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A NOTE ON VALUTAION IN ENTREPRENEURIAL SETTINGS

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Introduction

A NOTE ON VALUTAION IN ENTREPRENEURIAL SETTINGS1 This note addresses valuation issues that are relevant to entrepreneurial settings. In valuing any investment opportunity from a startup-up to a mature company, it is always worthwhile to use the APV and/or WACC methods as taught in class. In addition, it also is generally useful to use a comparable company or multiple based approach. The APV, WACC and comparable methods deliver values that are appropriate when a company or investment is valued by a capital market that is relatively liquid and well-behaved. The valuation of investments in private companies - particularly start-ups - generate additional problems, concerns and questions that are not generally present in valuing public companies. A number of methodologies and institutions have evolved to deal with these problem and concerns. This note will describe, discuss, criticize, and, hopefully improve upon some of those methodologies. The Venture Capital Method A. Calculation The venture capital (VC) method is commonly used in the venture capital community. A variant, descried in the LBO section, is used to value LBOs. Please note that as discussed in class VCs are professional investors who know an industry segment well, are fairly wealthy people, have pooled together money (along with money from third parties) and use their superior knowledge of an industry to ONLY invest in companies in that industry (example: www.kpcb.com, www.sequoia.com, www.3i.com., The VC method begins with the forecasts of the company's future operations, and the resulting free cash flows to leveraged equity. These cash flows represent the cash flows available to equity investors which include the VC. ...read more.

Middle

One adjustment involves discounting the terminal value at its required rate of return. Then the VC estimates what fraction of that terminal value will be available to investors who invest in year 0. For example, at the 50% discount rate, the VC values the terminal value at 20 million. Equity investors at year 0 will not own the entire 20 million because the equity investors at year 2 will also receive shares and own a piece of the company. At the 50% discount rate, the equity investors who put up 9 million in year 2 will receive 20% of the company. That means that the investor in year 0 will receive only 80% or 16 million of the total million in value. The VC will invest at a post-money value of 16 million not 20 million. Let's say, instead, that the investor in year 2 will not such a high return. Assume they are corporate investors who will required 15%. Then the post-money value in year 2 will be: 150/(1.15)3 or roughly 99 million. The new investors of 9 million will only receive only 9% of the terminal value. The VC investors in the year 0 then are looking at a post-money value of 18.2 million (91% of 20 million). The VC investors (year 0) will be willing to receive 22% of the company (4/18.2)=22%. Discount Rates As mentioned above, VCs typically apply very high discount rate to value proposed equity investment, ranging from as low as 25% for investments in mature businesses (lower risk) to as high as 70% ore even 80% for seed investments and investments in hi-tech ventures (high risk). ...read more.

Conclusion

3. I would discount the cash flows with value added by the VC, CFVC, by a CAPM based rate. This will generate the actual value of the firm with the value added VA. In doing this, the entrepreneur can obtain an explicit estimate of the value the VC is creating. This equals VA - VE. The entrepreneur also obtains an explicit estimate of the amount the VC is charging for creating that value: [VA - VVC] x Fraction of company the VC is purchasing. Finally the entrepreneur can determine both whether it is worthwhile to take money from a VC and which VC to take the money from. A simple example illustrates this analysis. Let's say an entrepreneur must raise 2 million. If the entrepreneur (E) goes to family and friends, E can raise the money at a post-money valuation of 6 million. Call this VE. If E goes to a VC, the VC will invest at a post-money value of 4 million. Call this VVC. The value of the company if the VC invests is, VA, is 10 million. The VC is adding 4 million in value, but is charging 3 million for it (50% of 10 less 4). Assuming the VC is truly adding 4 million in value, E will do the following analysis: If E raises money without a VC, E retain 2/3 of the company which will be worth 6 million. E gets 4 million. If E raises money from the VC, E retains only 1/2 of the company which will be worth 10 million. E gets 5 million and prefers going to VC. 1 Major portions of this note have been taken from text by Prof. Steve Kaplan, GSB, University of Chicago. ?? ?? ?? ?? Zia Imran, Introduction to Entrepreneurship, FAST-NU, Lahore 1 ...read more.

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