Venture Capital and the Finance of Innovation[Course number]

Professor [Name ][School Name]

Chapter 11DCF Analysis of Growth Companies

PHASES OF GROWTH

Growth vs. Age

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

1 2 3 4 5 6 7

Years since IPO

Rev

enu

e G

row

th -

In

du

stry

Ave

rag

e

75th percentile

median

25th percentile

Assumptions for exit-value DCFs

All-equity structure

No amortization costs

No non-operating assets

Leverage of VC-backed companies

Years Since IPO

Mean Median

0 4.7% 1.2% 1 4.0% 1.9% 2 5.7% 2.8% 3 6.8% 3.8% 4 7.2% 3.9% 5 8.1% 4.4% 6 8.2% 5.1% 7 9.1% 6.0% 8 8.7% 5.6% 9 10.6% 6.2%

10 11.0% 6.0% 11 11.8% 6.4% 12 12.4% 8.9% 13 11.0% 7.8% 14 7.7% 4.8% 15 11.0% 6.4%

DCF – Mechanics

CF = EBIT(1-t) + depreciation – Capital expenditures – Δ NWC

where,CF = cash flow,EBIT = earnings before interest and taxes,t = the corporate tax rate, andΔ NWC = Δ net working capital = Δ net current

assets – Δ net current liabilities.

CF and Investment

NI = capital expenditures + Δ NWC

- depreciation

Investment rate (IR) = Plowback ratio = revinvestment rate = NI / E

CF = E – NI = E – IR * E = (1 – IR) * E

NPV

NPV of perpetuity = X /(r – g)

Graduation Value = GV = CFS+1 / (r – g)

1 2

2 of firm at exit ... ...

1 (1 ) (1 ) (1 )T n ST T

n S T

CF CF GVCF CFNPV

r r r r

Graduation Value

EN+1 = EN + NI * R

g = (EN+1 – EN) / EN = (NI * R) / EN = IR * R

GV = (1 – IR) * E / (r – (IR * R))

GV = ( 1 – g/R) * E / (r – g)

R as a function of NI

Reality-Check DCF

On the exit date: Revenue is forecast for the average success case; Other accounting ratios (not valuation ratios) are

estimated using comparable companies or rule-of-thumb estimates.

The discount rate is estimated from industry averages or comparable companies.

Reality-Check DCF (2)

On the graduation date: The stable growth rate is equal to expected inflation; The return on new capital – R(new) – is equal to the

cost-of-capital (r); The return on old capital – R(old) – is equal to the

industry-average R; The operating margin is equal to the industry average. The cost-of-capital (r) is equal to the industry average

cost-of-capital.

Reality-Check DCF (3)

During the rapid-growth period: The length of the rapid-growth period is between five

and seven years; Average revenue growth is set to the 75th percentile of

growth for new IPO firms in the same industry, from data contained in growth worksheet of the DCF spreadsheet; (NOTE: for public companies, one can also use analyst estimates here.)

Margins, tax rates, and the cost-of-capital all change in equal increments across years, so that exit values reach graduation values in the graduation year.

Example

EBV is considering an investment in Semico, an early-stage semiconductor company. If Semico can execute on their business plan, then EBV estimates it would be five years until a successful exit, when Semico would have about $50M in revenue, 150 employees, a 10 percent operating margin, a tax rate of 40 percent, and approximately $50M in capital (= assets). Semico’s business is to design and manufacture analog and mixed-signal integrated circuits (ICs) for the servers, storage systems, game consoles, and networking and communications markets. It also plans to expand into providing customized manufacturing services to customers that outsource manufacturing but not the design function. It expects to sell its product predominantly to electronic equipment manufacturers.

ProblemTo make the transaction work, EBV believes that the exit value must be at least $300M. How does this compare with the reality-check DCF? How much must the baseline assumptions change to justify this valuation?