A NOTE ON VALUATION IN PRIVATE EQUITY

Aineas Mallios
aineas.mallios@handels.gu.se

May 24, 2021

1
Outline

Part I - A Short Introduction to PE and VC

Part II - Valuation Techniques

Part III - Assignments

2
Part I - A Short Introduction to PE and VC

3
A General Note

• Entrepreneurship is a key driver of value creation.

• Value creation starts with the recognition and pursuit of

opportunities.

• The opportunity must be compelling to enable the

entrepreneur to attract the necessary resources.

• Mechanisms to enable resource alignment with the best

opportunities.

• PE/VC is such a market mechanism.

4
 The Entrepreneurial Venture

Cash
Flow

I II III
“Pure entrepreneurship” “Strategic focus” “Systems building”
IV
“Corporate
management”
Time

5
Definitions

• Private equity: PE, consisting of venture capital and buyout capital, is the
professional provision of capital and management expertise to companies in
order to create value, and subsequently, with a clear view to an exit, generate
capital gains after a medium to long holding period. PE firms act as financial
intermediaries between business and, primarily, institutional investors.

• Venture capital: Independent, professionally managed, dedicated pools of

capital that focus on equity or equity linked investments in privately held, high-
growth companies, particularly focusing on firms in their seed, startup, or
expansion phase.

• Buyout capital: Investments in established private, or publicly listed, companies

that are expected to undergo a fundamental change in strategy and operations.

6
Venture Capital is a Sub-category of Private Equity

• What is private equity?

• Venture capital

• Leveraged buyouts

• Mezzanine investments

• Distressed debt

7
A Private Equity Setting

• Characteristics:

• Generally structured as a partnership.

• Huge growth in funds during the last decades ($5b in 1980 to $600b in 2010).

• Still a relatively small allocation as compared to public equities (1 to 40).

• Instability and volatility in valuation and funds flows.

• Illiquidity and information asymmetries, thus portfolio management is especially

problematic.

• A private equity fund is typically raised in several stages (staged financing). Why?

• Typically, venture capitalists do not buy common stock, but they rather focus on
convertible preferred stock. Why?

8
The Key Actors

Entrepreneurs Limited Partners

Perspective Perspective
Investment
Opportunity

General Partners
Perspective

9
An Overview of Private Equity Investing

10
A Generic Structure

11
The Key Actors (Con’t)

• Private equity funds typically have limited and general partners.

• The limited partners are institutional and individual investors who

provide capital. These are limited in the sense that their liability
only extends to the capital they contribute.

• The general partners are typically the private equity investors

who are responsible for the day-to-day management of the fund,
and thus are directly liable. They receive a substantial share of the
capital gains from the fund, and typically contribute only a modest
amount of fund’s capital. They protect themselves by not serving
directly as GPs, but they rather create a corporation that serves as
the general partner of which they are shareholders.

12
The Limited Partnership Structure

• In the private equity organizations, the limited partnership structure has

long been the traditional organizational form. Why?

• It handels illiquidity and uncertain opportunity. Management fees

support the GPs during the initial period of illiquidity, carried interest
keeps them closely involved in the success of the investment, and the
blind pool with capital (the investments) responds to the uncertain
opportunity. The manager who creates value in the portfolio is
rewarded very well. The LPs, investing in such a vehicle require a
huge leap of faith, because the limited partnership structure is
inefficient in encouraging accountability.

13
The Mechanism in a Snapshot
• Many start-up companies require capital.
• The founder does not have sufficient funds to finance the project alone, therefore
he/she seeks outside financing.

• Entrepreneurial companies that are characterized by significant intangible

assets, expect years of negative earnings, and have uncertain prospects.
• They are unlikely to receive bank loans or other debt financing.

• Private equity organizations finance these high-risk, potentially high-reward

projects.
• Typically, these investors do not primarily invest their own capital, but rather raises
funds from instituions and individuals.

• Large institutional investors (pension funds, university endowments, etc.) are

likely to want illiquid long-run investments in their portfolios (private equity).
• These groups have neither the staff nor the expertise to make such investments
themselves. They are specialized financial instituions that manage savings
collectively of small investors towards a specific objective in terms of acceptable
risk, return maximization, and maturity of claim.

14
Additional Characteristics of Private Equity

• The non-monetary aspects of private equity are critical to its success:

the screening of investments, the use of convertible securities, the
staging of investments, and the provision of oversight and informal
coaching.

• Private equity firms’ high-powered compensation schemes give these

investors incentives to monitor companies more closely, because their
individual compensation is closely linked to the firm’s returns.

• Reputation is a valuable currency to be husbanded in the private equity

industry.

• Funds with a history of success are able to raise and invest money
at better terms, and therefore enjoy better results.

• Limited partners spend easily as much energy trying to get into the
best funds, as the fund managers spend to become top-tier funds.

15
Initial Public Offering (IPO)
• Why?

• Better access to capital through the public markets.

• The ability to achieve greater liquidity through diversification.

• The help in interactions with customers and/or suppliers.

• Reputation

• Why not?

• Costly (10% of the IPO amount raised)

• More difficult to monitor management due to greater equity-holders’ dispersion.

• Disclosing

• IPO failure has serious consequences.

16
IPO Underpricing Puzzle

• When companies go public, the equity they sell in an IPO tends to be

underpriced, resulting in a substantial price jump on the first day of trading. Why?

• Research has found that 75% of first-day returns are positive. For instance,
the average first day return in the US is 18.3%. The issue price must be set
so that the average first-day return is positive. Why?

• The opportunity cost of going public is directly related to the level of

information asymmetry between informed and uninformed investors or
between corporate insiders and public investors.

• “Bandwagon effect”: Sophisticated institutional investors indicate interest in

a stock, other non-sophisticated investors rush in to purchase.

• Investment banks have market power, and thus deliberately set offering
prices too low in order to transfer wealth to selected investors whom they let
participate in the IPO.

17
Part II - Valuation Techniques

18
Comparison of Venture Capital and Traditional Corporate Finance Theory

ATTRIBUTE TRADITIONAL CORPORATE VENTURE CAPITAL

FINANCE THEORY
1. Tradeability of shares Liquid Illiquid

2. Monitoring ofmanagement by shareholders Passive/indirect Active/direct

3. Role of market for corporate control High Low

4. Access to capital Competitive ’anonymous’ capitalmarket 1.Early stage: access limited to set of financiers
with highly specialisedskills
2.Later stage/buy-outs: close to competitive
market but active monitoring skills required

5. Assetspecificity Generally relatively low Firms with non-redeployable/highlyspecialised

assets
6. Project valuation Application ofa wide range of Restricted range of techniques (e.g. where early
techniques stage investments do notpay dividends) and/or
a need for greater range of sensitivity analysis
because of greater uncertainty of cash flows

7. Information availability Private information is rare; provision of Private information is widespread and difficultto
public information ismandatory reveal, hence requirement for close monitoring
of managers

19
Valuation in Private Equity

• The valuation of private companies, especially those in the earlier

stages of their life cycle, is a difficult and often a subjective process. The
cash flow profile is very sensitive to the valuation assumptions made.

20
Valuation Techniques

• Comparables

• Net Present Value (DCF)

• Adjusted Present Value

• Monte Carlo Simulation

• Venture Capital Method

• Options Valuation (Real Options)

21
Comparables

• Seek other firms that display similar “value characteristics” to the

company we are interested in valuing.

• These value characteristics include risk, growth rate, capital structure,

and the size and timing of cash flows.

• Often, these value characteristics are driven by other underlying

attributes of the company that can be incorporated in a multiple.

+ Quick to use and simple to understand.

- It is difficult to ascertain what valuations have been assigned to other

privately held firms. Performance information measures such as key
ratios may be missed. The valuation assigned to comparable firms may
be misguided. Marketability of equity often induces a discount for
illiquidity.

22
 Comparables Example
• A shareholder of PH is considering selling his stake in the company and retiring. He has
asked PH’s CFO to calculate the value of the firm. The two main options that he is
entertaining are the sale of his interest to an Employee Share Ownership Plan and to
one of the firm’s publicly traded competitors. The CFO regularly receives research
reports from investment bankers eager to take the company public. From these reports
she is available to compare the following information for PH and two public similar
companies in the same region (amounts in millions of dollars unless indicated).

23
Comparables Example (Con’t)

• Calculate the following multiples (ratios): Price/Earnings, Enterprise Value/EBITDA,

Enterprise Value/Revenue, Equity Market Value/Equity Book Value, Enterprise
Value/Member.

• Calculate implied valuations for PH according to each of the above ratios.

• What is the value or value range of PH if sold to a public company.

24
Net Present Value

• NPV is one of the most common methods of cash flow valuation. It

incorporates the benefit of tax shields from tax-deductible interest
payments in the discounts rate (WACC).

• The terminal value should be calculated. This estimate is very important

as the majority of the value of a company, especially one in an early-
stage setting, may be in the terminal value. A common method for
estimating the terminal value of an enterprise is the perpetuity method.

+ Technically sound and less subjective than using comparables.

- Betas are required to calculate the discount rate, terminal values are
very sensitive to assumptions about both discount and growth rates, the
capital structure and the effective tax rate are both incorporated in
WACC and often assumed to be constant.

25
Implementing NPV

• Calculate the free cash flows:

• When free cash flow is negative (which often happens in high growth
firms), it means that they have to raise external funds.

26
Implementing NPV (Con’t)
• Calculate the terminal value (TV) assuming a growth rate (g):

• The NPV is then:

• The discount rate is calculated using WACC:

27
Implementing NPV (Con’t)
• The cost of equity is calculated using CAPM:

• If the firm is not at its target capital structure, it is necessary to “unlever”

and “relever” the beta:

28
NPV Example

• Value HT using the NPV method. The management has agreed on the following
projections (all data are in millions of dollaras):

• The company has $100 million of NOLs that can be carried forward and offset
against future income. In addition, HT is projected to generate further losses in
its early years of operation that it will also be able to carry forward. The tax rate
is 40%. The average unlevered beta of five comparable high-technology
companies is 1.2. HT has no long-term debt. Treasury yileds for ten-year bonds
are 6%. Capital expenditure requirements are assumed to be equal to
depreciation. The market risk premium is assumed to be 7.5%. Net working
capital requirements are forecast as 10% of sales. EBIT is projected to grow at
3% per year in perpetuity after Year 9.

29
NPV Example (Con’t)

• Calculate the WACC.

• Value the cash flows.

• Calculate the terminal value (TV).

• Perform a scenario analysis to determine the sensitivity of the value of HT to

changes in the discount rate and the terminal growth rate. Develop a scenario
table. (Sensitivity analysis can be easily undertaken using the Microsoft Excel
command Data Table).

30
Adjusted Present Value

• The adjusted present value method (APV) is a variation of the NPV method. It
is preferred over the NPV method, especially when a firm’s capital structure is
changing or it has net operating losses that can be used to offset taxable
income (leveraged buyouts).

• When the firm has been levered up, APV considers the cash flows generated
by the assets of a company, ignoring its capital structure. The savings from
tax-deductible interest payments are then valued separately. Likewise, it
accounts for the effect of the firm’s changing tax status by valuing also the
NOLs separately.

• Under certain conditions, the NOLs can be carried forward for tax
purposes and netted against taxable income.

31
Implementing APV
• Step 1: Value the cash flows, ignoring the capital structure.

• Assume that the company is financed totally by equity, implying thus that
the discount rate should be calculated using an unlevered beta, rather than
the levered beta used to compute the WACC used in the NPV analysis.

• Step 2: Estimate the tax benefits associated with the capital structure.

• The NPV of the tax savings from tax-deductable interest payments have
value to a company and thus it must be quantified. The interest payments
will change over time as debt levels are increased or reduced. By
convention, the discount rate often used to calculate the NPV of tax
benefits is the pretax rate of return on debt.

• Step 3: Quantify the NOLs.

• NOLs can be offset against pretax income and often provide a useful
source of cash to a company in its initial profitable years of operation. The
discount rate used to value NOLs is often the pretax rate on corporate debt.
32
APV Example

• A private equity organization was interested in purchasing TT, a financially

distressed company. A general partner of the PE organization used the
following projections to value TT:

• TT had $220 million of NOLs, which were available to be offset against future
income. At the beginning of Year 1, the company had $75 million of 8% debt,
which was expected to be repaid in three $25 million installments, beginning at
the end of Year 1. The tax rate was 40%. The GP believed an appropriate
unlevered beta for TT was 0.8. The 10 year Treasury Bond yield was 7% and
the market risk premium 7.5%. Net cash flows were forecast to grow at 3% per
year in perpetuity after Year 5.

33
APV Example (Con’t) - HW

• Calculate the cost of equity.

• Value the cash flows.

• Calculate the terminal value (TV).

• Calculate the present value of the interest tax shields.

• Value the tax shields from the NOLs.

• Conduct a sensitivity analysis.

34
Monte Carlo Simulation
• When undertaking sensitivity analysis, we simply alter variables one at a time
and determine the change in valuations. Monte Carlo simulation is an
improvement over simple sensitivity analysis because it considers all possible
combinations of input variables. It allows a more thorough analysis of the
possible outcomes than does regular sensitivity analysis.

• The user defines probability distributions for each input variable, and the program
(i.e., Crystal Ball) generates a probability distribution describing the possible
outcomes.
• First, set up the base case spreadsheet. Then define the assumptions and forecast
variables. Select an appropriate distribution and estimate the key parameters (i.e.,
mean and standard deviation).

+ The availability and simplicity of simulation packages make them a useful tool.
Interactions between the variables are explicitely specified, so at least
theoretically, this methodology provides a more complete analysis.

- Simulation is not the real thing.

35
Simulation
Report
Example

36
Simulation Report Example (Con’t)

37
Venture Capital Method
• The VC method is a valuation tool commonly applied in the private equity
industry. The VC method accounts for the cash profile of private equity
investments by valuing the company, typically using a multiple, at a time in the
future when it is projected to have achieved positive cash flow and/or
earnings. This terminal value is then discounted back to the present using a
high discount rate (i.e., 40% to 75%). Then, venture capitalists use this
discounted terminal value and the size of the proposed investment to
calculate their desired ownership interest in the company.

• For example, assume that the present value of the terminal value is
$10m and the venture capitalists intend to make a $5m investment.
Then, they will demand 50% of the company in exchange for their
investment, given no dilution of the venture capitalist's interest through
future rounds of financing!!! Problematic, why?

- Very large discount rates chosen arbitrary, rather then using more
objective techniques. The discount rates should not be inflated to
compensate for the entrepreneur's overly optimistic projections, more
judgement should instead be applied.
38
Implementing the VC Method

• Step 1: Estimate the company’s value in some future year of interest, i.e.,
shortly after the venture capitalists foresees taking the firm public.

• The terminal value is usually calculated using a multiple, or the

discounted cash flow methods.

• Step 2: Calculate the discounted terminal value using a target rate of return
instead of using the traditional cost of capital as the discount rate.

• Often, the target rate of return is the yield that the venture capitalists
require to justify the risk and effort of the particular investment.

39
Implementing the VC Method (Con’t)
• Step 3: Calculate the required final percent ownership.

• Assume that there is no subsequent dilution of their investment.

• Step 4: Estimate future dilution and calculate the required current percent ownership.

• To compensate for the effect of dilution, venture capitalists need to calculate the
retention rate which quantifies the expected dilutive effect of future rounds of financing
on the venture capitalists’ ownership.

• For example, consider a firm that intends to undertake one additional round of
financing, in which shares representing an additional 25% of the firm’s equity will be
sold, and then to sell shares representing an additional 30% of the firm at the time of
the IPO. If the venture capitalists own 10% today, after these financing their stake will
be 0.1 / (1+0.25) / (1+0.3) = 6.15%. Their retention rate is then 0.0615 / 0.1 = 61.5%.

40
VC Method Example

a A partner in a successful venture capital firm plans to invest $5 million in a start-

up biotechnology venture and must decide what share of the company he
should demand for his investment. Projections that he developed with company
management show net income in Year 7 of $20 million. The few profitable
biotechnology companies are trading at an average price-earnings ratio of 15.
The company currently has 500 000 shares outstanding. He believes that a
target rate of return of 50% is required for a venture of this risk.

b He and his partners are of the opinion that three more senior staff members will
need to be hired. In his experience, this number of top caliber recruits would
require options amounting to 10% of the common stock outstanding.
Additionally, he believes that at the time the firm goes public, additional shares
equivalent to 30% of the common stock will be sold to the public.

41
VC Method Example (Con’t)

a Calculate the discounted terminal value (TV).

• Calculate the required percent ownership.

• Calculate the number and price of the new shares.

• Calculate the implied pre- and post-money valuation of the company.

b Calculate the retention ratio.

• Calculate the required current percent ownership.

• Calculate the number and price of the new shares.

42
VC Method Example – Suggested Solution

a:

Discounted terminal value (TV) = (20*15)/(1+50%)^7 = $17.5m

Required percent ownership = 5/17.5 = 28.5%

Number of new shares = 500 000/(1-28.5%) - 500 000 = 200 000

Price per new share = 5/200 000 = $25 per share

Implied pre-money valuation = 500 000*25 = $12.5m

“a company’s valuation before the current financing round”

Implied post-money valuation = 700 000*25 = $17.5m

“a company’s valuation including the latest funding round”

43
VC Method Example – Suggested Solution (Con’t)

b:

Retention ratio = [1/(1+10%)]/(1+0.3) = 70%

Required current percent ownership = 28.5%/70% = 40.7%

Number of new shares = 500 000/(1-40.7%) - 500 000 = 343 373

Price per new share = 5/343 373 = $14.56 per share

44
Options Valuation
• Private equity-backed companies are often characterized by multiple rounds
of financing. Venture capitalists use this multistage investment approach to
motivate the entrepreneur to earn future rounds of financing and also to limit
the fund’s exposure to a particular portfolio company. The right to make a
follow-on investment has many of the same characteristics as a call option
on a company’s stock. Option pricing theory accounts for the manager’s ability
to wait and then decide whether to invest in the project at a later date, the so
called option to “wait and see”.

• We can evaluate a firm’s decision to invest in a project using the Black-

Scholes framework which requires five varibales as inputs.

+ Valuable when investment opportunities incorporate managerial flexibility.

- Real-world decisions can be difficult to reduce to mathematically solvable

problems. Some situations may not be appropriate for the B-S formula (i.e., a
series of call options that are nested).

45
Options Valuation (Con’t)

46
Options Valuation (Con’t)

• The Black – Scholes and Merton Formula (call and put):

• Note that the stock price inhere is denoted with F instead of S.

47
Options Valuation Example
• A venture capitalist was considering whether to invest in TT, which has
developed a new product that was ready to be manufactured and marketed. An
expenditure of $120 million was required for the construction of research and
manufacturing facilities. The venture capitalists was of the opinion that the
following projections developed by the manager of TT and his associates were
justifiable (all data are in millions of dollars):

• The investment can be broken into two stages. The initial investment, which
would need to be made immediately and would cost $20 million for R&D
equipment and personnel. The $100 million expenditure on the plant could be
undertaken any time in the first two years (i.e., whenever the project would be
undertaken, the present value of the plant construction expenditures would total
$100 million in today’s dollars). The risk-free rate is assumed to be 7%.
48
Options Valuation Example (Con’t)

• Calculate the regular NPV using a discount rate (WACC) of 25% and a terminal
growth rate of 3%.

• Calculate the expansion opportunity or the option to expand using the B-S
model. Assume, using comparable companies, that the volatility or standard
deviation lies in the range 0.5 - 0.6.

• Calculate the total net present value of the project.

• Would you recommend the venture capitalist to invest in the project or not?
Assume he/she would be granted first right of refusal on any subsequent
rounds of financing.

49
Part III - Assignments

50
Acmed Case Study

• A company has developed Acmed, a potential treatment for

asthma. A researcher has made a scientific breakthrough that
could be worth millions of dollars.

• The preclinical science and intellectual property are sound, and

Acmed has passed initial testing in animals and is now ready to
enter Phase 1 trials.

• The company is seeking venture funding and partnering

opportunities with multinational pharmaceutical companies.

• What should they charge for Acmed today?

51
 Drug development process

A Typical Clinical trials

Drug Early basic Phase I Phase II Phase III Regulatory review Phase IV
research/pre- clinical process
Development testing

Process Purpose Identify a drug target and a
candidate drug (CD) for pre-
clinical testing. Determine
toxicology and pharmacology
in animals
Determine Evaluate Confirm Receive approval Further evaluate
safety, effectiveness, look effectiveness and by FDA (US), safety in patients
pharmacolo gy for potential toxic show statistical EMEA (Europe) or evaluate the
and dosage in side effects, decide significance or other regulatory drug in additional
humans for the the optimal dose and according to pre- authority to market the indications with
next phase form of defined endpoints, drug. The regulatory the aim of
administration look for side effects decision is often broadening its use
from long-termuse preceded by a
recommendatio n by an
expert committee

Time 6.5 years 6-12 months 12-18 months 12-36 months 6-12 months 6-24 months

Number of Test tube and animal 20-80 100-300 1,000-5,000 50-5,000

patients studies healthy patients patients patients
volunteers

Success rate 5,000 compounds 5 1 compound

evaluated compounds approved
enter
clinical
trials

Probability of 10% 20% 30% 67% 81% 90-100%

approval

52
Inputs
• The annual market for asthma treatments is around $5.8
billion.

• To estimate Acmed’s market share, the product is compared

with other asthma medications on the market.

• Competition within the asthma market is intense, and the

anticipated market share for Acmed may be just 5% (a
”moderate to small” share).

• The annual gross return of Acmed is about $290 million.

• Of this sum, 60% is reserved for the eventual marketing and

manufacturing partner and 5% is reserved as royalty for the
university that invented Acmed.

53
Inputs (Con’t)

• This leaves 35%, or an annual return of about $100 million, as the royalty
due the biotechnology company that develops Acmed through pre-market
research and development stages.

• Consultation with a patent attorney suggests that Acmed will be defended

from competition for the next 18 years.

• The payoff for Acmed is, therefore, $100 million a year for 18 years minus
the years that it takes to get the product to market.

• It should take 8 years to carry out clinical trials and have the drug
approved by the US FDA.

• Acmed’s potential payoff for the biotechnology company is $1 billion ($100

million per year for 10 years beginning in Year 9).

54
Inputs (Con’t)

55
Inputs (Con’t)

56
Costs

57
Glossary

58
Risks

59
Risks (Con’t)

• The risk-adjusted value (computed here), rV, of an endeavor in which the

risk changes is the payoff (P) times the current risk (R0), minus each
associated cost (Ci) times the likelihood (R0 / Ri) of having to pay each
cost.

60
Risk-adjusted NPV

61
Assumptions

COMPANY Acmed
Astma market $5.8 billion/year
Anticipated Acmed market share 5%
Anticipated Acmed sales $290 million/year
Patent protection 18 years
Development status Safe & effective in animalmodel
Clinical status Ready to enter Phase 1 trials
Clinical development costs $20.5 million
Additional animal testing $2.5 million
Royalty due inventor 5% of sales
Anticipated cost of sales 60% of sales price

• Total anticipated Acmed sales are $2.9 billion (over 10 years).

62
Acmed Valuation Growth Profile

63
 Sensitivity Analysis

Description Base Low High Low High Delta SquaredRange Variability Cumul. Variability

Phase 3 costs 15 10 20 19,01 17,55 -1,46 2,1 0% 100%

Life of Drug 18 12 24 9,2 21,32 12,12 146,9 10% 100%
Gross profit (%) 0,4 0,3 0,5 11,49 25,07 13,58 184,4 13% 90%
Discount rate 0,2 0,25 0,15 10,23 32,23 22 484,0 34% 77%
Peak sales 290 140 440 6 30,57 24,57 603,7 42% 42%
1421,1 1

• Peak sales is the primary driver of uncertainty, accounting for 42%

of the total uncertainty in the modeling problem.

• The discount rate accounts for 34%. At the highest discount rate,
the NPV of the project is $10.23 million. At the lowest, it rises to
$32.34 million.

64
Geltex Case Study
• Geltex Pharmaceuticals is developing Renagel a treatment for
chronic kidney disease. The Renagel project has an estimated
patent protection of 14 years.

• The revenue estimates are as follows:

US EU
§ Number of patients: 210,000 165,000
§ Eligibility: 90% 70%
§ Growth rate: 8% 6%
§ Price per patient: $1000 $1000

65
Sales Forecasting

• Product sales will depend on:

• Prevalence, incidence and demographic/age segmentation of the target
population.
• Prevalence and incidence of any co-morbidities (i.e., related target
markets), plus potential off-label use.
• Diagnosis and treatment rates.
• Nature of the target diseases (i.e., chronic, acute, life threatening).
• Degree and nature of the product’s clinical efficacy, including the efficacy
advantage conferred over existing standard-of-care treatments.
• Treatment regimen, including dosing frequency, route of administration,
side-effect profile and so on (from which a patient compliance rate can
be estimated).
• Marketed and development-stage competition.
• Likely product pricing and reimbursement status.

66
 Data
Renagel market performance 1997 1998 1999 2000 2001 2002 2003
Market penetration, no launch delay 0% 0% 4% 9% 22% 34% 43%
Actual penetration 0% 0% 4% 9% 22% 34% 43%
US patients 210,000 226,800 244,944 285,703 308,559 333,244 359,903
Eligibility, US 90% 90% 90% 90% 90% 90% 90%
Total US customers - - 9,479 20,475 55,283 95,530 128,965
Europe patients 165,000 174,900 185,394 196,518 208,309 220,807 234,056
Eligibility, Europe 70% 70% 70% 70% 70% 70% 70%
Total European customers - - - 5,915 12,540 33,231 56,361
Total customer base - - 9,479 26,391 67,824 128,761 185,326
Total revenues ($000s) - - 8,247 22,960 59,007 112,022 161,234
Gross profit ($000s), 70% - - 5,773 16,072 41,305 78,416 112,863

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Ramp-up in sales 0% 0% 10% 20% 50% 80% 100% 100% 100% 100% 98% 95% 93% 90% 86% 80%

2013 2014 2015 2016 2017 2018

72% 60% 48% 35% 22% 8%

67
Costs

• Sales force = $200,000/sales rep (5% growth per year)

• Number of sales reps = 45 (ramp-up: 15 in Year 1, 30 in Year 2, 45 i n Ye a r 3 -

• Marketing costs (% of sales): 65% (y1), 30% (y2), 15% (y3), 8% (y4), 5% (y5-)

• G&A (% of sales force): 40%

• R&D expenses: $4,000 in Year 1, $3,000 in Year 2-

• Annual depreciation: $400 in Year 1, $400 in Year 2, $950 in Year 3-

68
 Unlevered Net Income Calculations

Expenses 1997 1998 1999 2000 2001 2002 2003

Sales force (number) - 15 30 45 45 45 45
Sales force ($000s) - 3,150 6,615 10,419 10,940 11,487 12,061
Marketing costs (% of sales) - - 65% 30% 15% 8% 5%
Marketing costs ($000s) - - 5,361 6,888 8,851 8,962 8,062
G&A (% of sales force) 40% 40% 40% 40% 40%
G&A ($000s) 800 800 2,646 4,167 4,376 4,595 4,824
R&D ($000s) 4,000 3,000 3,000 3,000 3,000 3,000 3,000
Depreciation 400 400 950 950 950 950 950
Total expense ($000s) 5,200 7,350 18,572 25,424 28,116 28,993 28,897

EBIT ($000s) (5,200) (7,350) (12,799) (9,352) 13,188 49,423 83,967

Tax ($000s), 38% - - - - 5,012 18,781 31,907

Unlevered Net Income ($000s) (5,200) (7,350) (12,799) (9,352) 8,177 30,642 52,059

69
 Calculating the Free Cash Flow

• Net wroking capital (NWC):

• Most projects will require an investment in net working capital.

• Trade credit is the difference between receivables and payables.

• The increase in net working capital is defined as:

∆𝑁𝑊𝐶 𝑡 = 𝑁𝑊𝐶 𝑡−1 − 𝑁𝑊𝐶 𝑡

Change in Net Working Capital 1997 1998 1999 2000 2001 2002 2003
Receivables (days) 45 - - 1,017 2,831 7,275 13,811 19,878
Inventories (days) 90 - - 610 1,698 4,365 8,287 11,927
Payables (days) 45 - - -305 -849 -2,182 -4,143 -5,963
Investment in Working capital - - 1,322 3,680 9,457 17,954 25,842
Net Change in Working Capital - - -1,322 -2,358 -5,777 -8,497 -7,887

70
Calculating Free Cash Flows (Con’t)
• Capital expenditure and depreciation:

• Capital expenditures represents the firm’s reinvestments (actual

cash outflows) in tangible and long-lived assets (typically in
property, plant and equiptment (PPE) and are included in
calculating free cash flows.

• Depreciation is a non-cash expense. The free cash flow estimate

is adjusted for this non-cash expense.

• Net capital expenditures represent the difference between capital

expenditures and depreciation. Depreciation is a cash inflow that pays
for the capital expenditures.

• Net capital expenditure = Capital expenditures – Depreciation

• In general, the net capital expenditures will be a function of how fast a

firm is growing or expecting to grow. High growth firms tend tol have
much higher net capital expenditures than low growth firms.
71
 Calculating Free Cash flow (Con’t)
1997 1998 1999 2000 2001 2002 2003
Unlevered Net Income ($000s) (5,200) (7,350) (12,799) (9,352) 8,177 30,642 52,059

Change in Net Working Capital

Receivables (days) 45 - - 1,017 2,831 7,275 13,811 19,878

Inventories (days) 90 - - 610 1,698 4,365 8,287 11,927

Payables (days) 45 - - -305 -849 -2,182 -4,143 -5,963
Investment in Working capital - - 1,322 3,680 9,457 17,954 25,842
Net Change in Working Capital - - -1,322 -2,358 -5,777 -8,497 -7,887

Capital expenditure -3,500 -2,500 -8,000 - - - -

+ Depreciation 400 400 950 950 950 950 950

Free Cash Flows -8,300 -9,450 -21,170 -10,760 3,349 23,095 45,122
Terminal value
Adjusted Free Cash Flows -8,300 -9,450 -21,170 -10,760 3,349 23,095 45,122

Discount factor 1.000 0.833 0.694 0.579 0.482 0.402 0.335

NPV 89,793

72
 Break-even Analysis

• The break-even level of an input is the level that causes the

NPV of the investment to be zero.

1997 1998 1999 2000 2001 2002 2003

Adjusted Free Cash Flows -8,300 -9,450 -21,170 -10,760 3,349 23,095 45,122
Discount factor 1.000 0.833 0.694 0.579 0.482 0.402 0.335
NPV 89,793
IRR 42.4%

73
 Sensitivity Analysis
NPV
Parameter Base Low High Low High Delta Sq. Range (m) Variability Cum. Variab.
Marketing cost multiplier 1 1.2 0.87 15,044 18,925 3881 15 0% 100%
Compliance (%) 0.87 0.75 0.94 6,133 23,967 17,834 318 2% 100%
Life of Drug (years) 14 10 20 3,484 23,018 19,534 382 2% 98%
Launch delay (years) 0 2 0 -4,75 17,396 21,871 478 3% 96%
Discount rate 0.2 0.23 0.1475 5,152 49,826 44,674 1,919 11% 93%
Gross profit (%) 0.7 0.55 0.85 -4,506 39,299 43,805 1,996 12% 81%
FDA approval, launch 1 0 1 -35,588 17,396 52,984 2,807 17% 69%
Price per patient ($) 1,000 600 1,300 -15,268 41,895 57,163 3,268 20% 53%
Peak penetration rate 0.43 0.2 0.59 -26.665 47,782 74,447 5,542 33% 33%
16,725 100%

• Peak penetration rate is the primary driver of uncertainty, accounting for 33%
of the total uncertainty in the modeling problem.

• The discount rate accounts for 11%. At the highest discount rate, the NPV of
the project is $5.15 million, while at the lowest, it rises to $49.83 million.

74
Epilogue

• In the base case scenario, peak sales of Renagel was expected to be $268
million in 2012. Actual sales turned out to be $1,209.8 million in 2012.

1400,0

1200,0
Forecasted sales
Actual sales
1000,0

800,0

600,0

400,0

200,0

0,0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011* 2012*

75
Analysis

• Analyze and value the firm (projects and the technology).

• Extensively motivate and discuss your input parameters in the valuation model.

• Perform an NPV analysis, options valuation, break-even analysis, and

sensitivity analysis to assess key assumptions that drive the enterprise value.

• Analyze value development over time and examine exit points of the
investment.

76
Analysis (Con’t)

• Discuss in detail the concepts of asymmetric information and moral hazard in the
context of the involved parties. Is asymmetric information likely to be a problem? Also
discuss potential conflicts of interest between the involved parties.

• Discuss how alliance contracts may depart the incentives of venture capitalists versus
the alliance partners. Discuss factors that determine how the control (cash flow and
voting) rights are allocated/assigned. At each stage different contracts are written and
signed by old owners and new investors. Suggest what type of cash, vote, and control
rights are appropriate to distribute between the different contract parties (at different
product development stages).

• Discuss different financing sources and strategic options available to risky companies.
Discuss also how the sources, but also the options, may interact and thus create
synergies. For example, what is the advantage/disadvantage of first engaging in a
collaboration agreement and then go public (or the opposite)? What factors determines
the decision to go public? Discuss the venture capitalists role in the going public
decision.

• The need of patents within this industry has pushed both stronger protection and global
recognition. Analyze the importance of patents for and the timing of patent applications.

77
MedMetric

• Seed-stage health care information technology company.

• No revenue expected until July 2016.
• Parker: $1m convertible note offering in exchange of 10%-15% equity ownership.
• Are the terms of the note sufficient to achieve the desired ownership?

• MedMetric is a small size company, has a low growth prospect, thus exit more
likely through a sale to a larger company.
• Small size addressable market, around $250m.
• Convertible notes are a high risky form of financing if the financing round does not
occur.

• Post-money valuation = 5/0.25

• Pre-money valuation = 15
• 2.5m pre-note shares outstanding
• Sweeteners: Interest rate 6%, conversion discount 20%, $10m valuation cap
• What is the price in absence of sweeteners?

78
MedMetric (Con’t)

• What is the price with sweeteners?

• Pre-money valuation with discount
• Compare with valuation cap and decide whether or not to convert the valuation cap.
• What is the discount that the noteholders receive now?

• What can Parker do to achieve 10-15%?

• Raise the interest rate or discount on the notes, but the better is to reduce the
valuation cap. Why?

• The Series A round was not completed until 3 years later!

79
Mobike

• The bike-sharing industry in China: duopoly/unicorns ($3b).

• The industry is young and not profitable yet - market share priority.
• Prisoner’s dilemma:

Maintain flexibility Expand agresively

Maintain flexibility (3;3) (1;4)
Expand agressively (4;1) (2;2)

• Multiple rounds of financing – milestones have been met.

• Real options: VCs usually make multistage investments.
• Pre-money valuation = Post-money valuation – VC investment
• % required by VC = VC investment/PV
• Apply the VC method: PV = (P/E ratio x terminal net income)/(1+IRR)^N
• Will Mobike achieve economies of scale? When?

80
Mobike (Con’t)

• Meituan-Mobike deal: $3.4b, the founders pocketed more than $1b in cash and kept
running the business.
• Assume investors’ ownership
• Compute Mobike’s fair value: revenues, costs, break-even, deposits, net profit, …
• Use Mobike’s 2017 Income Statement
• Post-money valuation vs fair value (fundamental value)?

• Are unicorns in general overvalued from the VC investors’ perspective? Why?

• Ofo was considering bunkruptcy due to cash flow problems (unpaid bills) in Oct 2018.

81
Sula

• A growing domestic demand for Indian wine.

• Capital-intensive Indian wine industry.
• 33% stake in Sula sold in return for a PE investment in 2005.
• Whether or not should Sula grow to meet forecasted demand!

• How firm’s growth is affected by its ability to increase production and finance the firm
efficiently.
• Inventory turnover and branch distribution – cash flow issues – ownership!

• Industry growth: 25-30% & Sula’s market share: 13.7%.

• Drinking age in India: 25yrs – Demographics

• Analyse the income statements: growth in net income? Profit margins? Firm’s value?
• Analyse the balance sheets: assets trend? Inventory growth? Growth in revenues?

82
Sula (Con’t)

• White vs red wine in India and comparable earnings.

• Does Sula have the ability to cover interest charges in order to obtain debt funds?
• Could Sula’s growth be achieved through continued borrowings?

• Market to book value ratio of 3:1 & Market value of equity to sales of 2.
• Price/EBITDA multiple of 13x
• Discount factor or WACC?

• Sula could be valued at $30-$40m, up from $10m in 2005. Can you show that?

• As of this case, it seems that Diageo was interested in purchasing an Indian wine
company.

83
Kaspi.kz

• Top one or two banks in retail banking. Compare with Halyk!

• Analyse the new customer-driven approach.
• Is this investment profile consistent with the goals of investors?

• How is Kaspi driving retailers’ sales? Show figures!

• Explain Kaspi’s ecosystem.

• Analyse the income statements: growth in net income? Profit margins? Firm’s value?
• Analyse the balance sheets: assets trend? Inventory growth? Growth in revenues?
• Was this a good time for the IPO?
• Can you value Kaspi? What could Kaspi’s IPO price be?

84
 Thank You

Aineas Mallios
aineas.mallios@handels.gu.se

85