WEBVTT Kind: captions Language: en 00:00:00.263 --> 00:00:04.183 The venture capital method for valuation is used by venture capitalists. 00:00:04.183 --> 00:00:09.943 To understand when this method is used and why we need to understand what venture capitalists are. 00:00:10.583 --> 00:00:15.543 There are two kinds of early stage investors that might be using this technique. 00:00:15.543 --> 00:00:17.943 We have angel investors and venture capitalists. 00:00:18.583 --> 00:00:24.663 Both of these are investing into small companies with the intention of helping them to grow. 00:00:24.663 --> 00:00:31.543 So the idea is that these investors give money but it's mark money because usually they give money 00:00:31.543 --> 00:00:35.623 contacts and and knowledge and other things help recruiting 00:00:35.623 --> 00:00:40.983 and so on. They can also organize more funding for the company in future rounds. 00:00:40.983 --> 00:00:45.783 The difference between angel investors and venture capitalists is that angel investors 00:00:45.783 --> 00:00:51.383 are wealthy individuals. Typically they have made a fortune in business and then they either want to 00:00:52.663 --> 00:00:56.023 invest to help other smaller companies to realize their dreams 00:00:56.023 --> 00:01:01.943 or they simply want to invest their money to get profits for their existing wealth. 00:01:02.503 --> 00:01:06.263 Venture capitalists on the other hand are professional investors. 00:01:06.263 --> 00:01:11.063 They typically don't invest their own money but instead they collect a fund 00:01:11.063 --> 00:01:16.663 from other wealthy individuals or organizations and then they invest from that fund. 00:01:16.663 --> 00:01:22.423 The venture capitalist typically has an... The fund has a planned expiration date 00:01:22.423 --> 00:01:28.663 when the fund returns the money to the owners. For example if the fund is active for seven years then 00:01:28.663 --> 00:01:33.623 it means that if an investor invests - venture capitalists invest into a company the first year 00:01:33.623 --> 00:01:39.463 then they should be exiting before the seventh year. So that they can actually return the money. 00:01:41.143 --> 00:01:45.303 Angel investors typically invest smaller amounts than venture capitalists 00:01:45.303 --> 00:01:51.063 and venture capitalists can invest substantial amounts through syndication when different 00:01:51.063 --> 00:01:56.743 venture capitalists join forces and for example invest in a second or third round 00:01:56.743 --> 00:02:01.143 when the size of the investment can be tens or hundreds of millions of euros or dollars. 00:02:01.943 --> 00:02:07.063 Let's take a look at how these kinds of investors value entrepreneur companies. 00:02:08.023 --> 00:02:13.863 The important things in valuations are the due diligence. So when an investor - a venture 00:02:13.863 --> 00:02:19.703 capitalist or angel investor - decides to do an investment they will do this process of 00:02:19.703 --> 00:02:26.503 due diligence where the companies are analyzed in detail and the valuation is developed. It involves 00:02:26.503 --> 00:02:33.063 also considering all kinds of possible risks. So you look at founders. You look at legal aspects. 00:02:33.063 --> 00:02:39.303 Markets. Finances. What kind of people there are and importantly you look at the exit strategy. 00:02:39.303 --> 00:02:45.383 So venture capitalist eventually needs to sell their shares and they need to do that 00:02:46.023 --> 00:02:50.983 with high profits. At least for some of their investments. The reason for 00:02:50.983 --> 00:02:58.023 that is that the companies or individuals who invested in the venture capital fund 00:02:58.023 --> 00:03:00.743 want to get their money back with interest at some point. 00:03:01.303 --> 00:03:07.543 So the exit strategy is something that we need to consider in venture capital financing. The 00:03:07.543 --> 00:03:12.183 idea of an exit is also important in the venture capital valuation method. 00:03:13.063 --> 00:03:20.743 The venture capital valuation could look like that. So most people know venture capitalists 00:03:20.743 --> 00:03:24.423 from the show sharks tank or lions den or dragons then 00:03:24.983 --> 00:03:30.983 depending on which country you happen to live in and in this show these angel investors 00:03:31.783 --> 00:03:38.743 propose investments to entrepreneurs repeat their ideas and they talk about valuation and 00:03:38.743 --> 00:03:43.863 pre-money valuation and post-money valuation and that kind of things. Where do these 00:03:44.423 --> 00:03:48.823 numbers come from? What is pre-money valuation and what is post-money valuation? 00:03:49.863 --> 00:03:54.503 When we look at the valuation for company - this is from Juhani Raatikainen's slide - the 00:03:54.503 --> 00:03:59.383 idea of a company value that it's a enterprise value which is the value 00:03:59.383 --> 00:04:04.023 of the assets value of the business and so on and then it's cash and equivalents. 00:04:04.023 --> 00:04:09.543 When we have a large company buying a smaller company they typically look at value adding this 00:04:09.543 --> 00:04:13.383 underpriced value here and then they just take the cash to themselves. 00:04:13.943 --> 00:04:18.903 With venture capital funding it's a bit different because venture capitalists typically 00:04:19.543 --> 00:04:24.823 inject money into the investment. They don't take money from the investment target like 00:04:24.823 --> 00:04:29.463 larger companies would do but they give money to the investment target to help that to grow. 00:04:30.183 --> 00:04:35.143 So when we look at venture capital funding and venture capital evaluation we need to look at 00:04:36.183 --> 00:04:42.983 these things. So a share gives you ownership of this full thing. The enterprise value and also the 00:04:42.983 --> 00:04:50.983 cash. So if you have one share and then one out of 100 then there is money in the bank. 1/100 of 00:04:50.983 --> 00:04:58.343 that money is yours. So share gives you ownership of the money and this is the pre-money valuation. 00:04:58.343 --> 00:05:04.263 When a venture capitalist invests into the company they typically don't give the money to the owners 00:05:04.263 --> 00:05:10.263 instead it's issued as new stock and the money that they invest goes into the target company. 00:05:10.263 --> 00:05:15.463 So when venture capitalist invests there is more money in the company. 00:05:16.103 --> 00:05:21.143 So we have new investment here and this new investment - this new money 00:05:21.143 --> 00:05:25.703 that the venture capitalists gave - is part of the post money valuation. 00:05:26.343 --> 00:05:30.583 So the difference between the pre-money valuation and post-money valuation is 00:05:30.583 --> 00:05:34.583 the amount of money that the venture capitalists invested in the company. 00:05:35.463 --> 00:05:41.623 We need the pre-money valuation and the post-money valuation both when we calculate valuations 00:05:42.263 --> 00:05:46.983 for venture capital financing. How a venture capital method works 00:05:47.783 --> 00:05:55.383 is that you basically start by estimating the exit value. The Xi here. So how much money - what would 00:05:55.383 --> 00:06:03.223 be the valuation of the company if everything goes well and the company is able to sell itself to a 00:06:03.223 --> 00:06:08.823 larger company in the same industry or able to do an IPO. So we need to determine the exit value. 00:06:09.463 --> 00:06:14.663 Then we discount the exit value to the current time. So the venture capitalist method does not 00:06:14.663 --> 00:06:21.943 really take into account what happens between the investment at the exit because that's considered 00:06:21.943 --> 00:06:28.903 to be unimportant. The company will not do issue dividends anyway because they want to 00:06:29.623 --> 00:06:34.503 invest all the money that they get into growing to get the exit value as high as possible. 00:06:34.503 --> 00:06:38.583 So the company doesn't really produce any value to their investors directly 00:06:38.583 --> 00:06:42.583 before the exit. So the exit is the time where the venture capitalist 00:06:42.583 --> 00:06:49.543 realizes the profit. Then pre-money valuation is simply the post-money valuation calculated 00:06:49.543 --> 00:06:56.823 from the exit value by discounting minus the investment and if you want to know how 00:06:56.823 --> 00:07:01.543 much share you will get then you can divide the investment by the post-money valuation. 00:07:01.543 --> 00:07:04.823 So that's where the ten percent comes from. Pre-money valuation 00:07:04.823 --> 00:07:07.543 post-money valuation and the amount of investment. 00:07:08.583 --> 00:07:13.543 The exit value is typically calculated based on IPO value. So if the company will be stock listed 00:07:13.543 --> 00:07:19.703 the venture capitalist will do an estimate of how much the value of that company would 00:07:19.703 --> 00:07:26.023 be in the stock markets. How much the trade save value would be. So if we sell a small 00:07:26.023 --> 00:07:31.703 software company to google or microsoft how much would a google and Microsoft pay for it. 00:07:32.263 --> 00:07:35.543 And then we can also apply terminal value discounted cash flow method 00:07:36.103 --> 00:07:40.983 and this would be the scenario where it's not clear who would buy the company 00:07:40.983 --> 00:07:48.423 but perhaps the current owners will buy out the venture capitalist. But these three techniques 00:07:48.423 --> 00:07:58.983 are being applied to calculate the terminal or the exit value in the venture capitalist valuation. 00:07:59.543 --> 00:08:08.583 Venture capitalists require a large profit. So the the rate of return must be substantially higher 00:08:08.583 --> 00:08:15.223 than 10 or 15 % that a normal investor would get. The reason for that is that venture capitalist 00:08:15.223 --> 00:08:20.983 investments are high risk. So a venture capitalist thinks that if everything goes 00:08:20.983 --> 00:08:27.383 well maybe one out of ten of their portfolio companies is a big success and they aim for 00:08:28.263 --> 00:08:35.143 getting their money back tenfold in for example five years. So if you have the equation for 00:08:36.183 --> 00:08:39.863 tenfold increase and you calculate how much 00:08:41.703 --> 00:08:47.143 the value of the company would need to increase every year to produce a 10-fold increase in 00:08:48.103 --> 00:08:56.663 five years you can calculate the raw here and it's going to be 0.58. So you need to have almost 60 00:08:56.663 --> 00:09:01.863 % return rate for every year and then you discount using that return rate. 00:09:01.863 --> 00:09:08.103 The reason for this high rates are that most venture capital funded companies fail 00:09:08.103 --> 00:09:12.503 and those failed companies are considered worthless for the venture capitalists. 00:09:14.183 --> 00:09:16.983 Only those companies that actually successfully exit 00:09:17.623 --> 00:09:22.343 make the money for the venture capitalists and all the other eggs in the basket are 00:09:22.343 --> 00:09:27.623 just not valuable at all because the venture capitalists can't sell them for a good profit. 00:09:29.463 --> 00:09:33.223 Summary of the venture capital method. So the idea of venture capital method is that you 00:09:33.223 --> 00:09:36.663 estimate the exit value. There are different techniques for doing so. 00:09:36.663 --> 00:09:41.383 You discount the current value - discount two current value - to get post-money valuation. 00:09:41.383 --> 00:09:44.903 You subtract the investment to get pre-money valuation 00:09:44.903 --> 00:09:50.823 and this technique makes a couple of assumptions. First no dividends before exit and that's because 00:09:50.823 --> 00:09:57.143 all the money that comes in needs to be invested to growth and failed companies valued at zero. 00:09:58.023 --> 00:10:02.743 Sometimes this technique is used with different scenarios. So you might calculate the scenario 00:10:03.623 --> 00:10:10.103 quick win where there is an early exit with 20 million euros. A bit later exit with 80 00:10:10.103 --> 00:10:15.223 million euros and an exit that is longer than the venture capitalists would like to have 00:10:15.863 --> 00:10:18.983 for 40 million euros or dollars. 00:10:18.983 --> 00:10:21.863 Then we calculate the probability of these different scenarios 00:10:22.423 --> 00:10:26.103 and we weight the different probabilities. We take the weighted sum 00:10:26.103 --> 00:10:31.783 and there we have our expected value. This is the post-money valuation. 00:10:33.543 --> 00:10:38.263 If there's a flop - the company can't be sold its value is going to be zero 00:10:38.263 --> 00:10:44.983 and this model estimates that complete failure to be a 50 % probability. 00:10:44.983 --> 00:10:48.263 So this is the venture capitalist method in a nutshell. You estimate 00:10:48.263 --> 00:10:54.903 the exit value. You discounted the current value and that gives the post-money valuation. 00:10:54.903 --> 00:10:57.943 You subtract the investment - that gives the pre-money valuation.