## More on Venture Capital Financing

January 26th, 2007Although I’m actually trying not to add to this albatross of a weblog, people find some of the stuff I’ve written about in Google and occasionally they write me long detailed questions which I answer. *I answer them because I’m a nice guy.* I go out of my way to help people because **I’m a nice guy**. I even had to fish these latest questions out of my spam filters. Some of my former classmates ceased to believe that trying to help people was a valid reason to do something.

Besides questions about various CDs and especially LPs and 45s I own, I recently was contacted by someone from China with questions on valuing a new high growth company using discounted cash flows. They pointed to a website which I had found and recommended and then asked some questions about residual value. None of the three spreadsheets I’ve made had a residual value calculation.

The residual value is an estimate of all future cash flows a company will earn beyond a certain point in time. It is difficult to estimate income, market share, market size and what have you in the far future. So after say five years of detailed estimates an additional sum is determined based on the last detailed income estimate to represent all future cash flows. This sum is then discounted and added to the discounted cash flows for the first five years. The total is the estimated present value of the venture.

**Why didn’t I do a residual value calculation?**

I don’t have a good reason, it could have been just an oversight, *it wasn’t laziness* because the three spreadsheets I did make took many hours of coding and debugging in VBA. My spreadsheets were experiments in writing VBA and were designed to perform quick *“what if” calculations*. If you really are seeking venture capital financing you will likely need to create a customized spreadsheet not rely on something some guy posted on his blog. ;-)

The other reason I didn’t do a residual value calculation is discounted cash flow is not the preferred method of valuing a company for VCs. There are a lot of ways to value a company:

- Discounted cash flows
- Comparing it to one or more publicly traded companies
- Asset based pricing
- Multiples of a company’s sales or earnings
- Anticipated growth in future market share

The fifth option is what **the Classic VC Method** does. This is the preferred way to quickly estimate the future value and present value of a risky high growth venture. All three of my spreadsheets implement this method. The reason I did ever more elaborate VBA based cash flow models was for comparison purposes and to determine when the company would be cash flow positive or if it would run out of cash at some point.

If you are trying to raise money from venture capitalists the three most important things they look for are:

- Team
- Market Attractiveness
- Sustainable Competitive Advantage

VCs invest in people as much as ideas. If they are not confident your team can execute your business plan they are unlikely to invest even if you have a great idea. VCs are looking for really large returns so the market you plan to sell into needs to be sufficiently large. The VC will also look at the existing and potential competitors, barriers to entry that can be erected, the role the government may play etc. Lastly if you can show a sustainable competitive advantage, something other than first mover advantage *which isn’t sustainable*, say intellectual property, patents, switching costs; you increase your chances of receiving funding.

The actual numbers will likely be completely redone by the VC, they will have their own estimates for market size, market share, and the amount of capital the venture requires. Besides market size, market share, and profit margin, the number that can have the biggest effect on your valuation using the classic VC method or discounted cash flows model is **the discount rate**. The VC wants to earn the highest return possible, the larger this number the greater percentage of the company you will likely have to give up to recieve their money.

In the final presentation of my venture capital financing class at the Sauder School of Business I concluded with the following quotation from Chester L. Karrass:

In business, you don’t get what you deserve. You get what you negotiate.

I made a spreadsheet to go along with the example on strategis.gc.ca which doesn’t use VBA so you’ll have to modify it to work with your own numbers. Maybe it will help people understand the online example better. However in addition to understanding discounted cash flow calculations you need to learn **the Classic VC Method** as outlined in Jeffry Timmons book and elsewhere:

- Estimate the company’s net income in a number of years, at which time the investor plans on harvesting. The estimate will be based on sales and margin projections presented by the entrepreneur in his or her business plan.
- Determine the appropriate price-to-earnings ratio or P/E ratio. The appropriate P/E ratio can be determined by studying current multiples for companies with similar economic characteristics.
- Calculate the projected terminal value by multiplying net income and the P/E ratio.
- The terminal value can then be discounted to find the present value of the investment. Venture capitalists use discount rates ranging from 35 percent to 80 percent, because of the risk involved in these types of investments.
- To determine the investor’s required percentage of ownership, based on their initial investment, the initial investment is divided by the estimated present value.

To summarize the above steps, the following formula can be used:Final ownership required = required future value (investment) / Total terminal value

= ((1=IRR)^years * investment) / P/E ratio (terminal net income)- Finally, the number of shares and the share price must be calculated by using the following formula:
new shares = percentage of ownership required by the investor / ((1 – percentage of ownership required by investor) * old shares)

I added a residual value calculation to my original and simplest spreadsheet. It only considers yearly income rather than monthly which is what I did in my two later spreadsheets. Although I have blogged about venture capital in China and elsewhere, I’m far from an expert don’t let the MBA and BSc. fool you. There are some excellent blogs which are written by successful venture capitalists or people more knowledgeable and connected than I:

Guy Kawaski has written another insightful post on obtaining venture capital, or at least getting to talk to a venture capitalist about your idea for a new business, product, or service. I’ve linked to Guy many times, even above in this very blog posting, but rather than a token ‘go read this elsewhere’ post, I’ll add a link to his latest advice from my most recent post on venture capital financing, that along with the trackback will probably be more useful. Note Guy again mentions using LinkedIn, *not Xing*. Maybe I’ll have to actually invite some people again, I’ve noticed people I’ve never met want to ‘link in’ with me, more and more…

This entry was originaly posted on , it was last edited on and is filed under: Finance and tagged: Excel, Spreadsheet, Valuation, Venture Capital.

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