The Venture Capital Method

This method is appropriate for investments in a accompany with negative cash flows at the time of the investment, but which in a number of years is projected to generate significant earnings. 


Venture capitalists are the most likely professional investors to partake in this type of investment, thus the reference to the venture capital method.

STEPS INVOLVED IN THIS METHOD:

1.       Estimate the company’s net income in a number of years, at which time the investor plans on harvesting. This estimate will be based on sales and margin projections presented by the entrepreneur in his or her business plan.

2.       Determine the appropriate price-to-earnings ratio, or P/E ratio. The appropriate ratio can be determined by studying current multiples for companies with similar economic characteristics.

3.       Calculate the projected terminal value by multiplying the net income and the P/E ratio.

4.       The terminal value can then be discounted to find present value of the investment. Venture capitalists used discount rates ranging from 35 percent to 80 percent, because of the risk involved in these type of investments.

5.       To determine the investor’s required percentage of ownership, based on their initial investment, the initial investment is divided by the estimated present value.

SUMMARY OF THE STEPS:

Final ownership  = Required future value (investment)

     Required        _____________________________

                                     Total terminal value

                                        

            (1 + IRR)years (investment)

                               

                  =    ---------------------------------------------

                            P/E ratio (terminal net income)

6.       Finally, the number of shares and the share price must be calculated by using the following formula:

   Percentage of ownership

    Required by the investor

New shares = -----------------------------------------------

                            1 – Percentage ownership required

by the investor  x old shares

This method commonly used by venture capitalists because the make equity investments in industries often requiring a large initial investment with significant projected revenues; in addition, the percentage of ownership is a key issue in the negotiations.