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VENTURE VALUATION

SS 2002

AN INTRODUCTION TO THE VENTURE CAPITAL METHOD

This note provides an introduction to the Venture Capital Method as a way of valuing highrisk long-term investments. Innovative ventures, who make up for the majority of Venture Capital Investments are characterized by negative cash flows and earnings for a significant amount of time, followed by expected rewards of extraordinary size. Valuing these companies at an early stage of their lifecycle bears noticable difficulties, as the vast majority of the firm value lies in the future. Thus, in those cases the saying that valuation is more an imprecise art than a mathematical science holds even more true than usually. Not rarely, due to the major element of judgement remaining and the often questionable validity of underlying data, traditional valuation methods and comparables may simply not work. Dealing with this dilemma, in these situations investors increasingly rely on the Venture Capital Method. This method has proved to be a useful technique to deliver a rough estimate of the current value of such future-oriented, uncertain investments. Therefore, especially in the US, this pragmatic approach, which takes an investor’s perspective instead of operating from the firm’s point of view (like for example the DCF method), is widely used among venture capitalists, business angels and other private equity investors. In section 1 the basic method is described. Due to their practical relevance this note covers both popular approaches to the Venture Capital Method. After explaining the steps of the procedure and pointing out the general case, these two approaches are illustrated by computing an actual example. Subsequently the basic proceeding is taken a step further in section 2 by putting dilutive effects into consideration. Again, the method is first explained for the general case and afterwards illustrated by computing the example. This note finishes with a look on some further sophistications like option pools or multiple investors.

This note was prepared by Postdoctoral Fellow Ron Engel at Stanford University as the basis for class discussion. Copyright © 2002 by the author. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means – electronic, mechanical, photocopying, recording, or otherwise – without author’s permission. To order copies or request permission to reproduce materials, send an email to ef.sekretariat@wi.tum.de. Version: 5/30/02

(2) This terminal value is then converted into a present value ( V0Post ) by applying a comparably high discount rate (r) stipulated by the investor. 1. Venture Capital Method applying the NPV-framework Step 1 Step 2 Estimating terminal value Determining present value eg. SP = 1− F Y 1 Corresponding to this. the pre money valuation would be V0 Pr e = V0Post − I . which itself is the sum of existing shares (X) and the new shares (Y) to be issued to the investor. As most students have had more exposure to the NPV framework. the emphasis of the course session will be on this approach. most often multiples (primarily comparable companies) are used.Teaching Note: An Introduction to the Venture Capital Method p. First a terminal value (Vt) of the company is estimated for the time of disinvestment (exit). the value of the company one logical second after the initial investment has been made. i. Some investors apply the concept of internal rates of return (IRR).2 General Case For the general case the described steps can be expressed by the following very simple equations.2 1 1. which means.1 For this conversion two ways of proceeding are common. The share price (SP) results from dividing the amount of the investment by the number of new shares being issued.: Vt = P/E Ratio * Earnings V0Post = Vt (1 + r ) t Step 3 Calculating demanded ownership fraction F= I V Post 0 Step 4 Obtaining number and price of new shares Y=X I F . in which the company fulfills all her and the investor’s expectations. (4) Expressed in terms of shares this fraction has to be set in relation to the number of total shares. (3) The ownership fraction (F) demanded by the investor is determined by the ratio of the amount of his investment (I) and this present firm value. The results are identical. This is called a post money valuation. that the investment by the investor (I) is already included.e. Nevertheless. To do so.1 The Basic Method Procedure (1) The Venture Capital Method follows a very simple pattern. . while others draw upon the net present value framework (NPV). Which comparable should be used in any given case depends on factors as the expected financial situation of the company and the industry it operates in. differences between the two practices are pointed out in this note. which also is a little more intuitive in some regards. this estimation is exclusively based on a success scenario. Following the basic Venture Capital Method.

The entrepreneurs try to raise external capital and pitch their idea to the early stage venture capitalist Easymoney (E).5 Mill. get typically valued with a sales multiple around 1.Teaching Note: An Introduction to the Venture Capital Method p.000 Mio.053. whose business model comes nearest to the one of C. Understanding this. Underlying this example is an actual Seed stage investment done by a German investor in 2001. 3. €. as the company does not expect to be profitable by the end of E’s investment horizon. there is a total of X = 250. Asking how many shares would E have to demand in this case. € * 1.580 .7. To secure anonymity all names have been replaced and all numbers slightly changed. the number of new shares being 0.5.1965 600.3 1. € = (1.000 shares.124 Step 4: Obtaining number and price of new shares As every one of the four founding entrepreneurs obtains 250.19652 ≈ 19. So a discount rate of 70% per year seems to be appropriate to them.000. which aims to offer software solutions in the field of human resources planning and services billing. At the moment the existing capital is divided equally among the 4 founding entrepreneurs who own 250 Tsd. shares each. €.053. The IT experts of E come to the conclusion that the market and the business model are undoubtedly attractive. 25.000 existing shares.65% . To reach their goals and get their company started they need 600 Tsd. Imagine a recently founded company Correx (C).580 with a share price of SP = € = 2. the Venture Capital Method provides the following results: Step 1: Estimating terminal value The estimation of the terminal value is done here by a sales multiple. € per year.000*4 = 1.5 Mill.4532 €. They state that at the end of E’s 4 year investment horizon they expect to have revenues of 17 Mill. Step 2: Determining present value Applying a discount rate of r = 70% = 0. = 244. €.3 Example To illustrate these steps (and further enhancements of the method) I will draw on the following example throughout this note.5 = 25.8035 244. Existing companies. E presently values C at V0Post = 3.7) 4 Step 3: Calculating demanded ownership fraction The ownership fraction to be demanded by E is F = 600. Her value 4 years from now is anticipated to be Vt = 17 Mill. but due to the lack of experience within the team and a couple of other reasons this is considered to be very risky business.124 Mill. issued to E is Y = 1 * 0.000 = 0.

5. 25.: Vt = P/E Ratio * Earnings W = I * (1 + i ) t F= W Vt F I . Step 3: Calculating the therefore needed ownership fraction To achieve this wealth by the given valuation at the terminal date.000 * (1 + 0.011.260 € by the end of year 4.000 €.4 1. the framing of this technique in the language of IRR is not discounting a future value to the present time but a forward looking way of determining the ownership fraction (and eventually the number of shares) to be demanded by the investor.19652 ≈ 19. Given this. which be will discussed in more detail.65% of C.500. E has to hold 5. that both approaches result in the same answers and figures. Assume E is asking for 70% IRR (represented by the variable i).7) 4 = 5.000 . €. At this point it is stressed again.260 F= = 0.011. SP = 1− F Y I or V0Post = SP * ( X + Y ) F Step 4 Y=X Step 5 Determining current valuation V0Post = V0Pr e = V0Post − I or V0Pr e = SP * X Using the above example the IRR-oriented approach proceeds as follows: Step1: Estimating terminal value The terminal value is estimated the same way as above.Teaching Note: An Introduction to the Venture Capital Method p. This rate of return equals the discount rate applied above. they will formulate a desired rate of return. Step 2: Determining desired future wealth by investor Whenever E invests in a company. E would like to attain W = 600. It is usually comparably high due to a number of reasons. V4 = 25. Mill. Again the general case can be expressed by some very simple equations: Venture Capital Method using the IRR-concept Step 1 Step 2 Step 3 Estimating terminal value Determining desired future wealth by investor Calculating the therefore needed ownership fraction Obtaining number and price of new shares eg. Again C needs an investment of 600.4 An alternative approach by applying the concept of IRR Other than the described approach to the Venture Capital Method.

So. The reason for thisis.without considering dilution – represents both. As new series of shares will be issued to future investors (actually those investors do not necessarily have to differ from the first round investor) the existing shareholders run the risk of getting diluted. Thus the staging of capital supply. the number of new shares to be issued to 0.053. but the amount of stock issued in the future partly depends on the amount of shares initially issued in the first round. also the future investors have to receive a higher stake to attain a given ownership fraction. these 19.19652 the total number of shares with the share price: V0Post = 2.000. how can this paradox be solved? (1) The starting point is the above derived ownership fraction F.4532 € * 1. However.000 €) within the 4 years of E’s investment horizon. Thus. the demanded ownership position after investing and the ownership . Venture Capital usually is staged over a number of rounds depending on the achievement of milestones and the development of capital needs. In reality single financing rounds usually do not take place.000 € buy 19.000. Therefore 100% or the whole company is 600. Being aware of this.19652 600.124 Mill. € = 244.580 Step 5: Determining current valuation Todays valuation can then be determined in more than one way.4532 € * (1.000 €. the early stage investor has to demand a higher ownership fraction. the value of the company before E’s investment of 600.8035 244.000.000 + 244.000 existing shares.65% should equal 600.e.000 E is Y = 1 * Mio. that they might lose part of their ownership due to the issuance of new shares. If 600. 2 2.5 Step 4: Obtaining number and price of new shares As above. The Pre Money valuation (i.1 Valuation assuming future dilution Problem and procedure In the example C was valued under the assumption.000 € = 2. to achieve his expected ownership position at the end of his investment horizon (terminal date). if more stock is issued to the earlier investor. to determine the necessary current ownership position.000). rather than raising one large lump sum in the first round often creates value for the founders of a venture. that it would only receive this one round of financing by E (600.600.65% of the company. Financing at later stages commands lower discount rates (and accordingly lower desired rates of return).4532 €. which .Teaching Note: An Introduction to the Venture Capital Method p. in other words they would have pay to much in first financing round.053.580 with a share price of SP = € = 2.580). not the whole company (without additional increases in capital) is any longer reference object for the ownership fraction but the – then larger – recapitalized company. This means. with a total of 1. 0.453. the earlier investor has to anticipate the amount of shares that will be issued in the future.000 valued at V0Post = € = 3.124 € (or 2.124 € . that without any changes in the investment amount I. €.000 €) consequentely is V0Pr e = 3. The same result is obtained by multiplying 0.

p. in the basic method F = F0Post = Ft holds true. Thus.2 This retention rate indicates how much of the initially determined ownership fraction will remain after the expected future financing rounds. This can be expressed by: RET = 1 − ∑ Fm . But compare Scherlis/Sahlman (1989). . Post Y 1 − F0 This step is to be repeated for the different financing rounds.Teaching Note: An Introduction to the Venture Capital Method p. the general case can be summarized as follows.6 fraction at the terminal date. 2. which will eventually be available to the current investor (and therefore base for his ownership fraction). This changes by assuming dilution. For the several relevant points of time (terminal date of current investor AND every date of capital increase) quantity and price of the shares can be calculated. m =1 n (2) Getting Ft = RET back Ft n to the equation before F0Post can now be calculated as F0Post = 1 − ∑ Fm m =1 (3) Based on F0Post the following steps match the procedure of section 1. As F0Post is sought after and F0 unknown at this stage. this equation per se is not sufficient for determining RET.2 The general case Adding these steps to the above described basic method. but you should pay attention to inserting the appropriate number of total shares at each time. Now Ft is expected to be considerably smaller than F0Post . 48 about the then arising circularity problem. 2 An alternative way would not draw upon the retention rate but directly upon the rate of dilution. But RET can also be thought of as the remaining share of the venture. For our seed investor this can be expressed F0Post I formally by Y * = X and SP * = * . To determine the extent of dilution. In other words this rate represents the ratio of the diluted final ownership fraction (Ft) and the current ownership Ft fraction being demanded by the outside investor: RET = Post . the application of the so called Retention Rate (RET) seems to be the best way.

this money is invested by another VC-company called Laterbird (L). 1 − F0Post I SP * = * Y Keep in mind that depending on the number of future investors and financing rounds you might have to exert step 4(a) as many times as there are future investments. Considering dilution Post Vtd = Vt (1 + r ) t −td . €.: Vt = P/E Ratio * Earnings V0Post = Vt (1 + r ) t Step 3 Calculating demanded ownership fraction F= I V Post 0 Step 4 (a) Calculating ownership fractions for dilutive (future) investments by pursuing steps 1-4 for those cases. Let us assume. the discount factor (i. Consequently.3 Example Going back to the example of Correx. which dilute the existing ownership positions.Teaching Note: An Introduction to the Venture Capital Method p. let us assume. . 2. F= I V Post td with td as time of dilutive investment (b) Determining Retention Rate RET = 1 − ∑ Fm m =1 n (c) Calculating increased demand of ownership fraction (dilution adjusted) Step 5 Obtaining number and price of new shares F0Post = Ft RET Y* = X F0Post .e. After this period of time C expects to be ready for market entry and intends to raise an additional 1. that ceteris paribus the initial investment is planned to provide enough liquidity for the first two years. where overall risks are normally considered to be noticeably lower.5 Mill.or expansion stage investment. As this time E’s E’s business concept will be developed further and it will not be considered as a seedinvestment but a start-up.7 Venture Capital Method (NPV) considering multiple rounds of financing Step 1 Step 2 Estimating terminal value Determining present value eg. the desired rate of return) will also be significantly lower – in this example 40%.

8 Step 1-3 are exactly the same as in section 1.010. L would value C in year 2 (the time of 25.7779 600. E’s 0. Therefore V2 4 = 13. Keep in mind. E’s retention rate is RET = 1-0.1153 = 0. Step 4(a): Calculating ownership fractions for dilutive (future) investments Then in step 5 (a) exactly the same calculations are done from L’s point of view.1965 time is calculated as F0Post = = 0.21% of the remaining 88.47% of the company. In our case the number of existing shares is 1.47%.500. Starting with the valuation at the end of year 4: V4 = 25. In other words by increasing her demanded ownership fraction E would be able to fully compensate the anticipated dilution caused by the financing round in year 2.000 + 285.4 Step 4(c): Calculating increased demand of ownership fraction To compensate for this dilution the increased ownership demand of E at the current point of 0. That is the sum of the founders’ shares and all other shares. the existing owners of the firm (the founders and E) would retain only 88.8847 4 E will not hold 22. but be sure to insert the correct total number of shares.500. €. . 285. the pre money valuation amounts simply this figure subtracted by the amount of the Pr e investment.4) as IL=1. which equals 19. The number of shares being issued to L 3 As said before.3. repeat this step.65% of the company.512 If you want to determin the number of shares to be issued to L as well. the value of these shares equals the pre money valuation in year 2 as a pre money valuation measures precisely the value for existing owners of a firm.204 Step 4(b): Determining Retention Rate Knowing that.000 € this investor would demand an ownership fraction of 1.010. that at the end of year 0.000.53%.512 shares with a share price 0. Not coincidently.204 €.21% .3 Given the amount of the investment 4−2 (1 + 0.8847 = 88.000.47% of the company’s shares altogether.5.204€ − 1.000 L’s investment) at V 2Post = € = 13. which have been issued to earlier investors.512.11529 ≈ 11. = 285.000€ = 11. Mill.000 FL = = 0. In other words.512 = 1.010.1015€ . 13.Teaching Note: An Introduction to the Venture Capital Method p. Step 5: Obtaining corresponding number and price of new shares Obtaining the resulting number and price of shares again works like in section 1.285.2221 demanded ownership fraction equals Y * = 1 * Mio.21% of the company but 22.204 €.000 of SP * = € = 2.2221 = 22.500.510.

considering and compensating the dilution of his stake. As the post money valuation is not affected by this.512 €.9 therefore is Y = 1. In cases. As the post money valuation (and the pre money valuation) by E would be unaffected. which will not get explored further at this point. shares. 2.500.2) already assumes the possibility of several financing rounds. pooling of value adding expertise. instead of 250 Tsd. More than one investor per round In the real world financing rounds . There are various reasons for such syndicated investments. In the case of two or more dilutive issuances of shares one has to proceed backwards from the last anticipated financing round (this investor is the only one.Teaching Note: An Introduction to the Venture Capital Method p.466 shares (without dilution) respectively 342. Especially technology-oriented ventures have to use this incentive instrument to a large degree to attract the best talent. Multiple financing rounds The general formulation of the Venture Capital Method (Section 2.0445 € (without dilution) or 1. Expressed in numbers. shares. The easiest way to account for those option pools is to assume that they are fed from the founder’s shares. the number of shares to be issued to E will increase by 20% (since 1. who will not get diluted). Since .285.2 Mio. Sometimes option pools are not established before a point of time when the venture is a little further developed. For the Venture Capital Method the implications are little. The first case implies that every founder now holds 200 Tsd.7512 € (with dilution).000 new shares for the option pool would lead to a total of 1. the increase of capital for the option pool is treated the same way as every issuance of new shares (anticipation of dilution by earlier investors).000 shares is established. dealflow-considerations.1153 1. like risksharing. when this takes place after the first financing round.615 shares (considering dilution) for a share price of 2. Imagine that in the example given above an option pool of 200.are carried out by more than one investor. or this amount of shares is issued for this purpose.2 Mio. Eventually.536 1 − 0.) and the share price decrease by 20%.95 167. E invests 600 Tsd. In this case the calculations do not change much. calculating the demanded ownership fraction of every investor.especially if it is not the first round . the demanded ownership fraction of the current investor (in our case E) can be computed.4 Steps beyond 0. € and demands 293.536 with a share price of SP = € ≈ 8.1153 Treatment of option pools Newly founded start-ups issue shares not only to investors to attain financing but also to provide incentives for their employees. Combined with the option pool the entire sum of share still totals 1 Mio.=120%*1 Mio. An issuance of 200.000 ≈ 167. either the amount of shares held by each founder is reduced by the relevant amount of shares. shares.

which corresponds to his part of the total investment sum.Teaching Note: An Introduction to the Venture Capital Method p. . the same applies. For the current round. Subsequently.10 split pricing is uncommon one can pool syndicated investments and treat investors of each future round as one big investor. every current investor demands an ownership ratio (expressed in a certain number of shares).

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