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Investing in a New Venture

The Venture Capital Method

Most venture capital investment scenarios involve investment in an early stage company that is showing great promise, but typically does not have a long track record and its earnings prospects are perhaps volatile and highly uncertain. The initial years following the venture capital investment could well involve projected losses.

The venture capital method of valuation recognizes these realities and focus on the projected value of the company at the planned exit date of the venture capitalist.

Valuation Analysis

The steps involved in a typical valuation analysis involving the venture capital method follow.

Step 1
Estimate the Terminal Value

Investment Duration
The terminal value of the company is estimated at a specified future point in time. That future point in time is the planned exit date of the venture capital investor, typically 47 years after the investment is made in the company.

Estimating the Terminal Value

The terminal value is normally estimated by using a multiple such as a price-earnings ratio applied to the projected net income of the company in the projected exit year.

Price/Earnings Ratio
In general, a price-earnings ratio of 15 is applied to the projected net income. For example, assume that the projected net income is $20 million in the planned exit year-- year 7. This yields a projected exit value of $300 million in year 7. The choice of multiple for the valuation is something that will be a matter of discussion during the venture capital negotiations.

PE Ratios for Public Companies PE ratios for comparable public companies will be used as a benchmark to select a PE for the venture, recognizing that PE ratios for public companies are likely to be higher due to their greater liquidity relative to a private company.

Step 2
Discount the Terminal Value to Present Value

In the net present value method, the firms weighted average cost of capital (WACC) is used to calculate the net present value of annual cash flows and the terminal value.

Target Rate of Return In the venture capital method, the venture capital investor uses the target rate of return to calculate the present value of the projected terminal value. The target rate of return is typically very high (30-70%) in relation to conventional financing alternatives.

In the example provided for illustration, the projected terminal value in year 7 of $300 million is discounted to a present value of $17.5 million using a target rate of return of 50%. PV = FV/(1+I)n = $300m/(1+.50)7 = $17.5 million

Step 3
Calculate the Required Ownership Percentage

Required Ownership

The required ownership percentage to meet the target rate of return is the amount to be invested by the venture capitalist divided by the present value of the terminal value of the company. In this example, it is assumed that $5 million is being invested. Dividing the $5m. by the $17.5 million present value of the terminal value yields a required ownership percentage of 28.5%.

The venture capital investment can be translated into a price per share as follows:
Assume that the company currently has 500,000 shares outstanding, which are held by the current owners. If the venture capitalist is given ownership of 28.5% of the shares after the investment (i.e. 71.5% owned by the existing owners), the total number of shares outstanding after the investment will be 500,000/0.715 = 700,000 shares.

Ownership

Therefore the venture capitalist will own 200,000 of the 700,000 shares. Since the venture capitalist is investing $5.0 million to acquire 200,000 shares the price per share is $5.0/200,000 or $25 per share. Under these assumptions the pre-investment or pre-money valuation is 500,000 shares x $25 per share or $12.5 million and the postinvestment or post-money valuation is 700,000 shares x $25 per share or $17.5 million.

Step 4
Calculate Required Current Ownership % Given Expected Dilution Due to Future Share Issues

The calculation in Step 3 assumes that no additional shares will be issued to other parties before the exit of venture capitalist. However, many venture companies experience multiple rounds of financing and shares are also often issued to key managers as a means of building an effective, motivated management team.

The Impact of Future Share

The venture capitalist will often factor future share issues into the investment analysis. Given a projected terminal value at exit and the target rate of return, the venture capitalist must increase the ownership percentage going into the deal in order to compensate for the expected dilution of equity in the future.

The required current ownership percentage given expected dilution is calculated as follows: Required Current Ownership = Required Final Ownership divided by the Retention Ratio For example, if company shares amounting to 10% of the equity are expected to be sold to managers and shares equivalent to 30% of the common stock w sold to the public in an IPO, Then:

Required Ownership Rate

The Required Current Ownership = 28.5%/70% = 40.7% In this case the Retention Ratio is [1/(1+0.1)/(1+0.3)] = 70% In other words, in order to preserve a 28.5% final ownership percentage at exit, the venture capitalist must get a 40.7% ownership interest going into the deal, given the expected future dilution.

New Shares

The number of new shares that will have to be issued at the outset will therefore have to be 500,000/(1-40.7%) 500,000 = 343,373 The price per share will therefore be $5 million/343,373 = $14.56 per share.

Let us assume a fictional start-up company called "Spiffy-Calc," which is seeking financing from a venture capital fund by the name of "Vulture Ventures." Studying their crystal ball, the founders of SpiffyCalc expect to be able to sell the company for $25 million in four years.1 At this point they need to raise $3 million. Vulture Ventures considers this a risky business and wants to apply a discount rate of 50 percent to be adequately compensated for the risk they will bear.2 The entrepreneurs also decided that whatever valuation they would get, they wanted to own 1 million shares, which they thought would be a cool number to brag about.

It is useful to define variables for the key assumptions we have made. V = terminal value (at time of exit) = $25 million (in four years) t = time to exit event = 4 years I = amount of investment = $3 million r = discount return used by investors = 50 percent x = number of existing shares (owned by the entrepreneurs) = 1 million

Step 1: Determine the Post-Money Valuation


The only positive cash flow in this model occurs at the time of exit (typically an IPO or an acquisition), where we measure the terminal value of the company, denoted by V = $25 million. This means that after receiving the required $3 million, the initial value of the company is simply the discounted terminal value in 4 years' time. If Vulture Ventures is using a discount rate of 50 percent, the NPV of the terminal value in four years is V/(l + r)1 = $25 million/ (1.5)4 = $4,938,272 = POST. This is called the post-money valuation, i.e., the value of the company once the initial investment has been made. Intuitively, this is the value that is being placed on the entire company. This value is obviously not realized at the time of financing, as it depends on the belief that there will be great financial returns in the future.

Step 2: Determine the PreMoney Valuation

Subtracting the cost of the investment of $3 million from the post-money valuation yields PRE = $1,938,272. This is called the premoney valuation.

Step 3: Determine the Ownership Fraction

Vulture Ventures is investing $3 million in a venture valued at $4,938,272. In order to get back its money it therefore needs to own a sufficient fraction of the company. If they own a fraction F = $3 million/$4,938,272 = 60.75 percent, they get their required rate of return on their investment.

Step 4: Obtain the Number of Shares


The founders want to hold 1 million shares. When Vulture Ventures makes its investment it needs to calculate the number of shares required to achieve its desired ownership fraction. In order to obtain a 60.75 percent ownership share, Vulture Venture makes the following calculation: let xbe the number of shares owned by the founders (x 1 million) and y be the number of shares that Vulture Ventures requires, then )//(l,000,000 + y) = F = 60.75 percent. After some algebraic transformation we get y = 1,000,000 [0.6075/(10.6075)] = 1,547,771. Vulture Ventures thus needs 1,547,771 shares to obtain their desired 60.75 percent of the company.

Step 5: Obtain the Price of Shares


The price of shares is thus given by $3 million/1,547,771 = $1.94.

The General Case


We can calculate all important variables of a deal in a simple five step procedure: POST is the post-money valuation. Step 2: PRE = POST - I PRE is the pre-money valuation. Step 3: F= I/POST F is the required ownership fraction for the investor. Step4:y=x[F/(l-F)] y is the number of shares the investors require to achieve their desired ownership fraction. Step5:p1=l/y pi is the price per share.

Sensitivity Analysis with the Basic Venture Capital Method It is interesting to do some sensitivity analysis. How will the value of the company change if we change our assumptions? We will examine the effect of changing the following assumptions: Variation 1: reduce the terminal value by 10 percent Variation 2: increase the discount rate by an absolute 10 percent Variation 3: increase investment by 10 percent Variation 4: increase time to exit by 10 percent Variation 5: increase the number of exiting shares: this has no effect on any real values!

Single Period NPV Method

Base Model

Variation 1

Variation 2

Exit Value Time to exit Discount rate Investment amount Number of existing shares Post-Money Pre-Money Ownership fraction of investors Ownership fraction of entrepreneurs

V t r I
X

$25,000,000 4 50.00% $3,000,000 1,000,000 $4,938,272 $1,938,272 60.75%

$22,500,000 4 50.00% $3,000,000 1,000,000 $4,444,444 $1,444,444 67.50%

$25,000,000 4 60.00% $3,000,000 1,000,000 $3,814,697 $814,697 78.64%

POST PRE F

1-F

39.25%

32.50%

21.36%

Single Period NPV Method Number of new shares Price per share Final wealth of investors Final wealth of entrepreneurs NPV of investors' wealth NPV of entrepreneurs' wealth

Base Model y 1,547,771 $1.94 $15,187,500 $9,812,500 $3,000,000 $1,938,272

Variation 1 2,076,923 $1.44 $15,187,500 $7,312,500 $3,000,000 $1,444,444

Variation 2 3,682,349 $0.81 $19,660,800 $5,339,200 $3,000,000 $814,697

Single Period NPV Method Exit Value Time to exit Discount rate Investment amount Number of existing shares Post-Money Pre-Money Ownership fraction of investors Ownership fraction of entrepreneurs Number of new shares Price per share Final wealth of investors Final wealth of entrepreneurs NPV of investors' wealth NPV of entrepreneurs' wealth
V t r

Variation 3 $25,000,000
4

Variation 4 $25,000,000
4.4

Variation 5 $25,000,000
4

I
X

50.00% $3,300,000 1,000,000 $4,938,272 $1,638,272 66.83% 33.18% 2,014,318 $1.64 $16,706,250 $8,293,750 $3,300,000 $1,638,272

50.00% $3,000,000 1,000,000 $4,198,928 $1,198,928 71.45% 28.55% 2,502,235 $1.20 $17,861,700 $7,138,300 $3,000,000 $1,198,928

50.00% $3,000,000 2,000,000 $4,938,272 $1,938,272 60.75% 39.25% 3,095,541 $0.97 $15,187,500 $9,812,500 $3,000,000 $1,938,272

POST
PRE F

1-F
y