Valuation of Entrepreneurial Ventures Entrepreneurial Thought Market transactions are often not abservable for assets such as privately held busi- nesses. Thus, fair market value must be estimated. An estimate of fair market value is usually subjective due to the circumstances of place, time, the existence of comparable ‘Precedents, ond the evaluation principles of each involved person. Opinions on value are always based upon subjective interpretation of available information at ihe time of assessment. = [Link] Chapter objectives 1 To explain the importance of 6 To hightight the avaitable methods valuation ‘of valuing a venture To descrive the basic elements of 7 To examine the three principal due diligence methods currently used in business valuations To examine the underlying issues involved in the acquisition process 8 To consider additional factors that affect a venture’ valuation To outline the various aspects af analyzing To present ‘a business tthe major points to consider when establishing a firm's value450 cuaptes 36, a7. 30, 39. a 2 2. 44, 45, Howard H. Stevenson and David B. Gumpert, “The Heaet of Entrepreneurship.” Harvard Busiess Review (dare Apel 1985): 06-87. Jeffry G. Covin and Dennis P. Slevin, “New Venture Strategie Posture, Structure, and Performance: An Industry Life Cycte Analysis," Journal of Business Venturing 5, na. 4 (March 1990): 123-33; see also Jerey G. Covin, Kimberly M. Green, and Dennis P. Slevin, “Strategle Process EIfects on the Entrepreneurial Orientation-Sales Growth Rate Relationships,” Entrepreneurship Theory and Practice 30, no. 1 (2006): 57-62, CChatles J. Fombran and Stefan Wally, “Structuring ‘Small Firms for Rapid Growth” Journal of Business Venturing 4, no. 2 (March 1989}: 107-22; Donna J Kelley and Mark P. Ree, "Advantage Beyond Founding: The Strategic Use of Technologies Journal of Business Venturing V7, 20.1 (2002): 441-38; see aso Andrew J. Sherman, Grow Fast Grow ight (Chieage: Kaplan, 2007) Donald C, Hambriek and Lynn M. Crozer, “Stumblers and Stars in the Management of Rapid Growth, “ournal of Business Venturing 1, no. 1 (laary 1985}: 31-45, Richard L. Osborne, “Second Phase Entrepreneurship Breaking Through the Growth Wall,” Business Horizons (lanuary/February 1994): 00-86. Ibid, 62-5. ‘See Jeny R. Cornwell, “The Entrepreneur as @ Buildin lock for Community." Journal of Developmental Entrepreneurship (FalfWinter 1998): 183-28 David E. Gumpert and David P. Boyd, “The Loneliness of the Small Business Owner.” Harvard Business Review (November/December 1984): 15-24 Douglas W. Nefleiger and Donald P. Kuratke, “An Tavestigaton into the Prevalence of Planning in Small Busines," Journal of Business and Enrepreneurship 3, no. 2 (October 1991): 99-110. Charles. Hobbs, “Time Power” Small Business Reports (January 1990); 46-55; and Jack Falvey, “New and Improved Time Management,” Small Business Reports (uly 1990]: 14-17. 5. Tey L. Besser, “Community Involvement and the Perception of Success Among Small Business Operators in Small Towns," Journal of Small Business Management 37, no. (October 1999} 16-29; and Rhonda Walker Mack, “Event Sponsorship: An Exploratory Study of Small Business Objectives, Practices, and Perceptions” Journal of Small Business Management 37,00. 3 duly 1999): 25-30, Shaker A, Zahra, “The Changing Rules of Global Competitiveness in the 215¢ Century." Academy of ‘Management Executive 13, no. 1 (1999): 36-42: 13. Strategic Entrepreneurial Growth 4a, en 54, Rosebeth Moss Kanter, "Managing the Extended Enterprise in a Globaly Connected World,” ‘Organizational Dymanies (Summer 193): 7-23; ke W. Peng, “How Entrepreneurs Create Wealth in ‘Transition Economies," Academy of Management Executive 15, no, 1 (2001): 95-110; and Stephanie A Femmhaber, Patricia P. McDougall, and Benjamin Mt Oviat, “Exploring the Role of Industry Suucture in New Venture Internationalleation,” Entreprencurskip Theory and Practice 3, no. 4 (2007): 517-2 [Niels Bosma, Kent Jores, Eekko Autio, and Jonathan Levie, Global Enirepreneurship Monitor (Babson College, Babson Park, MA, and London Business School, London, 2007 ‘Shaker Zahra, James Fayton, Jeremy Mare, and ugh O'Neil, “osteing Entrepreneurship During Intemational Expansion: Managing Key Challenges” Eurapean Managemen’ Sour! 13, no 4 (2001) 359-60; Peggy A. Clsinger and Benjamin M. Ova, ‘Service Content and he Intenationalization of Young Ventures: An Empirical Test” Enreprenewship Theory and Practice 31, no, 2 (2007): 293-56; and Shaker A. Zahra and Danes A Clayton, “The Efect of International Venturing on Firm Performance: The Moderating infience af Absorpiive Capacity.” ournal of Business Venturing 23, n0. 2 (2008) 195-220, W. Glenn Rowe, “Creating Wealth in Organizations ‘The Role of Static Leadership," Academy of ‘Management Exeutive 15, no. 1 (2001): 81-94, R. Duane Ireland and Michae! A, Hit, “Achieving and Maintaining Strategic Competitiveness in the 2ist Century: The Role of Strategie Leadership,” “Academy af Management Executive 13,10, 1 (1999) 57, ‘Michael A. Hit, R, Duane feland, S. Michael Camp, and Donald L Sexton, "Strategic Enepreneurship: Entrepreneurial Strategies for Wealth Creation.” special issue, Staregic Managemen: Journal 22, no. 6 (2001}2479-92: see also John L Thompson, “A Strategic Perspective of Entrepreneurship,” asemational Joureal of Entrepreneurial Behavior & Research 5, 20.6 (1999): 279-96; and Sharon A. Alvarez, R. Duane Ireland, and Jeffrey J. Reuer, “Entrepreneurship and Strategic Alliance” Journal of Business Venturing 21, no. 4 (2006): 401-4 E.H. Kessler and A. [Link], “Innovation Speed: A Conceptual Model of Coniext. Antecedents, and Outcomes,” Academy of Management Review 21, no. 4 (1996): 1143-81 Donald. Kuratho, R: Duane Ireland, and Jeffrey 5, Hornsby, “Improving inm Performance Through Entrepreneurial Actions: Acondine Cmparate Entrepreneurship Strategy,” Academy of Menagement Executive 15, nd. 4 (2001): 6O-T1452 CHAPTER 14 Voluation of Entrepreneurial Ventures The importance of Business Valuation Every entrepreneur should be able to calculate the value of his or her business and also should be able to determine the value of a competitor’ operation. Such business valuation is essential in the following situations: * Buying or selling # business, division, or major asset * Establishing an employee stock option plan (ESOP) or profit-sharing plan for employees * Raising growth capital through stock warrants or convertible loans * Determining inheritance tax liability (potential estate tax ability) 7 * Giving a gift of stock to family members © Structuring a buy/sell agreement with stockholders © Attempting to buy out a partner * Going public with the company or privately placing the stock Equally important is the entrepreneur's desire to know the real value of the venture. This valuation can provide a scorecard for periodically tracking the increases ot decreases in the business's value.! Underlying issues When Acquiring a Venture ‘As we demonstrated in Chapter 6, acquisition of a venture is one pathway to entering the entrepreneurial arena. Because one of the main reasons a valuation would take place with « venture is that itis being sold, we will examine a few more points concerning acquisition of 4 venture. Three issues underlie the proper valuation of a venture set to be acquiseds (1) the differing goals of a buyer and seller, (2) the emotional bias ofthe seller and (3) the ceavons i for the acquisition, Goals of the Buyer and Seller {tis important to remember one’s reasons for valuing an enterprise. Both major parties to the transaction, buyer and seller, will assign different values to the enterprise because oftheir basic objectives. The seller will attempt to establish the highest possible value for the busi. ness and will not heed the realistic considerations of the market, the envitonment, of the economy. To the seller, the enterprise may represent a lifetime investment-—or at the vety least one that took a lor of effort. The buyes, on the other hand, will try to determine the lowest possible price to be paid. The enterprise i regarded as an investment for the buyer, and he or she must assess the profit potential. As a result, a pessimistie view often is taken ‘An understanding of both positions in the valuation process is important, i Emotional Bias The second issue in valuing business is the emotional bias of the seller. Whenever some: i one starts a venture, nurtures it through early growth, and makes it a profitable business, the person tends to believe that the enterprise is worth a great deal more than outsiders believe ic is worth. Entrepreneurs therefore must try to be as objective as possible in deter, mining a fair value for the entesprise (realizing thae this fai amount will be negotiable), ! Reasons for the Acquisition ‘The thitd issue in valuing a business isthe reason an entrepreneut’s business is being acquired ' The following are some of the most common reasons for acquisition. * Developing more growth-phase products by acquiting a fim that has developed new | Products in the company’s industry egUnderlying Issues Whan Acquiring a Venture entrepreneurship The “Rollup Frenzy": An Acquisition Nightmare Be Indust players such as AutoNation and the now defunct NationsRent characterized the acquisition spree of the fate 1980s. These "rollups" of mom-and-pop businesses into national chains were geared to provide a standardized and efficient system by trimming office costs and boosting purchasing power. Unfortunately, many former awmers are nave suffering big Yosses 2s the Former moms and pops are buying back their businesses for sometimes less than half of what they were acquired For. Brad Daniel built up his florist business into five stores throughout south Florida before he decided ta ell ou for $130 milion to an industry rllup. Tho rollup ‘quickyyaverinfsted nd filed for Chapter 11 bankruptcy protection; Danie! gained back his business for loss ‘than half ofthe acquisition price. However, many smal: business overs were not as lucky. Entreproneurs who sold their businesses oten got burned by plunging share wore left to deal with unpaid workers and \oteroreting senices. The rollups’ cost savings never matorialized, hacause of conflicting office systams and people's reluctence to work togethe sreW toa fast and used too much dabt during expansion. Iv estimated that investors put $30 blfion into rolluns through stock offerings and private investments through the late 1990s, Since 1996 alono, rollups that had intial publi offerings raised approximately $2.6 bition in equity hile taking on $10 bilfon in debt Across the nation, the smartest entvepreneurs are digging through assets of failed rollups and finding treasures, The founders of Webshots, en online photo sharing service, sold their company and 13 milion registered users to Excite@Home, which made them instant millionaires. Whon the high-speed Internet ‘provider liquidated in 2001, Webshots was returned to ‘the hands of ts founders at» bargain price ‘Taose coups may have had the purchasing power and recognition tise capita for furor expansion, but ‘they lst touch of whet became their iabililies—service and experience “onze Charles Hadad and Brian Grow, “Supping Us the Spoils of Raped Rollope” BusinessWeek Online, Macch 5, 2002, htprwebusinsrrel comms! contenimar 3007200285 88 12-him feces! Ape! 17, 2008}. Increasing the number of customers by acquiring a fim whose current customers wil 453 broaden substantially the companys customer base © Increasing market share by acquiring a firm in the company’s industry Improving or changing distribution channels by acquiring a firm with racagnizee superiority in the company's current distribution channel + Expanding the product line by acquiring @ firm whose products complement anc complate the companys product fine © Developing ar improving customer service operations by acquiring a firm with an estab- lished service operation, as well as a customer service network that includes the company’s products Retlucing operating leverage and increasing absorption of fixed costs by acquiting a firm that hes @ lower degree of operating leverage and that can absorb the company’s fixed costs © Using idle or excess plant capacity by acquiring a frm that can operate in the company’s current plant facilities + Integrating vertically, either backward or forward, by acquiring a firm thats a supplier oF distributor454. CHAPTER 14 Veluation of Entrepreneurial Ventures Reducing inventory levels by acquiring a firm that is a customer (but not an end user) and adjusting the company’s inventory lovels to match the acquired firm's orders Reducing indirect operating costs by acquiring e firm that wil allow for elimination of éupi- cate operating costs (for example, warehousing and distribution} Reducing fixed costs by acquiring a firm that will permit the elimination of duplicate fxed costs (for example, corporate and staff functional groups)" In summary, itis important that the entrepreneur and all other parties involved objectively view the firm’s operations and potential. An evaluation of the follovring points can assist in this process: ‘Air's potential to pay fr itself during a reasonable period of ime ‘The diffcuties the new owners face during the transition period ‘The amount of security or risk involved in the transaction; changes in interest rates The effect on the company’s value if a turnaround is required “The number of potential buyers Current managers intentions to remain with the firm ‘The taxes associated with the purchase or sale of an enterprise? Due Diligence “When considering the acquisition of a venture, an entrepreneur should perform a complete due di mace, which means a thorough analysis of every facet of the existing business. ‘Table 14-1 provides a due diligence oucline that is used to assess the viability of a firm's thusiness plan, Notice how each major segment is analyzed by applying specific questions to that part. Due Diligence Evaluation Executive Summary A Company name. Does the management tear have whot i takes to implement the pon? PraduetlService Offering, fs the ideo viable? Key considerations uncovered by external research, Are there conditions i the industry, competitive environment, market, or ather areas not caressed the plan? Key considerations discovered through analysis ofthe pln, Is there something the plan does rt uncover or that needs to be put int the plan? Financial summary 1. Funding request. it oppropriate for success? 2. Valuation (pre-money). What is tei storting point? 3. Buin rat, fst sufficient or excessive? Does their equesttoke this into account? 12 Evaluation ofthe viability of the stated rate of returnjnvesiment potential When operations ore odjusted by your analysis i the stted return stil there? Nareative Analysis Intoduction (May be presented in bullets) AL Date BL Review team membersName of company Name of CEO Date founded location Funding goal Founders investment Prior venture funding 1. When? 2. How mucnz 3. From whom? 4. The Industry (broad foeus) A 8 c General industry information |. What are the chiet characterises of the industry (economic, technologies, politica, social, changel? 2 How does the plan address these? How isthe proposed venture impacted by these? 3. How attractive isthe industry in terms of is prospects for above average profitability? “4. What has the industry growth rate been forthe past Five years, and what i it roected to be forthe next five? Give specific support or justification for these projections 5, Have there been any recent transactions inthe industry, such as IPOs, 130s, private Dlacements, mergers, or acquisitions? Describe the transactions and provide a brict ‘planation ofthe nancial arrangements of esth transaction, Competitive environment |. What competitive forces (entry bariers, substitutes, power of buyers and suppliers~ fivalry is addressed in next section} are at work inthe industry, and hw strong are they? 2. Has the plan identified the competitive environment and how the company wil fit into tht environment? 3. Calculate total market available in dolar, 4. Calculate degree of market saturation. Primary Competitor Analysis-in-depth 1. Compare and contrast majar competitors (rom the plan and your own research) along core competitive dimensions, including but not limited to: Product/Service 1st Mover Pricing Market Share Distribution Technology Marketing Fnaneial Backing Operations Financial Performance Strategie Partnershis PIE (if publicy traded or revenue multisier 2 Calculate marketshare available fr this frm nt keady captured by competitors (otars and users) 1s this enough marketshare to achieve the financtal projections in the plan? 3. Which companico ure inthe stongestweakest competitive position? 4 Who wil kely make what competitive moves next? 5. What key factors will determine competitive success or file? I. Target Market(Customer Base (narow focus) A 8 Describe the target markt: si, scope, growth, growth potential, growthidemand drivers, price sensitty, sales cyte What is the need! or want that the company is satisfying? Continued456 CHAPTER 14 Valuation of Entrepreneurial Ventures cee il Due Diligence Evaluation (Conti What are the bariers that wil keep competitors from copying this venture’s product or service? What market inefficiencies exist? D. How strong are competitive forces (rivalry, substitutes) within ths target marker? What has the growth rate ofthe target market been forthe past five years, and What iit projected to be forthe next five? Provide supportusification for these projections. IM. The Company (This section asks you fo evoluate the plan in terms ofthe industry and target, ‘market characteristics ascussed) ‘A. Value proposition: What does the company do, and how does it provide vale to its ‘customers and investors? 8. Management team 1. Does this tam have what it takes to make this venture a success? 2 Is success dependent on one key person? IF so is this recogrized and dealt with in the plan (Succession, key man replacement, ete}? 3. HR gaps? Plans to address gaps? Business model 1. How does the company make money? 2. How and wen does it plan ta be profitable? 3. oes the plan follow a demonstrated success formula? Support with t to? examples For cxampl, briefly discuss similar companies in terms of size (evenuesemployes, ‘operations, revenue mode, andor business model, These companies could be direct, ‘competitors o similar firms that are not in the same market, but instead just similar type of companylmade DL Strategy 1. How does the company plan on achieving success in its business model? 2. What other strategic approaches might work well inthis situation? Give examples E. Marketing plan 1. How wil the company convert prospects into customers? 2. Who makes the customer's purchase decisions? When and how are the decisions made? What dimensions are critical ote eustomer in making the decison? I the pln specific in defining their strategy inthis area? 3. Does the company have a base of eutrent customers? Does thir plan address customer retention? F Operations 1 Dots the company’s operating plan make sense in terms of supporting ts strategy and business model? V. Company Situation Analysis ‘A. What are the company’ strengths, weaknesses, opportunites, andl treats? 8. Look at your competitor analysis; isthe company competitive on cost Ist lifferentiated compared to competitors? How? How strong isthe company’s competitive postion? Ave there eniybariers that protect the company? What key strategic factors suppor this proposition? Which ones are counter toits success? D. What strategic sues does the company face? i. Financial Analysis (Select the anes thot apply to this plan. Provide the analysis itis qppropriote ‘and especialy note fit is not included in the plan.) AL Ratio analysis: liquidity, solvency, profitability, viability. 8. Compare projected growth rates versus historical industry growth rates. Sate ‘why this company wil be able to sustain the projected rate above that ofitsDus Diligence 457 Due nce Evaluation (Continued) industry. If itis determined that the projections are too optimistic, what can be expected? Valuation 1. Calculate pre-money valuation. What supports this valuation (number of shares X price per share, curcent audited balance sheet/accepted revenue multiples, ete? 2. _Tiangulate this valuation by (1) comparing the PIE ratios or revenue malti- ples of simitor companies and (2) discounting the company’s cath flow projections. D,_ Other financial considerations: Start-up cash spent or needed Current bum rate Cash needed for years ane to five Bye-year revenues Five-year profits Break even: 1. Revenues When Comments regerding financial statements, such as 1. Accuracy 2. Abnormalities s the budget in line or out of hand? f the accounting correct? 3. Needed assumptions 4 Other VL. Adlitional Comments and Concerns [AL Is the plan well written? Is it concise and to the point? Can the “layperson” understand it? Is the idea viable? . Is this appropriate for venture investing? Can we expect enough growth? Whats the rislreward relationship? E omer Praeye Appendices 1LResourcesBibfography I. Other detailed support organized by section in arr of reference ‘Sonre:Dathesda, MD: Bescon Venuure Capital, 2008 “The entrepreneur also may apply a more general approach to better assess the viability of the pocential purchase; however, one critical area that always needs to be addressed is the future trends of the business, which eequite an overall look at the particular industry trends and how this business will ft inco chem. In addition, the financial health of the business needs to be projected, and how much capital is needed t0 buy the venture must be determined; this step requires understanding that the final purchase priee is not the only factor that needs to be taken into consideration. Repairs, new inventory, opening ‘expenses, and working capital are just afew of the additional costs that should be con- sidered, Figure 14.1 illustrates how to calculate the total amount needed to buy a businessase CHAPTER 14. Valuation of Entrepreneurial Ventures mm Total Amount Needed to Buy a Business Family Living Expenses From last paycheck to takeover day Moving expense For three manths afte takeover day — Purchase Price Total amount fr down payment plus three monthly installments) Sales Tax (On purchased furniture and equipment Professional Services Escrow, accounting, legal Deposits, Prepayments Last month's rent first months rent in Licenses Operating Expense below) Utility deposits Sales tax deposit Business licenses Insurance premiums Takeover Announcements Newspaper advertising Mail announcements Exterior sig changes New stationery and forms New Inventory New Fixtures and Equipment Remodeling and Redecorating Tiree Months’ Operating Expense Including loan repayments Reserve to Carry Customer Accounts cash Petty cash, change, ete Total. Analyzing the Business ‘When analyzing small, closely held businesses, entrepreneurs should not make compari- sons with larger corporations, Many factors distinguish these types of corporations, and valuation factors that have no effect on large firms may be significantly important to smaller enterprises. For example, many closely held ventures have the following shortcomings © Lack of management depth. The degrees of skils, versatility, and competence ar limited. © Undercapitalization. The amount of equity investments usually ow (often indicating a high lovel of dob) © Insufficient controls. Because of tha lack of available management and extra capitl, ‘measures in place for monitoring and controling operations are usualy limited. © Bivorgont goals. Tho entrepreneur often has a vision for the venture that difers from the investors’ goals or stockholders’ desires, thus causing intemal conflicts in the firm. th‘Analyzing the Business 459 ‘These weaknesses indicate the need for careful analysis of the small business, u ‘The checklist in Table 14.2, which is patterned after the information requied for an effec- tive business plan (see Chapter 12), provides a concise method for examining the various factors that differentiate one fiem from another History of the Business The original mame of business and any subsequent name changes Date company was Founded ‘Names of al subsidiaries nd divisions; when they were formed and their function ‘States where company i incorporated States where company is licensed to do busines asa foreign corporation Review of corporate charter, bylaws, and minutes ‘Company's arginal line of business and any subsequent changes Market and Competition Company's major business and market A Description of major projects Sales literature on products Growth potential of major markets in which company operates Name, size, and market position of principal competitors How does company’s product ifr from that af the competition? | Company's market niche formation on brand, trad, and product names Sales patter of product lines—that i, ae sales seasonal or cyclical? Review of any statistical information avaiable on the market—for example, trade association, ‘goverment reports, and Wal Street reports Comparative product pricing Sos promt margin on each product line (enayze sales growth and profit changes for three yeas) Concentration of government business Research and developrmentexpenltures-historcal and projected Sales and Distribution Few docs company sell-own sales force or through manufacturer representatives? Compensation of sales force Details on advertising methods and expenditures, | Details on branch sales offices, if any | Detaison standard sales tems, discounts offered, and retum and allowance palicies ‘Ae any sales made on consignment? Does company warchouse its inventory? i "company uses distributors, how are they pid, and what ae their responsibilities? (For example, do they prvide warranty services?) ‘Are company’s products distributed nationwide or in a certain geographie arcs? Continued460 CHAPTER 14 Voluation of Entrepreneurial Ventures Checklist for Analyzing a Business (Continued) Names and addresses of company’s principal customers Sales volume of principal customers by produc ine fr last few years How long have customers been buying from company? Credit rating of principal customers Historical bad-debt experience of company Details on private-label business, if any Do sales terms involve any maintenance agreements? bo sales tenms offer any express or implies warranties? Has company experienced any product liabity problems? Does company lease, a5 well as sel any ofits products? What is the pecentage of foreign business? How i this busines sold, nance, and delivered? Have any new peoducts come on the market that would make company's products obsolete or less competitive? Have any big customers been lost? 50, why? Size and nature of market—fragmented or contilled by large companies? Manufacturing Full ist ofall manufacturing fociies ‘Ae facilites owned or leased? ‘Does company manufacture from basic raw materials, ors it an assembly-type operation? Types and availabilty of materials required to manufacture the paduct Time length of production cle Does company make a standard shelf-type product, manufacture to specification, or bath? How is quality onteo! handled in the Facton? What isthe accounting system for work in process? Ae any licenses needed to manufacture product? \What isthe present sales capacity based on curtent manufacturing equipment? Does company havea propietary manufacturing process? what is company’s safety record In its factory operations? 1 any problems with OSHA or federal or state environmental regulations exist? What is stability of company’s supplier relationships? Employees Total number of employees by function ‘Does 2 union exist? If not, what f the probability of unionization? Ifa union exists, what have been its historical elations with company? Any strikes o¢ work stoppages? Details on local labor market Details on company’s wage and personne! policies Is employee level fixed or can workforce be varied easily in terms of business volume? What is company's historical bar turnover, especially in key management? Analysis of working conditionsAnalyzing the Business 487 -Anlyss of general emplayee morale | asthe company ever been cited fora federal volation—for example, OSHA, Pregnancy Discimination ‘et, Fa Labor Practices? What are fringe benefits, vacation time, sick leave, and so on? Physical Facilities st ofall company-used faites giving fartion. square footage. and east | Which Facilities are owned? Which leased? ‘Wat is present condition of all facts, including machinery and equipment? any faites are leased what are the details of expiration term, cost, renewal options, and so forth? ‘Are cutent facilities adequate for current and projected needs? Wil any major problems occur if expansion is needed? Is alequate insurance maintained? ‘Are facilities adequately protected against casualty los, such 2s fire damage, through sprinker systems, burglar alarms, or other measures? ‘Ae facies modern and functional for work process and employees? ‘Ae faces airconditioned and do they have adequate electric, heat, gas, water, and sanitary ‘ve Facilities easily acessible to required transportation? What is cost, net book value, and replacement value for company-owned buildings and equipment? Ovmership List of al current owners ofthe company’s comman and preferred stock, by clas if applicable List fal individuals ad the number oftheir shores exeresable under stock option and warrant agreements with pices and expiration dates Breskdown of ownership by shares and percentage: actual and pro forma [assuming warrants and ‘sock options exercised) | Does common stock have preemptive rights or lquidaton or dividend preference? 1o che shares carry an investment letter? ‘o vestitions on the transferability of the shares or n thee use as collateral exist? ‘00 any buylsell agreements exist? ‘oes an employee stack ownership plan or stock bonus plan exist? ‘ee the shares fly pai for? ‘re any shareholders agreements outstanding? Has any stock been sold below par or stated value? Does cumulative voting exist? [ith respect tothe principal owners stack, have any shares been gifted or placed in 3 trast? How many shares does the principal stockholder own directly and beneficially (including family)? ‘fall stock options and warrants are exercise wil the principal stockholder the company? Ifa business i being bought or soi, what percentage of the total outstanding shares is neeted for approval? still control 51 percent Continued462 CHAPTER 14 Valuation of Entrepreneurial Ventures Financial Three years of financial statements EB * Current ratio and net quick ratio + Net working capital and net quick assets 1 Total debt asa percentage of stockholder’ equity * Source and application of funds schedules ‘Analysis ofthe companys basic iquidty and turnover ratios + Cosh as a percent of curent liabilities © Accounts receivable and inventory tumovers * Age of accounts payable = Sales to net working capital '¥ company hos subsidiaries (or divisions), consolidating statements of profit and toss Verifeation ofthe cash balance and maximum and minimum cash balances needed throughout year "company owns marketable securities, whats ther degre of quit (ability) and curent market values? ‘Age ofall accounts and notes receivable, any customer concentration, and the adequacy of bd debt reserve Cost basis for recording inventories and any inventory reserves: age of mentory and relation to cost of sales turnover) Details onal fixed assets including date of purchase, original cost, accumulated depreciation, and replacement valve Current market appraisals onal fixed assets, real estate, and machinery and equipment ‘Analysis of any prepaid expenses or deferred charges a to nature and as to amortization in or ‘advance (0 affliates; comparison of tre value fo book valu; nana statements Personal financial statements of principal stockholders 'F company caries any goodwil o intangible items such s patents or trademarks, whats their ue value (to extent possible)? Does company have any intangible assets of value not carted on books (such 8s mailing lists in 2 publishing operation}? ‘Analysis of all curent lables, including age of accounts payable and decals ofall bank debt and lines of credit, including interest rate, term, and collateral loan agreements Details on all long-term debt by creditor, including loan agreement covenants that may affect future operations Do any contingent lilties r other outstanding commitments such as longterm supplier agreements exist? Details on franchise, lease and cayalty agreements Income statement accounts for atleast three years and analysis of any significant percentage variances, tha is, cost of sales as percent f sles Company tax retums—do they ifr from is financial statements? Which years stil may be open for audi? Three-year projection of income and cashflow for reasonableness of futuce sles and profits and to establish financing needs Pension, profit-sharing, and stock bonus plan for contractual commitments and unfunded past-servce lability costsEstablishing Firm's Value 463. Checklist for Analyzing a Business (Continued) Management Deteison all officers and drectors-length of service, age, business background, compensation, and fringe benefits COwreship positions: umber of shares, stock options, and warrants Simiar details on ather nonofficerinondeector key management Organizational chart ‘What conpennation-type Fringe benefits are offered 1 key management: bonuses, tient ‘stock bonuses, company-paid insurance, deferred compensation? What is management’ reputation in its industiy? Does management have any personal interests in any other businesses? Does it have anyother conflicts of interest? Docs key management devate 100 percent ofits time tothe business? ‘Any employment contracts—amount of salary, length af time, other terms Has key management agreed to a noncompete clause and agreed not to divuge privileged information ‘tained while employed with company? Establishing a Firm’s Value ‘After using the checklist ia Table 14.2, the entrepreneur can begin to examine the various methods used to valuate a business. The establishment of an actual value is more of an art | than a science—estimations, assumptions, and projections are all parr of the process. The ‘quantified figares are calculated based, in part, on such hidden values and costs as goodwill, personal expenses, family members on the payroll, planned losses, and ee like. Several traditional valuation methods are presented here, each using a particular approach that covers these hidden values and costs. Employing these methods will provide the entre- preneur with a general understanding of how che financial analysis ofa firm works. Remember, lls that many ofthese methods ace used concurrently and that the final value determination wil be the actual price agreed on by the buyer and seller Valuation Methods i ‘Table 14.3 lists the various methods that may be used for business valuation. Each method | js described and key points about them are presented. In this section, specific areention will the concentrated on the three methods that are considered the principal measures used in ceurrent business valuations: (1) adjusted tangible assets (balance sheet values), (2) price ccernings (multiple earnings value), and (3) discounted future earnings. ADJUSTED TANGIBLE BOOK VALUE ‘A common method of valuing @ business is to compute ies net worth as the difference between total assets and total liabilities. However, its important to adjust for certain assets in order to assess true economic worth, because inflation and depreciation affect the value cof some assets. In the computation of the adjusted tangible book value, goodwill, patents, deferred finane- ing costs, and other intangible assets are considered with the other assets and deducted from | or added to net worth, This upward or downward adjustment reflects the excess of the fair Il aass a Method Fired price Book value (anown as ‘balance sheet method) 1. Tangible 2. Adjusted tangible i Multiple of earings Pricefeaenings ratio (PIE) Discounted future eotnings (iscounted cash flow) CHAPTER 14 Valuation of Entrepreneurial Ventures [Seen eee ‘Methods for Venture Valu: Deseription/Explanation Two ar more owners st initial value Based on that ovners “think” business is worth Uses figures from any one or 3 ‘combination of methods Common for buyfsell agreements 1. Tangible book voive: Set by the business's balance sheet Reflects net worth of the fm Total assets less total liabilities adjusted or intangile asses) 2. Adjusted tangible book value: Uses tok value aporoach Reflects fai market value for certain assets Upwardfdownward adjustments in plant ‘and equipment, inventory, and bad deb reseres Net income capitalized using a price! earnings ratio (net income multiplied by PIE number) 158» capitalization rate often used (equivalent to a PE multiple of 67, which is 1 divided by 0.15) High-qrowth businesses use lower capitalization rate (9. 596, which fs 2 multiple of 20) ‘Stable businesses use higher eapitlization rate (204 108, which is 2 multiple of 10) Derived value divided by number of outstanding shares to obtain per-share value Similar to a return-on-investment approach Determined by price af common stack vided by after-tax earings Closely hel Firms must multiply net income bby an appropriate mulkpl, usually ‘ered from similar publily waded corporations Sensitive to mart conditions (prices of stocis) Attempts to establish future eamning power in eurent dollars Projects future eatnings (five years), caleulates present value using then sliscounted rate Based on projected “timing” of future Notes/Key Points Inaceuracies exist due to persnal tstimates ‘Should allow periodic update Some assets also appreciate or depreciate substantially thus, rot an accurate valuation ‘Adjustments in assets eliminate Some ofthe inaccuracies an reflect aft market value of each asset Capitalization rates vary 35 to ‘i's roth; ths, estimates or DIE used must be taken frm similar publicly traded corporation More common with pubic corporations Market contitions {stock ries) affet this ratio Based on premise that cash flow i most important fetar Effective method if (1) business being valued needs to generate a return greater shan investment and (2) only cash receiots ean provide the money fr ecowesting ingrowthEstablishing a Firm's Value 466, 14 | methods for Venture Valuation (Contioued) i Method Deseription/Exptanation Notes/Key Paints | Fetum on Net profit alivided by investment Will not establish a value for | investment (RO) Provides an earnings ratia the business | Need to calculate probabilities of future Does nat provide projected future ‘eanings earnings | Combination of return ratio, present value tables, and weighted i prbatiites| Replacement Based on value of each asset iit had to Useful fo sling a company that's vale be replaced at curent cost Seeking to break into 3 nev fine Firm's worth ealeuate as if building of business from “seateh” Falls to consider earnings potentiat Inflation and annual deprecation Does not include intangible assets of sssets are considered in easing (goodwil,gatents, and soon) the value above reported book value Does not reflect earning power of mangle assets Liquidation value Assumes business ceases operation ‘Assumes cach division of assets Sells assets and pays off abilities sold separately at aucion 1 Net amount after payment oF al abilities Effective in giving absolute bottom is distributed to shareholders value below which 3 fem shoul Retlets “bottom value” ofa fim liquidate rather than sll | Indicates amount of ney that | could be borrowed on a secured basis | Tends to favor seller since all assets are \olued a5 iF converted to ash | Excess earnings Bevelope by the US. Treasury t0 Method of last rsor if na other ‘termine 2 Fem's intangible assets method available) {for income tax purposes) Very seldom wsed Intent is for use only when no better | ‘method avaiable Intevnal Revenue Service refers to this method 35a last resort Method does not include intangibles with estimated useful lives (ie, patents, copyrights) Market value Needs 2 “knowa" price paid for @ Valuable only as 2 reference point ‘Similar hosiness Difficult to Find recent, smiar | DitRcult to find recent comparisons Firms that have been soe Methods of sale may dffer~instament versus cash | ‘Should be used only as a reference Point |466° CHAPTER 14 Valuation of Entrepreneurial Ventures : market value of each asset above or below the value reported on the balance sheet. Following is an example Book Value Fair Market Value Inventory $100,000 125,000, Plant and equipment 400,000 00.000 Other intangibles (60,000) $500,000 675,000 Excess = $175.00 Remember cha, in industry comparisons of adjusted values, only assets used in the actual operation of the business are included. Other significant balance sheet and income statement adjustments include (1) had clebt reserves; (2) low-interest, long-term debt securities; (3) investments in affiliates; and (4) loans and advances to officers, employees, or other companies. Additionally, earnings should be adjusted, Only true earnings derived from the operations of the business should be considered. One-time items (from the sale of a company division of asset, for example) should be excluded. Also, if the company has been using a net operational loss cacry forward, so its pretax income has not been fully taxed, this also should be considered, Upward (or downward) income and balance sheet adjustments should be made for any tsnusually large bad-debt or inventory write-off, and for certain accounting practices, such as accelerated versus straight-line depreciation. PRICE/EARNINGS RATIO (MULTIPLE OF EARNINGS) METHOD ‘The price/earnings ratio (P/E) is common method used for valuing publicly held corpota- tions. The valuation is decermined by dividing the market price of the common stock by the carnings pet share. A company with 100,000 shares of common stock and a net income of $100,000 would have earnings per share of $1. the stock price rose wo $5 per share, the P ‘would be 5 ($5 divided by $1). Additionally, since the company has 100,000 shares of com ‘mon stock, the valuation of the enterprise now would be $500,000 (100,000 shares % $5) ‘The primary advantage of a price/earnings approach is its simplicity. Howeven this advan- ‘age applies only to publicly traded corporations. Closely held companies do not have prices in the open market for their seock and ths must cely on the use of a multiple derived by comparing the firm to similar public corporations. This approach has four major drawbacks:* 1. The stock of a private company is not publicly traded. It is illiquid and may actually be restricted from sale (that is, not registered with the Securities and Exchange Com- ‘mission). Thus, any P/E multiple usually must, by definition, be subjective and lower than the multiple commanded by comparable publiely traded stocks. 2. The stated net income of private company may not truly reflect its actual earning Power To avoid or defer paying taxes, most business owners prefer wo keep pretax income down. In addition, the closely held business may be “overspending” on fringe benefits instituted primarily for the owner’s benefit. 3. Common stock thar is bought and sold in the public market normally reflects only a small postion of che business's cotal ownership. The sale of a large controlling block of stock (typical of closely held businesses) demands a premium, 4. Ie is very difficule to find a teuly comparable publicly held company, even in the same industry. Growth rates, competition, dividend payments, and financial peofiles (liquid- ity and leverage) carely will be the same. etEstablishing @ Fiem’s Value entrepreneurship Dusting Off Shelved Opportunities “he successful entrepreneur is always on the lookout for the next opportunity to seize. Some Lopportunitie ure mre evident than otters. For instance, when social networking became all the rage with the growing popularity of MySpace and Facebook, companies began to sprout up to offer various add-ons for both systems. Another example is the proliferation of accessory providers that followed the ‘success of Applt's Pods, iPhone, and iTouch. Although ‘Apple manufactures its own accessories, many off= ‘brand substitutes also have flooded the market. Motto device accessories and social notworking soplications are markets that developed as part of a growing social trend, both of which were movements ‘that were fairly abvious to the casual observer. Not sll ‘opportunities aro so easy to spat. Human nature is to ignore paths that havo beor previously dismissed, but ‘wih various economic farees constantly impacting the ‘environment, dsrogarding opportunities simply because usly considered is shortsighted they were prov ‘The ail industry presents a recont exemple of 2 market that has been opened to opportunities that were long forgatten,oferng challenges and, in tum, significant potential orbohestablished companies and star-ups. The ‘wo areas that have recently become popular are tar sands ‘and ol shale. Th fist oquies significant cost due to the state in which tt ail is racovarad, asa thick starry of tar and sand: th sacond also raquirs an expensive process to cover tho of as result of it boing trapped in rock. The required capita or both processes is what led companies tosis the reserves however as aresultof the sein the price of al they have become Finacial viable to pursue ‘The tar sands aro naw boing heavily sourced, but companies have bean slower ta pursue ail shale due ta the energy roquirod to heat the rock and extract ‘ne ol The Green River Formation is 17,000 syua nile stretch ofa pretistric riverbed that hols approximately {00 bilion barrels of recoverable oil, which is wipe the amount of Saud Arabia's reserves. This unconventional reserva, arguably the largest on the planst, presents «significant prize forthe company able to develop an ‘operationally officiont method to recover the ol, Royal Dutch Sill belies Unt it as crave the cous, ‘One of Shell's seientistshasengineered:tochnolagy ‘hat wil profitably exiract the oil from the shale as long ts the prieg of oil atoys ot 690 a borrel or highor. By 2000, the company is estimating it can produce 2 milion barrels @ day, The United States currently consumes 21 milion barrels daly, so the reserve would not lead to the country becoming slf-sufficint in rospaztto is fuel heads; however, the raserva woul alleviate some of the Fisk and reduce the premium currently charged for cil domestically due to international instability ‘Shell has fled more than 200 patons for recovering the ol shale and has begun te process of winning pubic approval for staring the process of diversifying the ‘country’s oil supply through oil shale. Unite other cil reserves, such as those found in Alaska, tho company projects thatol shale could support consistent: production {for hundreds of years. Shalls technology, known as the In Situ Conversion Process (ICP roquicas the company 1 dal 1 800-foot wells, insorthoating rads, ad raise the tamporsture ofthe shele to 850 dagraes Fetwenhet. The ‘company has spent 28 years and $200 ion exploring ‘the potential for oil shale, despite its competitors abandoning similar efforts and the market orci, unt recently, being unable to support the costs incurred. ‘Where other companies have filed, Shell has found an environmentally friendly, financially feasible method for praducing high-grade oi from ail shale, The elimbing price of ell was necessary for Sholl's invastnont to pay of; yet its commitment has led other conpanies to rovisit en opportunity they abandonad decades before. Shel’ foresight—along with a favorable market-—has positioned the company as the leader in a venture that coul! generate $2.2 blion in annual pretax profits 4 300,000 barrels a day and as much ws $2 bilin at $3 million barrels a day. Oil shale's revenu> potential, prawsn theough Shell's efforts. has forcad companies to rethink thei strategic positions in oréor to remain compstitve. Sonne: Adapted from Jon Binge, “Oil Shale May Fialy Havel Momeat” Forte, Noversber 1, 2007, bp! [Link] 2007/10 30ireagunestortune/O_ from Stone fortunes. tum (aceste’ Apo 9, 2008) 487468 CHAPTER 14 Veluation of Entrepreneurial Ventures ‘When applied to a closely held firm, the following is an example of how the mulkiple-of- earnings method could be used: Shares of common stock = 100,000 $100,000, 15% capitalization rate assumed = 6,7 price/earnings multiple (derived by dividing 1 by 15 and multiplying the result by 100) Price per share = $6.70 100,000 x $6.70 = $670,000 2010 nee income Value of company DISCOUNTED EARNINGS METHOD ‘Most analysts agree that the real value of any venture is its potential earning power, The discounted earnings method, more than any other, determines the firm's true value, One example ofa pricing formula that uses earning power as well as adjusted tangible book value fs illustrated in Figure 14.2 ‘The idea behind discounting the firm’s cash flows is that dollats earned in the future (based on projections) are worth less than dollars earned today (due to che loss of purchasing Power). With this in mind, the “timing” of projected income or eash flows is a critical factor “Entrepreneurial Process: What Is This Venture Worth?* provides a step-by-step exam ple of the process of discounting cash flows. Basically, the method uses a fourstep process: 1. Expected cash flow is estimated. For long-established firms, historical data are effective indicators, although adjustments should be made when available data indicate that future cash flows will change. 2. An appropriate discount rate is determined. The buyer's viewpoint has to be con- sidered in the calculation of this cate. The buyer and seller often disagree, because each requires a particular rate of return and will view the risks differently. Another point the seller often overlooks is that the buyer will have other investment oppor. {tunities to consider. The appropriate rate, therefore, must be weighed against these factors. 3. A reasonable life expectancy of the business must be determined. All ficms have a life cycle that depends on factors such as whether the business is a one produetlone mars ket or multiproduct/multimarker, ‘4. The firm's value is then determined by discounting the estimated cash flow by the appropriate discount rate over the expected life of the business.” Term Sheets in Venture Valuation ‘Whenever investors are examining a venture for potential infusion of capical, the value of the venture comes into play. This always involves what is called the term sheet. This docu ment outlines the material terms and conditions of a venture agreement. After a term sheet hhas been executed, it guides legal counsel in the preparation of a proposed final agreement Ie then guides, but is not necessarily binding, the final rerms of the agreement, ‘Term sheets are very similar to letters of intent (LOI) in that they are both preliminary, ‘mostly nonbinding documents meant to record two or more partes’ intentions to enter inte 2 future agreement based on specified (but incomplete ot preliminary) terms, Many LOIs, however, contain provisions that are binding, such as nondisclosure agreements, a covenant to negoriate in good faith, or a *stand-still” provision that promises exclusive rights to negotiate, eg‘Term Sheats in Venture Valuation 469 A Traditional Pricing Model The allowing step-by-step process outines the traditional pricing formula used when calcuting the value of a business: | ‘Step 1. Determine the adjusted tangible net worth of the busines. The total market value of al eurrent end fong- term assets les abilities) Step 2._ Estimate how much the buyer could earn annually with an amount equal to the value of the tangble net wort invested elsewhere Step 2. Ad to ths 2 salary normal for an owner-operator ofthe business This combined figure provides a reasonable 1 tetnate ofthe incur the buyer can cat chalice with the investment and effort involved in working in the business, Step 4 Determine the average annual net earnings ofthe business [net profit before subtracting owner’ salary) over the pat fe yea Tis is before income taxes, to make it comparable with earings from other sourees or by indniduals in ctiferent tax brackets, (he tax implications af aterative investments should be carefully considered) This tend of earings is a key factor Have they been rising stesdiyflling steaiy, remaining constant, oF ‘huetuatng widely? The earnings figure should be adjusted to reflect these trends. Step 5. Subtract the total of earning power (2) and reasonable salary (3} fom this average net earnings figure (4). ‘nis gives the extra earning power ofthe business. Step 6. Use this extra earnings figure to estimate the value ofthe intangibles, This is done by multiplying the extra camings by what is termed the "years-of-proft igure “This "years-of- profit multiplier pivots on these points. How unique are the intangibles offered by the firm? How long would i take to set up a similar business and bring it to this stage of development? What expenses A and risks woul be iavolved? Whit i the pice of goodwill in sila fms? Will the seller be signing an | fagecement witha covenant not to compete? H If the busines ie well-established, a factor of five or more might be use especially ifthe firm has a valu able name, patent, of location, A multiplier af three might be reasonable fr a moderately seasoned firm. A younger but profitable fim might merely have a one-year profit figure ‘Step 7._ Final price equals adjusted tangible net worth plus value of intangibles extra earnings times “yeas of profit’) Example Enterprise X___ Enterprise ¥ | 1. Adjusted valve of tangible net worth fsses Tess Habits) 7,000,000 72,000,030 | 2. Earning power at 8 of an amount equal to the adjusted tangible net worth if invested in a comparable risk business 160.000 160,020 23, Reasonable salar for wmner-operator in the business 0000 50,020 4, Net earnings of the business ove recent years (net profit before subtracting avner’ salary) 255.000, 209000 5, Extra caring power ofthe business line 4 minus ins 2 and 3) 45,000, (1,000) 6. Volue of intangibles—using three-year pei Figure for moderately well-established frm (3 times line 8) 9 1 Final price (lines 1 and 6) 2,135,000 2,000,000 (or less) With Entreprise X the seller receives a value for goodwill because the business is moderately well established and catning mare than the buyer could ear escwnere with sila risks and effort. With Enterprise Y, the seller receives no value for goodwill because the business even though it may have | existed for a considerable time, isnot earning as much as the buyer could through outside investment and effort Intact, the buye” may fee! that even an investment of $[Link],uU0—the current appratsed value of net assets—is too much because it cannot earn sufficient return “This isan aviary gc, ued fo illtration. A easonable igre depends on dhe stability and rativ sks of the business | od he investment peare genes The ae of reurn shold be sna that which coulé be cama elsewhere wi the same prensa sk470 CHAPTER 14 Valuation of Entrepreneurial Ventures the entrepreneurial What is This Venture Worth? en looking at a venture you wish to acquire, you will do the follawing 1, Present the met cash-flow projections for this business for five years (2010 through 2014) 2. Change the format for presenting the data (you may find it easier to use 3. Use a present value rate of 24 percent. Assume you have an opportunity to buy 2 small Aivision ofa large company. Because you know the business intimately, you ean accurately forecast tha companys gromth. Fight now is not profitable, but with your expontise and plans, you expect that ean sgenerote $340,000 net cash flowy aver five years and have e value (not worth| of $400,000 atthe end of year ive, The $380,000 net cash ow is after al cash curls} Question Because you want to earn a minimum annual rtuen of 24 percent an your investment {that is, the purchase price), how much should you pay forthe division? Hora are the facts: Assume thatthe aequisiion will occur on December 31, 2010, and the projected annual net cash flow {the excess of all cash inflow over al cash ‘outflow laos ie this: 1020112012 2013 2014 Neterh $0 $40 «$80 «S110_—S150 flow (thousands) Answer Because you want en annual return of 24 percent on your money, simply compute tha present value of the projactod not cash-flow stream. You alsa must compute the value of the $400,000 nat worth positon (projactod assets less labiltes) at the end af ‘year ve Referring to present value tables in financial hhendbooks (or using a calculator), you ean obtain the following date: Present Value Factor All thats needed now isto prepare table showing the net cash flows for the five-year period. You thon ‘nultipy the present value factor fora 24 percent return) by the na cash flow for each year Present Net Value Today's Cosh Flow Factor Value 2010 30 Ome 30 on 4oo00 sso 26,000 212 80000 0526 41920, 2013 wooo aaa. 46530 2ove ssoar 341 187,560" Totals $780,000 $302,000 AAs computad, the total velue ofthe projected net cash-flow stream is $302,000 today—and this includes the projectad $400,000 net worth atthe end af year five. In otor words, i the division were pucchased today for its nat cash-flow velue of $302,000, and ifthe projected cash flows forthe five years wore ganerated {including the projected net worth valu of $400,000), you ‘would realize 824 percent snaual rate of retum on your ‘$802,000 investment over the five-year period strcedes $150,000 net sh lw and $400,000 net worth of Avision ate ef fit yer SonnceThowas |. Martin, Vsbuion Rafrence Maa {tickvile, N¥ Thomar Publication, 1987), €8, Figures opdated, 2008.‘Term Sheets in Venture Valuation ‘The purposes of an LOI may be © To clarify the key points of a complex transaction for the convenience ofthe partes + To declare offically that the parties are currently negotiating * To provide safeguards in case 2 deal collapses during negotiation ‘The difference berween a term sheet and an LOI is slight and mostly a matce: of style: An LOI is typically written in letter form and focuses on the intentions; a term sheet skips most of the formalities and lists deal cerms in bullet-point format. To help clarify the concepts of tec sheets in the valuation process, we present the following terminology that is common in these documents. Price/Valnation The value of a company ie what diver the price javertore will pay for & piece of the action, The information used to determine valuation comes out of the due diligence process and has to do with the strength of the management team, market potential, che sustainable advantage of the product/service, and porental financial returns, Another way to look at valuation is how much money it will take to make the company a success. In the end, the value of a company is the price at which a willing buyer and seller ean complete a eeansaction, Fully Diluted Ovmnership and valuation is typically calculated on a fully diluted basis, ‘This means that all securities (including preferred stock, options, and warrants) that can result in additional common shares are counted in determining the tocal amount of shares outstanding for the purposes of determining ownership or valuation. ‘Type of Security Investors typically receive convertible preferred stock in exchange for making the investment in a new venture. Tis type of stock has priority over common scock ifthe company is acquired or liquidated and assets are distributed. The higher priority ofthe preferred stock justifies 2 higher price, compared to the price paid by founders for common stock. Convertible means that the shares may be exchinged for a fixed number of common shares, Liquidation Preference When the company is sold ot liquidated, the preferred stock- holders will receive a cectain fixed amount before any asses are distribuced tothe com- smon stockholders; this is known as liquidation preference. A participating preferred stockholder not only will receive te fixed amount but will also shaze in any additional amounts distributed 9 common stock Dividend Preference Dividends are paid first co preferred stock and then to common stock. This dividend may be cumulative, so that it accrues from year to year until paid in fall—or noncurnulative and discretionary. Redemption Preferred stock may be redeemed oF setire either atthe option of the company or the investors, or on 4 mandatory basis—frequenty at some premium over the initial purchase price of the stock. One reason why venture firms want this right is due to the finite life of each investment partnership managed by the firm Conversion Rights Prefered stock may be converted into common stock at certain conversion price, generally whenever the stockholder chooses. Conversion may also hhappen automatically in response to cectain events, such as when the company ‘goes public Antidilution Protection The conversion peice of the preferred stock is subject to adjustment for certain diluting events, such as stock splits or stock dividends; this is ‘sow ap aici proteuion, Te conversion price fs eypleally subject to price protection, which isan adjustment based on futuce sales of stock at prices below the conversion price. Price protection can take many forms. One form i called ratchet protection, which lowers the conversion price to the price at which any new stock is Sold no matter the number of shares. Another form is broad-based weighted average protection, which adjusts the conversion price according to a formula that incorporates the namber of new shares being issued and their price. In many cases, a certain number of shares are exempted from this protection to cover anticipated assurances to key employees, consultants, and directors. an472 CHAPTER 14 Valuation of Entrepreneurial Ventures Voting Rights Preferced stock has a number of votes equal tothe number of shares of common stock into which it is convertible, Preferred stock usually has special voting rights, such asthe right to elect one or more of the company’s directors, or to approve certain types of corporate actions, such as amending the articles of incorporation or creating a new series of preferred stock. Right of First Refusal Holders of preferred stock typically have the right ro purchase additional shares when issued by the company, up t thei current aggregate ‘ownership percentage. Co-Sale Right Founders will often enter inco a covsale agreement with investors. A co-sale right gives investors some protection against founders selling their interest to a third party by giving investors the right to sell some oftheir stock a5 pare of such a sale, Registration Rights Registration rights are generally given to prefeced invesors as pact of theic investment. These rights provide investors liquiity by allowing, them to require the company to register their shares forsale to the public—either as part ofan offering already planned by the company (called piggyback rights) or in a separate offering in tinted at the investors’ request (called demand rights), ‘Vesting on Founders’ Stock A percentage of founders’ stock, which decreases over time, can be purchased by the company at cost if founder eaves che company. This protects investors against founders leaving the company afer it gets funded." Additional Factors in the Valuation Process After reviewing these valuation methods, the entrepreneur needs to remember that addi tional factors intervene in the valuation process and should be given consideration. Presented next are three factors that may influence the final valuation of the venture. Avoiding Start-Up Costs Some buyers are willing to pay mote for a business than what the valuation methods illustrate 'ts worth tobe. This is because buyers often are trying to avoid the costs associated with start-up and are willing to pay a litle more for an existing firm. The higher price they pay willbe stil less than actual start-up costs and also avoids the problems associated with working to establish clientele. Thus, for some buyers a known commodity may command a higher price. Accuracy of Projections The sales and earnings of a venture are always projected on the basis of historical financial and economic data, Short histories, fluctuating markets, and uncertain environments are all ceasons for buyers to keep projections in perspective. Iris critical that they examine the trends, fluctuations, or patterns involved in projections for sales revenues (higher prices or ‘more customers?), market potential (optimistic or realistic assumptions?), and earnings potential (accurate costrevenue/market data?), because each area has specific factors that need to be either understood or measured for the accuracy of the projection, Control Factor ‘The degree of control, or control factor, an owner legally has over the firm can affect its valuation. Ifthe owner’ interest is 100 percent or such that the complete operation of the firm is under his or her influence, then that value is equal to the enterprise's value. If the ‘owner docs not possess such control, then the value is less. For example, buying out a 49 percent shareholder will nor be effective in controlling a $1 percent shareholder. Also, ‘two 49 percent shareholders are equal until a 2 percent “swing vore” shareholder makes & move. Obviously, minority interests also must be discounted due to lack of liquidicy—a ‘minority interest in a privately held corporation is difficult to sell. Overall, ris important 40 look at che control factor as another facet in the purchase of any interest in a firm. Senosummary “ Hersective If Dubai Can Do It... ote bigest tings happening in the (iit tie ren mien Setlpmert of Dba ema cy stat that seed ist ty baling an iteration prt 2s nell a5 highepied,highess ote ond Sherine venues sft had ran oto Toe tor ttey tat Dia! enbrced toed it at tnt to sabe exon tt fs lonensy become’ an sper on artectve and aban Gevlopmet ns male as eo dre Beng etd ro serves to othe cots Bi of min sr sping to bul the nes Do Fest woidconanits plain biting on sar Seto te oes cet conten Due ave dio stcted the stance os develope The secesof Dal ema nore saiacuar by tener spect ean parr talon start, Wes pete ich rego ining Sut fbi Abo Dot od Kita Sn canparos Dubie sbendned he wet srategy aster by pomingfosoing mee ott hos orained hon te Bu Aa, he sit tt fecha as cope Ta shred anew perfor, More imestnor lowe th omgatn ee tl th toch pet tom eqvly fot ate wxreveyom Geuneres nck Ager, Vetam, neni sd Senapl hove ited Dube develops te amine Sto ttc eres summary Ino Key to Uubars success is its raler, Sheikh Mohammed bia Rashid Al Maktoum, Despite the successful umaround that he has menaged to produce in Dubai, he reaizad that tho only way forthe emirate to continue to grow was for his largest davelopment companies—namely, Dubei Holding, Dubai World, and Emaar Properties—to diversity their slintola by offering their services tothe word. He understood that expanding the businesses outside of Dubsi not only ‘would ensure that they would be able to hedge against ‘th inovtable slowdown in Dubafs massive cevelopment forts, butslso would guarantoo thatthe word continued to view Dubsi as a modo to emulate, The companias are selling nothing les than the Dubai-fcatan af the globe, ‘which involves applying a simple formula: Run 2 country’s por, establish free-trade zonesto encourage commerce, ‘and build lnxury hotels wth residential properties nearby ‘tw esteblsh a stable esonamy. Dubai is 2 testament to the ability of an orgenization—in ths case, ¢region—to invent let Change fs raraly aasy, espacially whon it involves completely restructuring an establishment; howovey, ‘management bears the burden of knowing whon the ‘existing strategy must be abandoned in erdar for the compen to survive end prosper Source: Adapted fom Berney Gina, Searching fr the [Next Da” Bortuns, Feoeunry 22, 2008, bpumeneyison «om/200802/20faewsfnsenationa/Dub. dbcutortued index (acested Ap 9, 2008), Entrepreneurs need to understand how to valuate a business for either purchase or sale, ‘Many would like to know the value of theie businesses. Sometimes this sirietly for infor- ational purposes, and other times it is for selling the operation. In either case, a number of ways of valuing an enterprise exist. araATA CHAPTER 14 Valuation of Entrepreneurial Ventures ‘The first step is to analyze the business's overall opecations, with a view to acquiring a com- prehensive understanding of the firm’s strong and weak points. Table 14.2 provided a checklist for this purpose. The second step is to establish a value for the firm. Table 14.3 set forth ten ‘methods for the valuation of a venture. Three of the most commonly used are (1) adjusted tan. Bible assets, (2) price/earnings ratio (muliple of earnings), and (3) discounted future earsings, ‘The adjusted tangible book value method computes the value of the business by revalning the assets and then subtracting the liabilities. This isa fairly simple, straightforward process. ‘The pricelearnings ratio method divides the market price of the common stock by the earnings per share and then muleplies by the number of shares isued. For example, a company with a pricefearnings multiple of 10 and 100,000 shares of stock would be valued at $1 millon ‘The discounted earnings method takes the estimated cash flows for a predetermined num- ber of years and discounts these sums back to the present using an appropriate discount rate ‘This is one of the most popular methods of valuing, a business. Other factors to consider for valuing a business include start-up costs, accuracy of projections, and the control factor, Key Terms and Concepts adjusted tangible book value divergent goals liquidation preference antidilution protection due diligence pricelearnings ratio (PIE) emotional bias fully diluted letter of intent (LOT) business valuation term sheet control factor uundercapitalization discounted earnings method Review and Discussion Questions 1. Identify and discuss the three underlying isues in 5, Explain how the pricelearaings ratio method of the evaluation of a business, 2. Define the term due diligence. How is it applied {0 the acquisition of an existing venture? 3. To analyze a business, what types of questions or concerns should the entrepreneur address in the following areas: history of the business, market and competition, sales and distribution, manage ment, and finances? 4. One of the most popular methods of business valuation is the adjusted tangible book value. Describe how this method works, Experiential Exercise valuation works. Give an example. ‘What are the steps involved in using the discounted earnings method? Give an example. 7. How do the following methods of valuing a venture work: fixed price, multiple of earnings, return on investment, replacement vale, Ii tion value, excess earnings, and market value cach case, give an example. 3. Explain why the following are important factors to consider when valuing a business: start-up costs, accuracy of projections, degree of control. WHAT WOULD You RECOMMEND? Jane Winfield would like to buy Ted Garner's company. She has conducted a detailed finan ial analysis of Ted's firm and has determined the following: 1, Book value of the inventory: $250,000 2. Discount rate on furure earnings: 24 percent 3. Book value of the plant and equipment: $150,000Case 14.1 case 14.1475 |. Fair market value of the inventory: $400,000 market value of other intangibles: $60,000 ‘Number of shates of common stock 100,000 . Fair market value of the plant and equipment: $400,000 3. Pricelearnings multiple: 9 . Book marker value of other intangibles: $30,000 10, Estimated earnings over the next five years: Year 1 $200,000 Year2 300,000 Year 3 400,000 Year 4 500,000 Year S 600,000 Based on this information, how much should Jane valuate the business accerding to each of the following methods: adjusted tangible assets, price/earnings ratio, and discounted future earn- 1g? Based on yout findings, recommend the valuation method she should use. Finally, given all, of your calculations, estimate what the final price will be. Give ceasons for this estimate. Enter your answers here. a) Adjusted tangible asets valuation: b)Price/earnings valuation: o a Discounted furure earnings valvation: Final sales price: A VALUATION MATTER ‘Charles Jackson has always been inteested in determinin started the operation 1 value of his small business, He years ago with $1,500 of savings, and since then it has grown into a firm thar has 15 employees and annval sales of $1.88 million. (Charles has talked to his accountant regarding methods that can be used in valaing his business. tis accountant has briefly explained two of chese to Charles: adjusted tangible book value and discounted earnings. Charles has decided to vse both metho in arriving ata valuati Following, the information he has gathered to help him use both methods: Adjusted Assets and Total Liabilities Estimated Ear Total lables '$700,000 After revaluation Inventory 600.000 Plant and equipment 400000 Other assets 100,000 Charles also believes that it i best ro use a conservative discount rate. He has settled on 24 percent.476 CHAPTER 14 Valuation of Entraprengurial Ventures Questions 1, Using the adjusted tangible book value method, what is Charles's business worth? Show your calculations 2. Using the discounted earnings method, what is Charles's business worth? Show your calculations 3. Which of the two methods is more accurate? Why? Case 14.2 WHICH WILL IT BE? Georgia Isaacson and her son Rubin have been thinking about buying a busines. After talking to seven entrepreneurs, all of whom have expressed an interest in selling their operations, the Isaacsons have decided to make an offer for a retail clothing store. The store is very well located, and its earnings over the past five years have been excellent. The current owner has told the Isaacsons he will sell for $500,000. The owner acrived at this value by projecting the earnings of the operation for the next seven years and then using a discount factor of 15 percent ‘The Isaacsons are not sure the retail store is worth $500,000, but they do understand the ‘method the owner used for acriving at this figure. Georgia feels that since the owner has been in business for only seven years, ic is unrealistic ro discount seven years of futuce earnings. A five: year estimate would be more realistic, in her opinion. Rubin feels thatthe discount factor is too low. He believes that 20 to 22 percent would be more realistic. In addition to these concerns, the Isnacsons feel they would like to make an evaluation of the business using other methods. In particular, they would like o see what tte value ofthe company would be when the adjusted tangible book value method is employed, They also would like to look at the replacement value and liquidation value methods. “We know what the owner fels his business is worth,” Georgia noted to her son. “However, ‘we have to decide for ourselves what we think the operation is worth. From there, we can negoti ate a final price. For the moment, I think we have to look at this valuation process from a number of different angles, QUESTIONS 1. If the owner reduces the earnings estimates from seven to five years, what effec will cis have on the final valuation? If he increases the diseoune factor from 15 pescent to 20 to 22 percent, what effect will this have on the final valuation? 2. How do the replacement value and liquidation value methods work? Why would the Isaac- sons want to examine these methods? 3. Ifthe Isaacsons conclude that the business is worth $410,000, what will be the final selling price, assuming a sale is made? Defend your answer, Notes 1, See for example, W. G. Sanders and S, Bovie, 2. “Acquisition Srateges~Part 1,” Small Business “Sorting Things Out: Valuation of New Firms in Reports (January 1967) 4. Reprinted ith Uncertain Matkets” Strategic Management Journal peimision from Small Business Reports; sc also 25, no.2 (February 2004) 167-26; and Saat Laurence Capron, “The Long-Term Perfomance of Chaudhuri and Behnam Tabs, "Capturing the Real Horizontal Acquisitions.” Strategie Management Value in High-Tech Acquisitions” Harsard Business Tournal (Naverber 1995): 987-1018. i Review (September/October 1995}: 123-30, SS EEE3. ‘Valuing a Chsely Weld Business," The Small Business Report (Novernber 1986}: 30-31; see also Hal B, Heaton, “Valuing Small Businesses: The Cost of Capital” Tie Appraisal Journal (Ianuary 1998): 11-16; and Alan Mitchel, “How Much Is Your Company Really Worth?” Management Today anuary’ 1999): 68-70, 4, For additional insights, se Ted S. Front, “How t0 Be a Smart Buyes” D &t B Reports (Marel/April 1990) 56-58; and A fred Rappaport and Mark. Sirower, "Stock oF Cash? The Trade-Ofs for Buyers and Seiers in Mergers ani Acquisitions." Harvard Business Review (NovenbeeIDecember 1998): 147-58, 5. Gary RTrugnan, Understanding Business Valuation: A Practical Guide to Valuing Small fo Medium-Sized Businesses (New York: American Institute of ‘Ceried Public Accountants, 1998); Pricer and Alee C. Johnson, “The Accuracy of Valuation Methods in Predicting the Selling Price of Small Fis," Journal of Sruall Busiress Management 435, no. 4 (October 1997}: 24-35: see also Wayne Lonengan, The Valuation of Businesses, Shares and Other Equity (Australia: Allen & Unvin, 2003). ‘Adapted from Albert N, Link and Michael B. Boger, The Art and Science of Business Valuation (Westport, CT: Quorum Books, 1999 "Valuing a Closely Held Business” 34 Just 2. camp, Venue Capital Due Ditignce New ‘York: Wiley & Sons, 2002}; se also John B. Vinturella and Suzanne M. Erickson, Resing Exbepronerial, pita urington, MA: Eisevier, 200 arr