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OUTREACH NETWORKS

OUTREACH NETWORKS: FIRST


VENTURE ROUND
QUESTION 1:
Why do Everest Partners require a 30% equity stake in Outreach Networks in exchange
for an early-stage investment of $30 million? Show how Everest would justify requiring this
stake using the Venture Capital valuation methodology.
The valuation of the funding negotiations that are just about to start is a difficult task.
There are many methods which can determine the worth of the investment of the Venture
Capital. The Venture Capital valuation method was created by the Professor of Harvard Bill
Sahlman in the year 1987.
The valuation of the investment of Everest Partners has been done on the basis of Venture
capital valuation method. In order to calculate the value of the company or the terminal value at
the time of exit, the projected net income of the 6th year has been taken. This year has been
assumed to be the exit year for the venture capital firm. The case states that the anticipated return
on investment for Everest Partners is 40% to 60%. An average of this range which is 50% has
been used as the anticipated return of investment of the venture capital investment till year six.
The price-earnings multiple used in this calculation is the industry average price earnings ratio
which is assumed as similar to that of Outreach Network Company. Based on this information,
the valuation of the company has been calculated by discounting the terminal value of the
company to present value. The value of the company is $207.96 based on the venture capital
valuation method.
As the initial investment by the venture capital company is $30 million, therefore, based
on this the equity stake of the venture capital is around 14.43 % under the PE multiple method
and it is 23.03% under the EBITDA multiple method.. Also the post-money valuation would be
$207.96 million. This means that when the venture capital firm will exit in the sixth year, then it
could increase the wealth of the shareholder of Outreach Networks by $207.96 million (PE

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multiple method) or $130.26 million (EBITDA multiple method) and in this way the venture
capital firm can also earn a return on its investment of around 40% to 60%. Based on these
calculations the price per share would also be increased by $4.16 ($ 2.61 under EBITDA
multiple) by the time the venture capital firm will exit. Venture capital valuation method is
normally used in situations when the exit year and the exit value of the venture capital firm could
be estimated with certainty. In the case of Everest Partners, we can easily estimate the exit value
of the company. Based on these facts, the post money valuation is calculated in present value
terms today which take into account the risks and the time the investor takes to earn his target
rate of investment return. The calculations performed in the spreadsheet show that the value of
the company would increase after the venture capital funding is provided. The calculations
justify the equity stake which is required by the venture capital firm in Outreach Networks.
QUESTION 2:
Is Outreach Networks a typical start-up company seeking Venture Capital funding? Can
Perez argue that any of its particular characteristics mean that Everest should get a smaller equity
stake than the 30% they are asking for? Justify your answer with numerical analysis.
The Outreach Networks revenues had grown from around $9 million in the year 2009 to
$63 million in the year 2011. This is a very huge and rapid growth and it shows that the company
has been in the operations since almost 3 years. The companys revenues are also dispersed
throughout the major geographical areas of the world. 35% of the total revenue for the company
comes from Middle East, Europe and Africa, 31 % comes from North America, 26 % comes
from South America and the remaining 9% of revenue comes from Asia Pacific.
If the company goes for the venture capital funding options, these funds would be used
by the company to expand the scale of the companys operations and further expand the business
in the international markets quickly as compared to the current situation. The company has been
successful till date and it was now considering the option for Initial Public Offering in the next
few years. As the business was expanding, therefore, it would become necessary for the company
to raise equity financing in order to finance its future capital investments and other business

OUTREACH NETWORKS

expansion needs. The venture capital funding would also help the company to achieve this
objective in future.
The current offer for acquiring the 30% of Outreach Networks total worth has been
decided by the management at $30 million. However, the CEO and the founder of Outreach
Networks had argued that the equity stake of around 30% was very high for an amount of $30
million. He proposed that looking at the success and the past performance and also the rapid
expansion of the business without seeking any venture capital funding, the$30 million funding
should be worth only about 15 % of the total value of the company. Therefore, in order to justify
the equity stake of 30% and 15% for $30 million, the net present value calculations and the
returns on the investments have been calculated under both the scenarios. In the first scenario in
spreadsheet, 30% stake with $30 million investment funding, the net present value of the
company is found to be $40.49 million with a return on investment of around 64%. However, in
the second scenario, the equity stake is considered to be 15 % for $30 million. Based on this, the
net present value of the company is calculated as $56.09 million with the return on investment of
32%. Therefore, from the perspective of the CEO of Outreach Networks, it is in the best interests
of the company not to avail the venture capital funding by offering 30% equity stake but it
should propose that Everest Partners acquire 15 % of the stake for $30 million, but this would
then decrease their return on investment which would be less than their average 50 % return on
investment.
QUESTION 3:
Carry out a Discounted Cash Flow valuation on Outreach Networks that Perez could use to
determine the value of the company if it accepts Everest Partners investment. Critically compare
the DCF valuation with the VC methodology. What are some of the differences between a target
rate under the VC method and a market-adjusted rate, such as that obtained from the Capital
Asset Pricing Model (CAPM), used in carrying out a DCF Valuation?
The discounted cash flow valuation is a method under which the future cash flows for the
business are projected based on certain assumptions. These are then discounted back at an
appropriate weighted average cost of capital and a terminal value is also calculated based on the

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perpetuity value of the business in the foreseeable future. Summing up all these present values
and the terminal values gives us the enterprise value of the company.
The future free cash flows have been provided in the case exhibit 1. The cash flows have
been projected for 6 years from 2012 to 2017. In order to discount back these free cash flows to
present value, an appropriate discount rate has been calculated. In this case, the company
Outreach Networks is 100 % equity financed, therefore, cost of equity has been calculated based
on the information provided in the case. The risk free rate of 5% and the premium on market
return of around 6% is given in the case. The average of beta of the comparable companies has
been used in order to calculate the cost of equity for Outreach Networks. The average of Beta has
been taken here for two reasons. The first reason is that Outreach Networks beta is not given and
there is no valid information to calculate its beta. Secondly, the comparable of Outreach
Networks are operating in the same industry; therefore, the systematic risks would be more or
less same. Based on this information the future cash flows have been discounted. The terminal
value has also been calculated and the terminal growth rate of 3% has been assumed in this type
of industry taking a conservative approach. Also the present value of the funds that would be
received has been calculated for 6 years which is $20.57 million. Adding all these present values
the total enterprise value is $2743 million and $54.87 on a per share basis.
DIFFERENCES IN TARGET RATE & COST OF EQUITY
The target rate of return for a venture capital firm is the rate which measures the
justifiable rate of return over the investments made by the venture capital companies. This risk
incorporated the risks that are taken by the venture capitals to provide the funding to the newly
set-up companies. Another difference is that the target rate of return is usually set at a very high
level as compared to the traditional cost of equity of the company. Since, most of the venture
capital firms invest in companies that are in their early stages and they do not have a long track
record and also the future earnings prospects of the company are highly volatile, therefore, the
venture capital companies perform their valuation based on the target rate of return at the
planned exit date. However, the cost of equity on the other hand is used to discount the cash
flows of 100% equity financed company.

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QUESTION 4:
Given the high equity stake that Everest Partners is demanding, should Perez take the VC
funding? Estimate the DCF valuation of Outreach if it does not receive the funding from Everest
Partners, stating your assumptions. Critically analyze whether accepting the investment from
Everest Partners in exchange for 30% of the equity makes sense for Perez and the other
shareholders compared to choosing a go it alone approach.
The above discounted cash flow valuation for the company was performed after
incorporating the present value of the investment funds received by the venture capital company.
However, here the discounted cash flow valuation has been performed on the basis of the same
free cash flows from 2012 to 2017. All the calculation performed here are similar to the above
scenario, however, the present value of the venture capital funding has not been incorporated in
the calculations performed.
The enterprise value after the incorporation of the venture capital funding is around
$2743 million and without the venture capital funding the enterprise value is $2722 million. The
enterprise value is higher with the inclusion of the venture capital funding; however, there is no
significant increase in the wealth of the shareholders. Also, the previous calculation examined
the impact of either acquiring 30% or 15% of the stake also shows that, if the owners of Everest
Partners do not reduce their demand for acquiring 30% of the stake to 15% for $30 million, the
CEO of Outreach Networks should not accept this offer. However, if the owners of Everest
Partners still demand 30% stake in the company, then the offer should be declined and the
company should operate on a go alone approach. This would be in the best interests of the
company in the long term.

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REFERENCES

http://www.angelscorner.com/articles/valuation_methods.htm

http://www.venturevaluation.com/en/methodology/valuation-methods

www.vcmethod.com/basic

http://www.angelscorner.com/articles/valuation_methods.htm

http://kameir.com/understanding-the-venture-capital-valuation-method/

BIBLIOGRAPHY

Chang, S.J. (2004), Venture Capital Financing, Strategic Alliances and the Initial Public
Offerings of Internet Start-ups, Journal of Business Venturing, 19, 721-741.

Ernolde, P. (2000), Valuing Companies by Cash Flow Discounting - Ten Methods and
Nine Theories for Valuing Companies by Cash Flow Discounting, IESE Research Paper
No. 451, Navarra.

Hellman, T. and M. P. (2002), Venture Capital and the Professionalization of Startup


Companies: Empirical Evidence, Journal of Finance, 57, 169-197.

OUTREACH NETWORKS

APPENDIX
Ke FOR OUTREACH NETWORKS
Risk free Rate
Return on Market
Average Beta
Cost of Equity (CAPM)

5%
6%
1.49
6.49%
Venture Capital Method
Discount Terminal Value to Present Value

Annual Earnings(Projected NI)


In Year

$108.66

(at exit date)

(at exit date)

PE(multiple)

21.8

Required Rate of Return

50%

Value of firm

$207.96

Required Ownership Percentage


Initial Investment

$30.00

Equity Stake

14.43%

Total Outstanding Shares


Share Price
Post-Money Valuation

Funding Provided by Everest Partners


% of investment of Outreach Networks

50

(post)

$4.16
$207.96

$ 30 million
30%

If Everest Partners Acquire 30% of company for $ 30 million then:


Years
2012P
2013P 2014P 2015P 2016P 2017P
Investment
-30
$32.2 $40.8 $52.5 $66.6 $84.4
Total Free Cash flow
$20.39
6
0
8
7
6
$12.2 $15.7 $20.0 $25.3
30% of Free cash flow
$6.12 $9.68
4
7
0
4
($23.88
$12.2 $15.7 $20.0 $25.3
Net cash flows
) $9.68
4
7
0
4
NPV
$40.49

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Return on $ 30 million investment

64%

If Everest Partners Acquire 15% of company for $ 30 million then:


123.2
Years
38.16 59.13
75.4 97.18
3
Investment
-30
$32.2 $40.8 $52.5 $66.6
Total Free Cashflow
$20.39
6
0
8
7
$12.2 $15.7 $20.0
15% of Free cashflow
$3.06 $9.68
4
7
0
($26.94
$12.2 $15.7 $20.0
Net cash flows
) $9.68
4
7
0
NPV
$56.09
Return on $ 30 million investment
32%

YEARS
Free Cash Flow
Terminal Value
PV of Cash Flows
PV of funding received
ENTERPRISE VALUE
Per share Value
VC Target rate of return
Market adjusted rate

155.2
3
$84.4
6
$25.3
4
$25.3
4

DCF VALUATION WITH FUNDING


2012P 2013P 2014P 2015P 2016P 2017P
$20.39 $32.26 $40.80 $52.58 $66.67
$84.46
$
2,493.85
$228.88
$20.57
$
2,743.31
$
54.87
50%
6.5%

DCF VALUATION WITHOUT FUNDING


YEARS
2012P 2013P 2014P 2015P 2016P 2017P
Free Cash Flow
$20.39 $32.26 $40.80 $52.58 $66.67
$84.46
Terminal Value
$
2,493.85
PV of Cash Flows
$228.88
ENTERPRISE VALUE
$
2,722.73
Per share Value
$
54.45
VC Target rate of return
50%
Market adjusted rate
6.5%

OUTREACH NETWORKS