venture capital

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Contents

Introduction This sheet

Assumptions Primary data entry sheet

Simple Model 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 Formula

IPO Value $120Present Value $54.60Required equity at Exit 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.

$15 EBIT @ 8x IPO multiple

$120/(1+30%)^3

10/54.6

Venture Capital Valuation INTRODUCTION

Venture Capital Valuation INTRODUCTION

Adjusting for Dilution

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. Let’s 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 Formula

IPO Value $120Present Value $100Required equity at Exit 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)

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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.

$15 EBIT @ 8x IPO multiple

$120/(1+20%)^1

10/100


Stage 1 Stage 2

$5.0 $0.0

50.0% 30.0%

5.0 3.0

1,000,000

0.0%

$100.0 MM

5.0%

20.0 X

100.0$ MM

$0.0 MM

$0.0 MM

Terminal Calculations Stage 1 Stage 2 Total

Total Terminal Value $38.0 $0.0 100.0$ MM

Return of Principal -$ -$

Equity Value Required $38.0 $0.0

Terminal Share Stage 1 Stage 2

Equity Ownership 38.0% 0.0%

Pre-Money Valuation 38.0% 0.0%

Management Terminal Value 0.0

Return of Stage 2 Principal

Terminal Net Margin

Terminal PER

Terminal Value of Enterprise

Return of Stage 1 Principal


Investment Rounds

Investment Amount

Required Stage 1 ROR

Years to Terminal Stage

Shares outstanding before investment

Terminal Stage

Terminal Management Share

Terminal Sales

Venture Capital Valuation ASSUMPTIONS

Shares Outstanding (000's) Founder Stage 1 Stage 2 Terminal

Founder 1,000 1,000 1,000 1,000

Stage 1 612 612 612

Stage 2 0 0

Management 0

Total 1,000 1,612 1,612 1,612

Equity Ownership % Founder Stage 1 Stage 2 Terminal

Founder 100.0% 62.0% 62.0% 62.0%

Stage 1 38.0% 38.0% 38.0%

Stage 2 0.0% 0.0%

Management 0.0%

Total 100.0% 100.0% 100.0% 100.0%

Pre-Money Valuation ($MM) Stage 1 Stage 2 Terminal

Founder 8.2 #N/A 62.0

Stage 1 5.0 #N/A 38.0

Stage 2 #N/A 0.0

Management 0.0

Total 13.2 #N/A 100.0

Share Price $8.17 #N/A $62.03

Simple Two Stage Investment


Venture Capital Valuation Simple Model

venture capital

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