Private Equity Investment.

Private equity investments are a crucial part of the financial landscape, providing capital to companies at various stages of their lifecycle. This discussion focuses on the valuation of these investments in different scenarios, including venture capital, growth equity, and buyout situations. The valuation methods used can vary depending on the stability and maturity of the company, as well as the specific circumstances of the investment.

Valuation of Stable, Mature Private and Public Companies

Both private and public companies that are stable and mature can be valued using similar methods. One such method is the income-based approach. This approach involves discounting the expected free cash flow to both debt and equity holders, also known as the free cash flow to the firm (FCFF). For instance, a mature company like Microsoft can be valued using this approach.

The income-based approach uses the following formula to calculate the FCFF:

$$ \begin{align*} FCFF & = EBITDA(1-t) + \text{(Depreciation)}(t) \\ & – \text{Change in Long-Term Assets} \\ & – \text{Change in Capital} \end{align*} $$

Where:

• EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization
• t is the firm’s tax rate
• Depreciation (t) is the tax shield from depreciation
• Change in Long-Term Assets represents the investments in long-term assets
• Change in Capital represents the change in net working capital

Cash flows are projected over several periods. After these periods, a terminal value or exit value is assumed. This value is typically based on either constant growth or an expected market multiple. For example, a company like Amazon with a high growth rate might have a high terminal value.

Life Cycle Implications for Company Valuation

The life cycle stage of a company can have implications for its valuation. Different approaches may be used for different forms of private equity, such as venture capital, growth equity, buyout, and special situations. For instance, a startup in the venture capital stage might be valued differently than a mature company in a buyout situation.

Valuation Approaches for Special Situations

Special situations involving stressed, distressed, or event-driven investments require distinct valuation approaches. These will be covered in detail in a later reading. For example, a company facing bankruptcy might require a different valuation approach than a company undergoing a merger or acquisition.

Venture Capital and the VC Method

Venture Capital investors navigate the challenges of evaluating startups with uncertain futures, limited operational histories, and high failure rates. Traditional valuation metrics—like income, market, and asset-based approaches—fall short for these early-stage companies. The Venture Capital (VC) method, therefore, becomes a critical tool in establishing the current value of a young company alongside new financing.

• Pre-money Valuation: This is the valuation of the company before the addition of new equity from the latest round of funding. It is derived from the expected terminal value of the company, factoring in the required Return on Investment (ROI) by the venture capitalists.
  $$ \text{Pre-Money Valuation} = \text{Post-money Valuation} – \text{New Equity} $$
• Post-money Valuation: This reflects the company’s valuation after incorporating the new equity investment. It is a function of the expected exit value of the company’s equity, divided by the required ROI.
  $$ \text{Post-Money Valuation} = \frac{\text{Exit Value of Equity}}{\text{ROI}} $$
• ROI: The VC-required rate of return on investment, communicated to the limited partners of the fund, reflects the effective cost of capital to the VC. Typical ROIs range from 10x to 30x over a period of five to eight years.
  $$ \text{ROI} = (1+ \text{IRR})^n $$
• Fractional Ownership: Determined by dividing the new equity investment by the post-money valuation, it represents the percentage of the company owned by new investors after the funding round.
  $$ \text{Fractional Ownership} = \frac{\text{New Equity}}{\text{Post-Money Valuation}} $$
• Valuation and ownership can also be calculated in terms of shares, providing another perspective on the financial implications of new investments.
• Post-Money Valuation in terms of shares: $$ \begin{align*} \text{Post-Money Valuation} & = \text{Total Shares Outstanding (Old and New)} \\ & \times \text{Share Price} \end{align*} $$
• Fractional Ownership in terms of shares: $$ \text{Fractional Ownership} = \frac{\text{New Shares Issued}}{\text{Post-Money Shares Outstanding}} $$

Example: HealTech Innovations Series A Financing

HealTech Innovations, a burgeoning startup in the telehealth sector, recently introduced an advanced platform for remote patient monitoring systems. Anticipating rapid endorsement from healthcare regulators, HealTech Innovations projects it will reach USD 100 million in yearly revenue within seven years following its Series A funding round. The prevailing market price-to-sales ratio for telehealth services is estimated at 4x.

Initially, HealTech Innovations secured USD 4 million through seed funding, distributing 1.5 million shares in the process. In its Series A funding round, the company succeeded in raising USD 3 million in common equity, receiving USD 1.5 million from both NovaHealth Ventures and TechMed Partners. With the launch of its advanced remote patient monitoring system, HealTech Innovations envisions a company valuation of USD 400 million at the end of the seven-year period. Investors NovaHealth Ventures and TechMed Partners are aiming for a return on investment (ROI) of 25x over this seven-year investment horizon.

Calculation of Post-Money Valuation for HealTech Innovations

The post-money valuation of a company is crucial for investors and the company itself as it reflects the company’s worth after new funds have been injected during a financing round. Here, we will calculate the post-money valuation of HealTech Innovations.

• Exit Value of Equity: USD 400,000,000
• Required ROI: 25x

To find the post-money valuation for HealTech Innovations, we substitute the given values into the formula:

$$ \text{Post-Money Valuation} = \frac{400,000,000}{25} $$

Performing the calculation provides:

$$ \text{Post-Money Valuation} = 16,000,000 $$

Calculation of IRR

Determining if the HealTech Series A financing meets the strategic goal of TechMed Partners’ CEO for targeting venture capital (VC) investments with at least a 40% internal rate of return (IRR).

• ROI Target for HealTech Series A Financing: 25x
• Investment Period: 7 years
• TechMed Partners’ IRR Objective: \(\ge\) 40%

To calculate the IRR based on the given ROI, we use the formula:

$$ \text{ROI} =(1 + \text{IRR})^n \rightarrow \text{IRR} = \left(\text{ROI}^{\frac{1}{n}}\right) – 1 $$

Substituting the given values into the formula:

$$ \text{IRR} = (25^{\frac{1}{7}}) – 1 \approx 58.38\% $$

The calculated IRR for the HealTech Series A financing is approximately 58.38%, which significantly exceeds TechMed Partners’ CEO’s objective of achieving at least a 40% IRR on venture capital investments. This investment aligns well with TechMed Partners’ strategic goals, indicating a highly favorable investment opportunity within the medical device sector.

Calculation of Pre-Money Valuation

• Pre-Money Valuation: This is the valuation of HealTech before the Series A financing. It is calculated as the difference between the post-money valuation and the Series A financing amount.

  $$ \begin{align*} \text{Pre-Money Valuation} & = \text{Post-Money Valuation} \\ & – \text{Series A Financing Amount} \\
  \text{Pre-Money Valuation} & = \text{USD } 16,000,000 – \text{USD } 3,000,000 \\ & = \text{USD }13,000,000 \end{align*} $$

• Value to Initial Investors: This value reflects the total worth of HealTech to its initial investors after the Series A financing. It is calculated by adding the seed financing amount to the pre-money valuation.

  $$ \begin{align*} \text{Value to Initial Investors} & = \text{Pre-Money Valuation} \\ & + \text{Seed Financing Amount} \\
  \text{Value to Initial Investors} & = \text{USD }13,000,000 + \text{USD } 4,000,000 \\ & = \text{USD }17,000,000 \end{align*} $$

• Price Per Share Before Series A: This is calculated by dividing the pre-money valuation by the total number of shares issued before the Series A financing.

  $$ \begin{align*} \text{Price Per Share Before Series A} & = \frac {\text{Pre-Money Valuation}}{\text{Total Shares Issued Before Series A}} \\
  \text{Price Per Share Before Series A} & =\frac { \text{USD } 13,000,000 }{ 1,500,000 \text{ shares}} = \text{USD }8.67 \end{align*} $$

Calculating NovaHealth Ventures’ Ownership in HealTech

• Post-Money Valuation at Series A: USD 16,000,000
• Investment by NovaHealth Ventures: USD 1,500,000

$$ \begin{align*} \text{Fractional Ownership} & = \frac{\text{Investment by NovaHealth Ventures}}{\text{Post-Money Valuation}} \\
\text{Fractional Ownership} &= \frac{ {\text{USD } 1,500,000}}{{\text{USD } 16,000,000}} = 9.375\% \end{align*} $$

Considerations in the VC Method

• The path to revenue and profitability for most startups is highly uncertain, making it crucial to use performance metrics like the method of comparables to gauge potential success at the end of the investment horizon.
• Due to the high uncertainty associated with future revenue and the variability of sales-based multiples over time, estimating a range of potential scenarios for exit value is an important aspect of the VC valuation method.

Potential for Equity Dilution

The Venture Capital (VC) method assumes no equity dilution takes place over the remaining investment time horizon once the Series A financing is complete. However, the potential for equity dilution arises from three primary sources:

• Incentive-Based Equity Compensation: Startup firms often offer employees equity options to attract, retain, and incentivize them. These options grant the right to purchase common shares at a fixed price in the future. As option exercises increase shares outstanding, VC firms typically calculate ownership and per-share price on a fully diluted basis.
• Follow-on Equity Financing: New common equity issuance in a subsequent financing round, as well as mergers and acquisitions where shares are used instead of cash, increase the number of shares outstanding. This reduces the fractional ownership of earlier investors.
• Financing with Contingent Future Share Issuance: Use of instruments such as convertible preferred shares may result in additional share issuance if converted. This dilution must be taken into consideration when determining fractional ownership for new investors.

Tracking Cumulative Fractional Ownership and Share Price Evolution in Venture Capital

For early-stage companies undergoing multiple rounds of equity financing, it is crucial to monitor the evolving ownership structure. This includes calculating the post-financing fractional ownership of a private equity fund or investor, which considers both previous stakes and new investments.

The post-financing fractional ownership is calculated as follows:

$$FO_\text{post} = FO_\text{prior} \times \left(\frac{\text{Pre-Money Valuation}}{\text{Post-Money Valuation}}\right) + \left(\frac{\text{New Investor Equity}}{\text{Post-
Money Valuation}} \right) $$

• \(FO_\text{post}\) is the post-financing fractional ownership.
• \(FO_\text{prior}\) is the prior cumulative stake.
• Pre-Money Valuation is the valuation of the company before the new investment.
• New Investor Equity is the equity acquired by the new investor.
• Post-Money Valuation is the valuation of the company after the new investment.

The step-up in share price from one financing round to the next is determined by the following:

$$ \begin{align*} \text{Step-Up (multiple)} & = \frac{\text{New Round Share Price}}{\text{Prior Round Share Price}} \\
\text{Step-Up (percentage)} & = \left(\frac{\text{New Round Share Price}}{\text{Prior Round Share Price}} – 1 \right) \times 100 \end{align*} $$

• New Round Share Price is the share price in the new financing round.
• Prior Round Share Price is the share price in the previous financing round.

An increase in share price across funding rounds signals a company’s progress towards its growth objectives. Conversely, a decrease, or “down round,” may reflect challenges in performance or a negative shift in market conditions. To safeguard against dilution in such events, investors may negotiate “ratchet” provisions. These adjust the conversion price of previously issued securities to match the lower price of new shares, protecting the investor’s value.

Valuation in Growth Equity

The valuation of growth equity focuses on scaling developed, profitable, or near-profitable companies with established products and market opportunities, contrasting with the high-risk, high-reward nature of startup valuation. Unlike startups, growth equity targets companies at a more advanced stage, where proof of concept, product-market fit, and capital needs are already defined.

In growth equity, the pre-money valuation includes not just the expected exit value of equity and ROI, but also incorporates detailed revenue and profit projections over the investment horizon. This approach is more granular and tailored to the specific growth strategy of the company, reflecting both the necessary initial capital and the desired financial outcomes.

Growth equity investments aim for minimal capital injection at the lowest possible pre-money valuation, with an emphasis on executing a growth strategy to sell at a maximized valuation. The key risk involves achieving the projected growth within the set timeframe.

While sharing some methodologies with the Venture Capital (VC) method, growth equity distinguishes itself through larger investment sizes, a focus on earnings growth over broad revenue projections, and a preference for earnings-based multiples for exit valuation. Convertible preferred shares are a common investment vehicle in growth equity, accommodating potential dilution from employee options and other factors.

Use of the LBO Model to Establish Buyout Firm Value

The Leveraged Buyout (LBO) model is a valuation approach used by buyout investors to evaluate the attractiveness of acquisition targets. It is used to establish the maximum price that can be paid to a seller while satisfying the targeted returns of financing providers. The LBO model uses parameters such as cash flow projections, capital structure composition, and cost involved in generating a sufficient return for equity investors.

Value Creation in LBO Transaction

The value creation of an LBO transaction typically involves three elements:

• EBITDA Expansion: Increasing profitability over the investment period is an important element of value creation. In a buyout scenario, this is usually the result of increased efficiency or realizing synergies.
• Debt Reduction: As the company generates improved cash flows consistent with the EBITDA expansion projections, this cash flow should be projected to reduce financial leverage over the investment period, reducing the risk to equity investors.
• Multiple Expansion: As the acquired company transforms from an undervalued target to a more profitable firm with declining leverage, its market multiple is expected to rise as future prospects improve. This form of value creation is typically validated using a method of comparables analysis of a peer group of comparable publicly traded companies.

IRR Determination

The determination of LBO model inputs is complex due to the target company’s mature stage in the life cycle, the use of financial statement analysis to determine the entry and exit value of equity, and the complicating factor of changes in financial leverage. However, all three forms of private equity investments take a similar approach in determining the internal rate of return to investors.

Valuation of Buyout Equity

Income statement and balance sheet forecasts are used to show the expected impact of restructuring plan as well as cash flow available from increases in expected profit due to margin expansion and use of cash to reduce debt burden over the investment horizon. The financing structure includes multiple debt tranches and common and preferred shares; it also incorporates the potential dilution from stock options used to incentivize new management.

Scenario Analysis

Investors usually assess potential deals under varying assumptions of potential revenue growth, cost improvements, paydown of debt, and margin expansion to identify the key risks affecting an investment’s exit value. Scenario analyses often include sensitivity tables showing investment return given deviations from key base case assumptions. Specific downside scenarios that may result in lower returns or the loss of capital may be worth considering in detail.

Role of Private Equity Strategies

Private equity strategies across venture capital, growth equity, and buyout situations often play a critical role outside of the public capital markets for startups launching a business, young firms pursuing rapid growth, or mature companies reaching their potential following a period of transformation. Although the general valuation principles of these strategies across the investment life cycle have similarities, they require different levels of industry and technical knowledge, financial analysis, and detailed financial modeling and analysis.

Practice Questions

Question 1: A financial analyst is tasked with valuing a stable, mature company. The analyst decides to use the income-based approach, which involves calculating the Free Cash Flow to the Firm (FCFF). The FCFF is calculated using a formula that includes several variables such as EBITDA, the firm’s tax rate, and changes in long-term assets and capital. The analyst also considers the company’s life cycle stage and any special situations that may require distinct valuation approaches. Based on this information, which of the following is NOT a component of the FCFF calculation in the income-based approach to company valuation?

1. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
2. The firm’s interest rate
3. Change in Long-Term Assets

Answer: Choice B is correct.

The firm’s interest rate is not a component of the Free Cash Flow to the Firm (FCFF) calculation in the income-based approach to company valuation. The FCFF is a measure of a company’s financial performance and represents the cash that a company is able to generate after accounting for the money required to maintain or expand its asset base. It is calculated using several variables, including Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), the firm’s tax rate, and changes in long-term assets and capital. However, the firm’s interest rate is not included in this calculation. The interest rate is used in the cost of capital or discount rate, which is used to discount the future cash flows to their present value, but it is not a component of the cash flows themselves. Therefore, the firm’s interest rate is not a component of the FCFF calculation.

Choice A is incorrect. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a component of the FCFF calculation. It is a measure of a company’s operating performance and is used to calculate the FCFF because it excludes non-cash expenses such as depreciation and amortization, which do not affect the cash flow.

Choice C is incorrect. Change in Long-Term Assets is a component of the FCFF calculation. It represents the change in the company’s investment in long-term assets, which affects the cash flow. If a company invests in long-term assets, it uses cash, which reduces the FCFF, and vice versa.

Question 2: A financial analyst is valuing a mature, stable company using the income-based approach. This approach involves calculating the Free Cash Flow to the Firm (FCFF) and projecting cash flows over several periods. After these periods, a terminal or exit value is assumed. This value is typically based on either constant growth or an expected market multiple. Considering the life cycle stage of a company and any special situations, which of the following is NOT typically used to determine the terminal or exit value in the income-based approach to company valuation?

1. Constant growth
2. Expected market multiple
3. Current market interest rate

Answer: Choice C is correct.

The current market interest rate is not typically used to determine the terminal or exit value in the income-based approach to company valuation. The income-based approach, also known as the discounted cash flow (DCF) approach, values a company based on the present value of its projected future cash flows. The terminal or exit value represents the present value of all future cash flows beyond the projection period. This value is typically determined using either a constant growth model or an expected market multiple. The constant growth model assumes that the company’s cash flows will grow at a constant rate indefinitely, while the expected market multiple approach values the company based on a multiple of its earnings or cash flows, which is derived from the market values of comparable companies. The current market interest rate is used in the discounting process to calculate the present value of future cash flows, but it is not used to determine the terminal or exit value itself.

Choice A is incorrect. Constant growth is indeed used to determine the terminal or exit value in the income-based approach to company valuation. It is one of the most common methods used, especially for mature, stable companies that are expected to grow at a steady rate indefinitely.

Choice B is incorrect. The expected market multiple is also used to determine the terminal or exit value in the income-based approach to company valuation. This method is often used when there are comparable companies in the market whose multiples can be used as a benchmark.

Glossary

• Private Equity: A type of investment that involves buying shares in private companies or buying out public companies to make them private.
• Venture Capital: A type of private equity investment that is made in startups or young, high-potential companies.
• Growth Equity: A type of private equity investment that is made in more mature companies that are looking to expand or restructure operations, enter new markets, or finance a significant acquisition without a change of control of the business.
• Buyout: A type of private equity investment where a company is bought by a private equity firm and made private.
• EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. A measure of a company’s operating performance.
• FCFF: Free Cash Flow to the Firm. A measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures.
• LBO: Leveraged Buyout. A strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of financial leverage.

Private Markets Pathway Volume 1: Learning Module 3: Private Equity; LOS 3(d): Estimation and Interpretation of Key Inputs and Calculation of the Value of a Private Equity Investment for Venture Capital, Growth Equity, and Buyout Situations