valuation anand lunia shailesh v singh 23 jul 2011 v2

An Introduction To Venture Capital

Anand anand@seedfund.in

Shaileshsvs@seedfund.in

AgendaSaturday, July 23rd, 2011

1. The Billion Dollar Club?2. What is Venture Capital?3. Valuation Methodologies4. Valuation in Venture Capital5. Structuring a Fund6. Case Study: MMT

The Billion Dollar Club

The Billion Dollar Club

Airbnb is definitely in the club. The crowdsourced marketplace for turning your apartment into a hotel for a night grew 800 percent last year in nights booked to 800,000. There are currently 60,000 listings, and bookings keep growing by 40 to 50 percent a month. Sublets are next.

The Billion Dollar Club

Square is also in the club. It is raising at least $50 million. Square passed 500,000 card readers and 1 million transactions in May, and is processing more than $3 million a day in mobile payments. COO Keith Rabois told us at Disrupt NYC that Square will do $1 billion in transactions this year, and he thinks it could ultimately do better financially than Paypal (where he was an early executive). 

The Billion Dollar Club

Dropbox, the Y Combinator file-sharing startup that only ever raised $7.2 million might end up with the largest valuation in the club, perhaps as high as $1.5 billion or $2 billion. It’s just growing like crazy, with 25 million users saving 200 million files daily. That’s up from 4 million users 18 months ago.

The Billion Dollar Club

Gilt Groupe is already in the club. It closed a $138 million round at about a $1 billion valuation last May. One of the first companies to introduce online flash sales in the U.S., Gilt is on track to do $500 million in revenues this year and has expanded from fashion to food, travel, local deals, and more.

The Billion Dollar Club

Gilt Groupe is already in the club. It closed a $138 million round at about a $1 billion valuation last May. One of the first companies to introduce online flash sales in the U.S., Gilt is on track to do $500 million in revenues this year and has expanded from fashion to food, travel, local deals, and more.

The Billion Dollar Club

Just above this group, is

Pandora (which just went public with a $2 billion market cap),

LivingSocial (with a $3 billion valuation),

LinkedIn (already public, with a $6.3 billion market cap),

Twitter (which is worth anywhere from $3.7 billion to $10 billion),

Zynga (which will be worth north of $10 billionwhen it goes public),

Groupon (which could be worth more than $25 billion) and

Facebook (which is already worth $50 billion and could go as high as $100 billion by the time it IPOs).

Apple

The Billion Dollar Club-Google

Multiples will change with maturity

What is Venture Capital?

Private Equity & Venture Capital“Private Equity” means capital to companies

not quoted on a stock market, in exchange for an equity participation

Venture Capital (VC) is a sub-class of Private Equity characterized by investments made for the purpose of developing, launching, and expanding new products or service offerings

• Seed Fund• Venture Capital • Buyout / Leveraged Buyout • Growth Capital• Special Situation Funds

– Stressed Asset• Real Estate Fund• Infrastructure Funds• Secondary Funds

Type of Alternative Investment Class

Source : Erasmic Fund

Fund Raising Pattern – Life Cycle of a Startup

• Higher returns• Risk capital• Technology driven ?• Capital efficiency • Unlisted companies / PIPE

Key Attributes

How VC’s work

Investor

Investor

Investor

VCfund

Investor

Startup

Startup

Startup

• Fee Structure : 2 :20 model– During commitment period– Post commitment period

• Draw down schedule– Duration– Fund amount

• Alignment of interest– Carry structure– Claw back provision

Deal Structure

Attributes of a Great VC Fund

• Bets on people not trends• Driven by the big idea• Looking for a ‘Winner’• Not afraid of failure• Understand how to manage a portfolio of

risk• Serves as a fantastic coach• Does her best work outside of the board

room• Not waiting for validation from other VCs

In the VC’s Mind• Is this the right team?• What’s the entrepreneur's motivation?• Is this a billion dollar opportunity?• Is it a game changer?• How competitive is the space?• How defensible is the product?• How much is this thing going to take?• How long to maximize value and exit?

Stages of Investment

Stage vs. Return

In the VC’s mind• IRR (Internal Rate of Return)

– Company’s Current and Future Valuation• Comparables (P/E,P/S,…), “Number of”, DCF, …

– What’s The Best Strategy To Create Value• Which are the achievable milestones and what’s the financing

needed ?• When is the break-even expected ? With which margins and

revenues.

– Exit Strategy• Trade sale, IPO, Nth+1 round of financing, ..

• Minimizing Risks– Diluting the investment– Liquidation Preference rights

Valuation Methodologies

Factors Captured in Valuation• Time Value of Money – Value of dollar

today vs. tomorrow• Risk of Cash Flows – Certainty of cash

flows• Growth Potential of Cash flows –

Future potential of business

Valuation Methodologies• Two main valuation methodologies:

– Discounted Cash Flow Analysis (“DCF”)• Current value based on internal cash flows

projections• Adjusts for risk and time value of money

– Multiples• Useful in comparing similar companies • Captures operating and financial characteristics

(e.g. expected growth) in a single number that can be multiplied by some financial metric (e.g. EBITDA) to yield an enterprise or equity value

• Expressed as a ratio

Discounted Cash Flow Analysis• Current Value based on Discounting Projections• Key Components:

– Free Cash Flow– Terminal Value– Discount Rate

• This method works very well for businesses with stable cash flows (i.e. infrastructure, mature businesses)

• For start-ups, however, a DCF does not work as well due to: the volatility of cash flows and difficulty it's often impossible to model revenue correctly, let alone cash flow, and terminal value

DCF Example – Company A

Year 1 Year 2 Year 3 Year 4 Year 5Free Cash Flows 630 662 695 729 766

5% 5% 5% 5%Discount Factor (1+R)^n where R=discount rate and n=year being discounted

1.09 1.19 1.30 1.41 1.54

Discounted Cash Flows 578 557 536 517 498

Sum of Cash Flows 2,685

Perpetuity Value Year 5 Cash Flow x (1+g)/(R-g) where g= perpetuity growth rate7,848

Discounted Perp. Value Year 5 Discount Factor Used5,101

Total Equity ValueSum of Cash Flows 2,685Perpetuity Value 5,101Total Equity Value 7,786

Multiples• Multiples can be applied to a company’s financial

metrics from two sources:– Comparable Companies:

• Implied value in the public markets by analyzing similar companies' trading and operating metrics

• Depends on the level of comparability of the selected publicly traded companies

• Does not include a "control premium" – Precedent Transaction Analysis:

• Multiples derived from comparable precedent M&A transactions

• Reliability depends on the number of precedent transactions and their levels of comparability

• Market cycles and volatility impact on historical• Individual buyer synergies and structure of

transaction will also impact multiples

Commonly Used Multiples• Price / Earnings (“P/E”) – stable services company

• P/E/G (“PEG Ratio”) – extension of P/E; best for fast growing company

• Price / Sales (“P/Rev”)* - brand, negative cash flows

• Price / Book Value (“P/BV”) – banks, insurance

• TEV / EBITDA – removes the affect of capital structure

* Note – in companies with debt, enterprise value is used, where equity + debt equals enterprise value

Valuation in Venture Capital

VCs imperative- 10X in each deal

• The “Portfolio Effect”– Out of Ten Start-ups Funded, with Re 1 each,

• 2 successes at 10x or better 20• 5 ‘OK’ returns at 1.5x to 4x 10• 3 write-offs, total loss of invested money 0• Total Gains on Investment of Rs 10 30

• Venture Capital is fundamentally an institutionalized form of aiming for Outliers!

• Do we know which one is 10X? We expect each one to be 10X, and then pray

Super deal - Venture Capital Perspective

1. Goal - Build a highly profitable, industry dominant company to be taken public or harvested in another way at a high P/E multiple in 5-8 years.

2. Management Team - Well rounded with proven experience in building a company. Team works well together and is led by an industry star. Team must also posses high commitment and integrity.

3. Product - Proprietary product with a sustainable competitive advantage.

4. Market - Clearly identified large and growing market with minimal current and near-term competition

Valuations- What is a Fair Deal?

Not So fair Deal

Current Revenue- 1 crRev. at 5 years - 15 crCo. sold for - 60 cr

Investment made 2 crVC stake 60%VC return 36 crVC return 18 times

Not So fair Deal

Current Revenue- 1 crRev. at 5 years - 15 crCo. sold for - 60 cr

Investment made 2 crVC stake 15%VC return 9 crVC return 4.5 times

Co. grew by 15 times, VC got 18 times

Co. grew by 15 times, VC got 4.5 times

Valuations- What is a Fair Deal?

High sales multiple

Investment made 20 cr

Rev. at 5 years - 15 crRevenue Multiple 10Valuation 150 cr

VC stake 40%VC return 60 cr

Low Sales Multiple

VC return of 3X, not enough

Again, VC return not enough

Investment made 10 cr

Rev. at 5 years - 30 cr

Revenue Multiple 2Valuation 60 cr

VC stake 40%VC return 24 cr

Stake and Investment Lifecycle

What do we need to optimize? Size of the circle or Promoter Stake?

Valuation Soft Parameters

‘We want to raise money and hire some people and build the product. Of course, we will start with market research’

‘We have burnt the midnight oil for last two years to research this need, built the product and have left our jobs a few months ago because we just had to get started’

Valuation Soft Parameters

“We will hire a sales head as soon as we get set. We don’t mind even hiring a CEO”

‘Here is the Sales Head, my co-founder, and I remain the CEO till the company is large enough to attract a professional ’

Deal Structuring

• Types Of deals– Startups– Fresh Equity – Growth Capital– Buyouts – Leveraged Buyouts

• Issues– Performance clause– Dilution– Exit Scenario– Taxation Issues

Investment Deal Structures

• Startup Structure

– Startup aims to raise ~ USD 1 Crore– Proposal

• VC contribution ~ INR 1 Crore for 40% stake• Entrepreneur ~ 60% of share for idea, execution and

delivery

Deal Structure

• Risk faced by VC/ Investor if agreed to this this structure– Split of proceed if venture fails– Split of proceeds if venture succeeds– Investor IRR– Good faith investment from entrepreneur : Skin in

the game– Clause for staying in the venture : vesting

Deal Structure

• Proposed structure from PE/ VC player

Debt Investor Entrepreneur

Debt INR 50,00,000 $0

Preferred Stock INR 44,00,000

Common stock $0

60 shares @ INR 10000 per share (60% stake with Investor)

INR 6,00,000 -

40 shares @ INR 10,000 per shares(40% with Entrepreneur)

- INR 4,00,000

1,00,00,000/- INR 4,00,000/-

Deal Structure

• ROFR : Right of first refusal• Tag along rights : protection of minority share holder• Drag along rights :

– Drag Along : majority share holder Scenario (Protection to Majority)

– Drag along : minority share Scenario (Protection to Minority)

Protection Rights

• Management support or back seat driving• Later stage valuation issues• Management remuneration : too much or too less• Performance clause : too much equity???• Managing performance cycles• Exit points• Irrational exuberance

Conflict : Post Investment

Case Study: MMT

Make My Trip Financing Rounds• $1 million in the seed round (eVentures)• $10 million in Series A (SAIF partners)• $13 million in Series B (SAIF Partners,

Helion and Sierra)• MMT closed Series C investment of $15

million from Tiger Fund and the three existing venture capital investors – SAIF Partners, Helion Venture Partners and Sierra Ventures

• $70 million raised in IPO

Make My Trip OwnershipShareholder 2008 2009 2010 Post-IPO

Directors & Executive Officers 13.6%

SAIF 52.6% 51.5% 51.35% 43.8%

Tiger Global 5.6% 8.7% 12.09% 12.1%

Helion 12.1% 12.0% 11.98% 10.2%

Travogue 11.1% 10.1% 10.04% 8.8%

Sierra Ventures 8.1% 8.0% 7.98% 6.8%