Venture capital valuation method

Venture capital valuation method

With the estimation challenges that analysts face in valuing young companies, it should come as no surprise that they look for solutions that seem to, at least on the surface, offer them a way out. Many of these solutions, though, are the source of the valuation errors we see in young company valuations. In this section, we will look at the most common manifestations of what we view as the dark side in young company valuations, and how they play out in the venture capital valuation method.

  1. Top line and bottom line, no detail: It is difficult to estimate the details on cash flow and reinvestment for young companies. Consequently, many valuations of young companies focus on the top line (revenues) and the bottom line (earnings, and usually equity earnings), with little or no attention paid to either the intermediate items (that separate earnings from revenues) or the reinvestment requirements (that separate earnings from cash flows)
  2. Focus on the short term, rather than the long term: The uncertainty we feel about the estimates that we make for young companies become greater as we go further out in time. Many analysts use this as a rationale for cutting short the estimation period, using only three to five years of forecasts in the valuation. “It is too difficult to forecast out beyond that point in time” is the justification that they offer for this short time horizon.
  3. Mixing relative with intrinsic valuation: To deal with the inability to estimate cash flows beyond short time periods, analysts who value young companies use relative valuation as a crutch. Thus, the value at then end of the forecast period (three to five years) is often estimated by applying an exit multiple to the expected revenues or earnings in that year and the value of that multiple is itself estimated by looking at what publicly traded companies in the business trade at right now.
  4. Discount rate as the vehicle for all uncertainty: The risks associated with investing in a young company include not only the traditional factors – earnings volatility and sensitivity to macroeconomic conditions, for example – but also the likelihood that the firm will not survive to make a run at commercial success. When valuing private businesses, analysts often hike up discount rates to reflect all of the concerns that they have about the firm, including the likelihood that the firm will not make it.
  5. Ad hoc and arbitrary adjustments for differences in equity claims: As we noted in the last section, equity claims in young businesses can have different rights when it comes to cash flow and control and have varying degrees of illiquidity. When asked to make judgments on the value of prior claims on cash flows, superior control rights or lack of liquidity, many analysts use rules of thumb that are either arbitrary or based upon dubious statistical samples.

All five of these practices come into play in the most common approach used to value young firms, which is the venture capital approach. This approach has four steps to it:

Step 1: We begin by estimating the expected earnings or revenues in a future year, but not too far into the future: two to five years is the typical range. In most cases, the forecast period is set to match the point in time at which the venture capitalist plans to sell the business or take it public.

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Step 2: The value at the end of the forecast period is assessed by multiplying the expected earnings in the future year by the multiple of earnings (PE ratio) that publicly traded firms in the sector trade at. In some cases, the multiple is based on other companies in the sector that have been sold or gone public recently.

Equity Value at end of forecast horizon = Expected Earnings (in year n) * Forecasted PE

Alternatively, the revenues at the end of the forecast period can be multiplied by the revenue multiple at which publicly traded firms trade at to arrive at an estimate of the value of the entire business (as opposed to just equity).

Enterprise value end of forecast period = Expected Revenues (in year n) * Forecasted EV/Sales

This approach is used for companies that may not become profitable until later in the life cycle.

Step 3: The estimated value at the end of the forecast period is discounted back at a target rate of return, generally set high enough to capture both the perceived risk in the business and the likelihood that the firm will not survive. Since the latter is a high, venture capital required rates of return tend to be much higher than the discount rates that we see used with publicly traded companies.

Venture capital valuation method

The following table summarizes the target rates of return demanded by venture capitalists, categorized by how far along a firm is in the life cycle:

Venture Capital Target Rates of Return – Stage in Life Cycle

Stage of development

Typical target rates of return

Start up

50-70%

First stage

40-60%

Second stage

35-50%

Bridge / IPO

25-35%

How do we know that these rates of return have survival risks built into them? In addition to the intuitive rationale that they decrease as firms move through the life cycle and the chance of failure drops off, the actual returns earned by venture capitalists at every stage of the process are much more modest. The table below summarizes the actual returns earned by venture capitalists in the aggregate for investments across the life cycle.

Returns earned by Venture Capitalists – 2007

3 year

5 year

10 year

20 year

Early/Seed VC

4.90%

5.00%

32.90%

21.40%

Balanced VC

10.80%

11.90%

14.40%

14.70%

Later Stage VC

12.40%

11.10%

8.50%

14.50%

All VC

8.50%

8.80%

16.60%

16.90%

NASDAQ

3.60%

7.00%

1.90%

9.20%

S&P

2.40%

5.50%

1.20%

8.00%

Note that the returns earned by venture capitalists, especially on early stage investments, are significantly higher than the returns earned by investors in equity in public markets over the same period, but are no where near the target returns listed in the above table ‘Venture Capital Target Rates of Return – Stage in Life Cycle’.

For instance, early stage VC investors earned an annual return of 21.4% over the last 20 years, well below the 50-70% target returns. In effect, the high target rates of return that are used in analysis are not delivered by most investments (usually the ones that fail to make it to the exit valuation).

Step 4: Venture capitalists receive a proportion of the business in return for the capital they bring to the firm. To make a judgment on what proportion of the firm they are entitled to, the new capital brought in is added to the estimated value from step 3 (called the pre-money value) to arrive at the post money valuation of the firm.

Post money valuation = Pre Money valuation from step 3 + New capital infusion

The proportion of equity that the venture capitalist is entitled to is then computed by dividing the capital infusion by the post-money valuation.

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Proportion of equity to new capital provider =

New Capital Provided

Post Money Valuation

As we see it, there are several problems with the venture capital approach and many of them are rooted in the practices we listed before:

  1. By focusing on revenues and earnings, and ignoring both the intermediate items and those that come after, venture capital valuations encourage game playing. Since value increases as the projected earnings (revenues) increase, the existing owners of the business try to push up these values, without having to flesh out the consequences in terms of future capital investment. On the other side of the bargaining table, venture capitalists will argue for using lower numbers for earnings and revenues, since this pushes down the estimated value (and gives them a greater share of equity for the same capital investment). Consequently, the projected value becomes a bargaining point between the two sides rather than the subject of serious estimation.
  2. Venture capital valuations try to avoid the serious challenges of estimating operating details for the long term by cutting off the estimates prematurely (with a short forecast period) and using a multiple that is usually based on what comparable companies are trading at currently. However, the multiple of earnings or revenues that a business will trade at 3 years from now will be a function of the cash flows after that point. Not estimating those cash flows or dealing with the uncertainty in the cash flows does not mean that the uncertainty has gone away.
  3. There is a degree of sloppiness associated with the use of a target rate to discount the future value of the firm. This target rate is the rate demanded by venture capitalists, who are equity investors in the firm, and this rate incorporates the likelihood that the business will fail. There are two problems with using this number as the discount rate on the future value of the business. The first is that the future value discounted has to be an equity value; this is of course the case when we use expected equity earnings and a PE ratio, but will not be so if we use revenues and enterprise value multiples. In the latter case, we should be considering the cost of capital as the discount rate and not the rate demanded by just equity investors. The second is that building in a probability that the business will not survive into the discount rate also implies that this rate will not change over time, as a firm moves through the life cycle.
  4. 4. While the rationale for adding the new capital infusion to the pre-money value is simple, it works only if the new capital raised stays in the firm to be used to fund future investments. If some or all of the new capital is used by existing equity investors to cash out of their ownership in the firm, the portion that is removed from the firm should not be added back to get to the post-money value.

Case – Valuing Secure Mail

Secure Mail is a small software company that has developed a new computer virus screening program that it believes will be more effective than existing anti-virus programs. The company is fully owned by its founder and has no debt outstanding. The firm has been in existence only a year, has offered a beta version of the software for free to online users but has never sold the product (revenues are zero).

During its year of existence, the firm incurred $ 15 million in expenses, thus recording an operating loss for the year of the same amount. As a venture capitalist, you have been approached about providing $ 30 million in additional capital to the firm, primarily to cover the commercial introduction of the software and expanding the market for the next two years. To value the firm, the venture capitalist decides to employ the venture capital valuation method.

1. The founder believes that the virus program will quickly find a market and that revenues will be $ 300 million by the third year.

2. Looking at publicly traded companies that produce anti-virus software, the venture capitalist comes up with two companies that the venture capitalist feels are relevant comparables.

Company

Market Cap

Debt outstanding

Cash

Enterprise Value

Revenues

EV/Sales

Symantec

9,388

2,300

1,890

9,798

5,874

1.67

McAfee

4,167

394

3,771

1,308

2.88

From a practical point of view it is decided to use the average across the two companies, which yields an enterprise value of 2.275 times revenues. (As the venture capitalist, one would probably argue for an even lower number (Symantec’s multiple). To counter, the founder of Secure Mail will probably argue that his company will be priced more like McAfee)

Estimated value in 3 years = Revenues (in Year 3) * EV/Sales = 300 * 2.275 = $682.89 million

3. Since this business has a product, ready for the market, but has no history of commercial success, the venture capitalist decides to use a target rate of return of 50%. Since the firm has no debt outstanding, the estimated value is entirely equity and the value today can be estimated as follows:

Venture capital valuation method

4. To estimate the post-money valuation, the venture capitalist adds the cash proceeds that the venture capitalist will be bringing into the firm to the pre-money value of $202.34 million.

Post money value = Pre-money value + Capital infusion = $202.34 million + $ 30 million = $232.34 million

The proportion of the equity in the firm that the venture capitalist will receive for the capital infusion can then be computed as follows:

picture 4Note that these numbers are subject to negotiation and that this is the minimum share that the venture capitalist would accept. The venture capitalist will push for lower future revenues, a more conservative multiple of those revenues in the final year and a higher target rate of return, all of which lower the value of the firm and will give him a higher share of the equity (for the same capital investment). The existing owner of the firm will push for higher future revenues, a higher multiple of these revenues in the final year and a lower target rate of return, all in the interests of pushing up value, and giving up less equity ownership for the capital invested.

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