Venture Capital Method, Discounted Cashflow, Comparables Analysis

1. VALUATION II :VALUATION II :
VC METHOD, DCFVC METHOD, DCF
& COMPARABLES& COMPARABLES
Prof.Stephen OngProf.Stephen Ong
BSc(Hons)Econs (LSE), MBA (Bradford)BSc(Hons)Econs (LSE), MBA (Bradford)
Visiting Professor, Shenzhen UniversityVisiting Professor, Shenzhen University
Academic Fellow, Entrepreneurship & Innovation,Academic Fellow, Entrepreneurship & Innovation,
The Lord Ashcroft International Business School,The Lord Ashcroft International Business School,
Anglia Ruskin University Cambridge UKAnglia Ruskin University Cambridge UK
MSC TECHNOPRENEURSHIP :MSC TECHNOPRENEURSHIP :
VENTURE CAPITAL FINANCINGVENTURE CAPITAL FINANCING

2. Today’s OverviewToday’s Overview

3. LEARNING OBJECTIVESLEARNING OBJECTIVES
To understand the VC method ofTo understand the VC method of
valuation;valuation;
To discuss the Discounted Cash FlowTo discuss the Discounted Cash Flow
(DCF) analysis method of growth(DCF) analysis method of growth
companies;companies;
To discuss the Comparables AnalysisTo discuss the Comparables Analysis
as an alternative approach.as an alternative approach.

4. 1.Venture Capital Method

5. The VC Method of ValuationThe VC Method of Valuation
KEY IDEA:KEY IDEA: Estimate theEstimate the
value of the company in avalue of the company in a
successful exit.successful exit. DiscountDiscount
that value back to today atthat value back to today at
aa very high ratevery high rate..

6. VC Method: Main ElementsVC Method: Main Elements
““Successful” exit valuationSuccessful” exit valuation
Target multiple-of-moneyTarget multiple-of-money
Expected retention percentageExpected retention percentage
Investment recommendationInvestment recommendation

7. Exit ValuationExit Valuation
We want to estimate the valuationWe want to estimate the valuation
conditional on a successful outcome.conditional on a successful outcome.
Key distinction is betweenKey distinction is between absoluteabsolute
valuationvaluation ((discounted cash flowdiscounted cash flow
analysisanalysis) and) and relative valuationrelative valuation
((comparables analysiscomparables analysis).).

8. The Standard VC Method (1)The Standard VC Method (1)
Step 1) What is the requiredStep 1) What is the required
investment today?investment today? ( =( = $I$I ))
Step 2) What is the exit valuationStep 2) What is the exit valuation
for this company?for this company? (($ exit valuation)$ exit valuation)
Step 3) What is the target multiple-Step 3) What is the target multiple-
of-money on our investment?of-money on our investment? ((MM))
Step 4) What is the expectedStep 4) What is the expected
retention percentage?retention percentage? (retention)(retention)

9. The Standard VC Method (2)The Standard VC Method (2)
Step 5) Estimate the total valuation forStep 5) Estimate the total valuation for
the company todaythe company today:: total valuation =total valuation =
$ exit valuation * retention / M.$ exit valuation * retention / M.
Step 6) What is the proposedStep 6) What is the proposed
ownership percentage today?ownership percentage today?
((proposed %proposed %))
Step 7) Estimate the partial valuationStep 7) Estimate the partial valuation
for this investment:for this investment: partial valuation =partial valuation =
proposed % * total valuation.proposed % * total valuation.
Step 8) Investment Recommendation:Step 8) Investment Recommendation:
Compare partial valuation to $I.Compare partial valuation to $I.

10. The Modified VC Method (3)The Modified VC Method (3)
 Step 8) Estimate the LP cost for the investment:Step 8) Estimate the LP cost for the investment:
LP cost = $I (committed capital / investmentLP cost = $I (committed capital / investment
capitalcapital
 Step 9) What is the expected GP% for thisStep 9) What is the expected GP% for this
investment?investment? GPGP% = carry% *% = carry% *
(GVM*investment capital – carry basis) /(GVM*investment capital – carry basis) /
(GVM * investment capital).(GVM * investment capital).
 Step 10) Estimate the LP valuation from thisStep 10) Estimate the LP valuation from this
investment:investment:
LP valuation = (1 – GP%) * partial valuation.LP valuation = (1 – GP%) * partial valuation.
 Step 11) Investment Recommendation:Step 11) Investment Recommendation:
Compare LP valuation to LP cost.Compare LP valuation to LP cost.

11. 2.DCF Analysis of Growth

12. PHASES OF GROWTHPHASES OF GROWTH

13. Growth vs. AgeGrowth vs. Age
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
1 2 3 4 5 6 7
Years since IPO
RevenueGrowth-
IndustryAverage
75th percentile
median
25th percentile

14. Assumptions for exit-value DCFsAssumptions for exit-value DCFs
All-equity structureAll-equity structure
No amortization costsNo amortization costs
No non-operating assetsNo non-operating assets

15. Leverage of VC-backed companiesLeverage of VC-backed companies
Years
Since
IPO
Mean Median
0 4.7% 1.2%
1 4.0% 1.9%
2 5.7% 2.8%
3 6.8% 3.8%
4 7.2% 3.9%
5 8.1% 4.4%
6 8.2% 5.1%
7 9.1% 6.0%
8 8.7% 5.6%
9 10.6% 6.2%
10 11.0% 6.0%
11 11.8% 6.4%
12 12.4% 8.9%
13 11.0% 7.8%
14 7.7% 4.8%
15 11.0% 6.4%

16. DCF – MechanicsDCF – Mechanics
CFCF == EBITEBIT(1-t) + depreciation(1-t) + depreciation
–– Capital expenditures – Δ NWCCapital expenditures – Δ NWC
where,where,
CFCF = cash flow,= cash flow,
EBITEBIT = earnings before interest and taxes,= earnings before interest and taxes,
t = the corporate tax rate, andt = the corporate tax rate, and
Δ NWC = Δ net working capital = Δ netΔ NWC = Δ net working capital = Δ net
current assets – Δ net current liabilities.current assets – Δ net current liabilities.

17. CF and InvestmentCF and Investment
NI = capital expenditures + Δ NWCNI = capital expenditures + Δ NWC
- depreciation- depreciation
Investment rate (IR) = Plowback ratio =Investment rate (IR) = Plowback ratio =
revinvestment rate = NI / Erevinvestment rate = NI / E
CF = E – NI = E – IR * E = (1 – IR) * ECF = E – NI = E – IR * E = (1 – IR) * E

18. NPVNPV
NPV of perpetuity = X /(r – g)NPV of perpetuity = X /(r – g)
Graduation Value = GV = CFGraduation Value = GV = CFS+1S+1 / (r – g)/ (r – g)

19. Graduation ValueGraduation Value
EEN+1N+1 = E= ENN + NI * R+ NI * R
g = (Eg = (EN+1N+1 – E– ENN) / E) / ENN
= (NI * R) / E= (NI * R) / ENN = IR * R= IR * R
GV = (1 – IR) * E / (r – (IR * R))GV = (1 – IR) * E / (r – (IR * R))

20. R as a function of NIR as a function of NI

21. Reality-Check DCFReality-Check DCF
 On the exit date:On the exit date:
 Revenue is forecast for the averageRevenue is forecast for the average
success case;success case;
 Other accounting ratios (Other accounting ratios (notnot valuationvaluation
ratios) are estimated usingratios) are estimated using
comparable companies or rule-of-comparable companies or rule-of-
thumb estimates.thumb estimates.
 The discount rate is estimated fromThe discount rate is estimated from
industry averages or comparableindustry averages or comparable
companies.companies.

22. Reality-Check DCF (2)Reality-Check DCF (2)
 On the graduation date:On the graduation date:
 The stable growth rate is equal toThe stable growth rate is equal to
expected inflation;expected inflation;
 The return on new capital – R(new) –The return on new capital – R(new) –
is equal to the cost-of-capital (r);is equal to the cost-of-capital (r);
 The return on old capital – R(old) – isThe return on old capital – R(old) – is
equal to the industry-average R;equal to the industry-average R;
 The operating margin is equal to theThe operating margin is equal to the
industry average.industry average.
 The cost-of-capital (r) is equal to theThe cost-of-capital (r) is equal to the
industry average cost-of-capital.industry average cost-of-capital.

23. Reality-Check DCF (3)Reality-Check DCF (3)
 During the rapid-growth period:During the rapid-growth period:
 The length of the rapid-growth period isThe length of the rapid-growth period is
betweenbetween five and seven yearsfive and seven years;;
 Average revenue growth is set to the 75thAverage revenue growth is set to the 75th
percentile of growth for new IPO firms in thepercentile of growth for new IPO firms in the
same industry, from data contained in growthsame industry, from data contained in growth
worksheet of the DCF spreadsheet; (worksheet of the DCF spreadsheet; (NOTE:NOTE:
for public companies, one can also usefor public companies, one can also use
analyst estimates here.)analyst estimates here.)
 Margins, tax rates, and the cost-of-capital allMargins, tax rates, and the cost-of-capital all
change in equal increments across years, sochange in equal increments across years, so
that exit values reach graduation values in thethat exit values reach graduation values in the
graduation year.graduation year.

24. EXERCISEEXERCISE
Semico :Semico :
DCF AnalysisDCF Analysis

25. Example : SemicoExample : Semico
EBV is considering an investment in Semico, an early-stageEBV is considering an investment in Semico, an early-stage
semiconductor company. If Semico can execute on their businesssemiconductor company. If Semico can execute on their business
plan, then EBV estimates it would be five years until a successful exit,plan, then EBV estimates it would be five years until a successful exit,
when Semico would have about $50M in revenue, 150 employees, awhen Semico would have about $50M in revenue, 150 employees, a
10 percent operating margin, a tax rate of 40 percent, and10 percent operating margin, a tax rate of 40 percent, and
approximately $50M in capital (= assets). Semico’s business is toapproximately $50M in capital (= assets). Semico’s business is to
design and manufacture analog and mixed-signal integrated circuitsdesign and manufacture analog and mixed-signal integrated circuits
(ICs) for the servers, storage systems, game consoles, and networking(ICs) for the servers, storage systems, game consoles, and networking
and communications markets. It also plans to expand into providingand communications markets. It also plans to expand into providing
customized manufacturing services to customers that outsourcecustomized manufacturing services to customers that outsource
manufacturing but not the design function. It expects to sell itsmanufacturing but not the design function. It expects to sell its
product predominantly to electronic equipment manufacturers.product predominantly to electronic equipment manufacturers.
ProblemProblem
1.1.To make the transaction work, EBV believes thatTo make the transaction work, EBV believes that
the exit value must be at least $300M. How doesthe exit value must be at least $300M. How does
this compare with the reality-check DCF?this compare with the reality-check DCF?
2.2.How much must the baseline assumptions change toHow much must the baseline assumptions change to
justify this valuation?justify this valuation?

26. 3.Comparables Analysis

27. CompsComps
Comps = Comparables Analysis = MultiplesComps = Comparables Analysis = Multiples
Analysis = Method of Multiples = RelativeAnalysis = Method of Multiples = Relative
ValuationValuation
Simple Example: Forecast $50M exit revenue,Simple Example: Forecast $50M exit revenue,
average multiple in industry is Enterpriseaverage multiple in industry is Enterprise
Value (EV) =Value (EV) = 5X revenue5X revenue
$250M implied EV$250M implied EV
$250M implied EV

28. MultiplesMultiples
EV / RevenueEV / Revenue
EV / EBITEV / EBIT
EV / EBITDAEV / EBITDA
Price / EarningsPrice / Earnings
Price / BookPrice / Book
EV / EmployeesEV / Employees
EV/ Eyeballs, EV/ Patents, EV / Scientists,EV/ Eyeballs, EV/ Patents, EV / Scientists,
EV/ Drugs in Clinical Trials etc…EV/ Drugs in Clinical Trials etc…

29. DCF vs. CompsDCF vs. Comps
EV = CF / (r – g) = CF / (r – R * IR)EV = CF / (r – g) = CF / (r – R * IR)
CF = (1 – IR) * E = (1 – IR) * (1 – t) * EBITCF = (1 – IR) * E = (1 – IR) * (1 – t) * EBIT
EV / E = Market Cap / E (when debt = 0)EV / E = Market Cap / E (when debt = 0)
= P / E = (1 – IR) / (r – R * IR)= P / E = (1 – IR) / (r – R * IR)
EV / Revenue = margin * (1 – t) * (1 – IR) / (r – R *EV / Revenue = margin * (1 – t) * (1 – IR) / (r – R *
IR)IR)
EV / employees =EV / employees =
revenue per employee * margin * (1 – t) * (1 – IR) /revenue per employee * margin * (1 – t) * (1 – IR) /
(r – R * IR)(r – R * IR)

30. EXERCISEEXERCISE
Semico :Semico :
Comps AnalysisComps Analysis

31. Example : SemicoExample : Semico
EBV is considering an investment in Semico, an early-stageEBV is considering an investment in Semico, an early-stage
semiconductor company. If Semico can execute on their businesssemiconductor company. If Semico can execute on their business
plan, then EBV estimates it would be five years until a successful exit,plan, then EBV estimates it would be five years until a successful exit,
when Semico would have about $50M in revenue, 150 employees, awhen Semico would have about $50M in revenue, 150 employees, a
10 percent operating margin, a tax rate of 40 percent, and10 percent operating margin, a tax rate of 40 percent, and
approximately $50M in capital (= assets). Semico’s business is toapproximately $50M in capital (= assets). Semico’s business is to
design and manufacture analog and mixed-signal integrated circuitsdesign and manufacture analog and mixed-signal integrated circuits
(ICs) for the servers, storage systems, game consoles, and networking(ICs) for the servers, storage systems, game consoles, and networking
and communications markets. It also plans to expand into providingand communications markets. It also plans to expand into providing
customized manufacturing services to customers that outsourcecustomized manufacturing services to customers that outsource
manufacturing but not the design function. It expects to sell itsmanufacturing but not the design function. It expects to sell its
product predominantly to electronic equipment manufacturers.product predominantly to electronic equipment manufacturers.
ProblemsProblems
a) Identify comparable companies for Semico.a) Identify comparable companies for Semico.
b) Use accounting and market information from theseb) Use accounting and market information from these
companies to estimate a relative valuation forcompanies to estimate a relative valuation for
Semico.Semico.

32. Identifying CompsIdentifying Comps
Theme: Think about the “DCF vs.Theme: Think about the “DCF vs.
Comps” formulasComps” formulas
Revenue range (IR and R)Revenue range (IR and R)
Elasticity of product demandElasticity of product demand
(margins)(margins)
Place in the supply chain (margins, revPlace in the supply chain (margins, rev
per employee)per employee)
Industry, sub-industry (all variables)Industry, sub-industry (all variables)

33. Semico Comps
Cannot use negative multiplesCannot use negative multiples
Typical problem for high-growthTypical problem for high-growth
companies!companies!
Answer comes down to “whichAnswer comes down to “which
company is more comparable?”company is more comparable?”

34. Using comps for the cost of capitalUsing comps for the cost of capital
1) Identify a set of comparable companies;1) Identify a set of comparable companies;
2) Estimate a performance-evaluation2) Estimate a performance-evaluation
regression for each of these companies;regression for each of these companies;
3) Compute the3) Compute the unlevered betasunlevered betas for thesefor these
companies; (described below)companies; (described below)
4) Compute the average of these unlevered4) Compute the average of these unlevered
betas;betas;
5) Use the corresponding cost of capital5) Use the corresponding cost of capital
formula to estimate the cost of capitalformula to estimate the cost of capital

35. Unlevering betaUnlevering beta
If beta of debt (and other securities) = 0 and taxIf beta of debt (and other securities) = 0 and tax
shields are discounted at the unlevered cost ofshields are discounted at the unlevered cost of
capital, then we can compute the unlevered beta ascapital, then we can compute the unlevered beta as
ββUU = MC / EV *= MC / EV * ββLL
WhereWhere ββUU is the unlevered beta, MC is market cap,is the unlevered beta, MC is market cap,
EV is enterprise value, andEV is enterprise value, and ββLL is the levered beta.is the levered beta.
(NOTE: This simplification should not be used in(NOTE: This simplification should not be used in
highly levered industries.)highly levered industries.)

36. Cost of CapitalCost of Capital
Using unlevered beta(s), e.g.
r = 0.04 + βU* 0.07 (for the CAPM)

37. Further ReadingFurther Reading
 Metrick, Andrew and Yasuda, Ayako (2011) Venture
Capital & the Finance of Innovation. 2nd
Edition. John
Wiley & Sons.
 Lerner,Losh, Hardymon, Felda and Leamon, Ann
(2012). Venture Capital and Private Equity : A
Casebook. 5th
Edition. John Wiley & Sons.
 Dorf, R.C. and Byers, T.H. (2008) Technology
Ventures – From Idea to Enterprise 2nd
Edition,
McGraw Hill

38. QUESTIONS?