A startup-up to a mature company

This note addresses valuation issues that are relevant to entrepreneurial settings. In valuing any investment opportunity from a startup-up to a mature company, it is always worthwhile to use the APV and/or WACC methods as taught in class. In addition, it also is generally useful to use a comparable company or multiple based approach. The APV, WACC and comparable methods deliver values that are appropriate when a company or investment is valued by a capital market that is relatively liquid and well-behaved.

The valuation of investments in private companies – particularly start-ups – generate additional problems, concerns and questions that are not generally present in valuing public companies. A number of methodologies and institutions have evolved to deal with these problem and concerns. This note will describe, discuss, criticize, and, hopefully improve upon some of those methodologies. The venture capital (VC) method is commonly used in the venture capital community. A variant, descried in the LBO section, is used to value LBOs.

Please note that as discussed in class VCs are professional investors who know an industry segment well, are fairly wealthy people, have pooled together money (along with money from third parties) and use their superior knowledge of an industry to ONLY invest in companies in that industry (example: www. kpcb. com, www. sequoia. com, www. 3i. com. , The VC method begins with the forecasts of the company’s future operations, and the resulting free cash flows to leveraged equity. These cash flows represent the cash flows available to equity investors which include the VC.

For many VC investments these cash flows will be identical to free cash flows to an all-equity firm because the firms being funded are often financed without any debt. The VC will then estimate the time at which it is likely that the VC will exit the investment. The VC usually will have a specific exit strategy – an IPO, sale to a strategic buyer in mind, or restructuring – in mind. The VC will then attempt to put a value on the company at that exit date. Typically, this value is calculated by estimating the company’s earnings.

EBIT, EBITDA, sales (or other valuation relevant figure) and applying appropriate multiple. The resulting value at IPO or sales is taken as the terminal value of the investment. The VC method then discounts the free cash flows to leveraged equity and the exit or terminal value back to the present. The VC method will typically use a discount rate ranging from as low as 25% for investment in later stage or more mature businesses to as high as 70% or 80% for seed investments. These discount rates are typically higher, sometimes substantially so, than discount rates calculated using a CAPM based type model.

The resulting value is the pre-money value the VC will be willing to pay for the company. This assumes that the forecast case flows included a negative cash flow that will be covered by the financing round being contemplated. I, instead the cash flows do not include that negative cash flow, the resulting value is the post-money value. One important additional point, this methodology implicitly assumes that all negatives cash flows to leveraged equity will be funded by VC equity investments that will earn the same rate of return.

Here is an example: A VC is thinking of investing 4 million in a company today. The 4 million will be used immediately to buy new equipment. In give years, the VC believes the company will have net income of 5 million. Companies today n the same business trade at price-earnings (P/E) ratios of 30 times. So the VC will assume an exit value of 150 million (30 times 5). The company will not have any debt, will not required additional equity investments , and will not throw off nay other cash until the exit in five years. Before the new financing, the firm has 1. 6 million shared outstanding.