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Chapter 9
VALUING EARLY-STAGE VENTURES
FOCUS
In this chapter, we introduce basic concepts of valuation, the process of estimating
values. We consider the owner of a growing business who is beginning negotiations with
a potential investor. We introduce the mechanics of valuation and some mathematical
simplification that can be used to value the venture. By dividing the venture’s future into
an explicitly forecast period and a subsequent constant growth period, we can greatly
simplify the valuation problem faced by the venture’s entrepreneur. We discuss two
valuation methods that differ in how projected financial statements are created and when
credit for creating surplus cash is granted.
LEARNING OBJECTIVES
1. Explain why it is important to look to the future when determining a venture’s value
2. Describe how the time pattern of cash flows relates to venture value
3. Understand the need to consider both forecast period and terminal value cash flows
when determining a venture’s value
4. Understand the difference between required cash and surplus cash
5. Describe the process for developing the projected financial statements used in a
valuation
6. Describe how pseudo dividends are incorporated into the discounted cash flow equity
valuation method
7. Understand the differences between accounting and equity valuation cash flow
CHAPTER OUTLINE
9.1 WHAT IS A VENTURE WORTH?
A. Does the Past Matter?
B. Looking to the Future
C. Vested Interests in Value: Investor and Entrepreneur
9.2 BASIC MECHANICS OF VALUATION: MIXING VISION AND REALITY
A. Present Value Concept
B. If You’re Not Using Estimates, You’re Not Doing a Valuation
C. Divide and Conquer with Discounted Cash Flow
9.3 REQUIRED VERSUS SURPLUS CASH
9.4 DEVELOPING THE PROJECTED FINANCIAL STATEMENTS FOR A DCF
VALUATION
9.5 JUST-IN-TIME EQUITY VALUATION: PSEUDO DIVIDENDS
9.6 ACCOUNTING VERSUS EQUITY VALUATION CASH FLOW
A. Origins of Accounting Cash Flows
B. From Accounting to Equity Valuation Cash Flows
SUMMARY
LEARNING SUPPLEMENT 9A:
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Value Maximization and the First Entrepreneurial Team
LEARNING SUPPLEMENT 9B:
Discounting Growing Perpetuities
DISCUSSION QUESTIONS AND ANSWERS
1. What is a venture’s present value? Does the past matter?
A venture’s present value is the value today of all future cash flows discounted to the
present at the rate of return required by investors.
The value of the venture is not directly related to the quantity of past efforts in cash or
sweat. While accounting for the past is all well and good, an investor seeks to
quantify and value the future.
2. Describe what is meant by the statement “If you’re not using estimates, it’s not a
valuation.”
It is important to recognize that projected financial statements needed to calibrate
value reflect “best guesses” of future revenues, expenses, timing, and investment
requirements.
3. Define the terms (a) explicit forecast period and (b) terminal or horizon value as they
relate to a venture’s discounted cash flow valuation.
Explicit forecast period: two- to ten-year period in which the venture’s financial
statements are explicitly forecast
Terminal (or horizon) value: the value of the venture at the end of the explicit
forecast period
4. What is meant by a capitalization (or cap) rate in reference to calculating a terminal
value? What other types of terminal values might be appropriate (i.e., other than
smooth growth procedures)?
Dividing by the cap rate (r – g) in the perpetuity formula is the appropriate
mathematical simplification for discounting (at rate r) a perpetual series of cash flows
growing smoothly (at rate g). It is mathematically equivalent to the infinite sum of
the discounted value of all the future cash flows.
Rather than projecting a smooth growth, one could project no growth, multiple stages
of growth, liquidation value (with tax benefits, if any) or predict the terminal value
using the multiple methods that will be introduced in Chapter 10.
5. What is a venture’s reversion value?
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Reversion Value: the present value of the terminal value.
6. What is a stepping stone year? Why is it important in determining a venture’s value?
Stepping-stone year: first year after the explicit forecast period
The stepping stone year forces the evaluator to ramp revenue growth down to the long
term rate while making sure that the investment flows going forward are at a level
appropriate for that long-term growth rate. This level is lower than in the previous
years where investment supports much higher revenue growth rates.
7. Explain the difference between pre-money valuation and post-money valuation.
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
8. Describe the equity valuation method.
Equity valuation method (equity method): process of projecting and then
discounting the relevant cash flows available to equity investors
9. Define required cash and surplus cash. Why does it matter how we treat surplus cash
for valuation purposes?
Required cash: amount of cash needed to cover a venture’s day–to-day operations
Surplus cash: cash remaining after required cash, all operating expenses, and
reinvestments are made
To get an appropriate valuation, we separate required cash (treated as an investment)
from surplus cash (allowed to flow through to equityholders).
10. Briefly describe the process for projecting financial statements.
The process begins by projecting top-line sales forecasts annually for a specified
forecast period and for a stepping-stone year. We then generally use a percent-of-
sales method (described in Chapter 6) to first forecast annual income statements.
This is followed by a forecast of annual balance sheets and annual statements of cash
flows.
11. What is net operating working capital?
Net operating working capital: current assets less surplus cash less non-interest-
bearing current liabilities
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12. Identify and describe the major components that are used to calculate the equity
valuation cash flow.
Equity valuation cash flow = net income + depreciation and amortization expense –
change in net operating working capital (without surplus cash) – capital expenditures
+ net debt issues
13. Describe how pseudo dividends are used in the equity valuation method.
Pseudo dividend: excess cash not needed for investment in the assets or operations
to carry out the business plan
Pseudo dividends can be used to conduct an equity-method valuation (1) by altering
the projected financial statements to pay out the maximum dividend feasible each
period, and incorporating the recovery of those dividends when the capital is needed
for the execution of the business plan, or (2) by using a formula approach to directly
calculate the pseudo dividends.
Sometimes the pseudo dividend in an equity method valuation is referred to as the
“free cash flow to equity.” However, we use a more specific terminology because the
term “free cash flow” has different meanings to different people.
14. What is the relationship between equity valuation cash flows and dividends?
If you were to project the maximum possible dividend the venture could afford to pay
while maintaining all other asset investments, that resulting maximum dividend
would coincide with the equity valuation cash flow calculated by the approach given
in the textbook.
15. Why do the numerical examples of this chapter involve a large dividend in the last
year of the explicit forecast period?
The large “dividend” (or pseudo dividend in the equity valuation cash flow) derives
from the cash freed up by the assumed recapitalization through a debt issue. While
there need not be an explicitly forecast dividend when using the equity valuation cash
flow approach, there is a large equity valuation cash flow due to the recapitalization.
16. Why do net income and cash flow in the numerical examples in this chapter both
grow at the same rate (g) in the terminal value period? Why is this important?
After the explicit forecast period, the stepping-stone year provides the first step into
the infinite future. After the stepping-stone year, the assumption is that everything
grows at the same rate g due to the assumption that operating and financing ratios are
constant. Divergent growth rates are not permitted in estimating cash flow
perpetuities when determining terminal or horizon value.
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17. From the Headlines — Foursquare: What ingredients would you need to conduct a
traditional equity method valuation for Foursquare? If you had the necessary
projections, do you think that they would also suggest the $80 to $100 million
valuations mentioned in the article? Comment on the warnings you would provide to
accompany your projections and valuation if you completed them.
Answers will vary: Ingredients for a traditional equity method valuation include
projections of the income statement, balance sheet and statement of cash flows for an
explicit projections period and some projection of how the firm will grow on average
past that explicitly projected period, and required returns for equity now and in the
period beyond the explicit projections. The $80 to $100 million valuations are most
likely due to the anticipation of extremely high growth rates and quickly improving
revenue and profit streams for Foursquare. Whether they are justified depends on
one’s subjective beliefs regarding the prospects for success and its immediacy.
General warnings on Foursquare (and any other ventures in a similar situation)
include that projections and valuation include “garbage in – garbage out” and
“hockey stick revenue hype is nothing new – sometimes it happens; most times it
doesn’t” and “costs are seldom kept to the level originally projected.”
INTERNET ACTIVITIES
1. Web surfing exercise: Find a fast growth publicly traded firm with financial
statements posted on the firm’s web page. Relate that firm’s financial statements to
those of the examples in this chapter. Formulate the process by which you would
project that firm’s financial statements into the future in order to conduct a valuation.
Web-researched results vary due to constant updating of the related web sites.
2. Using a free stock quoting and research site on the Web (e.g.
http://www.bloomberg.com or http://www.cnnfn.com ), examine the current price for
an Internet company. Relate the financial data you can find on the firm to the current
stock price.
Web-researched results vary due to constant updating of the related web sites.
EXERCISES/PROBLEMS AND ANSWERS
1. [Present Value Valuation Concepts] Assume you sell for $100,000 a 10 percent
ownership stake in a future payment one year from now of $1.5 million.
A. What are you saying about the implied return for the 10 percent owner?
Investment of $100,000 for a dollar return of $150,000 ($1.5 million x .10) one year
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from now.
Implied return = ($150,000 – $100,000)/$100,000 = $50,000/$100,000 = 50%
Implied current (present) value of venture = $ Investment / Percentage Ownership =
$10,000/.10 = $1,000,000
Expected venture return = ($1,500,000 – $1,000,000)/$1,000,000 = 50%
B. What is the present value of the entire $1.5 million, using the implied return from Part
A?
PV = $1,500,000/(1.50) = $1,000,000
C. What is 10 percent of the value determined in Part B?
$1,000,000 x .10 = $100,000
D. Does it matter whether you grow the $100,000 at 50 percent to $150,000 and note it
is 10 percent of $1.5 million, or discount the $1.5 million at 50 percent to get $1
million and note that $100,000 is 10 percent of this present value?
No. Both approaches provide the same result:
a) $100,000 x 1.50 = $150,000 future value
[which is 10% of the $1,500,000 total FV]
b) $1,500,000/(1.50) = $1,000,000 present value
[$100,000 is 10% of total PV]
2. [Venture Present Values] The TecOne Corporation is about to begin producing and
selling its prototype product. Annual cash flows for the next five years are forecasted as:
Year Cash Flow
1 -$50,000
2 -$20,000
3 $100,000
4 $400,000
5 $800,000
[Note: Following is a spreadsheet solution for Problem 2 (TecOne
Corporation) and Problem 3 (LowTec Corporation).]
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TecOne Corporation Solutions
Problem 1
Part A:
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6
Annual Cash Flow (50,000) (20,000) 100,000 400,000 800,000 800,000
Terminal Value 2,000,000
