leach & melicher - ch 10 venture capital valuation methods - ef

Chapter 10VENTURE CAPITAL VALUATION METHODS

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© 2012 South-Western Cengage Learning

ENTREPRENEURIAL FINANCE Leach & Melicher

Chapter 10Learning 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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Definition of 'Venture Capital'

Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.

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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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75.9375%

5)5.(1 / 1,000,000] x [10/1

1,000,000

Tr)(1 / ]E x [P/E

I Ownership Final % Acquired5

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6,3111,688 .240625

(.759375) x 2,000,000

% Acquired -1%) (Acquired x mn Issued Be toShares

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shareper 15843622$.

shares 6,311,688$1,000,000 Price Share Issue

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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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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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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

Direct Capitalization:valuation by capitalizing earnings using a cap rate implied by a comparable ratio

Venture

5Year

Venture

5Year FirmsOther

Current

FirmsOther

Current P E x E

P

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Venture

5Year FirmsOther

Current

FirmsOther

Current

Venture

5Year P P/E

E


000,000,10 .10

1,000,000

20,000,000 / 2,000,0001,000,000 P

P/E E

:methodtion capitalizadirect Under

10,000,000 1,000,000 x 10

1,000,000 x 2,000,000

20,000,000P E x E

P

Venture

5Year FirmsOther

Current

FirmsOther

Current

Venture

5Year

Venture

5Year

Venture

5Year FirmsOther

Current

FirmsOther

Current

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g)-(r

g)(1 x b)-(1 E

P

and g)-(rb)-(1

g)(1E P

E P:assumptiongrowth smooth using and

g-rb)-(1

E P :grearrangin

g-rb)-(1 x E P

thenD)/E,-(E b of ratioplowback minus one ratiopayout and D/E ratio,payout constant x earnings dividends growth,constant In

rate.growth dividend g & ratediscount r whereg -r D P

:(P) price & (D), dividends (E), earnings of valuesshareper Given

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5

5

5

6

5

6

5

6

5

65

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Adjusting the VC Shortcut for Multiple Rounds

704,703,23.84375

2,000,000 Financingafter Shares Total

084375.759375.1562.1 % Remaining sFounder'

%9375.75 1,000,000] x [10/1

.5) (1 x 1,000,000 ]E x [P/E

r) (1 x I Acquired RoundFirst

%625.15 1,000,000] x [10/1

.25) (1 x 1,000,000 ]E x [P/E

r) (1 x I Acquired Round Second

5T

2T

5

5

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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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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

282,051,82.024375

2,000,000 Options Incentive and Financingafter Shares Total

024375.06.759375.15625.1 % Remaining sFounder'

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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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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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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

ratesdiscount utopian at forecasts plan businessutopian only gdiscountinby valuation:ProcessDiscount Utopoia

%536.8100$100,000,0

(1.7) x 0$20,000,00 0$60,000,00 0

return? portfolio annualized isWhat outcomes. allon years at twoliquidity with

return annualized 70%at 20% evenbreak at 60% loss at total % 20

:invests fund nturemillion ve $100 :Given

2/1)(2

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Three-scenario Mean Flow Approach

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Algebraically,

%49689.31

1.222 x 8,000,000

1.221,200

1.22 x 8,000,000

1.22400

1.22400

1.22400

1.220 1,000,000

76

54321

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Same As Taking Expectations Across Scenario Values

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Internal Rate of Return (IRR)

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IRR: compound rate of return that equates the present value of the cash inflows received with the initial investment

leach & melicher - ch 10 venture capital valuation methods - ef

Documents

exitsimilar venture

similar venture income

capital markets

single valuation

equity methodstaged

equity methodexample

financing exit

shares x