5. Business Valuation, Risk Analysis, The Due Diligence Process for the New Venture

1. 5. Business Valuation, Risk Analysis, The Due Diligence Process for the New Venture 5.1 Business Valuation Methods for NV’s 5.2 Risk Estimation and Analysis 5.3 Due Diligence

2. 5.1 Business Valuation • Two valuation perspectives: the entrepreneur and the VC • Different perspectives due to diversification opportunities • The VC fund is diversified and therefore has a lower required rate of return • The entrepreneur has a large allocation of assets in venture, therefore has higher required rate of return; cannot diversify away unsystematic risk. • The discount rate depends on the ability of an investor to diversify

3. 5.1 Business Valuation • Many Uses of Valuation: • Strategic Planning • Estate Planning • Partnership formation and dissolution • Initial public offering (IPO) • Stock options and Employee stock ownership plans (ESOPs) • Financing • Negotiating a merger or sale of a venture

4. 5.1 Business Valuation • Valuation Methods: • Multiple or ratio method: • Price to some measure of financial performance (e.g., revenues, operating CF, net income, operating income) • Use a proxy group or rule of thumb from other valuations used in deals • Use publicly-traded firm stock price and • Review some examples • DCF models • Growth rate (may change every year for first few years) and discount rate are key drivers • Use capital asset pricing model (CAPM), E/P, or risk premium method to estimate discount rate (to be discussed)

5. 5.1 Business Valuation Conceptually, value is determined by the PV of the free cash flows (Ct) of the firm discounted by the risk-adjusted discount rate or cost of capital (rt):

6. 5.1 Business Valuation • Gordon “Dividend” Discount Model: where P0 is the current estimate of the stock price or value of equity of the venture CF0 is the estimate of the “dividend,” in the case of a VC, the near term cash flow g is the long-term growth rate in cash flow k is the discount rate, or opportunity cost of capital Pn is the expected harvest price of the venture

7. 5.1 Business Valuation • Valuation Myths: • Beauty is in the eye of the beholder. • The future is anybody’s guess. • The VC demands unreasonable high ROR’s to compensate for their risk. • The outside investor determines what the venture is worth.

8. 5.1 Business Valuation • Asset-based approaches • Book Value • Replacement Cost • Liquidation Value • Market comparisons • Secondary-market financial claims on comparables • Primary-market transactions on comparables • Acquisition transactions • Revenue, Earnings, and Cash Flow-based approaches • Multiples of income statement variables or cash flows • Discounted Cash Flow • The objective is always to value future cash flows

9. 5.1 Business Valuation The market-determined discount rate can be estimated by the capital asset pricing model using betas of similar publicly traded firms or using accounting betas of other firms that are not traded (assuming all equity investment):

10. 5.1 Business Valuation

11. 5.1 Business Valuation • What cash flows should be valued? • The expected cash flows to an investor in the financial claim that is being valued. • “Expected cash flow” means the mathematical average of possible outcomes, weighted by their probabilities. • Leads to discussion of risk analysis

12. 5.1 Business Valuation Expected Actual Cash Flow Operating Cash Flow Operating Cash Flow = EBIT + Depreciation Expense - Capital Expenditures - Increase in NWC Cash Flow to All Investors (both stockholders and creditors) Total Capital Cash Flow = Operating Cash Flow - Actual Taxes

13. 5.1 Business Valuation Valuation Decision Criteria: NPV > 0 and IRR > Required rate of return

14. 5.1 Business Valuation: Multiples Change

15. 5.1 Business Valuation

16. 5.2 Risk Estimation Risk analysis can be either formal of informal Formal: Quantitative: Use financial/statistical methods to dispersions of CF and rates of return, and. most importantly, chance of disappointment or complete loss of investment Informal: Qualitative: Assess qualifications of management, compelling nature of the offer, customers, …, and due diligence to uncover actual and latent liabilities

17. 5.2 Risk Estimation Quantitative risk estimation methods: Standard deviation (error) of ROR or CF CAPM beta estimation Monte Carlo simulation of NPV, IRR (Outline 6)

18. 5.2 Risk Estimation Standard deviation or standard error of ROR or CF: usually a ratio based on coefficient of variation (compare with stock market): Standard deviation or standard error is (divide by n, n-1, or n-2 depending on E(CF) :

19. 5.2 Risk Estimation Discuss the normal distribution and the first two moments of the distribution, E(X) andσ2 and the relationship betweenσand E(X)

20. 5.2 Risk Estimation Capital asset pricing model: where E( ) is expected value k is the total rate of return on the stock rf subscript refers to “risk-free” rate of return m subscript refers to “market” rate of return βi is the systematic risk index for the stock

21. 5.2 Risk Estimation Capital asset pricing model beta can be estimated with the following regression: where ki,t is the total rate of return on stock i at time t rf subscript refers to “risk-free” rate of return m subscript refers to “market” rate of return βi is the systematic risk index for the stock αi is the intercept of the regression, referred to as Jensen’s alpha for this model specification εi,tis the regression error term

22. 5.2 Risk Estimation • CAPM estimation and use for a NV: • can be estimated with accounting returns since privately held using a measure of financial performance (referred to as accounting betas) • beta can be obtained from secondary information • does not capture all of the risk to be priced with the NV • be careful of relying on precise models such as the CAPM; it should be used only as additional information for the NV and not the sole risk measure

23. 5.3 Due Diligence Purpose is to verify credibility of management, product, financial statements, and other material representation of the management team. Involves financial, accounting, legal, reference / background, and engineering reviews Used to potentially rebut valuations, assess risk associated with credibility of representations, uncover latent and actual liabilities that reduce valuations