Finances: How does venture capitalist evaluate projects?
Typically, venture capitalist put his glance on the project in the horizon of 5-7 years. That’s suggested that it’s a good period to exit from the project (if that’s been succesfulle, definitely).
Put differently, venture investor is planning to exit of the project in period of 5 to 7 years after initiation (project, startup, company, etc.). And he wants to know how much money he can earn totally after he will sold his part of business. To answer that question properly, venture investor need to answer the following questions first:
- If current business plan will work find, theb when it’s be plausible for me to exit?
- How much (financial) resources is required to invest?
- What would be NPV and IRR?
- What market’s price of an object will be at that particular time?
- Who can buy my part of the business?
To summarize, the question is pretty simple - investor wants to know the difference between funds he will invest today and funds he will receive in the future. Neither cash flows, nor revenues, neither dividents, nor obligations are not interesting for investor. Moreover, used assessment technique isn’t substantial, but only exit multiplication versus inverstor’s Minimum Acceptable Rate of Return, MARR is important.
Let’s contemeplate to following example:
- Funds required: $10M
- Exit period: 6 years
- Potential buyer: public buyer
- Multiplication: Earned Value (EV) to EBITDA ratio is assumed as 4.8
- EBITDA forecast: $84M
- MARR: 45%, annually
Exit Value6 = (EV / EBITDA) × EBITDA6 = 4.8 × $84M = $403.2M
After that, we can calculate Present Value, PV:
Calculations above shown that if initiative will be succesfull after 5 years and business plan will be carried out completely, the company today’s prices should be evaluated as $43.4M. Since, initial funding is only $10M, that seems to be very lucrative bargain. Certainly, such analysis is very superficial and additional researches must to be done. Lots of supplementary steps are required. For instance, sharing policy, business structuring, other law and contract regulations, etc. Meanwhile, analysis like this helps investor to perform quick filtering of income offers.
Comparison: Trading VS Transaction Multiples
Exit Multiples asssessment method is ubiquitously levereged by venture investors and venture analysts for evaluation of potention Exit Value, EV in purpose of right investment decisions. There are several point you should to denote when you are using Trading and Transaction multiples methodology.
- Definition
- Transaction - multiples recently conduced corporate transactions.
- Trading - observed multiples for listed companies
- Common comparion option
- Transaction - widely presented variety of companies with different background (maturity, size, financing, etc.)
- Trading - matured companies within similar environment. Despite typical startups, featured with high stability and survival rate
- Trustoworthy
- Transaction - low, transacion produced today might not loom in the future
- Trading - higher stability, thanks to listed companies maturity
- Security
- Transaction - number of different types
- Trading - common stock
- Provisions
- Transaction - Additional provisions (such as extra compliance, legal issues, etc.)
- Trading - low risks of speculation limitations after IPO
- Liquidity
- Transaction - usually a subject of discounting
- Trading - in general case, high liquidity
- Control
- Transaction - highly dependent of different factors
- Trading - stock prices reflects bargains of minority shareholders
- Synergy
- Transaction - High influence of synergy on the final price.
- Trading - typically don’t depend
- Diversification
- Transaction - various
- Trading - for startups typically diversification is poor