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science, art or sorcery?

clues to .com valuations

Valuing a startup company has always seemed a mystery for startups companies now made doubly arcane for companies in the revolutionary, hyper-competitive Internet space. What's the secret? At this Morino Institute Netpreneur Program Coffee & DoughNets meeting held December 15, 1999, netpreneurs got clues from four expert perspectives: an investment banker, a valuations analyst, a venture capitalist and an entrepreneur who recently went through the first funding process.

Statements made at Netpreneur events and recorded here reflect solely the views of the speakers and have not been reviewed or researched for accuracy or truthfulness. These statements in no way reflect the opinions or beliefs of the Morino Institute, Netpreneur.org or any of their affiliates, agents, officers or directors. The archive pages are provided "as is" and your use is at your own risk.

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

 

fran witzel: introduction

Good morning. I'm Fran Witzel, vice president of the Netpreneur Program.

If the 600+ registrations for today's 300 seats is any indication, valuation appears to be a popular subject among netpreneurs. Although we only have time to barely scratch the surface, we hope you will find this an informative and thought-provoking introduction to this challenging and important subject. Beyond what we cover here, you may also want to visit Bond & Pecaro's Cybervaluation report, VentureOne's Customized Valuation reports, FairShare.com's Valuation Calculators and Fran's Funding Resources for more information.

Jeff Hooke of investment banker Hooke Associates, our first speaker and our moderator, will present some basic concepts on company valuation, after which we will hear different perspectives from Jeffrey Anderson, valuation expert with Bond & Pecaro; Scott Frederick, a venture capitalist (VC) with FBR Technology Venture Partners; and Angie Kim, a netpreneur who is president and chief customer officer of EqualFooting.com. We'll then open it up to the floor, taking your questions, as well as those that have come in by email.

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

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jeff hooke: the investment banker

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.

When you boil it down, there are basically two methods for valuing a stock. The first method is the Discounted Cash Flow (DCF) method. For those of you who have taken a business school course, that's the method you usually learn about. The second method is the one that's far more popular on Wall Street and in the real world, the Relative Value method, which looks at comparable companies and transactions.

Let's go over a quick example of a DCF calculation for an Internet company in today's world. Say the company is losing money in 1999, as many of them are, and it's forecasted to lose money for the next five years, finally making money in 2004. Using the DCF method (Figure 1), you would assume there are no dividends paid over that five-year period, so there is no dividend cash flow to project. For 2004, however, you apply standard earnings multipliers, either P/E ratio or EBITDA ratio. You now have a big number projected out in the future, and you discount that value to the present. If the company was Proctor & Gamble or General Motors, you might use a discount rate of 15%. Since Internet companies are more speculative, the discount rate should be 30% or 40%. If you apply that kind of discount rate to a company that is theoretically worth $100 million in the year 2004, it would be worth $27 million today.

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.

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jeffrey anderson: the valuation analyst

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.

Next, the enterprise value was divided by an appropriate metric. As Jeff mentioned, commonplace metrics may include revenues—either trailing revenues or year ahead projected revenues. Operating metrics may include subscribers, registered users, customers or monthly visitors, among many others. As expected (Figure 2), the multiples in all segments varied quite widely. The multiples in the charts are based upon trailing revenues. We next computed a weighted average for each full set of data in each segment. We analyzed the data for outliers and atypical transactions in order to determine a broad range of multiples (Figure 3). You can see that the variables were quite large, both between segments and among companies within each segment. It's interesting to note that the weighted average multiple by subscriber in the ISP sector is in the $1000-$2000 per subscriber range, which contrasts with recent sales of cable TV systems, many of which have traded in the $4000-$5000 range.

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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.

Very quickly, I'd like to touch on intangible asset valuation. If you take the purchase price paid for some of these companies and deduct the fixed assets, you are left with a huge value to allocate, probably 90% or more that is attributable to their intangible assets. The reason it's important is that many Internet companies, both new media and traditional companies, have been using intangible assets as a form of currency. A good example is CBS which traded advertising promotion dollars for an equity stake in Sportsline USA. There are many other examples that have occurred this year. Online companies also are shifting some of their assets to other companies as a form of currency. Take, for example, the opportunity in the media sector with broadband media developing so rapidly. Many of these new media companies have a great chance to monetize some of their valuable intangibles. These include content in the form of programming, audio/video archives, sports information and data. Customer assets include subscribers, audience bases, marketing in the form of promotion and unique distribution channels. It's possible to value these assets, for example, in a situation where a company might contribute banner ad space for a two-year period. You might consider the foregone opportunity of giving up the space. Could you have sold it? What are the implications of giving up the space for two years? Alternatively, from an income approach, what are the incremental revenues or operating profits that could have been derived if that space had not been contributed to a joint venture, marketing agreement or a new company. Take a close look at these intangibles, not just as a way to generate or monetize the revenues, but also as a form of currency for partnerships, joint venture or in raising equity.

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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.

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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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