After explaining the different sources of start-up capital and some key terms, the consultant stated that the next step should be to determine AFC's value. He believed that this value would be very important in ranking different financing proposals. Five
After explaining the different sources of start-up capital and some key terms, the consultant stated that the next step should be to determine AFC's value. He believed that this value would be very important in ranking different financing proposals. Five common methods are used to value the equity position in start-up firms:
Discounted Cash Flow Approach. The discounted cash flow approach to valuation recognizes that the value of a business is a function of the timing, riskiness, and amounts of cash flow that a business generates. The method entails a three-step process. First, historical financial data and current trends are used to forecast a venture's future cash flows to equity holders. In a start-up situation, the forecasting of cash flows is complicated by a lack of historical data. Therefore, good judgment and market research is very important. Second, a discount rate based on the riskiness of the cash flows is determined. Third, the present value of the cash flows is calculated to arrive at the equity value. The discounted cash flow approach is the most comprehensive valuation technique.
Liquidation Value. This method is based on the assumption that the business ceases operations and is liquidated. Any residual funds after all liabilities are satisfied belong to the equity holders. The liquidation value of a business is calculated by first summing the estimated net selling prices that would be realized if each asset were sold individually. Then subtract from this sum all existing liabilities to arrive at the liquidation value of a business. Included in liabilities are costs associated with liquidation such as severance pay for terminated employees. The liquidation value method establishes the minimum worth of a business's equity. Additionally, lending institutions sometimes use the liquidation value of an individual asset to determine the amount that can be loaned using that asset as collateral. Adjusted Tangible Book Value. This valuation method starts with the latest balance sheet. The book value of these account balances are adjusted upwards or downwards in order to arrive at their fair market values. The adjustments could be for items such as land appreciation, uncollectible accounts receivable, and obsolete inventories. Additionally, intangible assets like patents or goodwill and other assets or liabilities that are not on the books must be added. Once the adjusted book values have been established, total liabilities are subtracted from total assets to arrive at the business’s adjusted tangible book value. This method is similar to the liquidation value method except that fair market values are determined within the context of a continuing business.
Multiple of Earnings Method. To use this approach you first determine a company's projected average annual earnings. If historical income statements are available and it is believed that the past will be indicative of the future, then use the average earnings for a two to five year period as the company's projected annual earnings. Next, find the price-to-earnings ratios (P/E ratios) of public companies and recently sold private companies that are in the same industry and are similar in size to the firm being valued. Based on comparisons of the company being valued and the public companies, judgment is used to establish the P/E ratio to apply to the company's earnings. For example, suppose a company averaged $200,000 in net income for the last three years and a P/E of 5 was deemed appropriate. The value of the company's equity would be 5($200,000) =$1,000,000.
Replacement Value. This method requires a computation of the total cost that would be incurred if a business were to be reconstructed from scratch. The cost includes items like construction of buildings and purchases of equipment and land, marketing and advertising expenses associated with building a customer base, capital costs, and the development of necessary technical and industry expertise. This method is most often used to value firms with unique features and by insurance companies to determine potential liabilities and policy premiums. The firm's liabilities could be subtracted from the total replacement value to obtain the value of the equity. Combination of Methods. It is common practice to use more than one valuation method to value accompany. Several methods, which best fit a specific company, are chosen for the valuation process. The values derived from the application of these different methods are weighed to conclude upon a final value. Additionally, there are times when it is appropriate to segregate the assets or operations of a company into classifications. An appropriate valuation technique is then applied to each classification. For instance, a manufacturing company may have invested excess cash in unimproved real estate. In this situation, a potential buyer may decide to value the manufacturing operation using the multiple of earnings approach and the land at its liquidation value. A meeting is scheduled next week to finalize AFC's financing arrangements. Dr. Aplin, AFC's consultant, and several bank commercial loan officers and venture capital fund representatives are expected to attend. In preparation for the meeting you must provide an analysis based on the assumption that a bank may offer to loan $20 million of the $55 million financing requirement, and the after-tax cash outflows to service the bank debt are $5, $5, $5, $5, and $10million in Years 1 through 5, respectively. Based on the riskiness of the new business you believe a 30 percent discount rate is appropriate. Your research has indicated that stock of publicly traded firms with somewhat similar technologies sells at an average of eight times earnings. In addition Tables 1 and 2 have been extracted from the business plan.
- What type of financing might you be interested in providing to AFC?