PRIVATE EQUITY VALUATION

LESSON 6: VALUATION OF VENTURE CAPITAL DEALS

LOS 40j: Calculate premoney valuation, postmoney valuation, ownership

fraction, and price per share applying the venture capital method 1)
with single and multiple financing rounds and 2) in terms of IRR.
Vol 5, pp 166177
The Basic Venture Capital Method (in Terms of NPV)
The basic venture capital method using the NPV framework requires the following steps. The
calculations and the rationale behind them are illustrated in Example 6-1.
Step 1: Determine the postmoney valuation.
Step 2: Determine the premoney valuation.
Step 3: Calculate the ownership percentage of the VC investor.
Step 4: Calculate the number of shares to be issued to the VC investor.
Step 5: Calculate the price of shares.

Example 6-1: Applying the Basic Venture Capital Method with a Single Round of
Financing
The entrepreneur founders of Tiara Ltd. believe that in 5 years they will be able to sell the
company for $60 million. However, they are currently in desperate need of $7 million. A
VC firm that is interested in investing in Tiara estimates that the discount rate commensurate
with the relatively high risk inherent in the firm is 45%. Given that current shareholders hold
1 million shares and that the venture capital firm makes an investment of $7 million in the
company, calculate the following:
1.
2.
3.
4.
5.

Postmoney value
Premoney value
Ownership proportion of the VC firm
The number of shares that must be issued to the VC firm
Share price after the VC firm invests $7 million in the company

Solution:
1.

After receiving the $7 million, Tiara is expected to be worth $60 million in 5 years.
Therefore, the postmoney value of the company equals the present value of the
anticipated exit value.
Post-money value

Exit value
(1 Required rate of return) Number of years to exists
60
1.455

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$9.3608m

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2.

The premoney value is calculated as the postmoney value minus the VC firms
investment.
Postmoney value Investment
9.3608 7 $2.3608 million

Premoney value

3.

The VC firm is investing $7 million in a company that will be worth $9.3608 million.
Therefore, the ownership stake of the VC firm is calculated as:
Ownership proportion of VC investor

Investment
Post-money value
7 / 9.3608

4.

The current shareholders own 1m shares and they have a 25.22% ( 100 74.8%)
equity interest in Tiara. The number of shares that must be issued to the VC firm such
that it has a 74.78% ownership stake is calculated as:

Shares to be issued

Proportion of venture capitalist investment Shares held by

company founders
Proportion of investment of company founders
0.7478 1 million
(1 0.7478)

5.

74.78%

2,965,143

The price per share is then calculated as:

Price per share

Amount of venture capital investment

Number of shares issued to venture capital investment
7,000,000 / 2,965,143 $2.36 per share

Venture Capital Method in Terms of the IRR

The venture capital method can also be explained in terms of the IRR. Whether based on NPV
or IRR, the venture capital method gives exactly the same answer. The IRR method involves the
following steps. The calculations and the rationale behind them are illustrated in Example 6-2.
Step 1: Calculate the future wealth required by the VC investor to achieve its desired IRR.
Step 2: Calculate the ownership percentage of venture capital investor.
Step 3: Calculate the number of shares to be issued to the venture capital investor.
Step 4: Calculate the price of shares.
Step 5: Determine the postmoney valuation.
Step 6: Determine the premoney valuation.

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Example 6-2: Applying the IRRBased Venture Capital Method

Work with the information from Example 6-1 (regarding Tiara Ltd.) and calculate the following
using the IRRbased venture capital method.
1.
2.
3.
4.
5.
6.

The future wealth required by the VC to attain its desired IRR

Ownership percentage of the VC firm
The number of shares that must be issued to the VC firm
Stock price per share
Postmoney value
Premoney value

Solution:
1.

First we need to determine the amount of wealth the VC needs to accumulate over the
5 years to achieve the desired return of 45% on its $7m investment in Tiara.
Required wealth

2.

Investment (1 IRR)Number of years to exit

7m (1 0.45)5 $44.868m

The percentage ownership that the VC firm requires to achieve its desired 45% return
on a $7 million investment is calculated by dividing the required wealth by the expected
value of the company at exit:
Ownership proportion

3.

Required wealth / Exit value

44.868m / 60m 74.78%

The current shareholders of Tiara hold 1m shares in the company and have an equity
stake of 25.22% (100% 74.78%). The number of shares that must be issued to the
VC firm so that it owns 74.78% of Tiara is calculated as:

Shares to be issued

Proportion of venture capitalist investment Shares held by

company founders
Proportion of investment of company founders
0.7478 1 million
(1 0.7478)

4.

2,965,143

Given that the VC firm is investing $7m in Tiara, the price of a share is calculated as:
Price per share

Amount of venture capital investment

Number of shares issued to venture capital investment
7,000,000 / 2,965,143 $2.36 per share

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5.

The postmoney value can be calculated in two ways:

An investment of $7 million gives the VC firm a 74.78% equity interest in Tiara.
Therefore, the postmoney valuation of the company is calculated as 7m /
0.7478 $9.3608m (allowing for rounding error).
Alternatively, there are 3,965,143 ( 1,000,000 2,965,143) shares in the
company that are each worth $2.36. Therefore, the value of the company
equals 2.36 3,965,143 $9.3608m (allowing for rounding error).

6.

The premoney value can also be calculated in two ways:

The premoney value can be calculated as the postmoney value minus the
amount invested by the VC: $9.3608m 7m $2.3608m.
Alternatively, we can multiply the number of shares held by the current
shareholders by the price per share: 1m 2.36 $2.3608m (allowing for
rounding error).

Venture Capital Method with Multiple Rounds of Financing

When there are 2 rounds of financing, the venture capital method requires the following steps (see
Example 6-3):
Step 1: Define appropriate compound interest rates between each financing round.
Step 2: Determine the postmoney valuation after the second round.
Step 3: Determine the premoney valuation after the second round.
Step 4: Determine the postmoney valuation after the first round.
Step 5: Determine the premoney valuation after the first round.
Step 6: Determine the required ownership percentage for second round investors.
Step 7: Determine the required ownership percentage for first round investors. Note that this is
not their final ownership percentage as their equity interest will be diluted in the second round.
Step 8: Determine the number of shares that must be issued to first round investors for them to
attain their desired ownership percentage.
Step 9: Determine price per share in the first round.
Step 10: Determine the number of shares at the time of the second round.
Step 11: Determine the number of shares that must be issued to second round investors for them
to attain their desired ownership percentage.
Step 12: Determine price per share in the second round.

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Example 6-3: Applying the Basic Venture Capital Method with Multiple Rounds of
Financing
Suppose Tiara Ltd. actually intended to raise $10 million. However, doing so in a single round
of financing would not have been feasible as it would have led to a premoney valuation of
$0.639 million. Therefore, the company decided to undertake an initial financing round worth
$7 million and to follow that up with another financing round worth $3 million after 4 years.
The entrepreneur founders still believe the companys exit value will be $60 million at the end
of 5 years. Given that investors in the second financing round feel that a discount rate of 25% is
appropriate, calculate the price per share after the second round of financing.

This premoney
valuation is
calculated as 9.361m
(postmoney
valuation 10m).

Solution:
First we compute the compound discount rates:
Between first and second round (1.45)4 4.4205
Between second round and exit (1.25)1 1.25
Then we calculate the postmoney value after the second round by discounting the terminal
value for 1 year at 25%.
POST2

60 / 1.25

$48 million

Then we compute the premoney value at the time of the second round by deducting the
amount of second round investment from POST2.
PRE2

POST2 Investment2
48m 3m $45m

Then we compute the postmoney value after the first round by discounting the premoney
valuation at the time of the second round at 45% for 4 years.
POST1

PRE2 / (1 r1)t
45m / 4.4205 $10.18m

Then we compute the premoney value at the time of the first round by deducting the first round
investment amount from POST1.
PRE1

POST1 Investment1
10.18m 7m $3.18m

Then we determine the required ownership percentage for second round investors who will
contribute $3 million to a company that will be worth $48 million after they make the investment.
F2

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Investment2 / POST2
3 / 48 6.25%

This implies
that after the
second round,
the entrepreneurs
and first round
investors would
hold a combined
93.75% stake in the
company. This stake
is worth 0.9375
48m 45m,
which is also the
premoney valuation
at the time of the
second round.

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Then we determine the required ownership percentage for first round investors. First round
investors put $7 million into a company that will be worth 10.18 million after they make the
investment. Note that this is not their final ownership percentage as their equity interest will be
diluted by afactor of (1 F2) in the second round.
The final ownership
stake (after second
round dilution) of
first round investors
equals 0.9375
0.6876 64.47%.

F1

Investment1 / POST1
7 / 10.18m 68.76%

Then we determine the number of shares that must be issued to first round investors for them to
attain their desired ownership percentage and the price per share in the first round.
Number of new shares issued1
Price per share1

1m

[0.6876 / (1 0.6876)]

7,000,000 / 2,201,376

2,201,376

$3.18 per share

Then we determine the number of shares that must be issued to second round investors for
them to attain their desired ownership percentage and the price per share in the second round.
The important thing to note here is that the existing number of shares at the time of the second
round equals the 1m shares held by the entrepreneurs plus the 2,201,376 shares issued to first
round investors. This is why we must work from the earliest financing round to determine the
number of shares and price per share.
Number of new shares issued
Price per share

0.0625

3,000,000 / 213,425

[(1m

2.201m) / (1 0.0625)]

213,425

$14.06 per share

For more than two rounds of financing, the procedure is an extension of the one described above:

t
First define the compound discount rates between all rounds.

t
Then find the post and premoney valuation by working backward from the terminal
value to the first round. For each round, discount the premoney valuation of the
subsequent round to get the postmoney valuation of the round.
t
Given the postmoney valuations for each round calculate the required ownership
percentages.
t
Finally, compute the number of shares to be issued and price per share starting from the
first round.
Estimating the Terminal Value
Multiplesbased approaches for estimating terminal value have the following drawbacks when it
comes to venture capital/private equity:
t
It is difficult to come up with a good estimate of earnings (in order to apply an earnings
multiple) particularly in new or emerging industries.
t
It may be easier to estimate sales or assets, but then it can be difficult to find truly
comparable companies/transactions to extract benchmark multiples from.
t
Multiples extracted from similar transactions in the industry may be inflated if those
transactions occurred in an overexuberant market.

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For the NPV, CAPM, APT, and other equilibrium valuation models, it is difficult to come up
with reasonable cash flow forecasts so valuations obtained from these models are as likely to be
inaccurate as those estimated by applying multiples.

LOS 40k: Demonstrate alternative methods to account for risk in venture

capital. Vol 5, pp 169170
Venture capitalists typically apply very high discount rates when evaluating target companies for
the following reasons:
t
VC firms must be compensated for the significant nondiversifiable risk inherent in
portfolio companies.
t
Estimates of terminal value do not necessarily reflect expected earnings. They reflect
future earnings in some kind of success scenario.
There are two ways of dealing with this:

t
Adjusting the discount rate so that it reflects (1) the risk of failure and (2) lack of
diversification (see Example 6-4).
1 r
Adjusted discount rate
1
1 q
r Discount rate unadjusted for probability of failure.
q Probability of failure.
t
Adjusting the terminal value using scenario analysis (see Example 6-5).
Example 6-4: Accounting for Risk by Adjusting the Discount Rate
A venture capital firm is considering investing in a private company involved in generating
power through alternative sources of energy. The discount rate after accounting for systematic
risk is 35%. However, the venture capital firm believes that the founders of the private company
are too optimistic and that the chance of the company failing in any given year is 20%.
Calculate the adjusted discount rate that incorporates the companys probability of failure.
Solution:
Adjusted discount rate

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1
1
1
=
1

r
1
q
0.35
1 68.75%
0.2

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Example 6-5 : Accounting for Risk by Adjusting the Terminal Value Using Scenario
Analysis
Compute the terminal value estimate for Blue Horizons Pvt. Ltd. given the following scenarios
and their probability of occurrence:
1.
2.
3.

The companys earnings in Year 5 are $13 million and the appropriate exit priceto
earnings multiple is 8. The probability of occurrence of this scenario is 65%.
The companys earnings in Year 5 are $6 million and the appropriate exit priceto
earnings multiple is 5. The probability of occurrence of this scenario is 25%.
The company fails to achieve its goals and has to liquidate its assets in Year 5 for $5
million. The probability of occurrence of this scenario is 10%.

Solution:
Terminal value in scenario 1

13m

Terminal value in scenario 2

6m

Terminal value in scenario 3

$5 million

Expected terminal value

(104m

8
5

$104 million
$30 million

0.65)

(30m

0.25)

(5m

0.1)

$75.6 million

Some final notes:

t
The results of any method of valuation depend on the assumptions employed.
t
Our purpose here is not really to determine the true value of the company, but to establish
a ballpark figure that can be used by venture capitalists and entrepreneurs in negotiations
over how the returns of the venture should be split.
t
The actual split depends primarily on the relative bargaining power of the parties.

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