Foundations of New Venture Finance 281The internal rate of return on this stream of cash flows is 68.15 percent. This is cal-
culated by setting the initial investment ($1,000) equal to the 5-year stream plus the ter-
minal value and solving for k. As long as the entrepreneur can finance this project at rates
less than 68.15 percent, value is being created and appropriated by the firm. At rates
above 68.15 percent, the value is appropriated solely by the investor.
This brief example illustrates how an entrepreneur might use the DCF model to value
the firm from his or her point of view, but it is also important to consider how an
investor would value a new venture. One common method investors use is the residual
pricing method, so called because it is used to determine how much of the firm must
be sold to the investor in order to raise startup funds, with the “residual” left for the
entrepreneurs.
From the investor’s point of view, the pretax annual cash flows generated for Years 1
through 5 are not important, because they will not generally be available to the investor.
These will be paid out as perquisites to the entrepreneur and reinvested in the firm to
keep it growing. The investor is interested in the after-tax profits at a point (say Year 5).
If the pretax cash flow is estimated at $1,000,000 and the after-tax profits are $500,000,
this means that, at a multiple (P-E ratio) of 10 times earnings, the firm is valued at
$5,000,000 at the end of Year 5.
Instead of using a weighted-cost-of-capital figure—15 percent, for example—the
investor would use arequired-rate-of-returnfigure because the investor needs to see
whether the firm will be able to cover all the risk exposure, expenses, and cost of no- and
low-return investments the investor has made. The investor’s required rate of return is
invariably higher than the entrepreneur’s weighted cost of capital because the entre-
preneur will also use low-cost debt when possible.
If the entrepreneur wants to raise $500,000 from the investor for an equity share in
the business, how much equity (i.e., what percentage ownership of the business) should
the entrepreneur offer in exchange?
To achieve a 40-percent return on investment, the investor would need to have
$2,689,120 worth of stock at the end of Year 5 (calculated by taking the $500,000 ini-
tial figure and compounding it at 40 percent for 5 years (1.4)^5 ). The future-value factor
of this term is 5.378. If the investor’s stock must be worth $2,689,120 in five years and
the total value of the stock will be $5,000,000 in 5 years, then the investor must own
53.78 percent of the company ($2,689,120/$5,000,000).^33
To calculate the amount of equity ownership the investor will require, the entrepre-
neur needs to know:
- The investor’s required rate of return
- The amount of the investment
- The number of years the investment is to be held
- The after-tax profits for the horizon year
- The expected price-earnings multiple
As we will see in the next chapter, the investor may or may not actually require a
53.78-percent stake in the new firm. Elements such as potential dilution and manage-
ment control need to be factored into a negotiation. No formula can fully express the