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Chapter 10
VENTURE CAPITAL VALUATION METHODS
DISCUSSION QUESTIONS AND ANSWERS
1. What is meant by finding the value of a ventures assets is the same as finding the value of a ventures debt
plus equity?
This is just a statement of the accounting identity expressed in market values: Market Value of Assets = Market
Value of Debt + Market Value of Equity.
2. Describe the basic venture capital (VC) method for estimating a ventures value.
Venture capital (VC) method: estimates the ventures value by projecting only a terminal flow to investors at
the exit event.
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 discount rate to get a present
value. Divide the amount the new investor will contribute by that present value to determine the percentage of
the ventures ownership that must be sold.
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 the discounting is done at
the venture capital discount rate.
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
Post-money valuation: pre-money valuation of a venture plus money injected by new investors.
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
Capitalization (cap) rate: spread between the discount rate and the growth rate of the cash flow in terminal
value period
7. How is multiplying a projected earnings by a P/E ratio similar to discounting a perpetuity of earnings starting
at that level?

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Both convert a projected earnings number into a present value. The P/E multiple approach does so by
multiplication (P/E*E=P) and the discounting approach does so by division (E/(r-g)). When P/E=1/(r-g), these
give the same answer for a given projected E.
8. How would one expect P/E ratios to vary with a ventures risk and growth opportunities?
P/E should increase with valuable growth opportunities and decrease with risk, other things being equal.
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 or other multiple or to
divide final cash flow by the cap rate (r-g).
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 and need not have any
discounting interpretation. Direct capitalization capitalizes earnings by discounting using a cap rate (r-g)
implied by a comparable ratio. There is a direct discounting interpretation. Direct comparison can be used with
stock variables (like dollars per square foot) whereas direct capitalization is really restricted to flow variables
(like earnings, cash flow and dividends).
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 venture to pay a lower
current compensation, thereby lowering the current need for external financing.
A second reason is the substantial impact it can have in motivating employees toward the founders and venture
investors shared goal of a high value for the companys equity.
12. Describe the following terms from the perspective of venture performance: (a) black hole, (b) living dead, and
(c) 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 investors. A living dead venture is
a venture that provides minimal, if any, returns to venture investors. A venture utopia venture is a venture that
provides phenomenal returns the venture investors.
The typical business plan is utopian because most plans forecast the high end of the possible success spectrum.
In other words, they typically are overly optimistic in their projections.
13.

What is meant by the utopia discount process? Describe how expected PV is calculated.
Utopia discount process: allows the venture investors to value their investment using only the business plans
explicit forecasts.
The PV is calculated by discounting utopian projections at utopian required returns

14. Discuss the type of data and the procedural changes necessary to implement a fivescenario expected PV valuation for a venture investment.

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To conduct a five scenario expected PV valuation, we would need to start with an idea about what the five
levels of possible success or failure are. To each scenario, we would need to assign a probability (likelihood)
that that scenario would be the outcome. Using a single discount rate for all five scenarios, we would project
and discount the VCFs for each scenario. After multiplying the scenario PV by its likelihood we would sum to
get the expected PV across all five scenarios. Of course, we could just apply the probabilities to each of the
five scenarios periodic VCFs to get an expected cash flow and then discount these amalgamated cash flows by
the single discount rate to arrive at the same value.
15. 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 assumptions are the same.
16.

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 series of fundraising rounds
necessary prior to a liquidity/terminal event, the size of that liquidity event and the required return for investors
as it applies to business plan (or altered) projections culminating in that liquidity event. Whether a $15.5
million valuation is justified depends entirely on ones subjective beliefs about the size and timing of the
liquidity event and the current and future required returns necessary to entice the projected funding necessary to
reach the liquidity event.

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.
Cap Rate = (r g), so r = Cap Rate + g
r = 12% + 6% = 18%
r = 10% + 5% = 15%

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.
$2,000,000/(.20 - .07) = $15,384,615.38
B. Determine the present value of the venture at the end of year 0 if the venture investor wants a 40 percent
annual rate of return on the investment.
$15,384,615.38/1.405 = $2,860,529.72
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 the end of year 5 when the net income is
estimated at $1,600,000. A publicly-traded competitor or comparable firm has current earnings of
$1,000,000 and a market capitalization value of $10,000,000.

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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
New Venture Value: $1,600,000 net income times 10 = $16,000,000
Assumptions:
1. The comparable firm is really comparable to the new venture.
2. The current price-to-earning relationship of 10 will still be the appropriate multiple to use 5 years from
now.
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?
r = (300,000,000/15,000,000)^(1/5)-1 = 82.0564%
B. Suppose the founder wants to have a venture investor inject $15,000,000 in three r-15-15ounds of
$5,000,000 at time 0, 1 and 2 with time 5 exit value of $300,000,000. If the founder anticipates returns of
70%, 50% and 30% for round 1, 2 and 3, 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
Second Round FV: 5,000,000 x (1.5)^4 = 25,312,500
Third Round FV: = 5,000,000 x (1.3)^3 = 10,985,000
Total FV = 107,290,350
First Round % of Total FV = 23.66% = 70,992,850/300,000,000
Second Round % of Total FV = 8.44% = 25,312,500/300,000,000
Third Round % of Total FV = 3.66% = 10,985,000/300,000,000)
Founder final ownership = 1 23.66% - 8.44% - 3.66% = 64.24%
= 192,709,650/300,000,000
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)?

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Founder shares = 10,000

Total shares at year 5: =10,000 / .6424 = 15,567
Round one shares = .2366 x 15,567 = 3684
Round two shares = .0844 x 15,567 = 1313
Round three shares = .0366 x 15,567 = 570
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%
Total shares at year 5 = 10,000 / .54.24 = 18,438
Round two shares = .0844 x 18,438 = 1556
Round two price = 5,000,000 / 1556 = 3213/share
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%
5 years: (1+.50)^.2 -1 = 8.45%
3 years: (1+.7)^(1/3) -1 = 19.35%
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 simple average here is
only dividing by the three outcomes (not their years). Consequently, it is open for debate whether this
simple project averaging is the best way to calibrate a required return for projects of widely varying known
durations. However, at the time the venture is funded, it is not known what the duration will be and if it is
like a small replication of all of the previous funded ventures, it is reasonable to use the hybrid discount rate
for all of the ventures possible outcomes.
2.

[Multiple Financing Rounds] Rework the two-stage example of section 10.5 with 1,000,000 initial
founders shares (instead of the original 2,000,000 shares). What changes?
Total Shares After Financing

1,000,000
11,851,852.
.084375

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First Round
Shares Issued .759375 * 11,851,852 9,000,000
Share Price

$1,000,000 / 9,000,000 $.1111 per share

Pre - Money Valuation $.1111 1,000,000 $111,111

Post - Money Valuation $.1111 * 10,000,000 $1,111,111
Founder % Between First and Second Rounds 1,000,000/10,000,000 10%
First Round Investor % Between First and Second Rounds 9,000,000/9,000,000 90%

Second Round
Shares Issued .15625 11,851,852 1,851,852
Share Price
1,000,000 / 1,851,852 $.54 per share
Pre - Money Valuation .54 10,000,000 5,400,000
Post - Money Valuation .54 * 11,851,852 6,400,000
Founder % Between Second Round and Exit 1,000,000/11,851,852 8.4375%
First Round Investor % Betweeen Second Round and Exit 9,000,000/11,851,852 75.9375%
Second Round Investor % Between Second Round and Exit 1,851,852/11,851,852 15.625%

3.

[Multiple Financing Rounds] Rework the two-stage example of section 10.5 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.
I * 1 r
1,000,000 * 1 .40

19.60%
P
10
* E5
* 1,000,000
E
1
T
5
I * 1 r
1,000,000 * 1 .55
First Round Acquired %

89.47%
P
10
* E5
* 1,000,000
E
1
T

Second Round Acquired %

This venture is not financially feasible with these required returns.

4.

[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.
Pre-money = Share Price * Pre-money shares = 3 * 200,000 = 600,000
Post-money = Share Price * Post-money shares = 3 * 300,000 = 900,000
Proceeds = Post-money Pre-money = 900,000 600,000 = 300,000 = 3 * 100,000

5.

[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.

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Comparables EPS = $300,000 / 150,000 = 2

Comparables P/E = 30/2 = 15
Ventures projected value at year 4 = 15 * 3,000,000 = 45,000,000
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?
1,500,000 / 11,713,869 = 12.81%
6.

[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 compound rate of return of 25 percent on venture investments like Black Hawk
Products. Depending on the success of products currently under development, Vail Ventures investment in
Black Hawk could turn out to be a complete failure (black hole), barely surviving (living dead), or wildly
successful (venture utopia). Vail Venture assigns 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
Black Hole
Living Dead
Venture Utopia

Yr1
0
0
0

Yr2
0
0
0

Yr3
0
0
0

Yr4
0
0
0

Yr5
$0
$10 million
$50 million

Part A
A. Calculate the present value of each scenario or outcome for Black Hawk Products.
PV of Black Hole
PV of Living Dead
PV of Venture Uptopia

0
$3,276,800
$16,384,000

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 (just the value multiplied probabilities)

C. Determine the acquired percentage of final ownership of Black Hawk Products that Vail Venture Investors
would need for its $5 million proposed investment.
Amount Invested
Firm Value
Equity percentage

$5,000,000
$6,553,600
76.29%

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177

[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 investment. Vail Venture Investors is interested in
estimating an expected compound rate of return on its investment. Depending on the success of products
currently under development, Vail Ventures investment in Black Hawk could turn out to be a complete failure
(black hole), barely surviving (living dead), or wildly successful (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
Living Dead
0
0
0
0
$10 million
Venture Utopia
0
0
0
0
$50 million
Part A
A. Calculate the internal rate of return (IRR) for each scenario or outcome for Black Hawk Products. (IRR
makes PV=0. PV= -5 + (10x0,4)/(1+i)5, on Excel: TIR)
Black Hole: -100%
Living Dead: -4.36%
Venture Utopia: 31.95%
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 = 0.2*(-100%)+0.5*(-4.36%)+0.3*(31.95%) = -12.6%
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%
Living Dead: -6.89%
Venture Utopia: 28.47%
Weighted average IRR = .2*(-100%)+0.5*(-6.89%)+.3*(28.47%) = -14.9%
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%
Living Dead: 0.40%
Venture Utopia: 38.52%
Weighted average IRR = .2*(-100%)+.5*(0.40%)+.3*(38.52%) = -8.24%

MINI CASE: R.K.MAROON COMPANY

R.K. Maroon is a seed-stage web-oriented entertainment company with important intellectual property. RKMs
founders, all technology experts in the relevant area, are anticipating a quick leap to dot-com fortune and believe

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that their unique intellectual property will allow them to achieve a subsequent (year 3) $100,000,000 venture value
with a one-time initial $2,000,000 in venture financing.
In contrast, similar dot-commers in their niche are currently seeking multistage financing amounting to
$10,000,000 to achieve comparable results. The founders have organized with 1,000,000 shares and are willing to
grant venture investors a 100% return on their business plan projections.
A. What percent of ownership must be sold to grant the 100% three-year return?
2,000,000*(1+100%)^3=16,000,000 (terminal value)
Percent owned by investors = 16,000,000 / 100,000,000 = 16%
B. What is the resulting configuration of share ownership (starting from the 1,000,000 founders shares?
1,000,000 / 0.84 = 1,190,476 total shares (0,84= 1-16%)
190,476 new shares issued to investors
1,000,000 founder shares
C. Suppose the venture investors dont 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
Second round investor final ownership = 11,200,000 / 100,000,000 = 11.2%
Founder final ownership = 1 - 0.16 -0.112 = 0.728 (100% - 1st round 2nd round)
Total shares outstanding at exit = 1,000,000 / 0.728 = 1,373,626
Second round shares = 153,846; final ownership = 0.112
First round shares = 219,780 ; final ownership = 219,780 / 1,373,626 = 0.16
Founder shares = 1,000,000; final ownership = 1,000,000 / 1,373,626 = 0.728
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
Shares percent owned by Founder + First Round = 1 - 0.112 = 0.888
Total shares at exit = 1,190,476 / 0.888 = 1,340,626
Second Round final ownership = 0.112
First Round final ownership = 190,476 / 1,340,626 = 0.1421
Founder final ownership = 1,000,000 / 1,340,626 = 0.7459
The %s of ownership decrease for everybody, not just the owner, there is a change in the methodology. In part
C the investment that was already forecasted, the only one who looses is the founder (whenever the 2 nd round of
financing is planned ahead). While if it is not planned and it turns out to be wrong, everybody looses.
Whenever the investor makes a mistake, both the funder and the investor loose percentage of control.
2. Compare these to your results for Part C.
First round investors get less shares. Founders retain more percent ownership.

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3. Who bears the dilution from an anticipated round?

Founders bear the costs of all rounds anticipated by the first round investor.
4. Who bears the dilution from an unanticipated round?
Instead of shifting second round dilution entirely onto the founders, the first round investors failure to
anticipate a second round causes the first round investor to bear some of the dilution costs.
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 investors hedging. Consequently, if the second round never arrives, the first
round investors greatly benefit from not bearing the anticipated dilution. While the founders would also not
like to have the second round unless they have to, the deal is not as sweet as it would have been had they been
able to convince the first round investor that a second round would not be needed. First round investors and the
founders have an incentive to enter into a bonus or incentive arrangement for avoiding a second round.
Perhaps this incentive will move the allocation of shares back closer to what t it would have been had the
founders convinced the first round investors that a second round was not needed.