Venture Capital Financial Modeling

When it comes to venture capital investment, each company is unique. There is no single model that can cover all situations. The good news is that there are certain underlying, well-known concepts and methods that can be brought together into a cohesive model to help automate and improve the decision-making process in analyzing an investment. In Venture Capital Financial Modeling, Praveen Gupta, one of the top modelers in venture capital, attempts to bring these concepts together, explaining and applying them to various financial models used by venture capitalists in evaluation of their investments.

The models analyzed in Venture Capital Financial Modeling provide immeasurable financial benefit to entrepreneurs and venture capitalists and will save both groups countless hours of analysis. Entrepreneurs will be better able to perform a financial analysis on their companies and get a realistic view of possible decisions by venture capitalists. Venture capitalists will be able to perform a similar analysis, resulting in smoother negotiations with educated entrepreneurs.

The subjective approach to venture capital financing is not going away, mainly due to the nature of the business model. However, various financial models enable some coherent quantification of the decision-making parameters and reduce the subjectivity of decisions. Numbers and facts speak the truth, and less subjectivity will lead to a more educated and justified investment decision-making and a smoother negotiation process.

All interactive financial models described in this book - valuation modeling, dilution modeling, investment return analysis modeling, and M&A distribution modeling - are available on the accompanying CD-ROM. These models can be adapted to individual company requirements based on the number of investors and founders by adding or removing appropriate line items.

The table of contents for Venture Capital Financial Modeling includes:

• Chapter 1) Overview - Venture Capital Financial Modeling
• Chapter 2) Valuation Modeling
  • Method 1: Desired Ownership
  • Method 2: Financial Ratios
• Chapter 3) Dilution Modeling
  • Method 1: No Adjustment
  • Method 2: Broad-Based Weighted Average
  • Method 3: Middle-of-the-Road Weighted Average
  • Method 4: Narrow Based Weighted Average
  • Method 5: Full Ratchet
  • Dilution Method Comparison
• Chapter 4) Investment Return Analysis Modeling
  • Initial Public Offering
  • Merger & Acquisition
• Chapter 5) Exit Analysis Modeling
  • Initial Public Offering
  • Merger & Acquisition
• Appendix A - Valuation Model in Excel
  • The spreadsheets provides two general methods to value a private company:
  • 1) Desired Ownership: This scenario is typically applicable to pre-revenue companies. Many VC's have an internal Planning & Strategy of owning certain minimum percentage of a company. Typically, it is 15-20% post funding in early stage companies. Once the investor has made the decision to invest, they have estimated the exit potential and returns for their investment. Accordingly, they have also determined the amount of investment to be made to achieve the desired returns. The investor shall typically use the amount of investment and desired ownership to determine the valuation of a private company in such scenario.
  • 2) Financial Ratios: This scenario may typically be applied to revenue stage companies. First scenario may still be applicable either entirely or partially. A public company is typically valued in multiple ways using various financial ratios. These include Price to Earnings (PE), Price to Sales (PS), Discounted Cash Flow (DCF), Shareholder equity, or a combination of these ratios. Many of these ratios are not directly applicable to a private company due to lack of sufficient history and early revenue growth stage. Price to Sales (PS) and Price to Earnings (PE) are most applicable to such companies. Price to Earnings is generally applicable only in very late stage companies with significant revenue and profitability history. Private company investors use Price to Sales ratio as guide most of the time in valuing a revenue stage company.
• Appendix B - Dilution Model in Excel
  • The dilution model allows you to analyze the dilution impact of a new equity offering as well as other events such as options, warrants, etc. The model contains the following worksheets:
  • Summary - Provides a summary of dilution for various methods
  • Pre-Money Cap-Table - Allows you to enter your current capitalization and information on the new equity offering
  • Following worksheets do not require any input but shows complete computation
    • No Adjustment - No adjustments are made to counter the dilution
    • Full Ratchet - Applies price adjustments based on Full-Ratchet method
    • Narrow - Applies price adjustments based on Narrow based weighted average method
    • Middle of Road - Applies price adjustments based on Middle of the Road based average method
    • Broad - Applies price adjustments based on Broad based weighted method.
• Appendix C - Investment Return Analysis Model in Excel
  • As part of the investment process, venture capitalists will need to evaluate the prospect of return on their investment. Venture capitalists can use this model to perform such evaluation quantitatively. You will need the projected revenues and earnings of the prospect company and Price to Earnings (P/E) and Price to Sales (P/S) multiples for its industry or comparable companies. You will need to make an educated estimate of the probability of the company achieving its projections and also the stability of multiples holding up in the public markets. Such data should be entered in the 'Financial Data' worksheet. At this point, we can evaluate the return potential for three different options"IPO, conversion of preferred to common by all shareholders, and M&A. The first two of these options lead to the same results, since all shares are converted to common in case of an IPO also.
  • Initial Public Offering (IPO) - If all preferred are converted to common upon an M&A based exit, the returns are purely based on total ownership in the company and work similar to an IPO situation. So, for these two options, the most critical item is total ownership in the company on a fully diluted basis. The ownership data should be entered in the 'Return Analysis - IPO' worksheet. Follow the directions of use on this worksheet to determine your potential returns.
  • Merger & Acquisition - The return analysis for Merger and Acquisition scenario is more complex because of liquidation preferences and their seniority order among various preferred series and comparison with common shareholders. Management carve-out also comes into picture quite often in this scenario. For our model, we have left management carve-out and other related expenses out of our analysis. We assume that the valuation range for M&A is the net of such expenses. It is simply a matter of entering appropriate valuation if such expenses have to be accounted for. It is not critical to include these expenses at the time of analyzing a possible investment. The ownership and liquidation preference data should be entered in the 'Return Analysis - M&A' worksheet. Follow the directions of use on this worksheet to determine your potential returns.
• Appendix D - M&A & IPO Exit Analysis Distribution Model in Excel
  • An exit analysis has to take into account various data points and integrate them to come up with the answers. The ultimate goal of a company would be to determine the distribution to various shareholders or a particular shareholder. This also allows sensitivity analysis based on various valuation or market cap scenarios for the purpose of decision making in accepting certain deals or determining the best liquidity route for the company and its shareholders. The models focus on integrating various costs of a liquidity event and determining distribution to each shareholder. It can be used either as a decision-making tool or computing distributions after the liquidity event has taken place. We consider an IPO and an M&A event separately as these two require very different approaches for exit analysis.
  • IPO Based Exit Analysis - To analyze an exit based upon an IPO, the shareholder simply liquidates their shares when the lockout period expires. The returns are based on the market price per share and total shares owned at the time of liquidation. Depending on the IPO terms, the shares may be liquidated in parts at different times starting with the day of the IPO itself. The computation of return is very simple. You will simply multiply your shares with the price per share in the public market and subtract cost of trade to get the total value of your holding. If you can estimate the timing of liquidating your holding and estimate prices, you can have a good idea of projected returns post-IPO. You can compute your IRR using a standard Excel spreadsheet function or business calculator once you have an idea of your cash flow stream starting with the day of your investment.
  • M&A Based Exit Analysis - Analyzing an exit based upon an M&A can get complicated. Each M&A is structured very differently. Some of the M&A methods include acquirer's stock based, total cash based, hybrid, or split payment based M&A, etc. Regardless of deal structure, the exit analysis takes into account the overall value of the transaction less the costs of transaction to compute distribution for various shareholders. Our model ignores the type of currency, i.e., cash or stock, and uses the actual dollar value of the transaction. As an additional complexity, the acquirer will require a certain percentage of total proceeds to be set-aside in escrow to deal with any unforeseen expenses within a specified period after the deal closes. The acquirer may also split the transaction into multiple payments tied to the performance of the acquired company. In this scenario, there will be an initial payment for the transaction. Subsequently, at one or more milestones, additional payments, referred to as earn-out payments, will be due based upon a certain formula agreed by both parties at the time of the M&A transaction.
• About the Author:
  • Mr. Gupta is an accomplished venture capitalist focused on investments in early to late stage IT companies. He has served as a Board Member/Observer at various venture-backed companies during his career with CDIB Ventures. He is a mentor to entrepreneurs and is very actively involved in his portfolio companies. Prior to his VC career, Mr. Gupta has diversified operating experience in technology and service companies in multiple industries. He has successfully planned and launched multiple new products into the global market by bringing various business functions to work together. Mr. Gupta completed his Executive M.B.A from Golden Gate University, MSCS from University of Texas, MSEE from IIS, Bangalore (India), M.Sc. (Physics) from IIT, Roorkee (India).