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How do Venture Capitalists Value Companies?

What is the value of a company? That question comes up many times especially during mergers and acquisitions. Most venture capitalists value deals using an IRR hurdle rate or the minimum return they expect to receive in returns given risks of the new venture. Typically their goal is a potential IRR of at least 30%.

Let us look at five methods to value a company.

1. Price to Earnings ratio (P/E ratio): By using the P/E ratios of the industry we can value the company. For example, the medical device industry has a P/E ratio of 21-29 so given the earnings (or Net Income) we could calculate the price (offer to be made) to acquire the firm. If a medical device company had net income of 1.2M then taking 25 as the industry standard we can value the company at 1.2M*25= 30M.

2. Discounted Cash Flow (DCF): There are three methods to value a company using DCF as seen in the image. Its the main source of valuing a new venture as they are cash negative in the early years. Basically, you project the income for the first 6 years and discount it to the current year. You can forecast income in three ways - constant cash flow, constant growth and market multiple.

3. Price to Net Book ratio (PBR): This is is an indication of how much shareholders are paying for the net assets of a company. The book value is the difference between the balance sheet assets and balance sheet liabilities and is an estimation of the value if it were to be liquidated. When VCs want to buy companies they usually get all the financial statements from a company before making an offer. Thus, they have access to the balance sheets and the book value of the company. Based on their experience, the industry and the company, VCs usually have some  expectations of the PBR. They use this data and the book value of the company to arrive at the price they want to offer for the company.

4. Price to Sales Ratio (PSR): This is based  on the company's earnings or sales and does not consider debt and other liabilities. Again, there are industry standards for P/S ratio and if VCs know the sales of the company they can calculate the price they want to offer for the company.

5. EBITDA Multiple (Enterprise value /EBITDA): EBITBA is the earnings before interest, tax, depreciation, and amortization. This ratio measures the price (in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBITDA). An advantage of this valuation is that it is capital structure neutral, and, therefore, can be used for cross company valuations. VCs can get these numbers from the company's financial statements.

When to use which? Whichever method, brings you more money for your company. For example, companies that require big upfront investments or infrastructure (such as cable companies) and long gestation periods, EBITDA can be a more appropriate measure of the business's underlying profit potential since it excludes the cost of these investments so u=you would use the EBITDA multiple to value your company.

Three ways to calculate value of business at end of Year 6:

A.Constant Cash Flow: Assumes firm has lost its competitive advantage and is in steady state mode.

Method: Divide year 6 free cash flow by “k” cost of capital to value infinite earnings stream, then discount to present.

B. Constant Growth: Assume firm will continue to grow at constant percentage rate, with cash flow yield the same, to infinity.

Method: Multiply year 6 cash flow by 1+g (growth rate); divide that by

Kc – g (cost of capital less constant growth rate.) Discount to present.

C. Market Multiple: Assume firm could be sold at P/E multiple reflecting

year 6 earnings and growth rate.

Method: Apply industry average multiple to net income or EBITDA, tax effect proceeds, and discount to present.

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