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Chapter 10VENTURE CAPITAL VALUATION METHODS
1
© 2012 South-Western Cengage Learning
ENTREPRENEURIAL FINANCE Leach & Melicher
Chapter 10Learning Objectives
Relate venture capital methods to more formal equity valuation methods
Understand how valuation and percent ownership are related
Calculate the amount of shares to be issued to secure a fixed amount of funding
Understand the impact of subsequent financing rounds on the structure of the current financing round
Construct multiple-scenario valuations and unify them in a single valuation
2
Definition of 'Venture Capital'
Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.
3
Venture Capital (VC) Method VC Method:
estimates the venture’s value by projecting only a terminal flow to investors at the exit event
modifications of the basic VC method introduce additional rounds and incentive compensation
4
Venture Capital Shortcuts on the Equity Method Cash investment today Cash return at some future exit time Discount this entire return flow back
at the venture investor’s target return
Divide today’s cash investment by the venture’s present value
Equals percent ownership to be sold in order to expect to provide the venture investor’s target return
5
Venture Capital Shortcuts on the Equity Method
Example: Venture formed w/ 2,000,000 shares held
by founders New investor adds $1,000,000 for new
shares Exit (horizon) time = 5 years Investor demands 50% annualized return Venture income of $1,000,000 per year @
exit Similar venture sold shares to public for
$20,000,000 Similar venture income =$2,000,000 for
last year
6
Venture Capital Shortcuts on the Equity Method
75.9375%
5)5.(1 / 1,000,000] x [10/1
1,000,000
Tr)(1 / ]E x [P/E
I Ownership Final % Acquired5
7
Venture Capital Shortcuts on the Equity Method
6,3111,688 .240625
(.759375) x 2,000,000
% Acquired -1%) (Acquired x mn Issued Be toShares
8
Venture Capital Shortcuts on the Equity Method
shareper 15843622$.
shares 6,311,688$1,000,000 Price Share Issue
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Venture Capital Shortcuts on the Equity Method
Pre-money valuation: present value of a venture prior to a new money investment
Post-money valuation:pre-money valuation of a venture plus money injected by new investors
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Venture Capital Shortcuts on the Equity Method
Pre-Money Valuation= 2,000,000 shares x $.15843622 per share= $316,872
Post-Money Valuation= 8,311,688 shares x $.15843622 per share= $1,316,872
Founder % Between Financing & Exit= 2,000,000 / 8,311,688= 24.0625%
Investor % Between Financing & Exit= 6,311,688 /8,311,688= 75.9375%
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Dilution with One Round
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Venture Capital Shortcuts on the Equity Method
Staged Financing:financing provided in sequences of rounds rather than all at one time
Capitalization (cap) Rate:spread between the discount rate and the growth rate of cash flow in terminal value period
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Earnings Multipliers and Discounted Dividends
From P/E x E = P, we get:Direct Comparison:
valuation by applying a direct comparison ratio to the related venture quantity
Direct Capitalization:valuation by capitalizing earnings using a cap rate implied by a comparable ratio
Venture
5Year
Venture
5Year FirmsOther
Current
FirmsOther
Current P E x E
P
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Venture
5Year FirmsOther
Current
FirmsOther
Current
Venture
5Year P P/E
E
Earnings Multipliers and Discounted Dividends
000,000,10 .10
1,000,000
20,000,000 / 2,000,0001,000,000 P
P/E E
:methodtion capitalizadirect Under
10,000,000 1,000,000 x 10
1,000,000 x 2,000,000
20,000,000P E x E
P
Venture
5Year FirmsOther
Current
FirmsOther
Current
Venture
5Year
Venture
5Year
Venture
5Year FirmsOther
Current
FirmsOther
Current
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Earnings Multipliers and Discounted Dividends
g)-(r
g)(1 x b)-(1 E
P
and g)-(rb)-(1
g)(1E P
E P:assumptiongrowth smooth using and
g-rb)-(1
E P :grearrangin
g-rb)-(1 x E P
thenD)/E,-(E b of ratioplowback minus one ratiopayout and D/E ratio,payout constant x earnings dividends growth,constant In
rate.growth dividend g & ratediscount r whereg -r D P
:(P) price & (D), dividends (E), earnings of valuesshareper Given
5
5
5
5
6
5
6
5
6
5
65
16
Adjusting the VC Shortcut for Multiple Rounds
704,703,23.84375
2,000,000 Financingafter Shares Total
084375.759375.1562.1 % Remaining sFounder'
%9375.75 1,000,000] x [10/1
.5) (1 x 1,000,000 ]E x [P/E
r) (1 x I Acquired RoundFirst
%625.15 1,000,000] x [10/1
.25) (1 x 1,000,000 ]E x [P/E
r) (1 x I Acquired Round Second
5T
2T
5
5
17
Adjusting the VC Shortcut for Multiple Rounds
First Round (of 2 rounds): Shares issued = .759375 x 23,703,704 = 18,000,000 Share Price = $1,000,000/18,000,000 = $.055556 per
share Pre-money Valuation = $.055556 x 2,000,000 = $111,111 Post-money Valuation = $.055556 x 20,000,000
=$1,111,111 Founder % between 1st & 2nd round 2,000,000/20,000,000
= 10% 1st round investor % between 1st & 2nd rounds =
18,000,000/20,000,000 = 90%
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Adjusting the VC Shortcut for Multiple Rounds
Second Round (of 2 rounds): Shares issued = .15625 x 23,703,704 = 3,703,704 Share Price = $1,000,000/3,703,704 = $.27 per share Pre-money Valuation = $.27 x 20,000,000 = $5,400,000 Post-money Valuation = $.27 x 23,703,704 = $6,400,000 Founder % between 2nd round & exit =
2,000,000/23,703,704 = 8.4375%
1st round investor % between 2nd round & exit =18,000,000/23,703,704 = 75.9375%
2nd round investor % between 2nd round & exit =3,703,704/23,703,704 = 15.625%
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Adjusting the VC Shortcut for Incentive Ownership
282,051,82.024375
2,000,000 Options Incentive and Financingafter Shares Total
024375.06.759375.15625.1 % Remaining sFounder'
20
Adjusting the VC Shortcut For Incentive Ownership
First Round (of 2 + incentive rounds): Shares issued = .759375 x 82,051,282 = 62,307,692 Share Price = $1,000,000/62,307,692 = $.01604938 per
sh. Pre-money Valuation = $.01604938 x 2,000,000 = $32,099 Post-money Valuation = $.01604938 x
64,307,692=$1,032,099 Founder % between 1st & 2nd round =
2,000,000/64,307,692= 3.11%
1st round investor % between 1st & 2nd rounds =62,307,692/64,307,692 = 96.89%
21
Adjusting the VC Shortcut for Incentive Ownership
Second Round (of 2 + incentive rounds): Shares issued = .15625 x 82,051,282 = 12,820,513 Share Price = $1,000,000/12,820,513 = $.078 per share Pre-money Valuation = $.078 x 64,307,692 = $5,016,000 Post-money Valuation = $.078 x 77,128,205 = $6,016,000 Founder % between 2nd round & exit =
2,000,000/77,128,205 = 2.5931% 1st round investor % between 2nd round & exit =
62,307,692 / 77,128,205 = 80.7846% 2nd round investor % between 2nd round & exit =
12,820,513 / 77,128,205 = 16.6223%
22
Adjusting the VC Shortcut for Incentive Ownership
Incentive Ownership Round: Shares issued = .06 x 82,051,282 = 4,923,077 Founder % after Incentive Compensation Issue =
2,000,000 / 82,051,282 = 2.4375% 1st round investor % after Incentive Compensation =
62,307,692 / 82,051,282 = 75.9375% 2nd round investor % after Incentive Compensation =
12,820,513 / 82,051,282 = 15.625% Employee % after Incentive Compensation =
4,923,077 / 82,051,282 = 6%
23
Summary
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Scenario Methods
ratesdiscount utopian at forecasts plan businessutopian only gdiscountinby valuation:ProcessDiscount Utopoia
%536.8100$100,000,0
(1.7) x 0$20,000,00 0$60,000,00 0
return? portfolio annualized isWhat outcomes. allon years at twoliquidity with
return annualized 70%at 20% evenbreak at 60% loss at total % 20
:invests fund nturemillion ve $100 :Given
2/1)(2
25
Three-scenario Mean Flow Approach
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Algebraically,
%49689.31
1.222 x 8,000,000
1.221,200
1.22 x 8,000,000
1.22400
1.22400
1.22400
1.220 1,000,000
76
54321
27
Same As Taking Expectations Across Scenario Values
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Internal Rate of Return (IRR)
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IRR: compound rate of return that equates the present value of the cash inflows received with the initial investment