Chapter 10: Valuation method
1. [Discount Rates] Calculate the discount rate consistent with a cap rate of 12 percent and a
growth rate of 6 percent. Show how your answer would change if the cap rate dropped to 10
percent while the growth rate declined to 5 percent.
Cap rate = spread between discount rate and growth rate; Cap rate = (r – g)
Cap rate = 12%, growth rate = 6%, discount rate = Cap rate + g = 12% + 6% = 18%
Cap rate = 10%, growth rate = 5%, discount rate = Cap rate + g = 10% + 5% = 15%
2. [Venture Present Values] A venture investor wants to estimate the value of a venture. The
venture is not expected to produce any free cash flows until the end of Year 6, when the cash
flow is estimated at $2,000,000, and is expected to grow at a 7 percent annual rate per year into
the future.
A. Estimate the terminal value of the venture at the end of Year 5 if the discount rate at
that time is 20 percent.
B. Determine the present value of the venture at the end of Year 0 if the venture investor
wants a 40 percent annual rate of return on the investment.
2 (A)
T = VCFT/r – g
T= 2000000/0.2 – 0.07
T = $15384615.38
2 (B)
PV = $15384615.38/(1.40)5
PV = $2860529.72
3. [Venture Capital Valuation Method] A venture capitalist wants to estimate the value of a new
venture. The venture is not expected to produce net income or earnings until the end of Year 5
when the net income is estimated at $1,600,000. A publicly traded competitor or “comparable
firm” has current earnings of $1,000,000 and a market capitalization value of $10,000,000.
A. Estimate the value of the new venture at the end of Year 5. Show your answer using
both the direct comparison method and the direct capitalization method. What
assumption are you making when using the current price-to-earning relationship for the
comparable firm?
B. Estimate the present value of the venture at the end of Year 0 if the venture capitalist
wants a 40 percent annual rate of return on the investment
3 (A)
Direct comparison
P/E = $10000000/$1000000 = 10 times
POther firm/EOther firm x EVenture Y5 = $10000000/$1000000 x $1600000 = $16000000
Direct capitalization
EVenture Y5 / (EOther firm/POther firm) = $1600000/($1000000/$10000000) = $16000000
Assumption
The assumption that I make when using current price to earning relationship for the comparable
firm is that the firm has certain similar characteristics to my firm such as capital structure and
risk. Besides that, the comparable firm is really comparable to the new venture.
3 (B)
PV@40% = $16000000/1.405 = $2974950.91
4. [Multiple Financing Rounds] Ratchets.com anticipates that it will need $15 million in venture
capital to achieve a terminal value of $300 million in five years.
A. Assuming it is a seed-stage firm with no existing investors, what annualized return is
embedded in its anticipation?
B. Suppose the founder wants to have a venture investor inject $15 million in three rounds
of $5 million at times 0, 1, and 2 with a time 5 exit value of $300 million. If the founder
anticipates returns of 70 percent, 50 percent, and 30 percent for rounds 1, 2, and 3,
respectively, what percent of ownership is sold during the first round? During the
second round? During the third round? What is the founder’s Year 5 ownership
percentage?
C. Assuming the founder will have 10,000 shares, how many shares will be issued in rounds
1, 2, and 3 (at times 0, 1, and 2)?
D. What is the second-round share price derived from the answers in Parts B and C?
E. How does the answer to Part D change if 10 percent of total equity in Year 5 is set aside
for incentive compensation? How many total shares are outstanding (including incentive
shares) by Year 5?
4 (A)
$15000000 x (1+r)5 = $300000000
R = 82.05%
4 (B)
First round percent ownership
Acquired % ownership at time 0 = I(1+r)r/(P/E x E) = $5000000(1+0.7)5/300000000
Acquired % ownership at time 0 = I(1+r)r/(P/E x E) = 23.6643%
Second round percent ownership
Acquired % ownership at time 0 = I(1+r)r/(P/E x E) = $5000000(1+0.5)4/300000000
Acquired % ownership at time 0 = I(1+r)r/(P/E x E) = 8.4375%
Third round percent ownership
Acquired % ownership at time 0 = I(1+r)r/(P/E x E) = $5000000(1+0.30)3/300000000
Acquired % ownership at time 0 = I(1+r)r/(P/E x E) = 3.661667%
Founder ownership Y5 = 100 -23.6643-8.4375-3.661667 = 64.236533%
4 (C)
Total shares to finance = 10000/0.64236533 = 15567.46532 ≈ 15567 shares
Shares to issue in round 1 = 0.236643 x 15567 = 3684
Shares to issue in round 2 = 0.084375 x 15567 = 1313
Shares to issue in round 3 = 0.03661667 x 15567 = 570
4 (D)
Second round share price = $5000000/1313 = 3808/share
4 (E)
Founder ownership = 100 – 23.6643 – 8.4375 – 3.661667 – 10 = 54.236533
Total shares at Year 5 = 10000/0.54236533 = 18438
Second round shares = 1556 shares
Second round share price = $5000000/1556 = $3213.37/share
5. [Rates of Return] Suppose a venture fund wishes to base its required return (used in discounting
future terminal values) on its historical experience and suggests merely averaging the rates on
the last three concluded deals. These deals realized total returns of −67 percent at the end of
two years, 50 percent at the end of five years, and 70 percent at the end of three years,
respectively.
A. Assuming no intermediate flows before the terminal payoff, verify that the associated
annualized rates are −42.55 percent, 8.45 percent, and 19.35 percent.
B. What is the equally weighted average annualized return?
C. Does it make sense to use this as a single discount rate to apply across scenarios
involving different durations?
5 (A)
Annualized rate of -67%@2 years = (1-0.67)1/2 -1 = -42.55%
Annualized rate of 50%@5 years = (1+0.5) 1/5 -1 = 8.45%
Annualized rate of 70%@3 years = (1+0.7) 1/3 -1 = 19.35%
5 (B)
Equally weighted annualized return = (-0.4255+0.0845+0.1935)/3 = -4.92%
5 (C)
The returns have been realized over a total of 10 investment years. However, the simple
average here is only dividing by the three outcomes (not their years). Consequently, it is open
for debate whether this simple project averaging is the best way to calibrate a required return
for projects of widely varying known durations. However, at the time the venture is funded, it is
not known what the duration will be and if it is like a small replication of all of the previous
funded ventures, it is reasonable to use the hybrid discount rate for all of the venture’s possible
outcomes.
6. [Multiple Financing Rounds] Rework the two-stage example of Section 10.5 with 1,000,000
initial founders’ shares (instead of the original 2,000,000 shares). What changes?
Founder’s shares = 1000000 shares
Total shares after financing and incentive options = 1000000/0.024375 = 41025641 shares
1st round
Shares issued = 0.759375 x 41025641 = 31153846 shares
Share price = $1000000/31153846 = $0.03209876543
Pre-money valuation = 1000000 x 0.03209876543 = $32099
Post money valuation = (31153846 + 1000000) x 0.03209876543 = $1032099
Founder % between 1st and 2nd rounds = 1000000/(31153846+1000000) = 3.11%
1st round investor % between 1st and 2nd rounds = 31153846/(31153846+1000000) = 96.89%
So on and so forth (shares and price divide by 2 but percent ownership remains the same)
7. (Q8 textbook question) >> [Pre-money and Post-money Valuations] Suppose you are considering
a venture conducting a current financing round involving an issue of 100,000 new shares at $3.
The existing number of shares outstanding is 200,000. What are the related pre-money and
post-money valuations
Pre-money valuation = 200000 shares x $3 = $600000
Post-money valuation = (200000+100000) shares x $3 = $900000
8. (Q9 textbook question) >> [Venture Capital Valuation Method] A venture capitalist firm wants to
invest $1.5 million in your NYDeli internet venture that you started six months ago. You do not
expect to make a profit until Year 4 when your net income is expected to be $3,000,000. The
common stock of BioSystems, a comparable firm, currently trades in the over-the-counter
market at $30 per share. BioSystems’ net income for the most recent year was $300,000 and the
firm has 150,000 shares of common stock outstanding.
A. Apply the VC method to determine the value of the NYDeli at the end of four years.
B. If venture capitalists want a 40 percent compound annual rate of return on similar
investments, what is the present value of your NYDeli venture?
C. What percentage of ownership of the NYDeli dot-com venture will you have to give up
to the VC firm for its $1.5 million investment?
8 (A)
POther firm current/ Eother firm current x EVenture Y4 = (30 x 150000) / 300000 x 3000000 = $45000000
8 (B)
PV of NYDeli venture = $45000000/1.4 4 = $11713869.22
8 (C)
Acquired % for final ownership = $1500000(1+0/40) 4/45000000 = 12.81%
9. [Present Values and Investor Ownership] Vail Venture Investors, LLC, is trying to decide how
much percent equity ownership in Black Hawk Products, Inc., it will need in exchange for a $5
million investment. Vail Venture Investors has a target compound rate of return of 25 percent
on venture investments like Black Hawk Products. Depending on the success of products
currently under development, Vail Venture’s investment in Black Hawk could turn out to be a
complete failure (black hole), barely surviving (living dead), or wildly successful (venture utopia).
Vail Venture assigns probabilities of 0.20, 0.50, and 0.30, respectively, to the three possible
outcomes. Following are the three cash flow scenarios or outcomes for the Black Hawk Products
investment that Vail Venture expects to exit at the end of five years.
Part A:
A. Calculate the present value of each scenario or outcome for Black Hawk Products.
B. Calculate the weighted average of the present values for the three scenarios. What is the
total equity value for the Black Hawk Products venture?
C. Determine the acquired percentage of final ownership of Black Hawk Products that Vail
Venture Investors would need for its $5 million proposed investment.
9 (A)
PV(Black hole) = $0
PV(Living dead) = $10000000/1.255 = $3276800
PV(utopia) = $50000000/1.255 = $16384000
9 (B)
PV(Weighted average) = 0.20($0) + 0.50($3276800) + 0.3($16384000) = $6553600
9 (C)
Firm value = $6553600
Amount invested = $5000000
Acquired % of final ownership = $5000000/$6553600 = 76.29%
