Valuation Basics
An important component of the venture capital investment
process is the valuation of the business enterprise seeking
financing. Valuation is an important input to the negotiation
process relative to the percentage of ownership that will
be given to the venture capital investor in return for
the funds invested.
There are a number of commonly used valuation methods,
each with their strengths and weaknesses. The most commonly
used valuation methods are:
- Comparables
- The Net Present Value Method
- The Venture Capital Method
Comparables
Similar to real estate valuations, the value of a company
can be estimated through comparisons with similar companies.
There are many factors to consider in selecting comparable
companies such as size, growth rate, risk profile, capital
structure, etc.
Hence great caution must be exercised when using this
method to avoid an “apples and oranges” comparison.
Another important consideration is that it may be difficult
to get data for comparable companies unless the comparable
is a public company. Another caveat when comparing a public
company with a private company is that, all other things
being equal, the public company is likely to enjoy a higher
valuation because of its greater liquidity due to being
publicly traded.
Net Present Value Method
The Net Present Value Method involves calculating the
net present value of the projected cash flows expected
to be generated by a business over a specified time horizon
or study period and the estimation of the net present
value of a terminal value of the company at the end of
the study period. The net present value of the projected
cash flows is calculated using the Weighted Average Cost
of Capital (WACC) of the firm at its optimal capital structure.
Step 1: Calculate Net Present Value of Annual Cash
Flows
Cash Flow for each future period in the time horizon
or study period of the analysis is defined as follows:
CFn = EBITn*(1-t) + DEPRn – CAPEXn – .CNWCn
Where:
CF = cash flow or “free cash flow”
n = the specified future time period in the study period
EBITn = earnings before interest and taxes
t = the corporate tax rate
DEPRn = depreciation expenses for the period
CAPEXn = capital expenditures for the period
.NWCn = increase in net working capital for the period
It should be noted that interest expense is factored
out of the cash flow formula by using EBIT (earnings before
interest and taxes). This is because the discount rate
that is used to find the net present value of the cash
flows is the WACC. The WACC uses the after tax cost of
debt, which takes into account the tax shields that result
from the tax deductibility of interest. By using EBIT
in the cash flow calculation, double counting of the tax
shields is avoided.
Step 2: Calculate the Net Present Value of the Terminal
Value
The terminal value is normally calculated by what is
often referred to as “the perpetuity method.”
This method assumes a growth rate “g” of a
perpetual series of cash flows beyond the end of the study
period. The formula for calculating the terminal value
of the company at the end of the study period is:
TVt = [CFt*(1 + g)]/(r – g)
Where:
TVt = the terminal value at time period t, i.e. the
end of the study period
CFt = the projected cash flow in period t
g = the estimated future growth rate of the cash flows
beyond t
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 focuses on the projected value of the company
at the planned exit date of the venture capitalist.
The steps involved in a typical valuation analysis involving
the venture capital method follow.
Step 1: Estimate the Terminal Value
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
4-7 years after the investment is made in the company.
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.
Step 2: Discount the Terminal Value to Present Value
In the net present value method, the firm's weighted
average cost of capital (WACC) is used to calculate the
net present value of annual cash flows and the terminal
value.
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.
Step 3: Calculate the Required Ownership Percentage
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, $5 million is being
invested. Dividing 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.
The company currently has 500,000 shares outstanding,
which are owned by the current owners. If the venture
capitalist will own 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. 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 post-investment 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. 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 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
Source: University of New Brunswick
