 Venture Capital and Startups

What is VC?  Money provided by investors to startup firms and small businesses with perceived long-term growth potential  No access to Capital Markets  High risk, above average returns

Who?  Wealthy investors  Investment Banks  Investment groups (Pool Investment)

History of VC  Mid 1900’s  American Research and Development Corporation  Diverse sources of capital

Investment Act of 1958  Small investment companies could be licensed by Small Business Association  Qualified VC and PE funds  Gave them access to low-cost government guaranteed capital

Structure of VC

Investors in Startups  Incubator  Angel  Super Angel  Micro VC  VC

Incubator  Provide services to startups  Office space  Management Training  Connects startup with potential investors  Invests capital

Angel and Super Angel  Usually wealthy individual  Provides capital for startup  In form of debt or equity  Super angel (already in the industry)

Micro-VC  Early stage startups  Smaller amounts than traditional VC

Types of Investment  Debt/Bank Loans  Venture Debt  Convertible Debt  AR Line  Asset Loan  SBA Loan  Equity Stake

Convertible Debt  Debt that is convertible into equity  Usually convertible at specific times  At the discretion of the bond/debt holder

Venture Debt  Company with no:  Significant assets  Positive cash flow  No collateral  Use warrants as compensation for higher risk

AR Line  Accounts receivable line of credit  Uses AR as collateral  Revolving line of credit depending on company’s AR

Asset Loan  Standard Loan  Uses asset as collateral  Can anyone think of an example of an asset loan?

SBA Loan  Small Business Administration offers loaning programs  Borrow for a variety of reason  Adding to Working Capital  Refinancing Debts  Buying Real Estate  Financing Acquisitions

Equity  Seed Funding  Series A  20-40% of company  Series B  Venture Round  Series C  Bridge finance, LBO, expansion capital, etc.

Valuation  Discounted Cash Flow  Risk Adjusted NPV  Venture Capital  Market Comparables

Discounted Cash Flow DCF Forecasting Period

Discounted Cash Flow Revenue Growth

Discounted Cash Flow (FCF)  Sales Revenue  (Operating Costs)  (Taxes)  (Net Investment)  (Change in working capital)

Discounted Cash Flow Forecast Operating Cost  Look at previous operating cost margins  i.e. operating cost margin = 0.70  Meaning: For every $1.00 of revenue, the company incurs $0.70 of cost  Use the historic operating cost margins to predict future  Again, a conservative and optimistic estimate can be used

Discounted Cash Flow Taxes  Many companies do not pay the corporate tax rate on profits  Calculate average annual income tax over past projection period  Divide by average profits before income tax  Arrive at effective tax rate

Discounted Cash Flow Net investment  i.e. company originally has 8% net investment  Assuming 3% depreciation that becomes 5% of sales  Competition will return to level in projection period

Discounted Cash Flow Change in WC  Working Capital – cash required for daily operation  The faster a business expands the more cash it will require  It is fair to assume direct relationship with revenue growth

Discounted Cash Flow Discount Rate  Cost of debt (Market rate on debt)  Cost of equity (Dependent on what VC makes)  Annualized rate of return of VC  Finally to put it all together  WACC = Ce *(E/V)+Cd*(1-Taxrate)*(D/V)  Ce = Cost of equity, Cd= Cost of debt, E = equity, D = debt, V = Equity + Debt

Discounted Cash Flow Discounting and Analysis Free Cash Flow Current YearYear 1Year 2Year 3Year 4Year 5 Optimistic Revenue Growth Rate 0.2 Revenue$100.00$120.00$144.00$172.80$207.36$ Operating Costs-$7.00-$8.40-$10.08-$12.10-$14.52-$17.42 Taxes-$15.00-$18.00-$21.60-$25.92-$31.10-$37.32 Net Investment-$8.00-$5.00-$5.75-$6.50-$7.25-$8.00 Change in Working Capital-$1.50-$2.06-$2.62-$3.18-$3.74-$4.30 Free Cash Flow$68.50$86.54$103.95$125.10$150.75$ Discount RateCurrent YearYear 1Year 2Year 3Year 4Year 5 VC Equity Stake Value$15.00$20.00$28.00$43.00$46.00$62.00 Interest Rate on Debt2.95%3.05%2.72%2.43%2.99%2.86% Credit Lines$30.00$34.00$38.00$42.00$46.00$50.00 $0.89$1.04$1.03$1.02$1.38$1.43 Total Equity$100.00$124.00$156.00$203.00$253.00$ CAGR on VC Equity32.82% Cost of Equity$47.00 Total Debt$30.00$34.00$38.00$42.00$46.00$50.00 Average IR2.83% Cost of Debt$6.78 WACC25.80% Enterprise Value$68.79$103.95$125.10$150.75$ Total Enterprise Value$ Debt$50.00 Fair Value of Equity $580.38

Remarks on DCF  Very subjective  Many assumptions and predictions  Difficult for startups with limited financial data

Risk Adjusted NPV

Risk Adjusted NPV Questions  How would I factor in risk?  What could it also be known as?

Venture Capital Valuation  Investors looking for exit within 3-7 years  Exit price is estimated  Calculates backward  Arrives at ROI after taking into account risk

Market Comparables  Simple calculation using key ratios  Takes the market capitalization of comparable companies as basis