POE

Myth 1: Beauty is in the Eye of the Beholder. Myth 2: The future is anybody’s guess. Myth 3: Investors demand very high rates of return to compensate risk. Myth 4: The investor determines the value of the venture.

Entrepreneurs focus on qualitative factors, like vision or passion. Professional investors prioritize the tradeoff between cash flow and risk for valuation. This highlights the importance of using valuation tools for informed decisions.

Forecasting for new ventures is crucial due to high uncertainty. Single-scenario forecasts are not helpful in uncertain environments. Scenario analysis and simulation are key for managing risk and shaping strategies.

New ventures are high-risk investments with long-term capital commitment and no easy exit. Required VC returns are often assumed to be very high (e.g., 50-60%), but actual returns are typically lower (e.g., 17.3% over 20 years). Empirical evidence shows that not all investment assumptions hold true in practice.

Entrepreneurs’ knowledge of valuation helps avoid negotiation breakdowns. Investors base valuation on their research, but financing involves more than cash for equity. Valuation helps entrepreneurs understand value perceptions, deal structures, and investor perspectives. Competition among investors doesn’t replace the need for proper valuation.

DCF, Relative value (RV), The venture capital (VC), The First Chicago method.

Discounted Cash Flow (DCF) calculates the present value (PV) of future cash flows. Two approaches: Certainty Equivalent (CEQ) and Risk-Adjusted Discount Rate (RADR). Future cash flows are discounted to PV, considering both time value of money and risk.

The discount rate reflects the riskiness of expected cash flows and the time value of money.

Identify appropriate future cash flows. Determine appropriate discount rate. Calculate (sum of) present value(s).

Investors seek cash flows available for distribution to the new venture. Cash flows are identified for the entire venture or specific financial claims (equity vs. debt). Equity = dividends; Debt = interest payments and principal repayment; Terminal value = estimated value beyond the forecast period (5-10 years).

rFt: Return on a risk-free asset at time t (e.g., government bonds). RPjt: Risk premium based on the riskiness of the cash flow at time t, estimated using the capital asset pricing model (CAPM). The risk-adjusted discount rate reflects the opportunity cost of an alternative investment with similar risk and return.

PVj = sum(Cjt/(1+rt)^t) PV is present value of investment j. Cjt is expected CF of investment j at time t. Rt is risk-adjusted discount rate.

Primary approach for valuing early-stage ventures with high growth potential. Involves in-depth analysis to assess future growth and risks. Often used when traditional valuation methods are less applicable.

Difficult to apply for new ventures due to uncertainty in cash flows. Challenging to estimate the riskiness of cash flows in early-stage ventures. Risk factors can make accurate valuation harder.

Commonly used in corporate finance and for valuing early-stage ventures with high growth potential. Helps assess the future value of companies with uncertain cash flows. Widely applied in investment analysis and strategic planning.

Relative Value Method: Used to value assets without observable cash flows (e.g., owner-occupied housing). Common in real estate and based on data from similar public companies and market transactions. For ventures, often used to value companies during IPOs or acquisitions, comparing factors like square footage or number of bedrooms.

Price/earnings, Price/book value of equity, Enterprise value/revenue, Enterprise value/book value

Magazine publishing ventures (number of subscribers), Internet ventures (website visitors), Biotech ventures (number of patents)

Strength: Easy to implement when comparable data are available. Relies on observable market data for similar assets or companies. In practice, comparable data can be rare, as they are often not disclosed.

Application of multiples to current accounting items is challenging. Difficult to use for early-stage ventures with high growth potential. Accounting items may not reflect the true value of fast-growing companies.

Widely used for exit strategy valuations (acquisition).

Combines DCF and RV. Step 1: Select terminal year for valuation, typically 3-5 years, when exit or harvesting is feasible. Step 2: Develop a success-scenario projection based on the business plan (cash flow, earnings, etc.). Step 3: Use a price-to-earnings ratio or other measure to compute continuing value after the explicit value period. Step 4: Discount continuing value to present using a high hurdle rate to account for time value, risk, and financing effects.

Easy to use if the entrepreneur or investor is experienced. Can be effective for simple investment decisions. Provides a clear framework for valuing ventures.

Unrealistically high discount rates can be used. Requires significant experience and intuition to define an appropriate hurdle rate. Inaccurate hurdle rates may lead to incorrect valuations.

Popular in private equity.

Step 1: Select terminal year for valuation, typically 3-5 years, when exit or harvesting is feasible. Step 2: Estimate 3 cash flow scenarios: Success: Similar to VC method. Moderate success: Dividend return and recoup investment. Failure: No return and loss of investment. Step 3: Compute continuing value using a multiplier for financial projections: expected capitalization, lower value due to growth differences, and liquidation value. Step 4: Compute expected cash flow by weighting each scenario. Step 5: Discount the expected cash flows to calculate the present value. This method reduces bias of VC by considering multiple scenarios and opportunity costs.

Simplified DCF approach that addresses some issues in the VC method. More realistic discount rate compared to the VC method. Helps provide a more balanced valuation by considering multiple scenarios.

Requires the analyst to estimate possible outcomes and their probabilities. This can introduce subjectivity and uncertainty in the valuation.

Popular in private equity.

True.

False. Learn = focus/wait on resolution of uncertainty and act then; Wait = postponing an action by pondering about value acting now versus value of waiting; Abandon = includes the right to discontinue an activity and redeploy the assets to other use.

False - Valuation is an important tool for both entrepreneurs and investors and is a critical part of any negotiation.

True.

False. The present value of an investment (PV) = the value today of all of the cash flows that are generated by the venture’s operations (positive and negative). The net present value (NPV) = the investment required to receive the venture’s future cash flows. NPV = PV – investment required to acquire the venture.