Entrepreneurship Finance - Valuation of CloudCRM
You are working for Stamford Capital Partners, a leading Venture Capital firm based in West London. Your boss, Antony Conte, has asked you to prepare an investment case for CloudCRM. Having been intrigued by the business plan, Anthony is thinking of inviting Jane Willian and Alice Morata, the co-founders of CloudCRM, to pitch their idea. They have developed a cloud-based customer relationship management (CRM) software for the self-employed and small businesses.
Traditional CRM packages can feel overwhelming and over-complicated for small businesses, with all sorts of functionality that will never be used. And most of the major cloud-based competitors aim at big businesses and require heavy customization. This makes them expensive. Consequently, many small businesses tend to use ad hoc methods for keeping track of their customers and sales, which are not well suited to today's focus on digital marketing and tracking. CloudCRM integrates seamlessly with the main marketing platforms - such as Google, Facebook, LinkedIn etc. - and has received rave reviews during beta testing.
Their software runs on all operating systems including mobile devices. They are seeking an initial investment of £2-3m to develop and launch the product. Jane, who is 28 years old, has strong software development skills and previously co-founded another startup focused on viral marketing via social media. This was a modest success: the company had good technology and some loyal users, but did not become one of the market leaders. That company was sold to a competitor after 3 years, and Jane left the company at this stage. She has invested £150K in developing CloudCRM to this point. Alice is a friend of Jane's from their days at Chelsea University. She is 30 and was until recently a senior product manager at NetSuite.
This is her first start-up, but she brings strong domainknowledge and customer acquisition skills. She has also invested £150K in the venture, which has taken her entire savings. They have put together a small team of developers and have outsourced some programming to a team in India. Once the product is ready to launch they will have to invest heavily in building out sales and marketing, and customer support. Given the enthusiastic response to the beta version of CloudCRM, they want to develop the product and launch their first commercial version at the start of 2019.
The business model is SaaS - Software as a Service - and they plan to have simple monthly subscriptions of £20 a month for the first license and then £10 a month for all subsequent licenses within the same organization. They also plan to use a "free for the first X months" offer to get people to try the software at no initial cost.
They intend to create a superb user experience not only via their attractive and intuitive user interface, but also by keeping customer support in-house and closely integrated with the development team.
At this point the Jane and Alice each own 1/2 of the company. They have not yet established an option pool for current or future employees - although they have promised this to the existing small team. They also realize that they will need to strengthen the senior team, particularly in the areas of finance and marketing.
In addition, they also raised £200K on 1 January 2018 through a convertible note. This accrues interest (which is rolled up rather than paid) at 3% (simple, rather than compound, interest) per month and will convert into equity at the next financing round, subject to a valuation cap of £6m. CloudCRM has produced summary financial projections and is seeking an investment of between £2m and £3m. The entrepreneurs are, however, rather obsessed about not losing control of the company, and so will not consider a deal where they give away more than 50% of the equity.
The founders have no ability to provide any additional funding, but are prepared to work for below-market salaries of £60K each during the first 2 years. Both Jane and Alice understand that Stamford Capital Partners will be seeking to exit the investment by the end of 2022. If the deal goes ahead, both sides are aiming for a closing date of 1 July 2018. Your boss wants you to advise on whether a deal could be structured that would work for all parties.
He thinks the projections for the venture are reasonable. He likes the fact that SaaS can produce stable cash flows, and that such businesses can scale impressively. But he has been an investor for long enough to know that the risks are high, that building market share takes considerable investment, and that there are lots of current, and potential, competitors.
You have to produce a report for Anthony. His time is valuable, and he only wants to invite CloudCRM in for a pitch if there is a chance that Stamford Capital Partners could make decent returns. He likes clear, succinct Powerpoint presentations, and has a rule that they should never exceed 25 slides. He likes there to be a summary at the start, telling him what the answer is, before getting into the detailed analysis.
He also likes to be able to follow the various steps, calculations and logic of the argument. And he has a strict format for all such investment cases:
1. Summary recommendation
2. Valuation, and discussion of how the investment would be structured/staged
3. Summary term sheet, annotated to explain why the terms are important
4. A clear capitalization table showing ownership through to exit.
Anthony generally favours the VC method of valuation for this type of early-stage venture, although he encourages you to challenge and discuss the pros and cons of any valuation method you employ. And he always likes to consider options regarding staged investment. Finally, Anthony likes to have the key assumptions, uncertainties, and sensitivities made clear. Outline financial projections are given below.
CloudCRM - summary financial projections (calendar years)
£ ‘000 2018 2019 2020 2021 2022
Revenue 0 300 1500 5000 13000
Cost of sales 0 150 500 1200 1800 11200
Administrative expenses 250 800 2000 3500 4500
Net profit (loss) before tax (250) (650) (1000) 300 6700
Tax (1020)
Net profit (loss) after tax (250) (650) (1000) 300 5680
Memo: change in net working capital 0 150 700 800 1000
Notes: 1. It is conventional for SaaS companies to include the following expenses in the cost of sales: hosting of the application, costs of on-boarding clients, support and account management, credit card fees and any partner commissions.
2. Administrative expenses include sales and marketing, product development, facilities and general admin support.
3. Losses can be carried forward and offset against future profits; the corporate tax rate is 20%. The presentation should not exceed 25 slides (and no more than 4,000 words), including references, appendices, and tables.