The discounted values of these cash flows at 50% return is 12 million . The extra 9 million required in year 2 decreases the present value by 4 million (9/(1. 52). The post money value becomes 16 million. With 1. 6 million shares outstanding, the company now has a stock price of 7. 50, not 10. For 4 million, the VC (investor A) initially will receive 533,333 shares and own 25% of the company. Equity percentage = 533,333 / [1,600,000 + 533,333] = 4 million / 16 million = 25% It is worth noting that in year 2, new equity investors (Investor B) will invest 9 million. At that time, the post-money value of the company will be 150/1.53 = 45 million.
The 9 million will receive 20% of the post-money company or 533,333 shares. Variation 2 Instead of discounting at a given rate, VCs will often look at the cash flows associated with a deal and calculate IRR they can expect to earn. For example, in example 1, the VC is buying an at an equity value of 20 million. The VC expects the equity to be worth 150 million in year 5. The IRR, then is 50%. In example 2, the VC is buying in at an equity value of 16 million. The VC expects to raise an additional 9 million in equity in two years, and for the equity toe be worth 150 million in year 5.
The IRR, then is 50%. It is most common for VC (investors) to think of investments in terms of expected IRRs. Variation 3 Some VCs might be uncomfortable discounting all free cash flows to leveraged equity at the VC discount rate. For example, it is possible that corporate investors will provide later equity investment at rats of return somewhat lower than the VC method. To account for this possibility, some VC makes and adjustment to this methodology to value the investment in example 2. One adjustment involves discounting the terminal value at its required rate of return.
Then the VC estimates what fraction of that terminal value will be available to investors who invest in year 0. For example, at the 50% discount rate, the VC values the terminal value at 20 million. Equity investors at year 0 will not own the entire 20 million because the equity investors at year 2 will also receive shares and own a piece of the company. At the 50% discount rate, the equity investors who put up 9 million in year 2 will receive 20% of the company. That means that the investor in year 0 will receive only 80% or 16 million of the total million in value.
The VC will invest at a post-money value of 16 million not 20 million. Let’s say, instead, that the investor in year 2 will not such a high return. Assume they are corporate investors who will required 15%. Then the post-money value in year 2 will be: 150/(1. 15)3 or roughly 99 million. The new investors of 9 million will only receive only 9% of the terminal value. The VC investors in the year 0 then are looking at a post-money value of 18. 2 million (91% of 20 million). The VC investors (year 0) will be willing to receive 22% of the company (4/18. 2)=22%.
Discount Rates As mentioned above, VCs typically apply very high discount rate to value proposed equity investment, ranging from as low as 25% for investments in mature businesses (lower risk) to as high as 70% ore even 80% for seed investments and investments in hi-tech ventures (high risk). Such high discount rates cannot be explained as being a reward for systematic risk. Form most venture capital investments, APV or WACC approaches – based on CAPM assumptions that higher systematic risk requires a higher return – would generated discount rates well below 25%.
Instead, there are at least three reasons these discount rates re so high. First in principal, VCs are active investors who spend a large amount of time, reputational capital, and other resources on the companies they invest in. The higher required discount rate over and above the CAPM – based rates is one way a VC can reflect its investments of time and resources. One concern an entrepreneur (or outside observer) might have with the VC using the higher discount rate to charge for its services is that the higher discount rate implicitly charges for the VC services as long as the VC expects to be invested in the company.
IN reality, a successful VC may add more value earlier on and relatively little later when company starts to mature. It would be more accurate to compensate the VC explicitly for the value that they are expected to add. Second VCs will argue that they require a higher return to compensate them for the illiquidity of their investment, that is, a VC cannot sell an investment in a private company as easily as it could sell public company stock. The problem with this argument is that the venture capitalist makes most of its money when the firm goes public and is fully liquid.
It also is true that there are many investors who do not have short-term liquidity needs (wealthy individuals or groups of investors). The third reason for higher discount rate is that they represent crude ways to adjust for situations in which the VC doesn’t believe the cash flow forecasts are the expected cash flows. To see this more clearly, assume that the venture capitalist is shooting for a portfolio return of 25%. , but he discounts the cash flow forecasts for a start-up investment at a 50% discount rate.