Valuation Basics
An important component of the venture capital investment process
is the valuation of the business enterprise seeking financing.
Valuation is an important input to the negotiation process relative
to the percentage of ownership that will be given to the venture
capital investor in return for the funds invested.
There are a number of commonly used valuation methods, each with
their strengths and weaknesses. The most commonly used valuation
methods are:
- Comparables
- The Net Present Value Method
- The Venture Capital Method
Comparables
Similar to real estate valuations, the value of a company can
be estimated through comparisons with similar companies. There
are many factors to consider in selecting comparable companies
such as size, growth rate, risk profile, capital structure, etc.
Hence great caution must be exercised when using this method
to avoid an “apples and oranges” comparison. Another
important consideration is that it may be difficult to get data
for comparable companies unless the comparable is a public company.
Another caveat when comparing a public company with a private
company is that, all other things being equal, the public company
is likely to enjoy a higher valuation because of its greater liquidity
due to being publicly traded.
Net Present Value Method
The Net Present Value Method involves calculating the net present
value of the projected cash flows expected to be generated by
a business over a specified time horizon or study period and the
estimation of the net present value of a terminal value of the
company at the end of the study period. The net present value
of the projected cash flows is calculated using the Weighted Average
Cost of Capital (WACC) of the firm at its optimal capital structure.
Step 1: Calculate Net Present Value of Annual Cash Flows
Cash Flow for each future period in the time horizon or study
period of the analysis is defined as follows:
CFn = EBITn*(1-t) + DEPRn – CAPEXn – .CNWCn
Where:
CF = cash flow or “free cash flow”
n = the specified future time period in the study period
EBITn = earnings before interest and taxes
t = the corporate tax rate
DEPRn = depreciation expenses for the period
CAPEXn = capital expenditures for the period
.NWCn = increase in net working capital for the period
It should be noted that interest expense is factored out of the
cash flow formula by using EBIT (earnings before interest and
taxes). This is because the discount rate that is used to find
the net present value of the cash flows is the WACC. The WACC
uses the after tax cost of debt, which takes into account the
tax shields that result from the tax deductibility of interest.
By using EBIT in the cash flow calculation, double counting of
the tax shields is avoided.
Step 2: Calculate the Net Present Value of the Terminal Value
The terminal value is normally calculated by what is often referred
to as “the perpetuity method.” This method assumes
a growth rate “g” of a perpetual series of cash flows
beyond the end of the study period. The formula for calculating
the terminal value of the company at the end of the study period
is:
TVt = [CFt*(1 + g)]/(r – g)
Where:
TVt = the terminal value at time period t, i.e. the end of
the study period
CFt = the projected cash flow in period t
g = the estimated future growth rate of the cash flows beyond
t
The Venture Capital Method
Most venture capital investment scenarios involve investment
in an early stage company that is showing great promise, but typically
does not have a long track record and its earnings prospects are
perhaps volatile and highly uncertain. The initial years following
the venture capital investment could well involve projected losses.
The venture capital method of valuation recognizes these realities
and focuses on the projected value of the company at the planned
exit date of the venture capitalist.
The steps involved in a typical valuation analysis involving
the venture capital method follow.
Step 1: Estimate the Terminal Value
The terminal value of the company is estimated at a specified
future point in time. That future point in time is the planned
exit date of the venture capital investor, typically 4-7 years
after the investment is made in the company. The terminal value
is normally estimated by using a multiple such as a price-earnings
ratio applied to the projected net income of the company in the
projected exit year.
Step 2: Discount the Terminal Value to Present Value
In the net present value method, the firm’s weighted average
cost of capital (WACC) is used to calculate the net present value
of annual cash flows and the terminal value.
In the venture capital method, the venture capital investor uses
the target rate of return to calculate the present value of the
projected terminal value. The target rate of return is typically
very high (30-70%) in relation to conventional financing alternatives.
Step 3: Calculate the Required Ownership Percentage
The required ownership percentage to meet the target rate of
return is the amount to be invested by the venture capitalist
divided by the present value of the terminal value of the company.
In this example, $5 million is being invested. Dividing by the
$17.5 million present value of the terminal value yields a required
ownership percentage of 28.5%.
The venture capital investment can be translated into a price
per share as follows.
The company currently has 500,000 shares outstanding, which are
owned by the current owners. If the venture capitalist will own
28.5% of the shares after the investment (i.e. 71.5% owned by
the existing owners), the total number of shares outstanding after
the investment will be 500,000/0.715 = 700,000 shares. Therefore
the venture capitalist will own 200,000 of the 700,000 shares.
Since the venture capitalist is investing $5.0 million to acquire
200,000 shares the price per share is $5.0/200,000 or $25 per
share.
Under these assumptions the pre-investment or pre-money valuation
is 500,000 shares x $25 per share or $12.5 million and the post-investment
or post-money valuation is 700,000 shares x $25 per share or $17.5
million.
Step 4: Calculate Required Current Ownership % Given Expected
Dilution due to Future Share Issues
The calculation in Step 3 assumes that no additional shares will
be issued to other parties before the exit of venture capitalist.
Many venture companies experience multiple rounds of financing
and shares are also often issued to key managers as a means of
building an effective, motivated management team. The venture
capitalist will often factor future share issues into the investment
analysis. Given a projected terminal value at exit and the target
rate of return, the venture capitalist must increase the ownership
percentage going into the deal in order to compensate for the
expected dilution of equity in the future.
The required current ownership percentage given expected dilution
is calculated as follows:
Required Current Ownership = Required Final Ownership divided
by the Retention Ratio
Source: University of New Brunswick
