Subject line: [Flawless Financials] Valuation Terminology Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode February, 2004 Sent monthly to over 400 subscribers. Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: Valuation Terminology * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * 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 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * NEWSLETTER ARCHIVE AVAILABLE Make sure to visit the Minotaur Financial website for the Newsletter Archive at http://www.brode.net/resources/ * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * ABOUT DAVID BRODE I’m a financial modeling specialist. Over the last fifteen years I’ve completed dozens of models and certainly thousands of versions to support corporate development, M&A, strategic planning, and debt and equity transactions. These models have raised over $1B in debt and $100M in venture capital and private equity. Over time I’ve consistently revised software tools and work processes to get the job done quickly and well. If you have a financial forecasting issue, I’d love to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2004 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net " * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * 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) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. 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