My name is Karl Ulrich, I'm a professor at the Wharton school. And this session is on Equity Financing: Valuation. I want to start with a story. I'm an investor in a start up called Wholly Moly! And Wholly Moly takes organically grown oatmeal sourced in the United States and sells it in China where the Chinese consumer is very concerned about food safety. Wholly Moly was started by a former student of mine named Claire. Claire and her childhood friend, Shui Shui, started this company. Now, Claire had been my student but Claire and I had become friends. In fact, she had guided me around China on two separate occasions. I actually introduced her to her husband and I spoke at their wedding. So, I really consider Claire to be a friend. Claire then asked me if I would be interested in investing in Wholly Moly. And that caused our relationship to take an entirely different turn because now we had to focus on business. So this image shows a dinner we had in San Francisco with her two first investors me and Don. And we're shown here with Claire and Shui Shui. And we're all smiling here at this dinner but this was a pretty tense dinner because we had to focus on the question of, if I invest my hard earned cash in your business, what do I get in return? That's the essential question we face in valuation, how do we decide what the company is worth? Now value, as any real estate agent will tell you, is simply defined as the price of a transaction between a willing buyer and a willing seller. Value is what someone will pay for something and usually in the context of entrepreneurship, the transaction is between an investor who is providing cash and the entrepreneur who's giving up a share in his or her company. So, that's the transaction that defines value. And in any specific case, valuation or value of the company is defined through a negotiation. It's basically a horse trade, you and the other party are trying to agree on a price for something that's very hard to quantify. Now, ideally the negotiated value would reflect something about the fundamental cash flows that that business would generate over a long time period. I mean that's after all what we care about in determining financial value. But the problem is, that we're trying to establish this value when there's a lot of uncertainty before we've even really built the business. And so valuation, in this context, is really based on some beliefs about the future, what we believe the business can be out in the future, given all of that uncertainty. Why do you even need to establish the value of a business or establish a valuation for your company? Well, you don't really ever need to do it until you need to raise some money, until you need to sell some portion of that company for cash. And that's usually in the context of the initial financing that's required to get the business going. Now of course, once you're successful, and once your business is established, you may be interested in selling that business entirely to a third-party, and that's the other setting in which you need to establish a value, set the valuation for the business. And to be even more precise the investor is typically asking the question, if I invest a certain amount of money, let's say $10,000 or a $100,000, what fraction of your company do I get in exchange? That's the fundamental question we're trying to establish, or trying to answer, with valuation. Before we get into the details I want to review two terms, pre-money and post-money valuation. Pre-money valuation, which I'll call X, is the value of your business before you take the investment. So, let's just say for example that you establish a value for your business on a pre-money basis of 1 million US dollars. Post money valuation is what your business is worth after the investment. So, let's imagine that an investor provides $100 thousand in capital. After the investment, you have what you started with. The $1 million in company value plus you have $100 thousand in the bank. And so your company must be worth $1 million plus $100,000 or $1.1 million, that's the post money valuation why? So, if we want to understand what the investor owns after the investment, we think about the investor providing $100,000 in cash divide that by the post money valuation, or $1.1 million. And that fraction is one eleventh, and so the investor providing $100,000 on a pre money valuation of $1 million. Results in the investor owning one-eleventh of the company or about 9.1%. So again, pre-money valuation is what the company is worth before the investment. Post-money valuation is simply the pre-money valuation plus the value of the cash invested. And the ownership's stake of the investor is defined as the cash divided by the post money valuation. I want to just point out that it's in everyone's interest to estimate the value accurately. Some people might think, well gee, as the entrepreneur I'd like to have as high a valuation as possible so that I give away as little of my company as possible for the amount of cash invested. But that's not such a good idea because if your valuation is too high then your investor won't make a good return. That's not fair first of all, but it's also not good for you and your reputation. The other thing is that if you set your expectations too high, if you set in effect a price that's too high for your company, you won't be able to attract the investors of the type that you'd like. On the other hand, if your valuation is too low. That's not good for you, of course, because you've given away a lot of your company. But it's also not good for the investor because it doesn't leave you with enough ownership that you have a strong incentive to make the business a success. So, you and your investor both want this estimate to be as accurate as possible. And that's really the reason to treat this exercise quite seriously as you're thinking about raising money. There are four approaches that I've used in establishing valuation and I want to just to through those approaches. The first is, that you can look at what the inputs cost. That is, what would it cost to replicate what you've created to date? The second approach is, to compare your company to other similar companies, and to other transactions, fund raising transactions, those companies have entered into. The third approach is that you can discount for time and risk from some estimate of future value, and I'm going to go through each of these with some examples. And then the fourth approach you could take is you can apply a multiple to the actual earnings of the company, either the earnings or the revenues. But remember, this is ultimately a negotiation between you and an investor. And so you should think of these approaches as just ways to calibrate your intuition to prepare you for that negotiation. Most of the time in the transactions I've been involved with, I've actually used at least two of these and usually three of these different methods. In order to triangulate on an estimate of value, to really just to inform my intuition going into a negotiation. Okay, so let's look at these four methods. The first is that you could look at the value of the inputs. And the way to think about this is what would it cost for someone to recreate what the entrepreneur has to date. And the reason that's important is if, if it wouldn't cost very much for somebody else to create what you've done, then it's not really fair to ask for some huge premium over that cost. To ask the investor to pay something premium over that cost, because the investor would just say, well, why don't I just start from scratch, find some other entrepreneur who could get to where we are today at lower cost. So let me give you an example. Let's imagine that you're very early in your start up and you've put in about six months of full time effort with a partner, so you've put in together, the two of you have put in, six months each for about 12 months of human effort. And let's say you're a recent college graduate, you might have earned $100,000, actually, that would be quite an impressive salary after graduation, but let's just say, you could have earned, the two of you together working six months could have earned $100,000. Second, let's say you require some cash for the initial expenses to get started, and let's say that's $25,000. Third, let's say you've committed to work for the next six months with no salary. The two of you have committed another year of human effort, and let's value that at $100,000. And lastly, let's put some value on the idea, itself. Now let's imagine this is a fairly simple idea for a business, it's not like some new patented molecule or something like that. And let's just put a value of $25,000 on the intellectual property. If we add up the value of those inputs, then we get $250,000 in total value, and that's what I mean by starting with what would it cost to replicate what you've got here today. Now let's imagine that an outside investor provided $25,000, provided that cash that you needed to get started. Under that logic, the investor would own 10% of your business, using the value of the inputs as the method of value in the company. Now, the problem with this approach is that it doesn't really account for the fact that the entrepreneur might have resolved a bunch of uncertainty, might have gotten lucky with this business idea, might have considered three or four other businesses before settling on one that eventually worked. And so, in some ways, it doesn't account for the fact that the entrepreneur whose gotten this far has actually resolved quite a bit of risk and uncertainty associated with the opportunity. However, this first approach is quite useful, particularly in very early stage investments, and when you don't really have much, you've just started with some inputs of labor, capital, and maybe an idea. So it's a good calculation to do. It probably would be considered a low estimate for the value of the company. The second approach you can take to valuation is to base your valuation on comparable deals. Now you have to have some data in order to do that. And there are a variety of data sources on the Internet and in reports on venture transactions. You could also ask around, get a few data points for your region and for your industry. Shown here, is some data that was put together by a prominent law firm in Silicon Valley called Wilson Sonsini. And, shown here is the pre-money valuation and the amount raised for all of the transactions that they handled that involved less than $2 million, of capital raised. And what you'll see here is that the valuation varies by sector. So, consumer hardware is going to be different from software. And healthcare pharmaceuticals will be different from consumer products or Internet commerce. And so, but for instance, software companies here, show there's a pre-money valuation of about $4 million for companies that are raising about $1 million in capital, and so if you're a software company, and you're in Silicon Valley, and you're raising capital, the, you could use this data to argue that comparable companies are valued at a pre-money valuation of about $4 million. And in that case, you probably wouldn't want to set your valuation at $1 million, or conversely at $10 million. It's probably going to be somewhere in the neighborhood of $4 million in this seed stage investment, that is, in a setting where you're raising about $1 million. This approach makes sense in a well defined category for venture backed companies, where you can actually get data on the prices at which the transactions occurred. The third approach you can take is to discount some future outcome, based on time and on risk. And, that's sort of an arcane, and I realize, not too clear of a description. To make matters worse, I'm going to give you an acronym, which is PWERM, which stands for probability weighted expected return method. And that mouthful refers to an approach that's taken in investment banking to estimate the value of companies. And the PWERM method is actually not so complicated, but I'm going to walk you through the steps. The first thing you do is you define several different outcome scenarios that could occur at some future date. And I'll give you an example, in a minute. Secondly, you estimate the probability of each of those outcomes. Third, you calculate a risk-adjusted future value, which takes into account what those scenarios are worth and their probabilities. And then fourth, you discount that future value back to the present, accounting for the investor's opportunity cost of capital. Now, I realize those may be very unfamiliar terms. So let me walk you through a specific example. Let's imagine you're trying to value your company, and that you can imagine that one year from now, 12 months from now, there might be four possible outcomes. The first possible outcome is that everything is going just as you planned. And you actually are successful in raising venture capital at a $4 million pre-money valuation. Now by definition, in that scenario, your company is worth $4 million. That's what it means for a venture capital to invest in you at a $4 million pre-money valuation. So let's call that the first scenario, everything goes just as planned and your company is worth $4 million as evidenced by a venture capital transaction that occurs one year from now. Now a second scenario is that progress is actually slower than expected, and you have to take another angel investment at a much lower valuation, let's say $2 million. The third scenario you might consider is that things are going quite badly, and you're forced to sell your business to a competitor in what might be considered a distressed sale. And maybe you would get $500,000 from that transaction. And then the fourth scenario is that your company fails, you go bankrupt, and nobody gets anything. So those are four scenarios. The next step is to assign probabilities to those scenarios. Now in this example, I've simply assigned even probabilities. So I've said there are four scenarios, let's assume that there's a 25% chance of each of these outcomes. And in the absence of better information, a sort of even probability distribution is not a bad way to go. But, I would say, if you have some better information or some better way to estimate what you really think the likelihood of the different scenarios is, you could use that. They don't have to be even chances of all the different scenarios. Okay, now if you have a 25% chance of getting $4 million, then that scenario is worth, on a risk adjusted basis, $1 million. That's 25% of 4 million. The second scenario, it's worth 25% of 2 million, or $500,000. The third scenario, it's worth 25% of $500,000 or $125,000. And the fourth scenario, it's 25% of 0 which is still 0. So in calculating a risk adjusted future value, you simply add up those probabilities times those outcomes and you get $1.625 million. And that's what I call the risk adjusted future value of the company. Which means, all that's equal, accounting for the different probabilities of the different scenarios, one year from now, we expect the business to be worth, on average, averaged across all the things that might happen, $1.625 million. Now, the problem is, that's $1.625 million one year from now, and you want your investor to give you some money today. And so you have to account for the fact that that's a future value, that's a value that's out a year from now. And so, you need to discount that future value back to the present. Accounting for the investors opportunity cost of capital. Now the subject of the topic of how to calculate the opportunity cost of capital is fairly complex and is the subject of a corporate finance course. But I'm just going to assert that for most venture investments, the opportunity cost of capital for investments of this type is probably around 20%. And so if you take that 20% and discount it back to today, then you are simply taking 1.625 million dividing it by 1.2 and that results in a present day valuation of 1,354,000 and yes $167. So that, I don't want to with that precision suggest that this is a precise value. But that's just how the arithmetic works out. So that approach, called PWERM, basically says, hey, maybe I can't estimate the value today, but I have a better chance of estimating some future scenarios at some future point, and putting some probabilities on those. And so I'm going to use those future scenarios and probabilities to estimate some risk adjusted future value and then I'm going to discount it back to the present. If you're not comfortable with those calculations, talk to a friend who's really good at finance. They'll probably already know about the PWERM method and they could help you think through those scenarios. And let me just say one other thing about PWERM. I have never seen that calculation done in public between an investor and an entrepreneur. It's a little bit academic, it's a little bit analytical and it's so dependent on assumptions that I think it's primarily a method that you would use yourself to get comfortable with what do I really think is the future value of this business and how would I account for the risk. You would use it to calibrate your intuition, I don't think I would use it, for instance, in a business plan to set valuation. The fourth method that you can use is to base a valuation on actual earnings. Now, of course, the problem with this method is that you probably don't have earnings yet. And so valuations based on earnings typically apply to later stage transactions in which the company has an operating history and actually does have earnings. And so, in many respects, this fourth method is more relevant for an acquisition, for an outright sale of an ongoing company than it is for an investment in the early stages. Nevertheless, the method usually involves taking what's called the EBITDA, or the earnings before interest, taxes, depreciation, and amortization. Think of this as effectively the cash flow that the company generates. Taken that EBITDA, or the cash flow the company generates, and multiplying it times some multiple. And the logic here would be, let's imagine that your company is generating $1 million per year in cash, what would it be worth to an investor to acquire that entire company? That is, what would an investor be willing to pay to have an income stream of $1 million per year? Now, the problem with this method is that the multiples themselves depend on lots of other factors. And it's quite easy to imagine scenarios in which the multiple would only be 5x, that is, where you would only be able to sell the business for five times the annual earnings. And that would be a scenario in which the company isn't growing very fast. Or faces a lot of risks out in the future, where those cash flows are quite uncertain. That would explain a multiple of about 5x. You can also imagine a scenario where an acquirer would be willing to pay 50x. And that would be a scenario in which there was a lot of growth anticipated. And where the company had a very strong, competitive position and the competition was likely to be weak in the future. To give you some rough numbers, on average in the United States public companies are valued at about 15 times their EBITDA. That is, an investor is willing to pay about 15 times the annual earnings of a company, in order to own the company outright. However, some companies are valued at much, much more than that. So for instance, Amazon is currently valued at a multiple of about 400 times EBITDA. And so that's just to illustrate that this method has a lot of uncertainty surrounding the actual multiple that's used to multiply times the EBITDA. The last approach you can take, and I didn't put a number on it because it's not really an approach to valuation but it's an approach to this problem, which is, that you can defer the valuation question. And I might just say you kick the valuation question down the road. You avoid having to even deal with it, you put it off. And the way you can put it off is through the use of what's called a convertible note. And the idea here is that the investor, instead of agreeing in advance on what the investor gets for their cash, the investor lends the money to the company in what's called a convertible note. But they lend that money with the understanding that when and if a future investment occurs, an investment, let's say, a year from now. That that loan will convert to equity, will convert to an ownership stake in the company at the future valuation. That is, at the valuation that's established later. Probably by a more sophisticated investor, maybe a venture capitalist. And so sometimes investors and entrepreneurs don't even want to establish the valuation today. They want to kick that decision down the road, put it off until a more significant transaction happens. Usually, convertible notes, there will be an agreement that they convert at a discount, discounts often around 20%. So the investor puts some money into the company with the assumption that when and if there's a future investment, their loan will convert to equity at a discount to what the future investment would pay. And that accounts for the risk that the investor is taking in providing the money earlier in the process. There's often also a cap, meaning if things go amazingly well, we agree in advance that my note won't convert at a value of any higher than this predetermined cap. Often maybe around 4 to $8 million is often the cap that's used in convertible notes. So in sum, valuation is critically important when you're taking investor's money because the investor wants to know, what do I get in exchange for my investment? At the end of the day it's a horse trade, it's a negotiation between two parties, but it's very important that you do your best to estimate value accurately. Because that's what's fair to investors, you want your investor to make money. And you also don't want it to be too low because you need to retain an incentive to make the business successful. So I've given you four methods, you can apply two or three of these methods to your particular situation. Get some numbers to help calibrate your intuition. Which you can then use in the actual negotiation, where you set the value for your company in negotiation with an investor.
