New Venture Valuation

Antoinette Schoar
MIT Sloan School of Management
15.431

Spring 2011

What is Different About Valuing New Ventures?

• Higher risks and higher uncertainty

• Potential rewards higher? Option Values?
• Exit and liquidity more important
• Not just a go-no/go decision; the actual valuations
matter

1
Valuation Approaches

• Discounted Cash Flow/ Adjusted Present Value

• The Venture Capital Method

→Comparables

• Real Options

These lecture notes draw from three sources: S. Kaplan, “A Note on Valuation in Entrepreneurial Settings,”
University of Chicago; J. Lerner, “A Note on Valuation in Private Equity Settings,” HBS Note 9-297-050;
and W. Sahlman, “A Method for Valuing High-Risk, Long-Term Investments,” HBS Note 9-288-006.

Discounted Cash Flow/Adjusted Present

Value (APV)

• Use APV not WACC

→ Capital structure involves hybrid securities not easily classified
as debt or equity
→ Capital structure changes over time
→ Interest tax shields change over time as company’s tax status
changes
• APV is a more flexible method that can accommodate
these features of new venture valuation.

2
 APV Approach for New Ventures
• The Standard APV Calculations:
• Stepp 1: Calculate Free Cash Flows (FCFs)) to an “all-eq quity”
y firm
for a period of years until company reached a “steady-state.”
• Step 2: Discount these FCFs at the discount rate of an all-
equity firm (k).
• Step 3: Calculate a Terminal Value as the present value of a
growing perpetuity of FCFs assuming some growth rate in FCFs
and discounting by k.
• Step 4: Value tax shields of debt financing separately (trD) and
discount by a rate that reflects the riskiness of those cash flows.
• Step 5: Steps 1-4 give you the Enterprise Value. To determine
the Equity Value subtract the market value of debt (the present
value of interest payments).

Cost of Capital for All-Equity Firm (k)

k = risk-free rate + β * market risk premium

→Risk-free rate = Long-term bond rate

→beta = “unlevered” beta of comparable firms in
the industry
→βU = βL* E co / [Eco + Dco]

→Market risk premium = 7%

3
Where Can We Find Beta?

• Standard to look at publicly-traded

publicly traded comparable
firms in same industry.
• But often there aren’t many that are in similar stage
of development.
• Later stage companies will tend to have lower
betas (all else equal) than early stage companies
b
because start-up
t t expenses ini early
l stage
t
companies (e.g. R&D) tend to be more fixed than in
later stage companies.

Terminal Value Calculation

• Run out Free Cash Flows until they reach a stable

pattern
• Assume a growth rate of g% from then on; use
conservative growth rates

• The terminal value formula is:

TV = FCF*[1+g] / [k-g]
PV(TV) = TV / [1+k]n

4
Wrinkles on Standard APV Calculations
• Company may not have taxable income for many years.
→ Tax rate in these years is 0. Tax losses can be carried forward
for up to 15 years to lower taxable income in profitable years.
→ What discount rate should be applied?
• Interest expense is not deductible in years when the
company has tax losses.
→ Carry forward interest expense to years when it can be
deducted (up to three years carry forward).
• Explicit modeling of idiosyncratic uncertainty is
particularly important.
→ Take expected value of cash flows over various scenarios

APV Example: Medical Diagnostics, Inc.

"Medical Diagnostics, Inc"
($000)
2002 2003 2004 2005 2006
Revenue 734 6,475 22,445 55,960 110,402
Cost of Goods Sold 318 2,406 7,175 16,723 32,564

R&D 1,191 1,343 1,665 3,555 8,630

Sales and Marketing 2,517 4,908 8,805 16,815 25,745
Regulatory and Clinical 704 904 1,199 1,345 1,595
Other Expense 2,137 3,397 4,733 6,740 9,394
Total SG&A 6,549 10,552 16,402 28,455 45,364
EBITDA (6,133) (6,483) (1,132) 10,782 32,474
Depreciation 184 334 544 579 723
EBIT (6,317) (6,817) (1,676) 10,203 31,751
Taxes 0 0 0 0 10,858
Depreciation Addback 184 334 544 579 723
Capital Expenditures 543 567 742 880 959
NWC (364) 1,410 6,416 16,316 32,315
Ch In
Ch. I NWC (364) 1 774
1,774 5 006
5,006 9 900
9,900 15 999
15,999
Free Cash Flow (6,312) (8,824) (6,880) 2 4,658

Discount Rate 13% Growth 3% 7%

PVFCF (14,735) (14,735)
TVFCF 18,410 17,870
TV 184,096 297,826
PVTV 99,920 161,648
Value 85,185 146,913

5
Notable Features of this Valuation
• Tax Losses. No taxes until year 5; use accumulated net tax
losses from previous years to offset taxable income in year 5.
• Equity Value. In general we subtract a measure of the market
value of debt (MVD) at the time of the initial valuation to get equity
value. Here it is zero; so enterprise value equals equity value.
• Terminal Values and Growth Rates. Note that we have assumed
relatively slow terminal value growth rates: 3% or 7%. Still, the
value of the business in the second case is nearly twice that of the
first case. Most of the value of this firm comes from the terminal
value!!
→ Model cash flows explicitly until the firms is in steady state
→ This may be reasonable if there is IP protecting profits or
barriers to entry, but we need to be careful

The Venture Capital Method

The Standard calculations:

• Step 1: Forecast sales or earnings for a period of years years.
• Step 2: Estimate the time at which the VC will exit the
investment (typically through an IPO or sale to strategic buyer).
• Step 3: Value the exit price based on an assumed multiple of
earnings or sales or customers, etc. The multiple is typically
based on comparable public companies or comparable
transactions.
• St
Step 4: Di
Discountt iintteriim cash
h flflows and
d exit
it vallue att rattes
ranging from 25% - 80%.
• Step5: Determine the VC’s stake
.

6
Example: MIT.com, Inc.

• Step 1: Forecast Sales or revenues

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Earnings -5 0 0 0 0 100

• Step 2: Assume company exits after 5 years

• Step 3: Assume that the company will have earnings of 5 and it
will go p
public at a multip
ple of 20x earning
gs for a value of $100M.
• Step 4: Valuation at 50% Discount Rate
→ Post-money = $100M/(1.50)5 = $13.2M
→ Pre-money value = $8.2M

Example: MIT.com (cont.)

• Step 5: VC share
→ VC will ask for 5/13
5/13.2
2 = 38
38.0%
0% equity stake to invest $5M

→ Assume N0= 1M shares outstanding prior to financing.

How many new shares, N1, does the VC get?

s
→ N1/(N0+ N1 ) = s N1 = 1 − s N 0

→ N1 = 0.612M shares
→ Stock price = $5M/0.612M = $8.17

7
Stock Option Pool

• If the firm needs to reserve 15% of the equity (by the exit date)
t recruitit managementt team,
to t then
th we need d to
t adjust
dj t the
th numberb
of shares. The VC still gets 38% of the equity.
• If m is the stock option pool percentage, and Nm is the number
of shares issued to the stock option pool, then we know that the
shares issued to the VC and the option pool (N1+ Nm) are:
s+m
N0
1− s − m
• The shares held by the VC investor, N1, are then:
s
N0
1− s − m

Stock Option Pool (cont.)

• Thus in our examp

ple:

→ N1 = 0.38/(1 - 0.38 - 0.15) * 1M = 0.809M shares

→ Nm = 0.15/(1 - 0.38 - 0.15) *1M = 0.319M shares.

→Price per share is $6.18.

8
New Investor in Follow-on Round (with
Lower Discount Rate)

• Forecast Earning
gs
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Earnings -5 0 -3 0 0 100

• New investor (discount rate of 30%):

→ Values company at end of year 2 at $100M/1.33 = $45.5M
→ Requires share, s2, $3M/$45.5M = 6.6% of firm in second
round.
→ First-round VC still requires 38% of firm at exit, but will start
off with more shares and greater percentage (which will then
be diluted). N = s1
1 N 0
1 − s1 − s 2 − m

New Investor in Follow-on Round (cont.)

• Initial VC:
→ N1 = 0.38/(1 - 0.38 - 0.066 - 0.15)* 1M= 0.941M;
→ p1= $5M/0.941M=$5.33

• Follow-on Investor:
→ N2 = .066/(1 - 0.38 - 0.066 - 0.15)*1M=0.163;
→ p1= $3M/0.163M=$18.40

• Option Pool
→ Nm=0.15/(1 - 0.38 - 0.066 - 0.15)*1M = 0.371M

9
New Investor (cont.)

• Note that the first round VC investor starts off with a 40.7% equity
q y
stake, which then gets diluted to 38% ownership when the second
round VC investor comes on board.
• If development time slips by two years then the second round
investors require 11.1% equity share, since their valuation at this
point is $26.9M = 100/1.35. If we still have to give 15% in option
pool, this implies that:
s2
N2 = (N 0 + N1)
1 − s2 − m

which is (0.111/(1 - 0.111 - 0.15))*1.940M = 0.291M shares.

• The first-round VC ends up with only 35.8% of the shares at the
exit date and the IRR on the investment falls to 32.5% from 50%.

Comparable Multiples For Exit Values

• Find exit values by looking at similar companies

→ Take multiples of EBITDA, sales, customers, eyeballs etc.

• Strength:
→ Tells you what the market thinks about growth potential.
• Weaknesses:
→ Tells you what the market thinks about growth potential
potential.
→ May be hard to find real comparable firms at similar stages that
are already public and for whom data are available.

10
Caveats About Multiples

• Industry Cycles
→ Young industries might have high multiples for firms that enter
the market today, since they have first mover advantage
• Mean Reversion
→ High multiples for firms that enter the market during a “hot”
market need not apply for firms that go public in a few years
→ How well can you “market time”?
• Vesting Period
→ IPO multiples overstate gains due to long term under-
performance
→ Choose your multiples wisely!!

Why Are Discount Rates so High?

• Such high discount rates cannot be explained as

being a reward for systematic risk.

• In most practical cases, CAPM would give discount

rates well below 25%, let alone 80%.

• Th
Three (limit
(li ited)
d) “rati
“ tionalles””:
→ Compensate VC for illiquidity of investment;
→ Compensate VC for adding value;
→ Correct for optimistic forecasts and idiosyncratic risk.

11
Rationale I: Investments Are Illiquid

• Investments in a private companies cannot be sold

as easily as stock in public companies.
→ All else equal, this lack of marketability makes private equity
investments less valuable than easily-traded public
investments.

• Caveat: How much less valuable?

→ Practitioners in private equity investments often use liquidity
discounts of 20%-30%, i.e., they estimate the value to be
20% to 30% less than an equivalent stake in a publicly
traded company.

Rationale II: VC Adds Value

• VCs are active investors and bring

g more to the deal
than just money:
→ spend a large amount of time,
→ reputation capital,
→ access to skilled managers,
→ industry contacts, network,
→ and other resources.

• A llarge di
discountt ratte is a crud
de way to compensatte
the VC for this investment of time and resources.

• Caveat: Why not compensate the VC explicitly for

services?

12
Rationale III: Optimistic Forecasts

• VC method assumes that the firm hits its targets

targets.
→ Forecasts tend to rely on cash flows in the best case

• A higher discount rate is a crude way to correct

forecasts that are too optimistic.

• Caveatt:
→ Build uncertainty into the cash flow estimates
→ 80% of 0 is still 0
→ This is not the time to be lazy!

Rationale IV: VC Market Power

• Valuations are influenced by the distribution of

bargaining power between VC and entrepreneur
→ Affects the rent distribution between VC and entrepreneur

• Factors that influence bargaining power:

→ Supply and demand for capital; when a lot of capital flows
into the VC market,, valuations are hig
gher
→ Valuations increase with the number of active VC firms in the
market
→ Reputation and track record of VC / entrepreneur; repeat
entrepreneurs get better valuations

13
 An Alternative to High Discount Rates:
Scenario Analysis

• Since VCs certainly use this method, you need to

know how to use it!
→But it does not preclude you from taking a more
sophisticated approach to the problem.

• Explicitly model cash flows and sources of uncertainty.

→Allows you to better understand the sources of risk and
theiir implilicati
th tions for vallue
→Reduces your reliance on “guessing” terminal values
→Allows you to value an investment’s “real options” - the
ability to change plans as new information arrives

Appendix
Some Useful Calculations

14
Free Cash Flows to an All-Equity Firm

• Eq
quivalent Approach
pp 1
FCF = EBIT x(1-t) + DEPR - CAPX - ΔNWC

• Equivalent Approach 2
FCF = EBITDx(1-t) + t x DEPR - CAPX - ΔNWC

• Equivalent Approach 3
FCF = EBITx(1 t) - ΔΝet Assets
EBITx(1-t)

• Note:
EBIT = Earnings before interest and taxes
EBITD = Earnings before interest, taxes and depreciation

Example of Free Cash Flow Calculation (2000)

(‘99) (‘00)
• Sales 1000 1200
• Cost oof Goods Sold
So d 700
00 850
• Depreciation 30 35
• Interest Expense 300 200
• Capital Expenditures 40 40
• Accounts Receivable 50 60
• Inventories 50 60
• Accounts Payable 20 25
• tax rate
rate=40%
40%

• FCF = EBIT(1-t) + Depr. - CAPX - Ch. NWC

→ EBIT = 1200 - 850 - 35 = 315
→ Ch. NWC = (60+60-25) - (50+50-20) = 15
→ FCF = 315 (1-.40) + 35 - 40 - 15 = 169

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Example of A Tax Loss Carry Forward

• FCF1= 270 x (1- 0.4)) + 30 - 40 + 0 = 152

• ITS1 = min(0.4 x 270, 0.4 x 300) = 108
• CCF1 = FCF1 + ITS1 = 260
• cannot use $30 of our interest expenses = $12 interest tax
shield

• FCF2 = 315 x (1-.40) + 35 - 40 - 15 = 169

• ITS2 = min(0.4 x 315, 0.4 x 200 + 12) = 92
• CCF2 = 261
• If interest expenses + tax shield were greater than tax expense
($125.6), tax shield would be carried forward again

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15.431 Entrepreneurial Finance

Spring 2011

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