Chapter 11: Venture Capital Valuation Methods 170

Chapter 11

VENTURE CAPITAL VALUATION METHODS

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”?

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 venture’s value.

Venture capital (VC) method: estimates the venture’s 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 venture’s
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
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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
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 venture’s 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 company’s
equity.

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
investors. A living dead venture is a venture that provides minimal, if any, returns to
 Chapter 11: Venture Capital Valuation Methods 172

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 present value
is calculated.

Utopia discount process: allows the venture investors to value their investment
using only the business plan’s explicit forecasts.

The PV is calculated by discounting utopian projections at utopian required returns

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

valuation approach which considers that two or more outcomes could occur. First,
the present value of each outcome would be calculated. Second, each outcome’s
present value would be multiplied by the probability that the outcome would occur.
Third, the resulting probability-weighted outcomes would be summed to get an
expected present value for the 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

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.

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
assumptions are the same.
 Chapter 11: Venture Capital Valuation Methods 173

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
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 one’s 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.
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.

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

 Chapter 11: Venture Capital Valuation Methods 174

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
rounds 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)?

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
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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

6. [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?

1,000,000
Total Shares After Financing   11,851,852.
.084375

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%

1.