Valuation Discounting the Future The Venture Capital Method by liaoqinmei


									4.4.4: Valuation: Discounting the Future-The
Venture Capital Method

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There are almost as many methods of calculating value[1] as there are world religions, since the
questions are metaphysical in part and depend on the appetites of the observer. In one of the most
common scenarios, the Venture Capital Method, a five-year forecast is prepared, the thought
being that an exit strategy will be implemented in the fifth year (assuming the projections are
accurate), that is, investors will sell their securities for cash or the securities will become publicly
traded, the equivalent of cash.[2] It is usually assumed that the investors will realize their entire
return upon implementation of the exit strategy; there will be no interim returns since all
revenues will be retained in the business. The valuation formula most often used in connection
with the forecast is relatively simple:

An investor plans to invest X dollars in the enterprise today for some as-yet-to-be-determined
percentage of the company's equity. The projections predict the company will enjoy Y dollars of
net after-tax earnings as of the day the exit strategy is accomplished, that is, the company is sold
or goes public.[3] The analyst then picks a multiple of earnings per share in order to hypothesize
what the stock might sell for in a merger or an IPO. Since there is no way of forecasting that
multiple, the next best strategy is to use existing multiples in the given industry. What is the PE
(ratio of share price to earnings per share) of companies in comparable fields today?[4] Let's
assume that multiple to be 10, meaning that the total market capitalization of the company
immediately prior to the IPO will be 10 times the net earnings for such year. The investor then
picks that return on his investment that corresponds to the risk he deems himself encountering,
taking into account the return on competing investments, another subjective judgment. He may
believe that he is entitled to a 38 percent compounded rate of return,[5] which means, by rule of
thumb in the venture community, that the company's forecast should be holding out the
expectation of a "five times" return;[6] that is, the investor will get back, before tax, $5 for every
$1 invested. If the investment called for is $250,000, then five times $250,000 is $1.25 million. If
the company is forecast to be worth $10 million in year five, then the investor's $250,000 should
command 12.5 percent of the company in year one.
For a more calibrated approach that takes into account future dilutions, consider the following
six-step process:

Example I :
Step 1: Valuation

Assume the value of the company given a future event (a liquidity event through IPO or some
type of M&A activity). For example, the company will be worth $150 mm in three years. This
"terminal value" is usually calculated by using a multiple, for example, a price to earnings
multiple may be multiplied by project EBIT in the exit year.

Step 2: ROI

Determine an ROI that the investor requires, based on the stage of the company (60%, 45%,
25%, 10% etc.). Oftentimes, the earlier-stage companies command the higher risk and therefore,
should command the higher ROI requirements.

Step 3:Discounting

Discount the event to a present value by use of the required ROI (i.e. the discount rate
determined in Step 2). Example: Terminal Value/(1+ Target ROI)years

So, in the situation where a 45% ROI over a three year period is required, the calculation would
be: $150mm/(1 + 45%)3 = $49.2 mm

Step 4: Pricing

Determine the current investment of capital that the company will require to achieve the future
liquidity event. (Example: It will take $5mm dollars in capital infusion for the company to be
worth $150mm in three years).

Step 5: Percentage Ownership

Divide the capital investment into the present value of the future event. In this example, it would
be $5mm/$49.2 mm equals 9.82%. Thus, the investment of $5 mm would be worth roughly 10%
of the company in year one.

Step 6: Caveat: Future Dilution and Retention Ratio[7]

The VC should estimate future dilution of the shares (from new hires for example, see below) or
from future rounds of financings. To compensate from the effect of dilution from future rounds,
the Retention Ratio must be calculated. Assume the company will issue shares representing an
additional 25% of the firm's equity, in addition to the planned IPO which would represent an
estimated additional 33% of the company.
If the VC owns 10% today, after these financings, his stake will be 10%/(1 + .25)/(1 + .3) =
6.15%. His retention ratio, is, therefore 6.15%/10% =61.5%.

The required current Percent Ownership in this case is 9.82%/61.5% = 15.96 %. Simply put, due
to the dilution effects of future financings, in order to maintain a 10% stake in the company, the
VC must own roughly 16% of the company in the first round financing if they seek to achieve
the ROI goals.

Of course, many of the elements of the formula are highly speculative, particularly the reliability
of the company's forecast.[8] The method of taking that subjectivity (risk of error) into account is
to adjust the rate-of-return target, or "bogey" or "hurdle rate" as it is sometimes called. If the
investor thinks the forecast is suspect, one way of sensitizing the equation to his suspicion is to
increase the rate of return target from, say, 38 percent to as much as, perhaps, a 50 percent
compounded rate of return.

If an adjustment has to be made to conjugate a rate of return much higher than 50 percent, then
it's arguable the investor should not make the investment in the first place. Because compounded
rates of return in excess of 50 percent are so unusual, many investors feel it is unrealistic to
predicate an investment on that kind of expectation.[9] The power of compounding is enormous.
Many neophytes are inhabiting fantasy worlds when they dream of investments continuing to
compound at double digit rates over an extended period.

To reiterate, the most important variable has to do with the dillution, i.e. the probability that the
initial investment will be diluted prior to the terminal event. To illustrate, consider the
hypothetical set forth in Willinge, Appendix 4:

James is a partner in a very successful Boston-based venture capital firm. He plans to invest $5
million in a start-up biotechnology venture and must decide what share of the company he
should demand for his investment. Projections he developed with company management show
net income in year seven of $20 million. The few profitable biotechnology companies are trading
at an average price-earnings ratio of 15. The company currently has 500,000 shares outstanding.
James believes that a target rate of return of 50 percent is required for a venture of this risk. He
performs the following calculations:

Discounted Terminal Value = Terminal Value/(2+Target)years= (20*15)/(1+50%)7 = $17.5

Required Percent Ownership - investment/Discounted Terminal Value - 5/17.5 = 28.5%

Number of New Shares = 500,000/(1-28.57%) - 500,000 = 200,000

Price per New Share = $5 million/200,000 shares = $25 per share

Implied Pre-money Valuation = 500,000 shares * $25 per share = $12.5 million

Implied Post-money Valuation = 700,000 shares * $25 per share = $17.5 million
James and his partners are of the opinion that three more senior staff will need to be hired. In
James's experience this number of top caliber recruits would require options amounting to 10%
of the common stock outstanding. Additionally, he believes that, at the time the firm goes public,
additional shares equivalent to 30% of the common stock will be sold to the public. He amends
his calculations as follows:

Retention Ratio = [1/(1 + .1)] / (1+.3) = 70%

Required Current Percent Ownership = Required Final Percent Ownership/Retention Ratio =
28.5%/70% = 40.7%

Number of New Shares = 500,000/(1-40.7%) - 500,000 = 343,373

Price per New Share = $5 million/343,373 shares = $14.56 per share"

Example II:10
Company Valuation Model / Ownership Percentage Offered

This model explains a simple way to value a start-up company when working with investors.

                          Explanation                                   Example of

1. Assumptions Investors will want somewhere between 50-
                                                           Assumptions The
100% annual return on their investment (ROI). The market
                                                                    market will value
will value the company on a P/E basis somewhere between 8-
                                                                    somewhere around 15 time
15 times earnings if it was a public company. While some
                                                                    earnings. Initial Investment
internet companies have outrageous price to earnings ratios,
                                                                    Needed: $1,000,000
you are better off to use a conservative price to earnings ratio.

2. Valuation Multiply the p/e ratio by the third year after tax
expected profit. This number gives you the estimated value of Valuation 15 x
the company in three years. Why three years--that is                $1,650,000 = $24,750,000
traditionally what is used as a harvest time frame.

3. Future Value of Investors Investment Use the following
formula to determine the future value of investors initial
investment. Let PV equal the initial investment; let r equal the
return on investment; let n equal the number of years; and let
FV equal the future value of the investors investment. Future
Value of Investors Investment 1,000,000 (1 +
1.0)?3= 8,000,000

4. Percentage of Company Offered in order to determine the Equity Structure
amount of the percent-age of the Company to be offered,             [Suggested Structure:
divide the future value of the investors initial investment (see     Founders[ 68%
number 3) by the estimated value of the Company in three             New Investor(s) 32% Total
years (see number 2).                                                100%

  Valuable materials on valuation theory are collected in Gilson, The Law and Finance of
Corporate Acquisitions, Chs. 2-7 (1993). Gilson explicates the two techniques most commonly
used to calculate the attractiveness of a good investment: the internal rate of return and net
present value techniques. Id. at 2.
   In point of fact, the day of the initial public offering does not automatically make the
investor's stock liquid. It is unlikely that their shares will be registered in any significant amount
for distribution or indeed be eligible for "dribble out" privileges under Rule 144 until the
expiration of a period during which all secondary sales are barred by the underwriters and/or by
state securities administrators.
   Some investors work with not one but three forecast scenarios: best, middle, and worst case.
They then weight each of the three according to probability of occurrence and come up with a
weightedaverage result. This is sometimes referred to as the First Chicago method, because it
was prominently employed by Stanley Golder when he was managing the portfolio of the
venture arm of that bank holding company. See Morris, Pricing of a Venture Capital Investment,
in Pratt, Pratt's Guide to Venture Capital Sources 55 (11th ed. 1986). To be sure, attaching
probabilities to the occurrence of a given projection is conceptually impure since probability
theory requires that no statement whatsoever can be made about the probability of a single
event?i.e., there is no probability attached to one flip of a fair coin. Nonetheless, the practice is
useful when it is taken for what it is?a way of helping an investor in reaching a decision, rather
than purporting to make that decision for him with scientific exactitude. When businessmen
measure value using methods such as "First Chicago" they are described as using "personal or
subjective probabilities." Grayson, The Use of Statistical Techniques in Capital Budgeting, in
Brudney & Chirelstein, Corporate Finance: Cases and Materials 52 (3d ed. 1987).
   Finding the appropriate PE ratio is often discussed in finance textbooks. See Fama,
Foundations of Finance (1976). As the Text suggests, the most often used criterion is "what other
people are willing to pay for comparable streams of earnings." See Shannon Pratt, Valuing a
Business: The Analysis and Appraisal of Closely-Held Companies 61 (1981). In addition to
matching comparable industries to divine the appropriate PE, one must consider the growth
potential and risk of the specific investment in question. In general, the types of firms in which
venture capitalists like to invest will have high growth potential (meriting a higher PE ratio), but
will be risky (compensated for by a lower PE ratio). The earnings of a highly leveraged company
are riskier than those enjoyed by a debt-free firm; one way to compare apples and oranges in this
environment is to recalculate the earnings of the leveraged company as if it were debt free.
Shannon Pratt at 64-66.
   The expectations of professionally managed pools are high. Brentwood Associates' reportedly
targets a "ten times" return in five years. See Kozmetsky, Gill, & Smilor, Financing and
Managing Fast Growth Companies, at xv (1985).
   If five years is the time horizon, then compounded rates of return interrelate with multiples of
the cash invested as follows:
For three times one's investment in five years, you need a 25% compounded pretax rate of return;
For five times one's investment in five years, you need a 38% compounded pretax rate of return;
For seven times one's investment in five years, you need a 48% compounded pretax rate of
For ten times one's investment in five years, you need a 58% compounded pretax rate of return.
      Willinge, "A Note on Valuation in Venture Settings," No. 295-064.
  For a valuable discussion on how reliable forecasts can be obtained, see Walker & Petty,
Financial Management of the Small Firm 78-87 (1986).
   Any number of rules of thumb are used by venture capitalists, in part because the universe of
possible opportunities is so large that some handy, ready-to-wear criteria are necessary to screen
wheat from chaff. Thus, one prestigious fund uses what it calls a "second-round scenario." The
manager arbitrarily assumes that, when a second round of financing is called for, no start-up is
likely to be given a premoney valuation much in excess of $5 million. Since the manager wants
his first-round investment to be "worth" somewhere around 50% more as a result of a second-
round mark-up, first round valuation rarely exceeds $2 to $3 million after the money.
    The information in example 2 is provided courtesy of Joe Ollivier of First Capital
Development, a private investment and hard money lending firm based in Provo, Utah. For more
information, see First Capital Advisors; the information in EXAMPLE
II appeared at:

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