13.6.1 Key steps to the venture capital method The key steps to the venture capital method are Step 1: Terminal value calculation Step 2: Future value of the investment Step 3: Perc
Trang 1
13.6.1 Key steps to the venture capital method
The key steps to the venture capital method are
Step 1: Terminal value calculation
Step 2: Future value of the investment
Step 3: Percentage of shares to subscribe
Step 4: Amount of shares to issue
Step 5: Value of newly issued shares
Step 1: Terminal value calculation — The expected holding period and
the calculation of the terminal value are addressed The terminal value is usually calculated with comparables, typically P/E and DCF approaches For example :
If the expected holding period is 4 years and the expected net income at y 4
is €6 million, a terminal value calculated through a P/E comparable of 5 would
be €30 million
value of the investment taking into account the expected holding period and the expected IRR, which is defi ned from the constraints of the investor For example : If the investment is €2 million, the holding period is 4 years, and the expected IRR is 55%, the future value is €11,54 million
Step 3: Percentage of shares to subscribe — Calculation of the shares
the investor has to buy to acquire the expected IRR The number of shares is found by dividing the future value of the investment by the terminal value of the fi rm For example : If the future value of the investment is €11,54 million and the terminal value is €30 million, the percentage of shares for the investor
is 38,46%
Step 4: Amount of shares to issue — Calculation of the number of new
shares that the venture-backed company has to issue to ensure a lar percentage of capital to the investor This calculation consists of a simple proportion:
where new and old represent the number of new and old shares For example :
If the percentage of shares the investor must have is 38,46% and existing shares are 300.000, the number of new shares available to issue is 187.488
13.6 Venture capital method
Trang 2200 CHAPTER 13 Techniques of equity value defi nition
Step 5: Value newly issued shares — Calculation of the price of newly
issued shares for the investor is executed dividing the amount of the investment
by the number of new shares For example : If the investment is €2 million and the number of new shares is 187.488, the price per new share is €10,67 The implied pre money valuation is 10,67 so the value of 300.000 shares equals
€3,201 million and the post money value of all 487.488 shares equals €5,201 million
It is important to point out that venture capitalists presume there will be dilution of their participations To mitigate the effect of this dilution, the reten-tion ratio is used to quantify the decreasing participation realized between the closing and exiting of the deal In the previous example, if 20 to 30% more capi-tal is subscribed, then the participation of 38,46% will become 24,36% of the
fi nal equity capital and the retention ratio equals 64% Therefore, to ensure an equivalent participation to the fi rst investor, the actual percentage of the partici-pation will be 60%; that is the ratio between the percentage of 38,36% and the retention ratio
The formula of retention ratio is
5 Value of new issued shares
4 Number of new shares to issue
3 Percentage of shares
2 Future value of the investment
1 Terminal value calculation
Investment /number of new shares (existing shares ∗ percentage)/(1 – percentage)
Future value of the investment /terminal value Investment (1 expected IRR) ^(expected time)
P/E or DCF approaches
Formulas applied Steps
FIGURE 13.4
Venture capital method steps
Trang 3201 13.6 Venture capital method
A business case: MAP
MAP S.p.A is an Italian retail distributing company operating in the food sector It has local branches in central and southern Italy with more than 650 shops with an average size of
650 m 2 Growth is expected to be quite strong, and the real estate policy is not to buy shops but to rent them due to their strong negotiation of rental installments In 2002, MAP needed a private equity investor to support the expansion strategy, but the existing shareholders did not want to lose control No acquisition of competitors was planned in the short-medium run, and the general forecast of selling food was expected to be positive in the central and southern part
infor-€20 million coming from a cash position of infor-€20 million (see Figure 13.6 )
The main comparables on the market came not only from Italy (where only the company Eat & Food can be considered a comparable, even if it is not listed) but from all over Europe See Figure 13.7 for the data
Considering the capital structure of MAP, the book value of the debt was €30.000 and the book value of equity was €3.000 The risk free rate was 3% (calculated as 5-year 2003 Italian Government bonds) and the return on market investment was estimated at a level of 10% with
an expected holding period of 5 years
Trang 4202 CHAPTER 13 Techniques of equity value defi nition
6,677 0
11,276
12,843
3,891 8,538
6,021 0
11,469
11,663
3,519 8,583
16,650
2,874
7,374
2,238 5,492
Cash fl ow unlevered statements (€/000)
Beta EV/sales EV/EBITDA D/E
A13.1.1 Sample valuation using comparables
It was decided not to use the data from the comparables because there were too many ences between these business and MAP such as the average size of the shops, the geographi- cal area covered, and the status of company (public or private) For this reason, the average value of the ratios EV/S and EV/EBITDA were calculated:
Based on the averaged values, two values were identifi ed, as shown in Figure 13.8 The German company Essen & Trinken was used even though it was not an Italian company, because it has a market very similar to MAP in terms of population and average salary, but the average size of its shops is smaller, only 350 m 2 and it is quoted on the stock market Assuming that Essen & Trinken is the most comparable competitor to MAP, its valuation is cal- culated by applying the EV/EBITDA equal to 18, thus obtaining €231.588
After these calculations it was possible to defi ne an enterprise value for MAP of €218.722 to 231.588, but considering the MAP’s private status, it would be appropriate to apply a discount
of 15 to 20% leading to a new value of €174.978 to 185.270
Trang 5203 13.6 Venture capital method
EV/sales EV/EBITDA
Average MAP Implied Value €/000
1.16
€ 228,525
Mangiare & Bere (ITA) 1.4 17
17
€ 218,722
FIGURE 13.8
Average of comparables and MAP’s implied value (€/000)
A13.1.2 Sample valuation using the net present value method
The key point of this method is identifying the WACC by calculating the cost of debt Based on this, the book value of the debt was €30.000 and the interest forecasted for 2003 was €1.428 and the cost of the debt equaled 4,76%, which was obtained by using the ratio between the two values
The second step is to identify the cost of capital necessary to fi nd the correct β Because MAP was a private company, the only way to consider the average of the β of the comparables, excluding the effect of the capital structure and then re-levering the β according to MAP’s cap- ital structure, was to follow the formula from Section 13.3.4 The average β of the comparables equaled 0,785, the tax rate was 33%, and the average D/E ratio of the comparables equaled 5,98, so the β unlevered equaled 0,1568 The MAP’s β levered was calculated applying the relevant formula as per Section 13.3.4 The D/E ratio of MAP equaled 10 and the tax rate was 33%, so a re-levered β equaled 1,207 Using this β , the desired risk premium equaled 10% and the free risk rate was 3%, so the MAP’s cost of equity capital was 11,45%
The next step was to identify the weight of the debt and equity of MAP, which were 91 and 9%, respectively Then the averaged value of the cost of debt and equity capital was calculated obtaining a WACC equal to 3.94%
Using the cash fl ow shown in Figure 13.6 we obtain:
Present value of the cash fl ows for the years 2003 to 2007 equal to €8.662,18
Terminal value discounted to year 2002 equals €235.909,42
The NPV of MAP was calculated adding the terminal value and the present value of the cash
fl ow This result was deducted by the net fi nancial position, €20.000, so the NPV equaled
€224.571,60 In this sample, there were no surplus assets or minorities
Trang 6204 CHAPTER 13 Techniques of equity value defi nition
Appendix 13.2
Business case Rainbow: Sample valuation using the venture capital method
Rainbow is a company active in the biotechnology industry and the two entrepreneurs, who are also the two founder engineers of the company, have developed a new product and regis- tered the patent They have already reached an agreement with a big European partner who is
a leader in pharmaceutical product distribution for a future launch of their innovative product They asked Iris Partners, a private equity investor specializing in start-up fi nancing,
to fi nance their initiative, focused on implementing the plant needed to start the new ness, with an investment of €4,5 million Iris ’ strategy for this type of investment requires
busi-an IRR of 45% to be realized within 5 years, so the future value of the investment equals
€28.843.803,28 as per the formula included in Section 13.6
Based on the business plan redacted by the entrepreneurs, the terminal value of the pany was €42 million, calculated by the formula in Section 13.6 using a terminal year net income of €3,5 million and a comparable P/E of 12
Iris Partners considered the correct percentage of new share to be issued and subscribed 68,68% calculated with a total of 100.000 old shares; the total new shares to be issued is 219.241,20 with a price of €20,53
The valuation of Rainbow before the investment was €2.052.534, after the investment it was valued at €6.552.533,94 The difference between these two values is equal to the invest- ment of €4,5 million realized by Iris Partners
Trang 7Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals
Financing seed and
Each entrepreneurial project is developed through several phases according to the life cycle time of a company It is easy to identify the development phase by the problems that occur at different points in the fi rm’s structure During this phase the venture capitalist is considered more than a simple supplier of risk capital and he ends up as a fi nancial intermediary able to support and improve the growth of venture-backed companies How and why the venture capitalist decides to invest in a business idea that has to be defi ned and planned before the company even exists are reviewed in this chapter
To understand the investment activity in risk capital, it is necessary to lyze the key management process realized by the investor This analysis focuses
ana-on critical topics related to the relatiana-onship between the entrepreneur and the venture capitalist and all the building steps necessary to organize the complex structure owned by the venture capitalist initiative The classical approach to the venture capitalist investment, realized in the emerging entrepreneurial initia-tive, leads to the study of fi nancing and managerial resources and their impor-tance The resources are destined to be used for highly innovative projects with good potential These are matched with minority participation to reach capital gains because of the revaluation of the stakes and the opportunity to differenti-ate the risk
It is therefore important to emphasize that venture capitalists
Operate with a pre-established and limited period of time, usually between
3 and 5 years
CHAPTER
Trang 8206 CHAPTER 14 Financing seed and start up
Acquire only minority participation because of the entrepreneurial risk and diffi culty selling the control participation
Point out, from the fi rst time with the target company, the importance of the return on the investment; his investment is in part remunerated during the holding period, by dividends and advisory fees, paid by the target company
14.1.1 Seed fi nancing
Figure 14.1 identifi es the different stages during the life cycle of a company This chapter focuses on the fi rst phase — early stage fi nancing It is possible to further subdivide this phase into two parts, risk and return profi le Each part has specifi c objectives
Seed fi nancing is defi ned as a participation in favor of using a special purpose vehicle (SPV) specifi cally meant for developing a research project It is impor-tant to underline the difference between seed and start-up fi nancing In the start-up fi nancing phase there is no company to fi nance, but there is a person or team of researchers who want to invest in and develop a project that hopefully will produce a successful business idea
Industry sectors typically targeted for seed fi nancing include information technology, pharmaceutical, chemical, telecommunication, and biomedical
Time
Revenues
Early stage financing
Vulture and distressed financing Expansion financing
FIGURE 14.1
Life cycle of a company
Trang 9Regarding the risk profi le, two things must be considered First, entrepreneurs
in need of seed fi nancing have no existing fi rm, and are usually a team of researchers ready to join a capital investor to obtain funds necessary to found
a company that will lead and develop their business idea Secondly, the venture capitalist has to consider the management and its risk profi le related to a good performance of the fi nanced project
Risks that affect investors include:
1 Sudden death — In the beginning the project is owned just by the researchers The fi rst thing they do is share their valuable know-how with the founders Usually the fi rst promoter of the business idea obtains the copyright
2 Support structure for the researchers — To facilitate research, the private
equity investor has to provide an adequate infrastructure:
Incubator — A group of instruments and infrastructures necessary to ensure the correct development of the project
Joint venture between several centers of research — The return will be shared if the project becomes a successful business (bilateral agreement) The incubator structure is very expensive when compared with the bilateral agreement It does not allow the private equity investor to invest in different industries, but if the project is successful the investor does not have to share his earnings Bilateral agreements permit the investor to operate in different indus-tries at the same time, but they impose the division of the investment return if the business idea is profi table Considering the industries involved, seed fi nanc-ing is similar to charity Most researchers can collect the money they need with
a fundraising campaign As mentioned in Chapter 9, during the screening of potential projects to be fi nanced, the private equity investor applies the famous golden rule: start with one thousand projects valuated, go through one hundred projects fi nanced, and just ten projects will be successful
There are two tools used to manage investment return: diversify because of the large amount of resources divided between different business initiatives and mitigate the potential risk on the capital invested by having sub-products guaran-teed by the project There can be potential ethical problems with the second tool
14.1.2 Start-up fi nancing
This type of participation fi nances an already existing company that needs vate equity resources to start the business The risk is based on launching a com-pany built on a well-founded business idea and not on the gamble of discovering
pri-a new business idepri-a
14.1 General overview of early stage fi nancing
Trang 10208 CHAPTER 14 Financing seed and start up
At this point in the business, risk depends on two variables: the total amount
of the net fi nancial requirement and the time necessary to reach the breakeven point of the activity fi nanced The risk is not strongly connected with the entre-preneur or the validity of his business idea, which are preconditions for the participation What is really important is the growth of the industry in terms
of capital intensity required and the forecasted trend of the turnover The high level of risk is due to the investment realized at the time (t 0 ) when it is uncertain
if the business will reach the breakeven point
The performance profi le of a start-up initiative, in terms of IRR, is connected with the ability and capacity to re-sell the participation on the fi nancial market The track record and credibility of the private equity investor are key factors
in the success of the exit strategy when obtaining the desired return from the investment realized The main investor’s goal (a good and successful exit from the investment) can be facilitated by drawing up agreements with other private equity funds regarding their availability and commitment to buy the participation after a predefi ned period of time Another solution is to sign a buy back agreement with the entrepreneur or other shareholders who agree to repurchase the venture cap-italist’s participation in the company after a predefi ned period of time
Different stages of a company’s development need different types of capital investment From the origination to the implementation up to the exit strategy, each phase needs different capital and know-how During the start-up phase, the venture capitalist has an intense and complex interaction with the entrepre-neur to verify the necessary fi nancial and managerial support During the seed
fi nancing phase the technical validity of the product or service is still unproven,
so the venture capitalist offers limited fi nancial resources to support the opment of the business idea and the preparation of the commercial feasibility plan Consequently, there is huge risk faced by the investor
Start -up fi nancing provides the funds needed to start production out commercial validity of the product or service offered During this stage, the entrepreneur risk is huge, but there is also risk connected to the fi nancial resources provided This is usually more important than the risks invested dur-ing the seed phase
First stage fi nancing is linked to the improvement of production capacity after it is completed but the commercial validity of the business idea is still not totally verifi ed This requires a large amount of fi nancial resources, but is less risky and managerial support is still limited
Trang 11Two types of organization structures are used in venture capital operations ing the seed or start-up initiative: Business Angels and corporate venture capital-ists A Business Angel is a private and informal investor who decides to bring risk capital to a small or medium fi rm during its start up or fi rst development phase Business Angels are sustained by networks that match them with companies to meet the demand and supply of fi nancial funds This type of fi nancial operator is common in the United States, but faces problems in Europe Because of this situ-ation, which directly affects new business, the European Strategy was launched
dur-in Lisbon dur-in 2000 1 It defi ned the central role of Business Angels as concrete tributors to the improvement of European competitiveness and productivity
Corporate venture capital is an investment in risk capital executed by very large industrial groups The necessity to strengthen research and development
to continue the high-tech evolution has created investment opportunities Unfortunately, increasing investments is not linked with satisfactory results Small companies have shown a high level of effi ciency and competence in the innovation sector so several industrial groups have started to specialize in the development of new projects; either founding them directly or acquiring partic-ipation These groups have also acquired minority participations in small enter-prises that are technologically qualifi ed This form of fi nancing allows small or medium fi rms to collaborate in a positive way with the big industrial groups
The private and venture capital system is a fi nancial tool with potential to accomplish the competitiveness, innovation, and growth objectives implemented
14.3 Structure of venture capitalists in early stage fi nancing
1 The investment is ongoing
Trang 12210 CHAPTER 14 Financing seed and start up
by the Lisbon protocol The venture capitalist is motivated by the potential ity and long-term growth of industrial leverages operating in innovative indus-tries as well as the ability to improve management skills
Private equity operations realized during seed and start-up fi nancing have to focus their attention on:
Supporting the development of an entrepreneurial environment based fi rms are still not widespread in Europe because there are no structured and uniform legal regulations The prevalence of innovative businesses is possible due to the acquisition of fi nancial, strategic, and cor-porate knowledge, which can be offered by a professional fi nancial inves-tor with international experience
Implementing research and development and the ability to spread the vation through centers of excellence by fi rms focused on research A key factor toward this evolution is a structured relationship between fi rms and universities
The fi rst aspect the venture capitalist has to consider, to guarantee the optimal composition of his investment portfolios, is the effectiveness of his deal fl ow In American markets, where risk capital is widespread and well established, deal
fl ow is represented by a relevant number of well-structured business proposals formalized with business plans These are sent by fi rms to specifi c groups of venture capitalists selected based on their previous investments and their indus-try and/or geographical areas of interests In fi nancial markets where risk capital
is not so widespread, the venture capitalist needs specifi c ways to promote this form of fi nancing; for example, his network of relationships is an effective and useful tool to create fi nancial business opportunities
Important to the venture capitalist is the opportunity to analyze the est number of business projects, which allows a better range of choices, and proposals that include the optimal and ideal requirements needed by investors For example, in the developed and complex risk capital markets, competition between venture capitalists to fi nance the best projects has provoked opera-tors to specialize their fi nancing toward a specifi c stage of a fi rm’s life cycle, the average dimension of the funds required, and the industry
Each venture capitalist decides the minimum and maximum investment entrance The minimum investment includes fi xed costs during the screening
of all business projects such as due diligence and monitoring and managerial