Enrepreneurial Resource Management
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Chapter 11VENTURE CAPITAL VALUATION METHODSEXERCISES/PROBLEMS AND ANSWERS[Discount Rates] Calculate the discount rate consistent with a cap rate of 12% and a growth rate of 6%. ¬†¬†Show how your answer would change if the cap rate dropped to 10 percent while the growth rate declined to 5 percent.Cap Rate = (r ‚Äď g), so r = Cap Rate + gr = 12% + 6% = 18%r = 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.$2,000,000/(.20 – .07) = $15,384,615.38¬†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.¬†¬†¬†¬†¬†¬†¬†¬†¬† ¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†$15,384,615.38/1.405¬†= $2,860,529.723. ¬† [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 ‚Äúcomparable firm‚ÄĚ 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?¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†P/E of comparable firm = $10,000,000/$1,000,000 = 10 times¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†New Venture Value: ¬†$1,600,000 net income times 10 = $16,000,000¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†Assumptions:¬† ¬† ¬† ¬† ¬† ¬† 1. The ‚Äúcomparable firm‚ÄĚ is really comparable to the new venture. ¬†¬† ¬† ¬† ¬† ¬† ¬† 2. The current price-to-earning relationship of 10 will still be the appropriate multiple to use 5 years from now.¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†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. ¬† ¬†¬†¬†¬†¬†¬†¬†¬†¬†$16,000,000/1.405¬†= $2,974,950.914. ¬† [Multiple Financing Rounds] Ratchets.com anticipates that it will need $15,000,000 in venture capital to achieve a terminal value of $300,000,000 in five years.

Assuming it is a seed stage firm with no existing investors, what annualized return is embedded in their anticipation?r = (300,000,000/15,000,000)^(1/5)-1 = 82.0564%Suppose the founder wants to have a venture investor inject $15,000,000 in three rounds of $5,000,000 at time 0, 1 and 2 with time 5 exit value of $300,000,000. ¬†If the founder anticipates returns of 70%, 50% and 30% for round 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 founders‚Äô year-five ownership percentage?First Round FV: 5,000,000 x (1.7)^5 = 70,992,850Second Round FV: 5,000,000 x (1.5)^4 = 25,312,500Third Round FV: = 5,000,000 x (1.3)^3 = 10,985,000Total FV = 107,290,350First Round % of Total FV = 23.66% = 70,992,850/300,000,000Second Round % of Total FV = 8.44% = 25,312,500/300,000,000Third Round % of Total FV = 3.66% = 10,985,000/300,000,000)Founder final ownership = 1 ‚Äď 23.66% – 8.44% – 3.66% = 64.24% ¬†= 192,709,650/300,000,000Assuming 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)?Founder shares = 10,000Total shares at year 5: =10,000 / .6424 = 15,567Round one shares = .2366 x 15,567 = 3684Round two shares = .0844 x 15,567 = 1313Round three shares = .0366 x 15,567 = 570What is the second round share price derived from the answers in Parts B and C?Second Round Price = 5,000,000 / 1313 =3808/shareHow does the answer to part D change if 10% of the year-five firm is set aside for incentive compensation? ¬†How many total shares are outstanding (including incentive shares) by year 5?Founder final ownership = 1 -23.66% – 8.44% – 3.66% -10% = 54.24%Total shares at year 5 = 10,000 / .54.24 = 18,438Round two shares = .0844 x 18,438 = 1556 Round two price = 5,000,000 / 1556 = 3213/share5. ¬†[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 ‚Äď67% at the end of 2 years, 50% at the end of 5 years and 70% at the end of three years, respectively. ¬†Assuming no intermediate flows before the terminal payoff, verify that the associated annualized rates are ‚Äď42.55%, 8.45% and 19.35%. ¬†2 years: (1-.67)^.5 ‚Äď 1 = -42.55%5 years: (1+.50)^.2 -1 = 8.45%3 years: (1+.7)^(1/3) -1 = 19.35%What is the equally weighted average annualized return? ¬†(-42.55% + 8.45% +19.35%) / 3 = -4.92%Does it make sense to use this as a single discount rate to apply across scenarios involving different durations?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‚Äôs possible outcomes.

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Chapter 11Venture Capital Valuation Methodsexercises And Financing Rounds. (April 3, 2021). Retrieved from https://www.freeessays.education/chapter-11venture-capital-valuation-methodsexercises-and-financing-rounds-essay/