Venture Capital by yurtgc548

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									         Lecture 4:
Valuation of the Opportunity /
          Business




                             1
         Financial Questions

1. Is this a financially viable business?
2. What will the likely returns be to the
   various stakeholders?
3. What is the probable value of the
   business?
4. What will the cash flows look like?
5. How much funding is required?
                                            2
 VC Discount Rates and Risk Reduction
             Idea is           Technology            A Customer
            Feasible             Works                  Buys

                                                               P(success) = 80%
                                                               Req’d IRR = 30%

                                                                               Valuation

                                         P(success) = 50%
                                         Req’d IRR = 50%



                    P(success) = 40%
                    Req’d IRR = 70%
P(success) = 30%
Req’d IRR = 100%

                                                                               Risk (ß)
                                                                              Capital
    Seed            R&D           Go-to-Market              Expansion
   Funding         Capital          Capital                  Capital      Source: Jim White (SHV)




                                                                                                    3
 Financial Valuation Methods

1. Comparables

2. NPV

3. Adjusted NPV

4. Venture Capital Method

5. Real Options
                               4
                  Comparables
•       Multiples – P/E, P/NAV, P/S etc.
•       Problem: difficult to find info,
        especially on private deals.
•       Fall-back: publicly traded equity.
•       When valuing a non-listed business,
        apply a discount for:
    •     Liquidity.
    •     Corporate governance and under-
          regulation.
    •     Skills and resource issues (inexperience).
                                                       5
      Net Present Value (NPV)
•   Cash flows - scenarios and timing.
•   Typically cash inflows distant – most value
    in terminal value (TV).
•   TVs – tricky to estimate, scenarios and
    ranges.
•   Discount rates – WACC, using CAPM for
    cost of equity (re).
•   Problem: need beta of comparable public
    firm.
•   Changing capital structures and effective tax
    rates – WACC (constant assumption)
    inappropriate.
                                                  6
     Adjusted Present Value (APV)
Appropriate where:
•    Hybrid securities (neither debt nor equity).
•    Changing capital structure.
•    Assessed tax losses and tax rates.

Sequence:
1.   Value cash flows at CAPM derived all-equity
     discount rate.

2.   Using (usually) pre-tax rate on debt, value (a) tax
     benefits of capital structure (interest payments),
     and (b) assessed tax losses.

3.   Subtract value of debt.
                                                           7
      Discount Rate and Beta
Discount Rate:

r = [(D/V) x re] + [(D/V) x rd x (1 – t)]
V=E+D
re = rf + β x (rm – rf)




                                            8
   The Venture Capital Method
Sequence:
1. Forecast cash flows to equity for period.
2. Predict exit point.
3. Value exit price using multiple (based on
   public company or comparable transaction
   multiple).
4. Discount cash flows at required RR.
5. Determine own share of this value.
6. Consider share option pools and follow-on
   funding rounds (dilutions)                9
      PE vs. Public Numbers
Multiples:
•   20-30% liquidity discount vs. market.

Discount rates:
•   Between 30% and 70% in SA.

Why so high?
•   Liquidity risk.
•   Compensation for value addition.
•   Correcting for optimistic forecasts.
•   Bargaining power of investor.
                                            10
             Real Options
•   Flexibility i.t.o. follow-on investments
    (funding rounds).
•   Right of first refusal = call option on
    equity in the business.
•   Black-Scholes model.
•   Not commonly known or used,
    complex in “real world”.

                                               11
        Black Scholes Variables
                      C  SN (d1 )  Ke  RT N (d 2 )
                      where
                              S        2 
                           ln     R 
                                            T
                              K        2 
                      d1 
                                   T
                      and
                      d 2  d1   T
Variable definitions:
    S =           current stock price
    K =           option strike price
    e =           base of natural logarithms
    R =           riskless interest rate
    T =           time until option expiration
     =           standard deviation (sigma) of returns on underlying security
    ln =          natural logarithm
    N(d1) and N(d2) = cumulative standard normal distribution functions 12
           Black Scholes Variables
Variable Financial Option                         Firm Option
                                                  PV of expenditures to
     X         Exercise price.
                                                  undertake project.
                                                  PV of expected project
     S         Stock price.
                                                  cash flows.
                                   Length of time that inv.
      t        Time to expiration.
                                   decision can be deferred.
                                                  Riskiness of underlying
     σ         SD of returns.
                                                  assets.
               Time value of
     rf                                           Risk-free rate of return.
               money.
Source: Venture Capital and Private Equity, Lerner and Hardymon, J Wiley & Sons, 2002.
                                                                                         13
    Valuing Ideas: Non-Financial Determinants

•     The management team.
•     Market opportunity.
•     Value proposition.
•     Intellectual capital.
•     Skills, systems and structures.
•     Competitors.
•     Regulatory environment.
•     Control, bargaining power and influence.
                                            14
 Assessing the Management Team

• Motives and passion.
• Business experience.

• Can skills gaps be bridged?

• Personalities & conflict potential.

• Governance issues.

                                        15
Passion by itself is not enough…




                                   16
      The Essence of VC…
 “Good ideas and good products are a
  dime a dozen. Good execution and
  good management - in a word, good
          people - are rare.”

                                   - Arthur Rock

(78-Year old Venture Capitalist and Multi-Millionaire
with NW of $1bn).


                                                        17
          Investment Structure
•       Convertible Preferred Shares.
    •     Downside protection: ranks above
          common equity in case of liquidation
          and pays dividends.
    •     Upside potential: convertibility.


•       Strategic influence.
    •     Board representation.


                                                 18
                    Common Mistakes
                                                            Venture
                                            Entrepreneur
                                                           Capitalist
 Unrealistic projections                        8%           21%
 Weak analysis of market/competition            16%          18%
 Other                                          4%           18%
 Lacking clarity                                16%          17%
 Mistakes and errors                                         10%
 Incomplete                                     15%           8%
 Management weak                                4%            8%
 Not realistic about challenges                 27%
 Incorrect valuation and exit strategy          10%

Source: Profit Dynamics, Inc, March, 2002
                                                                        19
Many VC Investments Fail




                           20
         Phrases to avoid…
•   We conservatively project…
•   The project is 98% complete
•   We have a 1 year lead…
•   Customers are clamoring for our product…
•   We are the low cost producer…
•   Our team has a great deal of experience…
•   If you invest on our terms you will earn a 68%
    IRR...


                                                 21
The Basis: Projected Sales




                             22
Cumulative Sales & Penetrations




                                  23
Sales Converted to Revenue




                             24
Unit Production Costs




                        25
Total Cost of Sales




                      26
Gross Profit & Gross Margin




                          27
Capital Expenditures




                       28
Running Costs (1)




                    29
Running Costs (2)




                    30
Annual Cashflows




                   31
Monthly Cashflows




                    32
Valuation of Idea




                    33
The Negotiation: Different Objectives

Entrepreneur
• Maximum capital/valuation.
• Low cost of capital.
• Dilution and control.
Investor
• Maximum return (lower valuation).
• Minimise risk.
• Control/ input into future.
                                      34
The Negotiation: Common Objectives


• Growth in value of business.

• Additional financing at more
  favorable valuations

• Mutually beneficial exit strategy

                                      35
       Another take on Risk.
•   Entrepreneur cannot diversify away
    risk.
•   But PE Fund can and does across
    many investments.
Therefore:
•   Transferring part of risk to fund
    through equity investment reduces
    overall risk.
                                         36
Management / Monitoring of Investments

•   Strong, balanced team required.
•   Across all areas of business sciences.
•   Direct and active involvement.

In some ways:
•   PE investing is hybrid between
    business consulting and investment
    science.
                                         37
        Liquidity and Exit
• The key risk.
• No public market.
• Over-the-counter markets (OTC).
• Secondary markets (PE portfolios,
  e.g. banks).
• IPOs.
• Third-party sales.
                                      38
BJM OTC Market




  http://www.bjmdirect.com   39
    Initial Public Offerings (IPOs)
•   Attractive if public valuations are high
    (e.g., high P/Es on listed equities).
•   Moves in cycles.
•   V/C firm is insider – retains equity
    subject to lock-in period (usually 2
    years).
•   Thereafter, distributes equity to Limited
    Partners.
                                               40
    3rd Party Sale : Pleasure Foods
•       The PE Fund:
    •    Ethos PE Fund III.
    •    Part of RMB Group

•       The Investment:
    •    Date: 1996.
    •    Business: Pleasure Foods
    •    Seller: AngloVaal Industries.
    •    Reason: MBO / strategic refocusing.
    •    Cost: unknown
    •    Shareholding: 79% Ethos, 21% management

                                                   41
    Pleasure Foods (2)
•        Restructuring:
     •     1996 - 2003.

•        Exit (after 7 years):
     •     Phase 1:
             • June 2003.
             • Sale of Juicy Lucy and Milky Lane to Ola
               (part of Unilever).
     •     Phase 2:
             • December 2003.
             • Sale of remainder to Steers Holding for
               R150.6 mn.

                                                          42
                     Assignment (1):
•       Topic: A basic business plan of a novel business idea / concept / product.

•       Target Audience: A venture capitalist or VC firm.

•       Objective: To obtain funding from the venture capitalist to start the business.

•       Format: MS Word format. Maximum length of text: 15 A4 pages of (minimum)
        font 11.

•       Should include (at a minimum):
    •       A description of the concept
    •       The need and how this idea will satisfy it
    •       The target market
    •       Why it would be a good investment for the venture capitalist (build an investment
            case).
    •       The financial case (attached financial projections as an Annexure)
    •       Competition issues.
    •       A clear indication of the amount of funding that will be required and why.

•       Annexures may be added to the above (e.g. supporting material, competing
        products etc., website info, additional research etc.).
                                                                                                43
    Assignment: Practical Arrangements
•    To be done in groups of between 3 and 5.
     You are expected to form your own groups timeously and will not be required
     to register your groups in advance.
     Assignments handed in by groups of more than 5 or less than 3 members will
     automatically be marked down 25%.
•    The key will be to be original, comprehensive and concise within the space
     constraints
•    Deadline for hand-in: 12:00 on 15 August 2006 to Nonnie Falala (LC 5.39)
•    Grading will be on a relative basis – therefore there is no absolute right or
     wrong.
•    Remember you will be graded on how well you achieve your objective, namely
     to convince the venture capitalist of the size of the opportunity, the novelty of
     the idea, the profits that can be made from it etc.
•    Therefore, you have to achieve a fine balance between being creative and
     being realistic. The more realistic your assumptions, idea, financials etc,. the
     better your mark will be. This is an exercise in realism, not a license to dream
     or go on a flight of fancy.
•    In short: You have to come up with an idea that can work and that can make
     money, and you have to be able to sell this idea as being realistic and
     profitable in order to get funding from a VC, which is your objective.

                                                                                     44
                     The Exam
•       17 May, 15:00, Kramer 1 and 2, Class 2A
•       Extra timers in Classroom 2A
•       Essay / Case Study based.
•       1 Essay of 5 pages.
•       Know / broadly understand:
    •     Issues, challenges and financing issues facing
          entrepreneur.
    •     Functioning of the P/E and V/C industries
    •     Considerations of private equity investor.
    •     Etc.
                                                           45
                  Exam (2)
•   No correct answer.
•   Insight and lateral thinking will be
    rewarded.
•   You may make some assumptions if
    needed, but do not invent your own story.
•   Correct application of material from other
    parts of the course can be useful.
•   Slides and readings to form basis – do not
    need to know readings and specific info
    on VC and P/E industries.

                                                 46
                 Exam (3)
Slides and readings to form basis

What you do not need to know:
  •   Specific stats on VC and P/E industries
      (SA, US etc.)
  •   The readings on areas of research in
      Entrepreneurial Finance.
  •   You will not be directly tested on
      specifics, but rather on application and
      understanding.
                                                 47
For the Exam, Remember…




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