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Subject 4. A note on valuation of venture capital deals

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.

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.

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.

For example, if a price-earnings ratio of 15 is applied to the projected net income of $20 million in the planned exit year (year 7), this will yield a projected exit value of $300 million in year 7. The choice of multiple for the valuation is something that will be a matter of discussion during the venture capital negotiations. PE ratios for comparable public companies will be used as a benchmark to select a PE for the company, recognizing that PE ratios for public companies are likely to be higher due to their greater liquidity relative to a private company.

Step 2: Discount the Terminal Value to Present Value

In the net present value method, the firm's 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.

For the example above, the projected terminal value in year 7 of $300 million is discounted to a present value of $17.5 million using a target rate of return of 50%.

PV = FV/(1+I)n = $300m/(1+.50)7 = $17.5 million

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 the 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 million /200,000 or $25 per share.

Under these assumptions the pre-money valuation is 500,000 shares x $25 per share or $12.5 million and the 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 / Retention Ratio

In the example, shares amounting to 10% of the equity are expected to be sold to managers and shares equivalent to 30% of the common stock will be sold to the public in an IPO.

In this case the Retention Ratio is [1/(1+0.1)/(1+0.3)] = 70%.

Therefore, Required Current Ownership = 28.5%/70% = 40.7%.

In other words, in order to preserve a 28.5% final ownership percentage at exit, the venture capitalist must get a 40.7% ownership interest going into the deal, given the expected future dilution.

The number of new shares that will have to be issued at the outset will therefore have to be 500,000/(1-40.7%) - 500,000 = 343,373.

The price per share will therefore be $5 million/343,373 = $14.56 per share.

Accounting for Risk

There are two approaches:

  • Increase the discount rate. The discount rate should incorporate a "risk of failure" component already.
  • Reduce the expected returns (terminal value).

Practice Question 1

In a venture capital investment project, the post-money valuation is $4 million. The investor is going to invest $3 million, and the existing number of shares is 1 million. How many newly issued shares will the investor get?

A. 0.75 million.
B. 2 million.
C. 3 million.

Correct Answer: C

3 / (4-3) x 1 million.

Study notes from a previous year's CFA exam:

4. A note on valuation of venture capital deals