Venture Capital Theory Questions and Answers

Venture Capital Theory Questions and Answers What is meant by a capitalization (or cap) rate in reference to calculating a terminal value? What other types of terminal values might be appropriate (i.e., other than smooth growth procedures)? Dividing by the cap rate (r - g) in the perpetuity formula is the appropriate mathematical simplification for discounting (at rate r) a perpetual series of cash flows growing smoothly (at rate g). It is mathematically equivalent to the infinite sum of the discounted value of all the future cash flows. Rather than projecting a smooth growth, one could project no growth, multiple stages of growth, liquidation value (with tax benefits, if any) or predict the terminal value using the multiple methods that will be introduced in Chapter 10. Explain the difference between pre-money valuation and post-money valuation. Pre-Money valuation: present value of a venture prior to a new money investment Post-money valuation: pre-money valuation of a venture plus money injected by new investors Describe the equity valuation method. Equity valuation method (equity method): process of projecting and then discounting the relevant cash flows available to equity investors Briefly describe the process for projecting financial statements. The process begins by projecting top-line sales forecasts annually for a specified forecast period and for a stepping-stone year. We then generally use a percent-of-sales method (described in Chapter 6) to first forecast annual income statements. This is followed by a forecast of annual balance sheets and annual statements of cash flows. Identify and describe the major components that are used to calculate the equity valuation cash flow. Equity valuation cash flow = net income + depreciation and amortization expense - change in net operating working capital (without surplus cash) - capital expenditures + net debt issues Describe how pseudo dividends are used in the equity valuation method. Pseudo dividend: excess cash not needed for investment in the assets or operations to carry out the business plan Pseudo dividends can be used to conduct an equity-method valuation (1) by altering the projected financial statements to pay out the maximum dividend feasible each period, and incorporating the recovery of those dividends when the capital is needed for the execution of the business plan, or (2) by using a formula approach to directly calculate the pseudo dividends. Describe the basic venture capital (VC) method for estimating a venture's value. Venture capital (VC) method: estimates the venture's value by projecting only a terminal flow to investors at the exit event. Describe the process for estimating the percentage of equity ownership that must be given up by the founder when a new equity investment is needed. Estimate the value of the exit event. Discount that value at the venture capital discount rate to get a present value. Divide the amount the new investor will contribute by that present value to determine the percentage of the venture's ownership that must be sold. How does a present value venture valuation pie differ from a future value valuation pie? The present value valuation pie is the present value of the future valuation pie where the discounting is done at the venture capital discount rate. How is multiplying a projected earnings by a P/E ratio similar to discounting a perpetuity of earnings starting at that level? Both convert a projected earnings number into a present value. The P/E multiple approach does so by multiplication (P/E*E=P) and the discounting approach does so by division (E/(r-g)). When P/E=1/(r-g), these give the same answer for a given projected E. How would one expect P/E ratios to vary with a venture's risk and growth opportunities? P/E should increase with valuable growth opportunities and decrease with risk, other things being equal. What are the common ways to estimate a terminal value for a venture? A few common ways to estimate terminal value for a venture would be to use a P/E or other multiple or to divide final cash flow by the cap rate (r-g). What is the difference between the direct comparison method and the direct capitalization method? Direct comparison applies a direct comparison ratio to the related venture quantity and need not have any discounting interpretation. Direct capitalization capitalizes earnings by discounting using a cap rate (r-g) implied by a comparable ratio. There is a direct discounting interpretation. Direct comparison can be used with stock variables (like "dollars per square foot") whereas direct capitalization is really restricted to flow variables (like earnings, cash flow and dividends). Describe the types of resources (assets) needed for a new product venture during its development and startup stages. Comment on the likely revenues and expenses during these early life cycle stages. Development Stage in Life Cycle: Assets: acquire initial assets (e.g., initial cash, office furniture, computer, etc.) Revenues: no sales (consequently no money is coming in) Expenses: e.g., rent, utilities, subsistence salary for entrepreneur Startup Stage in Life Cycle: Assets: acquire production assets (e.g., inventories and equipment to produce products and give credit to customers) Revenues: making sales (money begins flowing in) Expenses: additional expenses to produce and market products and to record business transactions Briefly describe the typical types of accounts that are found in the current assets of a new venture. Typical current asset accounts are cash, which includes cash accounts and marketable securities, accounts receivable, inventory and other current assets. What is meant by the terms "depreciation" and "accumulated depreciation"? Depreciation refers to the amount of decrease in value of the firm's long-term depreciable assets based on a preset schedule of the individual assets. Accumulated depreciation is the accrued amount of depreciation the firm has on its existing assets. What types of liabilities might show up on a venture's balance sheet? Liabilities might include: payables, accrued wages, bank loan, other current liabilities, long-term debts, and capital leases. What does an income statement measure or track over time? The income statement is a performance measure of a firm's operations over a period of time. Many different accounts that make up the income statement are used to determine trends in costs and revenues. Define the term "EBIT." How does EBIT differ from a firm's net income or net profit? EBIT is defined as the earnings of a company before accounting for any interest expense/income and the taxes to be paid. Net income results from subtracting interest expense and taxes from EBIT. Define the term EBITDA. The acronym EBITDA stands for earnings before interest, taxes, depreciation, and amortization. What is a venture's contribution profit margin? Contribution profit margin is the portion of the sale of a product that contributes to covering the fixed costs. Define the term EBDAT. EBDAT is a firm's earnings before taxes, depreciation and amortization. Describe the meaning of EBDAT breakeven and survival revenues. EBDAT breakeven occurs when the firm's survival revenues cover all of its cash expenses. Briefly describe venture debt capital and venture equity capital. In general, early-stage ventures raise debt capital from individuals, venture lenders, and when profitably entering rapid-growth, possibly other financial institutions. The founding entrepreneurial team, business angels, and venture capitalists are the primary sources of early-stage equity capital. In some instances, debt and/or preferred stock convertible into shares of common equity is held by venture investors. What is meant by an investment risk premium? What is a market risk premium? An investment risk premium is the additional return above the risk-free rate that investors can expect to earn by investing in a risky common stock. The market risk premium is the additional return above the risk free rate per unit of beta risk that a stock investor can expect. How do we estimate the cost of equity capital for private ventures? In developing your answer describe the major components that are considered when estimating the rates of return required by venture investors. Equity capital for private ventures is estimated by adding together the risk free rate, an inflation premium, an advisory premium, a liquidity premium, and a hubris projections premium. What discount rates are typically used for development- stage, startup-stage, survival-stage, and early-growth-stage ventures? The discount rate for the development stage is typically above 40%, between 30% and 50% for the startup stage, between 25-45% for the survival stage, and between 25-35% for the early growth-stage. What is meant by the weighted average cost of capital or WACC? Weighted average cost of capital (WACC): weighted average of the cost of the individual components of interest-bearing debt and common equity capital. How is a venture's WACC likely to change as it moves through a successful life cycle? Most early-stage financing is high-cost equity capital. However, the opportunity to use usually less-costly debt increases as a successful venture progresses through its life cycle. Thus, the WACC is likely to decrease over time for a successful venture. What is meant by sweat equity? Sweat equity is an individual's work-related, non-financially compensated, contribution to the enhancement of a venture's value. What is a venture's reversion value? The present value of the terminal value. What is a stepping stone year? Why is it important in determining a venture's value? The stepping stone year forces the evaluator to ramp revenue growth to the long term rate while making sure that the investment flows going forward are at a level appropriate for that long term growth rate. The level is lower than in previous years where investment supports much higher revenue growth rates. Define required cash and surplus cash. Why does it matter how we treat surplus cash for valuation purposes? Required cash: the amount of cash needed to cover a venture's day to day operations. Surplus cash: cash remaining after required cash, all operating expenses and reinvestments are made. To get an appropriate valuation, we separate required cash (treated as an investment) from surplus cash (allowed to flow through to equity holders).