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Adjusted Present Value Analysis

Do venture capitalists actually use the adjusted present value ("APV") analysis, discussed more generally in our section on valuation, when evaluating investments? Not necessarily. In fact, relatively little of a VC's time is spent on valuation, since valuing companies with limited financial histories is more of an art than a science. However, the APV analysis is useful in illustrating, from a more theoretical/academic standpoint, how VCs and entrepreneurs approach valuation of a company differently. In practice, intangibles like the quality of the management team and soundness of the business plan play important and unquantifiable roles in VC valuation.

The "pre-money" value of a business is the theoretical valuation before investment by the venture capitalist ("VC"). Accordingly, the "post-money" value is the theoretical valuation after investment by the VC. Therefore,

Post-Money Valuation - Investment = Pre-Money Valuation

Entrepreneurs want to maximize their pre-money valuation, making investment as small as possible to meet their funding needs while maximizing their ownership percentage. This can be accomplished by doing multiple rounds of financing or staging a single round. That is, entrepreneurs get VC money only when they need it, or when they achieve certain goals or milestones set by the VC in the term sheet. If the money flows into the company in stages from a single round, theoretically the time value of money is taken into account, making the PV pf the pre-money valuation larger (and the required investment smaller) than if the investment was made all at once.

VCs, on the other hand, want to minimize the pre-money valuation of the company. They do this by assuming that they are exposed for the total value of the round, even though the actual flow of investment funds may be staged. However, VCs do not take into account the time value of money in the investment. Instead, they consider themselves committed for the total required investment at time t=0. This makes the pre-money valuation smaller than if the investment was given on an as-needed basis as the entrepreneurs want.

It is important to understand how both parties value the company because such understanding may help explain why valuations performed by each party differ.

Exhibit – APV Valuation

In the spreadsheet below, we first show how the entrepreneur performs the pre-money valuation. The negative cash flows in Years 0 and 1 (colored red) are "holes" that need to be plugged with venture capital. These negative FCFs indicate that funding will occur in the future to offset negative cash flows, making the resulting sum of the cash flows' present values a pre-money valuation. Accordingly, the entrepreneur discounts the negative cash flow in Year 1 to account for the time value of money, thereby "maximizing" the pre-money valuation.

Next, we show how the VC calculates the pre-money value of the company. Because the VC considers itself committed for the entire investment in Year 0, the VC does not discount the negative cash flow in Year 1. The absence of negative present values of free cash flows in Years 0 and 1 reflects the full investment in Year 0. Therefore, the value at time t=0 is a post-money valuation.

You should note that the post-money valuations are the same under both methods, but the pre-money valuations differ because of the entrepreneur's and VC's different perspectives on the timing of investment in the company.

Conclusion

Entrepreneurs often calculate the pre-money value first, then add the present value of the investment to yield the post-money valuation. VC's do the opposite; they first find the post-money value by zeroing out the cash flows (i.e. plugging the "holes"), then subtract the whole investment at time t=0 to yield a minimized pre-money valuation. Don't stop reading here. Our next section shows how the APV analysis is adjusted to account for the probability that the company will succeed.

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