

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By Andrew Maxwell

In my last blog, The Goldilocks Sydrome,  I talked about how specific entrepreneurial characteristics are linked to venture success and to an entrepreneur’s ability to attract money.

In this blog, I will try and explain another factor investors consider when making their investment decision – company valuation.

It often surprises entrepreneurs that experienced investors can make rapid investment decisions with very limited information.  This is because experienced investors develop simple routines (known as heuristics) that leverage their previous experience. The case of an entrepreneur’s valuation of their own company provides interesting insights for entrepreneurs seeking finance.  It also shows the importance of the information exchanges between investor and entrepreneur and how specific actions and comments provide a rich data source that influences an investor’s decision.

For example, an entrepreneur decides to ask for $300,000 in return for 30% of their company. It is interesting to understand what an investor can tell from this about the venture and specifically the entrepreneur.

First,  the investor will want to know why the entrepreneur needs $300,000 and whether the money is being used wisely. Will it allow the entrepreneur to reach an important milestone in the venture and attract  additional funds or revenues?

Next, the investor will assess whether the company might need less money at this stage (giving up less equity) or perhaps more money (giving up more equity).  Importantly, the investor will also evaluate if giving up equity is the best approach, sometimes debt is a more appropriate instrument (for example if you are buying a building or inventory, debt might be better).

The investor will analyze the request in the context of the whole venture. It is commonly assumed that an entrepreneur providing 30% of the company’s equity for $300,000 values the company after investment at $1 million. This assumes that the valuation before the investment is $700,000 (known as the pre-money value).  While this is a simplified approach, it is a good first approximation.

If an  investor considers $700,000 to be a reasonable pre-money valuation, then the investor will be interested, and have confidence in the ability and judgment of the entrepreneur. If this value is much too high or too low, an investor may doubt the competence of the entrepreneur and be less likely to invest.

Importantly, while there is a link between equity percentage and valuation, there is also a link between equity percentage and control. An investor will construe important information about the entrepreneur’s view of future investment rounds from the percentage offered.  There are two reasons for this. First, an investor working with an inexperienced entrepreneur might want to own 50% of the equity to control the venture and avoid foolish mistakes. Second, if the company is on a high growth path, it will likely need to attract future funding. Giving up equity now can cause a problem, as there will be less to give up in the future. Alternatively, a willingness to surrender equity can be viewed as a positive sign that the entrepreneur recognizes the need to dilute their equity position in the long term (for example in companies making an Initial Public Offering founders typically have only 4% of the companies equity at that time).

As you can see, experienced investors can learn a good deal from a single piece of information, and we have not even discussed the effect of alternate equity mechanisms or syndicated investors.  Understanding the importance of each of the signals provided should encourage entrepreneurs to think carefully about the implications of their initial valuation.

Andy is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.

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Reposted from Maple Leaf Angels

PART 2

By Craig Hayashi

In Friday’s post I spoke with Jim Pullen, partner at Concert Partners about how to engineer value into a company to maximize exit potential. As managing director at Regent Associates; the company studied 250 M&A transactions, and developed a framework to rank and assess a company on various factors that were proven to drive exit valuation. The various categories of the framework are Financial, Market & barriers to entry, Human Resources, Strategic fit and Governance.

Read Part 1 where we discussed Financial and  Market & barriers to entry. Today we look at Human Resources, Strategic fit and Governance.

Human resources

In the category of human resources, the model looks at both technical skills and management skills. “In the early stages of a start-up the founders are the key people that have the technical skill set to drive innovation and the leadership qualities to drive the company forward,” says Jim.

“As companies grow, it is important to distribute these skill sets deeper across the company. Often after an exit, the founders will want to leave, either since they have the largest financial gain or they just prefer to be entrepreneurs rather than work in a large corporation. As such, a buyer will place a premium on a deep management team where the company can continue to innovate and execute even with the loss of the founders.”

Strategic fit

This factor relates to the degree that the company that is being acquired is a strategic fit into the buyer’s product portfolio. “We have seen cases where buyers are willing to pay a 50%-70% price premium for a company that fills out a missing piece of the buyer’s product portfolio and gives them access to the IP and expertise of the company they are acquiring,” says Jim. “That being said, companies should not lose sight of their customers and try to build a company that serves the needs of a few companies they feel may acquire them. There is always the risk the targeted buyers will acquire another company or develop something internally. Partnerships are an excellent way to lay the foundation with a potential buyer. A partnership is a low-commitment way that a potential buyer can start to get deeper experience with a company. If things work out well and strategic synergies start to develop then this can help lead to a deeper relationship such as exclusive arrangement or acquisition.”

Governance

The last factor involves good governance. “We have found that a strong board of directors can add a 25% premium to the value of a company,” says Jim. “This is due to the buyer having more assurance that the company was well governed and there will be no unexpected surprises the buyer needs to deal with.”

This talk has focused mainly on an exit via an acquisition because this is the most likely exit scenario. “Even in the 90’s when IPOs were more frequent, we found an exit by acquisition was 15 times more likely than IPO,” says Jim. “In this scenario, companies received valuations in the range of 0.5x to 3x revenue or 8x to 20x EBITDA. These are large potential ranges since the valuation of a private company is very subjective. As such, it is important for start-ups to be aware of the factors that drive exit valuation and to ensure they are building these up as they grow their company. The more deeply rooted that these factors are in a company will put the company in a stronger position once they start to attract acquisition interest.”

Good advice indeed. Whether you are an entrepreneur or investor, if you rank your start-up that you are involved with across these factors, there are probably going to be a few areas you identify that can be strengthened. Starting to strengthen these areas now will help the company operationally in the short term and also provide benefit in the long term by building in stronger value that a buyer will place on the company.

Craig Hayashi is a founding board director of Maple Leaf Angels, Ontario’s largest and most active angel investment group with more than 40 members and approximately $6m in financings closed since the group’s inception in 2007. Follow Craig at www.mapleleafangels.com and www.startupnorth.ca

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Reposted from Maple Leaf Angels

PART 1

By Craig Hayashi

Entrepreneurs launch, employees get involved, and investors invest in start-ups for a variety of reasons and motivations. Underlying each group’s individual motivations is a desire/dream of hitting it big with an exit and getting a cash-out for the hard work and belief placed in the company. It’s clearly in everybody’s best interest to ensure the company receives the maximum possible value as a result of the exit. But what is the best way to do this and when does this work need to start?

To find out more, I spoke with Jim Pullen, partner at Concert Partners. Jim helps advise entrepreneurs on how to engineer value into a company to maximize exit potential. He also leads workshops on planning for exits given by the ISCM Investment Network. Previously he was managing director at Regent Associates, a European company specializing in mergers and acquisitions for technology companies where he worked in London and then Boston.

A few years ago, Regent Associates did a study of 250 M&A transactions that they were involved within the technology space over a span of 8 years. This covered transactions in Europe, US, and Canada. Specifically they wanted to find out the key areas that buyers looked for in a transaction so they could better advise their clients on how they could best position themselves to drive a higher exit valuation. Based on this study, they developed a framework as to how they could rank and assess a company on various factors that were proven to drive exit valuation.

“A good example of this framework in action is with a client that had approached us wanting to be sold,” says Jim. “We reviewed the company against the framework and felt they would be undervalued based on low scores against some of the framework areas. We advised them to develop these areas of their business and then come back to us. The company successfully improved themselves and when they came back to us 18 months later we were able to sell them for a 40% premium over the valuation we felt they would have received when they first approached us”.

The various categories of the framework are Financial, Market & barriers to entry, Human Resources, Strategic fit and Governance. When working with clients, Jim typically scores the company in each factor in the framework. These scores are compared to a company’s peers to help focus on the areas where the company can improve to optimize the value a buyer will see in the company.

Today we look at Financial and Market & barriers to entry.

Financial

This category includes basic financial metrics such as profitability and revenue growth. Companies with high profit margins and high rates of revenue growth will obviously command a higher valuation.

Other aspects include the type of revenues a company generates. Due to their nature, recurring revenues can add to the valuation of a company as it makes the company’s cash flow more predictable.

“The SaaS model is the example most technology entrepreneurs would think of in terms of a recurring revenue business model,” says Jim.
“However, even if the company does not have a business model that supports SaaS, they can look to adapt their model to provide more recurring revenues. For example, a company that sells big-ticket one-off products could look to build up more of an offering around maintenance and post-sales services for their product where they can sign their clients into multi-year maintenance contracts. This will give the company more of a recurring revenue stream and insulate them from a peaky revenue stream.”

“Companies with strong cash generation are also more attractive to buyers,” says Jim. “Such a company can take on more debt that can be used to finance growth. It also makes a leveraged buy-out an exit possibility.”

Market & barriers to entry

In this category the factors include the strength of customer relationship and degree of uniqueness the company enjoys in its market. “Companies that have a direct and strong relationship with the end users/purchasers of their product will get a higher exit valuation,” says Jim. “If a company sells through a channel and fails to build up a relationship with the end client, they run the risk of the channel swapping them out for another product that may offer the channel partner a better financial relationship. Even if they sell through channel partners, it is important for companies to build up strong relationships with end users.”

“We have also found that a company’s brand plays a large role in the value a buyer is willing to place on a company,” says Jim. “We have found that a strong brand can make up to 70% of the value in a company. Companies should proactively cultivate their brand to ensure they are recognized and well-regarded in their space.”

In terms of barriers to entry, companies should use many mechanisms to defend their position. This can include things such as legal protection though patents and trademarks, relationships through exclusive arrangements with key suppliers, and internal expertise through strategic hiring. “Anything a company can do to make it harder for competitors to enter their space will help command a premium on valuation,” states Jim.

On Monday we continue with Human Resources, Strategic fit and Governance.

Craig Hayashi is a founding board director of Maple Leaf Angels, Ontario’s largest and most active angel investment group with more than 40 members and approximately $6m in financings closed since the group’s inception in 2007. Follow Craig at www.mapleleafangels.com and www.startupnorth.ca

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