The Impact of Venture Fund Inflows on Private Equity Valuation

The growth of capital investment

Before the dawn of early 1946, only a limited number of venture funds were established, and the annual inflows of money into new venture funds were small. However, the capital under management in the asset class of private equity market has grown drastically from $4 billion in 1978 to $200 billion in 1998, and observers have thereby proclaimed that increasing capital inflows has resulted in higher security prices. Since investors in venture capitalists were allowed to invest more in high-risk-high-reward start-ups. In fact, venture capitalists have backed many high-technology companies including Cisco Systems, Genentech, Intel, Microsoft, and Netscape. These small startups later became a successful IPOs that were sold back from venture capitalists to the underwriter at a sweet deal. This article intends to show the relation of capital inflows to the pricing of investment.  Typically, we are fully aware that the increase in capital inflows would lead to higher capital investment of venture funds, and thus higher valuation of funds. But we’d like to understand how else capital inflows would influence the valuation and pricing venture capital funds.

In a financial theorists’ perspective, the valuation of a firm is primarily dependent on its forecasted cash flows. So, if investors expect future profitability to be higher, the value of a firm should increase and vice versa. Similarly, if investors learn that the firms will be less or more riskier than anticipated, the cost of capital will change accordingly in the valuation of firms. Higher cost of capital means that valuation would be lower and vice versa.

Characteristics of equity valuation

  • More mature firms receive higher valuation than newly established firms: Firms often go through 6 stages with private financing: start-up stage, development stage, beta stage, shipping stage, profitable stage, and restart stage. Mature private firms are those who enter the profitable stage, where they start to generate excessive revenue and obtain attractive gross margin. These firms often receive higher valuation, however, mature firms that undergo the restart phrase (financial and product market restructure) will exceptionally receive dramatically depressed valuations.
  • Industry of firm: venture capitalists often focus their attention on companies that offer cutting edge technology or product platforms to the market. They believe the technology sector has the highest risk-to-reward ratio where investors can achieve potentially significant rewards for the high-risk startup firms. The valuation of technology companies also varies by specific “industry”. Semiconductor, data processing, and communication companies on average receive higher valuation, while industrial equipment and instrumentation companies have a relatively lower valuation.
    • For medical related and data processing firms, the probability of being funded is significantly negatively correlated with venture capital inflows. During the years when venture capital inflows, firms in the data processing industry greater funding than those in the medical field, which deter higher valuation of data processing industry and lower valuation for startup medical firms.

The effects of venture capital inflows to valuation and pricing:

  • The pricing of investment by private equity firms reflect equity valuation levels in the public market, but only a substantial lag. Negotiations between venture investors and entrepreneurs can be prolonged, hence, the price of the investment might be tentatively agreed upon well before the date of the closing.
  • Prices may be affected by differences between first, and later round investors. Entrepreneurs seeking additional funds tend to syndicate second and later rounds with less well-established venture capitalists. Since less well-established venture capitalists would associate with a substantial premium for the startup valuation.

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