CFA® Program Curriculum: Volume 6, page 166
Here, we describe the valuation of an investment in an existing company using the venture capital (VC) method.
At the time of a new investment in the company, the discounted present value of the estimated exit value, PV(exit value), is called the post-money value (after the
investment is made). The value before the investment is made can be calculated as the post-money value minus the investment amount and is called the pre-money value.
POST = PV(exit value) PRE = POST – INV
In order to determine the number of new shares isvsued to the venture capital firm (sharesVC) for an investment in an existing company, we need to determine the fraction of the company value (after the investment is made) that the investment represents.
Based on the expected future value of the company (exit value) and the expected or required rate of return on the investment, we can do this in either of two ways with the same result.
The fraction of VC ownership (f ) for the VC investment can be computed as:
The first method (NPV method):
where:
INV = amount of new investment for the venture capital investment.
POS = post-money value after the investment.
The second method (IRR method):
where:
FV(INV) = future value of the investment in round 1 at the expected exit date.
exit value = value of the company upon exit.
As long as the same compound rate is used to calculate the present value of the exit value and to calculate the future value of the VC investment, the fractional ownership required (f ) is the same under either method.
Once we have calculated f, we can calculate the number of shares issued to the
VC (sharesVC) based on the number of existing shares owned by the company founders prior to investment (sharesFounders).
The price per share at the time of the investment (price) is then simply the amount of the investment divided by the number of new shares issued.
Example: Calculations using the NPV venture capital method and a single financing round Ponder Technologies is a biotech company. Ponder’s entrepreneur founders believe they can sell the company for $40 million in five years. They need $5 million in capital now, and the entrepreneurs currently hold 1 million shares.
The venture capital firm, VC Investors, decides that given the high risk of this company, a discount rate of 40% is appropriate.
Calculate the pre-money valuation, post-money valuation, ownership fraction, and price per share applying the NPV venture capital method with a single financing round.
Answer:
Step 1: The post-money (POST) valuation is the present value of the expected exit value (this assumes the investment was made in the company):
Step 2: The pre-money (PRE) valuation is what the company would hypothetically be worth without the investment:
PRE = 7,437,377 – 5,000,000 = 2,437,377
Step 3: To put $5 million in a company worth $7.4 million, the private equity firm must own 67.23% of the company:
Note that under the IRR method, f is the same:
Step 4: If the entrepreneurs want 1 million shares, the private equity firm must get 2.05 million shares to get 67.23% ownership:
Step 5: Given a $5 million investment and 2.05 million shares, the stock price per share (P) must be:
MODULE QUIZ 44.4
To best evaluate your performance, enter your quiz answers online.
Use the following information to answer Questions 1 through 5.
ScaleIt is a startup specializing in mobile applications. The company’s founders believe they can sell the company for $50 million in four years. They need $7 million in capital now, and the founders wish to hold 1 million shares. The venture capital investor firm decides that, given the high risk of this company, a discount rate of 45%
is appropriate. Use the NPV venture capital method, assuming a single financing round.
1. What is the post-money valuation?
A. $4,310,922.
B. $11,310,922.
C. $50,000,000.
2. What is the pre-money valuation?
A. $4,310,922.
B. $7,310,922.
C. $43,000,000.
3. What is the ownership fraction for the venture capital firm?
A. 14.00%.
B. 38.11%.
C. 61.89%.
4. What is the number of shares for the venture capital firm?
A. 615,846.
B. 1,623,983.
C. 2,603,078.
5. What is the stock price per share?
A. $2.69.
B. $4.31.
C. $11.37.
Use the following information to answer Questions 6 through 9.
The venture capital company’s founders believe they can sell the company for $70 million in five years. They need $9 million in capital now, and the entrepreneurs wish to hold 1 million shares. The venture capital investor requires a return of 35%. Use the IRR venture capital method, assuming a single financing round.
6. What is the investor’s ownership fraction?
A. 12.86%.
B. 42.35%.
C. 57.65%.
7. What is the stock price per share?
A. $2.39.
B. $6.61.
C. $12.25.
8. What is the post-money valuation?
A. $6.61 million.
B. $15.61 million.
C. $70.00 million.
Video covering this content is available online.
9. What is the pre-money valuation?
A. $6.61 million.
B. $9.00 million.
C. $61.00 million.