Journals on Venture Capital Valuation - Venture Capital Valuation

Chapter 2 Literature Review

2.3 Venture Capital Valuation

2.3.1 Journals on Venture Capital Valuation

In a research, Hand (2005) mentioned existing facts supporting the idea that financial statement is important in valuing venture capital based firms. First he mentioned FASB’s Conceptual Statements and Issued Standards are designed to be useful to investors in any types of for-profit businesses, not merely publicly traded entities. Second, based on the first hypothesis, Hand (2005) then assumes the nature of the associations between equity values and financial statement data in the venture capital market will align with his economic intuition and therefore should be the same as those in the public markets.

Using a sample of U.S. biotechnology firms from 1992 to 2003 and running the data into regression models that measure value relevance measured using R². Hand (2005) concluded that equity values are positively related to a firm’s cash balances, non-cash assets, R&D expense, and are negatively related to its long-term debt and stock dilution, indicating that GAAP also successfully provide information that is useful to investors in private equity market. However, he also stated financial and non-financial information are substitutes rather than complements: Non-financial statement data are more relevant in the venture capital market than is financial statement information when firms remain young, and vice versa when firms mature- When firms mature, the significance of assets-in-place increases compared to that of investment returns expectation, and financial statement data are at that time better than non-financial information when reflecting the value deriving from assets-in-place.

However, another recent study held different views. In their study, they mentioned, even though in reality, venture capitalists gather both non-financial and financial information when implementing due diligence, there is little evidence discussing how significant the role of financial information is when valuing venture capital-backed start-up firms compared to publicly listed firms (Sievers, Mokwa, &

Keienburg, 2013). According to this study, there are two main reasons. First, there is comparatively little evidence itself discussing the value relevance of financial statements (accounting information) in venture capital environments. Second, existing relevant studies mainly emphasize their research on discovering how non-financial performance metrics are value relevant.

Given these assumptions, Sievers, Mokwa and Keienburg (2013) adopted Ohlson’s (1995, 2001) equity valuation model which links between firm accounting information and other non-financial information (Ohlson, 1995, 2001) in the effort to extend the past studies. Adopting Ohlson’s (1995, 2001) equity valuation model, Soenke Sievers et al. (2013) quoted the studies by Hand (2005) and Armstrong, Davila and Foster (2006) to justify the assumption that accounting information is relevant when explaining the values of venture capital-backed firms beyond nonfinancial characteristics. Subsequently, they based on the findings on prior research (Keeley & Roure, 1990; Schefczyk and Gerpott, 2001), identifying five key factors that should logically represent non-financial information in terms of team quality: Team composition, founding team size, management team size, CEO education and team experience.

Soenke et al. (2013) evidenced that a model that considers financial statement information and deal characteristics alone actually explains approximately 51% of the variation in valuations. In other words, financial statement information was evidenced

as powerful as non-financial information when explaining venture capital based firms values. Second, valuations based on accounting and non-accounting information yield a level of valuation accuracy that is comparable to that of publicly traded firms: A level of valuation accuracy of 53% median absolute percentage error. Last, this journal revealed total asset multiples outperform revenue multiples significantly.

However, valuation inaccuracies reached 68%-113% when implementing multiple-based valuation approaches. On the other hand, prediction models reach a valuation inaccuracy of only 50%, indicating multiples lead to less accurate results than those obtained from the more comprehensive valuation models.

2.3.2 Damodaran’s (2012) Venture Capital Valuation

Damodaran (2012) argued that valuations for start-up firms are accurate only when traditional discount models are implemented. Even though young firms tend not to have histories, have negative earnings, and do not have sufficient tangible assets, cash flow discount models should not take the blame. In other words, the reliability of cash flow discount models still remain and the present value of a firm should still equal the present value of the expected cash flows from its assets, despite how hard the firms’ cash flows can be estimated. Damodaran (2012) also argued, for those who came up with different models to value start-up firms’ value, weak assumptions neither made explicitly nor tested may cause the whole valuation unrealistic.

Damodaran (2012) demonstrated a general framework for analysis:

Step 1: Assess the Firm’s Current Standing

As venture capitals tend to have negative earnings and high growth in revenues, the numbers change dramatically from period to period. Therefore, it makes more sense to look at the most recent information available, at least for revenues and

earnings.

Step 2: Estimate Revenue Growth

Damodaran (2012) recommended three factors in general to be considered before determining the revenue growth rate: Past growth rate in revenues at the firm itself, growth rate in the overall market that the firm serves, and the barriers to entry &

competitive advantage possessed by the firm. Subsequently, Damodaran (2012) provided with two explicit methods to determine young firm’s future revenue growth.

One way is to work backwards by first considering the share of the overall market that the firm expects to have once it matures, then the revenue growth rate the firm would need to arrive at the market share would be determined. Another approach is to forecast the expected growth rate in revenues in the next three to five years based on past growth rats. Once the firm forecasted the revenues in year 3 or 5, the firm can then forecast a revenue growth rate based on the rate at which companies with similar revenues grow currently.

Step 3: Estimate a Sustainable Operating Margin in Stable Growth

The principle here is to estimate an operating margin when growth stabilizes. A few guidelines are provided with,

1. Looking at the underlying business that this firm is in, consider its true competitors: In the long-run, a start-up firm’s sustainable operating margin should approach those of other same industry’s performances.

2. Deconstruct the firm’s current income statement to get a truer measurer of its operating margin: Damodaran (2012) believes that many start-up firms report losses because their operating expenses are large. However, often times there is a

significant portion of operating expenses that accounts for future growth and hence should be considered to be capital expenditures. These expenses should be removed from the operating expenses.

More explicitly, Damodaran (2012) stated that when firms have a stable return on capital, its expected growth in operating income is the product of the reinvestment rate and the quality of these reinvestments. The formula is illustrated in equation (1);

equations (2) and (3) define the formulas’ components.

Expected Growth EBIT = Reinvestment Rate * Return on Capital (1) Where

Reinvestment Rate = (Capital expenditure – Depreciation + Δ Noncash WC) / [EBIT

(1 – Tax Rate)] (2)

Return on Capital = EBIT (1- Tax Rate) / (Book Value of Equity + Book Value of

Debt – Cash and Marketable Securities) (3)

However, when valuing young firms, they often don’t have stable returns on capital. In this case, it is more realistic and conservative to use the average operating margin of competitors in the business. The formula is illustrated in equation (4).

Projected EBIT = Projected Revenue * Projected Operating Margin (4) The average operating margin is the target operating margin that the firm expects when its ROC becomes stable. Before then, the improvements in operating margin will be greatest in the earlier years and then tappers off as the firm approaches maturity.

Step 4: Estimate Reinvestment to Generate Growth

In forecasting free cash flows to the firm, Damodaran (2012) first predicts the reinvestment (Rate) for the future years. The concept can be demonstrated in equations (5) and (6).

Equity Reinvestment = Capital Expenditures – Depreciation + Change in Noncash Working Capital – New Debt Issues + Debt Repayments (5) Free Cash Flow to Equity = EBIAT – Equity Reinvestment (6) In other words, as long as EBIAT can be predicted, free cash flow to equity can be determined when equity reinvestment (Rate) is forecasted.

If the firm is in a steady state, the reinvestment needs can be computed using the expected operating income growth rate and the expected ROC. The formula is illustrated in equation (7).

Expected Reinvestment Rate stable = Expected Growth stable / ROC stable (7) However, this equation becomes inoperable as young firms usually don’t have a stable return on capital, let alone the fact that operating earnings are often times negative for young firms. In this case, Damodaran (2012) recommends using the sales-to-capital ratio. The concept is illustrated in equation (8), and equation (9) defines sales-to-capital ratio.

Expected Reinvestment = Expected Change in Revenue / Sales-to-capital Ratio (8) Where

Sales-to-capital Ratio = Δ Sales / Δ Capital (9)

The last approach provided by Damodaran (2012) is to use the industry-average reinvestment rate to estimate cash flows.

Step 5: Estimate Risk Parameters and Discount Rates

In the standard approaches for estimating beta, stock returns are regressed against market returns. However, young start-up firms, even when publicly traded, have little historical data, so the conventional approach to estimate risk parameters can not be implemented. Damodaran (2012) suggests using the bottom-up approach to reach the beta for start-up firms. Details on bottom-up approach will be explained in later section.

Step 6: Estimate the Value of the Firm

With the inputs of earnings, operating margins, reinvestment rates, and risk parameters, this valuation now starts to resemble a conventional valuation. At this point the expected future cash flows can be discounted and aggregated to the present time being.

Step 7: Estimate the Value of Equity

To get from firm value to equity value, non-equity claims need to be subtracted from the value. The non-equity claims include debts, bonds, and preferred equity.

Within the whole valuation, Damodaran (2012) believes revenue growth and sustainable margins poses the greatest impact on the valuation results.

2.3.3 Comparison of Different Perspectives

To summarize, we can analyze the different perspectives of valuing venture capitals in equation (10).

Value of Firm= Value of Assets in Place + Value of Growth Potential. (10) Hand (2005) takes the position that financial information and non-financial

information are substitutes, and as long as a firm is at the stage before its IPO, the value of the firm equals value of growth potential, referring to zero value of assets in place. The opposite scenario occurs after a firm goes IPO; Soenke et al. (2013) take the position that financial and non-financial information are complements rather than substitutes. Moreover, only when complementing them together will the valuation results be as accurate as those valued for publicly traded companies. However, assuming the traditional cash flow discount models don’t include non-financial information, the authors adopted Ohlson’s (1995, 2001) valuation model for valuation and determined five-non financial factors within Ohlson’s (1995, 2001) model. The equation, Value of Firm = Value of Assets in Place + Value of Growth Potential, holds, but conventional cash flow discount models are abandoned; Damodaran (2012) affirms the equation, Value of Firm = Value of Assets in Place + Value of Growth Potential, holds, and it is also necessary to use traditional cash flow discount models.

Non-financial information are considered and included when determining the most important inputs of the cash flow discount model- The assumptions.

2.4 Free Cash Flow to Equity Discount Model

2.4.1 Definition of Free Cash Flow to Equity Model

Given the fact that free cash flow is not required by U.S. GAAP to disclose to the public, there is little theoretical and conceptual guidance on how to calculate free cash flow. However, generally speaking, there are two methods: Operations-based method and income-based method. Among the sample of the FCF disclosures, 55.6 percent uses CFO-based method and 14.2 percent uses income-based method (Adhikari &

Duru, 2006).

According to Adhikari and Duru (2006), operations-based method calculates free

cash flows by making adjustment to cash flow from operations. Free cash flows’

definitions are illustrated in equations (11) to equation (14).

Free Cash Flow = CFO – Capital Expenditures (11)

Free Cash Flow = CFO – Capital Expenditures – Depreciation +/– Change in Noncash

Working Capital (12)

Free Cash Flow = CFO – Nonrecurring Charges – Maintenance Capital Expenditure (13)

Free Cash Flow = CFO – Investing Activities (14)

On the other hand, income-based method adjusts net income or EBITDA to replace CFO, and subsequently reaches free cash flow. Within the income based method, free cash flow derived from net income accounted for 80% among all the experimented samples, and EBITDA accounted for 20%.

Under operations-based method, there are generally two perspectives: Capital maintenance perspective and all-inclusive perspective. More than 50 percent of the firms using the operations-based method rely on the capital maintenance perspective, as it aligns to The International Accounting Standards Board (IAS 7) (Adhikari &

Duru, 2006). Under the capital maintenance method, free cash flow indicates, without reducing the value of the business, the amount of cash that owners can consume (Hicks 1946; Hackel & Livant 1996). Free cash flow is calculated as net cash flow from operating activities less the necessary capital expenditures to maintain the business for future production. Discretionary expenditures such as dividends, outlays for debt reduction, and stock repurchases are not taken into account. The capital maintenance method is also called the unlevered DCF approach: The enterprise value

of a firm equals the present value of its future free cash flows, where the appropriate free cash flows are before the effect of leverage (Meaning free cash flow has not been adjusted down for interest or principal payments). The cash flow represents to both equity and debt holders, and the discount rate reflects the cost of capital to both the parties.

Under the all-inclusive perspective, debt payments, normal dividend payouts are deducted when calculating free cash flow as businesses have relatively little discretion in paying those expenses. All-inclusive maintenance method is also called levered DCF approach, the interest expense, the interest tax shield, and principle payments are explicitly projected in the calculation of cash flows, which represent cash flows only to equity holders, and the discount rate reflects the cost of capital only to equity holders.

2.4.2 Constant Growth FCFE Model

The constant growth FCFE model is designed to value firms that eventually reach a stable growth rate and hence in steady state. The value of equity, under the constant growth model, is a function of the expected FCFE in the next period, the stable growth rate, and the required rate of return. When using the capital maintenance method, or the unlevered DCF approach, weighted average cost of capital should be used (Instead of cost of equity), reflecting the cost of debt and equity weighted by their respective proportions of the total capital invested in the enterprise.

The constant growth FCFE model is illustrated in equation (15); equations (16) to equation (19) define the model’s components.

Value = FCFE 1 / (WACC-gn) (15)

Where

Value = Value of Stock Today (16)

FCFE1 = Expected FCFE Next Year (17)

WACC = Weighted Average Cost of Capital (18)

gn = Growth rate in FCFE for the firm forever (19)

The growth rate used in the model has to be reasonable relative to the nominal growth rate in the economy in which the firm operates. As a general rule, a stable growth rate cannot exceed the growth rate of the economy in which the firm operates.

It is ideal to be conservative with the item (Wall Street Prep Inc., 2008).

2.5 Costs of Financing

2.5.1 Cost of Equity

The cost of equity is the rate of return that investors require on an equity investment in a firm. The expected return is illustrated in equation (20).

Expected Return = Risk Free Rate+ Beta (Risk Premium) (20) The risk free rate should theoretically reflect the yield to maturity of default-free government bonds of equivalent maturity to the duration of each cash flows being discounted. However, in practice, the lack of liquidity in long-term bonds have made the current yield on 10-year the specific nation’s treasury bond as the preferred proxy for the risk-free rate for the nation’s companies (Wall Street Prep Inc., 2008). The market risk premium represents the excess returns of investing in stocks over the risk free rate (Wall Street Prep Inc., 2008). Users of risk and return models have developed a consensus that historical premiums are the best estimate of the risk premium (Damodaran, 2012).

2.5.2 Cost of Debt

The cost of debt measures the current cost to the firm of borrowing funds to finance projects. It is determined by three variables: The riskless rate, the default risk (Default spread) of the company, and the tax advantage associated with the debt. The function is demonstrated in equations (21) and (22).

After-tax Cost of Debt = Pretax Cost of Debt (1 – Marginal Tax Rate) (21) Where Pretax Cost of Debt = Riskless Rate + Default Spread of the Firm (22) Firms with bonds outstanding and traded can use the ratings that the service companies determine. The service companies then determine a default spread with each rating grades.

2.5.3 Cost of Capital

The cost of capital is defined as the weighted average of each of the costs. In general, the cost comes from equity and debt. The cost of equity (Ke) reflects the riskiness of the equity investment in the firm. The after-tax cost of debt (Kd) is a function of the default risk of the firm. The weights of each of these components should reflect their market value proportions, since these proportions best measure how the existing firm is being financed. Assume E and D represents the market values of the equity and debt, cost of capital can be illustrated in equation (23).

Cost of Capital = Ke [E/(E+D)] + Kd [D/(E+D)] (23)

2.6 Mean-variance Models Measuring Market Risk

In the previous section, definitions and descriptions on cost of equity, cost of debt, and how they combine to represent cost of capital is discussed. However, cost of

equity has alternative forms (models) and needs to be discussed further. Despite different perspectives, all cost of equity models measure market risk.

The three most used models measuring market risk are CAPM, arbitrage pricing model, and multifactor model. These models are attempts by economists to build risks and return models from the mean-variance base established by Markowitz (1991). For all the three models, the expected returns are all assumed to be normal and lognormal distributions, symmetric distributions, and also continuous distributions.

For the three mean-variance models, they all assume the estimated risk should be measured from the perspective only of marginal investors who are well diversified and the risk comes from the distribution of actual returns around the expected returns.

We can then derive two additional assumptions from the first assumption: Marginal investors are all well diversified. First, there are no transaction costs, investments are infinitely divisible, and all assets are traded. Second, everyone has the access to the identical information and hence investors can not under- or overvalue assets in the marketplace. Only when these two additional assumptions hold can mean-variance models assume the marginal investors would keep diversifying and hold a small proportion of every traded asset in the portfolio in the purpose of reducing firm-specific risk. After all, investors would probably not want to diversify when the marginal benefit of diversification is less than additional transaction costs. Neither would they invest on an asset in order to diversify when he or she knows the asset or

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