ENTREPRENEURIAL FINANCE

Leach & Melicher

Chapter 9

VALUING EARLY-STAGE VENTURES

2009 South-Western Cengage Learning

Chapter 9: Learning Objectives

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Explain how the time pattern of cash flows relates to venture value Describe how valuation incorporates projections of nearand long-term success Extract the necessary valuation data from projected financial statements Understand the relationship between dividends and equity valuation cash flow Put the pieces together for a unified treatment of financial projections and valuation

What is a Venture Theoretically Worth?

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Present value (PV): value today of all future cash flows discounted to the present at the investors required rate of return Investors pay for the future; entrepreneurs pay for the past. If youre not using estimates, youre not doing a valuation.

Basic Mechanics Of Valuation

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Discounted cash flow (DCF):

valuation approach involving discounting future cash flows for risk and delay

Explicit forecast period:

two- to ten-year period in which the ventures financial statements are explicitly forecast

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Terminal (or horizon) value:

value of the venture at the end of the explicit forecast period

Stepping stone year:

first year after the explicit forecast period
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Divide and Conquer: Terminal

VCFT Terminal Value = r - g where : VCFT = current value of next period' s cash flow r = constant disount rate g = growth rate

Useful Terms
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Capitalization (cap) Rate:

spread between the discount rate and the growth rate of cash flow in terminal value period (r g)

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Reversion value:
present value of the terminal value

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

More Useful Terms

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Net Present Value (NPV):

present value of a set of future flows plus the current undiscounted flow

Required Cash:
amount of cash needed to cover a ventures day-to-day operations

Surplus Cash:
cash remaining after required cash, all operating expenses, and reinvestments are made

Equity Valuation: Maximum Dividend Method

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Maximum Dividend Method (MDM):

valuation method involving explicitly forecasted dividends to provide surplus cash of zero

MDM Value:
sum of discounted maximum net dividends (Dividends Equity Issues)

Equity Valuation: Maximum Dividend Method

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Formally eliminate all cash surpluses by paying them out as dividends Balance sheet will have zero for all surplus cash balances Ventures equity can be valued directly using Net Dividends (Dividends Issues) in CF Statement (or by equity VCF method) No excess cash in end
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MDM Income Statements (Yearly Surplus Cash Paid as Dividends)

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MDM Balance Sheets

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MDM Statements of Cash Flow

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Maximum Dividend Method: (PV of Net Dividends)

65,403 20,125 - 1,704 - 7,797 + + + PDC' s PV = 2 3 1.25 (1.25) (1.25) (1.25) 4 423,346 117,598 + + = 520,979 5 5 (1.25) (1.25) (.18 .06) 65,403 20,125 - 1,704 - 7,797 + + + PDC' s NPV = 6,487 + 2 3 1.25 (1.25) (1.25) (1.25) 4 423,346 117,598 + + = 527,466 5 5 (1.25) (1.25) (.18 .06)
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Equity Valuation Cash Flows

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Equity Valuation Cash Flow =

Net Income + Depreciation and Amortization Expense - Change in Net Operating Working Capital (w/o surplus cash) - Capital Expenditures + Net Debt Issues

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Working Capital Calculation

Current assets July balance March balance Change in current assets Surplus cash July amount March amount Change in surplus cash Current liabilities July amount March amount Change in current liabilities Change in net operating working capital (= 967 6,487 + 3,105) (= 967 6,487 + 3,105)
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175,307 174,340 967

6,487 0 6,487

45,310 48,415 3,105 2,415

Equity Valuation Cash Flows

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Equity Valuation Cash Flow for PDC Company

Net Income + Deprec. & Amort. Exp. - Change in NOWC (w/o surplus cash) - Capital Expenditures + Net Debt Issues = Equity Valuation Cash Flow $6,372 +4,600 +2,415 - 6,900 0 $6,487

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Equity Valuation Cash (Shortcut) Approach

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Pseudo Dividend Method (PDM)

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PDM: valuation method involving zero explicitly forecasted

dividends and an adjustment to working capital to strip surplus cash Pseudo dividends, or dividends that could be paid but are retained inside the venture are valued Pseudo dividends do not appear on any projected financial statement

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Pseudo Dividend Method (PDM)

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Formally retain all cash surpluses in surplus cash account Project all dividends at zero Value ventures equity using equity VCF with working capital calculations that omit surplus cash Projected balance sheets indicate surplus cash balances treated by valuation as already paid. Cant be added to terminal value or stripped out again.

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PDM Income Statements (All Surplus Cash Retained)

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PDM Balance Sheets

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PDM Statements of Cash Flow

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PDMs Shortcut Approach (strip surplus cash from NWC)

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