2. New Topics in this Course

Overview

This course incorporates new model features such as foreign exchange calculations, minority stakes and liquidation preferences. In this lesson, I describe each of these new features in detail.

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Summary

  1. Lesson Goal (00:04)

    The goal of this lesson is to learn about the unique aspects of investing in a startup company.

  2. Lesson Goal (00:04)

    The goal of this lesson is to learn about the unique aspects of investing in a startup company.

  3. Valuing a Startup (00:26)

    Startups generally cannot be valued using the discounted cashflows method. This is because startups tend to generate little cash. Instead they prioritize growth. The revenue they do generate is immediately invested in Research & Development, to improve the product, or Sales & Marketing, to increase revenue.

    Instead, startups can be valued using multiples. Common multiples used to value startups include Enterprise Value / EBITDA, and Enterprise Value / Revenue. As startups grow quickly, the values of these multiples can be higher than they would be for a more established company.

  4. Valuing a Startup (00:26)

    Startups generally cannot be valued using the discounted cashflows method. This is because startups tend to generate little cash. Instead they prioritize growth. The revenue they do generate is immediately invested in Research & Development, to improve the product, or Sales & Marketing, to increase revenue.

    Instead, startups can be valued using multiples. Common multiples used to value startups include Enterprise Value / EBITDA, and Enterprise Value / Revenue. As startups grow quickly, the values of these multiples can be higher than they would be for a more established company.

  5. Incorporating Currency Conversions (01:57)

    Real world financial models often require you to deal with multiple currencies. In this example, the company TrackerTime is based in the USA, while the venture capitalists are based in the UK. As a result, our model will need to account for these different currencies.

  6. Incorporating Currency Conversions (01:57)

    Real world financial models often require you to deal with multiple currencies. In this example, the company TrackerTime is based in the USA, while the venture capitalists are based in the UK. As a result, our model will need to account for these different currencies.

  7. Liquidation Preferences (02:25)

    Startup investments differ from LBOs because the business has multiple investors after the deal is complete. For this reason, these investments may include a liquidation preference. This gives the venture capitalist priority over other investors if the company generates lower returns. For example, a liquidation preference of 2.0x means the venture capitalist must receive double their initial investment before other investors receive anything.

  8. Liquidation Preferences (02:25)

    Startup investments differ from LBOs because the business has multiple investors after the deal is complete. For this reason, these investments may include a liquidation preference. This gives the venture capitalist priority over other investors if the company generates lower returns. For example, a liquidation preference of 2.0x means the venture capitalist must receive double their initial investment before other investors receive anything.

  9. Other Differences From LBOs (03:20)

    Startup investments often include no debt. This is because banks often consider startups to be too risky to provide debt to them. Also, startup financial models are often inaccurate. With fewer years of past data, it’s more difficult to make reliable projections for revenue, costs etc. into the future.

  10. Other Differences From LBOs (03:20)

    Startup investments often include no debt. This is because banks often consider startups to be too risky to provide debt to them. Also, startup financial models are often inaccurate. With fewer years of past data, it’s more difficult to make reliable projections for revenue, costs etc. into the future.

Transcript

In the previous lesson, we were introduced to a startup called TrackerTime that is considering an investment from the venture capital firm Ventura. As I mentioned in that lesson, there are a couple of aspects to venture capital investing which are quite different to how we've modeled previously, and in this lesson, I'm going to walk through some of these differences. Firstly, a discounted cashflow valuation won't work for TrackerTime. Why? Because the company has very little to no cash generation at this point in time. You might be asking yourself, "Why would we invest "in a company when there's no or little cash "being generated?" Well, it turns out that for startups, growth is often more important than cash generation, and all the cash generated is reinvested immediately in growing faster and faster, and so TrackerTime is taking any cash and reinvesting it in research and development to improve the product, and sales and marketing to attract more customers. TrackerTime could generate more cash if it decided to slow growth, but this has risks in itself.

So if we're not going to use a discounted cashflow, what will we use? Well, obviously, we'll need to use multiples. Startups can be valued on a range of different multiples, but the two most common enterprise value all over EBITDA and enterprise value all over revenue. Revenue will be used primarily if EBITDA is not available, although most companies should have a positive EBITDA, particularly after a couple of years of operation. Because startups tend to grow very quickly, the EBITDA and revenue multiples that you will see tend to be a lot higher than you would see for a typical private equity transaction. Another new aspect of this model will be currency conversion and we will need to build foreign exchange functionality into our model. The reasoning is simple. TrackerTime is US-based and files its accounts in US dollars. Ventura is based in the United Kingdom and invests in Great British pounds. In this course, we will figure out how to account for this in a financial model. As I mentioned previously, venture capital investments are fundamentally different to LBOs. In addition to not being able to use discounted cashflows, only a minority stake is being purchased in the business. This actually makes the model a little easier to build. Separately, Ventura will be looking for something called a liquidation preference of 2.0x. A liquidation preference simply states that Ventura must recoup double its money before any other investor gets paid. Of course, if Ventura can make more than two times its money it will take that option. But in a situation where the company does not do well and gets sold at a very low price, Ventura's investment will be protected, and this can have a big impact on the founders, who will often own the remainder of the shares. In addition, there will be no debt in this deal. The company is simply too young and too risky for a bank to provide debt in the deal. And again, this will serve to make our model that bit easier to build. Lastly, we need to remember that this model will likely be a lot more inaccurate than our LBO model. Because the company is still so young, it's even more difficult to project future revenues and costs for the business. However, the model will still provide us with some very valuable insights in determining the eventual outcome for the founder, SeedCo, and Ventura. In the next lesson, we'll jump into Excel and begin building our model.