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Copyright 1999 President and Fellows of Harvard College

Venture Capital Valuation

INTRODUCTION

Contents Introduction Assumptions Simple Model

This sheet Primary data entry sheet Primary report sheet

Introduction Venture Capitalists (VCs) are regularly presented with valuation challenges. Since the projects they are investing in rarely have a reliable external valuation (such as the publicly quoted market price for a company listed on a stock exchange), the VC is on his or her own in attempting to value a potential portfolio investment. To complicate things further, the most popular valuation tools for established companies or for projects with predictable revenue streams are problematic when applied to early-stage companies. Discounted cash flow might be an ideal tool for valuing a mature company with stable cash flow, or an investment expected to produce predictable cost-savings or revenue improvement. Applying DCF to start-up companies that have a significant chance of either failure or explosive success, and where business plan estimates of future results are notoriously unreliable, is not likely to be terribly effective. Similarly, while a late-stage private company could be valued by comparing it with similar publicly traded companies, the comparable companies for an early-stage investment are likely to be privately held themselves, with only limited use for establishing a reasonable valuation. An additional concern with conventional valuation techniques is that they ignore a key element of the VC business model: the exit. A portfolio manager of a mutual fund may hold his Microsoft shares indefinitely, and a business manager is making a capital investment for its returns over an expected useful economic life. A VC, however, typically expects to exit her investment within a fairly short time frame (typically two to five years). The Venture Capital Method: Discounting Exit Value The Venture Capital Method involves estimating an achievable exit value for the investment, discounting that to present value, and determining what percentage of equity the VC will need to hold at the time of exit in order to achieve their required rate of return. Once that has been determined, the VC can adjust this percentage for any expected dilution (e.g. from further rounds of financing or options set aside for employees) and determine how much equity she needs at the time of investment. Example 1: A Venture Capitalist is considering investing $10 million in a start-up venture. She estimates that at the end of year 3 the company will generate $15 million in EBIT and will be ready for an IPO, at which point she expects to sell her shares. IPO multiples for this sort of company have typically been roughly 8x trailing year EBIT. Her investment hurdle rate is 30% p.a. No further dilution is expected. How much equity must she receive for her investment? Dollar amounts in Millions IPO Value Present Value Required equity at Exit Formula $15 EBIT @ 8x IPO multiple $120/(1+30%)^3 10/54.6

$120 $54.60 18.30%

Thus, in order to earn a 30% annual return over three years, the VC must receive 18.3% of the equity in exchange for her $10 million investment.

Venture Capital Valuation

Adjusting for Dilution

INTRODUCTION

VCs have an additional challenge compared with investors in mature companies or managers deciding whether to go ahead with a capital investment project. Most entrepreneurial firms do not raise their entire venture funding at one time. Rather, funding is raised in separate stages, each one of which will involve a separate valuation and may include different VCs as investors. In addition, many entrepreneurial firms provide a significant amount of options to attract and motivate managers and other key employees. Thus, in determining how much equity to receive at the time of investment, the VC must often take dilution of that equity into account. Example 2: Let us assume that in the above example, an additional round of financing would be required at the beginning of year three. $10 million would have to be raised. Lets also assume that these investors will need a somewhat lower rate of return (20%) because the venture is at a more mature stage. We would calculate their required equity stake as follows: Dollar amounts in Millions IPO Value Present Value Required equity at Exit Formula $15 EBIT @ 8x IPO multiple $120/(1+20%)^1 10/100

$120 $100 10%

So, the equity of the company will have to be increased by 11.1% in order for the new investors to have a 10% stake. This will dilute the investment of the first round VC, so that in order to have 18.3% at exit she will have to receive 20.3% at the time she invests. Example 3: Now suppose that management wishes to award certain employees with options. These options will be issued at the same time as the second round of financing, and will give employees the right to buy equity that will equal 15% of the company after that round is complete. How will this affect the required stakes of the original VC investor? To answer this, we must first assess the needs of the second round investors, since that will affect the total dilution suffered by the original VC. These investors require a 10% stake at the time of the IPO. The options will dilute them by 15%, so we divide 10% by (1-0.15). They will require an initial stake of 11.8%. Now we can address the dilution of the original VC. Her investment will be diluted by 11.8% by the second round investors and then by a further 15% by the employee options. Thus, to calculate how much she needs to receive in order to have 18.3% at exit we calculate as follows: 18.3%/(1-0.15)/1-0.118). She will require a 24.4% stake.

Directions Developed for use with "The Venture Capital Method - Valuation Problem Set" (HBS Case 396-090)

Note About Using Internet Explorer The default setting in Internet Explorer is to open these tools in the Explorer application instead of Excel. We recommend against this and provide directions in the Help section of the HBS Toolkit web site to change this default behavior.

HBS Menu Show/Hide Sample Data: Show Calculator: Show/Hide Celltips: Print Sheet with Celltips: Set Zoom: Visit Web Links: About HBS Toolkit:

Displays or removes sample entries Launches Windows calculator Toggles in/out red Celltips in documented cells Prints Celltip documentation on current sheet Provides quick access to 80%, 100%, and 125% zoom levels Links to HBS Toolkit website, Toolkit Glossary, and Toolkit Feedback, as well as HBS and HBS Publishing web sites Launches the about box for the HBS Toolkit

Research Associate Andrew S. Janower developed this software under the supervision of Professor William A. Sahlmanas the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrativesituation. Formatted for the HBS Toolkit by Jon B. DeFriese, MBA `00 and Chad Ellis, MBA `98.
Copyright 1999 President and Fellows of Harvard College

Venture Capital Valuation

Investment Rounds Stage 1 Stage 2 Investment Amount $5.0 $0.0 Required Stage 1 ROR 50.0% 30.0% Years to Terminal Stage 5.0 3.0 Shares outstanding before investment 1,000,000 Terminal Stage Terminal Management Share Terminal Sales Terminal Net Margin Terminal PER Terminal Value of Enterprise Return of Stage 1 Principal Return of Stage 2 Principal Terminal Calculations Total Terminal Value Return of Principal Equity Value Required Terminal Share Equity Ownership Pre-Money Valuation Management Terminal Value

ASSUMPTIONS

0.0% $100.0 MM 5.0% 20.0 X $100.0 MM $0.0 MM $0.0 MM Stage 1 Stage 2 $38.0 $0.0 $$$38.0 $0.0 Stage 1 Stage 2 38.0% 0.0% 38.0% 0.0% 0.0 Total $100.0 MM

Copyright 1999 President and Fellows of Harvard College

Venture Capital Valuation

Simple Two Stage Investment Shares Outstanding (000's) Founder Stage 1 Stage 2 Management Total Equity Ownership % Founder Stage 1 Stage 2 Management Total Pre-Money Valuation ($MM) Founder Stage 1 Stage 2 Management Total Share Price Founder 1,000 Stage 1 1,000 612 Stage 2 Terminal 1,000 1,000 612 612 0 0 0 1,612 1,612 Stage 2 Terminal 62.0% 62.0% 38.0% 38.0% 0.0% 0.0% 0.0% 100.0% 100.0% Stage 2 Terminal #N/A 62.0 #N/A 38.0 #N/A 0.0 0.0 #N/A 100.0 #N/A $62.03

Simple Model

1,000 Founder 100.0%

1,612 Stage 1 62.0% 38.0%

100.0%

100.0% Stage 1 8.2 5.0

13.2 $8.17

Copyright 1999 President and Fellows of Harvard College