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Venture Capital Method of Valuation

Page history last edited by Brian D Butler 15 years, 1 month ago

 

The Venture Capital Method of Valuation

 

    see also:   business valuation, and Angel investor valuation method

 

 

Invest in high-risk, high-return investments, with horizon of five or 6 years. Goal is to either go public or sell to a competitor. To manage risk, VC’s typically make staged investments in which the company must meet stated business milestones before qualifying of next financing round. VCs typically specialize in one stage (startup, early stage or mezzanine). Risk and return demanded diminishes from one round to the next.

 

Standard discounted cash flow technique does not work well for VC’s because the cash is intended to cover near-term, negative free cash flows. But more importantly, the standard techniques of discounting cash flows does not take into consideration the multiple financing rounds at different required rates of return.

 

 

Table of Contents:


 

 

 

 

 

Venture Capital - model

This is a hypothetical (unrealistic) situation, but will be used for an example.

 

VC valuation method 01-1.xls

 

http://www.liquidscenarios.com/  By far the best software Ive seen so far: Liquid Scenarios provides software that estimates valuations of private companies, and determines the benefits or outcomes of liquidation events versus financings for all parties involved.

 

 

Simplified Model - just one round of financing

 

 

Venture Capital Method of Valuation          
             
Facts and Assumptions            
             
owners originally issues (t=0) 2,000 shares        
Net Income (year 5)  $            8,000 estimate        
PE ratio (year 5)                    15 from similar company       
Investment required t=0  $            5,000 estimate from company      
VC target rate of return 60%          
             
Cash Flow and Valuation            
  0 1 2 3 4 5
Investment 5000          
Net Income x x x x x  $             8,000
Valuation t=5            $         120,000
Valuation t=0 (discounted) = Post money valuation  $          11,444          
Pre-money valuation  $            6,444          
VC ownership requirment 43.7%          
Number of shares (owner) 2,000 56.3%        
Number of shares (VC) 1,552 43.7%        
Total Shares 3,552          
price per share   $             3.22 per share        
             

 

 

Simplified Model - two rounds of financing:

 

 

 

Venture Capital Method of Valuation            
             
Facts and Assumptions            
             
owners originally issues (t=0) 2,000 shares        
Net Income (year 5)  $            8,000 estimate        
PE ratio (year 5)                    15 from similar company       
Investment required t=0  $            5,000          
Investment required t=2  $          10,000          
VC(1) target rate of return 60% annually        
VC(2) target rate of return 40% annually        
             
Cash Flow and Valuation            
  0 1 2 3 4 5
Investment 5000   10000      
Net Income x x x x x  $             8,000
Valuation t=5            $         120,000
2nd Round Investor            
Valuation t=2      $          43,732      
Pre-money valuation      $          33,732      
Time 5 ownership to earn targeted returen     22.9%      
1st Round Investor            
Valuation t=0 (discounted) = Post money valuation  $          11,444          
Pre-money valuation  $            6,444          
VC#1 ownership requirment (t=5) 43.7%          
Retention Ratio (1-previous round owners %) 77.1%          
VC#1 ownership requirement (t=0) 56.6%          
Number of shares (owner) 2,000 33.4%        
Number of shares (VC#1) 2,613 43.7%        
Number of shares (VC#2) 1,368 22.9%        
Total Shares 5,980          
price per share (t=0) for VC#1  $             1.91 per share        
price per share (t=2) for VC#2  $             7.31          

 

 

 

Valuations and Internet Companies

 

Valuing internet start up companies is tricky business.  click here for more discussion:

Valuations and internet companies 

 

 

 

 

 

 

Some tools

 

Here is a nice tool for estimating the value of your startup:

  • http://www.liquidscenarios.com/  By far the best software Ive seen so far:  Liquid Scenarios provides software that estimates valuations of private companies, and determines the benefits or outcomes of liquidation events versus financings for all parties involved.
  • Valuation Estimator - excellent for high tech startups (not just for internet, but for all companies raising money).
  • http://younoodle.com/predictor  This is a fancy algorithm.   The value is understanding how VCs try to put a value on future worth of a start up.  Take the numbers with a grain of salt, though, because its still just a bunch of guess work, based heavily on the managment team, past success, etc...
  • http://pedatacenter.com/pedc/ Fee = $325 per month.  " venture-backed company valuations and the venture capital deal terms used to reach those valuations!"

 

 

 

 

 

Venture Capital Deal Algebra

 

Link to original article

 

I've found that even sophisticated entrepreneurs didn't necessary grasp how valuation math (or "deal algebra") worked. VCs talk about pre-money, post-money, and share price as though these were universally defined terms that the average American voter would understand. To insure everyone is talking about the same thing, I started passing out this document. Recognize that this is about the math behind the calculations, not the philosophy of valuation (which Fred's blog addresses).

 

In a venture capital investment, the terminology and mathematics can seem confusing at first, particularly given that the investors are able to calculate the relevant numbers in their heads. The concepts are actually not complicated, and with a few simple algebraic tips you will be able to do the math in your head as well, leading to more effective negotiation.

 

The essence of a venture capital transaction is that the investor puts cash in the company in return for newly-issued shares in the company. The state of affairs immediately prior to the transaction is referred to as “pre-money,” and immediately after the transaction “post-money.”

 

  • The value of the whole company before the transaction, called the “pre-money valuation” (and similar to a market capitalization) is just the share price times the number of shares outstanding before the transaction: -Pre-money Valuation = Share Price * Pre-money Shares

 

  • The total amount invested is just the share price times the number of shares purchased: -Investment = Share Price * Shares Issued

 

  • Unlike when you buy publicly traded shares, however, the shares purchased in a venture capital investment are new shares, leading to a change in the number of shares outstanding: -Post-money Shares = Pre-money Shares + Shares Issued

 

  • And because the only immediate effect of the transaction on the value of the company is to increase the amount of cash it has, the valuation after the transaction is just increased by the amount of that cash: -Post-money Valuation = Pre-money Valuation + Investment

 

  • The portion of the company owned by the investors after the deal will just be the number of shares they purchased divided by the total shares outstanding: -Fraction Owned = Shares Issued /Post-money Shares

 

  • Using some simple algebra (substitute from the earlier equations), we find out that there is another way to view this: -Fraction Owned = Investment / Post-money Valuation = Investment / (Pre-money Valuation + Investment)

 

  • So when an investor proposes an investment of $2 million at $3 million “pre” (short for premoney valuation), this means that the investors will own 40% of the company after the transaction: -$2m / ($3m + $2m) = 2/5 = 40%

 

  • And if you have 1.5 million shares outstanding prior to the investment, you can calculate the price per share: -Share Price = Pre-money Valuation / Pre-money Shares = $3m / 1.5m = $2.00

 

  • As well as the number of shares issued: -Shares Issued = Investment /Share Price = $2m / $2.00 = 1m

 

  • The key trick to remember is that share price is easier to calculate with pre-money numbers, and fraction of ownership is easier to calculate with post-money numbers; you switch back and forth by adding or subtracting the amount of the investment. It is also important to note that the share price is the same before and after the deal, which can also be shown with some simple algebraic manipulations.

 

 

A few other points to note:

 

Investors will almost always require that the company set aside additional shares for a stock option plan for employees. Investors will assume and require that these shares are set aside prior to the investment, thus diluting the founders.

 

If there are multiple investors, they must be treated as one in the calculations above.

 

To determine an individual ownership fraction, divide the individual investment by the post-money valuation for the entire deal.

 

For a subsequent financing, to keep the share price flat the pre-money valuation of the new investment must be the same as the post-money valuation of the prior investment.

 

For early-stage companies, venture investors are normally interested in owning a particular fraction of the company for an appropriate investment. The valuation is actually a derived number and does not really mean anything about what the business is “worth.”

Link to original article

 

 

 

 

 

 

 

Valuations:

 

 

Using "Options" to value a startup:

 

Avoid just using net present value when valuing a company.  For more info, please see our discusson on real options for more about this very valuable technique. 

 

 

 

 

 

Venture Capitalists and Valuations

Link to original article

 

In general, there are only two things that venture funds really care about when doing investments: economics and control. The term "economics" refers to the end of the day return the investor will get and the terms that have direct impact on such return. The term "control" refers to mechanisms which allow the investors to either affirmatively exercise control over the business or allow the investor to veto certain decisions the company can make. If you are negotiating a deal and an investor is digging his or her feet in on a provision that doesn't affect the economics or control, they are probably blowing smoke, rather than elucidating substance.

 

Obviously the first term any entrepreneur is going to look at is the price. The pre-money and post-money terms are pretty easy to understand. The pre-money valuation is what the investor is valuing the company today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount. There are two items to note within the valuation context: stock option pools and warrants.

 

Both the company and the investor will want to make sure the company has sufficiently reserved shares of equity to compensate and motivate its workforce. The bigger the pool the better, right? Not so fast. While a large option pool will make it less likely that the company runs out of available options, note that the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation. If the investor believes that the option pool of the company should be increased, they will insist that such increase happen prior to the financing. Don't bother to try to fight this, as nearly all VCs will operate this way. It is better to just negotiate a higher pre-money valuation if the actual value gives you heartburn. Standard language looks like this:

 

Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.

 

Alternatively:

 

Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully-diluted pre-money valuation of $ million and a fully-diluted post money valuation of $ million. For purposes of the above calculation and any other reference to fully-diluted in this term sheet, fully-diluted assumes the conversion of all outstanding preferred stockof the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Companys existing option pool by shares prior to this financing.

 

Recently, another term that has gained popularity among investors is warrants associated with financings. As with the stock option allocation, this is another way to back door a lower valuation for the company. Warrants as part of a venture financing - especially in an early stage investment - tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, we recommend the entrepreneur negotiate for a lower pre-money valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with existing investors who - for some reason - want to artificially inflate the valuation since the warrant value is rarely calculated as part of the valuation (but definitely impacts the future allocation of proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as the bridge investor wants to get a lower price on the conversion of their bridge into the next round - it's not worth fighting these warrants.

 

The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in his company - (economics 101: If you have more demand (VCs interested) than supply (equity in your company to sell) then price will increase.) In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the existing investors dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process.

 

 

 

 

Overvaluation - Bubble?

 

see internet bubble

 

 

 

 

Links

 

External:

 

Links from GloboTrends

 

Valuation tools for investors and Entrepreneurs

 

      more...

 

 

 

internet

 

 

trends

 

 

Pages names with "Venture Capital"

 

More pages wtih subject "Venture Capital"

 

 

Private Equity

 

 

More related links:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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