hello this is dr. adam jae bok we're gonna wrap up our conversation about finance for entrepreneurial ventures we've already covered a number of different topics and now we're gonna cover a little bit about valuation and exit early stage valuation that is how much is a company worth at the very early stage is much more art than science the bottom line is that it's whatever the market will bear so you'll want to look at the recent value of exits in a related industry or geography is the idea really sound what is the track record of the management team look like does their a working prototype that's been tested with customers or are their existing sales and what's the size of the potential exit it's important to recognize that there's no single calculation that can be done in all circumstances to figure out how much an early-stage company is worth more sophisticated finance courses can address things like discounted cash flow net present value analysis internal rate rates of return but in most cases early-stage valuation is done by sophisticated guesswork rather than a formula and it's important to remember that everything is negotiable and will be determined by context so when markets are up valuations for early-stage companies tend to go up when markets are down valuations for early-stage companies tend to go down and industries are cyclical so some periods of time are good for biotech and some periods of time or bad for biotech it's good to remember that a rule of thumb is that if you have a startup company that really just has an idea or a patent and you do have really good long-term potential well into eight or nine figure potential for revenue twenty fifty hundred million dollars five hundred million dollars in revenue a reasonable early-stage valuation is probably going to be less than a million dollars and that can be very disappointing sort of feeling for a lot of first-time entrepreneurs who've seen media stories about billion dollar valuations for companies like uber and such but you need to remember that those are credible outliers and by the time they're getting written about in the Wall Street Journal they've already made substantial progress so be aware that early stage valuations are often much lower than entrepreneurs expect we want to think just a little bit about how valuation the valuation equation for a round of funding works it's actually quite simple the post-money valuation that means how much the company is worth after the investment is equal to the pre-money valuation how much the company is worth before the investment plus the investment so obviously this can get very very complicated based on trying to figure out how much the company is worth beforehand and some investment processes are quite sophisticated bringing in money at multiple times but eventually it all boils back down to this so maybe a really quick example let's imagine for a moment that we have a company that we think is worth $500,000 maybe it has a patent maybe it already has some sales or it has a really strong management team and we're also now going to bring $500,000 of cash into the company as well so how much is what is the post-money valuation that is how much is the company worth after the investment is made and as a bonus what ownership stake do the investors get so I'd encourage you to pause for a moment and see if you can figure this out how much is the company worth after the investment and what ownership stake to the investors actually get hopefully the answer was pretty obvious if the pre-money valuation is a half a million dollars and another half million dollars of cash goes into the company then the company is now worth 1 million dollars the combination of how much it was already worth and the new money that just went in and that should then suggest that the ownership stake is pretty straightforward it's $500,000 over a million dollars that is the investment stake that the owners get is 50% so if this is not clear have a chat with a colleague see if you could make sense out of this it is pretty straightforward obviously in the real world it gets more complicated but this is what it boils down to the concept of dilution is the idea that an ownership stake decreases as a company brings in more money the goal is that the van overall value of the company is growing so that even though you're have you have a smaller percentage of the company the value you have is worth more there'll be a cap table example in an audio presentation in the separate audio presentation that should be helpful to you but a simple way of thinking about it is quite simply that here the owners of the company had a hundred percent ownership before the owner before the investment was made and their ownership stake was worth a half million and now they have 50 percent ownership sake but it's still worth half a million because the company is worth more and the goal is that if the if this company were to grow in value to 2 million dollars then their 50 percent stake would be worth a million dollars there are other funding options out there that can in some cases avoid dilution we're going to talk briefly about crowdfunding and then briefly about incubators and accelerators so crowdfunding is something you may be familiar with you may have seen crowdfunding plans campaigns on platforms like Kickstarter and you may be familiar with this particular one which was quite successful the exploding kittens game the game for people who are into kittens and explosions and laser beams and sometimes goes and the idea is that was that they had this thought for a game but rather than spend the money themselves to build the game and and then try to sell it they basically went to Kickstarter and they pre-sold copies of the game on Kickstarter and so people could put a certain amount of money down and it was probably like $24 and then the idea was that when the game was ready they would get their copy of the game they'd be one of the first people to get a copy of the game and Kickstarter has been really sort of pioneered the entire crowdfunding phenomena around the world and many many successful companies have gotten their start through kraut through crowdfunding in this way and what it basically does is it allows you to raise money in advance for a startup company from people you don't know that's why it's called crowdfunding so it's pretty straightforward an accelerator and incubator is an organization that helps support early-stage companies usually by a combination of mentoring or facility space and sometimes capital and there's many many examples of these like tech stars Y Combinator out in California and generator which is now nearly national but it was really based here in Wisconsin right here in Madison originally so what usually happens is companies have to apply into a competitive process and they're selected based on their potential they're usually given some space in an office they're usually given a certain amount of funds often you know five or ten thousand dollars and then the incubator or an accelerator might take an ownership stake these are not standard models every single one of these types of accelerators or incubators works a little bit differently you can learn a lot more about generator in particular generator also has the G beta program which is designed for very very early-stage companies and the G beta program does not take equity ownership it's a free mentoring program and so if you have an early stage idea you might consider applying into the G beta program in order to get access to some expertise that can be made available to you for free I want to talk about one last kind of funding event specifically convertible debt this is often quite confusing to first-time entrepreneurs this is a debt note that can be converted to equity in other words it's a loan so it could come from a bank but it's much more likely to come from a private investor and the idea is that they loan you money so at the in the short term you owe them that money back and it might have interest on it or it might not and there's usually a time frame during which you have to pay it back but there's a trigger on it that converts it into stock and you might ask well why would we do this well there's a lot of different reasons one reason is because we might not know what the value of the company you may remember that I said that valuation is more art than science in some cases it's nearly impossible to agree on evaluation for a start-up venture and in those situations a convertible debt note can be effective because you don't have to agree on the valuation right now it's a loan the second reason that these are often very effective is because they protect the investor from downside if the if a certain types of events which could be very good for the company could be bad for the investor so let me give you an example of that so this looks complicated but I think if you walk through it you'll see what's going on so let's imagine that we have a company that we think is worth $900,000 the outside investor puts in $100,000 for 10% right so let's imagine this is an equity investment upfront so post-money valuation is clearly a million dollars the 900,000 the company was worth plus the hundred thousand that the investor put in and the investor owns 10 percent well let's imagine that for some reason the next day the founder is offered a half million dollars to sell the company and you might think well why would the founder do that well it could be that they're desperate for cash it could be that they didn't invest very much and they built it up mostly with bootstrapping and so even though it's worth a million they might be willing to take a lot less than that to sell out and in fact if this is common stock that is the investor really did take their 10 percent then look at what happens over here on the Left 10 percent of $500,000 is only $50,000 the founder walks away with 450,000 the outside investor only gets $50,000 in other words the outside investor in this situation loses $50,000 in one day that's clearly not a very attractive proposition for an outside investor if this were done as convertible debt however it would mean that this is still treated as a loan the founder would get $400,000 and the outside investor would get a hundred thousand because the debt is repaid first you might remember that from our prior conversation so in theory there might be a trigger in the long-term that would convert the debt into equity for example if maybe the trigger is that if the company is sold for more than five million dollars but a more common trigger is if the company raises more money then the equity converts at a set rate which could be set in dollars per share or it could be set as a percentage of the share price of the new investing round so I don't want to make this more complicated than it needs to be but you do need to understand why this is a potentially attractive way for someone to invest in an early-stage company and the finance reading also goes into this in a little more detail you just need to understand this basic concept that it protects the investor from a downside situation and gives them the ability to convert into equity at some point in the future finally we just want to talk about exit a little bit an exit is an event with implications for corporate ownership that is it's a situation in which something significant changes about who owns the company so one example could be where the entire business or all of its assets or technologies are sold to another organization could be a merger it could be a bankruptcy in which the company fails those are not good exits sometimes they're not called exits at all but they are often a significant change in ownership another type of exit is an initial public offering where the company is allowed to sell its stock on a public exchange you just need to recognize that while these can be incredibly attractive and you probably this is what you read about in The Wall Street Journal where founders walk away with billions and billions of dollars these are unbelievably rare so there's roughly 600,000 new businesses formed in the United States in 2019 and in 2019 there were 159 in initial public offerings so these are unbelievably rare and they're not something that you can count on when you're launching a venture as being the way that you're going to eventually become incredibly wealthy I want to point out just to wrap up here a resource that's available to you it's pitchbook it's a database this is a very expensive database that tracks venture capital deals but it is available to UW students the link is in canvas it's also on the next slide this can be really useful because you can look up deals and find out things like comparable deals or what happened with companies how much money they raised it might help you value a start-up or help you think about looking for companies that might be attractive employers and it's also just useful because you can use it to compare how you things like how well universities create startup companies you discover that uw-madison undergrad alumni are ranked number 14 in the world for startups from in the years 2016 and 2017 and I'll just give you an example that you can start with Meridiist or per a ssin is actually a company that I co-founded a number of years ago out of Northwestern University there's a little article if you'd like to see that just mentions that it was a past finalist in the Wisconsin governor's business plan competition and if you go to pitchbook and the link is right here you can create an account using your Wisc dot edu email account you'll have to create a new password and then you can go in to pitch book and you could search for inner idiocy what happened with that company and you would see that there were a couple of rounds of financing and then eventually it would show you that there was an exit event and the exit event was the sale of the company for twenty million dollars in 2011 to a larger biotechnology company called Kinsey Nash so I encourage you you can look up all sorts of companies you can look up each street you can look up Google you can look up almost anything in pitchbook in order to find out and if there is information that's been registered with the federal government which most American companies are required to do you would be you would be able to find out what their financing history looked like so I hope this gives you some useful background on finance in general for start-up companies your reading is excellent for providing a lot more details whether just for this course or whether you have some financing opportunities ahead of you in your personal entrepreneurial journey