Once a Venture Capital Firm has looked into the firm seeking finance and is also willing to finance an agreed sum, the next issue is how much of ownership should the Venture Capital Firm seek in lieu of its funding?
This is generally a negotiable process between Entrepreneurs and the Venture Capital firm. However, the evaluation process described below is only used as a baseline for these negotiations. The term given to this mostly used evaluation method is known as ‘Venture Capital Method’.
Objective of the Venture Capital firm is to finance an upcoming firm, for a Limited Period, in return for an Equity Ownership in that firm. It will seek to sell out its stake at the end of that period thru an IPO or a Private sale. Length of this period is very important to the Venture Capital Firm, as its capital will be tied up into Entrepreneur Firm for such expected period.
Evaluation Process begins by having Forecasted Statements of Earnings, prepared by Entrepreneur Firm for the period of Venture Capital Investment. Now, based on Final Period forecasted Earnings from this statement, Value of the Firm is determined using a comparable market P/E multiple. For example, if final period earnings are $1m and average P/E multiple of listed firms in the same industry as the Entrepreneur Firm is 10x, then the Value of the Entrepreneur Firm at the end of Financing Period is 1 X 10 = $10m.
Next, the terminal value of $10m is discounted to today’s value using an appropriate Discount Rate (say 30%). That would give us the Value of the Firm as of today.
Knowing the value of the firm as of today (say $2m) and knowing the funding asked for (say $1m), ownership percentage of Venture Capital Firm would be $1m/$2m = 50%.
As we see, there are several assumptions used in this process.
· Earnings Forecast is a big assumption and is expected to be overly optimistic as it is prepared by Entrepreneurs.
· Comparable P/E is another assumption. Usually, it will be difficult to find existing listed firms of the similar size and industry as the Entrepreneur Firm.
· Discount Rate is another assumption.
Venture Capital firm will negotiate on Earnings Forecast for them to be consistent with appropriate risks it sees. Another way to reduce value would be to reflect those risks in the Discount Rate used. If Cash flows are overly optimistic, Discount Rate could be higher to subdue them.
So, during negotiations, Projected Earnings/Cash Flows is where Entrepreneurs could be optimistic and Discount Rate is where Venture Capital firm can be pessimistic. So, both have their negotiation tools in the valuation process.
Another issue for Venture Capital Firm is to know, if Entrepreneurs are planning any future Venture Capital financing in that firm. If they are, then, any such future funding will dilute their existing ownership. But, if these future fundings are known at the time of first financing, Venture Capital firm would increase their ownership proportionately, so as to get its expected ownership after any future dilution/s.
To summarize, objective of this evaluation is not to project an accurate value for that firm, but rather to provide a good basis for any negotiated value.
This is generally a negotiable process between Entrepreneurs and the Venture Capital firm. However, the evaluation process described below is only used as a baseline for these negotiations. The term given to this mostly used evaluation method is known as ‘Venture Capital Method’.
Objective of the Venture Capital firm is to finance an upcoming firm, for a Limited Period, in return for an Equity Ownership in that firm. It will seek to sell out its stake at the end of that period thru an IPO or a Private sale. Length of this period is very important to the Venture Capital Firm, as its capital will be tied up into Entrepreneur Firm for such expected period.
Evaluation Process begins by having Forecasted Statements of Earnings, prepared by Entrepreneur Firm for the period of Venture Capital Investment. Now, based on Final Period forecasted Earnings from this statement, Value of the Firm is determined using a comparable market P/E multiple. For example, if final period earnings are $1m and average P/E multiple of listed firms in the same industry as the Entrepreneur Firm is 10x, then the Value of the Entrepreneur Firm at the end of Financing Period is 1 X 10 = $10m.
Next, the terminal value of $10m is discounted to today’s value using an appropriate Discount Rate (say 30%). That would give us the Value of the Firm as of today.
Knowing the value of the firm as of today (say $2m) and knowing the funding asked for (say $1m), ownership percentage of Venture Capital Firm would be $1m/$2m = 50%.
As we see, there are several assumptions used in this process.
· Earnings Forecast is a big assumption and is expected to be overly optimistic as it is prepared by Entrepreneurs.
· Comparable P/E is another assumption. Usually, it will be difficult to find existing listed firms of the similar size and industry as the Entrepreneur Firm.
· Discount Rate is another assumption.
Venture Capital firm will negotiate on Earnings Forecast for them to be consistent with appropriate risks it sees. Another way to reduce value would be to reflect those risks in the Discount Rate used. If Cash flows are overly optimistic, Discount Rate could be higher to subdue them.
So, during negotiations, Projected Earnings/Cash Flows is where Entrepreneurs could be optimistic and Discount Rate is where Venture Capital firm can be pessimistic. So, both have their negotiation tools in the valuation process.
Another issue for Venture Capital Firm is to know, if Entrepreneurs are planning any future Venture Capital financing in that firm. If they are, then, any such future funding will dilute their existing ownership. But, if these future fundings are known at the time of first financing, Venture Capital firm would increase their ownership proportionately, so as to get its expected ownership after any future dilution/s.
To summarize, objective of this evaluation is not to project an accurate value for that firm, but rather to provide a good basis for any negotiated value.
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