In the previous example we used a 12% discount rate in calculating the present value of cash flows. This discount rate might have been calculated using the CAPM formula and betas from comparable companies. Of course, a 12% discount rate seriously understates the riskiness of investment in a start-up business. Therefore, VCs apply a "probability of success", p, in determining the proper discount rate to use, based on the maturity of the business, quality and experience of the management team, and other factors. Early seed financing often calls for a probability of success on the order of 10%. First stage financing might call for a 25% probability of success. The VC hurdle rate (i.e. the VC's required rate of return) is then calculated by dividing the required return on equity calculated using CAPM, for example, by the probability of success.
So, if the CAPM return on equity is 15% and the probability of success is 30%, the VC hurdle rate is 50%.
The probability-adjusted APV analysis is the same as before, except that the rate used discount free cash flows is the VC's hurdle rate. Let's now revisit our example from the previous page to see how to value the company using the VC's required rate of return.
Exhibit A – Probability-Adjusted APV Valuation
In the first spreadsheet below, we show how the entrepreneur performs the pre-money, probability-adjusted valuation. We assume probability of success of 25%, which yields a VC hurdle rate of 52% (= 13%/25%). The entrepreneur acknowledges the VC's required rate of return, but still has a different perspective on how to calculate the pre-money value of the company. He/she uses assumes that funding is received only as needed, as demonstrated above, and that the VC can earn a CAPM rate of return while waiting to fund the required investments. Therefore, the entrepreneur applies a discount factor in the first two years based on a CAPM required rate of return.
As before, the VC considers itself committed for the entire investment in Year 0 and, therefore, does not discount the negative cash flow in Year 1 (even though the rate used to compute the discount factors in Years 0 and 1 is 52% rather than the 13% used by the entrepreneur).
You should again note that the post-money valuations are the same under both sets of calculations, but the pre-money valuations differ because of the entrepreneur's and VC's different perspectives on the timing of investment in the company.
In practice, VCs use comparable companies analysis to determine the multiple of sales or EBITDA to use in the valuation of a company. Sales multiples are used for early-stage start-ups that do not yet have positive or meaningful EBITDA, and EBITDA multiples may be used in valuing more mature companies. The multiple chosen is first discounted to reflect the illiquidity of the investment, since the VC cannot simply sell its investment in an open market. The multiple is again discounted to reflect the VC's view on the company's probability of success.
Exhibit B – Comparable Companies Valuation
Assume that comparable companies are valued at 2.00x sales, on average, and that we discount this multiple by half a turn (0.50x) to account for the illiquidity of the investment and the VC's view on the company's probability of success. Also, assume that the terminal year sales and net debt for the company are as shown in the spreadsheet below. What are the pre- and post-money values?
Note that the pre- and post-money valuations achieved using comparable valuation metrics are similar to those calculated using the probability-adjusted APV analysis. Also, the comparable companies valuation mimics the VC's perspective, since the post-money value is computed first and the investment is subtracted to yield the pre-money value.
An interesting exercise would be to set the VC's probability-adjusted APV valuation equal to the valuation obtained through comparable companies analysis to see what hurdle rate (and, thus, probability of success) the terminal multiple implies, and vice versa. Doing so can help a VC determine if the multiple (hurdle rate) used in the valuation of a company is too high or low.
Let's now calculate ownership percentages for each valuation analysis we have performed. The entrepreneur's percent ownership is simply the pre-money value divided by the post-money value, and the VC's ownership is calculated as the amount of investment divided by the post-money value. Differences between the entrepreneur's and VC's methods of computing pre-money values result in different post-investment ownership percentages.
Exhibit C – Calculation of Ownership Percentages
Note that the pre- and post-money valuations achieved using comparable valuation metrics are very similar to those calculated using the probability-adjusted APV analysis.
Post-money valuations are the same, but pre-money valuations are different because of differences in how entrepreneurs and VCs look at the investment. Entrepreneurs typically assume that the cash is funded as needed, and they assume that the VC can invest any committed, but uninvested, capital at the CAPM discount rate. VCs, on the other hand, consider themselves exposed for the entire round of financing at time t=0 and, thus, use the hurdle rate from that point forward. Download the Excel spreadsheet that contains all the analyses shown above and on the previous page.