Lecture 4 Flashcards
What is the historically annualized VC return index ?
Superior of those of public stock market indices but individual investment outcomes vary greatly.
What are the key distinctions between two kinds of risks ?
• Beta risk = market risk = non-diversifiable risk = systematic risk
• Idiosyncratic risk = diversifiable risk = firm-specific risk = residual risk
o Can be removed by diversification
→ investors only rewarded for systematic risk
What is the VC method of valuation ?
• Deciding allocation of committed capital in VC funds requires investment analysis of private firms to identify opportunities
• Most common approach used in VC industry = VC method
o Essentially variant fo DCF and Comparables analysis
• Key idea : estimate value of company in successful exit then discount at very high rate
What are the VC main elements ?
- Successful exit valuation
- Target multiple of money
- Expected retention percentage
- Investment recommendation
How to estimate the VC cost of capital ?
Use historical aggregate VC industry return data and estimate equation :
R(VC) - Rf = α + β(RM - Rf) + e
Where α = unexpected portion of return = skills of portfolio managers.
What is another relevant issue solved by PSM for VC ?
Investors may require premium for illiquid investments
What is the Pastor-Stambaugh Model ?
- Same model as FAMA-FRENCH but includes illiquidity risk
* More sensitive return on asset is to liquidity factor, higher premium investors will demand
What is the issue concerning aggregate VC industry price index ?
Are updated based on reported valuations of private portfolio companies.
What is the third adjustment ?
- Aggregate VC industry price index based on most recent round of financing → stale prices
- Include values from past periods in regression
How is the Exist Valuation performed ?
• Successful exit valuation : estimate of value of company at IPO or buyout year
o Estimate of valuation conditional on success
- Valuation taken at exit date (no discounting)
- Focus on successful events = bulk of money for VC comes from
- Not include only cases of staggering success
- Key distinction between absolute valuation (discounted CF analysis and relative valuation (comps analysis)
What is the target multiple-of-money ?
• VC funds often target firms yielding exit valuations at least a multiple of dollar investment
→ Multiple called target multiple of money
- Reason VC funds require multiple → successful exits need to compensate for failures + account for time value of money
- PV of exit = exit valuation x p/(1+r(vc)^T where p = probability of exit
• Target multiple M & target return TR linked to cost of capital and p via : p/(1+r(VC)^T = 1/M + 1/(1+TR)^T
where T = # yrs firm remains private
What is the expected retention ?
Expected percentage of shares all current owners will own at exit date
How to estimate retention ?
- Start with # shares VC own after round of financing
- Include all founder’s shares
- Include all options
- Add # shares issued in subsequent rounds
- Add # shares necessary at successful exit given past experience
What is an investment recommendation ?
Comparison of costs and benefits of given investment
What does investment recommendation involve ?
Partial valuation exercise
What does the partial valuation exercise show ?
How much of PV given valuation LPs expected to capture
Why recommendation rather than decision of investment ?
Uncertainties in valuation of private firms.
What is the Standard VC method steps ?
- Required investment today ? ($I)
- Exit valuation of comapny ? ($ exit valuation)
- Target multiple-of-money on investment ? (M)
- Expected retention percentage ?
- Total valuation for company today ?
→ total valuation = $ exit valuation x retention/M - Proposed ownership percentage ?
- Estimate partial valuation for investment
→ partial valuation = proposed % x total valuation - Investment recommendation : comapre partial valuation to $I
- Estimate LP cost for investment
→ LP cost = $I (committed capital / invesmtent capital) - Expeced GP% fo investment ?
→ GP% = carry% x (GVM x investment capital - carry basis)/(GVM x Investment capital) - LP valuation from investment ?
→ LP valuation = (1 - GP%) x partial valuation - Investment recommendation : compare LP valuation to LP cost
2 Ways to value firm conditional on successful exit ?
- Input market’s opinion given investment at exit date = comparables method
- Make projections of CF of firm from year exit until infinity and discount them to present (DCF approach)
How is the discount rate estimated ?
From industry avg or comparable companies
What does the discount rate refer to ?
Cost of capital of financed firm ≠ cost of capital of VC
What is the discount rate used for ?
Compute value of firm in the date of exit
How to estimate cash flows on exit date ?
- Revenue forecasted for avg success case
- Other accounting ratios estimated using comparable companies or rule of thumb estimates
- Not estimate CFs from valuation ratios
- Point of DCF analysis = form own opinion about potential investment
What does Forecasting CFS need to take into account after exit date ?
Growth trajectory over lifetime of firm
What do pioneering firms exhibit ?
Spectacular growth in early years
What happens to growth ?
Slows over time = Not easy to generate spectacular ideas perpetually
What happens to new invested capital ?
Fetches lower returns
What do costs for larger firms lead to ?
Decreasing returns to scale
What happens to success ?
Gets imitated by new competitors leading to declining margins
What happens to growth in the long term ?
Stabilize at low levels
Why does quantity of investment increases the return on each new invested dollar declines ?
Decreasing returns to scale
What happens during rapid growth period ?
- Last for 5-7 years
- Avg revenue growth set to 75th percentile of growth for new IPO firms in same industry
- Margins, tax rates, cost of capital : change in equal increments across years so that exit values reach graduation values in graduation year
What happens on graduation date ?
- Stable growth rate = expected inflation
- Return on new capital = cost of capital
- Return on old capital = industry average
- Operating margin = industry avg
- Cost of capital = industry average cost of capital
What are the steps of using comps for cost fo capital ?
- Identify set of comparable companies
- Estimate performance-evaluation regression for each of these companies
- Compute unlevered betas
- Compute avg of unlevered betas
- Use corresponding cost of capital formula to estimate cost of capital
