Valuation of Venture Capital Deals

Ricky Ng

What are Venture Capital Investments?

Financial capital invested in early stage, high growth new start ups.

Stages of investments:Seed: Earliest stage. Company is just an idea.

Startup: A prototype exists.

Series A: Company is expanding but not profitable.

Series B: Company is cash flow positive and scaling.

Ingredients for Success.

Team

Idea

Market size Financing

Post-MoneyValuation

Exit Value

Investor ownership

Determine exit value1

2

Investor has $5,000,000 to investDivide investment amount by the ownership percentage required after dilution impact to find minimum post-money valuation

Calculate ownership % at exit needed to satisfy hurdle rate

3Factor in dilution from new rounds and options pool

4

Investor ownership

Valuation – find future value and work backwards.

Valuation example.

Year 1 2 3

Earnings 10 million 15 million 20 million

Exit Multiple 10x

Exit Value 200 million

Company projections

Investment 5,000,000 Initial investment

Hurdle rate 30% Required rate of return

Investor exit value 10,985,000 5,000,000 x (1.30)^3

Exit ownership needed 5.49% 10,985,000/200,000,000

Expected dilution 25%

Initial ownership needed 7.32% 5.49%/(1-25%)

Post-money valuationPre-money valuation

68,300,00063,300,000

5,000,000/7.32%68,300,000 – 5,000,000

Valuation calculations

Dilution modeling and considerations.

Company value determines the ownership the investor can attain from the amount invested.

However…

An options pool needs to be created to attract key staff and motivate the team,

and additional rounds of funding is needed from other investors,

which will lead to dilution!!!

Dilution modeling – initial equity cap table.

Pro Forma Cap TableStart-up Capitalization

Common Total %

Founders 1,000,000 1,000,000 100.0%Options Granted 0 0.0%Options Available 0 0.0%Investor 1 0 0.0%Investor 2 0 0.0%Investor 3 0 0.0%

Total 1,000,000 1,000,000 100.0%

Suppose we have an IT company. It has 1,000,000 shares outstanding and owned by the founders.

Dilution modeling – options pool.

A few months later, the founders need to hire professionals and need to create an options pool.

Talent needed include:EngineersMarketing managersProduct managersGraphic artistsSales

New Options Pool

Pre-Money  New Options Total %

Founders 1,000,000 87.0%

Options Granted 0 0.0%

Options Available 150,000 150,000 13.0%Investor 1 0 0.0%Investor 2 0 0.0%Investor 3 0 0.0%

Total 150,000 1,150,000 100.0%

The company issues 150,000 new shares in options.Notice the dilution of 13%!!

Dilution modeling – Series A funding.

The company’s operations cannot keep up with their success and need to raise money.

They need $5,000,000 and agree on a pre-money valuation of $20,000,000 from the VC.

Pre-Money $20,000,000 Negotiated

Shares outstanding 1,150,000 Founders + Options

Price per share $17.39 Pre-money/shares

Total $ invested $5,000,000 Investment

Post-money valuation $25,000,000 Pre-money + 5,000,000

Date 6/30/2012

From the valuation, share price is calculated as $17.39.

Dilution modeling – new equity cap table.

  Series A FundingSeries A Series A Post-Money FD

  Investment Preferred Total %Founders 1,000,000 69.6%Options Granted 0 0.0%Options Available 150,000 10.4%Investor 1 $5,000,000 287,500 287,500 20.0%Investor 2 $0 0 0 0.0%Investor 3 $0 0 0 0.0%

Total $5,000,000 287,500 1,437,500 100.0%

New shares issued = Investment amount/Share price = $5,000,000/17.39 = 287,500

30% Dilution

Dilution modeling – Takeaway.

With Venture investments, key points to keep in mind include:1.Future dilution will impact returns.2.Dilution will be based on the negotiated valuation of the business.

VC Method and WACC.

CAPM only considers systematic risk and assumes everything else can be diversified away.

Most startups are unlikely to use debt financing.

VC Method and APV.

•Startups initially don’t use debt.•Useful for finding later stage valuations or exit value.•Beneficial to use in conjunction with VC method, but not by itself.

APV Method

Conclusion.