Demystifying Private Equity Valuation

Valuation - Valuation of Private Equity assets and funds are one of the most complex matter bewildering professionals and students alike. After over 17 years in the industry and as a PhD Researcher, I noticed that valuation of PE assets can be simplified if we break down the vast topics in chunks and start from the fundamentals. Here is my attempt of demystify the topic.

Traditionally, companies assign value to enterprises as a result of financing event. Generally, the approach is based on a per-share value and valuation on a fully diluted basis.

1.????Pre-money Value – This is the valuation of company just before the injection of funds or rather capital. A company’s pre-money valuation, or PMV, is its estimated value immediately prior to accepting funding. Every time entrepreneurs seek to sell ownership in their company in exchange for financing, they must figure out PMV. It determines how much ownership existing shareholders or members will give investors in exchange for financing.

Say you want to raise $1 million in financing. If you place a PMV of $1 million on your startup, then investors would receive 50 percent ownership and the company would forgo 50 percent. If the PMV was instead $3 million but you still only needed to raise $1 million, investors would only receive 25 percent ownership in the company and existing shareholders would give up only 25 percent.?

2.????Post Money Value – is the valuation of a company including the capital provided by the current round of financing:

Step-ups describe the increase in share price from one financing round to the next. They also describe the increase in the value of the company since the last round of financing. Step-ups help motivate all the shareholders (both management and investors) to remain engaged in the enterprise’s effort to build value. Note that if options have been issued between financings, each of the two methods of calculating the step up will give different results. The method using share price is the one generally cited

3.????Common Stock Valuation - What are the implications to the VCs if they agree to accept common stock? In the absence of restrictive covenants or a vesting period for the founders, the founders maintain a controlling stake and are free to sell the company under terms of their choosing.

4.????Preferred Stock – This method would provide a downside protection due to its negotiated rights and allows investors to profit from share appreciation through conversion. The face value of preferred stock is generally equal to the amount that the VC invested. For valuation purposes, convertible stock is usually regarded as a common stock equivalent.

Typically, convertible preferred stock automatically converts to common stock if the company makes an initial public offering (IPO). When an investment banking underwriter is preparing a company to go public, it is critical that all preferred investors agree to convert so the underwriter can show public investors that the company has a clean balance sheet. Convertible preferred is the most common tool for private equity funds to invest in companies. Lets see in Excel.

5.????Participating Preferred stock – Lets see the excel

6.????Multiple Liquidation Pref – lets see excel

7.????Full Rachet

8.????Weighted average -?Weighted average provisions are generally viewed as being less harsh than full ratchets. In general, the weighted average method adjusts the investor’s conversion price downward based on the number of shares in the new (dilutive) issue. If relatively few new shares are issued, then the conversion price will not drop too much and common stockholders will not be crammed down as severely as with a full ratchet. If there are many new shares and the new issue is highly dilutive to earlier investors, however, then the conversion price will drop more. The actual mathematical equation used may vary from deal to deal, but a common form is as follows:

New conversion price = (A+B) / (A+C) * old conversion price,

where A = number of shares outstanding before the dilutive issue

B = number of shares that would have been issued at the old conversion price for the investment in the dilutive round

?C = number of shares actually issued in the dilutive round

The weighted average protection may be broad-based, taking into account all shares outstanding before the new dilutive issue (A is calculated on a fully-diluted basis), or narrow based, where A may take into account only preferred stock or omit options outstanding.