Here, we are presenting the basis of Private Equity in the aim to be familiar with risks, costs, structure and terms that are unique to private equity funds. Next, we will explain how the use of the venture capital method allows to calculate pre-money valuation, post-money valuation, ownership fraction, number of new shares issued, and the price per share for the new investment. Interesting isn’t it?
Introduction
Private equity is of increasing importance in global economy. Private equity firms make investments ranging from investments in early stage companies (venture capital investment) to investments in mature companies (generally in a buyout transaction).
The sources of value creation in private equity are:
The ability to re-engineer the company
The ability to obtain debt financing on more favorable terms
Superior alignment of interests between management and private equity ownership.
Differences between buyout and venture capital
Relative to buyouts, venture capital companies are characterized by:
Unpredictable cash flows and product demand;
Weak asset base and newer management team;
Less debt;
Unclear risk;
Unclear exit strategy;
High demand for cash and working capital;
Less opportunity to perform due diligence;
Higher returns from few highly successful companies;
Limited data for valuation and comparisons (benchmarks may not be available).
Exit Strategies
The means and timing of the exist strongly influence the exit value. and therefore the value of the firm.
There are 4 types of exits:
IPOs that result in the highest exist value due to increased liquidity, greater access to capital, and the potential to hire better quality manager
Sales to other investors or firms (strategic or financing investors)
Management Buyout where the company is sold to management who utilize a large amount of leverage
Liquidation when the company is no longer viable and results in the lowest exit value
Risk Factors
The major risk factors for private equity investments are:
Liquidity risk: private equity investments are not publicly traded, it may be difficult to liquidate a position;
Competitive environment risk: the competition for finding reasonably-priced private equity investment may be high;
Capital risk: withdrawals of capital may jeopardize the company;
Regulatory risk: government regulations could affect the company;
Valuation risk: valuation is subjective;
Diversification risk;
Market risk: private equity is subject to long-term market changes (i.e. interest rates).
Furthermore, the costs of investing in private equity are significantly higher than those associated with publicly traded stocks.
Valuation with the Venture Capital Method
Here, we describe the valuation of an investment in an existing company using the Venture Capital Method.
At the time of a new investment in the company, the discounted present value of the estimated exit value (PV exit value) is called the post-money value (after the investment is made). The value before the investment is made can be calculated as the post-money value minus the investment amount and is called the pre-money value.
POST = PV (exit value)
PRE = POST – INV
In order to determine the number of new share issued to the venture capital firm (share VC) for an investment in an existing company, we need to determine the fraction of the company value (after the investment is made) that the investment represents.
Based on the expected future value of the company (exit value), and the expected or required rate of return on the investment, we can do this either with the NPV method or the IRR method, both give the same result (as long as the same required return r is used).
The fraction of venture capital ownership (f) for the investment can be calculated by
NPV Method
IRR Method
The IRR method uses the future value of the investment in round 1 at the expected exit date.
Once we have calculated f, we can calculate the number of shares issued to the VC (shares VC) based on the number of existing shares owned by the company founders prior to investment (shares Founders).
The price per share at the time if the investment (price) is then simply the amount of the investment divided by the number of new shares issued.
If there is a second round of VC financing (INV2), we can calculate the new fractional ownership from the new investment (f2) and the number of new shares required (shares VC2) using the NPV method.
Where POST 2 is the discounted present value of the company as of the time of the second financing round, its post-money value after the second round investment.
POST 1 is the discounted present value of the company as of the time of the first financing round, its post-money value after the first round investment.
We can calculate the fractional ownership from the first round investment (f1) using the NPV method:
The new shares required to be issued to the VC in return for the first round financing amount (INV 1) and the price per share can be calculated as:
The new shares required to be issued to the VC in return for the second round financing amount (INV 2) and the price per share can also be calculated as:
If the second round of financing is considered less risky than the first round, a different and lower required return may be used in calculating the present value of the exit value at the time of the second round of financing.
Account for Risk in Venture Capital Valuation
As we saw, the required rate of return and the estimated terminal value will strongly influence the valuation.
In the aim to take into account the probability of failure, we can either adjust the required rate of return or adjusting the terminal value by using scenario analysis.
Adjusting the required rate of return
We adjust the required rate of return by taking into account the probability of failure q.
Adjusting the Terminal Value using Scenario Analysis
Scenario analysis is used to calculate an expected terminal value reflecting different values under different assumptions.
Conclusion
Venture Capital valuation is highly dependent on the assumptions used and how risk is accounted for. Additionally, scenario and sensitivity analysis should be used to determine how changes in the input variables will affect the valuation of the company.
Please note that what we discussed here is not to ascertain the exact value of the company. Rather, the purpose is to place some bounds on the value of the company before the negotiations begin between the startup and the VC.
Article written by Tristan Van Iersel
