Raising Entrepreneurial Capital

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Raising Entrepreneurial Capital

• Chapter 5 Valuation

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Valuation Methodologies

• Asset based valuation
• Market comparables
• Capitalization of earnings
• Excess earnings approach, and
• Discounted cash flow (DCF) valuation or present
  value of the firm's free cash flows.

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Finance theory

• would argue that only the discounted cash flow
  method is theoretically correct.
• the value of any asset is the present value of
  cash flows that the asset will generate over its
  useful life, adjusted by the risk of achieving
  those cash flows.

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The problem for new ventures

• is that the information that provides the basis
  for the free cash flow estimates is generally so
  speculative that the more sophisticated DCF
  method may not be perceived as worth the effort
  it takes to generate a value.

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Asset-based approaches

• Assume that the value of a firm can be determined
  by examining the value of its underlying assets
• Liquidation value of the assets
• Replacement value of the assets
• Modified book value of the assets.

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Liquidation value

• Neglects that part of the firms value that would
  be contingent upon the business continuing in
  operation.
• This does provide a lower bound estimate for a
  valuation, however.

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Replacement value

• Estimates the cost to replace each of the firm's
  assets. The value of the business is the sum of
  the replacement costs of the individual assets.
• Based not on what a willing buyer would pay for
  the assets, a market value test, but rather what
  it would cost to replicate the company by buying
  the assets in the open market.

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Problems with replacement value

• There are likely to be large discrepancies
  between book value and replacement cost for
  assets like land, plant and equipment.
• Often ignores value adding assets such as human
  capital and intellectual property, potentially
  seriously understating the value of the business.
  

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Modified book value approach

• Assets and liabilities are restated to their
  current fair market values.
• Items not found on the balance sheet, but that
  add to firm value, are included.
• On the liability side, the value of any pending
  lawsuits or tax disputes are disclosed.

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Market multiple approach

• Most common method of valuation sometimes called
  guideline company approach.
• Value of a firm is based on the observed market
  value of a comparable company relative to some
  metric.

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Comparison factors

• Capital Structure
• Credit status
• Depth of management
• Personnel experience
• Nature of the competition
• Maturity of the business

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Valuing service businesses

• Multiples are usually applied to sales or
  earnings.
• Sales is better for a service business because
  sales drive profits and cash flows and expenses
  are more controllable than they are in an asset
  intensive business.
• The implicit assumption is that a certain level
  of revenue will result in a certain level of
  profit.

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Discounted cash flow

• Vt CFt (1 g)
• (r-g)
• Vt the value of the firm at time t
• CFt the cash flow at time t
• g the constant growth rate of cash flows in
  perpetuity
• r the appropriate risk-adjusted discount rate.

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Appropriateness of methods

• Value a firm from earnings? Some contend that
  markets value a firm based on future cash flows,
  and not reported earnings. Also, there are many
  ways to influence the firm's reported earnings.
• Proponents of the market multiple method argue
  that companies are more similar than they are
  different at various stages of fundraising and
  therefore standard multiples can be applied to
  companies at each stage of their financing.

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Capitalization rate

• Inverse of market multiple.
• A multiple of 5 would correspond to a cap rate
  of 1/5 or 20.
• Cap rates are typically applied to the next
  years earnings forecast, and chosen to reflect
  the risk of the investment.

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Excess earnings aproach

• An interest rate reflective of current returns on
  tangible assets (plant, equipment, land) is used
  to determine a fair return on the business'
  assets.
• This rate is relatively low, reflecting the low
  risk of investing in tangible assets.
• The dollar return on tangible assets is
  calculated by multiplying the fair market value
  of the assets by this risk-adjusted rate.

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Excess earnings - calculated

• An imputed return is subtracted from the
  forecasted normalized earnings for the next year
  to calculate excess earnings.
• Tangible assets are forecast to return the
  risk-adjusted rate for tangible assets. Excess
  return is then due to some intangible factor left
  off of the balance sheet.

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Excess earnings - goodwill

• The excess earnings are capitalized at a higher
  rate than the rate on tangible assets to
  determine the present value of the company's
  goodwill.
• The sum of the present value of goodwill and the
  firm's tangible assets equals the total firm
  value.

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Problems in implementation

• Excess earnings, cap rate and DCF methods all
  require the use of a risk-adjusted discount rate.
  
• The excess earnings method requires the use of
  two risk adjusted rates which doubles the
  opportunity for error in the valuation.

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Free cash flow valuation

• Defines the value of the firm as the present
  value of the expected future cash flows in excess
  of those needed to operate the company.
• A firm's economic or intrinsic value is then
  equal to the present value of its free cash
  flows discounted at the companys cost of
  capital, plus the value of the firms
  non-operating assets.