Entrepreneurship Chapter 11e Describe the following terms from the perspective of venture performance: black hole, living dead, and venture utopia. In what sense is the typical business plan utopian

Chapter 11

VENTURE CAPITAL VALUATION METHODS

FOCUS

In this chapter, we present several variations on the simplified valuation procedures and

rules of thumb frequently grouped under the designation “venture capital methods.” We

introduce a three-scenario approach to examining the value of different possible future

venture outcomes.

LEARNING OBJECTIVES

LO 11.1: Discuss how venture capital shortcut valuation methods differ from basic cash

flow-based equity valuations.

LO 11.2: Describe the use of estimated terminal cash flows in the basic venture capital

CHAPTER OUTLINE

11.1 BRIEF REVIEW OF BASIC CASH FLOW-BASED EQUITY VALUATIONS

11.2 BASIC VENTURE CAPITAL VALUATION METHOD

A. Using Present Values

B. Using Future Values

A. Utopian Approach

B. Mean Approach

SUMMARY

DISCUSSION QUESTIONS AND ANSWERS

1. What is meant by “finding the value of a venture’s assets is the same as finding the

value of a venture’s debt plus equity”?

2. Describe the basic venture capital (VC) method for estimating a venture’s value.

3. Describe the process for estimating the percentage of equity ownership that must be

given up by the founder when a new equity investment is needed.

Estimate the value of the exit event. Discount that value at the venture capital

4. How does a present value venture valuation pie differ from a future value valuation

pie?

The present value valuation pie is the present value of the future valuation pie where

5. What is meant by pre-money valuation? What is post-money valuation?

Pre-money valuation: present value of a venture prior to a new money investment

6. What is staged financing? Describe how the capitalization (cap) rate is calculated.

Staged financing: financing provided in sequences of rounds rather than all at one

time

7. How is multiplying a projected earnings by a P/E ratio similar to discounting a

perpetuity of earnings starting at that level?

Both convert a projected earnings number into a present value. The P/E multiple

8. How would one expect P/E ratios to vary with a venture’s risk and growth

opportunities?

P/E should increase with valuable growth opportunities and decrease with risk, other

9. What are the common ways to estimate a terminal value for a venture?

A few common ways to estimate terminal value for a venture would be to use a P/E

10. What is the difference between the direct comparison method and the direct

capitalization method?

Direct comparison applies a direct comparison ratio to the related venture quantity

11. Describe two important motives for having an equity component in employee

compensation.

One reason is that the expected deferred and tax-preferred compensation allows the

12. Describe the following terms from the perspective of venture performance: black hole,

living dead, and venture utopia. In what sense is the typical business plan utopian?

A black hole venture is a venture that results in a 100 percent loss to venture

13. What is meant by the utopia discount process? Describe how expected present value

is calculated.

Utopia discount process: allows the venture investors to value their investment

14. Describe how expected present value is calculated when there are two or more

scenarios.

The alternative to a “utopian” venture valuation approach is a “mean” venture

15. Discuss the type of data and the procedural changes necessary to implement a five-

scenario expected PV valuation for a venture investment.

To conduct a five scenario expected PV valuation, we would need to start with an

16. What is the difference between discounting expected cash flows from multiple

scenarios at a constant rate and averaging the scenarios’ PVs calculated with that

single discount rate?

These are the same when a single fixed discount rate is used and all other

17. From the Headlines — Excaliard: What ingredients would you need to conduct a

VCSC valuation for Excaliard? Does your calculation suggest that a $15.5 million

Series A round is reasonable?

Answers will vary: Typical ingredients in a VCSC valuation are a projection of the

INTERNET ACTIVITIES

1. Web-surfing exercise: Using a particular industry as a focus, find an industry report

that covers several ventures having various levels of maturity and/or performance.

Compare their performances in recent years. Develop a model of how you would

conduct a multiple-scenario valuation for a newcomer in that industry. What type of

discount rate would be appropriate for your approach?

Discussion and findings will depend on the industry chosen. Chapter 7 provides a

discussion of possible discount rates by life cycle stage (see Figures 7.6 and 7.7).

EXERCISES/PROBLEMS AND ANSWERS

1. [Discount Rates] Calculate the discount rate consistent with a cap rate of 12% and a

growth rate of 6%. Show how your answer would change if the cap rate dropped to

10 percent while the growth rate declined to 5 percent.

2. [Venture Present Values] A venture investor wants to estimate the value of a venture.

The venture is not expected to produce any free cash flows until the end of year 6

when the cash flow is estimated at $2,000,000 and is expected to grow at a 7 percent

annual rate per year into the future.

A. Estimate the terminal value of the venture at the end of year 5 if the discount rate

at that time is 20 percent.

3. [Venture Capital Valuation Method] A venture capitalist wants to estimate the value

of a new venture. The venture is not expected to produce net income or earnings until

A. Estimate the value of the new venture at the end of year 5. Show your answer

using both the direct comparison method and the direct capitalization method.

What assumption are you making when using the current price-to-earning

relationship for the comparable firm?

P/E of comparable firm = $10,000,000/$1,000,000 = 10 times

B. Estimate the present value of the venture at the end of year 0 if the venture

capitalist wants a 40 percent annual rate of return on the investment.

$16,000,000/1.405 = $2,974,950.91

4. [Multiple Financing Rounds] Ratchets.com anticipates that it will need $15,000,000

in venture capital to achieve a terminal value of $300,000,000 in five years.

A. Assuming it is a seed stage firm with no existing investors, what annualized return

is embedded in their anticipation?

respectively, what percent of ownership is sold during the first round? During the

second round? During the third round? What is the founders’ year-five

ownership percentage?

First Round FV: 5,000,000 x (1.7)^5 = 70,992,850

C. Assuming the founder will have 10,000 shares, how many shares will be issued in

rounds 1, 2 and 3 (at times 0, 1 and 2)?

Founder shares = 10,000

D. What is the second round share price derived from the answers in Parts B and C?

Second Round Price = 5,000,000 / 1313 =3808/share

E. How does the answer to part D change if 10% of the year-five firm is set aside for

incentive compensation? How many total shares are outstanding (including

incentive shares) by year 5?

Founder final ownership = 1 -23.66% – 8.44% – 3.66% -10% = 54.24%

5. [Rates of Return] Suppose a venture fund wishes to base its required return (used in

discounting future terminal values) on its historical experience and suggests merely

averaging the rates on the last three concluded deals. These deals realized total

returns of –67% at the end of 2 years, 50% at the end of 5 years and 70% at the end

of three years, respectively.

A. Assuming no intermediate flows before the terminal payoff, verify that the

associated annualized rates are –42.55%, 8.45% and 19.35%.

2 years: (1-.67)^.5 – 1 = -42.55%

B. What is the equally weighted average annualized return?

(-42.55% + 8.45% +19.35%) / 3 = -4.92%

C. Does it make sense to use this as a single discount rate to apply across scenarios

involving different durations?

The returns have been realized over a total of 10 investment years. However, the

6. [Multiple Financing Rounds] Rework the two-stage example of section 11.4 with

1,000,000 initial founders’ shares (instead of the original 2,000,000 shares). What

changes?

.852,851,11

084375.

000,000,1

FinancingAfter Shares Total ==

shareper $.1111 9,000,000 / $1,000,000 Price Share

9,000,000 11,851,852 * .759375 Issued Shares

==

RoundFirst

1,851,852 11,851,852 .15625 Issued Shares

==

Round Second

7. [Multiple Financing Rounds] Rework the two-stage example of section 11.4 with first-

and second-round required returns of 55% and 40% (instead of the original 50% and

25%). Interpret your results as they relate to the founders’ ownership and the

feasibility of the financing.

( ) ( )

%60.19

000,000,1*

1

10

40.1*000,000,1

*

1*

% Acquired Round Second

2

5

=

+

=

+

=

E

P

rI T

8. [Pre-money and Post-money Valuations] Suppose you are considering a venture

conducting a current financing round involving an issue of 100,000 new shares at $3.

The existing number of shares outstanding is 200,000. What are the related pre-

money and post-money valuations?

Share price = $3.

9. [Venture Capital Valuation Method] A venture capitalist firm wants to invest $1.5

million in your NYDeli dot.com venture that you started six months ago. You do not

expect to make a profit until year four when your net income is expected to be $3

million. The common stock of BioSystems, a “comparable” firm, currently trades in

the over-the-counter market at $30 per share. BioSystems’ net income for the most

recent year was $300,000 and the firm has 150,000 shares of common stock

outstanding.

A. Apply the VC method to determine the value of the NYDeli at the end of four

years.

Comparable’s EPS = $300,000 / 150,000 = 2

B. If VCs want a 40% compound annual rate of return on similar investments, what

is the present value of your NYDeli venture?

45,000,000 / 1.4^4 = 11,713,869

C. What percentage of ownership of the NYDeli dot.com venture will you have to

give up to the VC firm for its $1.5 million investment?

10. [Present Values and Investor Ownership] Vail Venture Investors, LLC is trying to

decide how much percent equity ownership in Black Hawk Products, Inc. it will need

in exchange for a $5 million investment. Vail Venture Investors has a target

Part A

A. Calculate the present value of each scenario or outcome for Black Hawk

Products.

PV of Black Hole 0

B. Calculate the weighted average of the present values for the three scenarios.

What is the total equity value for the Black Hawk Products venture?

Weighted Average Present Value $6,553,600

C. Determine the acquired percentage of final ownership of Black Hawk Products

that Vail Venture Investors would need for its $5 million proposed investment.

Part B

Now assume under the venture utopia scenario that, in addition to the $50 million cash

inflow in year 5, there will be an annual $1million preferred dividend (to be paid to Vail

Venture Investors but not other equity investors). Vail Venture expects to receive this $1

million dividend under the venture utopia scenario in each of the five years that the Black

Hawk investment will be maintained. No preferred annual cash flows are expected under

either the black hole or the living dead scenarios.

D. Calculate the acquired percentage of final ownership of Black Hawk Products that

Vail Venture Investors would need to earn a 25 percent compound rate of return

on its investment. Use the “mean flow method” described in the chapter. [Hint:

use “goal seek” in a spreadsheet software program to find the necessary

percentage ownership.]

Outcome Yr1 Yr2 Yr3 Yr4 Yr5 Probability

E. Use the “expected present value (PV) method” described in the chapter when

solving for the acquired percentage of final ownership in the Black Hawk to Vail

Venture needs to earn its 25 percent target rate of return.

Outcome PV Yr1 Yr2 Yr3 Yr4 Yr5 Probability

Black Hole $0.00 0 0 0 0 $0 0.2

11. [Internal Rates of Return] Vail Venture Investors, LLC has recently acquired a 40

percent equity ownership in Black Hawk Products, Inc. in exchange for a $5 million

(venture utopia). Vail Venture has assigned probabilities of .20, .50, and .30,

respectively, to the three possible outcomes. Following are the 3 cash flow

scenarios or outcomes for the Black Hawk Products investment that Vail Venture

expects to exit at the end of five years.

Outcome Yr1 Yr2 Yr3 Yr4 Yr5

Black Hole 0 0 0 0 $0

Part A

A. Calculate the internal rate of return (IRR) for each scenario or outcome for Black

Hawk Products.

Black Hole: -100% (assuming that the loss is realized in the first year)

B. Calculate the weighted average of the IRRs for the three scenarios. What is the

expected IRR for the Black Hawk Products venture?

Weighted average IRR = .2*(-100%)+.5*(-4.36%)+.3*(31.95%) = -12.6%

While this number can be calculated once we tie down the IRR for the Black

C. What would be Vail Venture Investors expected IRR if its $5 million investment in

Black Hawk Products bought only a 35 percent interest in the venture?

Black Hole: -100% (assuming that the loss is realized in the first year)

Living Dead: -6.89%

is this calculation advocated or promoted. Students can be asked why not.

D. Show how your answer in Part C would change if Vail Ventures received a 51

percent ownership stake in the Black Hawk Products venture for $5 million.

Black Hole: -100% (assuming the loss is realized in the first year)

Part B

Now assume under the venture utopia scenario that, in addition to the $50 million cash

inflow in year 5, there will be an annual $1million preferred dividend (to be paid to Vail

Venture Investors but not other equity investors). Vail Venture expects to receive this $1

E. Calculate the revised internal rate of return for the venture utopia scenario if Vail

Venture’s equity ownership stake in Black Hawk Products is 40 percent.

IRR = 44.97%

While we have provided this “Expected IRR” exercise as an illustration of what many

students will conjecture as interesting, neither of the authors promotes the use of

Expected IRRs in such a context. While using “Expected PV” across scenarios makes

sense with a constant discount rate, “Expected IRR” has no simple interpretation as the

MINI CASE: R.K.MAROON COMPANY

R.K. Maroon is a seed-stage web-oriented entertainment company with important

intellectual property. RKM’s founders, all technology experts in the relevant area, are

anticipating a quick leap to dot-com fortune and believe that their unique intellectual

A. What percent of ownership must be sold to “grant” the 100% three-year return?

2,000,000*(1+1)^3=16,000,000

B. What is the resulting configuration of share ownership (starting from the 1,000,000

founders’ shares?

1,000,000 / .84 = 1,190,476 total shares

C. Suppose the venture investors don’t buy the business plan predictions and want to

price the deal assuming a second round in year 2 of $8,000,000 with a 40% return.

What changes?

8,000,000(1.4)^1=11,200,000

D. Suppose the venture investors agree with the founders’ assessment, price the deal

accordingly (as in Part B) and turn out to be wrong (an additional $8,000,000 at

40% must be injected for the final year).

1. What is the impact on the founders’ and round one investors’ final ownership

assuming the second round is funded by outsiders?

Founder shares + First Round Shares = 1,000,000 + 190,476 = 1,190,476

2. Compare these to your results for Part C.

First round investors get less shares. Founders retain more percent ownership.

3. Who bears the dilution from an anticipated round?

4. Who bears the dilution from an unanticipated round?

Instead of shifting second round dilution entirely onto the founders, the first round

E. Suppose that the deal is priced assuming the second round (as in Part C) and it turns

out to be unnecessary. Comment on the final ownership percentages at exit (year 3).

What do you conclude about the impact of anticipated but unrealized subsequent

financing rounds?

When first round investors get a share allocation that protects them from second

round dilution, the founders bear the cost of the first round investor’s hedging.