Chapter 10: Valuing Early-Stage Ventures 143

Chapter 10

VALUING EARLY-STAGE VENTURES

DISCUSSION QUESTIONS AND ANSWERS

1. 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.

2. What is a venture’s present value? Does the past matter?

A venture’s present value is the value today of all future cash flows discounted to the
present at the rate of return required by investors.
The value of the venture is not directly related to the quantity of past efforts in cash or
sweat. While accounting for the past is all well and good, an investor seeks to
quantify and value the future.

3. Describe what is meant by the statement “If you’re not using estimates, it’s not a
valuation.”

It is important to recognize that projected financial statements needed to calibrate

value reflect “best guesses” of future revenues, expenses, timing, and investment
requirements.

4. Define the terms (a) explicit forecast period and (b) terminal or horizon value as they
relate to a venture’s discounted cash flow valuation.

Explicit forecast period: two- to ten-year period in which the venture’s financial
statements are explicitly forecast

Terminal (or horizon) value: the value of the venture at the end of the explicit
forecast period

5. 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.
144 Chapter 10: Valuing Early-Stage Ventures

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.

6. What is a venture’s reversion value?

Reversion Value: the present value of the terminal value.

7. What is a stepping stone year? Why is it important in determining a venture’s value?

Stepping-stone year: first year after the explicit forecast period

The stepping stone year forces the evaluator to ramp revenue growth down 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. This level is lower than in the previous
years where investment supports much higher revenue growth rates.

8. 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

9. Describe the equity valuation method.

Equity valuation method (equity method): process of projecting and then

discounting the relevant cash flows available to equity investors

10. Define required cash and surplus cash. Why does it matter how we treat surplus cash
for valuation purposes?

Required cash: 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 equityholders).

11. 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.
 Chapter 10: Valuing Early-Stage Ventures 145

This is followed by a forecast of annual balance sheets and annual statements of cash
flows.

12. What is net operating working capital?

Net operating working capital: current assets less surplus cash less non-interest-
bearing current liabilities

13. 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

14. 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.

Sometimes the pseudo dividend in an equity method valuation is referred to as the

“free cash flow to equity.” However, we use a more specific terminology because the
term “free cash flow” has different meanings to different people.

15. What is the relationship between equity valuation cash flows and dividends?

If you were to project the maximum possible dividend the venture could afford to pay
while maintaining all other asset investments, that resulting maximum dividend
would coincide with the equity valuation cash flow calculated by the approach given
in the textbook.

16. Why do the numerical examples of this chapter involve a large dividend in the last
year of the explicit forecast period?

The large “dividend” (or pseudo dividend in the equity valuation cash flow) derives
from the cash freed up by the assumed recapitalization through a debt issue. While
there need not be an explicitly forecast dividend when using the equity valuation cash
flow approach, there is a large equity valuation cash flow due to the recapitalization.
 146 Chapter 10: Valuing Early-Stage Ventures

17. Why do net income and cash flow in the numerical examples in this chapter both
grow at the same rate (g) in the terminal value period? Why is this important?

After the explicit forecast period, the stepping-stone year provides the first step into
the infinite future. After the stepping-stone year, the assumption is that everything
grows at the same rate g due to the assumption that operating and financing ratios are
constant. Divergent growth rates are not permitted in estimating cash flow
perpetuities when determining terminal or horizon value.

18. From the Headlines -- Foursquare: What ingredients would you need to conduct a
traditional equity method valuation for Foursquare? If you had the necessary
projections, do you think that they would also suggest the $80 to $100 million
valuations mentioned in the article? Comment on the warnings you would provide to
accompany your projections and valuation if you completed them.

Answers will vary: Ingredients for a traditional equity method valuation include
projections of the income statement, balance sheet and statement of cash flows for an
explicit projections period and some projection of how the firm will grow on average
past that explicitly projected period, and required returns for equity now and in the
period beyond the explicit projections. The $80 to $100 million valuations are most
likely due to the anticipation of extremely high growth rates and quickly improving
revenue and profit streams for Foursquare. Whether they are justified depends on
one’s subjective beliefs regarding the prospects for success and its immediacy.
General warnings on Foursquare (and any other ventures in a similar situation)
include that projections and valuation include “garbage in – garbage out” and
“hockey stick revenue hype is nothing new – sometimes it happens; most times it
doesn’t” and “costs are seldom kept to the level originally projected.”

EXERCISES/PROBLEMS AND ANSWERS

1. [Present Value Valuation Concepts] Assume you sell for $100,000 a 10 percent
ownership stake in a future payment one year from now of $1.5 million.

A. What are you saying about the implied return for the 10 percent owner?

Investment of $100,000 for a dollar return of $150,000 ($1.5 million x .10) one year
from now.
Implied return = ($150,000 - $100,000)/$100,000 = $50,000/$100,000 = 50%

Implied current (present) value of venture = $ Investment / Percentage Ownership =

$10,000/.10 = $1,000,000

Expected venture return = ($1,500,000 - $1,000,000)/$1,000,000 = 50%

B. What is the present value of the entire $1.5 million, using the implied return from Part
 Chapter 10: Valuing Early-Stage Ventures 147

A?

PV = $1,500,000/(1.50) = $1,000,000

C. What is 10 percent of the value determined in Part B?

$1,000,000 x .10 = $100,000

A. Does it matter whether you grow the $100,000 at 50 percent to $150,000

and note it is 10 percent of $1.5 million, or discount the $1.5 million at 50 percent to
get $1 million and note that $100,000 is 10 percent of this present value?

No. Both approaches provide the same result:

a) $100,000 x 1.50 = $150,000 future value
[which is 10% of the $1,500,000 total FV]
b) $1,500,000/(1.50) = $1,000,000 present value
[$100,000 is 10% of total PV]

2. [Venture Present Values] The TecOne Corporation is about to begin producing and
selling its prototype product. Annual cash flows for the next five years are forecasted as:

Year Cash Flow

1 -$50,000
2 -$20,000
3 $100,000
4 $400,000
5 $800,000

[Note: Following is a spreadsheet solution for Problem 2 (TecOne

Corporation) and Problem 3 (LowTec Corporation).]

TecOne Corporation Solutions

Problem 1
Part A:
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6
Annual Cash Flow (50,000) (20,000) 100,000 400,000 800,000 800,000
Terminal Value 2,000,000
Total Flow to Discount (50,000) (20,000) 100,000 400,000 2,800,000
Present Value @ 40% $615,264.47

Part B:
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6
Annual Cash Flow (50,000) (20,000) 100,000 400,000 800,000 900,000
Terminal Value 2,812,500
Total Flow to Discount (50,000) (20,000) 100,000 400,000 3,612,500
Present Value @ 40% $766,336.20
148 Chapter 10: Valuing Early-Stage Ventures

Part C:
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6
Annual Cash Flow (50,000) (20,000) 100,000 400,000 800,000 900,000
Terminal Value 7,500,000
Total Flow to Discount (50,000) (20,000) 100,000 400,000 8,300,000
Present Value @ 40% $1,637,903.85

Part D:
Pre-money valuation = $1,637,903.85
Investor investment $3,000,000.00
Post-money valuation = $4,637,903.85 ($1,637,903.85 + $3,000,000)
% ownership to investor 64.7% ($3,000,000/$4,637,903.85)

LowTec Corporation Solutions

Problem 2
Note: It is assumed that the cash flows in Part C of Problem 1 exist for the LowTec Corporation
Part A:
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6
Annual Cash Flow (50,000) (20,000) 100,000 400,000 800,000 900,000
Terminal Value 8,181,818
Total Flow to Discount (50,000) (20,000) 100,000 400,000 8,981,818
Present Value @ 30% $2,554,336.65

Part B:
Pre-money valuation = $2,554,336.65
Investor investment $1,500,000.00
Post-money valuation = $4,054,336.65
% ownership to investor 37.0%

A. Assume annual cash flows are expected to remain at the $800,000 level after Year
5 (i.e., Year 6 and thereafter). If TecOne investors want a 40 percent rate of
return on their investment, calculate the venture’s present value.

DCF PV = -$50,000/1.4 + -$20,000/1.42 + $100,000/1.43 + $400,000/1.44 +

[$800,000 + ($800,000/(.4 - .0))]/1.45 = $615,264.47

See TecOne Corporation spreadsheet solution for Part A.

B. Now assume that the Year 6 cash flows are forecasted to be $900,000 in the
stepping stone year and are expected to grow at an 8 percent compound annual
rate thereafter. Assuming that the investors still want a 40 percent rate of return
on their investment, calculate the venture’s present value.

See TecOne Corporation spreadsheet solution for Part B.

 Chapter 10: Valuing Early-Stage Ventures 149

C. Now extend Part B one step further. Assume that the required rate of return on the
investment will drop from 40 percent to 20 percent beginning in Year 6 to reflect a
drop in operating or business risk. Calculate the venture’s present value.

See TecOne Corporation spreadsheet solution for Part C.

D. Let’s assume that TecOne investors have valued the venture as requested in Part
C. An outside investor wants to invest $3,000,000 in TecOne now (at the end of
Year 0). What percentage of ownership in the venture should the TecOne
investors give up to the outside investor for a $3,000,000 new investment?

See TecOne Corporation spreadsheet solution for Part D.

4. [Venture Present Values] Ben Toucan, owner of the Aspen Restaurant, wants to
determine the present value of his investment. The Aspen Restaurant is currently in
the development stage but hopes to “begin” operations early next year. After-tax cash
flows during the next five years are expected to be as follows: Year 1 = 0, Year 2 = 0,
Year 3 = 0, Year 4 = $2.5 million, and Year 5 = $3 million. Cash inflows are expected
to be $3.18 million in Year 6 and are expected to grow at a 6 percent annual rate
thereafter. Recall from Chapter 7 that venture investors often use different discount
rates when valuing ventures at various stages of their life cycles. For example, target
discount rates by life cycle stage are development stage, 50 percent; startup stage, 40
percent; survival stage, 35 percent; and early rapid-growth stage, 30 percent. As
ventures move from their late rapid-growth stages and into their maturity stages, a 20
percent discount rate is often used.

A. Determine the Aspen BrewPub’s terminal or horizon value at the end of five
years.
VCF5 1  .06  3,180,000
Terminal Value = = = 22,714,285.71
rg 20%  6%

B. What is the present value of the Aspen BrewPub?

VCF1 VCF2 VCF3 VCF4 VCF5  TermnalVal ue

PV =    
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) 4
(1  r ) 5
2,500,000 3,000,000  22,714,285.71
=0+0+0+  = 3,880,070.55.
(1  50%) 4 (1  50%) 5

C. What percent ownership interest should Ben Toucan be willing to give to a

venture investor, Sherri Isitar, for her $1,000,000 investment?

Under the assumption, (consistent with the textbook treatment in Section 9.2) that
the cash flow in years 4 and 5 are fixed and have already incorporated the use of
 150 Chapter 10: Valuing Early-Stage Ventures

the new financing (in operating expenses), then the percent of this fixed
$3,880,070.55 “pie” is:

1,000,000
 25.77%
3,880,070.55

Some students will assume that the $1,000,000 is not already projected as being
used to generate the $3,880,070.55 “pie.” (This is the type of conjecture that is
suggested in founder’s initial “thinking” in Section 9.1, but is not consistent with
the story elsewhere.) Accordingly, they will assume that that pie is enhanced by
the $1,000,000 in present value or equivalently that the future value of the
$1,000,000 will survive to be added to $22,714,285.71 terminal value currently
conjectured. The percent of this larger enhanced pie is therefore smaller at

1,000,000
 20.49%
1,000,000  3,880,070.55

6. [Equity Valuation Cash Flows] Following are financial statements (historical and
forecasted) for the Global Products Corporation.

GLOBAL PRODUCTS CORPORATION

Forecast
2016 2017

Cash $50,000 $60,000

Accounts Receivables 200,000 290,000
Inventories 450,000 570,000
Total Current Assets 700,000 920,000
Fixed Assets, Net 300,000 380,000
Total Assets $1,000,000 $1,300,000

Accounts Payable $40,000 $180,000

Accruals 50,000 70,000
Bank Loan 80,000 90,000
Total Current Liabilities 270,000 340,000
Long-Term Debt 400,000 550,000
Common Stock ($1 par) 50,000 50,000
Capital Surplus 200,000 200,000
Retained Earnings 80,000 160,000
Total Liab. & Equity $1,000,000 $1,300,000

Forecast
2016 2017
 Chapter 10: Valuing Early-Stage Ventures 151

Net Sales $1,300,000 $1,600,000

Cost of Goods Sold 780,000 960,000
Gross Profit 520,000 640,000
Marketing 130,000 160,000
General & Administrative 150,000 150,000
Depreciation 40,000 55,000
EBIT 200,000 275,000
Interest 45,000 55,000
Earnings Before Taxes 155,000 220,000
Income Taxes (40% rate) 62,000 88,000
Net Income $93,000 $132,000

A. Assume that the cash account includes only required cash. Determine the dollar
amount of equity valuation cash flow for 2017.

Equity Valuation Cash Flow =

Net Income: $132,000
+ Depreciation: $55,000
- Change in NOWC: [($60,000 + $290,000 + $570,000 - $180,000 - $70,000) –
($50,000 + $200,000 + $450,000 - $140,000 - $50,000)] = $670,000 - $510,000 =
$160,000
- Change in Gross Fixed Assets: ($380,000 - $300,000 + depreciation of $55,000) =
$135,000
+ Net Debt Issues: ($90,000 + $550,000) – ($80,000 + $400,000) = $640,000 -
$480,000 = $160,000

Equity Valuation Cash Flow = $132,000 + $55,000 - $160,000 - $135,000 + $160,000

= $52,000

B. Now assume that Global Product’s required cash is set at 3 percent of sales. Any
additional cash would be surplus cash. Re-estimate the dollar amount of equity
valuation cash flow for 2017.

Required Cash: 2016 = $1,300,000 x .03 = $39,000

Surplus Cash: $50,000 - $39,000 = $11,000

Required Cash: 2017 = $1,600,000 x .03 = $48,000

Surplus Cash: $60,000 - $48,000 = $12,000

Change in NOWC (without surplus cash): [($48,000 + 290,000 + $570,000 -

$180,000 - $70,000) – ($39,000 + $200,000 + $450,000 - $140,000 - $50,000)] =
$658,000 - $499,000 = $159,000

Equity Valuation Cash Flow = $132,000 + $55,000 - $159,000 - $135,000 + $160,000

= $53,000. The 2017 stripping of the additional $1000 of surplus cash leads directly
to a $1000 increase in the valuation cash flow.
152 Chapter 10: Valuing Early-Stage Ventures

C. Let’s assume that investors in Global Products want to estimate the venture’s present
value at the end of 2016. Forecasted financial statements reflect the stepping stone
year. Cash flows are expected to grow at a perpetual 8 percent annual rate beginning
in 2018. Assume that all cash is required cash as was done in Part A. What is the
Global Products venture’s present value if investors want an annual rate of return of
25 percent?

Present Value @ 25% = $52,000/(.25 - .08) = $305,882.35

D. Work with the assumptions in Part B about Global Products required cash being 3
percent of sales. Calculate the present value of the Global Products venture at the
end of 2016 if investors want an annual rate of return of 25 percent and cash flows
are expected to grow at a perpetual 8 percent annual rate beginning in 2018.

Present Value @ 25% = $53,000/(.25 - .08) = $311,764.71