Chap 11 Solutions

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Chapter 11 VENTURE CAPITAL VALUATION METHODS DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by “finding the value of a venture’s assets is the same as finding the value of a venture’s debt plus equity”? This is just a statement of the accounting identity expressed in market values: Market Value of Assets = Market Value of Debt + Market Value of Equity. 2. Describe the basic venture capital (VC) method for estimating a venture’s value. Venture capital (VC) method: estimates the venture’s value by projecting only a terminal flow to investors at the exit event. 3. Describe the process for estimating the percentage of equity ownership that must be given up by the founder when a new equity investment is needed. Estimate the value of the exit event. Discount that value at the venture capital discount rate to get a present value. Divide the amount the new investor will contribute by that present value to determine the percentage of the venture’s ownership that must be sold. 4. How does a present value venture valuation pie differ from a future value valuation pie? The present value valuation pie is the present value of the future valuation pie where the discounting is done at the venture capital discount rate. 5. What is meant by pre-money valuation? What is post-money valuation? Pre-money valuation: present value of a venture prior to a new money investment Post-money valuation: pre-money valuation of a venture plus money injected by new investors. 6. What is staged financing? Describe how the capitalization (cap) rate is calculated. Staged financing: financing provided in sequences of rounds rather than all at one time Capitalization (cap) rate: spread between the discount rate and the growth rate of the cash flow in terminal value period

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7. How is multiplying a projected earnings by a P/E ratio similar to discounting a perpetuity of earnings starting at that level? Both convert a projected earnings number into a present value. The P/E multiple approach does so by multiplication (P/E*E=P) and the discounting approach does so by division (E/(r-g)). When P/E=1/(r-g), these give the same answer for a given projected E. 8. How would one expect P/E ratios to vary with a venture’s risk and growth opportunities? P/E should increase with valuable growth opportunities and decrease with risk, other things being equal. 9. What are the common ways to estimate a terminal value for a venture? A few common ways to estimate terminal value for a venture would be to use a P/E or other multiple or to divide final cash flow by the cap rate (r-g). 10. What is the difference between the direct comparison method and the direct capitalization method? Direct comparison applies a direct comparison ratio to the related venture quantity and need not have any discounting interpretation. Direct capitalization capitalizes earnings by discounting using a cap rate (r-g) implied by a comparable ratio. There is a direct discounting interpretation. Direct comparison can be used with stock variables (like “dollars per square foot”) whereas direct capitalization is really restricted to flow variables (like earnings, cash flow and dividends). 11. Describe two important motives for having an equity component in employee compensation. One reason is that the expected deferred and tax-preferred compensation allows the venture to pay a lower current compensation, thereby lowering the current need for external financing. A second reason is the substantial impact it can have in motivating employees toward the founders’ and venture investors’ shared goal of a high value for the company’s equity. 12. Describe the following terms from the perspective of venture performance: black hole, living dead, and venture utopia. In what sense is the typical business plan utopian? A black hole venture is a venture that results in a 100 percent loss to venture investors. A living dead venture is a venture that provides minimal, if any, returns to

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venture investors. A venture utopia venture is a venture that provides phenomenal returns the venture investors. The typical business plan is utopian because most plans forecast the high end of the possible success spectrum. In other words, they typically are overly optimistic in their projections. 13.

What is meant by the utopia discount process? Describe how expected present value is calculated. Utopia discount process: allows the venture investors to value their investment using only the business plan’s explicit forecasts. The PV is calculated by discounting utopian projections at utopian required returns

14. Describe how expected present value is calculated when there are two or more scenarios. The alternative to a “utopian” venture valuation approach is a “mean” venture valuation approach which considers that two or more outcomes could occur. First, the present value of each outcome would be calculated. Second, each outcome’s present value would be multiplied by the probability that the outcome would occur. Third, the resulting probability-weighted outcomes would be summed to get an expected present value for the venture. 15. Discuss the type of data and the procedural changes necessary to implement a fivescenario expected PV valuation for a venture investment. To conduct a five scenario expected PV valuation, we would need to start with an idea about what the five levels of possible success or failure are. To each scenario, we would need to assign a probability (likelihood) that that scenario would be the outcome. Using a single discount rate for all five scenarios, we would project and discount the VCFs for each scenario. After multiplying the scenario PV by its likelihood we would sum to get the expected PV across all five scenarios. Of course, we could just apply the probabilities to each of the five scenarios’ periodic VCFs to get an expected cash flow and then discount these amalgamated cash flows by the single discount rate to arrive at the same value. 16. What is the difference between discounting expected cash flows from multiple scenarios at a constant rate and averaging the scenarios’ PVs calculated with that single discount rate? These are the same when a single fixed discount rate is used and all other assumptions are the same.

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From the Headlines -- Excaliard: What ingredients would you need to conduct a VCSC valuation for Excaliard? Does your calculation suggest that a $15.5 million Series A round is reasonable? Answers will vary: Typical ingredients in a VCSC valuation are a projection of the series of fundraising rounds necessary prior to a liquidity/terminal event, the size of that liquidity event and the required return for investors as it applies to business plan (or altered) projections culminating in that liquidity event. Whether a $15.5 million valuation is justified depends entirely on one’s subjective beliefs about the size and timing of the liquidity event and the current and future required returns necessary to entice the projected funding necessary to reach the liquidity event.

EXERCISES/PROBLEMS AND ANSWERS 1. 2. [Venture Present Values] A venture investor wants to estimate the value of a venture. The venture is not expected to produce any free cash flows until the end of year 6 when the cash flow is estimated at $2,000,000 and is expected to grow at a 7 percent annual rate per year into the future. A. Estimate the terminal value of the venture at the end of year 5 if the discount rate at that time is 20 percent. $2,000,000/(.20 - .07) = $15,384,615.38 B. Determine the present value of the venture at the end of year 0 if the venture investor wants a 40 percent annual rate of return on the investment. $15,384,615.38/1.405 = $2,860,529.72 3. [Venture Capital Valuation Method] A venture capitalist wants to estimate the value of a new venture. The venture is not expected to produce net income or earnings until the end of year 5 when the net income is estimated at $1,600,000. A publicly-traded competitor or “comparable firm” has current earnings of $1,000,000 and a market capitalization value of $10,000,000. A. Estimate the value of the new venture at the end of year 5. Show your answer using both the direct comparison method and the direct capitalization method. What assumption are you making when using the current price-to-earning relationship for the comparable firm? P/E of comparable firm = $10,000,000/$1,000,000 = 10 times New Venture Value: $1,600,000 net income times 10 = $16,000,000

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Assumptions: 1. The “comparable firm” is really comparable to the new venture. 2. The current price-to-earning relationship of 10 will still be the appropriate multiple to use 5 years from now. B. Estimate the present value of the venture at the end of year 0 if the venture capitalist wants a 40 percent annual rate of return on the investment. $16,000,000/1.405 = $2,974,950.91 4. [Multiple Financing Rounds] Ratchets.com anticipates that it will need $15,000,000 in venture capital to achieve a terminal value of $300,000,000 in five years. A. Assuming it is a seed stage firm with no existing investors, what annualized return is embedded in their anticipation? r = (300,000,000/15,000,000)^(1/5)-1 = 82.0564% B. Suppose the founder wants to have a venture investor inject $15,000,000 in three rounds of $5,000,000 at time 0, 1 and 2 with time 5 exit value of $300,000,000. If the founder anticipates returns of 70%, 50% and 30% for round 1, 2 and 3, respectively, what percent of ownership is sold during the first round? During the second round? During the third round? What is the founders’ year-five ownership percentage? First Round FV: 5,000,000 x (1.7)^5 = 70,992,850 Second Round FV: 5,000,000 x (1.5)^4 = 25,312,500 Third Round FV: = 5,000,000 x (1.3)^3 = 10,985,000 Total FV = 107,290,350 First Round % of Total FV = 23.66% = 70,992,850/300,000,000 Second Round % of Total FV = 8.44% = 25,312,500/300,000,000 Third Round % of Total FV = 3.66% = 10,985,000/300,000,000) Founder final ownership = 1 – 23.66% - 8.44% - 3.66% = 64.24% = 192,709,650/300,000,000 C. Assuming the founder will have 10,000 shares, how many shares will be issued in rounds 1, 2 and 3 (at times 0, 1 and 2)? Founder shares = 10,000 Total shares at year 5: =10,000 / .6424 = 15,567 Round one shares = .2366 x 15,567 = 3684 Round two shares = .0844 x 15,567 = 1313

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Round three shares = .0366 x 15,567 = 570 D. What is the second round share price derived from the answers in Parts B and C? Second Round Price = 5,000,000 / 1313 =3808/share E. How does the answer to part D change if 10% of the year-five firm is set aside for incentive compensation? How many total shares are outstanding (including incentive shares) by year 5? Founder final ownership = 1 -23.66% - 8.44% - 3.66% -10% = 54.24% Total shares at year 5 = 10,000 / .54.24 = 18,438 Round two shares = .0844 x 18,438 = 1556 Round two price = 5,000,000 / 1556 = 3213/share

6. [Multiple Financing Rounds] Rework the two-stage example of section 10.5 with 1,000,000 initial founders’ shares (instead of the original 2,000,000 shares). What changes? Total Shares After Financing 

1,000,000  11,851,852. .084375

First Round Shares Issued  .759375 * 11,851,852  9,000,000 Share Price

 $1,000,000 / 9,000,000  $.1111 per share

Pre - Money Valuation  $.1111  1,000,000  $111,111 Post - Money Valuation  $.1111 * 10,000,000  $1,111,111 Founder % Between First and Second Rounds  1,000,000/10,000,000  10% First Round Investor % Between First and Second Rounds  9,000,000/ 9,000,000  90%

Second Round Shares Issued  .15625  11,851,852  1,851,852 Share Price  1,000,000 / 1,851,852  $.54 per share Pre - Money Valuation  .54  10,000,000  5,400,000 Post - Money Valuation  .54 * 11,851,852  6,400,000 Founder % Between Second Round and Exit  1,000,000/11,851,852  8.4375% First Round Investor % Betweeen Second Round and Exit  9,000,000/11,851,852  75.9375% Second Round Investor % Between Second Round and Exit  1,851,852/11,851,852  15.625%

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