Early-Stage Startup Valuation - Jeff Faust

Early-Stage Start-Up
Valuation Workshop
June
2015
By Jeff Faust, CVA

Director of Valuation Services
Objective of Presentation
Jeff Faust qualifications
FMV vs Investment Value
409A Overview
Overview of Valuation Methods
Sample valuation methods
Pre-revenue, pre-funding (FMV)
Pre-revenue, pre-funding (Investment Value)
Post-funding (FMV)
Profitable (FMV)
Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.
Jeff Faust Background

25 years in finance, serial entrepreneur.
20 years in Business Valuations.
Over 65 different industries.
All sizes and stages of development.
Employee Stock Ownership Plans (ESOPs), Stock Options (409A), Family Limited
Partnerships (FLPs), Buy-Sell Agreements, Estate/Gift Taxes, Mergers/Acquisitions
and Transactions, Litigation Support.
Testified in front of the Department of Labor and in several Superior Courts in the Bay
Area.
Certified Valuation Analyst (CVA) with the National Association of Certified Valuators
and Analysts (NACVA).
Instructor for the Venture Capital Academy (VCA).
Valuation Workshop
FMV vs Investment Value
Valuation Workshop
Overview of 409A
Deferred comp IRC Section
No discounted options (ISOs and NQSOs must be granted at FMV)
Options granted must follow 1 of 3 valuation methods
Valuation Methods
Is there one formula for valuation?
Income *
----------
Value
Risk
* Could be historical or projected but in all cases it is normalized
Valuation Methods
Most common
Income Approaches (DCF, DFE, Capitalized Earnings)
Market Approaches (Guideline, M&A and Comparable Transaction)
Asset Approaches (Book Value, Restated Net Worth)
Others used
Cost (Replacement)
Asset and Income Approaches (Excess Earnings)
Other / Start-Up Approaches (VC Method, Exit Multiples, Preferred
Rounds, Berkus Method, Scorecard Method, Cayenne Calculator,
People & Patents, Risk Factor Summation)
Valuation Preparation (Know what Stage you are in!)

Stage of Development
1
Start-up
Enterprise has no product revenue and limited expense

history. Typically an incomplete management team has an
idea, plan, and possibly some initial product development.
Seed capital or first-round financing is usually provided by
friends and family, angels, or venture capital firms focusing on
early-stage enterprises. The securities issued to those
investors are occasionally in the form of common stock but are
more commonly in the form of preferred stock.
Development
Enterprise has no product revenue but substantive expense

history. Product development is underway and business
challenges are thought to be understood. Typically, a second
or third round of financing occurs during this stage. Investors
are usually venture capital firms which may provide additional
management or board of directors expertise. Securities
issued are typically in the form of preferred stock.
Alpha/Beta
Enterprise has made significant progress in product

development; key development milestones have been met
(e.g. hiring of the core management team); and product
development is near completion (e.g. alpha and beta testing
of the product, service, web site). Third party revenue is
beginning, although there may have been progress/milestone
payments from strategic business partners. Later rounds of
financing occur during this stage. Typical investors are venture
capital firms and strategic business partners. The typical
securities issued to those investors are in the form of
preferred stock.
Early Revenue
Enterprise has met additional key development milestones

(e.g. grow ing customer orders and revenue shipments). It
has a sufficient customer base to support ongoing operations,
but is still operating at a loss. A manufacturing and
distribution plan is being implemented Typically, mezzanine
rounds of financing occur during this stage. Discussions
frequently start with potential acquirers or investment banks
for an initial public offering (IPO).
Positive Cash
Flow
Enterprise has a history of product revenues, and has recently

achieved breakthrough measures of financial success, such as
operating profitability or positive cash flow s. Regulatory
approvals (e.g. Food and Drug Administration) have been
obtained. A liquidity event, such as an IPO or a sale of the
enterprise, could occur late this stage.
IPO
Enterprise has an established financial history of profitable

operations and generation of positive cash flow s. It is a
mature candidate for acquisition or an IPO. The form of
securities issued is typically all common stock, with any
outstanding preferred converting to common upon an IPO
(and perhaps also upon other liquidity events).
Valuation Preparation
(What discount range is appropriate)
Risk Discounts Ranges for Start-Ups

Scherlis and
Sahlman
Study (4)
Sahlman,
Stevenson
and Bhide
Study(5)
50% - 70%
50% - 70%
50% - 100%
40% - 60%
40% - 60%
40%-60%
Stage of
Development
Characteristics
Frei & Leleux

Life Sciences
Study (1)
Start-up
Pre-prototype
70% - 100%
60% - 80%
Early development
Pre-commercialization
50% - 70%
50% - 60%
First Stage
Commercialization
40% - 60%
40% - 50%
NA
NA
NA
Expansion
Shipping Product
35% - 50%
30% - 40%
35% - 50%
30% - 50%
30%-40%
Mezzanine/ IPO
Profitable
25% - 40%
25% - 30%
25% - 35%
20% - 35%
20%-30%
Seiffer
Software
Study (2)
Plummer
Study (3)
(1)
Frei, P. & Leleux, B. Valuating the Company. Starting a Business in the Life Sciences- from Idea to Market. (Luessen, H. (ed.).) 42-55 (Edition Cantor Verlag,
Aulendorf, Germany, 2003).
(2)
John Seiffer, "The Business of Software: The Venture Capital Rate of Return". < http://discuss.joelonsoftware.com/default.asp?biz.5.254929.9> (21 November
2005)
(3) Plummer, James L., QED Report on Venture Capital Financial Analysis, Palo Alto: QED Research, Inc., 1987
(4)
Scherlis, Daniel R. and Sahlman, William A., "A Method for Valuing High-Risk, Long Term, Investments: The Venture Capital Method," Harvard Business School
Teaching Note 9-288-006, Boston: Harvard Business School Publishing, 1989
(5) Sahlman, William A. and Howard H. Stevenson, Amar V. Bhide, Financing Entrepreneurial Ventures, Business Fundamental Series, Boston: Harvard Business
School publishing, 1998.
Sample Valuation Methods

Pre-Revenue, Pre-Funding (FMV)
Cost Approach
Est Repl Cost (low)
Est Repl Cost (high)
Current Expenses
$400,000
$400,000
Services In Lieu
$200,000
$400,000
Estimated Replacement Cost
$600,000
$800,000
Equity Value
Shares Issued
Stock Option Pool
Fully Diluted Shares
Price / Share
$600,000
$800,000
12,000,000
3,000,000
15,000,000
12,000,000
3,000,000
15,000,000
$0.040
$0.053
$0.05
10

Pre-Revenue, Pre-Funding (Investment Value)
Funding
Pre and Post Money Illustrations (value continuation)

A Round
Pre Money Valuation
B Round
$
Pre A Shares
4,000,000
Px/Share of Preferred A
0.27
Money Raised
1,000,000
Share Issued for A
3,750,000
Post A Shares
Post Money Valuation
Pre Money Valuation
15,000,000
20%
18,750,000
$
Pre B Shares
Px/Share of Preferred B **
0.27
Money Raised
1,250,000
Share Issued for B
4,687,500
Post B Shares
5,000,000
5,000,000
18,750,000
20%
23,437,500
$
6,250,000
** Although the price per share is the same, the Post Money Valuation is clearly higher after the B Round
11

Pre-Revenue, Pre-Funding (Investment Value)
Funding
Pre and Post Money Illustrations (value increase)

A Round
Pre Money Valuation
B Round
$
Pre A Shares
4,000,000
15,000,000
Px/Share of Preferred A
0.27
Money Raised
1,000,000
Share Issued for A
3,750,000
Post A Shares
Pre Money Valuation
18,750,000
$
5,000,000
$ 10,000,000
Pre B Shares
20%
18,750,000
Px/Share of Preferred B
0.53
Money Raised
2,500,000
Share Issued for B

Post B Shares
4,687,500
20%
23,437,500
$ 12,500,000
12
How do preferred terms impact value?

CVM The Effect of Different Capital Structures
Company 1
(No Preferred)
Company 2
(Non-Participating)
Company 3
(Full Participation)
Assumptions
Value
Common Shares Outstanding
$12,000,000
$12,000,000
$12,000,000
12,000,000
12,000,000
12,000,000
4,000,000
4,000,000
$12,000,000
$12,000,000
$12,000,000
$0
$4,000,000
$4,000,000
$12,000,000
$8,000,000
$8,000,000
12,000,000
12,000,000
16,000,000
$1.00
$0.67
$0.50
Preferred Shares Outstanding

(Assume Liquidation Preference is $1/share)
Share Calculation
Value
Less: Liquidation Preference
Equals: Remaining Amount
Divided by: Shares
Equals: Price Per Share
13

(Pre-)Revenue, (Pre-)Funding (Investment Value)
VC Method
Year 1
Revenue Projections
Which year will you be profitable?
What is your Peer Group Multiple?
Percent of Projections
Implied Future Valuation
Year 3
1,000,000
5,000,000
Year 4
20,000,000
Year 5
50,000,000
(Software = 2-3, SaaS = 4-6, Cloud = 5-8, Data = 8-12, Social = 10+)
50%
30,000,000
Enter discount rate (stage chart)

Estimated Funding Valuation
Year 2
90%
2,300,000
14

(Pre-)Revenue, (Pre-)Funding (Investment Value)
VC Method Multiples (Peer Group)

Market Value of Invested Capital (MVIC) as a Multiple of:
TTM
TTM
TTM
NFY
Revenue
EBITDA
EBIT
Revenue
Company Name
Abbott Laboratories
Baxter International Inc.
Mead Johnson Nutrition Company
Amicus Therapeutics, Inc.
Zalicus Inc.
Perrigo Co.
2.7
2.4
4.2
5.6
16.9
3.6
Maximum
Third Quartile
Average
Median
First Quartile
Minimum
Harmonic Mean
Coefficient of Variance
Selected Multiples
x
x
x
x
x
x
9.2 x
8.6 x
16.5 x
NM
NM
16.1 x
12.7 x
10.4 x
17.9 x
NM
NM
19.7 x
2.5 x
2.3 x
3.8 x
3.0 x
10.6 x
3.3 x
16.9 x
5.3 x
5.9 x
3.9 x
2.9 x
2.4 x
3.9 x
94%
16.5 x
16.2 x
12.6 x
12.7 x
9.1 x
8.6 x
11.5 x
34%
19.7 x
18.3 x
15.2 x
15.3 x
12.1 x
10.4 x
14.2 x
29%
10.6 x
3.7 x
4.3 x
3.2 x
2.7 x
2.3 x
3.3 x
74%
2.9 x
9.1 x
12.1 x
2.7 x
15

Early Stage (Investment Value)
Scorecard Method
Two-Step
(1) determine average pre-money of companies like yours
(2) compare target to perception of similar deals
Strength of Management Team
0-30%
Size of the Opportunity
0-25%
Product/Technology
0-15%
Competitive Environment
0-10%
Marketing/Sales Channels/Partnerships
0-10%
Need for Additional Investment
0-5%
Other
0-5%
-------100%
16

Scorecard Method
Software Company
A company has an above average product and technology (125% of
norm), an average management team (100% of norm) and a large
market opportunity (150% of norm). The company can get to
positive cash flow with two rounds of angel investment (80% of
norm). Looking at the strength of competition in the market, the
target is average (100%) but early customer feedback on the product
is excellent (Other = 100%). The company needs some additional
work on building sales channels and partnerships (75%).
17

Scorecard Method
COMPARISON
FACTOR
Strength of
Management Team
Size of Opportunity
Product/Technology
RANGE
TARGET
COMPANY
FACTOR
30%
100%
0.3000
25%
150%
0.3750
15%
125%
0.1875
Competitive
Environment
Marketing/Sales/
Partnerships
Need for Additional
Investment
10%
100%
0.1000
10%
75%
0.0750
5%
80%
0.0400
Other factors
5%
100%
0.0500
Sum: 1.1275
Assuming the average pre-money valuation is $2.7
million, we multiply that figure with the Sum of
Factors (1.1275 x $2.7 million). Therefore, we arrive
at a pre-money valuation of $3.04 million.
18

Berkus Method
Developed by Dave Berkus of Tech Coast Angels
Characteristic
Add to Pre-money Valuation
Quality Management Team
0 - $500,000
Sound Idea
0 - $500,000
Working Prototype
0 - $500,000
Quality Board of Directors
0 - $500,000
Product Rollout or Sales
0 - $500,000
19

Berkus Method
Characteristic
Add to Pre-money
Valuation
Target Company
Quality Management
Team
0 - $500,000
$375,000
Sound Idea
0 - $500,000
$425,000
Working Prototype
0 - $500,000
$500,000
0 - $500,000
$375,000
0 - $500,000
$375,000
0 - $2,500,000
$2,050,000
Quality Board of
Directors
Product Rollout or
Sales
TOTAL
20
10

People and Patents

Each patent and engineers is ~$1M
21

Risk Factor Summation

Series of Questions
Management, State of the business, Legislation/Political risk, Manufacturing risk,
Sales and marketing risk, Funding/capital risk, Competition risk, Technology risk,
Litigation risk, International risk, Reputation risk, Potential lucrative exit
+2 for very positive, +1 positive, 0 neutral, -1 negative, -2

very negative
For every +1 you add $250,000 (+$500k for +2) and subtract
$250,000 for every -1 (-$500k for a -2)
22
11

Risk Factor Summation

Assume the average premoney valuation is $2.3 million,
and after tallying the points, the
sum is +1.
Therefore, you would add
$250,000 to the $2.3MM
average, bringing the
companys pre-money value to
$2.55 million.
Risk Factors
Risk Rating
Management
State of the Business
+1
Legislation/Political Risk
Manufacturing Risk
Sales and Marketing Risk
-1
Funding/Capital Risk
-1
Competition Risk
Technology Risk
+1
Litigation Risk
International Risk
Reputation Risk
Potential Lucrative Exit
+1
TOTAL
=+1
23

Any Stage (Investment Value)
Cayenne Calculator
www.caycon.com/valuation.php
Series of questions
24
12

Summary of Values
Method
Software
VC Method
$2.30 Million
Scorecard
$2.59 Million
Berkus
$2.05 Million
Cayenne
$1.84 $2.25 Million
Risk Factor
$2.55 Million
25

Post-Funding (FMV)
Discounted Cash Flow (DCF) [exit multiples]

Projected Financials
FYE
12/31/12
Projected Earnings
FYE
12/31/13
FYE
12/31/14
FYE
12/31/15
(9.238) $
(5.235) $
1.528 $
6.859 $
1.00
0.624
(5.782) $
2.00
0.390
(2.042) $
3.00
0.244
0.373 $
4.00
0.152
1.045 $
Terminal
Year
FYE
12/31/16
10.537
Terminal Value Calculation
Revenue Multiple
12/31/16 $
165.526
2.7
Terminal Value
Present Value Period
Present Value Factor (3)
Present Value of Debt-free Cash Flow
60.0% Discount Rate
Sum of Present Value of Debt-free Cash Flow in Projection Period

Plus: Present Value of Terminal Value
(5.403)
32.406
Total Equity Value (Controlling, Marketable)
27.003
27.003
Less: Discount for Lack of Control

Total Equity Value (Non-controlling, Marketable)
0.0%
430.37
5.00
0.095
1.004 $
5.50
0.075
32.406
26
13

Profitable (FMV and Investment Value)
Discounted Future Earnings (DFE)

Projected Financials
FYE
12/31/12
Projected Earnings
FYE
12/31/13
FYE
12/31/14
FYE
12/31/15
1,454,100 $
1,537,125 $
1,703,328 $
1,885,410 $
1.00
0.813
1,181,525 $
2.00
0.661
1,015,436 $
3.00
0.537
914,822 $
4.00
0.437
823,264 $
Terminal
Year
FYE
12/31/16
2,181,030
Terminal Value Calculation

Gordon Growth Method
23.0% risk rate, 3.0% growth rate
Terminal Value
Present Value Period
Present Value Factor
Present Value of Net Income
23.0% Discount Rate
Sum of Present Value of Net Income in Projection Period

Plus: Present Value of Terminal Value
Indicated Equity Value
Less: Discount for Lack of Control
Total Equity Value (Non-Controlling, Marketable)
$
$
0.0%
$
11,232,307
5.00
0.355
774,265 $
5.00
0.355
3,987,467
4,709,312
3,987,467
8,696,779
8,696,779
27
Great Website Resources

https://angel.co/
http://visual.ly/vizbox/startup-universe/
(search for Startup Universe)
28
14
Q&A
Any questions?
29
Contact Information
Jeff Faust, CVA
jfaust@aslcpa.com
(408) 377-8700 x232
Abbott Stringham & Lynch
1550 Leigh Avenue
San Jose, CA 95125
(408) 377-8700
Copy of presentation can be found here:
www.GoDead.com/valworkshop/earlystage2.pdf
(Password = earlystage2)
30
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Early-Stage Start-Up

By Jeff Faust, CVA

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Jeff Faust Background

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

* Could be historical or projected but in all cases it is normalized

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Valuation Preparation (Know what Stage you are in!)

Enterprise has no product revenue and limited expense

Enterprise has no product revenue but substantive expense

Enterprise has made significant progress in product

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Enterprise has met additional key development milestones

Enterprise has a history of product revenues, and has recently

Enterprise has an established financial history of profitable

Risk Discounts Ranges for Start-Ups

Frei & Leleux

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Est Repl Cost (high)

Estimated Replacement Cost

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Pre and Post Money Illustrations (value continuation)

Share Issued for A

Pre Money Valuation

Share Issued for B

Post Money Valuation

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Pre and Post Money Illustrations (value increase)

Share Issued for A

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Pre Money Valuation

Share Issued for B

How do preferred terms impact value?

Preferred Shares Outstanding

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

What is your Peer Group Multiple?

Enter discount rate (stage chart)

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

VC Method Multiples (Peer Group)

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Size of the Opportunity

Need for Additional Investment

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Add to Pre-money Valuation

Quality Management Team

Quality Board of Directors

Product Rollout or Sales

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods

Copyright @ 2014 Abbott, Stringham & Lynch. All rights reserved.

Sample Valuation Methods