LOS c: Contrast and describe the valuation characteristics and issues in venture capital vs. buyout.

Q1. A private equity investor is considering making an investment in a venture capital firm. The investor values the firm at $1.5 million following a $300,000 capital investment by the investor. The venture capital firm’s pre-money (PRE) valuation and the investor’s proportional ownership, respectively, are:

               PRE valuation   Ownership proportion

A)       $1.5 million                25%

B)       $1.5 million                20%

C)      $1.2 million                  20%

Q2. A private equity firm is considering the valuation characteristics of both a venture capital and a buyout investment. Increasing working capital requirements and stable EBITDA growth is most likely associated with:

         Increasing working capital        Stable EBITDA growth

A)          Buyout                                 enture capital

B)      Venture capital                              Buyout

C)          Buyout                                     Buyout

Q3. The most appropriate pairing for valuing a buyout and a venture capital investment, respectively, is:

                         Buyout                                  Venture capital

A)    Relative value approach       Discounted cash flow

B)    Pre-money valuation           Relative value approach

C)    Discounted cash flow          Pre-money valuation

Q4. Analysts Jordan Green and Noelle Lafonte are discussing terminal value estimation in venture capital and buyout investments.

Lafonte states: “Private equity firms often use scenario analysis in both venture capital and buyout investments to estimate terminal value.”

Green adds: “Private equity firms only use the multiple of net income approach in leveraged buyout (LBO), but not in venture capital investments to estimate terminal value.”

With respect to their statements:

A)   Lafonte is correct but Green is incorrect.

B)   Green is correct but Lafonte is incorrect.

C)   Neither Lafonte nor Green is incorrect.

LOS c: Contrast and describe the valuation characteristics and issues in venture capital vs. buyout. fficeffice" />

Q1. A private equity investor is considering making an investment in a venture capital firm. The investor values the firm at $1.5 million following a $300,000 capital investment by the investor. The venture capital firm’s pre-money (PRE) valuation and the investor’s proportional ownership, respectively, are:

               PRE valuation   Ownership proportion

A)       $1.5 million                25%

B)       $1.5 million                20%

C)      $1.2 million                  20%

Correct answer is C)

The pre-money valuation (PRE) is simply the venture capital firm’s post-money valuation (POST) less the capital investment (INV):
PRE = POST ? INV = $1.5 million ? $300,000 = $1.2 million.
The ownership proportion is the investor’s fractional ownership of the firm value after the capital infusion:
Ownership proportion = INV/POST = $300,000 / $1.5 million = 0.20 or 20%.

Q2. A private equity firm is considering the valuation characteristics of both a venture capital and a buyout investment. Increasing working capital requirements and stable EBITDA growth is most likely associated with:

         Increasing working capital        Stable EBITDA growth

A)          Buyout                                 enture capital

B)      Venture capital                              Buyout

C)          Buyout                                     Buyout

Correct answer is B)

Venture capital investments often have high and increasing working capital (current assets less current liabilities) requirements to finance growth. Buyouts typically have low requirements due to more reliable cash flows and earnings and a substantial asset base.
Stable EBITDA (or EBIT) growth is generally a characteristic of buyout investments. These firms traditionally have a history of stable sales and cash flows and have already established a strong market position. The high amount of debt required by the private equity firm to make the investment also requires that the buyout firm have stable and steady earnings to finance the interest payments.

Q3. The most appropriate pairing for valuing a buyout and a venture capital investment, respectively, is:

                         Buyout                                  Venture capital

A)    Relative value approach       Discounted cash flow

B)    Pre-money valuation           Relative value approach

C)    Discounted cash flow          Pre-money valuation

Correct answer is C)

Buyout investments have predictable cash flows and there are typically several comparable firms in the industry. Both the discounted cash flow and relative value approach are thus reasonable valuation techniques for buyout firms.
Venture capital firms, on the other hand, have less stable cash flows and few industry comparables given their young age and position in the business life cycle. Pre- and post-money valuation techniques are frequently used valuations for these firms.

Q4. Analysts Jordan Green and Noelle Lafonte are discussing terminal value estimation in venture capital and buyout investments.

Lafonte states: “Private equity firms often use scenario analysis in both venture capital and buyout investments to estimate terminal value.”

Green adds: “Private equity firms only use the multiple of net income approach in leveraged buyout (LBO), but not in venture capital investments to estimate terminal value.”

With respect to their statements:

A)   Lafonte is correct but Green is incorrect.

B)   Green is correct but Lafonte is incorrect.

C)   Neither Lafonte nor Green is incorrect.

Correct answer is A)

Lafonte’s statement is correct. Private equity firms can use scenario analysis to estimate terminal value in both venture capital and LBO investments. Under scenario analysis, terminal values are calculated under multiple scenarios using different assumptions.

Green’s statement is incorrect. Private equity firms often use a relative value approach to estimate terminal value in both venture capital and LBO investments. Under the multiple of net income approach, terminal year net income is multiplied by the P/E ratio to project terminal equity value.

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