2: The Venture Capital Method

Question 1

1. What is the Exit Valuation

Answer 1

Estimates:

• Company’s value at the time of a “successful exit” (future value)
• The time VC will exit the investment

Question 2

2. What is usually the VC exit strategy?

Answer 2

• IPO
• Sale to strategic buyer (e.g., larger firm in industry)
• Restructuring

Question 3

3. How do you find the exit value?

Answer 3

• Forecast the firm value at the exit date (e.g., IPO)

- Use this value as Terminal Value

Question 4

4. What multiples are often used to estimate the Exit Value?

Answer 4

Typically estimated asa multiple of

• EBIT
• EBITDA,
• Sales or Employees (or other valuation-relevant figure).

Question 5

5. The multiples is typically based on….

Answer 5

Comparable publicly traded companies

Comparable transactions

Question 6

6. Exit Value: Some Standard Issues

Answer 6

• Which comparables?
• Which multiples?
• When? E.g., how is IPO market in 4 years?

Question 7

7. When comparable firms have negative earnings, we can’t use ___. Should rather use

Answer 7

Can’t use EBIT etc. Should use Sales or Employees.

Question 8

8. VC Discount rate will typically range from ___%

Answer 8

25% to 80%

Question 9

9. Discount rates will be lower for

Answer 9

• Later stage

- More mature businesses

Question 10

10. Are VC investments usually short term or long term?

Answer 10

Short term. Usually plans to exit after a few years.

Question 11

11. What is an “successful exit”?

Answer 11

Not one or the other, but can generally say it is successful when:

• IPO or competitive sale
• Competitive sale “could have done IPO, but sale was better”

Question 12

12. What is the main approaches for Exit Valuation?

Answer 12

1) Relative Valuation – Based on Market Opinion
- Finds other companies and use them as Comparables based on their similarities

2) Absolute Valuation – Based on Discounted Future Cash Flows

Both have strength and weaknesses, and both should be done in the valuation

Question 13

13. What are Target Returns

Answer 13

• The appropriate yield for a VC

- uses this to find the Exit Valuation

Question 14

How are Target Returns calculated

Answer 14

Calculated as:

• money invested + profit investor wants
• adjusted for Time Value of money

Question 15

14. What is the Retention Ratio

Answer 15

• Ratio of Net Income kept in the business for further growth
• Dividend ratio the opposite

Question 16

15. What is Expected Retention

Answer 16

Multiple rounds of investments are normal with start-ups or small companies. The Expected Retention tells us the retention of the fraction that the VC will have from his INITIAL INVESTMENT. Given by retention percentage.

Question 17

16. Retention Percentage

Answer 17

Retention from INITIALL investment.

VC holds 25%, or 5m of 20m shares.

VC does a Serie B investment of another 5m. Equity now 25m.

The retention percentage is then 20/25 = 80%. This is the retention rate for the investors.

Question 18

17. The Investment Recommendation

Answer 18

Final step in any VC. Based on the comparisons the investor have made (cost versus benefits). Call it “recommendation” because valuation is not exact science.

First we need to find the total valuation. Then this is multiplied by the proposed ownership, to find the PARTIAL VALUATION.

Question 19

18. Steps in the Standard VC method

Answer 19

Step 1: Estimate the VC’s exit date.
Step 2: Estimate the exit price. Use it as TV.
Step 3: Choose a high discount rate (VC discount rate).
Step 4: Discount TV using this discount rate.
Step 5: Determine the VC’s stake in the company.

Question 20

Step 1

Answer 20

Estimate the VC’s exit date

Question 21

Step 2

Answer 21

Estimate the Exit Price. Use it as the TV

Question 22

Step 3

Answer 22

Choose a (high) Discount rate (VC Discount rate)

Question 23

Step 4

Answer 23

Discount TV using the Discount rate from Step 3

Question 24

Step 5

Answer 24

Determine the VC’s stake in the company

Question 25

19. What is the difference between the Standard VC Method and the Modified VC Method?

Answer 25

Difference in the recognition of costs of VC investing: management fees and carried interests

Question 26

20. What is Carried Interests?

Answer 26

A compensation based on profits. Carried interest is made to give the manager incentive to invest the money good. A % of the profits goes to the manager to motivate he’s performance. Give incentives.

Question 27

21. Why is not the assumption of costs like management fees and carried interest included in the target multiple of money, not ideal?

Answer 27

First, it mixes costs into the valuation step. Total valuation may not be same across different investors. Second, it makes it difficult to be precise about target rates.

Question 28

23. Oz.com will go public in 5 years. In year 5, the Net Income will be $ 5 million. Public comps trade at P/E ratios of about 30x. The VC’s target rate of return is 50%. The FCF in years 0-4 is -4 in year 0 and 0 for the rest of them. Show how the Venture Capital Method steps.

Answer 28

Step 1: Exit Date • Exit Date is in 5 years Step 2: Exit Value: • Exit value is 30 * 5 = $150 million. Step 3: VC Discount Rate • Discount Rate is 50% Step 4: Valuation • Post money value: 150/(1+50%)^5 = $20 million • Pre-money value: 20 – 4 = $16 million • This is a positive NPV project (if you believe 50% is OK) Step 5: VC’s Equity Stake • To invest $4 million, the VC will ask for 4/20 = 20% equity stake.

Question 29

24. When does Expected Retention matter?

Answer 29

Only when the VC expects future rounds of investment

Question 30

``` Firm Data Risk free rate 5 % Volatility 90% Time to exit 5y Investment $ 6 Mio Firm Value $18 Mio Shares Outstanding 10 Mio Structure 1 RP (”and”) $ 5 Mio Plus VC Shares 5 Mio Structure 2 CP (“or”) $ 6 Mio Or VC Shares 5 Mio ``` SERIES B: Firm Risk free rate 5 % Volatility 90% Time to exit 4y Investment $ 12 Mio Series A Shares OVC (not converted) 10 Mio (Convertible Preferred) LP (junior to new investor) 6 Mio Management Share Employees 10 Mio Structure 1 – Series B RP $ 20 Mio (Participating Preferred) VC Shares 5 Mio Structure 2 – Series B Convertible $ 12 Mio (Convertible Preferred) VC Shares 10 Mio How many shares does NVC hold? When does OCV convert?

Answer 30

OCV converts is $ 6m < 2/5 (V - 20) -> V = 35 ``` NVC = 5m # OVC = 10m # Management = 10m # ``` 25m # in total