Early-stage Valuation with the Venture Capital method.

Case Study: Valuation of a venture firm under R&D yet

An entrepreneur established a limited company, ‘JC Health’, in the UK a year ago to commercialise ‘Remote diagnosis for knee health’ in the UK. The core of it is to measure how healthy the knee is with sensor trackers on it when it moves or bends and to provide customised physical therapy contents.

The initial capital was £100,000, and the company issued 100,000 shares at £1 per share. The CEO set up a business plan, started registering intellectual property rights related to the technology, and begun to meet industry officials for sales. For the full-fledged business, R&D expenses for the next two years and operating capital were estimated at £1million. They decided to raise it from venture capital (VC).

Let’s evaluate the equity value of JC Health to raise £1,000,000 from VC.

 

 

Three elements you need when using relative valuation.

In general, you need three pieces of information when using the relative valuation.

  • First, from the current financial statements, you can recognise the company’s financial structure, turnovers, profit margin, and reinvestment of retained income.
  • Second, from the past financial statements, you can see the turnover trends, the degree of improvement in profit margin, and the efficiency of R&D investment. Also, the company’s specific risk can be measured to some extent by taking into account the volatility of turnovers or profits.
  • Finally, necessary is the company’s peer group. You can compare the target company to the competitors and then identify the stage in the industry cycle. Eventually, you can estimate the equity value of the target company.

(Some references: Damodaran‘s ‘Investment Valuation’)

 

 

Difficulties in the valuation of venture firms with insignificant sales

The primary reason it is difficult to evaluate venture companies is that it is hard to obtain some or all of the three sources mentioned above. Early companies do not have long past financial statements literally. Therefore, you have to rely on the latest financial statements, but there is not much information available from them. There are little tangible assets that could be assessed in the balance sheet, and in some cases, the debt-to-equity ratio is very high and/or capital is severely impaired. In most cases, turnovers have not yet been formed or are insignificant in the income statement. Also, there might be negative profits or losses due to high sales and management costs. Therefore, the evaluator should be able to price the company’s own technology and intangible assets such as R&D personnel, patents, or copyrights not shown in the financial statements.

Besides, in the case of companies in the new technology field, it is hard to find comparable companies with the target company. The reason is that it is the field of newly-born technology that did not exist before. In this case, it is struggling to determine the stage in the industry life cycle or scale of the industry through the comparative companies. Furthermore, it is also challenging to estimate the level of profit margin and risk of the industry.

 

 

Equity valuation using the VC method

Step 1: Estimate turnovers and income

Figures 1: Excel screen – JC Health sales estimate

 

Let’s find out the equity value of JC Health mentioned in the case using the VC method. To begin it, you’d better understand the VC’s investment objective first. The purpose of their investment in venture companies is to recover them at an appropriate time with a high rate of return. One of the best ways is to list them on the stock market. Thus, the first thing to do is to estimate when JC Health could be listed and how much the turnovers and income would be at that time.

 

JC Health’s turnovers and net profit estimate for the next five years

Unit: £, thousand

Year

Turnovers

Turnovers
growth rate

Net income

Profit margin

-1

0

-50

N/A

0 (present)

20

-116

-580.0%

+1

320

1500%

-275

-85.9%

+2

1,120

250%

20

1.8%

+3

3,136

180%

240

7.7%

+4

6,899

120%

670

9.7%

+5

12,419

80%

1,340

10.8%

 

VC would have read the business plan of JC Health to judge whether to invest in and interviewed with the manager. Through the process, turnovers would have been estimated, and net income calculated as above. After discussion, VC and JC Health would have decided that the company would go public after five years. 

Let’s not forget that the above turnovers, income, and listing in 5 years are possible only when the VC invests.

 

 

Step 2: PER of the comparable companies

Figures 2: Excel screen – PER of JC Health’s peer group

 

The listed companies that operate similar businesses to JC Health should be selected to predict the equity value at the listing time. The business is to manufacture and sell medical diagnostic equipment for knee health in the UK, and it plans to go public to the London Stock Exchange. Therefore, you should select comparable companies that meet these conditions.

 

Figures 3: Yahoo Equity Screener

 

The four companies below were selected from among the 22 medical equipment ones in the healthcare sector on the UK stock market using Yahoo Equity Screener as above.

 

Peer Group’s PER 

Company

PE Ratio

Smith & Nephew plc

21.78

Medica Group Plc

18.17

Immunodiagnostic Systems Holdings PLC

22.84

Inspiration Healthcare Group plc

32.38

Average

23.79

 

The average PER of the four companies is 23.79. This PER will be used to estimate the equity value of JC Health in 5 years.

 

 

Step 3: Valuation

Figures 4: Excel screen – JC Health valuation using the VC method

 

All the hard-working is over. Now, with the data obtained as above, we can calculate the equity value through the following formula.

 

Expected exit value in n year = Net income in n year x PER
Discounted exit value = Expected exit value/(1+Target return)n

Exit value: Amount to recover from the investment by VC
Target return: Venture capital’s required rate of return

 

As shown in the first equation above, by multiplying the target company’s estimated net income in n year by the peer group’s PER, the equity value in n year can be calculated.

The second formula is used to convert the equity value in n year to the present value. Here, the target return is the return rate required by VC for the exposure to risk, which is much higher than the typical cost of capital used in the DCF model. The target return would reflect the assessor’s subjective judgement factors as the rate of return compensated for the venture company’s specific risk, industry risk, and management risk. To calculate the equity value of JC Health, let’s assume a target return of 40%.

 

Target return = 40%

Exit value in 5 year for JC Health = £1,340 thousand x 23.79 = £31,882thousand

Discounted or Present exit value = £31,882 thousand / 1.45= £5,928thousand

 

Using the above formula, JC Health’s value is estimated at £5,928 thousand, nearly £6 million.

 

 

Step 4: About target return

When investing in an early-stage company, the target return is a mixed outcome of evaluator’s judgment, experience, and estimation based on due diligence data. In practice, it may be decided through negotiation between the investor and the target company.

 

There are three reasons why the venture corporate return on investment should be high. First, early-stage or venture companies are more exposed to macroeconomic risks, so they require a high β in terms of CAPM. Second, venture investors are often exposed to specific industries or sectors. Therefore, they could demand a high premium for risk that could not be diversified. Finally, venture firms are more likely to fail in terms of corporate permanence than listed firms or growth and mature firms. Given these things, the rate of return required by investors is naturally very high.

 

 

Step 5: Calculate the investor’s stake

The next blog will explain the calculation of it.

 

 

Limitations of the VC method

The equity value of the early-stage company with no or insignificant turnovers was calculated using the VC method. In the VC method, the relative valuation using PER is used to obtain the future exit value. Plus, the VC’s target return was used to convert it into the present value. Therefore, you need to note that the following factors can influence the result of the VC method.

  • Estimating future turnover and net income: The more positive the estimate is, the higher the equity value.
  • Exit timing, n: As timepoint n gets longer, turnovers estimation may be inaccurate, and the volatility of the current value will inevitably increase due to the target return.
  • PER: The current PER is used for the value at a specific point in the future, but the actual PER at that point may be different from the present.
  • Target return: It is highly subjective because analysing data, investment experience, degree of risk interpretation, and required risk premium vary depending on assessors.

 

 

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  1. Pingback: How to properly use the market approach? | JCINUS [제이씨이너스]

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