Expexted rates of return

It is the expected returns combined with the valuation of the company that determine the price per share a venture capitalist will be willing to pay to buy equity in the company. Since venture capital is invested in growing companies, the venture capital firm wants to know what the value of the company is likely to be at some future  time when it can sell its investment and realize a capital gain. It estimates the valuation of the company at some future date then discounts it back to its present value.

Here is a simplified Illustration of the most commonly used method. A one­year-old company is seeking $4 million of start-up financing. Its projections show that it will have earnings (net income) of $ 10 million five years in the future. The venture capital firm believes that the company can have an IPO or an other EXIT in five years and the price to earnings (p/e) ratio will be 20. Thus, the future total valuation of the company will be $200 million (20 x $10 million)

The venture capital firm wants a 60 per cent rate of return; so the present value of the company is $19.07 million [$200,000,000/(1.6)⁵].

Hence, for an investment of $4 million,the venture capital firm need 21 ^'per cent [($4/$19.08)*100] of the company's equity to achieve a 60 per cent return.

There are huge uncertainties in that computation: the earnings are only projections; even if the company achieves its projections five years hence, it might not be able to go public or other EXIT if the market is in a slump; and who is wise enough to foresee what the p/e ratio will be five years in the future?

This ►Table shows._,how the percentage ownership required to yield ä_, 60 per cent return one a 4 million investment varies wich the future valuation of the company  and the holding period. It contains some simple messages for entrepreneurs seeking venture capital.

First, they should think big enough when making their projections because the greater the future valuation 'of the company, the less equity they will have to seil to raise their venture capital.

Second, they should propose an early public offering, because the shorter the  expected holding period for the investment, the less equity they will need to seil.

Third, they should grow their companies as big as possible before raising venture capital, because the longer they wait, the lower the required rate of return and the shorter the holding time to-harvest the investment. In this example, if the company were a first-stage instead of a starr-up-investment, the required rate of return would be 50 per cent instead of 60 per cent, and it might be ready to go public in four years instead of five. Hence, the company would need to sell only 10 per cent of its equity instead of 21 per cent.

Target annual returns that can go as high as 80 per cent seem to be outra­geously exorbitant to neophyte entrepreneurs. But they have to keep in mind that returns from good investments have to compensate for losses on bad ones. In a successful venture capital portfolio, out of every ten investments, two will make or exceed the target rate of return, two will be total write-offs and the remaining six will range from the'Iiving dead' where the companies never get big enough for a significant harvest to the ´walking wounded' that need refinancing if they are to have a chance of making it.