Methods in evaluation of projects by Venture Capital Institutions

The venture capital institutions invariably finance industries either on the basis of idea or on the basis of growth. It is here they are different from other financial institutions which are assets-based. We can now see different approaches in the evaluation of projects by venture capital institutions.

Methods of evaluation of projects by VCI

There are basically three methods adopted by venture capital institutions (VCI) while financing projects. These are –

  1. Conventional venture capitalist evaluation method.
  2. The First Chicago method.
  3. The revenue multiplier method.

1. Conventional venture capitalist evaluation method

ln this method, VCIs give importance to two aspects, which are

  • the time of starting the investment and
  • the time of quitting the investment.

The institution will judge the borrowing concern in the following manner—

1. Annual revenue of the borrowing concern over a period of 7 years and whether these revenues are on the upward trend.

2. The borrowing concerns’ expected earnings (after deducting tax liability) at the initial stage and also at the time of quitting the borrowing concern will be taken into consideration.

3. Market evaluation of the borrowing concern on the basis of P/E ratio (P = price of the security and E= earnings of the security). The evaluation of this ratio is the lesser the ratio, better will be the condition of the borrowing company.

4. Finding out the net present value (NPV) of the borrowing concern, based on suitable discount factor.

5. The borrowing concern must have net worth equivalent to the borrowing amount.

Example: If the value of enterprise is Rs. 10 crores, and the borrower wants Rs. 4 crores, then he must have a net worth of 40 percent of the total value.

The above method may not be practically feasible as most of the borrowing firms will not be in a position to provide regular stream of income and in the case of firms incurring losses, this method cannot be worked out.

2. The First Chicago method

This method is different from the previous conventional method of evaluation, as it gives some discount to the starting point and the exit point. There is more consideration given for the earnings during the entire period. This scheme has the following aspects.

1. Three alternative positions are taken which are

  • Success
  • Sideways survival
  • failure.

A probability rating is given to the three positions.

2. Through the discounted cash flow, the discounted present value is assessed by giving a high discount rate to accommodate the risk factor.

3. The discounted value is multiplied by probability ratings which will provide expected present value.

4. If the expected present value is Rs. 10 lakhs, and the fund required is Rs. 5 lakhs, then the borrowing concern must have a minimum net worth of 50%.

3. Revenue Multiplier method

In this method, the value of the borrowing concern is based on an estimated value. The estimated value is calculated on the basis of

1. Present value of the borrowing concern

2. Annual revenue

3. Expected rate of growth of revenue per year

4. Expected holding period ( number of years for the repayment)

5. Profit margin after tax

6. Expected P/E ratio at the time of quitting the borrowing concern.

This method will be useful for such concerns which have started earning and where in the course of years their revenue will be increasing. But this system is based on more data which may not be available, especially in underdeveloped countries.