ENTREPRENEURIAL FINANCE Leach & Melicher
VENTURE CAPITAL VALUATION METHODS
Chapter 10
© 2012 South-Western Cengage Learning
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Chapter 10
Learning Objectives
Relate venture capital methods to more formal equity
valuation methods
Understand how valuation and percent ownership are
related
Calculate the amount of shares to be issued to secure a fixed
amount of funding
Understand the impact of subsequent financing rounds on
the structure of the current financing round
Construct multiple-scenario valuations and unify them in a
single valuation
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Venture Capital (VC) Method
VC Method:
estimates the venture’s value by projecting only a
terminal flow to investors at the exit event
modifications of the basic VC method introduce
additional rounds and incentive compensation
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Venture Capital Shortcuts on the
Equity Method
Cash investment today
Cash return at some future exit time
Discount this entire return flow back at the
venture investor’s target return
Divide today’s cash investment by the
venture’s present value
Equals percent ownership to be sold in order
to expect to provide the venture investor’s
target return
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Venture Capital Shortcuts on the
Equity Method
Example:
Venture formed w/ 2,000,000 shares held by
founders
New investor adds $1,000,000 for new shares
Exit (horizon) time = 5 years
Investor demands 50% annualized return
Venture income of $1,000,000 per year @ exit
Similar venture sold shares to public for $20,000,000
Similar venture income =$2,000,000 for last year
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Venture Capital Shortcuts on the
Equity Method
I
Acquired % Final Ownership
[P/E x E 5] / (1 r)T
1,000,000
[10/1 x 1,000,000] / (1 .5) 5
75.9375%
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Venture Capital Shortcuts on the
Equity Method
m x (Acquired %)
Shares to Be Issued n
1 - Acquired %
2,000,000 x (.759375)
.240625
6,3111,688
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Venture Capital Shortcuts on the
Equity Method
$1,000,000
Issue Share Price
6,311,688 shares
$.15843622 per share
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Venture Capital Shortcuts on the
Equity Method
Pre-money valuation:
present value of a venture prior to a new money investment
Post-money valuation:
pre-money valuation of a venture plus money injected by new
investors
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Venture Capital Shortcuts on the
Equity Method
Pre-Money Valuation
= 2,000,000 shares x $.15843622 per share
= $316,872
Post-Money Valuation
= 8,311,688 shares x $.15843622 per share
= $1,316,872
Founder % Between Financing & Exit
= 2,000,000 / 8,311,688
= 24.0625%
Investor % Between Financing & Exit
= 6,311,688 /8,311,688
= 75.9375%
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Dilution with One Round
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Venture Capital Shortcuts on the
Equity Method
Staged Financing:
financing provided in sequences of rounds rather than all at one
time
Capitalization (cap) Rate:
spread between the discount rate and the growth rate of cash
flow in terminal value period
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Earnings Multipliers and Discounted
Dividends
From P/E x E = P, we get:
Direct Comparison:
valuation by applying a direct comparison ratio to the related
venture quantity
PCurrent
Other Firms
x E Venture
Year 5
P Venture
Year 5
E Oth er Firms
Current
Direct Capitalization:
valuation by capitalizing earnings using a cap rate implied by a
comparable ratio
E Venture
Year 5
P Venture
Year 5
E Other Firms
Cu rrent
/ P Other Firms
Cu rrent
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Earnings Multipliers and Discounted
Dividends
PCuOther Firms
20,000,000
rrent
x E Year 5 PYear 5
Ventu re Venture
x 1,000,000
E Curren t
Other Firms
2,000,000
10 x 1,000,000 10,000,000
Under direct capitaliza tion method :
E Venture 1,000,000
Year 5
PYear 5
Venture
E Cu rrent / PCu rrent
Other Firms Other Firms
2,000,000 / 20,000,000
1,000,000
10,000,000
.10
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Earnings Multipliers and Discounted
Dividends
Given per share values of earnings (E), dividends (D), & price (P) :
D6
P5 where r discount rate & g dividend growth rate.
r-g
In constant growth, dividends earnings x constant payout ratio, D/E and
payout ratio one minus plowback ratio of b (E - D)/E, then
E6 x (1 - b)
P5
r-g
P5 (1 - b)
rearrangin g :
E6 r-g
P5 P5 (1 - b)
and using smooth growth assumption : and
E6 E5(1 g) (r - g)
P5 (1 - b) x (1 g)
E5 (r - g)
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Adjusting the VC Shortcut for
Multiple Rounds
I x (1 r)T 1,000,000x (1 .25)2
Second Round Acquired 15.625%
[P/E x E 5] [10/1x 1,000,000]
I x (1 r)T 1,000,000x (1 .5)5
First Round Acquired 75.9375%
[P/E x E 5] [10/1x 1,000,000]
Founder's Remaining% 1 .1562 .759375 .084375
2,000,000
Total Sharesafter Financing 23,703,704
.84375
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Adjusting the VC Shortcut for
Multiple Rounds
First Round (of 2 rounds):
Shares issued = .759375 x 23,703,704 = 18,000,000
Share Price = $1,000,000/18,000,000 = $.055556 per share
Pre-money Valuation = $.055556 x 2,000,000 = $111,111
Post-money Valuation = $.055556 x 20,000,000 =$1,111,111
Founder % between 1st & 2nd round 2,000,000/20,000,000 = 10%
1st round investor % between 1st & 2nd rounds =
18,000,000/20,000,000 = 90%
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Adjusting the VC Shortcut for
Multiple Rounds
Second Round (of 2 rounds):
Shares issued = .15625 x 23,703,704 = 3,703,704
Share Price = $1,000,000/3,703,704 = $.27 per share
Pre-money Valuation = $.27 x 20,000,000 = $5,400,000
Post-money Valuation = $.27 x 23,703,704 = $6,400,000
Founder % between 2nd round & exit =
2,000,000/23,703,704 = 8.4375%
1st round investor % between 2nd round & exit =
18,000,000/23,703,704 = 75.9375%
2nd round investor % between 2nd round & exit =
3,703,704/23,703,704 = 15.625%
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Adjusting the VC Shortcut for
Incentive Ownership
Founder' s Remaining % 1 .15625 .759375 .06 .024375
2,000,000
Total Shares after Financing and Incentive Options 82,051,282
.024375
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Adjusting the VC Shortcut For
Incentive Ownership
First Round (of 2 + incentive rounds):
Shares issued = .759375 x 82,051,282 = 62,307,692
Share Price = $1,000,000/62,307,692 = $.01604938 per sh.
Pre-money Valuation = $.01604938 x 2,000,000 = $32,099
Post-money Valuation = $.01604938 x 64,307,692=$1,032,099
Founder % between 1st & 2nd round = 2,000,000/64,307,692
= 3.11%
1st round investor % between 1st & 2nd rounds =
62,307,692/64,307,692 = 96.89%
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Adjusting the VC Shortcut for
Incentive Ownership
Second Round (of 2 + incentive rounds):
Shares issued = .15625 x 82,051,282 = 12,820,513
Share Price = $1,000,000/12,820,513 = $.078 per share
Pre-money Valuation = $.078 x 64,307,692 = $5,016,000
Post-money Valuation = $.078 x 77,128,205 = $6,016,000
Founder % between 2nd round & exit = 2,000,000/77,128,205 = 2.5931%
1st round investor % between 2nd round & exit =
62,307,692 / 77,128,205 = 80.7846%
2nd round investor % between 2nd round & exit =
12,820,513 / 77,128,205 = 16.6223%
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Adjusting the VC Shortcut for
Incentive Ownership
Incentive Ownership Round:
Shares issued = .06 x 82,051,282 = 4,923,077
Founder % after Incentive Compensation Issue =
2,000,000 / 82,051,282 = 2.4375%
1st round investor % after Incentive Compensation =
62,307,692 / 82,051,282 = 75.9375%
2nd round investor % after Incentive Compensation =
12,820,513 / 82,051,282 = 15.625%
Employee % after Incentive Compensation =
4,923,077 / 82,051,282 = 6%
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Summary
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Scenario Methods
Given : $100 million ve nture fund invests :
20 % at total loss
60% at break even
20% at 70% annualized return
with liquidity at two years on all outcomes.
What is annualized portfolio return?
0 $60,000,000 $20,000,000 x (1.7) 2 1 / 2
( ) 1 8.536%
$100,000,000
Utopoia Discount Process : valuation by discountin g only utopian business plan
forecasts at utopian discount rates
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Three-scenario Mean Flow Approach
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Algebraically,
0 400 400 400 8,000,000 x
1,000,000 1
2
3
4
1.22 1.22 1.22 1.22 1.225
1,200 8,000,000 x 2
6
1.22 1.227
31.49689%
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Same As Taking Expectations Across
Scenario Values
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Internal Rate of Return (IRR)
IRR:
compound rate of return that equates the present value of the cash
inflows received with the initial investment
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TUTORIAL
EXERCISES/PROBLEMS
• No 3, 9
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