Subject Entrepreneurship

Segment Financial Elements

Topic New-Venture Valuation

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Table of Contents
1. Overview
2. Asset-based Valuations
3. Earnings-based Valuations
4. Determining the Capitalisation Factor of LiveREADS
5. Discounted Cash Flow (DCF) Valuations
6. LiveREADS: Determining Equity Share
7. Corporate Approaches to Valuation
8. Self-Assessment
9. Summary

1. Overview
One of the most challenging things to do in the business world is to value a business
that has not had very much operating history, or any history at all?
What is such a business worth? How much should someone pay for this kind of
business, or a part of this kind of business?
Frankly, this is more an art than a science. You can use some techniques to
determine the value of a business. However, just because you can quantify the
analysis, it does not mean that the analysis is highly accurate. The great uncertainty
of the future of a new venture prohibits us from doing much more than making
guesstimates. Valuing new business ventures may seem strange while still in the
development stage, but without a valuation estimate, it is impossible for investors
(and the entrepreneurial team) to determine how to structure a financial deal.
Therefore, valuation must be done, either explicitly in a deal agreement or implicitly
when we take a friend or family member in as a partner or shareholder with a
handshake and a smile.
In this topic, you will learn about three commonly used approaches to new venture
valuation: asset-based valuations, earnings-based valuations and the use of
discounted cash flow techniques.
Objectives: New-Venture Valuation
Upon completion of this topic, you should be able to:
 describe the three basic methods of new-venture valuation:
o asset-based valuations
o earnings-based valuations
o use of discounted cash flow techniques
 explain the use of the residual pricing model to determine the share of equity
to be sold to potential investors

2. Asset-based Valuations

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Subject Entrepreneurship
Segment Financial Elements
Topic New-Venture Valuation

The accounting profession and Generally Accepted Accounting Principles (GAAP) give
us guidelines for valuing businesses, based on the worth of their physical assets and
resources. This form of valuation is known as asset-based valuation. The four basic
forms of asset-based valuation are:
 Book value
 Adjusted book value
 Replacement value
 Liquidation value

Basic forms of asset-based valuation

Book value: The book value is simply the price of purchase of an asset less the
depreciation.
Adjusted book value: The value of the asset is adjusted (positively or negatively)
to reflect what it is currently worth.
Replacement value: It represents the money that would be needed if today the
company would have to buy the same asset.
Liquidation value: It is the value of an asset if the company had to sell it now,
because of liquidation or bankruptcy.

The liquidation value of a company is what it is worth if it were in bankruptcy and its
assets were to be sold off. This is a tough time for an entrepreneur, but it is also a
tough time for the creditors who are not sure what they will get in value for what is
owed to them. Read the article below about the liquidation of a British firm that fell
on bad times.
“British Tycoon Puts Car Supermarket Business into Liquidation”, Knight Ridder
Tribune Business News (15 Sept 2002): 1

3. Earnings-based Valuations

Asset-based valuations frequently produce the absolute bottom-of-the-range value

for a venture. A second method of valuation is the earnings-based valuation. This
method will almost always produce a higher valuation for an enterprise, except for
an enterprise that is losing money and has no prospects for turning this around.
This method of earnings-based valuation presents us with a series of questions.
"Which earnings"? is the first question that we must address. If we have a
completely new start-up, then we really only have the projected and forecasted
earnings of the entrepreneurial team. These are guesstimates based on projected
sales forecasts, estimated operating expenses and estimated finance charges. Of
course, entrepreneurs tend to be quite optimistic about the earnings, and this has
the result of inflating the value of their enterprise. Investors will want to be more
cautious in estimating the earnings because a conservative projection will give them
a large stake in the business for their investment. There is a natural conflict of
interest here.

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Subject Entrepreneurship
Segment Financial Elements
Topic New-Venture Valuation

"What capitalisation factor should be used"? is the second question. Earnings-based

valuations are determined by multiplying the firm's projected earnings with a
number, either the capitalisation factor or the price-earnings ratio (P-E ratio). This is
a number that represents an estimated future growth and profitability of the firm and
the reliability of the firm's estimated earnings.

For example, if after study and consideration, a venture is determined to have a

capitalisation factor of 5 times earnings, and estimated earnings for the current
period is $50,000, then the value of the firm is $250,000.
Similarly, if after study and consideration, a venture is determined to have a P-E
ratio of 20 and projected earnings for the current period is $100,000, then the value
of the firm is $2,000,000.
We have used the phrase "study and consideration" to indicate that this factor should
not be picked out of the air. Entrepreneurs and investors must find common ground
on this by looking at the valuations of similar firms, by using a range or by
examining the industry's prospects for growth and profitability.

4. Determining the Capitalisation Factor of LiveREADS

You have seen how the entrepreneurs raised finances for LiveREADS. It is important
for LiveREADS entrepreneurs to determine the most value, let us call it factor X, for
the P-E ratio. If they attribute a high value to factor X, then they will be able to keep
a large portion of the company's stock for themselves, in case they get hold of
venture capital investors.
On the other hand, if they attribute a small value to X, then the total value of the
firm will be considerably less and they would have to give up a great deal of the
ownership and control of the business to the investors. This will influence how
attractive the alternative of being bought by a larger company appears.

5. Discounted Cash Flow (DCF) Valuations

Among the three methods, the discounted cash flow valuation is the most
sophisticated. It takes into account cash flow, not earnings, which might be distorted
for tax purposes. It is a multi-period method and measures more than a single
snapshot of the firm's performance. It also contains a capitalisation factor, but this
time uses the inverse of the capitalisation factor known as the discount rate. The
discount rate is the inverse of the capitalisation factor because it will appear in the
denominator (instead of the numerator) in our calculations. By using a discount rate,
we are able to build the time value of money into our analysis. Cash flows in the
early years are more valuable than in the later years.
The model works best when cash flows are more predictable and less uncertain. In
addition, note that any estimate of the cash flow in a period is actually just the
expected value of the entire probabilistic distribution of what that cash flow might

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Subject Entrepreneurship
Segment Financial Elements
Topic New-Venture Valuation

be. Therefore, there is lots of room for error here, in both a statistical sense as well
as in an analytical sense. Some of the key features of the DCF model are described
in the presentation below.

Key Features of the Discounted Cash Flow (DCF) Model

The key features of the DCF model are Free Cash flow, Cash flow in each period, and
Discount rate.
Free Cash flow
The focus is on free Cash Flow, that is, the amount of cash the company generates
after paying all of its real or out of pocket expenses. Non cash items, such as
amortisation, depreciation and goodwill that affect earnings are not counted here.
Cash flow in each period
Free cash flow from each period is considered, and these can vary from period to
period. Thus, the DCF model allows us to develop different scenarios of performance
and weigh these by the probability of them happening.
Discount rate
A discount rate is determined. In a capital budgeting situation for a larger firm, this
rate is usually set at the weighted cost of capital for the company. For most large
companies in current times, this is between 10 to 15%, indicating a discount rate of
.10 to .15. For small, new ventures, the weighted cost of capital must be enhanced
with the following additional factors,
1. The liquidity factor: It is difficult to sell the stock making the investment
illiquid.
2. The uncertainty factor: It is difficult to predict the cash flows making the
investment riskier.
3. The imputed failure factor: The investor understands that most
investments of risk capital will earn nothing because the business will not
succeed. Therefore, each investment must potentially pay for the failures.

Residual Pricing Model

One of the ways the DCF model can be used is to estimate how much equity in the
new venture the founding entrepreneurs will have to give up in order to raise a
specific amount of money. This technique is called the residual pricing model.
"Residual" because the technique requires that we do not consider cash flows already
claimed by other investors-only the residual available to the last investor. "Pricing"
because it has the effect of pricing or valuing the equity for this last investor.

6. LiveREADS: Determining Equity Share

In the LiveREADS case, the valuation of the firm is made using an assumed P-E
ratio. Then, the residual pricing model is applied to the valuation to determine how
much equity the venture capitalists are to receive for their investment.
If we employ the residual pricing model along with the data in the LiveREADS case,
we get the following set of values.
Assumptions and projections

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Subject Entrepreneurship
Segment Financial Elements
Topic New-Venture Valuation

Existing investor equity = 40%

P-E ratio = 30
VC investment = $5 million
Estimated VC annual return = 40%
LiveREADS year 5 earnings = $1.7 million

Let us review the valuation of LiveREADS.

Year 5 earnings are $1.7 million.
P to E ratio is 30. Note that this is an assumption for the time period.
Total value is $1.7 million multiplied by 30, which equals $51 million.
Now, let us determine the VC equity share for LiveREADS.
Residual value of LiveREADS, considering that 40% is already in other hands, is 60%
of $51 million, which equals $30.6 million.
Future value of VC investment of $5 million, compounded at 40% for 5 years, is $5
million multiplied by (1 + 40%), divided by 5, which equals $26.9 million.
VC equity share, of the remaining 60%, is $26.9 million divided by $30.6 million
multiplied by 100, which equals 88%.
Total VC equity share is 88% of 60% of total value, which equals 52.8%.
Founders share of equity, after subtracting the VC share and other's share of 40%,
equals 100% - (40%+52.8%), which equals 7.2%.

Now, use the capitalisation factor that you suggested, to calculate the amount of
equity the founders will receive.
Does your result differ from the example we just did? If so, why?
If you used a multiple more than the 30 in the example, you will have calculated a
higher valuation. This means that less equity needs to be sold to the investors and
the founders of LiveREADS can retain more equity. If you used a multiple less than
30, you will have calculated a lower valuation. This means that the founders of
LiveREADS have to sell more equity to the investors and keep less for themselves.
At some point, the value of the capitalisation factor may be so low that all equity has
to be sold to investors. If this is the case, then the alternative of selling the business
to the larger company becomes very attractive.

7. Corporate Approaches to Valuation

The concepts and techniques of modern financial analysis apply equally to

independent entrepreneurs as well as corporate intrapreneurs. Corporations use
discounted cash flow, net present value and internal rate of return calculations all the
time. Many corporations also employ Economic Value Added (EVA) ® analysis as well.

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Subject Entrepreneurship
Segment Financial Elements
Topic New-Venture Valuation

EVA® analysis evaluates whether or not the corporation is creating wealth by

launching the new business or actually decreasing the wealth of the shareholders.
Reading: EVA® Analysis
You can learn more about the EVA® technique by visiting Stern Stewart & Co: the
website of the creators of the concept.
Go to the About EVA section to learn how this form of analysis can be applied.
Corporate entrepreneurs have also been keen to adopt an approach to valuation
called "real options". Real options are based on the same model as stock options. A
call option gives the investor the right to buy the underlying security at a fixed price.
A put option gives the investor the right to sell the security for a guaranteed amount.
In real options, the underlying security is not a security at all - it is the real business
opportunity that the corporation is trying to develop. When a firm makes an
investment in R&D or technology or market research, it is buying a call option should
the investment later prove valuable. The firm can exercise its option and buy the
project (continue with it) or it can let the option expire and abandon the project.
Some real examples of real options are
 When a corporation purchases a license to commercialise technology
 When a corporation buys and equity stake in a partner
 When a corporation invests to build specific R&D capabilities
Reading: Real Options
If you wish to learn more about real options, their positives, negatives, calculation
and application, read the following article by Aswath Damodaran, "The Promise and
Peril of Real Options"
Corporate entrepreneurs also use qualitative criteria for evaluating new business
development that independent entrepreneurs will not find terribly relevant. This is
because the corporate entrepreneur has to work within the confines and constraints
of the existing organisation. Most corporations use a screening approach, sometimes
called gateways or protocols, to determine whether to proceed. These criteria are
based on the corporations' current portfolio of products, the customers it serves and
the distribution and pricing of current offerings. They will also evaluate existing
capabilities, possible competitor reaction and retaliation, and the future capabilities
(the gap) that their strategic intent calls for. Timing and cost factors are also
relevant.

8. Self-Assessment
Now, try the self-assessment questions to test your understanding of the topic. Click
the following link to open the Self-Assessment in a new window.
Self-Assessment
Q1. What type of valuation do book value, replacement value and liquidation value
constitute?
1. Asset-based valuations
2. Earnings-based valuations
3. Capitalisation factor valuations
4. Discounted cash flow (DCF) valuations
Q2. According to the residual pricing model, which three of the following does the
entrepreneur need to know in order to calculate the amount of equity to secure an
investment?

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Subject Entrepreneurship
Segment Financial Elements
Topic New-Venture Valuation

1. Potential amount of investment

2. Investor's required rate of return
3. Venture's expected P-E ratio
4. Book value of the firm
Q3. After study and consideration, a venture is determined to have a P-E ratio of 20
and projected earnings for the current period as $75,000. What would be the value
of the firm?
1. $ 150,000
2. $ 1,500,000
3. $ 370,500
4. $ 2,000,000
Q4. Given below is the data for a business. Calculate the residual value for this
business.Year 3 earnings = $1.2 million
P-E ratio = 25
xisting investor equity = 30%
1. $ 9 million
2. $ 18 million
3. $ 21 million
4. $ 3.6 million

9. Summary
This topic covered the following points:
 Entrepreneurs, who are looking for outside investors, must try to estimate the
value of their venture in order to determine the value to the investors.
 Asset-based valuations reflect the worth of the physical and financial assets of
the company and represent the lower range of a valuatio
 Earnings-based valuations are more generous to the entrepreneur, but
require the estimation of a capitalisation factor
 A discounted cash flow valuation might be the most accurate, but there are
still many sources of error in this method.
 You can use the residual pricing method to determine how much equity to sell
to investors so that they can achieve their required rate of return.
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