Describes the development of edocs, an Internet company aimed at revolutionizing the online bill presentment market. Kevin Laracey must negotiate a venture capital investment with Jonathon Guerster, an associate at Charles River Ventures. This case study can be used as a role-playing exercise in negotiating a venture capital deal.
Paul A. Gompers
Harvard Business Review (200015-PDF-ENG)
February 04, 2000
Case questions answered:
- Evaluate the potential investment in edocs, inc. from CRV’s point of view.
- What are the most important terms for Laracey? What is Guerster concerned about? How are these concerns reflected in the offered term sheet?
- Evaluate the deal terms qualitatively and quantitatively. Should Laracey ask for outside term sheets? What terms would you renegotiate?
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Case answers for edocs, Inc. (A)
This case solution includes an Excel file with calculations.
1. Evaluate the potential investment in edocs, inc. from CRV’s point of view
Qualitatively, CRV’s target investments include, among others, early-stage software companies, thereby making edocs a suitable fit for CRV. Applying the Outside Impacts framework (only the most relevant parts discussed here; full framework in App. I), edocs’ idea is innovative: within the electronic billing market, the company intends to sell software rather than to offer a service.
Contrary to service offerings, edocs software avoids the issue of third-party intermediation and allows for customers to have complete control over their respective data which customers, in turn, seem to value highly. Moreover, although competition entails a wide range of companies, no competitor seems to offer software, making edocs’ software offering a clear differentiating factor.
Moving on, there is Positive Value created by edocs: due to the cost advantages of electronic compared to paper billing, edocs’ technology makes the billing process a lot cheaper. Additionally, by offering more content compared to paper billing, edocs’ software makes the billing more interactive and personal.
Additionally, edocs has established a strong strategy stating its customer base (high-end producers of transactional documents), incentives for making users switch from paper to electronic billing, and how an additional licensing opportunity can look like. Furthermore, edocs’ Team has relevant and successful previous work experiences.
However, Laracey, Canekeratne, and Moran have not worked together yet showing that a good collaboration between them is uncertain. An additional uncertainty includes the company’s business model which is dependent on alliances and thus makes edocs’ success subject to strategic partners’ willingness to contribute. It can also be questioned if edocs’ two strategic alliances alone will be sustainable from a long-term perspective.
Also, changes in infrastructure and adjustments in the billing process are required from end customers, creating another dependency for edocs. To sum up, despite some uncertainties, the Outside Impacts framework shows the great future potential of edocs as business and suggests a high likelihood of success from a qualitative perspective.
From a quantitative perspective then, edocs’ target performance looks highly promising (although not indicative of edocs’ cash flows): sales (given a CAGR of 101 %) and EBIT margins are increasing over time (see App. III). Also, the suggested $2m investment (provided that another investor can be found) is near the lower end of the typical investment range of CRV and is also small compared to the size of CRV’s ninth fund of $175m.
Moreover, the high return of 100% on its last two funds allow CRV to take on the relatively low risk entailed in an edocs investment. However, at the time of the deal the VC market is in a positive state with VC commitments being on the rise in (ex. 8). While this makes CVR highly liquid, it may increase the risks of bidding wars among VCs and overpaying for portfolio firms. To further assess edocs from a quantitative perspective, an APV valuation was performed for all three scenarios (target, threshold, stretch) provided in the case (App. III).
For this valuation, the financial forecasts provided in Ex. 4 were assumed to be on a post-money basis. Based on these forecasts, free cash flows (FCFs) for the years 1998 to 2002 were computed. For simplicity reasons, over the entire forecast period, Cap. Ex. was determined as % of sales (8.05%), based on comparables, Depreciation was assumed to be 5% of Sales and Changes in NWC were considered not material. Additionally, FCFs for the years 2003 to 2007 were forecasted using for simplicity reasons an FCF growth rate of 15%. For the terminal value thereafter, a growth rate of 2.5% was applied.
Moreover, a tax rate of 25% was assumed over the entire period, with limited or no tax being paid in the first two years due to loss carryforwards. As a discount rate, R(A) was applied based on the median of asset betas of comparables (App. II). Using a risk-free rate of 5.5%, and MRP of 7% and an asset beta of 1.21, this yielded R(A) as 13.97%.
It is assumed furthermore that edocs does and will not have any debt nor any excess cash over the period considered, such that Net Debt in all cases amounts to 0 and hence Equity Value (EqV) = Enterprise Value (EV). Success probabilities of 10, 15, and 30% were applied for the stretch, target and threshold scenario, respectively. These entail the illiquidity discount and high risk associated with early-stage start-ups as well as the likelihood that management forecasts will be overstated.
Based on the valuations of the three cases edocs’ EV (and hence EqV) is between $4.7m and $37.3m. While the EqVs derived from these APV valuations are highly sensitive to the above-outlined inputs and changes in inputs might significantly alter the results, they still serve as good cross-checks to CRV’s valuation.
Additionally, a multiple valuation (App. IV) based on average P/Sales multiples of all comparables and edocs’ target, threshold, and stretch sales performance in 1998 was performed, yielding an EqV between $7.5m and $15.6m. No earnings multiples were used since edocs’ earnings figures in 1998 are negative.
Lastly, a valuation, based on the VC method was applied (App. V). Both a P/Sales and a P/E multiple (based on average figures of all comparables) were applied using the forecasted financial figures for 2002 for all three performance scenarios. This yielded a range of six different equity values in 2002. For simplicity reasons, it was then assumed that CRV will exit the edocs investment…