The venture capital method

Entry Notes

Posted: 12112006
Author: Peter Kolle
Category: Investing

Underlying this method is the desire to project the company's value based not on a forecast of the cash flows it is expected to generate, but rather on an estimate of the company's terminal value (TV) at the time of exit, which is the number regarded as relevant for the investors. The present value of the company is subsequently calculated. The result is the present value of the company after the investment (i.e., post-money).

While the determination of the terminal value of the company can be done using any of the methods described in this article, the most common method VCs use is the multiples model, primarily due to its simplicity, and that VCs are typically interested in the general range of values the company could fetch at an IPO, where it is typically valued by market participants based on industry multiples. There is no one parameter or a set of multiples that are always used, as these will vary from one investor to another, and particularly from one company to another. In addition, the more mature, advanced and well known the company, the more accurate and detailed the process will be, and the closer it will become to traditional valuations.

We note, though, that following the decline in the stock market in recent years, we already observe more extensive use of the other traditional methods of valuation described in this article, as well as usage of other advanced methodologies, such as option pricing and simulation tools.

The Venture Capital method is composed of several stages, the ultimate goal of which is to determine the share in the company that the venture capital investor will demand for his investment.

Illustrating the Venture Capital Method
Medica Example (all figures in $ millions) Lower Value Higher Value
Value at Exit TV $300 $500
Time to Exit t 4 4
Discount Rate r 75% 75%
Additional Raise I2 $20 $20
Value at 2nd Round V2 $80 $80
% dilution D=I2/(V2+I2) 20% 20%
Present Value PV=TV/(1+r)^t $32 $53
PV with Dilution DPV=PV*(1-D) $26 $43
Investment I $10 $10
Required % S=I/PV 31.26% 18.76%
Required % with Dilution
I/DPV 39.08% 23.45%

We will now detail the process and illustrate it using a medical technology firm as an example:

Stage 1: Analyze and Identify the Type and Time of the Exit

In the first stage, the fund attempts to weigh the risks involved in the investment against the chances of success. The fund examines the management, market, product, and business model. In this process, the fund manager is required to use intuition and experience; the product of this process is not necessarily one figure, but rather a range of values the company will be worth at approximately the time of the desired exit. The VC is looking at the value ascribed to similar companies, the competitive environment in which the company operates, and the sentiment in the market toward companies in the particular field—as well as estimating the chances of an exit by selling the company to a strategic entity, and the company's value to such an entity.

The VC tries to identify the possible type of exit from the company in the range of three to five years, which is the time frame preferred by venture capitalists, who are required to return all of their investments within seven to ten years. It is worthwhile to note that if the possible foreseeable exit is more than five years away, then only some investors will be suitable for such an investment. Such longer-term exits are appropriate for venture capital funds with a long-term outlook (i.e., funds that operate in areas with long-term exit-horizons, or funds that are just starting out investing for their current fund) or for strategic investors.

The investor tries to estimate which type of exit from the company will be feasible: an IPO, a sale, or a merger. If he or she thinks that a sale or merger is conceivable, he or she examines who the potential buyers are.

Mini-Case Study: Medica—Stage 1

We shall assume that Medica (a fictitious company) has achieved a revolutionary development in the medical diagnostics market, which could be used as an add-on to the CT scanner, a field over which medical equipment giants such as GE Medical, Philips, Toshiba, and others are competing.

Medica could potentially sell its products to all of the manufacturers, to be bundled in their products, or sell the products to distributors of these systems, to be marketed as an add-on. However, given a thorough analysis of the competitive environment, the VC realizes that it is likely that Medica would not be able to achieve substantial sales on its own, and an exit via an acquisition by one of the manufacturers would be the preferred alternative. The giant companies are already well established in the market, and have experienced, global, visible, and proven marketing and sales forces, as well as a customer base.

It therefore follows that the company's value in a sale to one of the giants, which could use the add-on as a tool for obtaining a competitive advantage, would be derived from the synergy in sales of the larger CT machines. The value will be determined based on the value for the large company itself, as well as from the perceived threat of Medica's acquisition by one of the giant's competitors.

We shall assume that the VC decides that he or she is interested, in principle, in investing the required $10 million in the company (I=10). For the analysis in the next steps, the VC assumes the exit would be in the form of an acquisition by another company, which will take place in four years time, when the development and testing of the tool will be completed (t=4).

Stage 2: Estimate Terminal Value (TV)

In the second stage, the VC tries to estimate what the company's value will be three to five years after investment in the company. For this purpose, the investor uses one of the methods reviewed above: the market value of comparable mature companies, the company's sales or earnings multiple, and so on. Due to the great sensitivity to underlying assumptions, the investor does not work with only one number. In other words, he does not use a working-point, but rather a working-range.

Mini-Case Study: Medica—Stage 2

As discussed above, the company's value in a sale to one of the medical equipment giants could be derived from the value which the large company calculates for itself, and from the threat it perceives in the acquisition of Medica to one of its large competitors, which could increase their market share with the technology. In our example, the VC analyzes the potential contribution of the add-on to the value of the potential acquirers. Without going into too many details, we assume that after a careful analysis, utilizing the methods described in this article, the VC determines that the sale could be expected to yield $300–$500 million (TV= 300 in the lower valuation, and TV=500 in the higher valuation).

Stage 3: Determine the Discount Rate (r)

At this stage, the investor needs to decide upon the minimum return he will demand for his investment. This rate is affected by the main risks involved in the investment, such as the company's developmental phase, existence of sales, risk involved in the development, entrepreneurs' experience, quality of management, market and field, competition, and so on. All of these factors, even if they had already been analyzed and accepted by the investor when deciding to actually make the investment, must be weighed again in the context of their impact on the value according to which he or she will join the company.

The rates that VCs apply are typically much higher than those applied by investors in the stock market, or those that would have been anticipated using the standard models (such as CAPM) for determining the discount rate. Venture capitalists are interested in achieving annual returns of 20–40% on their investments. Because some of their investments will be lost, or may not succeed at the anticipated level, investors aim to only make investments that could potentially earn them very high rates of return, namely 50–100%. This reflects both the need to indemnify unsuccessful investments and the internal risks which could cause a delay in performance, and hence in the exit as well.

Experienced venture capital investors will try to take combined action. On the one hand, to they will make "conservative" investments in advanced startups that are close to an exit and are led by experienced and well known teams, in which they will make do with returns of 40% or less but have a good chance of succeeding. On the other hand, they will make earlier and riskier investments, in which they will demand a return of up to 100%.

Mini-Case Study: Medica—Stage 3

The investor has tremendous faith in Medica and its management team, but based on his or her past experience of investing in other firms in the sector and the relatively early development stage of Medica (which involves risks associated with potential delays in the development, testing, and regulatory approval of the tool), the VC decides that the discount rate to be used is 75% per annum (r=75%).

Stage 4: Estimate Additional Required Investment

At this stage, the investor tries to estimate how much money the company will need to raise in the future and according to which value, based on its needs and capital-raising options until the planned exit. This stage is important in order to estimate the dilution the investor is expected to experience if he or she does not exercise his or her pre-emptive rights to preserve his or her percentage of ownership by joining the next rounds.

Mini-Case Study: Medica—Stage 4

The VC and the company believe that until the exit, Medica will require an additional $20 million over and above the current investment (I2=20).

Let us assume the investor estimates that the additional investment will be raised in a single round in about two years, based on a (pre-money) company value of $80 million (V2=80). The VC does not plan to not take part in that round, and thus expects his or her holdings to be diluted by about 20% (D=I2/(V2+I2)=20%).

Stage 5: Calculate the Range of Values for Investment

At this stage, based on the company's range of values at the time of exit, the time range until such exit, the expected dilution, and the discount rate, the investor will calculate what the company's range of values is at the time of investment. Based on the results of the valuation, the investor will negotiate with the company to determine the actual value according to which the investment will be made. Dividing the desired investment by the company's present value produces the equity share that the investor will demand in the company.

Mini-Case Study: Medica—Stage 5

The resultant range of values for the investment is $32–$55 million without dilution (PV=TV/(1+75%)4 = $32 using the lower value, and $55 using the higher value). Taking into account the expected dilution, the derived range of values is $26–$43 million (DPV=PV*(1-D)

The investor will therefore require 23–39% of the company in consideration for the $10 million investment.

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