0:00

My name is Karl Ulrich, I'm a professor at the Wharton school.

Â And this session is on Equity Financing: Valuation.

Â I want to start with a story.

Â I'm an investor in a start up called Wholly Moly!

Â And Wholly Moly takes organically

Â grown oatmeal sourced in the United States and sells it

Â in China where the Chinese consumer is very concerned about food safety.

Â Wholly Moly was started by a former student of mine named Claire.

Â Claire and her childhood friend, Shui Shui, started this company.

Â Now, Claire had been my student but Claire and I had become friends.

Â In fact, she had guided me around China on two separate occasions.

Â I actually introduced her to her husband and I spoke at their wedding.

Â So, I really consider Claire to be a friend.

Â Claire then asked me if I would be interested in investing in Wholly Moly.

Â And that caused our relationship to take an entirely different turn

Â because now we had to focus on business.

Â So this image shows a dinner we had in San Francisco

Â with her two first investors me and Don.

Â And we're shown here with Claire and Shui Shui.

Â And we're all smiling here at this dinner but

Â this was a pretty tense dinner because we had to focus on the question of,

Â if I invest my hard earned cash in your business, what do I get in return?

Â That's the essential question we face in valuation,

Â how do we decide what the company is worth?

Â 3:01

Well, you don't really ever need to do it until you need to raise some money,

Â until you need to sell some portion of that company for cash.

Â And that's usually in the context

Â of the initial financing that's required to get the business going.

Â Now of course, once you're successful, and once your business is established,

Â you may be interested in selling that business entirely to a third-party, and

Â that's the other setting in which you need to establish a value,

Â set the valuation for the business.

Â And to be even more precise the investor is typically asking the question,

Â if I invest a certain amount of money, let's say $10,000 or

Â a $100,000, what fraction of your company do I get in exchange?

Â That's the fundamental question we're trying to establish, or

Â trying to answer, with valuation.

Â 4:50

So, if we want to understand what the investor owns after the investment,

Â we think about the investor providing $100,000 in

Â cash divide that by the post money valuation, or $1.1 million.

Â And that fraction is one eleventh, and so

Â the investor providing $100,000 on a pre money valuation of $1 million.

Â Results in the investor owning one-eleventh of the company or about 9.1%.

Â So again, pre-money valuation is what the company is worth before the investment.

Â Post-money valuation is simply the pre-money valuation

Â plus the value of the cash invested.

Â And the ownership's stake of the investor

Â is defined as the cash divided by the post money valuation.

Â I want to just point out

Â that it's in everyone's interest to estimate the value accurately.

Â Some people might think, well gee,

Â as the entrepreneur I'd like to have as high a valuation as possible so that I

Â give away as little of my company as possible for the amount of cash invested.

Â But that's not such a good idea because if your valuation is too high

Â then your investor won't make a good return.

Â That's not fair first of all, but it's also not good for you and your reputation.

Â The other thing is that if you set your expectations too high,

Â if you set in effect a price that's too high for

Â your company, you won't be able to attract the investors of the type that you'd like.

Â On the other hand, if your valuation is too low.

Â That's not good for you, of course,

Â because you've given away a lot of your company.

Â But it's also not good for the investor because it doesn't leave you with enough

Â ownership that you have a strong incentive to make the business a success.

Â So, you and your investor both want this estimate to be as accurate as possible.

Â And that's really the reason to treat this exercise quite seriously

Â as you're thinking about raising money.

Â There are four approaches that I've used in establishing valuation and

Â I want to just to through those approaches.

Â The first is, that you can look at what the inputs cost.

Â That is, what would it cost to replicate what you've created to date?

Â The second approach is,

Â to compare your company to other similar companies, and to other transactions,

Â fund raising transactions, those companies have entered into.

Â The third approach is that you can discount for

Â time and risk from some estimate of future value, and

Â I'm going to go through each of these with some examples.

Â And then the fourth approach you could take is you can apply a multiple

Â to the actual earnings of the company, either the earnings or the revenues.

Â 8:13

The first is that you could look at the value of the inputs.

Â And the way to think about this is what would it cost for

Â someone to recreate what the entrepreneur has to date.

Â And the reason that's important is if, if it wouldn't cost very much for

Â somebody else to create what you've done,

Â then it's not really fair to ask for some huge premium over that cost.

Â To ask the investor to pay something premium over that cost,

Â because the investor would just say, well, why don't I just start from scratch,

Â find some other entrepreneur who could get to where we are today at lower cost.

Â So let me give you an example.

Â Let's imagine that you're very early in your start up and you've put in about

Â six months of full time effort with a partner, so you've put in together,

Â the two of you have put in, six months each for about 12 months of human effort.

Â And let's say you're a recent college graduate, you might have earned $100,000,

Â actually, that would be quite an impressive salary after graduation, but

Â let's just say, you could have earned,

Â the two of you together working six months could have earned $100,000.

Â 9:59

If we add up the value of those inputs,

Â then we get $250,000 in total value, and that's what I mean

Â by starting with what would it cost to replicate what you've got here today.

Â Now let's imagine that an outside investor provided $25,000,

Â provided that cash that you needed to get started.

Â Under that logic, the investor would own 10% of your business,

Â using the value of the inputs as the method of value in the company.

Â Now, the problem with this approach is that it doesn't really account for

Â the fact that the entrepreneur might have resolved a bunch of uncertainty,

Â might have gotten lucky with this business idea, might have considered three or

Â four other businesses before settling on one that eventually worked.

Â And so, in some ways, it doesn't account for the fact that the entrepreneur

Â whose gotten this far has actually resolved quite a bit of risk and

Â uncertainty associated with the opportunity.

Â 11:27

Now you have to have some data in order to do that.

Â And there are a variety of data sources on the Internet and

Â in reports on venture transactions.

Â You could also ask around, get a few data points for your region and for

Â your industry.

Â Shown here, is some data that was put together by a prominent law firm in

Â Silicon Valley called Wilson Sonsini.

Â And, shown here is the pre-money valuation and

Â the amount raised for all of the transactions that they handled

Â that involved less than $2 million, of capital raised.

Â And what you'll see here is that the valuation varies by sector.

Â So, consumer hardware is going to be different from software.

Â And healthcare pharmaceuticals will be different

Â 12:19

from consumer products or Internet commerce.

Â And so, but for instance, software companies here,

Â show there's a pre-money valuation of about $4 million for

Â companies that are raising about $1 million in capital, and

Â so if you're a software company, and you're in Silicon Valley, and

Â you're raising capital, the, you could use this data to argue that comparable

Â companies are valued at a pre-money valuation of about $4 million.

Â And in that case, you probably wouldn't want to set your valuation at $1 million,

Â or conversely at $10 million.

Â It's probably going to be somewhere in the neighborhood of $4 million in this seed

Â stage investment, that is, in a setting where you're raising about $1 million.

Â This approach makes sense in a well defined category for

Â venture backed companies,

Â where you can actually get data on the prices at which the transactions occurred.

Â The third approach you can take is to discount some future outcome,

Â based on time and on risk.

Â And, that's sort of an arcane, and I realize, not too clear of a description.

Â To make matters worse, I'm going to give you an acronym, which is PWERM,

Â which stands for probability weighted expected return method.

Â And that mouthful refers to an approach that's taken

Â in investment banking to estimate the value of companies.

Â And the PWERM method is actually not so complicated, but

Â I'm going to walk you through the steps.

Â The first thing you do is you define several different

Â outcome scenarios that could occur at some future date.

Â And I'll give you an example, in a minute.

Â Secondly, you estimate the probability of each of those outcomes.

Â 14:13

Third, you calculate a risk-adjusted future value, which

Â takes into account what those scenarios are worth and their probabilities.

Â And then fourth, you discount that future value back to the present,

Â accounting for the investor's opportunity cost of capital.

Â Now, I realize those may be very unfamiliar terms.

Â So let me walk you through a specific example.

Â Let's imagine you're trying to value your company, and that you can imagine that

Â one year from now, 12 months from now, there might be four possible outcomes.

Â The first possible outcome is that everything is going just as you planned.

Â And you actually are successful in raising venture capital

Â at a $4 million pre-money valuation.

Â Now by definition, in that scenario, your company is worth $4 million.

Â That's what it means for

Â a venture capital to invest in you at a $4 million pre-money valuation.

Â So let's call that the first scenario, everything goes just as planned and

Â your company is worth $4 million as evidenced by a venture capital transaction

Â that occurs one year from now.

Â Now a second scenario is that progress is actually slower than expected,

Â and you have to take another angel investment at a much lower valuation,

Â let's say $2 million.

Â 15:41

The third scenario you might consider is that things are going quite badly, and

Â you're forced to sell your business to a competitor

Â in what might be considered a distressed sale.

Â And maybe you would get $500,000 from that transaction.

Â And then the fourth scenario is that your company fails, you go bankrupt,

Â and nobody gets anything.

Â So those are four scenarios.

Â The next step is to assign probabilities to those scenarios.

Â Now in this example, I've simply assigned even probabilities.

Â So I've said there are four scenarios,

Â let's assume that there's a 25% chance of each of these outcomes.

Â And in the absence of better information,

Â a sort of even probability distribution is not a bad way to go.

Â But, I would say, if you have some better information or some better way to

Â estimate what you really think the likelihood of the different scenarios is,

Â you could use that.

Â They don't have to be even chances of all the different scenarios.

Â 16:59

The second scenario, it's worth 25% of 2 million, or $500,000.

Â The third scenario, it's worth 25% of $500,000 or $125,000.

Â And the fourth scenario, it's 25% of 0 which is still 0.

Â So in calculating a risk adjusted future value,

Â you simply add up those probabilities times those outcomes and

Â you get $1.625 million.

Â And that's what I call the risk adjusted future value of the company.

Â Which means, all that's equal, accounting for the different probabilities of

Â the different scenarios, one year from now, we expect the business to be worth,

Â on average, averaged across all the things that might happen, $1.625 million.

Â Now, the problem is, that's $1.625 million one year from now,

Â and you want your investor to give you some money today.

Â And so you have to account for

Â the fact that that's a future value, that's a value that's out a year from now.

Â And so, you need to discount that future value back to the present.

Â Accounting for the investors opportunity cost of capital.

Â Now the subject of the topic of how to calculate the opportunity cost of

Â capital is fairly complex and is the subject of a corporate finance course.

Â But I'm just going to assert that for most venture investments, the opportunity cost

Â of capital for investments of this type is probably around 20%.

Â And so if you take that 20% and discount it back to today,

Â then you are simply taking 1.625 million dividing it by 1.2 and

Â that results in a present day valuation of 1,354,000 and yes $167.

Â 19:11

So that approach, called PWERM, basically says, hey, maybe

Â I can't estimate the value today, but I have a better chance of estimating some

Â future scenarios at some future point, and putting some probabilities on those.

Â And so I'm going to use those future scenarios and

Â probabilities to estimate some risk adjusted future value and

Â then I'm going to discount it back to the present.

Â If you're not comfortable with those calculations,

Â talk to a friend who's really good at finance.

Â They'll probably already know about the PWERM method and

Â they could help you think through those scenarios.

Â And let me just say one other thing about PWERM.

Â I have never seen that calculation done in public between an investor and

Â an entrepreneur.

Â It's a little bit academic, it's a little bit analytical and

Â it's so dependent on assumptions that I think it's primarily a method that

Â you would use yourself to get comfortable with what do I really think

Â is the future value of this business and how would I account for the risk.

Â You would use it to calibrate your intuition, I don't think I would use it,

Â for instance, in a business plan to set valuation.

Â The fourth method that you can use is to base a valuation on actual earnings.

Â Now, of course,

Â the problem with this method is that you probably don't have earnings yet.

Â And so valuations based on earnings typically apply to

Â later stage transactions in which the company has an operating history and

Â actually does have earnings.

Â And so, in many respects, this fourth method is more relevant for

Â an acquisition, for an outright sale of an ongoing company than it is for

Â an investment in the early stages.

Â Nevertheless, the method usually involves taking what's called the EBITDA, or

Â the earnings before interest, taxes, depreciation, and amortization.

Â Think of this as effectively the cash flow that the company generates.

Â 21:45

Now, the problem with this method is that the multiples themselves

Â depend on lots of other factors.

Â And it's quite easy to imagine scenarios in which the multiple would only be 5x,

Â that is, where you would only be able to sell the business for

Â five times the annual earnings.

Â And that would be a scenario in which the company isn't growing very fast.

Â Or faces a lot of risks out in the future,

Â where those cash flows are quite uncertain.

Â That would explain a multiple of about 5x.

Â You can also imagine a scenario where an acquirer would be willing to pay 50x.

Â And that would be a scenario in which there was a lot of growth anticipated.

Â And where the company had a very strong, competitive position and

Â the competition was likely to be weak in the future.

Â To give you some rough numbers, on average in the United States

Â public companies are valued at about 15 times their EBITDA.

Â That is, an investor is willing to pay about 15 times the annual

Â earnings of a company, in order to own the company outright.

Â However, some companies are valued at much, much more than that.

Â So for instance, Amazon is currently

Â valued at a multiple of about 400 times EBITDA.

Â And so that's just to illustrate that this method has a lot of uncertainty

Â surrounding the actual multiple that's used to multiply times the EBITDA.

Â The last approach you can take, and I didn't put a number on it because it's

Â not really an approach to valuation but it's an approach to this problem,

Â which is, that you can defer the valuation question.

Â And I might just say you kick the valuation question down the road.

Â You avoid having to even deal with it, you put it off.

Â And the way you can put it off is through the use of

Â what's called a convertible note.

Â And the idea here is that the investor, instead of agreeing in advance

Â on what the investor gets for their cash, the investor

Â lends the money to the company in what's called a convertible note.

Â But they lend that money with the understanding that when and

Â if a future investment occurs, an investment, let's say, a year from now.

Â That that loan will convert to equity,

Â will convert to an ownership stake in the company at the future valuation.

Â That is, at the valuation that's established later.

Â Probably by a more sophisticated investor, maybe a venture capitalist.

Â And so sometimes investors and

Â entrepreneurs don't even want to establish the valuation today.

Â They want to kick that decision down the road,

Â put it off until a more significant transaction happens.

Â Usually, convertible notes, there will be an agreement that they

Â convert at a discount, discounts often around 20%.

Â So the investor puts some money into the company with the assumption that when and

Â if there's a future investment, their loan will convert to equity

Â at a discount to what the future investment would pay.

Â And that accounts for the risk that the investor is taking

Â in providing the money earlier in the process.

Â There's often also a cap, meaning if things go amazingly well,

Â we agree in advance that my note won't convert at a value of

Â any higher than this predetermined cap.

Â Often maybe around 4 to $8 million is

Â often the cap that's used in convertible notes.

Â So in sum, valuation is critically important

Â when you're taking investor's money because the investor wants to know,

Â what do I get in exchange for my investment?

Â At the end of the day it's a horse trade, it's a negotiation between two parties,

Â but it's very important that you do your best to estimate value accurately.

Â Because that's what's fair to investors, you want your investor to make money.

Â And you also don't want it to be too low because you need

Â to retain an incentive to make the business successful.

Â So I've given you four methods, you can apply two or

Â three of these methods to your particular situation.

Â Get some numbers to help calibrate your intuition.

Â Which you can then use in the actual negotiation, where you set the value for

Â your company in negotiation with an investor.

Â