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Valuation in a
Private Equity
Setting
Chapter Outline
• Introduction
• Overview of the Market for Private Equity
• Valuing Investments in Start-ups and Deal
Structuring
• Valuing LBO Investments
– Build-ups and Bust-ups
– Limitation of the LBO Valuation Approach
• Summary
• PE firms tend to
specialize in
companies which
operate in similar
life cycle stages
• Seed Capital –
typically supplied by
wealthy individuals
for brand new companies
• Venture Capital – early stage financing for established start-up companies
• Growth and Expansion Capital – provided by PE and venture capital firms for
developing companies
• Restructuring or Reorganization Capital – LBO firms provide financing to break
apart or reconfigure mature companies
= kHoped-for VC Return
• Computing Ownership
Interests: Under this deal
structure, the founder will
own the remaining 44% of
the common stock (100% -
56% = 44%), which would
entitle him or her to shares
worth $12,112,500 in five
years.
• If the preferred shares can be converted into $9,003,386 worth of common stock, then the VC’s $2
million investment will realize the VC’s desired 40% annual ROR. The VC will be given 32.98% of the
firm’s shares that were earlier valued at $27,300,000—a substantial savings over the 56% ownership
share that was required when using common stock.
• Private equity firms take use very high discount rates, reflecting the
fact that they are used to discount cash flows that are likely to be
overly optimistic.
• These investments should have high expected rates of return, given
their high risk and illiquidity.
• Investors often evaluate optimistic hoped-for cash flows.
– Valuation approaches taken in practice often differ from those
recommended by academics.
• We recommend that in situations where private equity investors
have estimates of expected cash flows, rather than hoped-for cash
flows, they evaluate the investment using the APV approach.
– Although this approach is not widely used in the private equity industry,
it is appropriate, given that most of these transactions involve a
substantial amount of initial debt that is paid down fairly quickly over the
planning period.