Understanding the Venture Capital Valuation Method

A core compenent of the venture capital investment process is the valuation of the business seeking outside investment. There following is a basic outline of commonly used valuation methods for  early stage companies.
Traditional Valuation Methods

Net Present Value Method. The net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows. In the case when all future cash flows are incoming (i.e. principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis – taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) – is called the yield, and is more widely used in bond trading.

Comparables. Similar to real estate valuations, the value of a company can be estimated through comparisons with similar companies. There are many factors to consider in selecting comparable companies such as size, growth rate, risk profile, capital structure, etc.
Hence great caution must be exercised when using this method to avoid an “apples and oranges” comparison. Another important consideration is that it may be difficult to get data for comparable companies unless the comparable is a public company. Another caveat when comparing a public company with a private company is that, all other things being equal, the public company is likely to enjoy a higher valuation because of its greater liquidity due to being publicly traded.
The Venture Capital Valuation method in contrast often involves investments in an early stage company that are showing great promise, but typically cannot be assessed through traditional valuation methods, as these companies do not have a long track record and its earnings prospects are volatile and /or uncertain. The initial years following the venture capital investment often will involve projected losses. The venture capital method of valuation recognizes these realities and focuses on the projected value of the company at the planned exit date of the investor.
The steps involved in a typical valuation analysis involving the venture capital method follow.
Step 1: Estimate the Terminal Value
The terminal value of the company is estimated at a specified future point in time. That future point in time is the planned exit date of the venture capital investor, typically 4-7 years after the investment is made in the company. The terminal value is normally estimated by using a multiple such as a price-earnings ratio applied to the projected net income of the company in the projected exit year.

Step 2: Discount the Terminal Value to Present Value
In the net present value method, the firm’s weighted average cost of capital (WACC) is used to calculate the net present value of annual cash flows and the terminal value.
In the venture capital method, the venture capital investor uses the target rate of return to calculate the present value of the projected terminal value. The target rate of return is typically very high (30-70%) in relation to conventional financing alternatives.

Step 3: Calculate the Required Ownership Percentage
The required ownership percentage to meet the target rate of return is the amount to be invested by the venture capitalist divided by the present value of the terminal value of the company. In this example, $5 million is being invested. Dividing by the $17.5 million present value of the terminal value yields a required ownership percentage of 28.5%.
The venture capital investment can be translated into a price per share as follows: The company currently has 500,000 shares outstanding, which are owned by the current owners. If the venture capitalist will own 28.5% of the shares after the investment (i.e. 71.5% owned by the existing owners), the total number of shares outstanding after the investment will be 500,000/0.715 = 700,000 shares. Therefore the venture capitalist will own 200,000 of the 700,000 shares.
Since the venture capitalist is investing $5.0 million to acquire 200,000 shares the price per share is $5.0/200,000 or $25 per share.
Under these assumptions the pre-investment or pre-money valuation is 500,000 shares x $25 per share or $12.5 million and the post-investment or post-money valuation is 700,000 shares x $25 per share or $17.5 million.

Step 4: Calculate Required Current Ownership % Given Expected Dilution due to Future Share Issues
The calculation in Step 3 assumes that no additional shares will be issued to other parties before the exit of venture capitalist. Many venture companies experience multiple rounds of financing and shares are also often issued to key managers as a means of building an effective, motivated management team. The venture capitalist will often factor future share issues into the investment analysis. Given a projected terminal value at exit and the target rate of return, the venture capitalist must increase the ownership percentage going into the deal in order to compensate for the expected dilution of equity in the future.
The required current ownership percentage given expected dilution is calculated as follows:
Required Current Ownership = Required Final Ownership divided by the Retention Ratio

For further reading see Brad Feld’s article VC Algebra.