PRIVATE EQUITY VALUATION

Valuation Issues in Venture Capital Transactions

There are two fundamental concepts in venture capital (VC) transactions:

• Premoney valuation (PRE) refers to the agreed value of the company prior to a
round of investment (I).
• Postmoney valuation (POST) refers to the value of the company after a round of
investment.

POST = PRE + I ... Equation 1

The proportionate ownership of the VC investor is calculated as: I/POST.

See Example 3-2.

Example 3-2: Investment and Ownership Interest of a VC Firm

A VC firm invested $6m in a company currently valued at $9 million. Calculate the

postmoney value and the ownership proportion of the VC firm.

Solution:

Postmoney value = Premoney value + Investment

= 9 million + 6 million = $15 million

Ownership proportion of the VC firm = 6 million/15 million = 40%

Factors That M ust Be Considered in Venture Capital Valuation

• Negotiations between the VC firm and the founder(s) of the portfolio company
determine the premoney valuation and the amount of venture capital investment.
The VC firm must bear in mind that its ownership stake in the company will be
diluted if (1) the company requires subsequent rounds of financing, (2) convertible
securities are converted into equity in the future, and/or (3) stock options are issued
to management.
• It is fairly difficult to apply the discounted cash flow model to value venture
capital investments due to the uncertainty involved in estimating its future
cash flows.
• The relative value approach is also difficult to apply, as startups generally have
unique features and it is generally not easy to find comparable public companies in
the same field.
• A sa result, alternative valuation methodologies, including the real option
methodology and venture capital approach (described later in this reading) are used
to determine value.
• Generally speaking, the premoney valuation is based on the value of the company’s
intangible assets, including the founder’s knowhow, experience, patents, and an
assessment of the potential market for the company’s product(s).

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RVPI equals the value of LPs’ shareholdings held with the fund as a proportion
of cumulative invested capital.

RVPI = NAV after distributions/PIC

RVPI = 266.7/210= 1.27

TVPI equals the sum of DPI and RVPI.

TVPI = DPI + RVPI = 2.4129

The TVPI indicates that when realized and unrealized returns are combined, LPs
should expect to earn almost 2.5 times their investment in the fund once all the
fund’s investments have been harvested.

LESSON 6: VALUATION OF VENTURE CAPITAL DEALS

LOS 41j: Calculate pre-money valuation, post-money valuation,

ownership fraction, and price per share applying the venture capital method
1) with single and multiple financing rounds and 2) in terms of IRR. Vol 6,
pp 166-177

The Basic Venture Capital Method (in Terms of NPV)

The basic venture capital method using the NPV framework requires the following steps.
The calculations and the rationale behind them are illustrated in Example 6-1.

Step 1: Determine the post-money valuation.

Step 2: Determine the pre-money valuation.

Step 3: Calculate the ownership percentage of the VC investor.

Step 4\ Calculate the number of shares to be issued to the VC investor.

Step 5: Calculate the price of shares.

Example 6-1: Applying the Basic Venture Capital Method with a Single Round of
Financing

The entrepreneur founders of Tiara Ltd. believe that in 5 years they will be able to
sell the company for $60 million. However, they are currently in desperate need of
$7 million. A VC firm that is interested in investing in Tiara estimates that the discount
rate commensurate with the relatively high risk inherent in the firm is 45%. Given that
current shareholders hold 1 million shares and that the venture capital firm makes an
investment of $7 million in the company, calculate the following:

1. Post-money value
2. Pre-money value
3. Ownership proportion of the VC firm
4. The number of shares that must be issued to the VC firm
5. Share price after the VC firm invests $7 million in the company

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Solution:

1. After receiving the $7 million, Tiara is expected to be worth $60 million in

5 years. Therefore, the post-money value of the company equals the present
value of the anticipated exit value.

Post-money value _____________ Exit value______________

(1 + Required rate of return)Numberofyearstoexit

= $9.3608m
1.45s
2. The pre-money value is calculated as the post-money value minus the VC firm’s
investment.

Pre-money value = Post-money value - Investment

= 9.3608 - 7 = $2.3608 million

3. The VC firm is investing $7 million in a company that will be worth $9.3608

million. Therefore, the ownership stake of the VC firm is calculated as:

Ownership proportion of VC investor = Investment

Post-money value
= 7/9.3608 = 74.78%

4. The current shareholders own lm shares and they have a 25.22% (= 100-74.8% )
equity interest in Tiara. The number of shares that must be issued to the VC firm
such that it has a 74.78% ownership stake is calculated as:
Shares to be issued
_ Proportion of venture capitalist investment x Shares held by company founders
Proportion of investment of company founders

0.7478 x 1 million = 2,965,143

(1 -0.7478)
5. The price per share is then calculated as:
Amount of venture capital investment
Price per share =
Number of shares issued to venture capital investment
= 7,000,000/2,965,143 = $2.36 per share

Venture Capital Method in Terms of the IRR

The venture capital method can also be explained in terms of the IRR. Whether based on
NPV or IRR, the venture capital method gives exactly the same answer. The IRR method
involves the following steps. The calculations and the rationale behind them are illustrated
in Example 6-2.

Step 1: Calculate the future wealth required by the VC investor to achieve its desired IRR.

Step 2: Calculate the ownership percentage of venture capital investor.

Step 3: Calculate the number of shares to be issued to the venture capital investor.

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Step 4: Calculate the price of shares.

Step 5: Determine the post-money valuation.

Step 6: Determine the pre-money valuation.

Example 6-2: Applying the IRR-Based Venture Capital Method

Work with the information from Example 6-1 (regarding Tiara Ltd.) and calculate the
following using the IRR-based venture capital method.

1. The future wealth required by the VC to attain its desired IRR

2. Ownership percentage of the VC firm
3. The number of shares that must be issued to the VC firm
4. Stock price per share
5. Post-money value
6. Pre-money value

Solution:

1. First we need to determine the amount of wealth the VC needs to accumulate

over the 5 years to achieve the desired return of 45% on its $7m investment
in Tiara.

Required wealth = Investment x (1 + I R R ) Number of years to exit

= 7m x (1 + 0.45)5 = $44.868m

2. The percentage ownership that the VC firm requires to achieve its desired 45%
return on a $7 million investment is calculated by dividing the required wealth
by the expected value of the company at exit:

Ownership proportion = Required wealth/Exit value

= 44.868m/60m = 74.78%

3. The current shareholders of Tiara hold lm shares in the company and have an
equity stake of 25.22% = (100% - 74.78%). The number of shares that must be
issued to the VC firm so that it owns 74.78% of Tiara is calculated as:

Shares to be issued
_ Proportion of venture capitalist investment x Shares held by company founders
Proportion of investment of company founders

0.7478 x 1 million 2,965,143

(1 -0.7478)

4. Given that the VC firm is investing $7m in Tiara, the price of a share is
calculated as:
_ . , Amount of venture capital investment
Price per share = —— -----— ------- :------ ------------------- :—z-.-------------
Number or shares issued to venture capital investment
= 7,000,000/2,965,143 = $2.36 per share

(74
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5. The post-money value can be calculated in two ways:

• An investment of $7 million gives the VC firm a 74.78% equity interest

in Tiara. Therefore, the post-money valuation of the company is
calculated as 7m/0.7478 = $9.3608m (allowing for rounding error).
• Alternatively, there are 3,965,143 (= 1,000,000 + 2,965,143) shares in the
company that are each worth $2.36. Therefore, the value of the company
equals 2.36 x 3,965,143 = $9.3608m (allowing for rounding error).
6. The pre-money value can also be calculated in two ways:

• The pre-money value can be calculated as the post-money value minus

the amount invested by the VC: $9.3608m - 7m = $2.3608m.
• Alternatively, we can multiply the number of shares held by the current
shareholders by the price per share: lm x 2.36 = $2.3608m (allowing for
rounding error).

Venture Capital Method with Multiple Rounds of Financing

When there are 2 rounds of financing, the venture capital method requires the following
steps (see Example 6-3):

Step 1: Define appropriate compound interest rates between each financing round.

Step 2: Determine the post-money valuation after the second round.

Step 3: Determine the pre-money valuation after the second round.

Step 4: Determine the post-money valuation after the first round.

Step 5: Determine the pre-money valuation after the first round.

Step 6: Determine the required ownership percentage for second round investors.

Step 7: Determine the required ownership percentage for first round investors. Note that
this is not their final ownership percentage as their equity interest will be diluted in the
second round.

Step 8: Determine the number of shares that must be issued to first round investors for them
to attain their desired ownership percentage.

Step 9: Determine price per share in the first round.

Step 10: Determine the number of shares at the time of the second round.

Step 11: Determine the number of shares that must be issued to second round investors for
them to attain their desired ownership percentage.

Step 12: Determine price per share in the second round.

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Example 6-3: Applying the Basic Venture Capital Method with Multiple Rounds of
Financing

Suppose Tiara Ltd. actually intended to raise $10 million. However, doing so in a single
round of financing would not have been feasible as it would have led to a pre-money
valuation of -$0,639 million. Therefore, the company decided to undertake an initial
financing round worth $7 million and to follow that up with another financing round
worth $3 million after 4 years. The entrepreneur founders still believe the company’s
exit value will be $60 million at the end of 5 years. Given that investors in the second
financing round feel that a discount rate of 25% is appropriate, calculate the price per
share after the second round of financing.

Solution:

First we compute the compound discount rates:

Between first and second round =(1.45)4 = 4.4205
Between second round and exit = (1.25)1= 1.25
Then we calculate the post-money value after the second round by discounting the
terminal value for 1 year at 25%.

POST2 = 60/1.25 = $48 million

Then we compute the pre-money value at the time of the second round by deducting the
amount of second round investment from POST2.

PRE2 = POST2-Investment 2
= 48m - 3m = $45m

Then we compute the post-money value after the first round by discounting the pre-
money valuation at the time of the second round at 45% for 4 years.

POSTJ = P R E 1/(1 + r l) 1
= 45m/4.4205 = $10.18m

Then we compute the pre-money value at the time of the first round by deducting the
first round investment amount from POST!.

PREi = POST i - Investment!

= 10.18m - 7m = $3.18m

Then we determine the required ownership percentage for second round investors who
will contribute $3 million to a company that will be worth $48 million after they make
the investment.

F2 = Investment2/POST2
= 3/48 = 6.25%

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Then we determine the required ownership percentage for first round investors. First
round investors put $7 million into a company that will be worth 10.18 million after they
make the investment. Note that this is not their final ownership percentage as their equity
interest will be diluted by a factor of (1 - F2) in the second round.

F i = Investment!/POST l
= 7/10.18m = 68.76%

Then we determine the number of shares that must be issued to first round investors
for them to attain their desired ownership percentage and the price per share in the first
round.
This implies
Number of new shares issued! = lm x [0.6876/(1 - 0.6876)] = 2,201,376 that after the
second round, the
entrepreneurs and
Price per share! = 7,000,000/2,201,376 = $3.18 per share first round investors
would hold a
combined 93.75%
Then we determine the number of shares that must be issued to second round investors stake in the company.
This stake is worth
for them to attain their desired ownership percentage and the price per share in the 0.9375 x 48m = 45m,
second round. The important thing to note here is that the existing number of shares at which is also the
pre-money valuation
the time of the second round equals the lm shares held by the entrepreneurs plus the at the time of the
second round.
2,201,376 shares issued to first round investors. This is why we must work from the
earliest financing round to determine the number of shares and price per share.
The final ownership
Number of new shares issued = 0.0625 x [(lm + 2.201m)/(l - 0.0625)] = 213,425 stake (after second
round dilution) of
first round investors
equals 0.9375 x
Price per share = 3,000,000/213,425 = $14.06 per share 0.6876 = 64.47%.

For more than two rounds of financing, the procedure is an extension of the one described
above:

• First define the compound discount rates between all rounds.

• Then find the post- and pre-money valuation by working backward from the
terminal value to the first round. For each round, discount the pre-money valuation
of the subsequent round to get the post-money valuation of the round.
• Given the post-money valuations for each round calculate the required ownership
percentages.
• Finally, compute the number of shares to be issued and price per share starting
from the first round.

Estimating the Terminal Value

Multiples-based approaches for estimating terminal value have the following drawbacks
when it comes to venture capital/private equity:•

• It is difficult to come up with a good estimate of earnings (in order to apply an

earnings multiple) particularly in new or emerging industries.
• It may be easier to estimate sales or assets, but then it can be difficult to find truly
comparable companies/transactions to extract benchmark multiples from.
• Multiples extracted from similar transactions in the industry may be inflated if
those transactions occurred in an over-exuberant market.

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For the NPV, CAPM, APT, and other equilibrium valuation models, it is difficult to come
up with reasonable cash flow forecasts so valuations obtained from these models are as
likely to be inaccurate as those estimated by applying multiples.

LOS 41k: Demonstrate alternative methods to account for risk in venture

capital. Vol 6, pp 171-172

Venture capitalists typically apply very high discount rates when evaluating target
companies for the following reasons:

• VC firms must be compensated for the significant nondiversifiable risk inherent in

portfolio companies.
• Estimates of terminal value do not necessarily reflect expected earnings. They
reflect future earnings in some kind of success scenario.

There are two ways of dealing with this:

• Adjusting the discount rate so that it reflects (1) the risk of failure and (2) lack of
diversification (see Example 6-4).
111 1
o Adjusted discount rate = --------
" “ *

or = Discount rate unadjusted for probability of failure.

oq = Probability of failure.
• Adjusting the terminal value using scenario analysis (see Example 6-5).

Example 6-4: Accounting for Risk by Adjusting the Discount Rate

A venture capital firm is considering investing in a private company involved in

generating power through alternative sources of energy. The discount rate after
accounting for systematic risk is 35%. However, the venture capital firm believes that the
founders of the private company are too optimistic and that the chance of the company
failing in any given year is 20%.

Calculate the adjusted discount rate that incorporates the company’s probability of
failure.

Solution:

Adjusted discount rate = -1—

“I- r
- - 1

= \ +_°q 32 ~ 1 = 68.75%

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Example 6-5: Accounting for Risk by Adjusting the Terminal Value Using Scenario
Analysis

Compute the terminal value estimate for Blue Horizons Pvt. Ltd. given the following
scenarios and their probability of occurrence:

1. The company’s earnings in Year 5 are $13 million and the appropriate exit price-
to-eamings multiple is 8. The probability of occurrence of this scenario is 65%.
2. The company’s earnings in Year 5 are $6 million and the appropriate exit price-
to-eamings multiple is 5. The probability of occurrence of this scenario is 25%.
3. The company fails to achieve its goals and has to liquidate its assets in Year 5
for $5 million. The probability of occurrence of this scenario is 10%.

Solution:

Terminal value in scenario 1 = 13m x 8 = $104 million

Terminal value in scenario 2 = 6m x 5 = $30 million

Terminal value in scenario 3 = $5 million

Expected terminal value = (104m x 0.65) + (30m x 0.25) + (5m x 0.1) = $75.6 million

Some final notes:

• The results of any method of valuation depend on the assumptions employed.

• Our purpose here is not really to determine the true value of the company, but to
establish a ballpark figure that can be used by venture capitalists and entrepreneurs
in negotiations over how the returns of the venture should be split.
• The actual split depends primarily on the relative bargaining power of the parties.

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