FEI Week 3 – Valuation Venture Capital Chris Ansell MBA CFA BPP BUSINESS SCHOOL BPP BUSINESS SCHOOL
VC Valuation Method — Conceptually just like any other valuation method —What’s special about it? 1. are risks really higher? 2. are potential rewards higher? 3. exit and liquidity more important 4. not just a go/no go decision – actual valuation matters! 2 BPP BUSINESS SCHOOL
VC Valuation — VC method a valuable tool commonly applied in the private equity(PE) industry — PE investments often show negative cash flows and earnings and are very uncertain, but there are possible substantial future rewards — VC method accounts for this usually by applying a multiple at a time in the future when it’s projected to have positive cash flow and/or earnings — VC then uses discounted terminal value and size of proposed investment to calculated desired ownership stake 3 BPP BUSINESS SCHOOL
Venture Capital Method —Step 1: estimate the VC’s exit date — Step 2: forecast cash flows to equity until exit date — Step 3: estimate exit price. Use it as terminal value (TV) — Step 4: choose a high discount rate (VC discount rate) — Step 5: discount TV using this discount rate —Step 6: determine VC’s stake in company 4 BPP BUSINESS SCHOOL
VC Method – Step 1: Exit date — VC money is not long-term money - typically, the VC plans to exit after a few years — Estimate likely time when VC will exit - this determines forecasting period — VC usually will have specific exit strategy in mind: - IPO - sale to strategic entity - restructuring 5 BPP BUSINESS SCHOOL
VC method – step 2: Cash flow to equity — Forecast FCFE until exit — These are the cash flows received by equity holders (VC included) FCFE = net income + depr – capex – change in NWC – principal repayment + new borrowing — Note: - need to forecast firm operations (could be very uncertain) - cash flow forecasts are key to sound valuation - for new ventures, cash flows are often zero or negative - if net inc = EBIT*(1-t) and principal repayments = new debt = 0, then ECF = FCF 6 BPP BUSINESS SCHOOL
VC method – Step 3: exit value — Forecast firm value at exit - forecast firm value at IPO or sale — Use this value as Terminal Value — Typically this value is calculated by estimating: - earnings, ebit, ebitda, sales or customers or other valuation relevant figures - apply an appropriate multiple — The multiple is typically based on comparable publicly traded companies or comparable transaction 7 BPP BUSINESS SCHOOL
VC method – step 4: discount rate — Determine rate for discounting terminal value back to present — Instead of using traditional cost of capital as discount rate, VC/PE usually use a target rate of return — Typically discount rates range from 25% to 80% - lower for investments in later stage or more mature businesses - high for “seed” investments — These rates are typically higher, often much higher, than those calculated using CAPM 8 BPP BUSINESS SCHOOL
VC method – step 5: valuation (post-money) — Use discount rate to estimate: - PV of exit value - discounted terminal value = terminal value/(1+target rate) years — This gives post-money value of the firm - This is value of firm after the investment is made. 9 BPP BUSINESS SCHOOL
VC method – step 6: VC’s stake — Post-money value: firm value after VC has injected funds - what an investor would pay for up and running firm Post money value = pre money value + VC investment — Post funding - VC’s stake is worth a fraction of post money value - For an equity stake the VC should be willing to pay: VC investment = VC % stake*post-money value — This implies: - VC % stake = VC investment/post money value 10 BPP BUSINESS SCHOOL
Example: Bizz.com — Bizz.com is privately owned: - 1.6m shares outstanding - seeking $4m investment by a VC — $4m will be used immediately to buy equipment — Negotiations over equity stake for VC have begun — Question: what is equity stake VC should get? 11 BPP BUSINESS SCHOOL
Bizz.com — Step 1: Exit Date - idea is for Bizz.com to go public in 5 years — Step 2: Forecast ECF - 5-year forecast of FCF: yr 0 yr 1 yr 2 yr 3 yr 4 FCF -4 0 0 0 0 — Bizz.com will have no debt and will not need additional equity 12 BPP BUSINESS SCHOOL
Bizz.com Step 3: exit value — in 5 years, VC forecasts Bizz.com net inc to be $5m — today, publicly traded firms in same business trade at P/Es of about 30 — estimate exit value of 30*$5m = $150m yr 0 yr 1 yr 2 yr 3 yr 4 yr 5 FCF -4 0 0 0 0 150 Step 4: VC discount rate - VC target rate of return for this investment is 50% 13 BPP BUSINESS SCHOOL
Bizz.com Step 5: mini valuation Year 0 1 2 3 4 5 FCF -£ 4 £ 150 Discount Factor 50% 1.000 0.667 0.444 0.296 0.198 0.132 PV -£ 4 £ - £ - £ - £ - £ 20 NPV £ 16 Step 6: VC’s equity stake - Bizz.com pre money value = $16 m - - if VC injects $4m, Bizz.com post money value = $16m + $4m = $20m - - VC will ask for $4m/$20m = 20% equity 14 BPP BUSINESS SCHOOL
Why are discount rates so high? —High discount rates can’t be explained as reward for systematic risk — In most practical cases, CAPM would give rates well below 25% - not even close to 50-80% — 3 (limited) rationales: - compensate VC for investment illiquidity - compensate VC for adding value - correct optimism factors 15 BPP BUSINESS SCHOOL
Rationale 1: Investment illiquidity VC can’t easily sell investment in private • firm as easily as traded shares Lack of marketability makes PE investments • less valuable than publicly traded ones PE practitioners often use illiquidity • discounts of 20-35% they estimate value of private equity • stake to be 20-35% less than equivalent stake in traded firm 16 BPP BUSINESS SCHOOL
Illiquidity Discount & the IRR Year 0 1 2 3 4 5 FCF -£ 4 £ 150 Discount Fa 50% 1 0.666667 0.444444 0.296296 0.197531 0.131687 PV -£ 4 £ - £ - £ - £ - £ 20 NPV £ 16 Year 0 1 2 3 4 5 FCF -£ 20 £ - £ - £ - £ - £ 113 IRR 41% 17 BPP BUSINESS SCHOOL TITLE HERE 00 MONTH 0000
Rationale 2: caveats • Rate used not only to value PE transactions, but also to calculate estate taxes • higher rate > lower valuation > lower taxes • VC/PE make most of their money at/after IPO when firm is fully liquid • Typical VC/PE fund investors are large institutions • pension funds, financial firms, insurance companies, endowments • illiquidity likely not a big concern for such investors as PE investments small part of their portfolios 18 BPP BUSINESS SCHOOL
Rationale 2: VC adds value VCs are active investors, bringing more to deal than just money: • large time commitment • reputational capital • access to skilled managers • industry contacts, network • other resources Large discount rate a crude way to compensate VC for investing time and resources Question: How do we know how to adjust discount rate? 19 BPP BUSINESS SCHOOL
Rationale 2: Caveats — Higher discount rate implicitly charges for VC services as long as VC expects to be invested in firm — In reality, a successful VC may add more value earlier on and relatively little later — Would be more accurate to compensate VC explicitly for value of what they are specifically adding/providing - Why not price these services explicitly? - may be better to pay for services/value added directly rather than adjusting discount rate 20 BPP BUSINESS SCHOOL
Rationale 3: optimistic forecasts — Forecasts tend not to be expected cash flows (ie, an average over many scenarios) - rather they typically assume that the firm hits its target — Higher discount rate crude way to correct forecasts: - that VC judges optimistic - that are objectively optimistic 21 BPP BUSINESS SCHOOL
Rationale 3: caveats — Better to make adjustment explicit to expected cash flow than playing with discount rate - apply probabilities to forecast cash flow to come up with true expected cash flows — May yield very different and more precise forecasts — Bottom line: better to fix forecast than to adjust discount rate ad hoc 22 BPP BUSINESS SCHOOL
Conclusion on VC method —VC/PE industry uses previous method, but this doesn’t preclude: - having healthy scepticism - taking more sophisticated approach to problem — Even if illiquid, value added and optimistic scenarios are important considerations, one size fits all discount rate adjustment is not appropriate: - illiquidity differs in magnitude in different situations - VC value added varies across VCs from deal to deal - difference between optimistic and average forecast varies across deals and entrepreneurs 23 BPP BUSINESS SCHOOL
Alternative to high discount rates:scenario analysis — Better to model sources of uncertainty and to place probabilities on various events - some major uncertainties might get resolved soon - others may take more time - some scenarios require you to take different actions — Other advantages - allows you to identify and value (roughly) the options embedded in many start ups — Bottom line: better to model those explicitly than assume one rosy scenario 24 BPP BUSINESS SCHOOL
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