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VALUATION

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START-UP BASIC VALUATION HOW MUCH ARE YOU WORTH?


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Introduction: dude, don't freak


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I know what you are saying…


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I know what you are saying… Oh god. Anything but finance.


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But, Seriously. Don't sweat it. I know what you are saying… Oh god. Anything but finance.


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But, Seriously. Don't sweat it. I know what you are saying… Oh god. Anything but finance. Finance is actually quite simple


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But, Seriously. Don't sweat it. I know what you are saying… Oh god. Anything but finance. Finance is actually quite simple when you focus on what matters.


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And you can't avoid it.


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And you can't avoid it. Because if you look weak


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And you can't avoid it. Because if you look weak If you actually let excel know you're scared


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And you can't avoid it. Because if you look weak If you actually let excel know you're scared Then you'll be on your ass


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So let's talk about valuation


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So let's talk about valuation Since you can’t avoid it


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So let's talk about valuation Since you can’t avoid it Since it's not actually that hard


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So let's talk about valuation Since it's not actually that hard And since it is one of those topics that absatively cannot be delegated to finance Since you can’t avoid it


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valuation is the process of defining what your start-up is worth! definition


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definition valuation is the process of defining what your start-up is worth! You do that in 3 simple ways


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definition valuation is the process of defining what your start-up is worth! You do that in 3 simple ways you're worth what you own


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definition valuation is the process of defining what your start-up is worth! You do that in 3 simple ways you're worth what you own you're worth what you can earn in the future


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definition valuation is the process of defining what your start-up is worth! You do that in 3 simple ways you're worth what you own you're worth what you can earn in the future you're worth what the market says you're worth


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Let's go through each of those…


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Part 1 You're worth what you own


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Valuation based on actual assets is probably the simplest and most intuitive


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You are worth exactly how much you have in your pocket! * (Advanced reader: What is in your balance sheet today?)


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Actually, What you’re worth right now can be divided into 2 major categories of value


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Tangible assets inTangible assets Inventory Cash or financial assets Buildings, land, vehicles, equipment Computers, desks, chairs (anything you can hock) Accounts receivable (what people owe you) Agreements that could be novated (franchize or distribution agreements) Copyrights Patents Trademarks Trade secrets Brand / reputation Unique knowledge


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So the first thing you need to do is figure out how much you can sell all the tangible & intangible assets for


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But…


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You’ll probably also have some liabilities too


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Rental agreements Accounts payable Bank loans Unpaid salary Salary liabilities (notice periods) Tax owed Bonds Leases Pension contribution Product warranties Other Contingent liability Shareholder debt


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You need to sum up all these liabilities as well


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And when you do that, you’re ready to value your firm: Firm value = (Tangible + intangible assets) - liabilities


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Simple right?


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Well simple comes at a cost


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Of the 3 methods, this results in the lowest valuation


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Which is why, it is really only used during liquidations


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Part 2 You're worth what you can earn in the future


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Of course the assets & liabilities method does not work well when you are pitching a true start-up which has nothing other than a big dream


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Because you have no assets


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In that case, we need to value the business based upon what is possible in the future


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But wait? Why would anyone place a value on possible future money


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Well it turns out that possible future money does have value


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Depending on how possible, and how much future money we’re talking about


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Think of it this way


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If your mother told you she’d give you 20 dollars tomorrow if you did 1 hour of chores today, would you do it?


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Sure you would


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What a good child


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You trust mom. You need the dough tomorrow. So you’ll pay in advance


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You see. promised Future money does have value today


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How about if a bank told you that they’d give you a guaranteed 110 dollars in a month if you deposited 100 dollars today?


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Sure you would


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The point is that there is definitely value today for future money


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However, there is a limit


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The value of future money and the value of money today is not equal


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Would you pay me 100 dollars today if I promised that I’d return 100 dollars in 10 years?


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Come on…you can trust me. I’ll pm you my bank details


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No, of course not


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First, if you deposited the 100 bucks in a bank, you’d get more than 100 back in ten years because of interest (well maybe not much more)


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In other words, the valuation of future promised money is affected by opportunity cost


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Second, who’s to say that I won’t run off with your money, or get hit by a bus


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So not only must we consider opportunity costs, we must also consider risks


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In other words, future promised money has value today, but it is not 1 for 1 value


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Future promised money is worth less than the same money right now.


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In other words, Future money needs to be discounted


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Fortunately, an army of mathematicians worked their magic and came up with a couple of nifty formulas


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Internal rate of return (irr) and net present value (npv) (Actually, it’s really the same formula, just solved forwards and backwards)


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These formulas look at your future promised cash flows, and discount them for today (Sometimes we call this discounted cash flow)


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It is not actually hard math, but it isn’t easy math either (Unless you are from anywhere outside of the US, in which case, it is easy)


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Fortunately, bill’s boys in the ms excel team have taken that math and transformed it into a very simple formula in excel which 7 of 9 chimpanzees can use


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The formula is: =npv (discount rate, cash flow1, cash flow 2,…)


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=npv (discount rate, cash flow1, cash flow 2,…) So, in order to use ms excel to calculate your start-up’s value, you need to know: What is the discount rate What are the future cash flows


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=npv (discount rate, cash flow1, cash flow 2,…) Getting Future cash flows is easy


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You just grab the profit (not revenue) line for your next 5 years (you get that in your pro-forma p&l) (note for advanced users: I am not a fan of terminal value for start-ups, so I won’t cover it here. I’m also not considering debt since it is a start-up. Corporate treasurers need to read something more advanced than this deck, as I’m sure you realized already) =npv (discount rate, cash flow1, cash flow 2,…)


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Choosing the Discount rate however, is slightly harder =npv (discount rate, cash flow1, cash flow 2,…) (Sometimes people refer to discount rate as weighted average cost of capital or WACC)


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The discount rate is a number from 0 to 1. the closer to 1 you get, the more you discount =npv (discount rate, cash flow1, cash flow 2,…)


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So a discount rate of .2 (20%) is not very risky at all, and a discount rate of .8 (80%) is super risky. =npv (discount rate, cash flow1, cash flow 2,…)


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The discount rate is actually calculated based on many criteria =npv (discount rate, cash flow1, cash flow 2,…)


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For example… =npv (discount rate, cash flow1, cash flow 2,…)


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risk How confident is the investor about the likelihood the profit you forecasted will actually materialize (revenue and cost assumptions accurate?) =npv (discount rate, cash flow1, cash flow 2,…)


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Opportunity costs How much money would the investor make if she invested the money elsewhere – especially in risk-free things like t-bills…And what about inflation… =npv (discount rate, cash flow1, cash flow 2,…)


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Market norms The discount rate will also vary from market to market where the wisdom of crowds has generated rules of thumb over the years (ie: Pharma rates are different from e-commerce portal rates) =npv (discount rate, cash flow1, cash flow 2,…)


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However, here is my personal INVESTING rule of thumb, GENERICALLY =npv (discount rate, cash flow1, cash flow 2,…)


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=npv (discount rate, cash flow1, cash flow 2,…)


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IN OTHER WORDS, IF YOU ARE USING A DISCOUNT RATE OF 50% AT THE IDEA STAGE, I’M JUST NOT GOING TO BITE =npv (discount rate, cash flow1, cash flow 2,…)


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BECAUSE THERE IS JUST SO MUCH DAMN RISK THAT YOUR FORECASTS WILL BE WRONG, OR YOU’LL DIE IN EXECUTION =npv (discount rate, cash flow1, cash flow 2,…)


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As I negotiate your discount rate with you, I’d also be considering a motley of factors… =npv (discount rate, cash flow1, cash flow 2,…)


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History of stable growth and profits Product Cycle point Size Market share Industry Customer base -diversification Growth potential-topline and bottom line trends Competitive positioning Product mix Uniqueness The value of similar companies Strategy for continued growth and profitability Timing


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SO, BY WAY OF EXAMPLE…IMAGINE A FRESH START-UP THAT EXPECTS TO HAVE PROFIT OVER THE NEXT 5 YEARS OF -250,000, 0, 250,000, 2,000,000, & 10,000,000 =npv (discount rate, cash flow1, cash flow 2,…)


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Using excel, today’s value of this firm’s future, promised profit is $623,719. That means, if I invested $150K today, I’d get ~25% of the firm (Which means 2.5M return in year 5 if we distribute the year 5 profit and I get my 25%)


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Ok, that's npv Let me quickly mention irr as well since irr is quite popular these days


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As we mentioned before, Internal Rate of Return (IRR) is like standing the NPV formula on it's head and shaking it up and down


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The IRR is the discount rate that would make the NPV zero Or, in other words, the IRR is the rate of expected growth The higher the IRR, the better the investment


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Again, bill's boys came to the rescue =IRR (investment, cash flow 1, cash flow 2…)


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In this example, we assume that we invest 150K in a start-up. the investment loses 250K in Year 1, breaks even in year 2, makes 250K in Year 3, 2M in Year 4 and Exits in year 5 for 10M Given this, the investor irr is 127.5% In other words, We expect this investment to grow 127.5%. Much better than a savings account!


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So….uh…which do you use: irr or npv?


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Honestly, it depends on the audience Use whatever the audience prefers


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That said, while irr is great for giant multi-national firms, I personally don't like it for start-ups


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To me, IRR works best when comparing projects of equal risk or equal cost & income realization


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it is great for a big firm trying to compare whether to build a new data center of extend the existing one


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but IMHO, it is not so useful at comparing whether to invest in a bio-informatics start-up or a B2B e-commerce portal, 2 projects with significantly different risk & spend profiles


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THERE IS ONE LAST THING I WANT TO ADD


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IN AN ACQUISITION SITUATION, rather than an investor situation, HOPEFULLY THERE IS SYNERGY VALUE BETWEEN BUYER AND SELLER


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WHICH MEANS THAT PART OF THE VALUE OF THE DEAL IS NOT JUST YOUR FUTURE REVENUE, BUT also THE POSITIVE IMPACT ON THE BUYER’S REVENUE AS A RESULT OF THE DEAL


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WHETHER THIS CAN BE ADDED TO THE BASE VALUATION IS UP TO YOUR NEGOTIATION SKILLS, BUT imho, IT SHOULD BE FACTORED IN TO BE FAIR


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Part 3 You're worth what the market says you're worth


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The final method of valuation leverages the wisdom of crowds


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Specifically, your value should be similar to the value of similar firms, in similar industries, in similar life cycle stages, at this point in time


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Basically, your value is the value that the invisible hand of the market gives you


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The most common way to guestimate market value is to look at comparables (similar-ish companies to yours)


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And since no company is just like yours, you need to take a bunch of data points to triangulate


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This is usually done with p/e ratio Actually, you can sometimes also consider: Price to Book Ratio, Equity / Sales, Equity / Cash flow, Equity / PAT, Equity / Book value of share. But PE is far more common for start-ups


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p/e stands for price / earnings (Think of price as synonymous with valuation for the moment)


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So if a firm’s value is 8 million and their earnings were 2 million, the p/e ratio would be 4 since 8 / 2 = 4


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We refer to the value of 4 as “the multiple”


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To get a value for you, we need to use the average multiple across all the comparable firms who have been valued. Let’s assume for now, that the average multiple turned out to be 4


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With the multiple and your profit this year, we can reverse calculate your price (valuation)


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If the multiple is 4 And your profit was 500K, then Your valuation is 2 million price / earnings = multiple Price = multiple x earnings 2M = 4 x 500K


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This magical multiple is not an absolute number of course


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The p/e ratio can change dramatically from industry to industry and it can change in the same industry over time


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Because like any wisdom of crowds, it is sensitive to market sentiment


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And market sentiment is fickle, irrational, uninformed, and full of emotions *(hey classical economics…you can kiss my A


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During the dot.com bubble, I saw tech valuations of 15x in asia. Whereas Today, tech valuations are closer to 4x


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The value of these companies did not change


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What changed was the hype surrounding the market


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summary


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Thanks for reading. I told you it wasn’t all that hard


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Here’s what you need to remember


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There are 3 ways to value your firm: What you own (use assets – liabilities) – used for liquidation What you’ll earn in the future (use Net Present Value) – used for investment What the market says (use P/E Ratio) – used for acquisitions


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CLICK HERE FOR MORE!!!!


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CREATIVE COMMONS ATTRIBUTIONS Dr. Evil: http://www.flickr.com/photos/bpage/ Attribution Slide: http://www.flickr.com/photos/21572939@N03/ Please note that all content & opinions expressed in this deck are my own and don’t necessarily represent the position of my current, or any previous, employers


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