Subject line: [Flawless Financials] Valuation Terminology
Flawless Financials
the Financial Forecasting Online Newsletter
from Minotaur Financial
and David Brode
February, 2004
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This month: Valuation Terminology
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In the world of corporate finance, valuation lives on its
own planet, and has its own language. In many ways, when
investors ask entrepreneurs about valuation, they really
aren't interested in hearing a numerical answer, but rather
in gauging the financial IQ of the entrepreneurs. For now,
let's leave aside the question of what kind of answer you
should provide--that's a complex issue for a future
newsletter--and focus on answering with confidence. I've
found many entrepreneurs are confused about valuation terms,
and so I provide the following primer as a service for my
readers.
Question #1: What's your valuation?
First of all, this question is short for "what is your pre-
money valuation," or more breezily, "what's your pre-
money?" PRE-money valuation is distinguished from POST-
money valuation. Pre-money valuation is the value of the
company now, before you put that check in the bank; post-
money valuation = pre-money valuation + funds raised.
There can be a big difference between pre- and post-money
valuations, so it's important to get the terms right. If a
company has 10M shares outstanding and is seeking $500,000,
the price per share for new shares sold depends on the pre-
money valuation, and when the pre-money valuation is higher,
investors own a smaller percentage of the company.
$M $M
Pre- Post- M
Money $/share Money Shares % Company
----- ------- ----- ------ ----------
1.0 0.10 1.5 5.00 33%
2.0 0.20 2.5 2.50 20%
3.0 0.30 3.5 1.67 14%
4.0 0.40 4.5 1.25 11%
5.0 0.50 5.5 1.00 9%
Question #2: How did you get that valuation?
The quick answer is that the value of the shares is what
someone is willing to pay for them. That being said, there
are many ways to calculate a valuation. Below are two
common methods.
a. Net Present Value (NPV)
Description
With more established companies, or when we have a known
series of cash flows over time, finance theory has developed
extremely straightforward ways of assigning a value today to
cash flows in the future by "discounting" them. Most
people acknowledge that a dollar today is worth more than a
dollar tomorrow, given inflation, risk, etc. A more
technical term for this discounting is to call it a
"present value." That is, the value today, at the present,
of a stream of cash flows in the future. And when we
compare the value of what we get (the present value of the
cash flows) against what it costs us (the initial
investment), we subtract or net out the cost, to get a Net
Present Value, or NPV.
Do People Use NPV for Startups?
Not generally. The problem is that the cash flows shown
in projections are so unlikely to actually occur that they
aren't a useful analytic tool for defining current value.
NPV falls apart because the discount rate depends on an
evaluation of risk, and the risk component of startups is
too high and hard to measure to make NPV a useful tool.
What if I'm Asked about it?
Ask what discount rate you should use, and promise to get
them an NPV.
b. Multiples
Description
Multiples are a favorite valuation tool, in part because
they are so easy to use. You can calculate a valuation
as a multiple of revenue, EBITDA, EBIT, net income,
operating cash flow, etc. Sometimes it's last year's
number, sometimes an annualized version of the last
quarter's number, sometimes it's the projected number for
the current year. So you may have a 2.0x Revenue
multiple which is equivalent to an 8.0x EBITDA multiple.
Do People Use it for Startups?
You bet. For very early stage companies, there's no
revenue and all profitability measures are negative, so
multiples don't work well. But once you're out of the
gate, people use them all the time. Also, when you're
defending your exit multiples at Year 5 of your plan,
people will probably want to talk multiples more than NPV
assumptions.
Question #3: What are the returns to investors?
Investors want to know how much money they can make on a
deal. I tend to answer this question with IRR and "cash on
cash" multiples, though there are other ways.
IRR
IRR (Internal Rate of Return), measures returns over an
investment's lifetime. Think of IRR as the ANNUAL interest
rate you would have to get paid on your initial investment
to equal the money you wind up with at the end of the deal.
If you invest $100 and get $140 back in 12 months, that's a
40% IRR. But if payback occurs at 24 months, you would need
$196 (100*1.4*1.4) to achieve a 40% IRR due to compounding.
IRR is quite distinct from ROE (Return on Equity) and ROI
(Return on Investment) in that IRR is concerned with an
entire project, where ROE and ROI measure returns to equity
or capital holders over a particular period, typically a
year.
Cash on Cash Multiple
Calculated as the dollars received at the end of a project
divided by the dollars initially invested. Very clean and
simple.
What I like about IRR and cash on cash multiples is that you
can convey financial IQ without giving away too much
information. If you tell someone the IRR is 55% and the
cash on cash multiple is 9.0x, they can get excited about
the deal meeting their return requirements, and you've
communicated that you speak their language, which is great
for an early stage meeting.
Conclusion
Clearly, this is a large topic and we've just started to
scratch the surface, so I'll plan on a follow-up newsletter
based on reader feedback. Please email back to David@Brode.net
with your comments on how to extend this valuation discussion.
Until next month, all the best,
David Brode -- Minotaur Financial
Removing Financial Issues as a Deal Roadblock
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ABOUT DAVID BRODE
I’m a financial modeling specialist. Over the last fifteen
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Over time I’ve consistently revised software tools and
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Are you struggling to convince others to do a deal which
you think is a no-brainer? To discuss how you can
take numbers off the table as a deal roadblock, call (303)
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