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New Venture Valuation
What is Different About Valuing New Ventures?
- Higher risks and higher uncertaintyHigher risks and higher uncertainty
- Potential rewards higher? Option Values?
- Exit and liquidity more important
- Not just a go-no/go decision; the actual valuations
matter
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Valuation Approaches
- Discounted Cash Flow/ Adjusted Present ValueDiscounted Cash Flow/ Adjusted Present Value
- The Venture Capital Method
→Comparables
Discounted Cash Flow/Adjusted Present
Value (APV)
- Use APV not WACCUse APV not WACC
→ Capital structure involves hybrid securities not easily classified as debt or equity → Capital structure changes over time → Interest tax shields change over time as company’s tax status changes
- APV is a more flexible method that can accommodate
these features of new venture valuation.
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Where Can We Find Beta?
- Standard to look at publiclyStandard to look at publicly traded comparable-traded comparable
firms in same industry.
- But often there aren’t many that are in similar stage
of development.
- Later stage companies will tend to have lower
betas (all else equal) than early stage companies
bbecause start-up expenses in early stage t t i l t
companies (e.g. R&D) tend to be more fixed than in
later stage companies.
Terminal Value Calculation
- Run out Free Cash Flows until they reach a stableRun out Free Cash Flows until they reach a stable
pattern
- Assume a growth rate of g% from then on; use
conservative growth rates
- The terminal value formula is:
TV = FCF*[1+g] / [k-g]
PV(TV) = TV / [1+k]n
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Wrinkles on Standard APV Calculations
- Company may not have taxable income for many years. → Tax rate in these yyears is 0. Tax losses can be carried forward for up to 15 years to lower taxable income in profitable years. → What discount rate should be applied?
- Interest expense is not deductible in years when the
company has tax losses.
→ Carry forward interest expense to years when it can be deducted (up to three years carry forward).
- Explicit modeling of idiosyncratic uncertainty isExplicit modeling of idiosyncratic uncertainty is
particularly important.
→ Take expected value of cash flows over various scenarios
APV Example: Medical Diagnostics, Inc.
"Medical Diagnostics, Inc" ($000) 2002 2003 2004 2005 2006 Revenue 734 6,475 22,445 55,960 110, Cost of Goods Sold 318 2,406 7,175 16,723 32, R&D 1,191 1,343 1,665 3,555 8, Sales and Marketing 2,517 4,908 8,805 16,815 25, Regulatory and Clinical 704 904 1,199 1,345 1, Other Expense 2,137 3,397 4,733 6,740 9, Total SG&A 6,549 10,552 16,402 28,455 45, EBITDA (6,133) (6,483) (1,132) 10,782 32, Depreciation 184 334 544 579 723 EBIT (6,317) (6,817) (1,676) 10,203 31, Taxes 0 0 0 0 10, Depreciation Addback 184 334 544 579 723 Capital Expenditures 543 567 742 880 959 NWC (364) 1,410 6,416 16,316 32, Ch ICh. In NWC NWC (364)(364) 1 774 1 ,774 5 0065,006 9 9009,900 15 99915, Free Cash Flow (6,312) (8,824) (6,880) 2 4, Discount Rate 13% Growth 3% 7% PVFCF (14,735) (14,735) TVFCF 18,410 17, TV 184,096 297, PVTV 99,920 161, Value 85,185 146,
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Example: MIT.com, Inc.
- Step 1: Forecast Sales or revenues
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Earnings -5 0 0 0 0 100
- Step 2: Assume company exits after 5 years
- Step 3: Assume that the company will have earnings of 5 and it will gg o public at a multipp ple of 20x earninggs for a value of $100M.
- Step 4: Valuation at 50% Discount Rate
→ Post-money = $100M/(1.50)^5 = $13.2M
→ Pre-money value = $8.2M
Example: MIT.com (cont.)
→→ VC will ask for 5/13 2 = 38 0% equity stake to invest $5MVC will ask for 5/13.2 = 38.0% equity stake to invest $5M
→ Assume N 0 = 1M shares outstanding prior to financing.
How many new shares, N 1 , does the VC get?
→ N 1 /(N 0 + N 1 ) = s N 1 = 1 −
s s
N (^) 0
→ N 1 = 0.612M shares
→ Stock price = $5M/0.612M = $8.
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Stock Option Pool
- If the firm needs to reserve 15% of the equity (by the exit date) tt o recruit management team, then we need to adjust the numberit t t th d t dj t th b of shares. The VC still gets 38% of the equity.
- If m is the stock option pool percentage, and Nm is the number of shares issued to the stock option pool, then we know that the shares issued to the VC and the option pool (N 1 + Nm) are: s + m N (^) 0 1 − s − m
- The shares held by the VC investor, N 1 , are then: s N 1 − s − m^0
Stock Option Pool (cont.)
→ N 1 = 0.38/(1 - 0.38 - 0.15) * 1M = 0.809M shares → Nm = 0.15/(1 - 0.38 - 0.15) *1M = 0.319M shares.
→Price per share is $6.18.
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N N N
New Investor (cont.)
- Note that the first round VC investor starts off with a 40.7% equityq y stake, which then gets diluted to 38% ownership when the second round VC investor comes on board.
- If development time slips by two years then the second round investors require 11.1% equity share, since their valuation at this point is $26.9M = 100/1.3^5. If we still have to give 15% in option pool, this implies that: N (^) 22 = 1 − s
s 2
2 − m
(( N (^) 00 + N (^) 11 ))
which is (0.111/(1 - 0.111 - 0.15))*1.940M = 0.291M shares.
- The first-round VC ends up with only 35.8% of the shares at the exit date and the IRR on the investment falls to 32.5% from 50%.
Comparable Multiples For Exit Values
- Find exit values by looking at similar companiesFind exit values by looking at similar companies
→ Take multiples of EBITDA, sales, customers, eyeballs etc.
→ Tells you what the market thinks about growth potential.
→→ Tells you what the market thinks about growth potentialTells you what the market thinks about growth potential. → May be hard to find real comparable firms at similar stages that are already public and for whom data are available.
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Caveats About Multiples
- Industry Cycles →→ Young industries might have high multiples for firms that enterYoung industries might have high multiples for firms that enter the market today, since they have first mover advantage
- Mean Reversion
→ High multiples for firms that enter the market during a “hot” market need not apply for firms that go public in a few years → How well can you “market time”?
→ IPO multiples overstate gains due to long term under- performance → Choose your multiples wisely!!
Why Are Discount Rates so High?
- Such high discount rates cannot be explained asSuch high discount rates cannot be explained as
being a reward for systematic risk.
- In most practical cases, CAPM would give discount
rates well below 25%, let alone 80%.
- ThThree (li(limitited)d) ““ratitionalles””: → Compensate VC for illiquidity of investment; → Compensate VC for adding value; → Correct for optimistic forecasts and idiosyncratic risk.
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Rationale III: Optimistic Forecasts
- VC method assumes that the firm hits its targetsVC method assumes that the firm hits its targets.
→ Forecasts tend to rely on cash flows in the best case
- A higher discount rate is a crude way to correct
forecasts that are too optimistic.
→ Build uncertainty into the cash flow estimates → 80% of 0 is still 0 → This is not the time to be lazy!
Rationale IV: VC Market Power
- Valuations are influenced by the distribution ofValuations are influenced by the distribution of
bargaining power between VC and entrepreneur
→ Affects the rent distribution between VC and entrepreneur
- Factors that influence bargaining power:
→ Supply and demand for capital; when a lot of capital flows into the VC market,, valuations are higgher → Valuations increase with the number of active VC firms in the market → Reputation and track record of VC / entrepreneur; repeat entrepreneurs get better valuations
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Since VCs use this need to
An Alternative to High Discount Rates:
Scenario Analysis
• Since VCs certainly use this method, you need tocertainly method, you
know how to use it!
→But it does not preclude you from taking a more
sophisticated approach to the problem.
• Explicitly model cash flows and sources of uncertainty.
→Allows you to better understand the sources of risk and
ththeiir iimplilicatitions ffor vallue
→Reduces your reliance on “guessing” terminal values
→Allows you to value an investment’s “real options” - the
ability to change plans as new information arrives
Appendix
Some Useful Calculations
Example of A Tax Loss Carry Forward
- FCF 11 = 270 x ((1- 0.4)) + 30 - 40 + 0 = 152
- ITS 1 = min( 0.4 x 270 , 0.4 x 300) = 108
- CCF 1 = FCF 1 + ITS 1 = 260
- cannot use $30 of our interest expenses = $12 interest tax shield
- FCF 2 = 315 x (1-.40) + 35 - 40 - 15 = 169
- ITS 2 = min(0.4 x 315, 0.4 x 200 + 12 ) = 92
- CCF 2 = 261
- If interest expenses + tax shield were greater than tax expense ($125.6), tax shield would be carried forward again
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