What is Valuation?

1. What is Valuation? • The process of determining what an asset is worth today and at some later date • Buyer Dependent • Financial buyers vs. strategic buyers • Stage Dependent • Early vs. late-stage investments • Company Evolution/Track Record Dependent • Thriving vs. struggling investments, expected or unexpected round • Capital Requirements Dependent • Is this one of a series of capital raises or the final one? • Market Driven • An estimate of the future cash flows or proceeds from the sale of assets held by a business • Subject to the Risks Associated with the Firm • Basis for negotiating private equity investments • Pre-money/post-money analysis • LBO purchase price Valuation Overview

2. Valuation • The Importance of Cash, Cash Flow • Cash is the lifeblood of any business • Financial reports can misrepresent cash flow • Every modeling assumption impacts cash flow and projected return on investment • Ultimately a company is worth only as much as you want to pay for it, though someone else may want or be able to pay more Valuation Overview

3. Deal Analysis Framework Valuat ion Valuation Overview

4. Pre-Money and Post-Money Value • Pre-Money/Post Money Valuation • Lexicon for determining common equity ownership for investors • Establishes a value for the a business • “Value” can either be derived or set prior to a fundraising • Many entrepreneurs focus on valuation too much and lose value because of liquidation preference provisions Post-Money Valuation V/(1+r)t Pre-Money Valuation Post-Money - Investment Ownership Fraction Investment / Post-Money Pre-Money / Post-Money Valuation

5. Early-Stage Investment Scenario • Early stage investment in a software company • Pre-money valuation of $3.0 million • Capital raised of $5.0 million • Post-money valuation of $8.0 million (pre-money + invested capital) • New investor owns 62.5% of the common stock while founders and/or original investors own 37.5% • If new stock is redeemable preferred equity plus warrants for 62.5% of the common stock, then new investors would be able to receive their principal plus any accrued dividends as well as any multiple of capital paid from a liquidation preference • Despite the preferred stock and the fact that the bulk of the proceeds at exit go to the investors, the post-money valuation is still $8.0 million Example: Early-Stage Investment

6. Structure, Valuation and Risk • Why a $3.0 million pre-money valuation? • Early stage companies tend to lack well defined products, multiple customers, revenues and profits. Firms tend to be more about ideas and management • Risks include competitive risk, product development risk, market acceptance/customer adoption risk, execution risk, financing risk • Venture capitalist wants to own a large percentage of the equity because there is a high risk of dilution in future rounds • Why use preferred equity? • These securities allow the investor to recover all of the invested capital before management receives any consideration and the investor earns any meaningful upside • What will drive value at exit? • Company is expected to run losses for the foreseeable future so value will most likely be created at some point in the future via an M&A or IPO process • Why would a founder accept such a high level of dilution? • Venture capitalist may bring skills, experience and network that will facilitate the company’s success • May have been the best offer on the table Example: Early-Stage Investment

7. Late-Stage Investment Scenario • Series D investment in a software company • Pre-money valuation of $48.0 million • Capital raised of $12.0 million • Capital raised in Series A-C: $18.0 million • Post-money valuation of $60.0 million (pre-money + invested capital) • While the Series D represents 40% of the capital raised, the new investor only has a claim on 20.0% of the common stock while founders and/or original investors retain a 80.0% interest • The new stock is convertible preferred equity. • Series D Preferred Equity is pari passu with all other preferred stock. So it will take 40% of the proceeds paid out in a liquidation event that does not result in a conversion by all investors of their preferred equity into common stock Example: Late-Stage Investment

8. Structure, Valuation and Risk • Why a $48.0 million pre-money valuation? • The company has attained a modicum of success. It has a viable product and customer list. It also expects to become cash-flow positive next year. • The new equity is being used to open up three new sales offices • Management expects to take the company public in 12-18 months • Why would the new investors make this investment without the protection of a liquidation preference? • The company’s performance appears to be solid and the likelihood of exiting in the near future at a favorable valuation is likely. In order to get in the deal, the new investors had to forgo certain protections Example: Late-Stage Investment

9. Valuation Approaches • Comparables • Venture Capital Method • Net Present Value Method • Adjusted Present Value Method • Real Options Analysis Valuation Approaches

10. Comparables • Look for data on firms with similar value characteristics and benchmark accordingly • Investment data, purchase price data • May need to normalize data according to factors such as general business risk profile, size of business or market, market, revenue or profitability growth rate, capital structure, stage of company evolution, etc. • Look for data on publicly traded firms with the same value characteristics • Investment data, purchase price data • The use of public company “comps” also needs to be viewed with caution. In addition to the need to normalize according to the factors listed above, public company valuation are subject to swings in the capital markets that may be firm specific, but are equally likely to be sector driven, market driven or caused by some exogenous shock Comparables

11. Comparables Pro’s • Quick to use • Easy to understand • Commonly used • Market based Con’s • Private company comparables may be difficult to find • When using public firm comparables, one must discount result because private firms are illiquid • Easy to fall prey to mania, market forces Comparables

12. Weakness of Comparables • Based on accounting adjustments and interpretations, which may not accurately reflect cash flow • Based on a static result which may not accurately reflect the past or projected performance • Relying on multiples can shift focus from fair market value to strategic value • Comparables may be of different scope • Historical transaction multiples may not reflect current market conditions Source: Valuation for M&A Comparables

13. Venture Capital Method • Simplified NPV method • Venture deals have negative cash flow for years, then emerge with substantial earnings • High degree of uncertainty • Value is imbedded in the terminal value • Based on a targeted rate of return • Valuations are based on percentage ownership of common stock • If the investment is done with a preferred security (which is the norm) or has a liquidation preference, this will not impact the pre-/post-money valuation despite the fact that the economics of the deal are skewed in the VC’s favor Venture Capital Method

14. Venture Capital Method Value = Terminal Value / (1+Target IRR) ^ TYears Required Final Ownership = Investment Commitment / Discounted Terminal Value Required Current Ownership = Required Final Ownership/ ((1-Dilution x+1)*(1-Dilution x+2)*(1-Dilution x+3) Venture Capital Method

15. Venture Capital Method Pro’s • Simple to understand • Quick to use • Commonly used Con’s • Relies on terminal values derived from other methods • Terminal value assumes success • Very rudimentary • Almost no visibility • Subject to market forces, swings Venture Capital Method

16. Net Present Value Method Cash flow based methodology CF1 = EBIT1*(1-t) + Dep1 – CapEx1 – DNWC1 + Other TVT = [CFT*(1+g)]/(r-g) NPV = [CF1/(1+r)] + [CF2/(1+r)2]+…+[(CFT + TVT)/(1+r)T] r = (D/(D+E))* rd * (1-t) + (E/(D+E))*re re = rf + B*(rm -rf) NPV Methodology

17. Net Present Value Method Pro’s • Easy to run different investment scenarios • By assigning probabilities to each scenario you can generate E(EV) • Not impacted by distorted market metrics • Technically sound and well known within the investment community Con’s • With so many estimates and assumptions it is hard to arrive at a definitive result(s) • Capital structures can change over the lifetime of a firm, WACC assumes it does not • In many instances most of the value is in driven by the terminal value NPV Methodology

18. Adjusted Present Value Method • Useful if a firm’s capital structure is changing or if NOLs can be used to offset taxable income • Useful in LBO transactions where firms seek to reduce leverage going forward • NPV method assumes constant effective tax rate • APV looks at cash flows generated by assets and values the interest based, tax savings separately • APV values NOLs separately Adjusted NPV

19. Adjusted Present Value Method • Value cash flows (like NPV) using an unlevered beta (i.e., all-equity beta) • Estimate tax savings from interest costs • Use an NPV calculation • Discount rate is the debt’s nominal interest rate • Value NOLs available to the firm • Discount rate is the debt’s nominal interest rate • If NOLs are certain to be used (over time), discount rate should be the risk-free rate Adjusted NPV

20. Adjusted Present Value Method Pro’s • Theoretically sound • Useful in situations where capital structure changes (i.e., a typical leveraged buyout) • Effective when a firm’s effective tax rate changes over time Con’s • More complicated than NPV method • Not well known • Hard to arrive at a true value estimate since many estimates and assumptions are used • Bulk of the firm’s value may be generated by the terminal value Adjusted NPV

21. Real Options Analysis • NPV and APV don’t work when a manager or investor has “flexibility” • Private equity deals require multiple rounds • Helps you delay the investment decision, or at least hold back on putting additional money in Real Options Analysis

22. Real Options Analysis Pro’s • Theoretically sound • More useful than NPV and APV methods if managers or investors have options Con’s • Not well understood or commonly used • Hard to turn investment decision into an option problem • Subject to limitations of Black-Scholes Real Options Analysis

23. Monte Carlo Simulation • Considers all possible combinations of input variables so it generates a probability distribution of outcomes • Can determine probability of a “total loss” • User set ranges for each assumption, not discrete observations • Software supports a range of statistical distributions • Output ranges can be defined • Some outcomes can be spurious • Not widely used or well known within private equity community Monte Carlo Simulation

24. • Revenue/Growth • COGS • Gross Profit • Operating Expenses • EBITDA • Working Capital • Capital Expenditures • Free Cash Flow Drivers of Value in DCF-based Analysis Valuation Drivers

25. Valuation • What is IRR? • The discount rate at which a project would have zero NPV • A tool for evaluating the performance of a PE transaction • Companies (and investors) should accept any investment with any IRR in excess of the opportunity cost of capital • Can get spurious results when there are several sign changes within the stream of cash flows • The highest IRR’s are usually found in short-lived projects that require little upfront investment. Unfortunately, few of these projects (and investment opportunities) exist • Any result can be manipulated, so be careful Drivers of Returns

26. Impact of Good Timing and Execution Drivers of Returns

27. What Drives Valuation? • Historical and Projected Financial Results • Past and future performance are both subject to interpretation • Expectations about future capital requirements • Growth Rate of Underlying Market • Strength of Business Model, Perceived Value of Product or Underlying Technology • Quality of Management Team • Methodology Employed • Competitive Environment • Is lots of money chasing a few “hot deals” • Market Dynamics (particularly with respect to exits) Monte Carlo Simulation

28. What Drives Returns? • Successful Execution of Plan • Continued Growth of Underlying Market, Perceived Attractiveness of Business Opportunity • Proof of a Defensible Business Model • Timing of Exit (at least for IRR calculation) • Presence of Strategic Buyers, Open Capital Markets • Good Fortune/Luck Monte Carlo Simulation

29. Valuation Wrap-Up: Deal Analysis Framework Valuat ion Valuation Wrap-Up