Venture Capital Method
 A method for valuing high risk and long term investments by
venture capitalists
 Investments that are characterized by negative early cash
flows or earnings, followed by significant return in later years
 A critical assumption is that the investors stay in the business
until the harvest comes
 It is for start-up ventures, high tech firm or leveraged buyout
 This method is already adjusted for risk incorporated in
investment
Venture Capital Method
 First, a company’s net income is projected for some terminal
year, for instance five years
 The estimate of net income is typically based on a success
scenario - attaining sales and margin projection
 Then, P/E ratio is determined. Use the PER for a company
with similar characteristics that have accomplished some
success in forecasted income
 The terminal value is calculated by multiplying the projected
net income with the assumed PER
 Then the terminal value is converted to PV at a very high
discount rate, typically 30 to 80 percent per year
Venture Capital Method
 The result is the value of the equity today
 Then, the venture capitalists will determine their portion in
the firm by diving the investment by the value of the equity
 Issues to consider:
– Valuation is partly an art and partly a science
– Asking the right questions can help reduce the uncertainty and risk
– Focus first on quality of management, opportunity and resources
then valuation. The assumption is a key part to accurate valuation
Venture Capital Method
 Total present value
= PV (PER * Terminal Income)
 Ownership requirement
=
 Ownership requirement
=
Investment
PV (PER * Terminal Income)
Investment
Total Present Value
Venture Capital Method
 Investment today
=
Required Future Value
(1+IRR) ^ year
 Required Future Value
= Investment * (1+IRR) ^ year
 Final Ownership required
=
 Final Ownership required
= Investment * (1+IRR) ^ year
Total Terminal Value
Required Future Value
Total Terminal Value
Venture Capital Method
 Example of Venture Capital Method
– Target Return or IRR
– Investment
– Term
– Year 5 Net Income
– Year 5 PER
– Total Terminal Value
million
– PV( Terminal Value )
– Percentage of ownership
50 %
$2 million
5 years
$2.5 million
12
=
PER x Terminal Income
=
12 x 2.5
=
=
=
Terminal value/(1+IRR)^year
30 / (1.50) ^ 5
3.95 million
=
2 / 3.95 = 50.6%
= 30
Venture Capitalist’s Discount Rate
 The expected rate of return depends on the stage of
financing and the terminal value
1. Base Rate of return
= S-T or L-T Govt. Bond rate
2. Systematic (market) risk premium is defined as the
sensitivity of the return on the stock to the return of the
market as a whole and cannot be diversified
3. Unsystematic (non market) risk premium is defined as
uncertainty inherited in individual firm such as the risk
whether the product will be commercialized. This risk can
be eliminated through diversification
Venture Capitalist’s Discount Rate
4. Liquidity premium - A buyer should pay less for a private
company’s stock and VC uses a high discount rate to
compensate for this lack of liquidity
5. Value added - Some VCs are active investors which want
to increase value of a business through connections and
credibility
6. Cash Flow adjustments - VCs know from experience
that only 25 % of investments will produce target result.
This needs to be factored into the discount rate