ENTREPRENEURIAL FINANCE Leach & Melicher

VENTURE CAPITAL VALUATION METHODS

Chapter 10

© 2012 South-Western Cengage Learning

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Chapter 10
Learning 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

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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

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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

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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

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Venture Capital Shortcuts on the
Equity Method

I
Acquired % Final Ownership 
[P/E x E 5] / (1  r)T

1,000,000

[10/1 x 1,000,000] / (1  .5) 5
 75.9375%

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Venture Capital Shortcuts on the
Equity Method

m x (Acquired %)
Shares to Be Issued  n 
1 - Acquired %

2,000,000 x (.759375)

.240625
 6,3111,688

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Venture Capital Shortcuts on the
Equity Method

$1,000,000
Issue Share Price 
6,311,688 shares

 $.15843622 per share

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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
PCurrent
Other Firms

x E Venture
Year 5
 P Venture
Year 5
E Oth er Firms
Current

Direct Capitalization:
valuation by capitalizing earnings using a cap rate implied by a
comparable ratio

E Venture
Year 5
 P Venture
Year 5
E Other Firms
Cu rrent
/ P Other Firms
Cu rrent

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Earnings Multipliers and Discounted
Dividends

PCuOther Firms
20,000,000
rrent
x E Year 5  PYear 5 
Ventu re Venture
x 1,000,000
E Curren t
Other Firms
2,000,000
 10 x 1,000,000  10,000,000

Under direct capitaliza tion method :

E Venture 1,000,000
Year 5
 PYear 5 
Venture

E Cu rrent / PCu rrent

Other Firms Other Firms
2,000,000 / 20,000,000
1,000,000
  10,000,000
.10

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Earnings Multipliers and Discounted
Dividends
Given per share values of earnings (E), dividends (D), & price (P) :
D6
P5  where r  discount rate & g  dividend growth rate.
r-g
In constant growth, dividends  earnings x constant payout ratio, D/E and
payout ratio  one minus plowback ratio of b  (E - D)/E, then
E6 x (1 - b)
P5 
r-g
P5 (1 - b)
rearrangin g : 
E6 r-g
P5 P5 (1 - b)
and using smooth growth assumption :   and
E6 E5(1  g) (r - g)
P5 (1 - b) x (1  g)

E5 (r - g)

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Adjusting the VC Shortcut for
Multiple Rounds

I x (1  r)T 1,000,000x (1  .25)2

Second Round Acquired   15.625%
[P/E x E 5] [10/1x 1,000,000]

I x (1  r)T 1,000,000x (1  .5)5

First Round Acquired   75.9375%
[P/E x E 5] [10/1x 1,000,000]

Founder's Remaining%  1  .1562 .759375 .084375

2,000,000
Total Sharesafter Financing  23,703,704
.84375

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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

Founder' s Remaining %  1  .15625  .759375  .06  .024375

2,000,000
Total Shares after Financing and Incentive Options   82,051,282
.024375

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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%

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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%

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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%

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Summary

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 Scenario Methods

Given : $100 million ve nture fund invests :

20 % at total loss
60% at break even
20% at 70% annualized return
with liquidity at two years on all outcomes.
What is annualized portfolio return?
0  $60,000,000  $20,000,000 x (1.7) 2 1 / 2
( )  1  8.536%
$100,000,000

Utopoia Discount Process : valuation by discountin g only utopian business plan

forecasts at utopian discount rates

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Three-scenario Mean Flow Approach

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Algebraically,

0 400 400 400 8,000,000 x  

1,000,000  1
 2
 3
 4

1.22 1.22 1.22 1.22 1.225
1,200 8,000,000 x  2
 6

1.22 1.227

  31.49689%

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Same As Taking Expectations Across
Scenario Values

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 Internal Rate of Return (IRR)
 IRR:
compound rate of return that equates the present value of the cash
inflows received with the initial investment

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TUTORIAL

EXERCISES/PROBLEMS
• No 3, 9

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