Wednesday, February 20, 2008

Understanding Valuation

There is a simple aspect of valuation which many of us find pretty difficult to grasp. Lets say you think your company is worth Rs 100. If you want to give somebody a 10% stake, he should pay you Rs 10 right? Nope, not necessarily. It depends on whether you are considering a pre-money (pre-funding) or post-money (post-funding) valuation.

The idea is best explained through shares. Lets say you have 100 shares in your company each worth Rs 10. So you are worth Rs 1000. Now, you require a funding of 100, so you issue 5 new shares at Rs 20 to an investor. So the investor has put in Rs 100. Your shareholding is 100/105% and the investors shareholding is 5/105%.

On a valuation basis, the pre-money basis the value of the business is 1000, money going in is 100 and post money value is 1100. If you were thinking of giving someone a stake in the company, you would do so on the funding being bought in, i.e. on the post money valuation.

So how does that work:
1) Project: Lets say NPV of a project is 100 (equity value). The equity funding required is 50. Post money valuation is 150. You want to give a 20% stake to an investor. So 20% works out to 20%*150=30. So he pays 30 for a 20% stake, and you pay 20 for a 80% stake. Obviously he is coming at a premium. Lets say par value is 1. So your shares = 20/1=20 shares, total number of shares = 20/0.8=25. investor’s no of shares = 5.. His share price= 30/5=6 or he has come in at 500% premium.
2) P/E in case there is capex is post-money.
3) Todays post money is t’rows (for the next cycle of investment) pre-money.
4) IPO valuation is post money. The IPO valuation assumes the proceeds of the IPO have been factored into the business plan.
5) A company X has a subsidiary Y. An investor has valued company A at 100 and will put in 49 for a 49% stake. 10 of it will remain in the company for funding. The value of Y for X s valuation is 90 (because the 10 will give rise to the cash flows which give the valuation 90).

As a closure, let me explain the idea in terms of selling of the company. In case you are selling the company, since the entire money needs to be put in by the new entity, the firm is sold at the pre-money valuation.


niharika said...

were u trying to make valuation sound simpler?

Wally said...

@ niharika: Nope the post was trying to address a particular problem.

Will elaborate more