Venture Capital and the Finance of Innovation
[Course number]
Chapter 11
DCF Analysis of Growth Companies
Professor [Name
[School Name]
]
PHASES OF GROWTH
Growth vs. Age
70.0%
Revenue Growth Industry Average
60.0%
50.0%
40.0%
75th percentile
30.0%
median
20.0%
25th percentile
10.0%
0.0%
-10.0%
1
2
3
4
5
-20.0%
Years since IPO
6
7
Assumptions for exit-value DCFs
 All-equity structure
 No amortization costs
 No non-operating assets
Leverage of VC-backed companies
Years
Since
IPO
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Mean
4.7%
4.0%
5.7%
6.8%
7.2%
8.1%
8.2%
9.1%
8.7%
10.6%
11.0%
11.8%
12.4%
11.0%
7.7%
11.0%
Median
1.2%
1.9%
2.8%
3.8%
3.9%
4.4%
5.1%
6.0%
5.6%
6.2%
6.0%
6.4%
8.9%
7.8%
4.8%
6.4%
DCF – Mechanics
CF = EBIT(1-t) + depreciation
– Capital expenditures – Δ NWC
where,
CF = cash flow,
EBIT = earnings before interest and taxes,
t = the corporate tax rate, and
Δ NWC = Δ net working capital = Δ net current
assets – Δ net current liabilities.
CF and Investment
NI = capital expenditures + Δ NWC
- depreciation
Investment rate (IR) = Plowback ratio =
revinvestment rate = NI / E
CF = E – NI = E – IR * E = (1 – IR) * E
NPV
NPV of perpetuity = X /(r – g)
Graduation Value = GV = CFS+1 / (r – g)
CFT n
CFS  GV
CFT 1 CFT 2
NPV of firm at exit 

 ... 
 ... 
2
n
1  r (1  r )
(1  r )
(1  r ) S T
Graduation Value
EN+1 = EN + NI * R
g = (EN+1 – EN) / EN = (NI * R) / EN = IR * R
GV = (1 – IR) * E / (r – (IR * R))
GV = ( 1 – g/R) * E / (r – g)
R as a function of NI
Reality-Check DCF

On the exit date:



Revenue is forecast for the average success case;
Other accounting ratios (not valuation ratios) are
estimated using comparable companies or rule-ofthumb estimates.
The discount rate is estimated from industry
averages or comparable companies.
Reality-Check DCF (2)

On the graduation date:





The stable growth rate is equal to expected inflation;
The return on new capital – R(new) – is equal to the
cost-of-capital (r);
The return on old capital – R(old) – is equal to the
industry-average R;
The operating margin is equal to the industry average.
The cost-of-capital (r) is equal to the industry average
cost-of-capital.
Reality-Check DCF (3)

During the rapid-growth period:



The length of the rapid-growth period is between five
and seven years;
Average revenue growth is set to the 75th percentile of
growth for new IPO firms in the same industry, from
data contained in growth worksheet of the DCF
spreadsheet; (NOTE: for public companies, one can
also use analyst estimates here.)
Margins, tax rates, and the cost-of-capital all change in
equal increments across years, so that exit values reach
graduation values in the graduation year.
Example
EBV is considering an investment in Semico, an early-stage
semiconductor company. If Semico can execute on their business plan,
then EBV estimates it would be five years until a successful exit, when
Semico would have about $50M in revenue, 150 employees, a 10 percent
operating margin, a tax rate of 40 percent, and approximately $50M in
capital (= assets). Semico’s business is to design and manufacture analog
and mixed-signal integrated circuits (ICs) for the servers, storage systems,
game consoles, and networking and communications markets. It also plans
to expand into providing customized manufacturing services to customers
that outsource manufacturing but not the design function. It expects to sell
its product predominantly to electronic equipment manufacturers.
Problem
To make the transaction work, EBV believes that the exit value must be at
least $300M. How does this compare with the reality-check DCF? How
much must the baseline assumptions change to justify this valuation?