Building and Valuing the Business Model

Chapter 8

Steps in Developing a Business Model

Identify the value chain

Who pays you? And how much?

Are you dealing with radical innovation?

Can you create multiple revenue streams?

Business Models with Radical Innovation

How do you prevent cannibalization of current products?

How do you overcome customer resistance when switching costs are high?

How do you avoid the inertia of a current business model?

Sources of Opportunity for New Business Models

Reposition on the Value Chain Look for unserved or underserved niches and customer dissatisfaction.

Reinvent the Value Chain Tear apart what currently exists and create a whole new value chain. Extrapolating from other industries is often the inspiration for a reinvented value chain in your industry

Redefine value-added If, for example, competitors in your industry seek out contracts from work from customers, you may choose to learn what customers typically want, do the work first, and then sell it to them in a turn-key package. You’re selling convenience. That’s what J.D. Powers & Associates did in the market research industry.

Redefine distribution Think about where customers spend a lot their time and put your product there. If customers typically are at the end of a long chain of intermediaries, consider selling direct.

Consulting GroupBuilds S/Wapplications

BusinessDevelopment

GroupIdentifies Projects& Resources for

developmentgroups

Game Lab -Develops video

games

$

Licensing GroupCreates

licensableConcept &Characters

$

RevenuesConsulting Clients

RevenuesVideo Game Publishers

RevenuesOther media publishers

$$

Sudden Presence Business Model

Centurian School

CenturionSchool

AncillaryServices

Revenue:Fee for daycare

service

K-12 gradeeducation

Revenue:Tuition fee

RegistrationFees

Eveningcomputer

classes foradults

Revenue:Tuition fee

RegistrationFees

food services/cafeteria

Revenue:Fee for food

service

Sales ofbooks,

uniforms,computerequipment

Revenue:Margins from

sale of products

RevenueStream

CorporateSponsorships

Grants

Scholarships

Fund-raisingactivities

Create Multiple Revenue Streams

Expose the technology to people in different industries

Understand and protect the value of the core technology so it can be licensed for a variety of applications.

Go beyond the original invention team to find new applications.

License applications outside the company’s core competency to gain critical mass and become a standard

Most Effective Model

Based on your understanding of the value chain and how it works.

Based on your positioning in the chain

Based on your ability to experiment, learn and evaluate.

Based on your ability to defend what you’re doing.

Drivers of Value

Size of the market and its readiness to adopt Competitive advantage of the firm and its

ability to sustain that advantage Skills, experience, and track record of

management team Upside potential of the venture Downside potential of the venture An appropriate exit time for the investors Current state of the economy and the industry

Financial Models for Assessing Value

Increasing Risk from Things Company Can’t Own

Labor Technologies

Business models

Greatest Challenge:

Understanding the difference between balance sheet and market valuation,

which is intellectual capital

The Highest Valuations Require Options.

Options are greatest when growth is possible, when there’s high volatility and

high risk

Valuation with Real Options

Total Value

Economic ValueEconomic Value Strategic ValueStrategic Value

Diminishing Returns

Innovation

Risk

Diminishing Returns

Innovation

Risk

Calculating Total Value

Step 1: Calculate the Economic Value

Step 1: Calculate the Economic Value

Step 2: Frame the OptionsStep 2: Frame the Options

Step 3: Determine the Option Premium

Step 3: Determine the Option Premium

Step 4: Determine the valueOf the business plan

Step 4: Determine the valueOf the business plan

Step 5: Calculate the option value

Step 5: Calculate the option value

Step 6: Calculate totalStep 6: Calculate total

1. Value of the underlying security2. Strike or exercise price3. The time period of the option4. The volatility5. The risk-free rate

1. Value of the underlying security2. Strike or exercise price3. The time period of the option4. The volatility5. The risk-free rate

Valuing Early-Stage Technology

Stages and Values for New Ventures

Seed CapitalSeed Capital

First Round/Second RoundFirst Round/

Second Round

MezzanineMezzanine

IPOIPO

Stage 1: Seed Capital

Trojan Haptics

Founders = $1 M

+$3 M

Early Investors

3/7 of stock Value

(Cum R&D$ X Step-up ratio) + Financing = Postmoney Valuation

($1M X 4) + $3 M = $7 million

Stage 2: Private Placement, Round 1

Trojan Haptics

$4M in R&DBusiness Plan $7M VC

Post Money Valuation = ($4M x 2.5) + $7 M = $17

Stage 3: Private Placement, Second or Mezzanine round

Trojan Haptics

$11M in R&D

PreMoney

$30 Million

2.8 SU Ratio$17M VC

Post Money Valuation = ($11M x 2.8) + $17 M = $47.8M

Stage 4: Initial Public Offering

Trojan Haptics

$28M in R&D

PreMoney

$70 Million

2.5 SU Ratio$40M IPO

Post Money Valuation = ($28M x 2.5) + $40 M = $110M

Licensing Value

Valuing Via License Agreement

Proven technologies

Unproven or partially proven technologies

Patent rights only – no technology

applications

Proven Technology

Question of balancing technology gains with market forces

Licensor is the sole inventor

For licensee, little risk of non-application since plant design and operating procedures part of licensing package.

Unproven or Partially Proven

LicensorLicensee

Higher risk

Lower royalty

(Capital investment + R&D investment) x ROIC – WACC) + License fees (licensee assumes role of inventor of application)

Valuing the Royalty Stream

Evaluation fees: get rid of tire kickers- refundable

Appropriate discount rate = licensor’s cost of capital

Up-Front Fees

Sign of commitment

Minimum Royalties/

Running Royalties

Discounted Cash Flow Analysis

Essential when part of return is in the future.

Need combination of analytical tools and critical judgment.

DCF says a dollar received tomorrow worth less than one received today.

NPV: present value of future stream of cash flows less any investment

PV/NPV

PV = Pn/(1+M)n

NPV = -I0 + Pn/(1+M)n

Discount Rate

Corporation’s cost of money absent any risk.

Impact of DCF increases as discount rate is higher and time span between present and receipt of rewards increases.

Cost of Money

Debt: short & long-term – comparable risk Weighted Average Cost of Capital (WACC) =

(% debt) x (after-tax cost of debt) + (% equity) x (cost of equity)

Equity: risk-free return + risk premium (beta x market premium)

Rule of Thumb: cost of equity is double prime rate.

Terminal Value

Liquidation Value: multiple of net income, pretax operating earnings (EBIT) or EBITDA.

TV as a perpetuity. Assumes no growth & constant earnings.

Value = Annual payment/Cost of money

Growth in perpetuity

Estimates future growth + degree of profitability. Use only when growth rate is several % less than discount rate.

Build a Revenue Model

Estimate target revenues in a medium-term time horizon from time of commercial launch.

Look for natural limits of size of market or your market share.

Determine the nature of the end game

Software – 2 years

Computers – 3-4 years

Pharmaceuticals – 10 years

Assume that growth will decline

Take-Aways

Add students’ comments here