TEACHING NOTE ON VALUATION OF HIGH TECHNOLOGY VENTURESProfessor Tom ByersValuation is not a precise science and can be quite complex. Yet, understanding and estimating companyvalue is one of the entrepreneur's critical tasks. The entrepreneur wants the highest possible valuationfor the company; the investor, usually less optimistic, recognizes that most business opportunities facegreat uncertainty and wants a lower valuation.Rates of Return Required by InvestorsThe required return on investment will vary depending on the type of investor and the perceived risk ofthe investment. The following table illustrates the range of returns required by private investors andventure capitalists for investing in new ventures: Required ReturnTriple investment in three years 44.2%Triple investment in five years 24.6Quintuple investment in three years 70.9Quintuple investment in five years 38.0Ten times investment in three years 115.4Ten times investment in five years 58.5Venture capitalists financing seed or startup companies require compound annual returns exceeding50%. For later stage financing, venture capitalists require compound annual returns of 30% to 40%.Private investors, on the other hand, may only require compound annual returns of 25% to 30%.Factors Affecting ValuationProspective investors must evaluate the risks of the specific investment. Some of the risks which mustbe evaluated include: (i) market risk, (ii) technology risk, and (iii) management risk. The potentialrewards for investors must compensate for these risks. The greater the perceived risk of the investment,the greater the required return on investment. Though analysis may help identify and assess the risksand potential of a venture, the final determination of value will be based on the experience and judgmentof the investor.11/14/19/1/14/19/1/14/19 1The critical questions that investors must consider include:• What is the potential of this venture?- What can go right?- Is the market ready for the product(s) to be supplied by this venture?- Does the venture possess any sustainable competitive advantage? Can this round of funding create any sustainable competitive advantage?- Does the management team have the skills, knowledge, contacts, experience and resources to execute the business plan for this venture? Is the management team committed emotionally and financially to this venture?• What is the downside of this venture? What can go wrong?• Given the business and financing strategy of the venture, what is the likely dilution that would occur based on later rounds of financing?• How will investors be able to liquidate their investment in this venture? Will the company be able to "go public"? How attractive will the venture be to a potential buyer?• How has the company fared since inception? Have they met their business and financial targets? What realistic milestones must be achieved to raise future funding at ever increasing valuations?• Can the management team and the investors work together effectively? Has trust been established? Is their good "chemistry" between the management and investors?In addition to the internal factors, the outside environment must also be considered, including: (i) thestate of the economy, (ii) the condition of the stock market and the venture capital industry, and (iii) theindustry of the venture itself. The more favorable the outside environment, the easier to raise money onfavorable terms.Valuation MethodsAlthough there are several valuation methods used by financial theorists, entrepreneurs often timessimplify the valuation process. They apply a relevant price-earnings (“P/E”) ratio to a firm’s futureearnings in order to determine a company's value at a future point in time. This future expectedvaluation is used to: (i) assist in determining the attractiveness of a given opportunity and (ii) assist instructuring a deal with potential investors today.In our class, we will use the following method to value a given company in a given year:21/14/19/1/14/19/1/14/19 2FIRM VALUE t = ƒ(t, Pt, Mt)FIRM VALUE t = Pt * Mtwhere t = year numberPt = after tax profits in year t (also called net income)Mt = relevant price-earnings multiple or P/E ratio applicable in year tHow do you determine Pt? As we have discussed, this is a difficult number to estimate. This requiresthe entrepreneur to develop reasonable proforma income statements. It could be helpful to use a rangefor P to understand how sensitive your analysis is to changes in P.How do you determine Mt? M represents the relevant price earnings multiple applicable to a givencompany in a given year. This number is also difficult to estimate. However, you can estimate M byexamining the P/E multiples of comparable publicly traded companies today and then adjusting themedian upwards or downwards for the unique characteristics of your company.How do you determine t? Typically, t ranges from 3 to 5. It is very difficult to project earnings beyonda five year period.Another important question: What portion of the company should investors receive if they are willing toinvest today?INVESTOR SHARE I * (1 + r)t OF COMPANY’S STOCK = _______________ FIRM VALUEtwhere I = amount invested todayr = required rate of return on investmentt = year number (or number of years)How do you determine I? Your cash flow projections should tell you how much funding you require inorder to successfully operate your business. The amount required should allow you to meet enoughmilestones in order to be able to raise your second round of financing.How do you determine r? Conceptually, r is determined by exploring the risk associated with a givenventure. The greater the risk of the venture, the greater r must be in order to compensate the investorappropriately. Typically, start-up investors require a rate of return of 40 - 70%.It is important to remember that these techniques can only provide a benchmark. These techniques willnever provide the answer. Typically, negotiations occur between the investors and the entrepreneurs,and ultimately, deals happen.31/14/19/1/14/19/1/14/19 3ExampleFirm A requires $500,000 in order to start its business. The firm expected to earn $1 million in its fifthyear. The investor has reviewed the company's business plan and believes that she is entitled to a 50%return on her investment. Publicly traded companies in this