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Subject 2. Valuation characteristics and issues in venture capital vs. buyout PDF Download
Venture capital refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business.

A leveraged buyout, or LBO, is the acquisition of a company or division of a company with a substantial portion of borrowed funds.

The textbook has a detailed list of differences between the two. Here is another perspective on the comparison.

VC firms and buyout shops differ in their strategy and culture. While both of them have a clock ticking, there is a different expectation, urgency, and ultimate multiple goal between the two. A venture firm must provide returns to its investors and has a long horizon to do so. Therefore, it has to make a high multiple on its investment and must hold out for a nice acquisition or an IPO. So it must build the business from scratch to be able to carry a very high enterprise value.

On the other hand, a buyout firm, while it does have investors to report to, uses leverage for its transaction so it must pay off its lenders and service debt. Thus buyouts are bank driven deals. A bank won't lend a venture fund money to invest in a startup because it knows that it will probably go down in flames. A bank will lend a buyout fund money because there is collateral in place, and that collateral comes in the form of a company's cash flow and assets. So a buyout fund will seek companies that are undervalued with high predictable cash flow and operating inefficiencies. If it can improve the business, it can sell the company or its parts, or it can pay itself a nice dividend or pay down some company debt to deleverage.

The essential difference is that the venture funded company has little to no debt because it has issued equity. The buyout funded company has issued equity and loaded on debt.

As for the actual exit, a venture fund will usually go for the IPO or acquisition. The highest valuation will usually be what is available on the open market and that is why a venture fund will try that route first. A buyout fund will go for either of those but it also has the option of paying itself out some cash or of selling off parts or of selling in a secondary buyout to another firm.

Valuation Issues in Buyout Transactions

The LBO model is used to determine the impact of the capital structure, purchase price, and various other parameters on the returns expected the PE fund from deal. It has three input parameters:

  • The cash flow forecasts of the target company. This includes the estimated exit year and exit value.
  • The expected return from different providers of financing.
  • The amount of financing available for the transaction.

The LBO model then provides the maximum price than can be paid to the seller.

Value creation of a LBO comes from different sources: earnings growth, multiple expansion and debt reduction. Typical components of performance in a LBO are debt, preference shares, PE equity and management equity. The equity components are most sensitive to the level of exit. Please refer to the textbook for a detailed example.

Valuation Issues in Venture Capital Transactions

A pre-money valuation refers to the valuation of a company prior to an investment or financing. A company receives many rounds of financing rather than a big lump sum in order to reduce the risk for investors. A post-money valuation is simply the sum of the pre-money valuation and the amount of new equity. Pre- and post-money valuation concepts apply to each round.

POST = PRE + Investment

Example

If a company is worth $100 million (pre-money) and an investor makes an investment of $25 million, the new, post-money valuation of the company will be $125 million. The investor will now own 20% of the company.

The venture capital approach and the real option methodology are often used to determine value in VC transactions.

Exit Routes

Because private equity funds have incentives to acquire, add value, and then exit within the lifetime of the fund, they are considered buy-to-sell investors. Private equity funds generally receive a return on their investments through one of the following avenues:

  • An Initial Public Offering (IPO) - shares of the company are offered to the public, typically providing a partial immediate realization to the financial sponsor as well as a public market into which it can later sell additional shares. The timing of the IPO, among other factors, is an important consideration.
  • Secondary market. The company is sold to other investors for either cash or shares in another company.
  • Management Buyout (MBO). It is similar to a LBO, except that buyers are managers of the company.
  • Liquidation.

Planning the exit route for the investment is a critical role for the GP, and a well-timed and executed investment can be a significant source of realized value.

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I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
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