Week 6 Lecture s2 2014 - FINS3623 Venture Capital Week 6...

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FINS3623 Venture Capital Week 6 – Quantitative Valuation Techniques in Private Equity Settings
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Lecture Outline Major Difficulties in Private Equity Valuation Common Assumptions and Flaws Valuation Techniques Comparable valuation How to select comparable firms? DCF NPV, Venture Capital Method, APV
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THE MAIN DIFFICULTIES
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Information Asymmetries “A share of stock is worth either what you paid for it or what someone else is willing to pay you for it” - John Maynard Keynes When valuing private firms, you know neither
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Predicting the Unpredictable? No or little operating history Start-up firms No earnings or even no revenue in early years Research-intensive firms, e.g. biotech Lack of comparables, uncharted territories Firms seeking venture funds often concentrate in entirely new industry/market Lack of reliable (audited) financial information
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Long-term Investment, Short-term Exit Firms seeking venture funding for long-term investment Venture funds, however, have to provide regular returns to their investors Early exit can result in long-term cash flows to be overlooked or inaccurately estimated Lack of a market to realise investments
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Extreme Uncertainty Successful ventures (1%) Firms receiving venture funding (6%) Failed and Rejected Ventures (94%) Break-even line What required rate of return (discount rate) is appropriate?
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ASSUMPTIONS and FLAWS
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Common Assumptions Entrepreneurial owners are always over-optimistic in their reporting and forecasting The importance of the due-diligence process Sensitivity analysis Venture funds are unlikely to receive dividends as a form of return The main return comes from capital gain when exiting the investment The terminal value is critical All start-up investments are extremely risky and must be compensated by very high required rate of return (discount rate)
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Common Assumptions Discount rate is likely to differ according to the investment stages of investee firms. For example, Investment stage Annual expected return Seed capital 100% Start up 50% Second round 40% Third round 30% Bridge to public offering 25% Distressed firm 50% Leveraged buyout 35%
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Common Assumptions Revenue/ Profit Time Startup / Pre- production phase Rapid expansion Stable high growth Maturity growth REVENUE PROFITS Revenue None / ad hoc Very high growth Stabilising Low and constant growth Profits -ve and increasing Turning +ve Growing steadily Low growth in line with rev History None Very limited Can rely on margins Substantial history Comparable firms None Some, unlisted Many, often listed Most firms in industry Source of value Future growth Mostly future growth Growth + assets Mostly existing assets
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Common Assumptions Zooming in on the very early stages
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Common Flaws Trusting entrepreneurs’ own figures and forecasts Inadequate due-diligence Comparing private firms against listed firms Ignoring the value of liquidity
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