Monday, September 19, 2016

Venture Capital valuation methods: the basics

There's been some talk about Andreessen Horowitz returns lagging other prominent venture capitalists such as Sequoia, Benchmark and Founders Club.

In response, Scott Kupor of A16Z published a rebuttal outlining valuation methods used in the industry. Kupor differentiates between the "marks" (quarterly snapshot of realized and unrealized gains ) from the actual cash and stock distibutions (which constitute the returns). Generally speaking, VCs require companies to get an independent 409A FMV valuation. A 409(A) Primer is available at Axiom Valuation. Accordingly the methods used to value investments are:

  1. Last Round Valuation Waterfall.
  2. Comparable Company Analysis. For example, if a portfolio company is generating $100 million of revenue and its “comparable” set of companies are valued in the public markets at 5x revenue, a venture firm would then value the company at $500 million ($100 million*5x) ". A  firm will then also apply what’s known as a DLOM (a discount for lack of marketability) to reduce the carrying value of the company described as often 20-30%.
  3. Option Pricing Model. OPM uses Black-Scholes to value a portfolio company as a set of “call options  whose strike prices are the different valuation points at which employee options and preferred shares all convert into common stock." Kupor points out Black-Scholes is the method his firm widely uses. If a firm has raised Series C at $5.00/share, OPM using Black-Scholes will assign a value to the Series A and B that is a substantial discount to the $5 per share price assigned to the Series C. Adding those up gives the company value. " (Kupor).  The strike price of an option here corresponds to the other(s) equity values reached (but it could have been the liquidation preferences on each preferred series). Calculate the incremental value of each option based on the option's strike prices. Of course the common class participation percentage would be multiplied by the incremental value of the call options, them sum them all up.

             To those three1 we could add:
         4. VC Method (needed: exit price estimation).
         5. Risk adjusted NPV -ex.:pharma licensing valuation at Torreya Partners.

On the trails of A16Z post. Marck Suster of Upfront Ventures points out the uncertainty of the outcome for funds that generally make it out great, but may yet have a trailing fund.  IRR may be the method used to gauge investments but the money returned to investors can only be the cash on cash (realized returns).

We've seen the largest players in private equity (KKR)making a play for the Venture Capital class attracted to potential outsize returns. KKR recently invested in Ping, AcuFocus, Darktrace and others.
Will that ultimately pay off ?


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