Business Value
DCF for Exit Valuation
The use of the Venture Capital (VC) method for valuing an organization begins with determining the Exit Valuation, i.e., the value that the organization is expected to have when the fund successfully exits (either through an IPO or a sale to a PE fund).
There are two approaches here: using the multiples method (comparative) or the discounted cash flow (DCF) method (absolute). In this entry, I will discuss the DCF method.
The life of an organization can be divided into three stages:
- Initial stage – the organization is financed externally, by VC funds;
- Rapid growth stage – the organization goes public and grows quickly;
- Stable growth stage – when the metrics align with the industry average.
The DCF method involves assessing the expected cash flows during the 2nd and 3rd stages and determining the organization’s value at the time of the IPO, which represents the Exit Value for the VC fund. Calculations using the VC method start from this figure.
What important factors should be considered when making such long-term assessments using DCF:
Model in General:
First, I’ll begin by saying that the model will not be as complex as the DCF used for valuing publicly traded companies. This is because there is neither sufficient statistical data nor are the details as crucial for providing any rational benefit. The main focus is to ensure that critical parameters are not misjudged.
It should be understood that the two stages after the IPO differ in terms of growth rates and reinvestment needs. The faster the organization grows, the more investment is required, as growth without the necessary assets is impossible (there is a logical connection between assets and sales).
Sales and Margins:
The graph below compares the sales growth dynamics of individual companies after going public with the industry average. In other words, the growth rates of companies have been adjusted by subtracting the industry’s growth rate.
Statistically, “new” companies tend to fall within the industry growth rate range within 5-7 years in terms of growth rates. Moreover, new companies often have lower margins, as there is aggressive competition to expand market share.
Financial Leverage:
As shown in the table below, the crediting of new companies is done in very small amounts during the early years. Therefore, complicating the financial model with leverage has little significance (the proportion of Cost of Debt in WACC will be negligible).
ROI converges to and equals r:
The organization continues rapid growth as long as it can find new positive NPV projects. However, as the scale grows, maintaining growth rates becomes increasingly difficult (due to the challenges of finding good projects proportional to the scale). Consequently, the return on new projects gradually decreases and eventually matches the cost of capital in a state of equilibrium. This is the equilibrium point that the book’s* authors refer to as “zen.”
From this moment onward, growth no longer creates value, and therefore, the model is no longer sensitive to the growth rate. More accurately, it will be sensitive to the extent that the difference between the return on capital (ROI) and the discount rate (r) is planned. The good news is that a reduced growth rate also lowers the need for reinvestment.
Here you can find an Excel model I built adapted from the book’s example:
Source:
*Venture Capital & the Finance of Innovation
by Andrew Metrick & Ayako Yasuda