Valuing Companies

Valuing Companies
• Getting the valuation correct in a Private Equity setting
is extremely difficult.
• Valuation techniques are based on the company’s
stage of development.
➢ For Venture Capital investment in early-stage
companies, valuation is used as a tool to determine
the equity stake a VC firm requires for a given amount
invested.
➢ For Growth Capital, and buyout investment in mature
companies, valuation is typically based on the target’s
profits, its operating cash flows and multiples of
comparable businesses.
Target Valuation 2
 Valuing Companies

Valuation
Methods

Early Later
Stage Stage

Venture
Without With High
Capital
Leverage Leverage
Method

Intrinsic Valuation
LBO Valuation
– DCF / Relative

Target Valuation 3
Valuing Early-Stage Companies
 Valuing Early Stage Firms
• The Venture Capital Method is widely used to value a
firm in the early stage.
• It is basically a simplified version of the NPV method
but devoid of the details associated with the more
widely used DCF method.
• Simplifications are justified by the uncertainty
associated with projecting many of the inputs required
by DCF method.

Valuing Early Stage Firms 5

 Venture Capital Valuation Method
Given:
• Investment requirement : Rs 3.50 Mn
• Projected Turnover : Rs 25 Mn by the 5th year
• PAT Margin : 10% of sales
• Min. Hurdle rate of return : 50% (5 year horizon period)
• Exit P/E : 15x
1. Value of Initial Investment 3.50 *(1.50)5 = Rs. 26.60 Mn
2. Market Capialisation after 5 years (25*10%)*15x = Rs. 37.50 Mn
(Earnings * P/E) (Exit Value)
3. % age of VC’s Ownership 26.60/ 37.50 = 70.9%
(Value of VC’s Ownership / Total Value)
4. Post-Investment value of Firm, today 3.50/70.9% = Rs. 4.94 Mn
(Post-Money Value)
5. Less: Investment by VC made today Rs. 3.50 Mn
6. Pre-Investment Value of firm (4-5) Rs. 1.44. Mn (Pre-Money Value)
Valuing Early Stage Firms 6
 Venture Capital Valuation Method
0 1 2 3 4 5
Investment Cash Flow 3.50 0.00 0.00 0.00 0.00 37.50
Present Value of Exit Value 4.94 37.50/(1.50)5
Future Value of Amount 3.50(1.50)5➔ 26.60
invested
VC Ownership % age 70.9% 3.50/4.94 26.60/37.50 70.9%
➔

• Suppose 1,000,000 shares have already been issued to the

promoters
• No. of shares to be issued to the VC investors for 70.9%
ownership: N
= 70.9% N = 2,436,426 shares
N + 1,000,000
Total no. of shares: 1,000,000+2,436,426 = 3,436,426 shares
Issue Price = Investment / New Shares
=Rs. 3.50 Mn / 2,436,426 = Rs. 1.44 per share.
Valuing Early Stage Firms 7
 Venture Capital Valuation Method
Post Money Pre Money Amount Invested
Value (Rs Mn) 4.94 4.94 – 3.50 = 1.44 3.50
No. of Shares 3,436,426 1,000,000 2,436,426
Value per Share 1.44 1.44 1.44
(Rs/Share)
Post-Money Pre-Money Investment
Old + New Shares Old Shares New Shares

Valuing Early Stage Firms 8

 ESOPs in VC Valuation
• Increasingly, employees of such firms are being
compensated with ESOPs - either to augment their
compensation or to hire and retain talented workers.
• Firms need to reserve a pool of shares for issuance in
the future.
• Suppose the Post-money value estimated is Rs. 4.94
Mn, and 250,000 shares have been allocated to the
reserve pool, then the VC shall seek to include them in
the no. of shares outstanding
N
= 70.9%
N + 1,000,000 + 250,000 N = 3,045,533 shares

instead of 2,436,426 shares

Valuing Early Stage Firms 9
 ESOPs in VC Valuation
• However, it is the interest of the promoters to try and
exclude the shares in the ESOP pool from valuation.
• If the promoters are successful, the VC investors would
be issued 2,436,426 shares only (as originally
estimated)
• As the reserved shares are issued to the employees, it
will dilute the shareholding of the VC investors.
• The fully diluted price would be Rs. 1.34 per share but
the VC investors would be holding 2,436,426 shares,
hence their shareholding will not be 70.9% but
66.09%.

Valuing Early Stage Firms 10

 Venture Capital Valuation Method
• Pre-Money Value is the value of the company
immediately before the infusion of funds from the
Venture Capital / PE Fund.
✓ Pre-Money = Total No. of OLD Shares * Share Price
✓ Pre-Money = Post-Money – Investment
• Post-Money Value is the value of the company
inclusive of investment in the current round.
✓ Post-Money = Investment / % of ownership acquired
✓ Post-Money = Pre-Money + Investment
✓ Post-Money = Total No. of Shares (O+N)*Share Price
✓ Share Price = Investment / No. of New Shares issued.
Deal Sourcing and Due Diligence 11
 Multiple rounds of Funding
• As new Equity is issued to later-round investors or to
new key employees, the early-round investors suffer
dilution (loss of ownership) due to issue of additional
shares.
• Instead of just one discount rate appropriate for one
round of funding, different discount rates for different
rounds of funding would be required.
Round of Funding Discount Rate Amount Raised
Round 1 (Year 0) 50% Rs. 1.50 Mn
Round 2 (Year 2) 40% Rs. 1.00 Mn
Round 3 (Year 4) 25% Rs. 1.00 Mn

Valuing Early Stage Firms 12

 Multiple rounds of Funding
• The final ownership that each investor must be left
with, given the terminal value, will be:
Future Value of Investment
Final Ownership (%) =
Terminal Value
Round of Discount Amount Final Ownership
Funding Rate (Rs Mn)
Round 1 50% 1.50 1.50*(1.50)5 / 15 *2.50
(Year 0) = 11.39/37.50 = 30.36%
Round 2 40% 1.00 1.00*(1.40)3 / 15 *2.50
(Year 2) = 2.744/ 37.50 = 7.32%
Round 3 25% 1.00 1.00*(1.25)1 / 15 *2.50
(Year 4) = 1.25/ 37.50 = 3.33%

• These are final ownerships that each investor requires

to achieve its target IRR.
Valuing Early Stage Firms 13
 Multiple rounds of Funding
• These final ownership %ages calculations are based on:
✓ Exit Value / Terminal Value;

✓ Current investment, and

✓ discount rates, they are not affected by the amount or

pricing of future investments i.e each investors’
required final ownership stake is not influenced by the
others investors’ final ownership %age.
• But early round investor must acquire enough shares
to make up for the dilution that would occur due to
further rounds of financing.
• When the future ownership is converted to current
ownership, that the effect of future financing is felt.
Valuing Early Stage Firms 14
 Conversion to Current Ownership %age
• Retention %age: Ratio of Final Ownership to the
Current Ownership% age is called the investor’s
Retention %age. Final %age Ownership
Retention % =
Current %age Ownership

• Reduction in ownership over time is caused by sale of

new shares / options to management.
Retention % = 1- (Total of Future Final %age Ownership)

• Retention %age can be thought of as the portion of

final ownership available to the current investor.
✓ As 2nd & 3rd round investors hold 7.3% & 3.3% of final
ownership, 1st round investor holds 1- (7.32% + 3.33%)
= 89.35% of his original stake.
Valuing Early Stage Firms 15
 Conversion to Current Ownership %age
• Similarly, 2nd round investor holds 1- (3.33%) = 96.67%
of original holding.
• 3rd round investor hold 100% of his holding.
• What %age of ownership should each investor acquire
at the time of financing is given by:
Final %age Ownership
Current %age Ownership =
Retention %

Valuing Early Stage Firms 16

 Multiple rounds of Funding

Round of Amount Final Retention (%) Current Ownership

Funding (Rs Mn) Ownership (%)

Round 1 1.50 30.36% 1 - (7.32% -3.33) 30.36%/89.35%

(Year 0) = 89.35% = 33.979%
Round 2 1.00 7.32% 1-(3.33%) 7.32%/96.67%
(Year 2) = 96.67% = 7.572%

Round 3 1.00 3.33% 1-(0%) 3.33%/100%

(Year 4) = 100% = 3.33%

Valuing Early Stage Firms 17

 Multiple rounds of Funding
%age Ownership
New Shares = * Old Shares
1- %age Ownership

Round Amount Current New Shares

of (Rs Mn) Ownership
Funding (%)

Round 1 1.50 33.979% 33.979%

(Year 0) * 1,000,000 = 515,055
1- 33.979%

Round 2 1.00 7.572% 7.52%

(Year 2) * 1,515,055 = 124,077
1- 7.52%

3.33%
Round 3 1.00 3.33% * 1,639,131 = 56,522
1- 3.33%
(Year 4)

Valuing Early Stage Firms 18

 Multiple rounds of Funding
Investment
Share Price =
New Shares
Round of Amount New Shares Share Price
Funding (Rs Mn) (Rs. / Share)
Round 1 1.50 515,055 =1500000/515055 2.91*1.505
(Year 0) = 2.91 = 22.12
Round 2 1.00 124,077 =1000000/124077= 8.06*1.403
(Year 2) 8.06 = 22.12
Round 3 1.00 56,522 =1000000/56522= 17.69*1.251
(Year 4) 17.69 = 22.12

• Terminal Value = Rs. 37.5 Mn

• Total No. of Shares =1,695,654
• Final Price = Rs. 22.12 per share
Valuing Early Stage Firms 19