Lecture 2 VC Valuation ESSEC PDF

20/01/2020
VENTURE CAPITAL VALUATION
FINE31341 Entrepreneurial Finance & Private Equity

Sridhar Arcot
NEW VENTURE VALUATION
• Conceptually, just like any other valuation.
• But, what’s special about new venture valuation?

• Risks higher (?)
• Potential rewards higher (?)
• Exit and liquidity are more important;
• Not just a go-no/go decision; the actual valuations matter.
FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 2
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20/01/2020
LITERATURE
• J. Lerner, “A Note on Valuation in Private Equity Settings,”
• Metrick/Yasuda, Chapter 10
• W. Sahlman, “A Method for Valuing High-Risk, Long-Term

Investments,” HBS Note 9-288-006.
• Koller, Goedehart, & Wessels, Valuation, Chapter 23
VALUATION APPROACHES
• DCF analysis:
• WACC.
• APV.
• Comparables
• Comparable Transactions
• Venture Capital Method

• Several variations
• We present the basics
• Real Options
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VENTURE CAPITAL METHOD
• Step 1: Estimate the VC’s exit date.
• Step 2: Estimate the exit price. Use it as TV.
• Step 3: Choose a high discount rate (VC discount rate).
• Step 4: Discount TV using this discount rate.
• Step 5: Determine the VC’s stake in the company.
STEP 1: EXIT DATE
• VC investments are short-term: Typically, the VC plans to exit after

a few years.
• Estimate the likely time at which the VC will exit the investment.
• The VC usually will have a specific exit strategy in mind:

• IPO.
• Sale to a strategic buyer (e.g., a larger firm in the industry).
• Restructuring.
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STEP 2: EXIT VALUE
• Forecast the firm value at the exit date (e.g. IPO or trade sale).
• Use this value as the Terminal Value.
• Typically estimated as a multiple of EBIT, EBITDA, Sales or

employees (or other valuation-relevant figure).
• The multiple is typically based on:

• Comparable publicly traded companies.
• Comparable transactions.
EXIT VALUE: SOME ISSUES
• Standard issues:
• Which comparables?
• Which multiples?
• When? E.g. IPO market is hot now but will it be in 4 years?
• VC Issues:
• Often comparable firms have negative earnings
• Can’t use EBIT etc.
• Rather use Sales or Employees
• Often only data on IPO’s available – what about TS?
• Might create upward bias in Valuations
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EXIT VALUE: SOME ISSUES
• Typically, do not estimate FCF until exit.  Exit value is meant to

reflect whole value of the company at exit.
• OK when FCF are close to zero.
• But beware of other cases
STEP 3: VC DISCOUNT RATE
• Determine a rate for discounting the TV back to the present.
• Typically, discount rates range from 25% to 80%:

• Lower for later stage, higher for seed investments.
• Lower for more mature businesses.
• These discount rates are typically higher, and oftentimes much

higher, than those calculated using a CAPM-type model.
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STEP 4: VALUATION (PRE-MONEY)
• Use the discount rate to estimate PV(TV).
• Subtract the initial investment
 Pre-money value (NPV) of the company.
• This is the value of the firm before the investment is made;
• Go ahead only if this is greater than zero.
STEP 5: VC’S STAKE
• Post-money value: Firm value after the VC has injected funds.
Post-money value = Pre-money value + VC investment
• It is what an investor would pay for the firm up and running.
• Post-funding, VC’s stake is worth a fraction of the post-money

value  For an equity stake the VC should be willing to pay:
VC % stake x Post-money value= VC Investment
• This implies:
VC % Stake = VC Investment / Post-money value
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PRE-MONEY & POST-MONEY
• Pre-money value:
TV
Pre Money  NPV (TV )  I 
(1  r )T
• Post-money = Pre-money + Investment Amount

TV TV
Post Money  PV (TV )  I  I 
(1  r )T
(1  r )T

• VC’s share :
TV (1  r )T I
  I    I  
(1  r )T TV PostMoney
EXAMPLE: OZ.COM
• Oz.com is a privately owned company:

• 1.6m shares outstanding.
• Seeking $4m investment by a VC.
• The $4m will be used immediately to buy new equipment.
• Negotiations over the equity stake the VC should receive.
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OZ.COM (CONT.)
Step 1: Exit Date

• The idea is for Oz.com to go public in 5 years.
• Five-year forecast of FCF:
Year 0 Year 1 Year 2 Year 3 Year 4

FCF -4 0 0 0 0
Step 2: Exit Value

• In five years, VC forecasts Oz.com’s Net Income to be $5m.
• Public comps trade at price-earnings (P/E) ratios of about 30x.
• Estimate an exit value of 30 x 5 = $150m.
OZ.COM (CONT.)
Step 3: VC Discount Rate

• The VC’s target rate of return for this investment is 50%.
Step 4: Valuation
• Post-money value: 150/(1+50%)5= $20m.
• Pre-money value: 20 – 4 = $16m.
• This is a positive NPV project (if you believe 50% is OK).
Step 5: VC’s Equity Stake

• To invest $4m, the VC will ask for 4/20 = 20% equity stake.
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SO FAR…
• We have seen a simple way of valuing high growth firms
• We have not taken into account a couple of problems:
• Often there is more than one round – there’s dilution
• Stock option programs may also lead to dilution
• We want to get a better grip on the discount rate
VC METHOD – EXTENSIONS
• Step 2: Estimate the exit price. Use it as TV.

• Step 2.1: What is the expected retention rate?
• Step 2.2: Stock option programs
• Step 3: Choose a high discount rate (VC discount rate).

• Same as choosing the target multiple of money
→ Make the discount rate less arbitrary
• Step 6: LP cost of investment & LP valuation

→VC is an intermediary and charges for his service
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EXPECTED RETENTION
• If there are multiple rounds of investment, the VC might lose some

fraction of his initial investment in later rounds.
• Assume that initially, the VC holds 25% or 5 m shares
• Series B investment reduces this to 20%
• So investors have a retention ratio of 0.2/0.25=0.8 or 80%
EXPECTED RETENTION
• When does this matter?
• Only when the VC expects future rounds of investment
• And the future price will be fair, i.e. with another investor.
→Happens frequently, in particular when using the VC method
• Empirical retention rates:

Round 1 Round 2 Round 3 Round 4
Retention rate 50% 60% 67% 70%
Source: Metrick, p.184
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STOCK OPTION PROGRAMS
• What happens if there are Stock-Option programs?
• Often outside management/employees get options.
• These options can be converted to equity at the IPO
→To calculate the VC’s share treat them as if converted already
• Thus, the VC’s share is not affected by conversion at the IPO
TARGET MULTIPLE OF MONEY
• Often VCs talk about target multiples of money or hurdle rates
• What are those and how can we include them?
• Conceptually, these are just other ways to refer to discount rates
• We will discuss this in the next couple of slides
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TARGET MULTIPLE OF MONEY
• We start by asking how likely it is that the firm succeeds. Let’s define p =
probability of a successful exit:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝐸𝑥𝑖𝑡 𝑝 ∗ 𝐸𝑥𝑖𝑡 𝑉𝑎𝑙𝑢𝑒
• Present value (PV): 𝑃𝑉 𝐸𝑉 ∗ 𝐸𝑉/𝑀, where we define M

as our exit multiple.
• So, if we have an initial investment of X, what multiple M do we need on X to get

a specific exit valuation EV?
𝑋 1 𝑟
𝑋 𝑃𝑉 ⟺ 𝑋𝑀 𝐸𝑉 ⟺ 𝐸𝑉
𝑝
TARGET DISCOUNT RATE
• If we know the VC’s discount rate 𝑟 , we can compute an implicit discount rate
for each project, 𝑟 .
• Let’s start with EV 𝑋𝑀. Rewrite as 𝑋. If we think of this as a present value

formula we can rewrite this as
.
• Solving for 𝑟 yields the following relationship:

1 𝑟
𝑟 𝑀 1 1
𝑝
• Depending on what we know we an now recover 𝑟 or 𝑟
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A NUMERICAL EXAMPLE
Target Returns and Target Multiples

Cost of
Venture 15% Probability of a successful exit = p
Capital
10% 15% 20% 25% 30% 35% 40%
2 264% 210% 159% 124% 99% 81% 67%
13.2 8.8 6.6 5.3 4.4 3.8 3.3
3 136% 113% 89% 71% 58% 49% 41%
Years to 15.2 10.1 7.6 6.1 5.1 4.3 3.8
Exit =T 4 79% 61% 50% 43% 38% 35% 32%
17.5 11.7 8.7 7 5.8 5 4.4
5 68% 57% 46% 38% 32% 27% 23%
20.1 13.4 10.1 8 6.7 5.7 5
Source: Metrick, p181
& 182 Target Returns: Top cell Target Multiples (M): bottom cell
WHY ARE THE DISCOUNT RATES SO HIGH?
• Is this the last word on discount rates? Not really. This is just a stop-gap
explanation.
• Such high discount rates cannot be explained as being a reward for

systematic risk.
• In most practical cases, CAPM would give discount rates well below
25%, let alone 80%.
• Four (limited) “rationales”:

• Compensate VC for illiquidity of investment.
• Compensate VC for adding value.
• Correct optimistic forecasts.
• The VC’s fees.
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SO FAR…
• Though VCs will certainly use the previous method --- and you
need to know how to do it --- it does not preclude you from:
• having a healthy dose of skepticism;
• taking a more sophisticated approach to the problem.
• In particular, even if illiquidity, value added, and optimistic

scenarios are important considerations, one-size-fits-all discount
rate adjustment is not appropriate:
• Illiquidity will differ in magnitude in different situations;
• VC value added varies across VCs, and from deal to deal;
• Clearly, the difference between optimistic forecast and average forecast
varies across deals, entrepreneurs, etc.
SCENARIO ANALYSIS:
AN ALTERNATIVE TO HIGH DISCOUNT RATES
• It’s better to model the sources of uncertainty and to put
probabilities on the various events.
• Some major uncertainties will get resolved soon;
• Others will take more time;
• Some scenarios will require you to take different actions.
• Other advantage: Allows you to identify and value (roughly) the

options embedded in many start-ups, particularly: options to
abandon, to expand, to switch strategies.
• Black-Scholes is usually an over-kill here. Simple decision trees

are more appropriate. (Simulations can be very useful).
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EXAMPLE
• Put up $10m now.
• In 2 years:
• Good news (proba.1/3): Invest $60m  Get out $300m.
• OK news (proba.1/3): Invest $60m  Get out $150m.
• Bad news (proba.1/3): Invest $60m  Get out $30m.
• If do not invest $60m, the firm is worth nothing.
EXAMPLE (CONT.)
• One approach:
• Discount the cash flow from the best case scenario (300 - 60) using a high
discount rate.
• This high rate would correct for the probability of less favorable outcomes.
• But which one? And why?
• Alternative:
• Analyze each scenario.
• Realize that you won’t invest if bad news arrives, so expected payoff in year
2 is really:
1/3 x (300-60) + 1/3 x (150-60) + 1/3 x 0
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DISCUSSION
• Here: rates are high because of uncertainty about final returns

• Make things clearer by breaking the rate into components:
• VC discount rate
• Probability of successful exit
• Time horizon of investment
• Beware:
• How can we estimate p?
• Still no fees or illiquidity included…
SO HOW SHOULD YOU APPROACH A TYPICAL

START-UP VALUATION PROJECT?
1. Begin by doing a simple VC valuation
2. You can compare it to a DCF valuation (or a multiple valuation)
3. Try to explore possible real options. Often staging or stepwise

expansion allows for real options.
16

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20/01/2020

VENTURE CAPITAL VALUATION

FINE31341 Entrepreneurial Finance & Private Equity

NEW VENTURE VALUATION

• Conceptually, just like any other valuation.

• But, what’s special about new venture valuation?

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 2

• J. Lerner, “A Note on Valuation in Private Equity Settings,”

• W. Sahlman, “A Method for Valuing High-Risk, Long-Term

• Koller, Goedehart, & Wessels, Valuation, Chapter 23

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 3

• Venture Capital Method

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 4

VENTURE CAPITAL METHOD

• Step 1: Estimate the VC’s exit date.

• Step 2: Estimate the exit price. Use it as TV.

• Step 3: Choose a high discount rate (VC discount rate).

• Step 4: Discount TV using this discount rate.

• Step 5: Determine the VC’s stake in the company.

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 5

STEP 1: EXIT DATE

• VC investments are short-term: Typically, the VC plans to exit after

• The VC usually will have a specific exit strategy in mind:

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 6

STEP 2: EXIT VALUE

• Use this value as the Terminal Value.

• Typically estimated as a multiple of EBIT, EBITDA, Sales or

• The multiple is typically based on:

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 7

EXIT VALUE: SOME ISSUES

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 8

EXIT VALUE: SOME ISSUES

• Typically, do not estimate FCF until exit.  Exit value is meant to

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 9

STEP 3: VC DISCOUNT RATE

• Determine a rate for discounting the TV back to the present.

• Typically, discount rates range from 25% to 80%:

• These discount rates are typically higher, and oftentimes much

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 10

STEP 4: VALUATION (PRE-MONEY)

• Use the discount rate to estimate PV(TV).

• Subtract the initial investment

 Pre-money value (NPV) of the company.

• This is the value of the firm before the investment is made;

• Go ahead only if this is greater than zero.

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 11

STEP 5: VC’S STAKE

• Post-money value: Firm value after the VC has injected funds.

Post-money value = Pre-money value + VC investment

• It is what an investor would pay for the firm up and running.

• Post-funding, VC’s stake is worth a fraction of the post-money

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 12

PRE-MONEY & POST-MONEY

• Post-money = Pre-money + Investment Amount

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 13

• Oz.com is a privately owned company:

• The $4m will be used immediately to buy new equipment.

• Negotiations over the equity stake the VC should receive.

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 14

Step 1: Exit Date

Year 0 Year 1 Year 2 Year 3 Year 4

Step 2: Exit Value

FINE31341 Entrepreneurial Finance & PE Sridhar Arcot 15