2: The Venture Capital Method Flashcards
- What is the Exit Valuation
Estimates:
- Company’s value at the time of a “successful exit” (future value)
- The time VC will exit the investment
- What is usually the VC exit strategy?
- IPO
- Sale to strategic buyer (e.g., larger firm in industry)
- Restructuring
- How do you find the exit value?
- Forecast the firm value at the exit date (e.g., IPO)
- Use this value as Terminal Value
- What multiples are often used to estimate the Exit Value?
Typically estimated asa multiple of
- EBIT
- EBITDA,
- Sales or Employees (or other valuation-relevant figure).
- The multiples is typically based on….
Comparable publicly traded companies
Comparable transactions
- Exit Value: Some Standard Issues
- Which comparables?
- Which multiples?
- When? E.g., how is IPO market in 4 years?
- When comparable firms have negative earnings, we can’t use ___. Should rather use
Can’t use EBIT etc. Should use Sales or Employees.
- VC Discount rate will typically range from ___%
25% to 80%
- Discount rates will be lower for
- Later stage
- More mature businesses
- Are VC investments usually short term or long term?
Short term. Usually plans to exit after a few years.
- What is an “successful exit”?
Not one or the other, but can generally say it is successful when:
- IPO or competitive sale
- Competitive sale “could have done IPO, but sale was better”
- What is the main approaches for Exit Valuation?
1) Relative Valuation – Based on Market Opinion
- Finds other companies and use them as Comparables based on their similarities
2) Absolute Valuation – Based on Discounted Future Cash Flows
Both have strength and weaknesses, and both should be done in the valuation
- What are Target Returns
- The appropriate yield for a VC
- uses this to find the Exit Valuation
How are Target Returns calculated
Calculated as:
- money invested + profit investor wants
- adjusted for Time Value of money
- What is the Retention Ratio
- Ratio of Net Income kept in the business for further growth
- Dividend ratio the opposite
- What is Expected Retention
Multiple rounds of investments are normal with start-ups or small companies. The Expected Retention tells us the retention of the fraction that the VC will have from his INITIAL INVESTMENT. Given by retention percentage.
- Retention Percentage
Retention from INITIALL investment.
VC holds 25%, or 5m of 20m shares.
VC does a Serie B investment of another 5m. Equity now 25m.
The retention percentage is then 20/25 = 80%. This is the retention rate for the investors.
- The Investment Recommendation
Final step in any VC. Based on the comparisons the investor have made (cost versus benefits). Call it “recommendation” because valuation is not exact science.
First we need to find the total valuation. Then this is multiplied by the proposed ownership, to find the PARTIAL VALUATION.
- Steps in the Standard VC 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
Estimate the VC’s exit date
Step 2
Estimate the Exit Price. Use it as the TV
Step 3
Choose a (high) Discount rate (VC Discount rate)
Step 4
Discount TV using the Discount rate from Step 3
Step 5
Determine the VC’s stake in the company
- What is the difference between the Standard VC Method and the Modified VC Method?
Difference in the recognition of costs of VC investing: management fees and carried interests
- What is Carried Interests?
A compensation based on profits.
Carried interest is made to give the manager incentive to invest the money good.
A % of the profits goes to the manager to motivate he’s performance. Give incentives.
- Why is not the assumption of costs like management fees and carried interest included in the target multiple of money, not ideal?
First, it mixes costs into the valuation step. Total valuation may not be same across different investors.
Second, it makes it difficult to be precise about target rates.
- Oz.com will go public in 5 years. In year 5, the Net Income will be $ 5 million. Public comps trade at P/E ratios of about 30x. The VC’s target rate of return is 50%. The FCF in years 0-4 is -4 in year 0 and 0 for the rest of them. Show how the Venture Capital Method steps.
Step 1: Exit Date
• Exit Date is in 5 years
Step 2: Exit Value:
• Exit value is 30 * 5 = $150 million.
Step 3: VC Discount Rate
• Discount Rate is 50%
Step 4: Valuation
• Post money value: 150/(1+50%)^5 = $20 million
• Pre-money value: 20 – 4 = $16 million
• This is a positive NPV project (if you believe 50% is OK)
Step 5: VC’s Equity Stake
• To invest $4 million, the VC will ask for 4/20 = 20% equity stake.
- When does Expected Retention matter?
Only when the VC expects future rounds of investment
Firm Data Risk free rate 5 % Volatility 90% Time to exit 5y Investment $ 6 Mio Firm Value $18 Mio Shares Outstanding 10 Mio Structure 1 RP (”and”) $ 5 Mio Plus VC Shares 5 Mio Structure 2 CP (“or”) $ 6 Mio Or VC Shares 5 Mio
SERIES B:
Firm Risk free rate 5 %
Volatility 90%
Time to exit 4y
Investment $ 12 Mio
Series A Shares OVC (not converted) 10 Mio
(Convertible Preferred) LP (junior to new investor) 6 Mio
Management Share Employees 10 Mio
Structure 1 – Series B RP $ 20 Mio
(Participating Preferred) VC Shares 5 Mio
Structure 2 – Series B Convertible $ 12 Mio
(Convertible Preferred) VC Shares 10 Mio
How many shares does NVC hold?
When does OCV convert?
OCV converts is $ 6m < 2/5 (V - 20) -> V = 35
NVC = 5m # OVC = 10m # Management = 10m #
25m # in total
