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Copyright 1999 President and Fellows of Harvard College
HBS Toolkit
LICENSE AGREEMENT
Contents
Introduction This sheet
Assumptions Primary data entry sheet
Simple Model Primary report sheet
Introduction
Venture Capitalists (VCs) are regularly presented with valuation challenges. Since the projects they are investing
in rarely have a reliable external valuation (such as the publicly quoted market price for a company listed on a
stock exchange), the VC is on his or her own in attempting to value a potential portfolio investment.
To complicate things further, the most popular valuation tools for established companies or for projects with
predictable revenue streams are problematic when applied to early-stage companies. Discounted cash flow
might be an ideal tool for valuing a mature company with stable cash flow, or an investment expected to produce
predictable cost-savings or revenue improvement. Applying DCF to start-up companies that have a significant
chance of either failure or explosive success, and where business plan estimates of future results are
notoriously unreliable, is not likely to be terribly effective.
Similarly, while a late-stage private company could be valued by comparing it with similar publicly traded
companies, the comparable companies for an early-stage investment are likely to be privately held themselves,
with only limited use for establishing a reasonable valuation.
An additional concern with conventional valuation techniques is that they ignore a key element of the VC
business model: the exit. A portfolio manager of a mutual fund may hold his Microsoft shares indefinitely, and a
business manager is making a capital investment for its returns over an expected useful economic life. A VC,
however, typically expects to exit her investment within a fairly short time frame (typically two to five years).
The Venture Capital Method: Discounting Exit Value
The Venture Capital Method involves estimating an achievable exit value for the investment, discounting that to
present value, and determining what percentage of equity the VC will need to hold at the time of exit in order to
achieve their required rate of return. Once that has been determined, the VC can adjust this percentage for any
expected dilution (e.g. from further rounds of financing or options set aside for employees) and determine how
much equity she needs at the time of investment.
Example 1: A Venture Capitalist is considering investing $10 million in a start-up venture. She estimates that
at the end of year 3 the company will generate $15 million in EBIT and will be ready for an IPO, at which point
she expects to sell her shares. IPO multiples for this sort of company have typically been roughly 8x trailing
year EBIT. Her investment hurdle rate is 30% p.a. No further dilution is expected. How much equity must she
receive for her investment?
Dollar amounts in Millions Formula
IPO Value $120
Present Value $54.60
Required equity at Exit 18.30%
Thus, in order to earn a 30% annual return over three years, the VC must receive 18.3% of the equity in exchange
for her $10 million investment.
$15 EBIT @ 8x IPO multiple
$120/(1+30%)^3
10/54.6
Venture Capital Valuation
INTRODUCTION
Venture Capital Valuation
INTRODUCTION
Adjusting for Dilution
VCs have an additional challenge compared with investors in mature companies or managers deciding whether
to go ahead with a capital investment project. Most entrepreneurial firms do not raise their entire venture
funding at one time. Rather, funding is raised in separate stages, each one of which will involve a separate
valuation and may include different VCs as investors. In addition, many entrepreneurial firms provide a
significant amount of options to attract and motivate managers and other key employees. Thus, in determining
how much equity to receive at the time of investment, the VC must often take dilution of that equity into account.
Example 2: Let us assume that in the above example, an additional round of financing would be required at the
beginning of year three. $10 million would have to be raised. Lets also assume that these investors will need a
somewhat lower rate of return (20%) because the venture is at a more mature stage. We would calculate their
required equity stake as follows:
Dollar amounts in Millions Formula
IPO Value $120
Present Value $100
Required equity at Exit 10%
So, the equity of the company will have to be increased by 11.1% in order for the new investors to have a 10%
stake. This will dilute the investment of the first round VC, so that in order to have 18.3% at exit she will have to
receive 20.3% at the time she invests.
Example 3: Now suppose that management wishes to award certain employees with options. These options
will be issued at the same time as the second round of financing, and will give employees the right to buy
equity that will equal 15% of the company after that round is complete. How will this affect the required stakes
of the original VC investor?
To answer this, we must first assess the needs of the second round investors, since that will affect the total
dilution suffered by the original VC. These investors require a 10% stake at the time of the IPO. The options will
dilute them by 15%, so we divide 10% by (1-0.15). They will require an initial stake of 11.8%.
Now we can address the dilution of the original VC. Her investment will be diluted by 11.8% by the second round
investors and then by a further 15% by the employee options. Thus, to calculate how much she needs to receive
in order to have 18.3% at exit we calculate as follows: 18.3%/(1-0.15)/1-0.118). She will require a 24.4% stake.
Directions
Developed for use with "The Venture Capital Method - Valuation Problem Set" (HBS Case 396-090)
Note About Using Internet Explorer
The default setting in Internet Explorer is to open these tools in the Explorer application instead
of Excel. We recommend against this and provide directions in the Help section of the HBS
Toolkit web site to change this default behavior.
HBS Menu
Show/Hide Sample Data: Displays or removes sample entries
Show Calculator: Launches Windows calculator
Show/Hide Celltips: Toggles in/out red Celltips in documented cells
Print Sheet with Celltips: Prints Celltip documentation on current sheet
Set Zoom: Provides quick access to 80%, 100%, and 125% zoom levels
Visit Web Links: Links to HBS Toolkit website, Toolkit Glossary, and Toolkit
Feedback, as well as HBS and HBS Publishing web sites
About HBS Toolkit: Launches the about box for the HBS Toolkit
Research Associate Andrew S. Janower developed this software under the supervision of Professor William A.
Sahlmanas the basis for class discussion rather than to illustrate either effective or ineffective handling of an
administrativesituation. Formatted for the HBS Toolkit by Jon B. DeFriese, MBA `00 and Chad Ellis, MBA `98.
$15 EBIT @ 8x IPO multiple
$120/(1+20%)^1
10/100
Copyright 1999 President and Fellows of Harvard College
Stage 1 Stage 2
$5.0 $0.0
50.0% 30.0%
5.0 3.0
1,000,000
0.0%
$100.0 MM
5.0%
20.0 X
100.0 $ MM
$0.0 MM
$0.0 MM
Terminal Calculations Stage 1 Stage 2 Total
Total Terminal Value $38.0 $0.0 100.0 $ MM
Return of Principal - $ - $
Equity Value Required $38.0 $0.0
Terminal Share Stage 1 Stage 2
Equity Ownership 38.0% 0.0%
Pre-Money Valuation 38.0% 0.0%
Management Terminal Value 0.0
Return of Stage 2 Principal
Terminal Net Margin
Terminal PER
Terminal Value of Enterprise
Return of Stage 1 Principal
Copyright 1999 President and Fellows of Harvard College
Investment Rounds
Investment Amount
Required Stage 1 ROR
Years to Terminal Stage
Shares outstanding before investment
Terminal Stage
Terminal Management Share
Terminal Sales
Venture Capital Valuation
ASSUMPTIONS
Shares Outstanding (000's) Founder Stage 1 Stage 2 Terminal
Founder 1,000 1,000 1,000 1,000
Stage 1 612 612 612
Stage 2 0 0
Management 0
Total 1,000 1,612 1,612 1,612
Equity Ownership % Founder Stage 1 Stage 2 Terminal
Founder 100.0% 62.0% 62.0% 62.0%
Stage 1 38.0% 38.0% 38.0%
Stage 2 0.0% 0.0%
Management 0.0%
Total 100.0% 100.0% 100.0% 100.0%
Pre-Money Valuation ($MM) Stage 1 Stage 2 Terminal
Founder 8.2 #N/A 62.0
Stage 1 5.0 #N/A 38.0
Stage 2 #N/A 0.0
Management 0.0
Total 13.2 #N/A 100.0
Share Price $8.17 #N/A $62.03
Simple Two Stage Investment
Copyright 1999 President and Fellows of Harvard College
Venture Capital Valuation
Simple Model