FEI Week 3 Valuation Venture Capital Chris Ansell MBA CFA BPP - - PowerPoint PPT Presentation

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FEI Week 3 – Valuation Venture Capital

Chris Ansell MBA CFA

BPP BUSINESS SCHOOL

—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! VC Valuation Method

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—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

VC Valuation

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—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 Venture Capital Method

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—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

VC Method – Step 1: Exit date

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—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

VC method – step 2: Cash flow to equity

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—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 VC method – Step 3: exit value

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—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

VC method – step 4: discount rate

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—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.

VC method – step 5: valuation (post-money)

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—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

VC method – step 6: VC’s stake

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—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? Example: Bizz.com

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—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

—Bizz.com will have no debt and will not need additional equity

Bizz.com

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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

150 Step 4: VC discount rate

• VC target rate of return for this investment is 50%

Bizz.com

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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

Bizz.com

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Year 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 5: mini valuation

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—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

Why are discount rates so high?

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Rationale 1: Investment illiquidity

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• 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

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Illiquidity Discount & the IRR

17 TITLE HERE 00 MONTH 0000

Year 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 1 2 3 4 5 FCF 20

• £
• £
• £
• £
• £

113 £ IRR 41%

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Rationale 2: caveats

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• 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

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Rationale 2: VC adds value

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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?

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—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

Rationale 2: Caveats

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—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

Rationale 3: optimistic forecasts

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—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 Rationale 3: caveats

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—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

Conclusion on VC method

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—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

• ne rosy scenario

Alternative to high discount rates:scenario analysis

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— Put up $60m now — In 2 years 3 possible situations with equal probabilities:

• good news: invest $60m -> receive $300m
• OK news: invest $60m -> receive $150m
• bad news: invest $60m -> receive $30m

— If you don’t invest $60m, firm is worth nothing — One approach would be to discount cash flow from best scenario ($300m from $60m) using a high discount rate to correct for probability of less favourable outcomes

Example: scenario analysis with real options

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—Alternatively, analyse each scenario and realize that you will not invest if bad news arrives

• so E(year 2) is really: = 1/3*($300m - $60m) +

1/3*($150m - $60m) + 1/3*0 —Bottom line: Black Scholes is usually too sophisticated

• here. Simple decision tree will be more appropriate

Example: scenario analysis with real options

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