Introduction to Corporate Finance

ONLINE CHAPTERS

Most important, convertible securities give VCs the right to participate in the upside when companies

they hold thrive. In fact, VCs are usually required to convert their preferred shares into ordinary

shares before venture-backed companies execute initial public offerings (IPOs) in order to present an

uncluttered balance sheet to prospective investors.

20-3d THE PRICING OF VENTURE CAPITAL AND PRIVATE

EQUITY INVESTMENTS

As you might expect, valuing the types of young, rapidly growing companies that venture capital

companies finance presents a huge challenge. How do VCs and PE managers value portfolio companies?

The empirical evidence suggests that they use a wide variety of valuation methods and that, from one deal

to the next, valuations can be rather idiosyncratic. As in all other areas of financial valuation, however,

venture capitalists employ the basic valuation process of investing in those ventures expected to earn

returns in excess of the appropriate risk-adjusted return, which is typically in the range of 30–50%. The

key distinction of VC investment is that the expected return must be quite high, because the risk of most

VC investments is also much higher than in other areas. The following example illustrates one common

valuation approach.

Assume that the president and founder of the startup company Biotech Concepts Corporation (BCC)

approaches a technology-oriented venture capital fund for $5 million in new funding to support her

company’s rapid growth. After intense negotiations, the parties agree that BCC is currently worth $10

million and that the risk of the company is such that the venture capitalist is entitled to a 50% compound

annual (expected) return. To arrive at the $10 million estimate, the VC may compare the candidate

company’s sales (or earnings, if there are any) to those of similar public companies and then apply a

pricing multiple. Assume further that both parties agree that BCC should plan to execute an IPO in five

years, at which time the company is expected to have net profits of $4 million and to sell at a price/

earnings multiple of 20, valuing the company at $80 million. To calculate the value of its stake in the

candidate company as of the IPO date, the VC uses basic future value techniques. The initial investment,

A, equals $5 million; the required rate of return, r, is 50%; and the time horizon, n, is five years. Therefore,

the future value (rounded to the nearest million) is:

Eq. 20.1 FV = A(1 + r)n = $5,000,000(1.50)^5 = $5,000,000(7.6) = $38,000,000

To determine what fraction of BCC’s equity it will receive now, the VC divides the future value of its

stake by BCC’s expected market valuation at the IPO:

Eq. 20.2 Equityfraction

FV

Expectedmarketvaluation

$38,000, 000

$80,000, 000

===0.475

This means that the venture capital fund will receive 47.5% of BCC’s equity in exchange for its

$5 million investment. If the VC agrees to accept a lower return, say 40%, then the VC’s expected IPO

payoff will be $26.9 million and the VC would require a 33.6% equity stake up front to achieve this

return. When the VC requires a higher return, the entrepreneur must relinquish a larger fraction of the

company.

LO20.3

thinking cap

question

A company has decided to

invest in young, rapidly growing

investee companies with new

technologies compatible with

the company’s products. Once

you determine the companies’

value and the amount to

be invested, how can you

determine the percentage of

the investee companies’ equity

the company should receive for

its investment? (Assume they

require a 45% return.)