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4.4.4: Valuation: Discounting the Future-The Venture Capital Method The VCExperts - Portfolio Company Analysis Tool Both buy-side and sell-side professionals use this on-line tool to drastically reduce the time it takes to analyze an investment or financing opportunity and model related exit scenarios. The system produces a wide variety of tabular and graphical outputs that explain the precise impact of valuation and deal terms on investment returns, and assist in compliance with FAS 157 reporting requirements. View a demonstration of the Portfolio Company Analysis Tool. 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 million 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 XYZ.com 1. Assumptions Investors will want somewhere between 50- XYZ.com Assumptions The 100% annual return on their investment (ROI). The market market will value XYZ.com 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 XYZ.com 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 XYZ.com Investors Investment 1,000,000 (1 + 1.0)?3= 8,000,000 4. Percentage of Company Offered in order to determine the XYZ.com 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% [1] 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. [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. [3] 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). [4] 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. [5] 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). [6] 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 return; For ten times one's investment in five years, you need a 58% compounded pretax rate of return. [7] Willinge, "A Note on Valuation in Venture Settings," No. 295-064. [8] For a valuable discussion on how reliable forecasts can be obtained, see Walker & Petty, Financial Management of the Small Firm 78-87 (1986). [9] 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. [10] 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 www.raisingcapital.com; the information in EXAMPLE II appeared at: www.infobaseventures.com