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Science, Art or Sorcery?
Perspectives on Setting (and Enhancing) the Valuation of .com Startups

Clues To The Mystery Game Of Valuation

From the netpreneur (Ms. Kim, in the drawing room, with the idea):

1. Kids, don't try this at home. Even if you've got a Wharton MBA, leave the esoterica of DCFs to the pros (who probably won't look at it anyway)— just make sure you have answers for business fundamentals like revenue growth and market comparisons.

2. Surf the right beaches. West Coast VCs tend to give higher valuations then East Coast VCs, but they like West Coast companies and may ask you to move. Psst, you can play 'em against each other.

3. I forgot to remember to forget. VCs tend to fix companies in a ballpark valuation range that usually won't change, even though your company grows between your first meeting and the signing of the term sheet. Put off initial meetings as long as possible, and sell your case for higher valuation if you reach milestones in between.

 

From the venture capitalist (Colonel Frederick, in the corner office, with the cash)

1. Don't work backward from the market cap of a "gorilla" like AOL or Cisco. Doing so ignores the private liquidity discount, the lower risk that has been beaten out of the gorilla and the fact that its current valuation may be unsustainable.

2. Don't minimize short-term dilution at the expense of long-term dilution. If you're talking to VCs, your goal should be to go public or some other exit strategy.

3. Make sure you understand VC-speak. Is your pre-money fully diluted?

4. Compare apples to apples. Not all fully diluted pre-money is created equal.

5. There are only two kinds of entrepreneurs—those who run out of money and those who don't. Make sure you're looking at your company's entire funding life cycle.

 

From the investment banker (Mr. Hooke, on the street, with the common stock)

1. To calculate Discounted Cash Flow: First, apply a reasonable value multiple (such as 25x P/E ratio or 12x EBITDA) to the results in the first year in which the company is expected to make money. Discount the future value to the present at a 30%-40% annual rate. Easy, huh?

2. The Relative Value Method is most effective with established firms having earnings and positive EBITDA. Calculate value multiples of similar public companies, M&A deals or private equity financings.

3. To calculate relative values for Internet companies in startup phase, use a combination of DCF and comparables using projected data, similar VC deals and VC rules of thumb such as $1 million for 20% ownership.

4. To calculate relative values for Internet companies beyond startup phase, look at comparable, publicly traded companies and/or VC deals and calculate Internet ratios such as price-to-sales, price-to-visits or price-to-employees.

 

From the analyst (Prof. Anderson, in the garden, with the data)

1. Internet company valuations fluctuate wildly. It may be no surprise, but the data bears out that even within sectors there can be large valuation differences between comparable companies.

2. Ultimately, value is equated with discounting cash flow that companies can hope to achieve. Though they're often the only numbers usable in the Internet space, remember that operating metrics are just potential indications of value.

3. Do not underestimate the value of intellectual property assets. In many Internet companies these can amount to 90% of value, and many firms can use them as currency.

(Washington, DC -- December 15, 1999) According to Jeff Hooke of Hooke Associates, valuation is not like physics. "You can't duplicate results by dropping a ball and seeing how many seconds it takes to fall."

Besides, people tend to nod off during physics lectures. Not the case for the more than 300 netpreneurs at this morning's Netpreneur Program Coffee & DoughNets meeting, where Hooke and his fellow panelists shed light on a subject that keeps more netpreneurs awake at night than almost any other—how to calculate the value of their company. It's a topic that can be mystifying for any entrepreneur, but in the Internet world it often seems to defy all logic.

Hooke, an investment banker, was joined by three other panelists, each with a different perspective on the subject, including Angie Kim, President of EqualFooting.com, a startup that recently completed its first funding round; Scott Frederick, principal in venture capital firm FBR Technology Venture Partners; and Jeffrey Anderson, principal at Bond & Pecaro, a consulting firm specializing in valuations, business consulting and related financial services for companies in the Internet, broadcasting, cable, wireless and publishing industries.

Each agreed with Hooke that there is no universal science to valuation, although there is plenty of math involved in the two main systems for assessing valuation: the Discounted Cash Flow (DCF) method taught in business schools, and the Relative Value method which calculates value by comparing similar companies, much as one determines the price of a home by looking at recent sales in the neighborhood. The latter tends to be the one used most often in the Internet space, so full of young companies and business models.

Hooke calls the valuation process, "a methodology for developing a rational justification for why you should make a purchase or sale of a stock or a company." Sounds simple, and yet, if it's not a science, is it an art? Few would call the process pretty, and, while it seems to involve a fair dash of sorcery, there should be reason behind it. While Frederick agrees that you can't rely on hard rules, nonetheless, "If you were to put the four of us who comprise FBR Technology Venture Partners in separate rooms and just slid business plans under each door, telling us to put them in [value] buckets without any communication between us, I bet you that we would have almost 100% unanimity."

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The "buckets" he talked about are threshold levels for venture funding linked by rules of thumb to various stages of a company's development. Other VCs may differ, but Frederick's buckets are $2-$5 million pre-money, $5-$10 million, $10-20 million, $20-$50 million and $50+ million. 'Two people with an idea,' for example, fall into the first bucket.

"Is there any rhyme or reason to those categories?" Frederick asked, then answered himself, "I don't know. It's kind of what I developed over time." For VCs, who are usually looking for 10-times return on investment, it's mostly a factor of magnitude, timing and risk of future earnings, with the emphasis on the risk.

The good news is, if you play your cards right, you can move up into the bigger buckets. Angie Kim and EqualFooting.com did so, in part by leveraging competition between VCs. She offered practical tips to help other netpreneurs improve their results. Regarding Frederick's buckets for example, Kim observed that, "A company's value seems to be pegged at the time when you do your first meeting with that particular VC." Time passed and milestones were made between that first meeting and closing the deal, but the VC's valuations didn't. Kim's advice, as long as you are comfortable that you can stay afloat financially, is to, "try delaying the meetings until you have gotten over a significant bump in the company's history, whether it's hiring a first employee outside the founding group, having a prototype or signing the first major marketing agreement."

Valuations can be particularly problematic in the Internet space because of factors like young technology, new business models, sky-high Wall Street numbers and the fact that so few companies today have profits, revenue or other traditional markers for estimating value. Bond & Pecaro's Anderson went through examples of the comparable metrics (Figure 1) and valuation multiples (Figure 2) for recent IPO companies. "It's particularly important to be careful in selecting comparables," he warned. "We try to look at companies that are similar in terms of structure, market position and size to those companies we are analyzing."

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Internet company valuations are also complicated by the fact that they are...well...Internet companies, and that can mean so many different things. Back when the telephone was invented, Frederick noted, if a stock broker used a telephone they didn't suddenly become a telephone company. Online brokers, on the other hand, are considered a new kind of beast. Though they have certainly changed the industry, they still make money by getting people to make transactions through their service, just like traditional stock brokers.

For all the rip-roaring, razzle-dazzle of the Internet space, there have actually been climates like this before in industries like cable and biotechnology. Frederick pointed out, "There were biotech companies whose stocks fell when the FDA announced approval of their products. One great Wall Street analyst said he was mortified because he could no longer garner a biotech multiple; it was now a real drug company."

So what's the verdict? Science, art or sorcery? None of the above. Just a fact of entrepreneurial life, like the law of supply and demand. In fact, according to Frederick, "Ultimately valuation is determined by supply and demand. In the end, if you have something that's red hot, I don't care what bucket I think it belongs in, if you absolutely sell us on the idea and we want to make sure that we are a part of it, we'll try to work with you to make a valuation work."

Copyright 1999, Morino Institute. All rights reserved.

 

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