The Art Of Financial Valuation With Certificate

Venture capital is as old as commerce. For the purposes of this class we are more concerned with Venture Capital in the recent history. While reviewing the presentation please pay attention to the fundamental concepts of venture capital described in the video.

Before 1946, Venture Capital was primarily the domain of wealthy families. Private equity as we know it today emerged with the formation of American Research and Development Corporation (ARDC) and J.H. Whitney and Company in 1946.

ARDC was created by Georges Doriot who is also referred to as the “Father of Venture Capital”.

ARDC is of significance to venture capital because of its investment in Digital Equipment Corporation (DEC). This investment laid the foundation of modern day private equity. Following are the fundamental featured of modern day private equity:

1. Private equity firms organize limited partnerships to hold investments in which investment professionals serve as general partners and the investors are passive limited partners.

2. Limited partners pay an annual management fee of 1.0–2.5% and a carried interest typically representing up to 20% of the profits of the partnership

Kleiner, Perkins, Caufield & Byers and Sequoia Capital were the 1st firms to emerge on Sand Hill Rd in 1972. Having a presence on Sand Hill Rd offers the benefit of access to silicon-valley’s semi conductor and computer hardware manufacturers. Both firms have played a pioneering role in the development of the information technology industry as well as the formation of the National Venture Capital Association (NVCA).

The National Venture Capital Association (NVCA) is an excellent resource for learning more about the venture capital industry.

An important development that has shaped the present day venture capital landscape is the Employee Retirement Income Securities Act (ERISA). ERISA is of significance to Venture Capital as in 1974 this act prohibited Corporate Pension Funds from investing in privately held companies. In 1978 the US Labor Department relaxed certain of the ERISA restrictions, thus allowing corporate pension funds to invest in the asset class and providing a major source of capital available to venture capitalists.

Fundamental Concept - The Investment Process:

In Silicon Valley or any Venture Capital deal Globally the number of shares a company starts out with are generally a few million if not 10,000,000 to 100,000,000. The number of shares outstanding and the value of the company should be in balance. If a company is publicly traded then it needs to maintain at least a value of $1/share. If the number of shares outstanding and the value of the company is not in balance then the share price will fall below $1/share. This can result in the stock becoming delisted.

The example in this chapter is based on 10,000 shares for simplicity.

Key concepts:

Pre Money Value: This is the value of the business before any investment. It does not include the impact of the expected investment.

Pre Money Shares: This are the number of shares before an investment has been made. These are the shares used to calculate the share price.

Post Money Value: This is the value of the company after an investment has been made. Pre money value + Investment = Post Money Value

Post Money Shares: These are the number of shares outstanding after new shares have been issued. Pre Money Shares + Issued Shares = Post Money Shares

The National Venture Capital Association (NVCA) is a valuable resource for learning about the trends in Venture Capital.

A fundamental concept to understand regarding venture capital is the formation of a venture capital fund. A venture capital fund is formed by a Limited Partnership.

A limited partnership requires General Partners and Limited Partners. The venture capital firm serves as general partners and the investors serve as limited partners.

The general partners are not obligated to invest in the venture capital fund. The limited partners make the investments that are managed by the general partners.

General partners are responsible for the day to day activity of the venture capital fund. General partners receive a management fee and may also receive a bonus based on the performance of the fund. There is no defined path for becoming a general partner in a venture capital firm. General partners come from all different backgrounds. General partners establish the strategy for the fund’s investment decisions which are communicated to the limited partners. However, a limited partner’s decision to invest in the fund is limited to the marketing material presented by the fund. Beyond the marketing material, the limited partner has no say in the daily activity of the fund.

Limited partners are the investors in a venture capital fund. Limited partners do not make the investment decisions for the fund. Limited partners may be: Public Pension Funds, Corporate Pension Funds, Insurance Companies, Hight net-Worth individuals

Family Offices, Endowments, Foundations, Fund-Of-Funds and Sovereign Wealth Funds.

Corporate investment activity: A corporation may invest in venture capital by starting its own venture capital firm or by investing in a venture capital fund.

The simplest way to remember the difference between nominal and real is to remember that real is adjusted.

A fundamental concept to understand is the difference between investing and buying. Investing requires the issuance of new shares and buying requires the transference of ownership.

A miss conception may lie around the around the concept of dilution of ownership. Dilution of ownership is the difference in percentage (%) ownership and results differently depending on “investing” or “buying”

In the case of investing, the dilution of ownership takes place because new shares are issued and existing shares form a smaller percentage of the new total outstanding shares.

In case of buying, an investor sells shares they currently own in a company thus reducing the total number of shares they own. This results in a reduced percentage ownership in the company. If the shares are sold by an investor, the funds from the sale do not belong to the company; they belong to the investor making the sale.

It is important to note that the only way to accommodate an investment is by issuing new shares.

The process of valuation begins with the creation of a cash-flow statement. The sales forecast in the cash-flow statement represents the sales strategy. Here we review a cash-flow statement and utilize this cash-flow statement for the calculation of the NPV.

In excel it is better to calculate the PV of each cash-flow separately. Excel offers an NPV formula as well, however this formula discounts the 1st year as well, which is not the case in calculating the NPV. The 1st year is the current year and there is no difference between nominal and real.

A good solution is to make a rough draft of a model first and then refine it over time. Once you start executing on your business strategy you will start discovering solutions that work. Thus the idea is to start making a simple model that reflects your current understanding of your business. It is important to note that there is no cooky cutter solution to making a business model. A business model reflects a business’s strategic competitive advantage. There is no universal equation for a strategic competitive advantage.

Every business has to have its own strategic competitive advantage. For a very early stage entrepreneur this can be a discovery process.

As an entrepreneur the only individual who can answer the question of how this business is going to make money is the visionary behind the business. In summary the business model is intended to reflect the business’s unique vision.