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Copyright © 1999, Morino Institute. All rights reserved. Edited for length and clarity.

We are truly fortunate to have a great lineup of speakers, starting with Jeff Hooke.

It's very nice to be here. Clearly, there is a great deal of interest in Internet valuation and, with this group of experts, I don't think we'll be disappointed.

So, let's start with how you value a company in a general way. I always like to tell people that valuation is not like physics where you can duplicate results by dropping a ball and measuring how many seconds it takes to fall. Valuation is not a science at all. It does, however, give you a methodology to derive a rational justification for why you should make a purchase or a sale of stock or of a company. This rational concept, however, is often clouded by herd psychology, emotion or just poor logic.

What about the Relative Value Method? Relative value involves taking the value multiples (such as P/E or EBITDA) of publicly traded firms, M&A deals or VC financings and calculating fundamentals to come up with a table of multiples that can be applied to the firm in question. This method is most effective with companies that have positive earnings or EBITDA, but it's not a great a method for companies that show losses. It's a little bit like real estate valuation. If you are looking to buy a four-bedroom home in McLean, Virginia, you look at comparable sales, including how the last three similar houses traded in McLean. For companies, you would look at four or five similar firms or deals, then apply the multiples to your situation.

If a firm is losing money and doesn't have an P/E ratio or EBITDA, it will typically find multiples of operating statistics. For example, enterprise value divided by number of eyeballs hitting the site, or divided by sales or number of employees. This is not new. People sometimes think so, but it's been done before with cable TV companies in their infancy. They were valued on numbers of customers or sales. Cellular phone companies would calculate value, based on the number of persons covered in their license area.

For companies that are past the startup phase, another alternative is to look at publicly-traded companies and VC deals, and apply the kind of ratios I mentioned such as price/sales, price/visits or price/employees. For companies that are still in the startup phase, VC firms and strategic investors like to use a combination of DCF, comparables based on projected value and similar VC deals. They might, for example, project that a certain company will have sales of $10 million four years from now. Companies are trading at 5x sales, so the company three years from now might have a value of $50 million—take it back to the future. They might also look at comparable VC deals that have taken place with similar businesses, although sometimes that can be hard to find. There are also a number of VC rules of thumb. For a "concept company" that has no real track record whatsoever, a rule of thumb might be $1 million for 20% of the ownership.

Good morning. Fran gave us the challenging test of covering the topic of valuation of Internet companies in five minutes or less. I had hoped that one of you entrepreneurs in the audience would have developed a Web site that would provided us with instant valuation for these companies—one where you could plug in the name of the company, its brand and the total cups of coffee consumed by each employee per day. I'm sure that those variables are closely correlated with success.

Although there are no magic formulas for valuing Internet companies, the good news is that there have been several hundred IPOs this year. This has provided us an opportunity to take a look at the financials and operation of many new, emerging growth companies. Jeff did a great job summarizing the methods available to assess value in companies today. We find it useful to look at as many of these tools as possible.

I'd like to share with you my thoughts in three areas: the market approach, income approach and the importance of intangible asset valuation as it relates to Internet companies.

The market approach analyzes recent sales transactions of businesses. In a recent study, we set out to illustrate the marketplace range of valuation multiples for Internet companies. As Jeff mentioned, the valuation multiple is simply a ratio or measure used to compare the relative values of businesses. We examined over 550 transactions involving Internet-related sales this year through the third quarter of 1999. These include IPOs, mergers and asset and stock sales. We then separated each transaction into four very broad categories: Internet service providers (ISP), portals, Internet retailers and business-to-business (B2B) ventures. As you can imagine, categorization of these companies is very difficult. The industry is changing quickly and many of the companies rated in several categories.

The calculation of valuation multiples was based upon a two-step process. First, we computed the enterprise value. In the case of asset sales, for 100% of the assets that were purchased, we used a purchase price paid for those assets as the enterprise value. In the case of stock sales or IPOs, we started with market capitalization of those companies at that time, added long-term debt and deducted working capital to get the enterprise value in those transactions.

There are three things to keep in mind when looking at this data. First, like any broad averages, they are just starting points for relative valuation. The operating metrics, whether you consider revenues, subscribers or anything else, are only potential indications of value. Ultimately, the value is equated with discounted cash flows that companies hope to achieve. Second, it's very important to be careful in selecting comparables. We try to look at companies that are similar in terms of structure, market position and size to those companies we are analyzing. Third, the multiples appear high on an absolute basis, but remember that these companies are growing at 100%, 200%, 300% in revenues per year. These multiples will be dropping quite rapidly in the next few years.

We regard the income approach as a primary method. It is extremely difficult with valuations as high as they are today to apply the discount and income approach to these companies; nonetheless, if you haven't tried, you really have to sit down and take a look at the revenues—hopefully the operating profits for two, three, five years out and for the long term. Even though it's difficult to predict what next year's revenues are going to be, in order to sustain these huge values, it's incumbent upon the operators and owners to look at the company in terms of getting to the steady state stage.

scott frederick: the venture capitalist

Good morning. Jeff and Jeffrey have done a very good job of laying out what happens in the public markets. Now I want to try to explain what happens at a much earlier stage in a company's life cycle.

I want to walk through some dos and don'ts in attempting to establish the valuation of a venture capital stage company, then conclude by taking you through our methodology—although I'm not even sure that's the right word for it. Let me start with the don'ts because they are easier.

The first thing is: don't work backward from the valuation or the market cap of a "gorilla," such as an America Online, Cisco or Microsoft, when trying to estimate what your rate of return is going to be. It's going to hurt you for two reasons. First, it's not going to be productive at all in determining the proper valuation for an early stage company. It ignores the private liquidity discount, as well as the fact that a large portion of the risk has already been beaten out of the gorilla. Remember, value is a function of the magnitude, timing and risk of future earnings. Hopefully, you heard that accent on the word risk. In addition, it ignores the fact that the gorilla's current valuation may not be sustainable. More importantly, doing so actually could hurt you in getting financing. We see about 1500 to 2000 business plans a year. If we see a plan that has an unrealistic valuation expectation in it, we have to take that into consideration when deciding how to allocate our time. Regardless of how great or compelling the business idea, we have to ask ourselves whether or not we want to bring you in if we think we're going to have to wrestle with you for a few weeks about valuation?

Another concept that I think is relevant is the concept of increasing returns. Success is nonlinear. Once a "gorilla" reaches a tipping point or critical mass, it's off to the races. Success breeds success and their valuations rise exponentially. Most of the companies we value have not yet reached that point, so they can't justify similar valuation multiples.

The second thing I urge upon you is: don't minimize short-term dilution at the expense of long-term dilution. Let me give you three examples straight from our portfolio—LifeMinders, webMethods and Silicon Wireless. We financed two of those companies at single digit pre-money valuations and one at a valuation of over $100 million pre-money. Two are going to be successful IPOs—one is already public and the other is going out very, very soon. The third is bankrupt. There is a lesson in that. The company we funded at the very high valuation tried to toe the line on dilution. They put themselves in a position where they had nowhere to go on subsequent financings. The other two companies realized that they had to get money quickly to build a business, and they did just that. Was the valuation right in single digits? It's going to work out great for us and it's certainly going to work out great for everybody on the management teams. There has been a lot of wealth created in those companies.

If I can get across one message, it's to look at a financing round not in isolation, but over the lifecycle of your company. Your goal is to go public or to have some sort of exit, I presume. If not, you are probably not appropriate for venture capital. If that is your goal, look at the sum total effect of dilution on your path to liquidity, not just the dilution you are going to suffer in your initial round of financing.

So, what are the dos? My time is limited, but, first, I urge you to make sure you understand VC-speak. We work in this field every day, so we tend to think that everybody knows what we are talking about when we use terms like pre- or post-money valuations, but it's not always intuitive. One term you will hear a lot is fully diluted pre-money.

Second, make sure that when you compare alternative ways to finance your business that you are comparing apples to apples. What do we mean when we say fully diluted pre-money? Why do we even use that term? We use it because it's the easiest way to give an indication of what valuation range we are coming in at—e.g. $10 million pre-money versus $50 million pre-money. But when a VC speaks of a pre-money valuation, he or she generally is speaking of a fully-diluted pre-money valuation. This means that they are going to include in the calculation all the options and any warrants. We all basically include anything that can turn into common stock at the end of the transaction.

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