This Newsletter continues Valuecruncher’s series on the valuation of early stage companies. We have previously covered alternative methods for valuing an early stage company (here and here) and now look at how that valuation is distributed across different equity instruments. Early stage companies generally have a number of different equity instruments in their capitalisation tables. Typically Founders will have common stock, employees will hold stock options and Investors (Venture Capitalists) will hold preferred stock. Each of these instruments represents different claims on the company’s equity.Â
 

Part 1 of the analysis of the liquidation preferences outlines common preference terms in early stage term sheets and looks at their payoff profiles. An interactive Excel workbook that allows users to consider the payoff profiles of different liquidation preferences accompanies this analysis.

Valuecruncher Newsletter – Liquidation Preferences

Excel Workbook: Valuecruncher Preference Stock Payoff Tool *
 

*This workbook uses Macros. If Excel’s macro security is set to High the functionality will be limited. To utilise the full functionality of this workbook:       Â
 

1. On the Tools menu, click Options.
2. Click the Security tab.
3. Under Macro Security, click Macro Security.
4. Click the Security Level tab, and then select the Medium security.                 Â
5. Excel must be restarted before these changes to take effect.                       Â
6. When opening the workbook select enable macros.

Related Reading:
 

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This Newsletter is a follow-up to the 30 March 2007 Newsletter Early Stage Valuations – A Venture Capital Approach. Since then we have extended our framework for the valuation of high-growth/pre-revenue companies. The Valuecruncher valuation report for early stage companies incorporates the Venture Capital (VC) approach and a detailed discounted cash flow (DCF) based scenario analysis. This Newsletter focuses on the appropriate DCF framework to use for early stage companies. Read more…

Valuecruncher has had a significant number of new subscriptions to the newsletter over the last month. For the benefit of new subscribers Valuecruncher would like to take the opportunity to highlight some of the most popular past newsletters.


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Early Stage Valuations – A Venture Capital Approach

Comparable Company Valuations

The Cost of an IPO in New Zealand

The recent initial public offerings (IPOs) of Xero and BurgerFuel have cast the spotlight on the capital raising options for growth companies in New Zealand. This newsletter examines on the costs of an IPO for a growth company in New Zealand. This analysis focuses on growth companies that cannot raise significant amounts of debt due to the uncertainty surrounding their expected earnings. Read entire newsletter.

Valuecruncher Valuation Reports include three approaches to valuation: economic (DCF), comparable and accounting (NTA). This newsletter discusses the role comparable company analysis plays in valuation.

Where DCF (discounted cash flows) and NTA (net tangible assets) focus on the specific characteristics of the company being valued comparable company analysis uses a relative approach. This relative approach values the company based on the market valuation of similar companies.

Comparable company valuation uses the valuation ratio of a publicly traded company or from the sale of a company and applies that ratio to the company being valued. The valuation ratio typically expresses the valuation as a function of a measure of financial performance (e.g. revenue, EBITDA or EBIT), occasionally operating metrics such as number of employees, customers or register users will be used in valuation ratios. The valuation figure used generally reflects the enterprise value (EV) or the value of the equity in the business; the equity value is usually represented by the share price.

Click here for a full pdf version of the Valuecruncher Newsletter.

In New Zealand there has been considerable debate about the increasing impact of private equity funds investing in the economy.  The recent acquisition of Telecom New Zealand’s Yellow Pages business by CCMP and the Ontario Teachers Pension Plan for NZ$2.24 billion is the most recent high profile example.

The common characteristic of these acquisitions is the use of significant amounts of very cheap debt.  The ability to obtain this debt has been a key factor in the valuations that private equity funds have been able to pay for acquisitions.

This increased private equity activity has only appeared in New Zealand over the last six to twelve months.

Just over twelve months ago there was a very high-profile transaction in the New Zealand market where the Australian media company Fairfax purchased on-line auction site Trade Me (Trade Me is New Zealand’s version of eBay) for NZ$700 million.  This price was generally greeted by the media with amazement – we thought the price looked more than reasonable.

The Trade Me sale was to an established media company while the recent acquisition of Yellow Pages was by a pure financial buyer using cheap debt.

What would a private equity buyer have potentially paid for Trade Me?

Private equity funds like certain characteristics in the businesses that they buy.  Private equity funds like: large businesses, dominant market positions, strong management teams and strong cash flows (to pay back the debt).  Yellow Pages have all of these characteristics – but so does Trade Me.

The question has been asked – does 1 Yellow Pages = 3.2x Trade Me?

We thought that was a great question – and decided to have a closer look.

This is what we did:

We took our previous valuation of Trade Me and made some amendments.  We assumed that EBITDA forecasts for the current year of NZ$45 million were met.  We then projected EBITDA at NZ$65 million for the current (2007) rising to NZ$100 million in 2009.  We then projected EBITDA growth for 10% in the next two years falling to a 3% long-term growth rate – this equals a 4% long-term growth rate in the Valuecruncher model.  We lowered our equity discount rate to 12% from the 15% we had previously used.  The Yellow Pages transaction was based on raising debt equal to 10x the forecast EBITDA ($157 million of EBITDA) for approximately NZ$1.6 billion.  For Trade Me we assumed that NZ$600 million of debt could be raised for a private equity transaction.  We assumed a cost of debt of 7.5% and a 12% cost of equity on a 50:50 debt to equity ratio (assuming a NZ$580 million debt capability – 8.9x NZ$65 million EBITDA) for a WACC of 9.75%, which we rounded up to 10%.  This WACC is probably conservative.  We used 8% in valuing the private equity transaction for Yellow Pages.

Our answer was a current valuation of Trade Me to a private equity buyer of NZ$1.16 billion.

Trade Me – Private Equity Valuation

We are not saying that Trade Me should have waited and not done the deal with Fairfax.  Decisions are made with the information that is available at the time – the potential impact of private equity on valuations of businesses such as Trade Me could not have been foreseen at the time of the transaction.  However, we do not believe that you can compare the two transactions without making the adjustments that we have.

Based on the raw numbers 1 Yellow Pages = 3.2x Trade Me.  Based on our adjusted analysis 1 Yellow Pages = 1.9x Trade Me.

Yellow Pages is a great business.  However, we see a significant number of challenges for the business moving forward.  Telecom New Zealand had an asset with significant potential on-line with Yellow Pages.  At Valuecruncher we believe that Telecom New Zealand would have struggled to achieve that potential had they retained ownership.  Telecom New Zealand probably did the right thing exiting the business – for a very good price.  We believe that on-line competition (from multiple current and potential sources) will potentially significantly disrupt the Yellow Pages business.  CCMP (one of the acquirers of Yellow Pages) brought the Singapore Yellow Pages equivalent in 2003.  Yellow Pages have announced some strategic measures it is implementing post the separation from Telecom New Zealand.  These include a revamp of the Yellow Pages website and a new physical DIY publication for the Auckland market.  We presume these activities are based on the successes that CCMP had with similar acquisitions – such as the 2003 Singapore acquisition.

Valuecruncher believes that the environment that Yellow Pages operates in is now dramatically different to 2003.  12 months ago 1 Yellow Pages might have equalled 3.2x Trade Me and today 1 Yellow Pages might equal 1.9x Trade Me.  Our bet is in 12 months time that ratio will have moved again – and not in Yellow Pages favour.  Especially if physical publications continue to be a cornerstone of the Yellow Pages strategy – the Yellow Pages acquisition requires a very good on-line strategy and flawless execution.

At Valuecruncher we have been seeing a number of companies approach us for valuation advice that are initiating discussions with venture capitalists (VCs). VCs are specialist investors that focus on investing in early-stage companies – where both the risks and rewards are significant.

Understanding how VCs approach valuation is very important for the owners of early-stage businesses. At Valuecruncher we have seen disputes between company owners and VCs over valuation that have prevented deals progressing. This is a shame – potentially for both parties. Aiming to improve this situation the first Valuecruncher Newsletter for 2007 attempts to explain the approach that VCs take to valuing companies they are looking to invest in.

Valuecruncher Newsletter: Early Stage Valuation – A Venture Capital Approach