A NOTE ON VALUTAION IN ENTREPRENEURIAL SETTINGS

University Degree Business and Administrative studies

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

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: , , .,

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. For many VC investments these cash flows will be identical to free cash flows to an all-equity firm because the firms being funded are often financed without any debt.

The VC will then estimate the time at which it is likely that the VC will exit the investment. The VC usually will have a specific exit strategy – an IPO, sale to a strategic buyer in mind, or restructuring – in mind. The VC will then attempt to put a value on the company at that exit date. Typically, this value is calculated by estimating the company’s earnings. EBIT, EBITDA, sales (or other valuation relevant figure) and applying appropriate multiple. The resulting value at IPO or sales is taken as the terminal value of the investment.

Variation 1

The VC method then discounts the free cash flows to leveraged equity and the exit or terminal value back to the present. The VC method will typically use a discount rate ranging from as low as 25% for investment in later stage or more mature businesses to as high as 70% or 80% for seed investments. These discount rates are typically higher, sometimes substantially so, than discount rates calculated using a CAPM based type model.

The resulting value is the pre-money value the VC will be willing to pay for the company. This assumes that the forecast case flows included a negative cash flow that will be covered by the financing round being contemplated. I, instead the cash flows do not include that negative cash flow, the resulting value is the post-money value.

One important additional point, this methodology implicitly assumes that all negatives cash flows to leveraged equity will be funded by VC equity investments that will earn the same rate of return.

Here is an example: A VC is thinking of investing 4 million in a company today. The 4 million will be used immediately to buy new equipment. In give years, the VC believes the company will have net income of 5 million. Companies today n the same business trade at price-earnings (P/E) ratios of 30 times. So the VC will assume an exit value of 150 million (30 times 5). The company will not have any debt, will not required additional equity investments , and will not throw off nay other cash until the exit in five years. Before the new financing, the firm has 1.6 million shared outstanding. The cash flows o (leveraged) equity are:

Example 1:

0 1 2 3 4 5

(4) 0 0 0 0 150

The VC has a target rate of return of 50% for this investment. The discounted terminal value, then is

Discounted Terminal Value = 150/(1.50)5 = 20 million (in today’s currency, discounted back 5 years to bring to back to year 1)

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Example 1:

0 1 2 3 4 5

(4) 0 0 0 0 150

The VC has a target rate of return of 50% for this investment. The discounted terminal value, then is

Discounted Terminal Value = 150/(1.50)5 = 20 million (in today’s currency, discounted back 5 years to bring to back to year 1)

The company’s pre-money valuation is 16 million. This is the value of 20 million, net of the 4 million that must be spent on equipment. With 1.6 million shares outstanding the pre-money value per share the VC would be willing to pay is 10 per share. The company’s post-money value is 20 million because this is the value the company attains after the 4 million financing is invested. If the VC is putting in 4 million, the VC will expect to receive 400,000 shares. The VC will end up owning 20% of the equity in the company.

Equity percentage = 400,000 / [1,600,000 + 400,000] = 4 million / 20 million = 20%

In practice, many VC financed firms will have negative cash flows in the year or two after a financing and positive cash flows later, but before exit. Discounting these interim cash flows to leveraged equity at the VC discount rate implicitly assumes that new investment in the company will earn VC returns and that cash outflows to investors will earn VC returns.

Let’s assume that the investment we considered before will require and additional

9 million in year 2. Everything else remains the same.

0 1 2 3 4 5

(4) 0 (9) 0 0 150

The discounted values of these cash flows at 50% return is 12 million .The extra 9 million required in year 2 decreases the present value by 4 million (9/(1.52). The post money value becomes 16 million. With 1.6 million shares outstanding, the company now has a stock price of 7.50, not 10. For 4 million, the VC (investor A) initially will receive 533,333 shares and own 25% of the company.

Equity percentage = 533,333 / [1,600,000 + 533,333] = 4 million / 16 million = 25%

It is worth noting that in year 2, new equity investors (Investor B) will invest 9 million. At that time, the post-money value of the company will be 150/1.53 = 45 million. The 9 million will receive 20% of the post-money company or 533,333 shares.

Variation 2

Instead of discounting at a given rate, VCs will often look at the cash flows associated with a deal and calculate IRR they can expect to earn.

For example, in example 1, the VC is buying an at an equity value of 20 million. The VC expects the equity to be worth 150 million in year 5. The IRR, then is 50%.

In example 2, the VC is buying in at an equity value of 16 million. The VC expects to raise an additional 9 million in equity in two years, and for the equity toe be worth 150 million in year 5. The IRR, then is 50%. It is most common for VC (investors) to think of investments in terms of expected IRRs.

Variation 3

Some VCs might be uncomfortable discounting all free cash flows to leveraged equity at the VC discount rate. For example, it is possible that corporate investors will provide later equity investment at rats of return somewhat lower than the VC method. To account for this possibility, some VC makes and adjustment to this methodology to value the investment in example 2.

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). Such high discount rates cannot be explained as being a reward for systematic risk. Form most venture capital investments, APV or WACC approaches – based on CAPM assumptions that higher systematic risk requires a higher return – would generated discount rates well below 25%. Instead, there are at least three reasons these discount rates re so high.

First in principal, VCs are active investors who spend a large amount of time, reputational capital, and other resources on the companies they invest in. The higher required discount rate over and above the CAPM – based rates is one way a VC can reflect its investments of time and resources. One concern an entrepreneur (or outside observer) might have with the VC using the higher discount rate to charge for its services is that the higher discount rate implicitly charges for the VC services as long as the VC expects to be invested in the company. IN reality, a successful VC may add more value earlier on and relatively little later when company starts to mature. It would be more accurate to compensate the VC explicitly for the value that they are expected to add.

Second VCs will argue that they require a higher return to compensate them for the illiquidity of their investment, that is, a VC cannot sell an investment in a private company as easily as it could sell public company stock. The problem with this argument is that the venture capitalist makes most of its money when the firm goes public and is fully liquid. It also is true that there are many investors who do not have short-term liquidity needs (wealthy individuals or groups of investors).

The third reason for higher discount rate is that they represent crude ways to adjust for situations in which the VC doesn’t believe the cash flow forecasts are the expected cash flows. To see this more clearly, assume that the venture capitalist is shooting for a portfolio return of 25%., but he discounts the cash flow forecasts for a start-up investment at a 50% discount rate. An example is given below:

Assumed Cash Flows: -10 -10 -10 -10 500

Discounted CF value at 50%: -10 + -10 + -10 + -10 + 500

---- ---- ---- ----- -----

1.5 1.52 1.53 1.54 1.55

But discounting at 50% is the equivalent of discounting at the true expected or required rate of 25%, but assuming that the expected cash flows are less likely than the forecasts (½ of 50% = 25%). This is illustrated by rewriting the discount value as:

Discounted CF value at 25%:

-10 (1.25) -10 (1.25)2 -10 (1.25)3 -10 (1.25)4 -500 (1.25)5

---- x ------- + ----- x -------- + ----- x ------- + ----- x ------- + -----x -------

1.25 1.5 1.252 1.52 1.253 1.53 1.254 1.54 1.255 1.55

This rewriting illustrates that the VC who discounts at 50% instead of 25% is implicitly assuming that the expected CF in the first year is only 1.25/1.50 or 83% of the forecast cash flow. In the second year, the expected cash flow is only (1.25/1.5)2 or 60% of the forecast cash flow. The example should make it clear that the reduction in likelihood declines each year. By the fifth year, the VC is assuming that the probability of obtaining the forecast CF is only (1.25/1.5)5 or 40%.

Is this method reasonable? The answer is depends. Applying a higher discount rate to cash flow forecasts that you do not believe that truly expected cash flows is reasonable because the higher discount rate adjusts for the disbelief/uncertainty. Any many VCs have succeeded by using artificially high discount rates.

Scenario Analysis

Nevertheless, it is even a better idea to try to make the adjustment explicit – that is, apply probabilities to the forecast cash flows to come up with true expected cash flow forecasts. The reason it is better to be explicit about the probabilities that this may yield very different and more precise forecasts than mechanically assuming a higher discount rate. As the examples above makes clear, this is true because the higher discount rate assume that each year the forecast cash flows become increasingly less probable and by the exact same amount – 83% in the example. In practice, uncertainty is more likely to be discrete, with large amounts of uncertainty being resolved in the early years and relatively little after that. This argues for an analysis that puts best guess probability distributions on the realization of different outcomes for the investment. The expected present value of the investment should be the expected value of the different possible outcomes. The @Risk and other add-in to EXCEL facilitates this type of analysis.

Recommendation

What would I do exactly if I were an entrepreneur or a VC? I would look at any transaction using at least two sets of cash flows and three different variations.

First, I would create the forecast cash flows that I truly believed would occur without investment by a VC, ideally basing this on different scenarios and probabilities. Call the resulting cash flows, CFE. I also would create the forecast cash flows that I truly believed would occur with investment by a VC, again, ideally basing this on different scenarios and probabilities. Call these cash flows, CFVC.

Second, I would discount these cash flows to obtain three values.

I would discount the cash flows without the VC, CFE by a CAPM base rate. This will generate the value to entrepreneur, which I will refer to as VE.
I would discount the cash flows with the value added by the VC, CFVC, by target discount rate that the VC expects. This will generate the value at which the VC will value the company’s equity and will want to invest. I will refer to this as VVC.
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 ½ of the company which will be worth 10 million. E gets 5 million and prefers going to VC.

Zia Imran, Introduction to Entrepreneurship, FAST-NU, Lahore

Major portions of this note have been taken from text by Prof. Steve Kaplan, GSB, University of Chicago.