Chapter 11: Venture Capital Valuation Methods 403 SECTION 11.2 Basic Venture Capital Valuation Method We begin our treatment of VCSCs with the simplest of the shortcuts, a procedure sometimes called the venture capital method. The basic venture capital (VC) method estimates the venture s value by projecting only a terminal flow to investors at the exit event (say, in four or five years). Modifications of this basic VCSC will allow us to consider additional rounds and incentive compensation. We will conclude our discussion of VCSCs by extending the basic method to reintroduce intermediate cash flows and incorporate scenario extensions. As an example, we will present a three-scenario venture valuation with intermediate flows. The basic VCSC approach is simple: (1) cash investment today, (2) cash return at some future exit time, (3) discount this entire return flow back at the venture investors target return, (4) divide today s cash investment by the venture s post-money present value, and you get (5) the percent ownership to be sold in order to expect to provide the venture investors target return. An example of this simple procedure will help clarify its structure. Lynda Chen founded a new venture last year with $10,000 in equity capital for which she received 2,000,000 shares of common stock. The venture is now moving into its startup stage and needs an additional $1,000,000 to carry out the business plan. If Lynda had $1,000,000 to invest, she could retain 100 percent ownership of the venture. However, because Lynda does not have additional equity funds to invest, she is negotiating with a venture investor who is willing to invest $1,000,000 for an ownership position in the firm in the form of newly issued shares of common stock. The investor and the founder agree that the horizon (time to exit) for the investment should be five years. The investor expects a 50 percent compound annual rate of return for the entire five years. We need to value the venture based on a fiveyear exit and determine how many shares to issue to the investor for the $1,000,000. Looking ahead five years, we can say that the successful venture is expected to produce $1,000,000 per year in income at that time. We also know that a similar venture recently sold shares to the public for $20,000,000 (denoted as P below), and that its last twelve months of income was $2,000,000 (denoted as E below). We infer from this that the going price per dollar of income in this technology sector is $10 ($20,000,000/$2,000,000) and estimate the venture s exit value five years from now. 2 Multiplying 10 dollars per dollar of income by the $1,000,000 of projected fifth-year income gives a venture exit value of $10,000,000. Discounting the $10,000,000 exit value by 50 percent per year for five years gives a present value of $1,316,872 or 10,000,000/(1.5) 5. Figure 11.1 depicts the $10,000,000 future value exit pie as well as the $1,316,872 present value of the exit pie. We can work the VC valuations using either form of the exit pie. For initial purposes, we will begin with the present value venture capital (VC) method a valuation method that estimates a venture s value by projecting only a terminal flow to investors at the exit event 2 This approach also is frequently referred to as identifying and applying a price-earnings multiple for valuation purposes. The implicit assumption is that the price per dollar of income is expected to be at the same level at the end of five years. This assumption is common when using current multiples to project future values. We are emphasizing the use of price-earnings multiples and earnings projections to estimate terminal value. Other comparison ratios are frequently used to estimate terminal value. Examples include price to cash flow, price to revenue, and price to customers. The procedure is the same: Find a recent ratio and multiply it by the venture s projected performance on that dimension (e.g., price to revenue multiplied by projected revenue).
404 Part 4: Creating and Recognizing Venture Value Figure 11.1 The Venture Valuation Pie Present Value Future Value $1,316,872 $10,000,000/(1.50) 5 $1,000,000 10 $10,000,000 exit pie, which is consistent with applying the discounted cash flow valuation methods in Chapter 10, whereby we discount future cash flows back to the present. To apply the VC shortcut method, one must first calculate the percent ownership to be sold and then calculate the shares necessary to achieve that ownership. Equations 11.1 and 11.2 implement the VC method. Using I for the investment, E5 for the venture s earnings or net income in Year 5, price/earnings ratio (P/E) for the comparable price per dollar of earnings or net income, m for existing shares, n for new shares to be issued, and r for the expected or demanded rate of return, we have: I Acquired % of Final Ownership (11:1) P E E 5=ð1 þ rþ 5 1,000,000 10 1 1,000,000 =ð1 þ 0:5Þ 5 75:9375% m ðacquired %Þ Shares to Be lssued n 1 Acquired % 2,000,000 ð0:759375þ 0:240625 6,311,688 (11:2) In equation 11.1, we have an investment (numerator) of $1,000,000. The denominator gives the venture s $10,000,000 future value (i.e., $1,000,000 in net income times the P/E multiple of 10) discounted back to the present using (1.50) 5. The result is $1,000,000/$1,316,872, which equals 0.759375 or 75.9375 percent, the equity ownership percentage that must be given to the $1,000,000 investor to get the deal done. Equation 11.2 calculates the number of shares to be issued to the new investor so that he can achieve his stated expected compound annual rate of return of 50 percent. The new shares to be issued can be found by dividing 1,518,750 by 0.240625, which equals 6,311,688. The total number of shares that will be outstanding after the investment will be 8,311,688 (i.e., 2,000,000 original shares plus 6,311,688 new shares). Dividing 6,311,688 by 8,311,688 gives the 75.9375 percent ownership acquired by the new investor. Likewise, the founder will own 2,000,000/ 8,311,688 or 24.065 percent of the venture after the new $1,000,000 investment.
Chapter 11: Venture Capital Valuation Methods 405 Although it is common practice to calibrate investment decisions using present values, ventures often require more than one round of financing and also may have an incentive ownership round. Because these additional financing rounds are likely to occur sometime in the future (up to the venture exit), venture capital shortcut methods sometimes work directly with future exit values instead of their present values. We can easily change the reference time frame from present values ($1,000,000 investment and $1,316,872 present venture value) to Year 5 values ($7,593,750 future value of the $1,000,000 investment and $10,000,000 future venture value). We will get the same answer: I ð1 þ rþ5 Acquired % of Final Ownership P E E 5 (11:3) 1,000,000 ð1 þ 0:5Þ5 10 1 1,000,000 75:9375% Equation 11.3 s numerator would be $7,593,750, which is equal to $1,000,000 inflated by (1.50) 5. The denominator is the same $10,000,000 exit value (i.e., $1,000,000 net income times the P/E of 10) as before. Dividing the future value of the investment by the future exit value also suggests granting a 75.9375 percent ownership position to the new investor. Although the result is the same whether the calculations take place in present or future values, it is important always to compare present values to present values (or future values to future values). Panel A of Figure 11.2 shows that founder Lynda Chen could retain 100 percent ownership if she could make the $1,000,000 investment herself. At exit, she then would own all of the $10,000,000 future value. However, because this is not feasible, Panel B illustrates what would happen to Lynda s ownership position assuming a new $1,000,000 investment (needed to carry out the business plan) in which the investor expects a 50 percent compound annual rate of return. After the $1,000,000 capital infusion, the founder would have only a 0.240625 (1 0.759375) ownership Figure 11.2 Dividing the Future Value Venture Valuation Pie: Founder Full Ownership and First-Round Financing Panel A: Founder Full Ownership FV $10,000,000 Panel B: First-Round Financing FV $10,000,000 Founder 24.0625 % Founder 100.00 % First-Round Investor 75.9375 %
406 Part 4: Creating and Recognizing Venture Value position, or 24.0625 percent of the venture. In other words, the ownership percentage for the founder drops from 100 percent ownership as follows: Founder % Between Financing and Exit 2,000,000=8,311,688 24:0625% Investor % Between Financing and Exit 6,311,688=8,311,688 75:9375% With our equations, it is easy to calculate deal parameters commonly used in discussing venture investments. First, we calculate the issue share price: Issue Share Price $1,000,000 $0:15843622 per share 6,311,688 shares 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 Venture investors sometimes refer to pre-money and post-money valuations. The pre-money valuation is the value of the existing venture and its business plan without the proceeds from the contemplated new equity issue. The post-money valuation is the pre-money valuation plus the proceeds from the contemplated new equity issue. 3 USING PRESENT VALUES Pre-Money Present Valuation 2,000,000 shares $0:15843622 per share $316,872 Post-Money Present Valuation 8,311,688 shares $0:15843622 per share $1,316,872 Put differently, the pre-money present valuation of $316,872 plus the proceeds of $1,000,000 results in a post-money present valuation of $1,316,872. It is important to recognize that both the pre-money and the post-money present valuations depend on executing the business plan and its necessary $1,000,000 investment. USING FUTURE VALUES Pre-Money Future Valuation 2,000,000 shares $0:15843622 per share ð1:50þ 5 $2,406,250 Post-Money Future Valuation 8,311,688 shares $0:15843622 per share ð1:50þ 5 $10,000,000 staged financing financing provided in sequences of rounds rather than all at one time The pre-money future valuation of $2,406,250 plus the future value of the $1,000,000 investment of $7,593,750 results in a post-money future valuation of $10,000,000. Both the present and the future value versions of the VCSC ignore all potential or actual intermediate cash flows to, or from, existing or future investors. As we mentioned in Chapter 10, the associated surplus cash penalty is partially diminished by providing financing in sequences of rounds called staged financing. Before we modify our example to include two rounds of financing, we first digress to consider the quick method we have used for calculating an exit value ($10,000,000 here) and how it relates to the terminal values found by discounting perpetual cash flows like we did in Chapter 10. 3 Much traditional valuation on the asset side is pre-money: new financing is not explicitly projected on the financial statements, where it does not affect valuation cash flows and where share prices are calculated by dividing the premoney value by current shares outstanding. These pre-money methods are easily adapted to post-money by formally including the proceeds on the balance sheet, adjusting the valuation flows, and calculating share value using the sum of outstanding and to-be-issued shares. A more detailed discussion can be found in Learning Supplement 11B.
Chapter 11: Venture Capital Valuation Methods 407 CONCEPT CHECK What is the role played by the existing shares in determining the number of new shares to be issued for the current financing round? How does one derive the post-money valuation from a given pre-money valuation? What is the role of the terminal value in venture capital shortcuts? SECTION 11.3 Earnings Multipliers and Discounted Dividends The application of an earnings multiplier to projected earnings to get a projected terminal value is intuitive. After all: P E E P This is the essence of the earnings multiple conversion of earnings into terminal price. We take a price-earnings ratio (multiple), apply it to earnings, and get price. This method doesn t get interesting until we give the price-earnings ratio (P/E) and the earnings (E) a separate existence and forget their rather direct relationship displayed here. For example, suppose we take a price-earnings ratio from another current venture s prices and earnings when selling shares to the public and apply that ratio to projected earnings for our venture five years in the future. The resulting estimated terminal value is no longer identical to the price (as in the equation above). It is an estimated future price: Other Firms PCurrent Other Firms Current E E Venture Year 5 PVenture Year 5 (11:4) A direct application of a price-earnings ratio to venture earnings is sometimes known as the direct comparison method. We are really just comparing other firms characteristics to a venture s expected characteristics to get a glimpse at possible values for the venture. This type of comparison is similar to examining dollars per square foot to estimate comparable values for real estate. For our current purpose of relating earnings-oriented and dividends-oriented terminal value methods, we focus on (variations of) the earnings multiplier. We get an idea of what s coming by rewriting the multiplier equation as: E Venture Year 5 Other Firms Other Firms Current =PCurrent E P Venture Year 5 (11:5) This is sometimes referred to as the direct capitalization method. Displaying the multiplier relationship this way hints that we may be doing something like discounting a perpetuity of E at a rate E/P. E/P looks like a return on an investment of P. It is like an accounting rate of return except that we have used price instead of book value per share. direct comparison valuation by applying a direct comparison ratio to the related venture quantity direct capitalization valuation by capitalizing earnings using a cap rate implied by a comparable ratio
408 Part 4: Creating and Recognizing Venture Value Returning to our previous valuation example, we used a projected earnings in Year 5 of $1,000,000 and a comparable venture P/E multiple of 10. The Year 5 value was calibrated (as in equation 11.4) to be: Other Firms PCurrent Other Firms Current E E Venture Year 5 20,000,000 2,000,000 1,000,000 10 1,000,000 10,000,000 P Venture Year 5 To reinterpret this valuation under the direct capitalization method, we note that a P/E ratio of 10 is a capitalization rate of 0.10: E Venture Year 5 Other Firms Other Firms Current =PCurrent E 1,000,000 2,000,000=20,000,000 1,000,000 0:10 10,000,000 P Venture Year 5 To examine more carefully the relationship (between price ratios and discounted perpetuities) suggested by the direct capitalization method, we can derive a representation for P/E (and E/P) when price equals the present value of future dividends. Denoting per-share values of earnings, dividends, and prices as E, D, and P, respectively, we know from the terminal value calculation (Chapter 10, equation 11.1) that the time 5 value (and assumed price) of a growing perpetuity of dividends, starting with a dividend of D 6, is: P 5 D 6 r g where r is the discount rate and the dividends grow at rate g. In a constant growth (smooth growth) mode, dividends are equal to the earnings multiplied by a constant payout ratio, D/E. The payout ratio equals one minus the plowback ratio of b = (E D)/E. The plowback ratio (b) is also known as the retention ratio (RR). We can therefore write: Rearranging gives: P 5 E 6 ð1 bþ r g P 5 1 b E 6 r g Using the smooth-growth assumption, we can write: P 5 P 5 E 6 E 5 ð1 þ gþ 1 b r g (11:6) P 5 ð1 bþ ð1 þ gþ E 5 r g Note that these formulas help confirm the intuition that, other things being equal, investors will pay more for a stock with higher growth (g) and lower required return (r). 4 4 As we show in Learning Supplement 10A, even when we are careful to incorporate the fact that b depends on (is a function of) g, we can confirm these basic intuitions about the relationship of P/E ratios to growth and discount rate.
Chapter 11: Venture Capital Valuation Methods 409 Now that we have an idea what multiplying by a price-earnings ratio is analogous to adjusting the flow by (1 b) (1 + g) and applying the cap rate (r g) it is possible to analyze ventures that grow only by retaining earnings and those that grow through both internal and external funding. Learning Supplement 11A provides a detailed examination of several such cases. CONCEPT CHECK Why is the cap rate increasing in g and decreasing in r? What types of growth rates are reasonable to use in (r g)? What is the direct comparison method? What is the direct capitalization method? SECTION 11.4 Adjusting VCSCs for Multiple Rounds As we mentioned in Chapter 10, venture financing is usually staged in rounds. If additional rounds of financing are needed to achieve the Year 5 projected earnings in our current example, the accompanying dilution must be considered in the current round. Failure to do so will result in the investor s not receiving an adequate number of shares to ensure the necessary percent ownership at the time of exit. Suppose the first-round investor believes that Lynda Chen s venture cannot reach the E 5 projection without an additional $1,000,000 infusion at the end of Year 3 from a second-round investor expecting a 25 percent compound annual rate of return on the money contributed at that time. In essence, the first-round investor is suggesting that he doesn t really buy the original business plan s optimism about getting to the $10,000,000 exit having spent only as much as that plan allowed. He s arguing that there s another $1,000,000 of expenses to be covered to get to that same $10,000,000 exit. By the exit, the $10,000,000 pie will therefore have to be split among three parties: the founders, the first-round investors, and the second-round investors. Because the first- and second-round investors will pay share prices that allow for their 50 percent and 25 percent expected returns, all of the loss in ownership resulting from the second round will be borne by the founder. As before, we calculate the acquired percent (of the same exit or terminal value) for the second-round investor to be [$1,000,000 (1.25) 2 ]/$10,000,000 = $1,562,500/ $10,000,000 = 15.625 percent. The first round s acquired percent remains at 75.9375 percent. This leaves only 8.4375 percent for the existing 2,000,000 shares. At the terminal period, the total number of shares outstanding will therefore be 2,000,000/ 0.084375 = 23,703,704 shares. We must therefore issue 0.759375 23,703,704 = 18,000,000 shares in round 1 and 0.15625 23,703,704 = 3,703,704 shares in round 2. Note that, at the first round, the initial percent ownership sold to the round-one investors is much higher than the 75.9375 percent ultimate ownership. It is 18,000,000/20,000,000 = 90 percent. A total of 84.375 percent (1 0.15625) of the investors ownership fraction will be maintained through the subsequent financing. The reasoning behind this example easily extends to multiple subsequent rounds.
410 Part 4: Creating and Recognizing Venture Value The equations for two rounds would be: I ð1 þ rþt 1,000,000 ð1 þ 0:25Þ2 Second-Round Acquired % P E E 10 5 1 1,000,000 15:625% I ð1 þ rþt 1,000,000 ð1 þ 0:5Þ5 First-Round Acquired % P E E 10 5 1 1,000,000 75:9375% Founder's Remaining % 1 0:15625 0:759375 0:084375 Total Shares After Financing 2,000,000 0:084375 23,703,704 FIRST ROUND Shares Issued 0:759375 23,703,704 18,000,000 Share Price $1,000,000=18,000,000 $0:0555556 per share Pre-Money Valuation $0:0555556 2,000,000 $111,111 Post-Money Valuation $0:0555556 20,000,000 $1,111,111 Founder % Between First and Second Rounds 2,000,000=20,000,000 10% First-Round Investor % Between First and Second Rounds 18,000,000=20,000,000 90% SECOND ROUND Shares Issued 0:15625 23,703,704 3,703,704 Share Price $1,000,000=3,703,704 $0:2700 per share Pre-Money Valuation $0:2700 20,000,000 $5,400,000 Post-Money Valuation $0:2700 23,703,704 $6,400,000 Founder % Between Second Round and Exit 2,000,000=23,703,704 8:4375% First-Round Investor % Between Second Round and Exit 18,000,000=23,703,704 75:9375% Second-Round Investor % Between Second Round and Exit 3,703,704=23,703,704 15:625% Panel C of Figure 11.3 depicts this further sharing of the exit value pie among the founder, the first-round investor, and the second-round investor. Notice that Figure 11.3 Dividing the Future Value Venture Valuation Pie: Adding Second-Round Financing and an Incentive Ownership Round Panel C: Second-Round Financing Founder 8.4375 % Second- Round Investor 15.625 % FV $10,000,000 Panel D: Incentive Ownership Round Incentive Ownership Round 6.00 % Second- Round Investor 15.625 % FV $10,000,000 Founder 2.4375 % First-Round Investor 75.9375 % First-Round Investor 75.9375 %
Chapter 11: Venture Capital Valuation Methods 411 the first-round investor retains his 75.9375 percent ownership interest and does not suffer ownership dilution associated with the second-round investor. Unfortunately, the founder (Lynda Chen) suffers the loss in ownership position from 24.0625 percent down to 8.4375 percent, or a difference of 15.625 percent, which goes to the second-round investor. CONCEPT CHECK What is the effect of a second round of financing on the ownership percentages of the founders and the initial first-round investors? How and why does the first-round investors ownership percentage change between rounds 1 and 2? How and why does the founder s ownership percentage change between rounds 1 and 2? SECTION 11.5 Adjusting VCSCs for Incentive Ownership For most early-stage ventures, there are at least two strong motives for having an equity component in employee compensation. The usual 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. The potentially more significant reason for the equity component 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. Almost without exception, professional venture investors demand that some equity (or deferred equity) compensation be formally anticipated and structured into any valuation. Some of the shares allocated to equity-based incentive compensation will be for current employees, and some will be for those added as the venture grows. In any case, the portion of final (exit year) value to be distributed as incentive compensation must be considered in valuing each round. As you might guess, this portion of ownership really comes from the entrepreneurs and founders stakes. That is, given a fixed exit value and fixed demanded returns for venture investors, the only place from which it can come is the dilution of existing (pre-external financing) ownership. Perhaps our example venture has agreed to set aside 6 percent of exit-time ownership for use as incentive compensation. The shares will be distributed through a stock option plan and are expected to generate $200,000 in exercise proceeds when the options are exercised (at the end of Year 5). Importantly, we assume that the use of the $200,000 in proceeds has already been included in the projected financial statements, so that we do not need to add it to the $10,000,000 exit valuation. (The valuation we seek is post-money and post-exercise.) For simplicity, we will treat the 6 percent issue as occurring in Year 5. In many respects, this issue is just another financing round. Proceeding as we did before, the relevant calculations are: Founder's Remaining % 1 0:759375 0:15625 0:06 0:024375 Total Shares After Financing and Incentive Options 2,000,000 0:024375 82,051,282
412 Part 4: Creating and Recognizing Venture Value FIRST ROUND Shares Issued 0:759375 82,051,282 62,307,692 Share Price $1,000,000=62,307,692 $0:01604938 per share Pre-Money Valuation $0:01604938 2,000,000 $32,099 Post-Money Valuation $0:01604938 64,307,692 $1,032,099 Founder % Between First and Second Rounds 2,000,000=64,307,692 3:11% First-Round Investor % Between First and Second Rounds 62,307,692=64,307,692 96:89% SECOND ROUND Shares Issued 0:15625 82,051,282 12,820,513 Share Price $1,000,000=12,820,513 $0:078 per share Pre-Money Valuation $0:078 64,307,692 $5,016,000 Post-Money Valuation $0:078 77,128,205 $6,016,000 Founder % Between First and Second Round and Exit 2,000,000=77,128,205 2:5931% First-Round Investor % Between Second Round and Exit 62,307,692=77,128,205 80:7846% Second-Round Investor % Between Second Round and Exit 12,820,513=77,128,205 16:6223% INCENTIVE OWNERSHIP ROUND Shares Issued 0:0600 82,051,282 4,923,077 Founder % After Incentive Compensation Issue 2,000,000=82,051,282 2:4375% First-Round Investor % After Incentive Compensation 62,307,692=82,051,282 75:9375% Second-Round Investor % After Incentive Compensation 12,820,513=82,051,282 15:625% Employee % After Incentive Compensation 4,923,077=82,051,282 6:00% Now we can see, numerically, how the outside investors are protected against the 6 percent incentive ownership dilution, the burden of which is borne entirely by the founders. Anticipation of the 6 percent dilution causes the first-round (and secondround) investor s necessary initial percent ownership to rise from 90 percent (15.6250 percent) to 96.89 percent (16.6223 percent). Simultaneously, the founders ownership percent after round 1 (and round 2) declines from 10 (8.4375 percent) to 3.11 percent (2.5931 percent). When we look at the difference between a single round and two rounds with incentive ownership, it is startling that non-founder shares issued rise from 6,311,688 for one $1,000,000 round to 21,703,704 for two $1,000,000 rounds, to 80,051,282 for two rounds and 6 percent incentive ownership. Panel D of Figure 11.3 illustrates what happens to the ownership positions of the investors and the founder after accounting for the incentive ownership round. Notice that the buy-in ownership positions of the first-round investor and the second-round investor remained at their initial levels of 75.9375 percent and 15.625 percent, respectively. Again, the ownership dilution associated with the 6.00 percent incentive ownership round was borne by the venture s founder. The result is that the founder now has only a 2.4375 percent ownership position in the exit valuation pie. The price per share in the first $1,000,000 round drops from a little less than $0.16 per share with one round to less than $0.06 per share with two rounds to less than $0.02 per share with two rounds and 6 percent incentive ownership. Such is the impact of dilution. Every entrepreneur should understand the principles and mechanics of dilution before negotiating any type of external financing.