Venture Capital Valuation Method

There are numerous ways to value a firm. There are even more books written on how to value a firm than there are valuation methods. 1 A review of different valuation methods is therefore understandably beyond the scope of this book. We will, in this section, describe the venture capital valuation method only. 2 Normally, when carrying out a business valuation, it is appropriate to use a few different methods to assess robustness of the valuation figure to different methods. 3 As well, within any given valuation method, it is normal to consider the robustness of the valuation result to assumptions underlying the method. In the end, it is important to be transparent about the sensitivity of the valuation results to alternative assumptions used in arriving at the valuation and to different valuation methods. The difficulty with valuing venture capital –backed entrepreneurial firms lies in the variability of the returns associated with venture capital investments. As shown in Chapters 19 –21, for example (see also Cumming and MacIntosh, 2003a,b; Cumming and Walz, 2004; Cochrane, 2005; Cumming et al ., 2006; Cumming, 2008), a significant percentage (often 20 to 30%) of investments are written off. Hence, there is huge variability in returns and a massive scope for valuation error. At best, therefore, valuation of venture capital investments is an art and not a science. One valuation method commonly used by venture capital fund managers is known as the venture capital method. This method involves assumptions that may on the surface seem rather arbitrary. A typical successful venture capital – backed entrepreneurial firm has negative cash flows in the early years of the life of the firm and thereafter positive cash flows (Chapter 1, Figure 1.2). The venture capital fund manager first determines the life of the investment before the exit event and the price at which the investment will be sold at that future exit date. For example, if there is a projection about the firm’s earnings in the exit year, then the sale price might be determined in reference to the price earnings multiple of a typical firm in the same industry. The sale price or “ terminal value ” is then discounted back to the day of first investment with the formula in equation 22.1.

Discounted Terminal Value = Terminal Value / (1 + target rate)^years (22.1)

The target rate is the discount rate required by the venture capital fund. This discount rate is critical to the valuation of the investment and varies depending on various factors that are explained following. In practice, the discount rate can be as large as 75%. Venture capital funds do not own 100% of the firms in which they invest. The venture capital fund’s valuation of the entrepreneurial firm must therefore be adjusted to account for the fact that it will hold less than 100% ownership. In the first step in making this adjustment, the venture capital fund calculates the eventual ownership percentage that it will have at the time of exit, or the “ Required Final Percent Ownership, ” as in equation 22.2.

Required Final Percent Ownership = Investment / Discounted Terminal Value (22.2)

The second step in this adjustment accounts for the fact that over successive financing rounds, investment syndication, and changes in the entrepreneurial firm’s management team’s ownership percentage (e.g., through the issuance of stock options), and so on, the venture capital fund’s ownership will get diluted. The required current percentage ownership depends on the venture capital fund’s retention ratio, or percentage of the investment that will be retained from first investment round to final investment round. Consideration of the retention ratio enables the venture capital fund to figure out what percentage of the firm the venture capital fund must own at the date of initial investment to maintain the required final ownership percentage at the date of exit so the venture capital fund maintains enough equity in the firm to achieve the desired rate of return. The calculation for the required current ownership is given by equation 22.3.

Required Current Ownership Percent = Required Final Percent Ownership / Retention Ratio (22.3)

Consider the following example. Suppose you are employed at the Soprano Venture Capital Fund, a hypothetical venture capital fund in New Jersey. Your first assignment is to value the price per share for a$10 million investment in a start-up green technology venture and to decide on what share of the firm you should demand. You project the firm will have net income in Year 6 of $ 40 million. Similar profitable green ventures listed on stock exchanges are trading at an average price-earning ratio of 15. The firm currently has 400,000 shares outstanding. Tony, your boss, tells you that the Soprano Venture Capital Fund requires a target rate of return of 80%. What is the appropriate price per share, and how many shares do you require? The answer is obtained by following the steps in equation 22.3. Notice in the preceding example that there is a problem associated with using the average price-earnings ratios of existing publicly trading green technology firms. Private firms are illiquid relative to publicly listed firms on stock exchanges, and typically an adjustment needs to be made downward (e.g., possibly by 20%) depending on the expected illiquidity of the private firm. More generally, the main difficulty in this venture capital valuation method involves the choice of discount rate. One justification for placing an arbitrarily high discount rate is the value-added advice provided by the venture capital fund manager. Empirical evidence has shown that more prestigious venture capital funds in fact charge higher discount rates (Hsu, 2004). Entrepreneurs are typically more than willing to accept inferior valuations from more prestigious venture capital funds because of the better advice they expect to receive, as well as the access to better networks of legal and accounting advisors, investments bankers, and other individuals and firms that will help the firm succeed. Therefore, in the next section we present evidence on returns and discuss how returns to venture capital fund investment vary systematically depending on the characteristics of the venture capital fund, entrepreneurial firm, transaction-specific issues, and legal and market conditions.