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ENTREPRENEURIAL FINANCE

Leach & Melicher

Chapter 9

VALUING EARLY-STAGE VENTURES

© 2009 South-Western Cengage Learning

Chapter 9: Learning Objectives

Explain how the time pattern of cash flows relates to venture value Describe how valuation incorporates projections of near- and 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

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What is a Venture Theoretically Worth?

Present value (PV): value today of all future cash flows discounted to the present at the investor’s required rate of return “Investors pay for the future; entrepreneurs pay for the past.” “If you’re not using estimates, you’re not doing a valuation.”

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Basic Mechanics Of Valuation

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 venture’s financial statements are explicitly forecast

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

Terminal Value =

VCF

T

r

- g

where : VCF

T

= current value of next period's cash flow

r

g

= constant disount rate

= growth rate

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Useful Terms

Capitalization (cap) Rate:

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

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

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More Useful Terms

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 venture’s day-to-day operations

Surplus Cash:

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

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Equity Valuation:

Maximum Dividend Method

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)

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Equity Valuation: Maximum Dividend Method

Formally eliminate all cash surpluses by paying them out as dividends Balance sheet will have zero for all surplus cash balances Venture’s 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)

MDM Income Statements (Yearly Surplus Cash Paid as Dividends) 10

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MDM Balance Sheets

MDM Balance Sheets 11

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MDM Statements of Cash Flow

MDM Statements of Cash Flow 12

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Maximum Dividend Method:

(PV of Net Dividends)

65,403

1.25

20,125

(1.25)

2

-1,704

(1.25)

3

- 7,797

(1.25)

4

PDC's PV =

+

+

+

+

+

423,346

(1.25)

5

= 6,487

117,598

(1.25) (.18

65,403

5

.06)

20,125

2

+

1.25 (1.25)

+

= 520,979

-1,704

(1.25)

3

PDC's NPV

+

+

- 7,797

(1.25)

4

+

423,346

(1.25)

5

+

117,598

5

(1.25) (.18

.06)

= 527,466

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Equity Valuation Cash Flows

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

175,307

March balance

–174,340

Change in current assets

967

Surplus cash July amount

6,487

March amount

–0

Change in surplus cash

6,487

Current liabilities July amount

45,310

March amount

–48,415

Change in current liabilities

–3,105

Change in net operating working capital (= 967 – 6,487 + 3,105)

–2,415

(= 967 – 6,487 + 3,105)

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Equity Valuation Cash Flows

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

Equity Valuation Cash (Shortcut) Approach 17

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Pseudo Dividend Method (PDM)

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)

Formally retain all cash surpluses in surplus cash account Project all dividends at zero Value venture’s 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. Can’t be added to terminal value or stripped out again.

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PDM Income Statements (All Surplus Cash Retained)

PDM Income Statements (All Surplus Cash Retained) 20

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PDM Balance Sheets

PDM Balance Sheets 21

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PDM Statements of Cash Flow

PDM Statements of Cash Flow 22

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PDM’s Shortcut Approach (strip surplus cash from NWC)

PDM’s Shortcut Approach (strip surplus cash from NWC) 23

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