AppendixBasic Terms in Measurement

Appendix—Basic Terms in Measurement

The purpose of this section is to review and recall the basic terms in the measurement of returns and statistics which are used in valuations.

Basic Terms in Returns Measurement

  • Net Present Value (NPV)— NPV is the sum of all discounted flows (both positive and negative) from a project. NPV is used as a gauge for measuring the advisability of an investment; an investment is only worthwhile if NPV>0.

    Example: We are contemplating investing $100 in the present (C0) and expect the investment to yield (Cn) $110 one year from now (n=1). We shall assume that the investment is "risky" and that the appropriate interest rate (k) is therefore 15%. Inserting these values in the formula reveals a negative NPV—i.e., the investment is not worthwhile.

    NPV = (-100) + 110/ (1 + 15%) = -4.348

  • Rate of return— The rate of return on an investment is the profit or loss made on the investment over the period of the investment, as a percentage of the initial amount invested. The rate of return is measured by dividing the sum of the cash flows (both positive and negative) by the amount of the investment. The rule is that an investment is worthwhile only when y>k, i.e., when the rate of return on the investment (y) is greater than the market return on such investment (k).

    y = (C0 + Cn)/-C0

    In the case of an initial investment (C0) of $100 and a return (Cn) of $110, the rate of return is:

    y = (-100 + 110)/100 = 10%

    If the appropriate interest rate (k) for an investment with such a risk profile is 15%, then the investment is not worthwhile.

  • Internal Rate of Return (IRR) – IRR is defined as the discount rate at which the NPV of the investment is zero.

    IRR = (Cn/C0)1/n - 1

    For example, in an investment of $100 now which is expected to yield $200 five years from now (n=5),

    IRR = (200/100)1/5 - 1 = 14.9%

Part III: Venture Capital Investors

The first two parts of the book focused on startup companies—their nature, establishment, development, and other relevant issues. The discussion in the third part focuses on the entities which finance ventures—the venture capitalists.

Within this framework, we review the issues related to venture capital investors while differentiating between venture capital funds (Chapter 10) and other venture capitalists (Chapter 11). An in-depth discussion is dedicated to each type of investor, its role in startup financing, how it operates, its structure, and its distinguishing characteristics. Understanding these issues is essential for anyone involved in the venture capital industry, whether he or she is an investor, entrepreneur, or an advisor. For example, such an understanding could enable ventures to contact the investors most suited to them, to conduct a more knowledgeable and comfortable dialogue with them, and to upgrade their work together.

Chapter 10. Venture Capital Funds

INTRODUCTION

The sources of capital which are available to startups are limited. Entrepreneurs usually lack the capital required to realize their ideas and must therefore seek outside financing. Capitalists, on the other hand (mutual funds, pension funds, trusts, etc.) lack the time and know-how required to make direct investments in new companies. Traditional sources of finance, such as bank loans or raising capital from the public, are not accessible to new companies. It was the meeting-point between the need to raise capital and the desire to achieve high returns from investing in private companies which led to the creation of venture capital funds. They serve both as an investment-management vehicle for the persons who invest in them (see the section on venture capital funds and their investors), and as financiers and added-value providers for the companies in which they invest (see the section on venture capital funds and their portfolios). The term venture capital fund refers mainly to an entity which raises capital for investments in private companies on an equity basis and which is managed professionally by a management company. This chapter describes their background, history, characteristics, and main methods of operation.