This page intentionally left blank 175 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Company evaluation in private and venture capital 12 12.1 COMPANY VALUATION As explained in Part Two, the private equity process can be divided into differ- ent phases. One of these is the investing phase, which includes choosing and closing the deal. Within this phase, company valuation is critical since it is fun- damental to the venture capitalist’s future economic return. The types of fi nancing available to venture capitalists are completely differ- ent; for example, an entry strategy with a majority participation and a position of control (typical in a buyout) and minority participation that supports the quo- tation of a fi rm for a short time. It is possible to identify standard phases common to all investments. Identifi cation of the target company — This is executed differently in US, UK, and European markets. In the US and the UK investment opportuni- ties offered to venture capitalists are already defi ned and structured by the entrepreneur. In Europe researching potential target companies is up to the institutional investor and done by direct marketing operations; there- fore, European venture capitalists need a developed and effi cient network or relationship to fi nd potential and interesting deals (deal fl ow). Valuation of the entrepreneur profi le and/or the management team — This phase follows the identifi cation of the target company and consists of a complete analysis of the entrepreneur and/or the management team’s pro- fi le, especially when they invest risk capital together with the private equity operator. It is important to check the reliability, knowledge, expertise, CHAPTER 176 CHAPTER 12 Company evaluation in private and venture capital and reputation between the management team and the validity or coher- ence of the business idea. Deep valuation of the target company and the operation structure — This phase is critical because it focuses on researching the equilibrium between the entrepreneur’s needs, the investor’s goals, and the real necessity of the target company. Analysis verifi es the potential and actual market of the com- pany, its technology potential, possible increase of company value, and the likely exiting strategy. If the results are satisfactory then the venture capital- ist proceeds with the deal structuring and defi ning the company’s value. Negotiation and setting of price — This is the direct outcome of the previous phases. It is focused on price setting as well as timing and payment execution. Monitoring and exiting — After closing the deal the investor monitors the venture-backed company’s performance to identify any problems inside the target company. On exit the venture capitalist realizes the economic return from the deal. 12.2 FIVE PHASES OF COMPANY VALUATION Company valuation calculates the fair value of the target company as well as supports value creation among investors so they can reach their economic goals in terms of expected IRR. The process of company valuation is realized through these phases. Business plan analysis Financial needs assessment Enterprise value analysis Price setting Exiting It is important to accomplish the previously listed valuation steps in the right sequence. Before this can be completed, it is necessary to know and use spe- cifi c techniques and methods to approach the items in the correct order. First, the venture capitalist must have focused goals that support the whole valuation process to execute appropriate investing or exiting decisions. However, the pro- cess has to be coordinated within the constraints of the investment vehicle such as global portfolio IRR, residual maturity, capital requirements, and expected IRR on the specifi c investment and the entire portfolio. Before analyzing each valuation phase, it is necessary to clarify critical aspects and key issues. This chapter identifi es and discusses the content of each phase, the equity investor’s role, and the goals and content of each stage. 177 12.2.1 Business plan analysis To start the valuation process the business plan must be created and analyzed. This document explains and illustrates the strategic intention of the management team, competitive strategies, and concrete actions necessary to realize company objectives, key value drivers, and fi nancial outcomes. It shows the management team’s vision and allows investors to evaluate and understand the potential returns of the business. The business plan has a large target audience including not only the investors and the management team, but other fi nancial supporters such as banks or leasing companies and members of the Board of Directors. A typical business plan that supports risky capital investment contains the status of past strategies (history of the fi rm) in terms of performance and analysis of strengths or weaknesses and opportunities or threats. Based on the analysis, the business plan describes the future of the company regarding the develop- ment of strategic goals, an action plan needed to realize the value proposition, assumptions about fi nancial planning, and fi nancial forecasts (see Figure 12.1 ). A business plan contains these elements. ■ Global view on the company — Information about the past, actual, and future organizational structure, relevant industries including the analysis of the com- petitive factors, and all the critical elements for an in-depth knowledge of the company such as legal entity structure, revenues, mission, and dimension. ■ Global view and explanation of the entrepreneurs and shareholders — This demonstrates the importance of the human factor in a business deal. A critical element is the clear disclosure of who the controls the capital. ■ Market competitive analysis — Includes the macro economics profi le (def- inition of its global dimension). The business plan uses the Porter Model 1 to analyze the market at a lower level. 12.2 Five phases of company valuation 1 See Chapter 9, Section 9.1, Valuation and Selection. IMPLEMENTED STRATEGY STRATEGIC PLAN ACTION PLAN ASSUMPTIONS FINANCIAL FORECAST Yesterday Tomorrow Today FIGURE 12.1 Business plan structure. 178 CHAPTER 12 Company evaluation in private and venture capital ■ Technological characteristics of the product and or services of the fi rms — This section describes the product and/or the service of the company in the easiest possible way emphasizing the innovative content of the offer. ■ Operation plans and fi nancial data — Contains detailed information regard- ing the operative actions executed in terms of production and marketing plans and timing data and costs. This part of the business plan shows a series of simulations about how the product and/or service would be real- ized considering different levels of bulk production. ■ Financial structure — Based on the previous analysis and defi ned needs, this phase covers two main areas: fi nancial requirements and the desired equity debt ratio. Financial requirements, satisfi ed by equity and debt, include differ- ent types of investments such as working capital investments, capital expen- ditures, immaterial expenditures, merger and acquisitions investments, and repayment of debts raised in the past. Equity contribution does not create any charged interest guaranteeing the company in case of default, and the inves- tor is directly interested in the performance of the fi rm. This structure limits the entrepreneur’s decision power as well as the profi t he must split with the new shareholders. Raising debt avoids the entrance of new shareholders, but interest has to be paid regardless of positive economic results. This form of fi nancing requires collateral issuings, which are not obviously apparent to the entrepreneurs. The key aspect of debt is the tax benefi t created by a signifi - cant contribution to the global value generated by the business idea. The business plan is usually prepared by the company with the help of a con- sultant and is the proposal sent to investors. It is common for the private equity investor to take part in the business planning process, even if it is risky and time- consuming. It usually happens with incubation strategies and previous venture- backed companies. Private equity investor assistance comes from the network of relationships in which the investor is involved. Different stages of investment, from the seed to vulture fi nancing, have spe- cifi c capital requirements and assumed levels of risk. This is refl ected in the busi- ness plan. Seed fi nancing — Three key issues: assessment of the potential entrepreneur’s curriculum vitae, creative understanding of the feasibility of the business idea, and identifi cation of the product’s potential market. Start-up fi nancing — Verifying both the market potential of the business idea, in terms of potential demand trend and expected level of price, and plan of investments is necessary. 179 Expansion fi nancing — The expansion trend of the demand and the sustain- ability of the required investment must be checked. Replacement fi nancing — Key issues include the feasibility of the acquisition and restructuring the deal. Vulture fi nancing — Focuses on verifying the new potential market with an accurate analysis of costs and the investment plan. The validity of the business plan, decided by the private equity investor, depends on the fi nancial sustainability of the industrial project. Sustainability is established based on the quality and quantity of the fi nancial resources, coher- ence between the realized strategies, strategic intention, real conditions of the fi rm and its economic and fi nancial hypothesis, and its reliability. The last condi- tion is satisfi ed when the industrial plan is drawn based on a realistic and reason- able hypothesis and expected and acceptable results. When the business plan includes a comparison with the past performance, it also includes further analy- sis related to forecasting possible scenarios and statements consistent with the competitive dynamics of the relevant industry. From the business plan the investor should trust the management about the business, the way capital will be used, the motivation of the management team, and the risk sharing. 12.2.2 Financial needs assessment If the analysis of the business plan is favorable, the investor moves to the second step of the company valuation process: fi nancial needs assessment. This step cal- culates the amount of money required to sustain company growth. The fi nancial assessment adds forecasting statements to the business plan, and its goal is to defi ne external fi nancial requirements and verify their use by the company. This step further identifi es the size of the potential demand for investment, percentage of the potential equity investment, and potential new debt to be raised in a medium term run. The fi nancial needs assessment is typically exe- cuted in house by the private equity investor, even if interaction with the com- pany is necessary to discuss and/or to revise the business plan. For an accurate fi nancial assessment it is necessary to answer a series of key questions to help decide whether or not it is convenient to launch an invest- ment. First, the capital investor must understand the size of the fi nancial need and then have a clear idea of how much can be fi nanced from the investor, the correct mix of debt and equity and, at the end, if it is possible and or necessary to recruit a new equity and/or debt investor. 12.2 Five phases of company valuation 180 CHAPTER 12 Company evaluation in private and venture capital It is impossible to predict a fi nancial solution. It depends on the deal’s level of risk, risk profi le of the project, and trust in the entrepreneur skills. During the fi nancial needs assessment there are key issues to be addressed. Seed fi nancing — Financial requirement consists of sustaining the investment to study, develop, and test the business idea or the project. It is very hard to identify the correct mix of debt and equity. The resources needed are not usually considerable, but it is necessary to have a large amount of sup- port for a high-tech initiative. Start-up fi nancing — Financial needs evaluation is the key point of the deal. It is critical to verify how much of the deal is fi nanced through equity capi- tal. The resources required are designed to defi ne and develop an already launched project. The outcome of start-up fi nancing depends on the qual- ity of the previous investment (seed fi nancing). The investment require- ment is not urgent because it is needed for the enlargement of existing corporate and business competences. First stage fi nancing — Represents the moment of launch for the initiative and the consolidation of previous research. This stage needs considerable fi nancial support, because funds are necessary to hire suitable human resources and develop know-how. The level of risk is quite high, but if the business initiative is successful, remuneration is considerable. Expansion fi nancing — Financial resources support corporate growth. The business idea and the combination of product and market have already been tested, consequently, fi nancial resources support commercial and marketing activities. Funds will probably be absorbed by the working capi- tal because warehouse goods increase and payment terms are postponed to satisfy customer demand. Bridge fi nancing — The position acquired by the company is steady and rein- forced by the introduction of new operative structures, the launch of new products or services, or an international expansion strategy. The funds required are tremendous, but risk is limited because the company has the capacity to forecast the business trend. Replacement — Controlling how fi nances are used during the development of corporate fi nance deals is a key issue. Economic resources are pro- vided to re-launch the company through restructuring and development operations. Since the re-launch is a new activity for the fi rm, an enormous amount of money and specifi c competences are necessary. Vulture fi nancing — Similar to start-up fi nancing, the fi nancial needs evalua- tion is key in the decision to turnaround a business. This type of fi nancing includes the re-launch and renewal of a mature company, and the available 181 resources are used to maintain market position and sustain the develop- ment process, which can be realized with either existing or non-existing technology (diversifi cation strategy). 12.2.3 Enterprise value analysis During the screening phase, the investor decides if the fi nancial need, as defi ned and evaluated, is sustainable. In doing so he moves to the third step of this process — analysis of the company’s value. This phase is based on the fore- casting statements included in the business plan. The goal is to understand and quantify the real value of the company and the business plan to defi ne the value of the investment. The enterprise value analysis identifi es the amount of money to be spent, the percentage of shares to buy, and the fi nancial impact on the company. The pri- vate equity investor executes the enterprise value analysis in house and listens to his advisors and technical committee. The valuation of a private company, especially when it is in the early stages of the life cycle, is diffi cult and subjec- tive because early stage companies usually forecast a period of negative cash fl ow with uncertain future economic returns. Enterprise value analysis fi nds a “ right value ” and an “ adjusted value ” of a company after comparing general trends in valuation within companies operat- ing in the same business. Usually, the output of the analysis consists of values attributed to the equity of the company. The analysis further focuses on differ- ent valuations for different stages of investment. Seed fi nancing — Equity valuation is impossible and can only be developed if the business plan is built on a realistic business idea. Start-up fi nancing — Valuation is based on forecasting, but there is a high risk of uncertainty regarding the future sales trends and the terminal value. Comparison with similar deals is useful here. Expansion fi nancing — Valuation analysis faces the same issues as start-up fi nancing. At this point comparison with similar deals can be very useful. Evaluation is usually easier here than during start up because the com- pany is considered successful and there are similar fi rms with which to compare. Replacement fi nancing — Equity valuation is connected to the profi le of the deal and related to the replacement structure. Typical deals are LBOs or buy-ins and family and management deals where the counterpar- ties involved are critical and affect the defi nition of the company value (inheritance). 12.2 Five phases of company valuation 182 CHAPTER 12 Company evaluation in private and venture capital Vulture fi nancing — Typical target companies are mature and equity valuation is based on forecasting, but there is a high risk of uncertainty regarding sales trends. The terminal value of the deal and the amount and structure of costs carried are hardly quantifi able. It is also diffi cult to support the equity valuation through comparison with similar companies. In later chapters the methods used for company evaluation will be analyzed more deeply. Next are highlights of the most widespread methods. 1. Comparables — Provide a quick and easy way to obtain a rough valua- tion for a fi rm. This method is used when a fi rm with similar values exists. Elements compared include risk, growth rate, capital structure, and the size and timing of cash fl ow. This method is quick, simple to understand, based on the market, and common in the industry. There are many potential prob- lems when this method is used for private companies, such as the lack of public information on private companies and problems fi nding comparable fi rms. When it is used to compare public companies, it is necessary to adjust the outcomes due to the private company’s lack of liquidity. Their shares are typically less marketable then public fi rms, so a discount for the lack of liquidity is applied (lack of marketability discount falls between 25 and 30%). 2. Net present value — Most common method for cash fl ow valuation. Net present value of a company is obtained by computing the expected value of one or more future cash fl ows discounting them at a rate refl ecting the cost of capital. This method considers the potential tax benefi t created by leverage. It presents a serious problem with forecasting cash fl ow because the terminal value is greatly affected by the interest rate used, so it is criti- cal to identify the correct interest rate when discounting future cash fl ow. one solution is to use the weighted average cost of capital, which is quite easy to calculate based on the current debt equity ratio at the time. In real- ity this ratio is always subject to change, especially in LBO operations. 3. Adjusted present value — A variant of the NPV approach used when a company’s level of indebtedness is changing or it has past operations losses that can be used offset tax obligations. This method attempts to solve the problems faced by the NPR by calculating cash fl ow without debt and discounting by using an unlevered (defi ned as the equity capital invested in the company) interest rate. It further requires the quantifi ca- tion of interest and the relevant tax benefi ts discounted at the pretax rate of return on debt. This method is appropriately used when the capital structure (highly leveraged transactions such as LBOs) and the tax rate are changing. It is more complicated then the net present value and presents 183 diffi culties when estimating future cash fl ow and selecting the correct dis- count rate. 4. Venture capital — Values the company at the end of a defi ned period of time using one of the methods previously discussed. Then it discounts this terminal value by a target rate of return that is the yield assumed by venture capitalists as remuneration for the risk and efforts of this specifi c investment. This TRR is usually between 40 and 70% and is the biggest source of criticism of this method. Venture capitalists use such a high level of discount because of the lack of liquidity of private fi rms, the provision of strategic advisors to the target company, and because the entrepre- neur’s forecasting, included in the business plan, is usually too optimistic. 5. Asset option — The methods previously explained are not usable when managers or investors are capable of making fl exible decisions. This fl ex- ibility affects the value of the company, and these changes are not accu- rately computed in the discounted cash fl ow methods. According to the venture capitalist, the value of a company depends on the value assumed by independent predictor variables. The asset option method is not well known and the real-world opportunity for simple options and the exact pricing of these options are diffi cult to defi ne. 12.2.4 Price setting Finance theory on company valuation states that value and price are two differ- ent measures, not always coincident and sometimes clashing, that depend on various factors. The theoretical concept of company value, which differs from market value, is connected with the idea of economic capital: the value of a company in normal market conditions compatible with company capital with- out the considerations of the parties, their contractual power, their specifi c interests, and potential negations. As per this defi nition, the economic capital, as a measure of the company value, is independent from the eventual deal between the parties, the possibility that a new buyer will interfere, the contingent demand and supply situation, and the status of the M & A market. Calculating the economic capital is necessary to have an objective value creation realized by management defi ned as fair value. It is easy to understand that the market value of a fi rm is affected by the same external pressures as company value. These pressures are infl uenced by fi nancial market effi ciency and demand and supply. The price of a public com- pany depends on the participation negotiated; should the participation allow a minority presence in the capital subscribed or a majority control of the fi rm. 12.2 Five phases of company valuation [...]... Company industry Different industries have different value drivers that reveal where the value of a firm is created In industries where tangible capital (fixed assets and working capital) is a large part of the capital invested — such as the manufacturing of metals, banking and insurance, chemistry, or the real estate business — the value of this capital should be included in the final valuation Other industries... the company’s assets Not taking into consideration its capital structure, these flows are discounted with a rate that expresses the capital cost of the company, including the leverage structure (Refer to the cost of equity capital as explained in Section 13.3.4.) Using the cost of equity capital means that the capital structure effects are included in the cash flow and not in the discount rate Secondly,... Operating costs (including R&D) ϭ EBITDA Ϫ Depreciation ϭ EBIT ϩ Other income Ϫ Interest expenses ϭ EBT Ϫ Income taxes ϭ NET INCOME OR LOSS FIGURE 13.2 Profits and losses statement 192 CHAPTER 13 Techniques of equity value definition of the company Deducted first are all the costs created by the operations including research and development expenditures and obtaining the earnings before interest, tax,... setting, but firm valuation is more relevant Replacement financing — The main point is the price setting Vulture financing — Price setting is insignificant 12.2.5 Exiting During this phase enterprise value and price are calculated based on the investor’s exit The same enterprise value analysis and price setting activities are carried out, but the investor has to calculate the “right value” of the firm and. .. financial need must be covered by equity capital supplied by investment companies This makes the correct pricing of an equity stake one of the most important keys to success in the venture capital industry Company evaluation is based on the forecasted financial statement and balance sheet An inaccurate business plan leads to an incorrect equity value To calculate the value of equity, it is necessary to use... corresponding years considered in the estimation of future margins The EBIT is useful to value a company because it only includes ordinary depreciations such as material depreciations, leasing fees, and immaterial depreciations including trademarks, patents, and computer software Immaterial depreciations do not include the depreciation of goodwill and transaction costs incurred during buyout and acquisition... intermediaries during negotiation The final step in this phase is closing the deal Investors need to understand how price setting is used during specific stages of the investment Seed financing — Insignificant because it does not affect this phase Start-up financing — Company valuation is more relevant than price setting because money is channeled to the development of the investment Expansion financing — Investors... losses, and plus or minus every special operation realized on the stakes; for example, an increase in the equity capital value 13.3.2 Profits and losses statement Figure 13.2 illustrates how the company has performed netting the incomes realized with the sustained cost starts from the revenues realized by the core activity PROFITS AND LOSSES STATEMENT ϩ Sales and other operating revenues Ϫ Operating costs... real and underlying value of a firm Theoretically, these techniques are used to calculate the equity value of a potential venture- backed company: 1 Comparables 2 Net present value Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc All rights reserved 2010 187 188 CHAPTER 13 Techniques of equity value definition 3 Adjusted present value 4 Venture. .. depreciations, and amortizations (EBITDA) This value is the gross margin realized by the company Obtained from the EBITDA, just after deducting all company depreciation, is the operating profit (earnings before interest and taxes; EBIT) Then, netting the EBIT by the revenues not realized during operations (usually financial revenues) and by interests paid servicing the debt, we have the earnings before . page intentionally left blank 175 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Company evaluation in. page intentionally left blank 1 87 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Techniques of equity. ed by equity and debt, include differ- ent types of investments such as working capital investments, capital expen- ditures, immaterial expenditures, merger and acquisitions investments, and repayment