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Portions of this text are taken from a similar note by Prof. Steve Kaplan at the Graduate School of Business, University of Chicago
Variation 1
The VC method then discounts the free cash flows to leveraged equity and the exit or terminal value back to present. The VC method will typically use a discount rate ranging from as low as 25% for investment in later stage or more mature businesses to as high as 70% or 80% for seed investments. These discount rates are typically higher, sometimes substantially so, then discount rate used by financial markets for other instruments. The resulting value is the pre-money value the VC will be willing to pay for the company. This assumes that the forecasts cash flows included a negative cash flow that will be covered by the financing round being contemplated. If, instead, the cash flows do not include the negative cash flow, the resulting value is the post-money value. One important additional point, this methodology implicitly assumes that all negative cash flows to leveraged equity will be funded by VC equity investment that will earn the same rate of return. Here is an example: A VC is thinking of investing PKR 4 million in a company today. The PKR 4 million will be used immediately to buy new equipment. In five years, the VC believes the company will have net income of PKR 5 million. Companies today in the same business trade at price-earnings (P/E) ratios of 30 times. So the VC will assume an exit value of PKR 150 million (30 times 5). The company will not have any debt, will not require additional equity investments, and will not throw off any other cash until the exit in five years. Before the new financing, the firm has 1.6 million shares outstanding. The cash flows to (leveraged) equity are:
Year 0 (4)
Year 1 0
Year 2 0
Year 3 0
Year 4 0
Year 5 150
The VC has a target rate of return of 50% for this investment. The discounted terminal value, then is: Discounted Terminal Value = 150 / (1.50)5 = PKR 20 million The companys pre-money value is PKR 16 million. This is the value of PKR 20 million, net of the PKR 4 million that must be spent on equipment. With 1.6 million shares outstanding the premoney value per share the VC would be willing to pay is PKR 10 per share. The companys post-money value is PKR 20 million because this is the value the company attains after the PKR4 million financing is invested. If the VC is putting in 4 million, the VC will expect to receive 400,000 shares. The VC will end up owning 20% of the equity in the company. Equity Percentage = 400,000 / [ 1,600,000 + 400,000] = PKR 4 million / PKR 20 million = 20% In practice, many VC financed firms will have negative cash flows in the year or two after a financing and positive cash flow later, but before exit. Discounting these interim cash flows to leveraged equity at the VC discount rate implicitly assumes that new investments in the company will earn VC returns and that cash outflows to investors will earn VC returns.
Lets assume that the investment we considered before will require an additional PKR 9 million in year 2. Everything else remains the same. Example 2: Year 0 (4) Year 1 0 Year 2 (9) Year 3 0 Year 4 0 Year 5 150
The discounted value of these cash flows at 50% is PKR 12 million. The extra PKR 9 million required in year 2 decreases the present value by PKR 4 million. The post-money value becomes PKR 16 million. With 1.6 million shares outstanding, the company now has a stock price of PKR 7.50, not PKR 10. For PKR 4 million the VC initially will receive 533,333 shares and own 25% of the company. Equity Percentage = 533,333 / [1,600,000 + 533,333] = PKR 4 million / PKR 16 million = 25% It is worth noting that in year 2, new equity investors will invest PKR 9 million. At that time, the post-money value of the company will be PKR 150/(1.50)3 or about PKR 45 million. The PKR 9 million will receive 20% of the post-money company or 533,333 shares.
Variation 2
Instead of discounting at a given discount rate, VCs will often look at these cash flows associated with a deal and calculate the IRR they can expect to earn. For example, in example 1, the VC is buying in at an equity value of PKR 20 million. The VC expects the equity to be worth PKR 150 million in year 5. The IRR, then is 50%. In example 2, the VC is buying in at an equity value of PKR 16 million. The VC expects to raise an additional PKR 9 million in equity in two years, and for the equity to be worth PKR 150 million in year 5. The IRR, then is 50%. It is most common for VCs to think of investments in terms of expected IRRs.
B. Discount Rates
As mentioned above, VCs typically apply very high discount rate to value proposed equity investments, ranging from as low as 25% for investment in mature businesses to as high as 70% or 80% for seed investments. Such high discount rates cannot be explained as being a reward for systematic risk. For most venture capital investments, traditional discount rate calculation (using APV {Adjusted Present Value} or WACC {Weighted Average Cost of Capital} approaches based on Capital Asset Pricing Model (CAPM) assumptions that higher systematic risk requires a higher return would generate discount rates well below 25%. Instead, there are at least three reasons these discount rates are so high. First in principle, VCs are active investors who spend a large amount of time, reputational capital, and other resources on the companies they invest in. The higher required discount rate
over and above the CAPM-based rates is one way a VC can reflect is investment of time and resources. Once concern an entrepreneur (or outside observer) might have with the VC using the higher discount rate to charge for its services is that the higher discount rate implicitly charges for the VC services as long gas the VC expects to be invested in the company. In reality, a successful VC may add more value earlier on and relatively little later. It would be more accurate to compensate the VC explicitly for the value that they are expected to add. Second VCs will argue that they require a higher return to compensate them for the illiquidity of their investment. That is, a VC cannot sell an investment in a private company as easily as it could sell public company stock. The problem with this argument is that the venture capitalist makes most of its money when the firm goes public and is fully liquid. Is also is true that there are many investors who do not have short-term liquidity needs. This is discussed in more details later.
Recommendation
What would I do exactly if I were an entrepreneur or a VC? I would look at any transaction using at least two sets of cash flows and three different valuations. I would also look at financing of comparable new startups in the space. Furthermore, I would also calculate the multiple of firms in the industry or close to it that are trading on the public markets.