Valuing a start-up business Pontus Engström, PhD, MSc

Session 2

Basic concepts – Accounting 101

Income statement

Sales

- Costs ------------ Net result

Cash Inventory Machinery ---------------- Total Assets

Liabilities

Equity ---------------- Total Liabil.

& Equity

Balance Sheet

=

The value of any business is the net present value of future cash flows

Increasing ROI & High Reinvestment

Above-Average but Fading ROI

Below-Average ROI

Average ROI

Growth Fading Mature Turnaround?

ROIs Discount Rate (Investors’ Required Rate of Return)

Reinvestment Rates

But what are the future cash flow of a startup? Introducing the firm life cycle

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START-UP

?

Given the uncertainty of the future, investors prefer to see several valuations – these are the common simpler ones Book value of equity – implies the business is not long term earning returns higher than the cost of capital. This is also known as net worth and is calculated as assets – liabilities. Adjusted net worth – estimates the value of assets such as inventories, supplies, and fixtures in terms of cost of purchase and replacement value, and land and buildings at market value. Price / Sales multiple – identifies peers and relate their market valuation to the current net sales volume Price / Book multiple – identifies peers and relate their market valuation to the current book value of equity EV / EBITDA multiple – identifies peers and relate their current Enterprise value (market value of equity + debt) to their current EBITDA (Earnings bef. interest, taxes, depr. & amort.)

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Valuing a business with losses and negative cash flow Introducing the Price / Sales ratio and Price / Book ratio. 1.  Identify the Price / sales and Price / book multiple used for

publicly listed peers, or private if you can find. Take note of the ratio of peers with high growth rates as their multiple may be more representative.

2.  Estimate current or near term yearly sales, for instance by

annualizing last quarter sales, or taking current sales x 12.

3.  Apply the average peer price / sales ratio to the startup sales company´s sales.

4.  Apply the average peer price / book ratio to the startup book value of equity. If a higher multiple, make a good argument why it needs to be higher.

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Example – valuing a homebuilder startup

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Name Symbol Country

Market Capitalizat

ion (bil) [USD]

Industry Code - GICS Sub-Industry

Price / Sales Ratio - Current

Price / Book - Current

D R HORTON INC DHI USA 11.240 Homebuilding 1.04 1.91 LENNAR CORP LEN USA 9.279 Homebuilding 0.98 1.64 PERSIMMON PLC PSN GBR 7.253 Homebuilding 1.93 2.28 PULTEGROUP INC PHM USA 6.997 Homebuilding 1.17 1.47 TAYLOR WIMPEY PLC TW GBR 6.521 Homebuilding 1.60 1.85 BARRATT DEVELOPMENTS PLC BDEV GBR 6.430 Homebuilding 1.32 1.34 NVR INC NVR USA 6.391 Homebuilding 1.24 5.16 TOLL BROTHERS INC TOL USA 4.895 Homebuilding 1.17 1.16 BERKELEY GROUP HOLDINGS PLC BKGH GBR 4.623 Homebuilding 1.79 1.97 CALATLANTIC GROUP INC CAA USA 3.959 Homebuilding 1.12 1.03 BELLWAY P.L.C. BWY GBR 3.763 Homebuilding 1.64 1.84 GRUPPA KOMPANIY PIK PAO PIKK RUS 3.071 Homebuilding 3.77 6.04 TAYLOR MORRISON HOME CORP TMHC USA 2.135 Homebuilding 0.72 1.09 TRI POINTE GROUP INC TPH USA 2.120 Homebuilding 0.88 1.27 JM AB JM SWE 1.980 Homebuilding 1.22 3.76 REDROW PLC RDW GBR 1.917 Homebuilding 1.07 1.45 MRV ENGENHARIA E PARTICIPACOES S.A. MRVE3 BRA 1.631 Homebuilding 1.11 1.11 BOVIS HOMES GROUP PLC BVS GBR 1.525 Homebuilding 1.24 1.23 KB HOME KBH USA 1.487 Homebuilding 0.49 0.88 CREST NICHOLSON HOLDINGS PLC CRST GBR 1.484 Homebuilding 1.42 1.82 MERITAGE HOMES CORP MTH USA 1.389 Homebuilding 0.54 1.12 TOPBUILD CORP BLD USA 1.274 Homebuilding 0.79 1.39 MDC HOLDINGS INC MDC USA 1.261 Homebuilding 0.66 1.00 CYRELA BRAZIL REALTY SA EMPREENDIMENTOS E PARTICIP CYRE3 BRA 1.257 Homebuilding 0.94 0.69

INSTALLED BLDG PRODUCTS INC IBP USA 1.129 Homebuilding 1.70 9.87 Median 2.135 1.17 1.45

Problem – most publicly listed companies are more mature and have much lower growth rate than the early startups

•  If data exist on the pricing of other startups, you can use these peer ratios for the valuation

•  Argue for a higher multiple, but it is less convincing if you cannot show peer valuations.

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Increasing ROI & High Reinvestment

Above-Average but Fading ROI

Below-Average ROI

Average ROI

Growth Fading Mature Turnaround?

ROIs Discount Rate (Investors’ Required Rate of Return)

Reinvestment Rates

Use peers that are closer to the startup, not towards the end of the life-cycle

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START-UP

?

Mature peer

Growth peer

Fading peer

Sick peer

But more importantly, investors know that multiples is a fuzzy concept to value any business – but it is simple, but is inaccurate

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R2= 0.00

0

5

10

15

20

25

30

35

40

-100% -50% 0% 50% 100%

Earning s Growth(F Y 0toF Y 1)

P/E

Ratio(FY1) We may as

well call it a “shot-gun approach” to valuations

Discounted Cash Flow Method When someone buys a business, they are not only buying the current assets and liabilities – they are also buying future earnings/cash flows. This is the most accurate method of calculating business value, but it is also the most difficult and suffers from many assumptions. The most critical assumptions are: 1.  What happens after the explicit 5 year forecast period?

2.  What is the long term growth and return on investment in the business? Same as WACC?

3.  What is an appropriate discount rate (WACC)?

Example DCF – please make your own or modify (available under Downloads on portal)

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Start-upInterna,onalAB 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17Forecast(SEK) 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033Netsales 500,000 850,000 1,300,000 1,800,000 2,300,000 Growthrate 70% 53% 38% 28% Netsales 450,000 686,250 958,732 1,235,289 1,492,641 1,775,496 2,081,858 2,409,324 2,755,220 3,116,729 3,491,011 3,875,299 4,266,980 4,663,657 5,063,182 5,463,684 5,863,576Growthrate(%) 53% 40% 29% 21% 19% 17% 16% 14% 13% 12% 11% 10% 9% 9% 8% 7%Opera6ngexpenses 710,000 838,000 1,075,000 1,380,000 1,680,000 EBITDA -210,000 12,000 225,000 420,000 620,000 EBITDA(%) -42% 1% 17% 23% 27% EBITDA -189,000 7,266 124,451 216,176 301,773 358,959 420,897 487,102 557,034 630,121 705,791 783,484 862,672 942,870 1,023,643 1,104,614 1,185,462EBITDA(%) -42% 1% 13% 18% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20%Interestexpense 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600 29,600Deprecia6on&Amor6za6on D&Aas%ofrevenue EBT -218,600 -22,334 94,851 186,576 272,173 329,359 391,297 457,502 527,434 600,521 676,191 753,884 833,072 913,270 994,043 1,075,014 1,155,862Taxes(28%) 26,558 52,241 76,208 92,221 109,563 128,101 147,681 168,146 189,334 211,088 233,260 255,716 278,332 301,004 323,641Result -218,600 -22,334 68,293 134,334 195,965 237,138 281,734 329,402 379,752 432,375 486,858 542,797 599,812 657,554 715,711 774,010 832,221 Sales/assets 2 2 2 2 2 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9ROA -97% -7% 14% 22% 26% 26% 25% 25% 24% 24% 24% 23% 23% 23% 23% 22% 22%Capex -67,500 -88,594 -102,181-103,709 -96,507-132,665-119,475-127,705-134,892-140,981 -145,962 -149,864-152,747-154,695-155,806 -156,187-155,949Capex%ofSales -15% 13% 11% 8% 6% 7% 6% 5% 5% 5% 4% 4% 4% 3% 3% 3% 3% FreeCashFlow(FCF) -121,500 95,860 200,073 267,643 322,071 399,404 430,809 486,706 544,244 602,956 662,420 722,261 782,159 841,849 901,117 959,798 1,017,770PresentvalueofFCFs -100,791 65,967 114,214 126,746 126,524 130,160 116,464 109,149 101,249 93,052 84,804 76,705 68,908 61,525 54,632 48,271 42,462SumofpresentvalueofFCFs 1,584,018 Discountrate: 20.5% EnterpriseValue 1,584,018 Less:Netdebt 370,000 EquityValue 1,214,018 DilutedSharesOutstanding 10,000 EquityValuePerShare(SEK) 121

Communicatedbymanagement SSEconserva6vees6mates Growthinperpetuitymethod: Longtermgrowthrate 2.0% WACC 20.5% Freecashflow(t+1) 328,513 TerminalValue 1,771,260 PresentValueofTerminalValue 695,830 Faderate: 10%

Example of DCF assumptions

0%

10%

20%

30%

40%

50%

60%

Forecast assumptions

Growth rate (%)

EBITDA (%)

1.  Evaluate the Opportunity using the seven dimension framework (Use John Mullins: “The New Business Road Test”).

i.  Is there genuine demandii.  Attractive market sizeiii.  Attractive industry (e.g. Porter´s 5 forces)iv.  Is there a competitive advantage / sustainable business model?v.  Team – aspirations & risk propensityvi.  Team – ability to execute on Critical Success Factorsvii.  Team – connectedness (suppliers, competitors, customers)

2.  Advice on the future financing strategy i.  Debt, equity issue, crowd funding or customer funded business

model

3.  Valuing the startup i.  Financial forecast 3-5 yearsii.  Valuation

Assignment: Evaluating a Start-up Opportunity

Thank you for the attention!

Pontus Engström, PhD, MSc. Stockholm School of Economics E-mail: pontus.engstrom@hhs.se