Advanced Valuation and
Strategy - M&A,
Private Equity, and
Venture Capital

Week 1

The value of flexibility

• Real Option view

Real options are everywhere!

Growth Option: This is an option to invest in future projects or expansions. It represents the opportunity a company has to undertake additional projects based on its current operations or investments. For instance, a company may have the option to develop a new product line or expand into a new market based on the success of its existing products.

Option to Defer: This is the option to delay an investment or project. It gives a company the flexibility to wait for more information or favorable conditions before committing resources. This option is valuable in uncertain environments where waiting can reduce the risk associated with the investment.

Option to Expand: This option provides the company with the ability to increase the scale of an operation or project if it proves to be more successful than initially anticipated. For example, a manufacturing company might have the option to increase production capacity if demand for its product is higher than expected.

Option to Contract: Conversely, this option allows a company to reduce the scale of operations in response to market conditions or project performance. This might involve scaling down production, reducing the workforce, or cutting back on investment.

Option to Abandon: This is the option to cease a project or close down operations entirely if they turn out to be unsuccessful or unprofitable. It is essentially an exit strategy, allowing a company to limit its losses by withdrawing from a failing venture.

Option to Temporarily Shut Down: This option allows a company to temporarily halt operations without completely abandoning them. It can be particularly valuable in industries with fluctuating prices or demand, as it allows a company to resume operations quickly when conditions improve.

Staged Financing: This refers to the process of funding a project or venture in phases rather than all at once. At each stage, investors can reassess the project's viability before committing further funds. This is commonly seen in venture capital funding, where a startup might receive funding in a series of rounds (Series A, B, C, etc.) based on achieving certain milestones or demonstrating potential for growth.

The value of strategic commitment

Flexibility vs Commitment Value --> Game Theory

Assessement #1

The concept of real options in venture capital, particularly in the context of staged financing (A, B, and C rounds), is a strategic approach that aligns with the principles of both financial options and game theory. In this scenario, each funding round (A, B, C) represents an option for the venture capitalist.

• Option Characteristics: Each round is akin to a call option in finance. The venture capitalist pays a premium (the investment made in each round) for the right, but not the obligation, to invest in the next round. This right becomes valuable under conditions of uncertainty.

• Managing Uncertainty: Uncertainty is a key element in new ventures. Real options allow venture capitalists to respond to new information as it becomes available. After each round, the investor can assess the start-up's performance, market conditions, and technological advancements before committing further capital.

• Growth Options Value:

  • A Round: The initial investment. It's a bet on the start-up's basic viability and potential for growth. This round is like acquiring a base option with a relatively lower investment, providing the initial right to future growth options.

  • B Round: Generally follows successful A Round outcomes. It's an option exercised based on initial success, often aimed at scaling the business. This round represents a significant increase in the company's valuation and growth prospects.

  • C Round: Typically focuses on scaling the company further, often towards preparing for an IPO or a major acquisition. This round is exercised when the start-up has proven its market fit and scalability, significantly reducing the uncertainty about its future prospects.

• Strategic Flexibility: The staged approach allows venture capitalists to limit losses if the venture underperforms (by not exercising the next option), or to capitalize on unexpected successes (by exercising the option for further investment).

• Game Theory Application: Game theory comes into play as the venture capitalist must anticipate the reactions of other stakeholders (like competitors, other investors, or the market) to each decision. Each round of funding is not just an investment decision but also a strategic move in a larger competitive landscape.

In summary, the growth options value in staged financing under uncertainty as a real option lies in the strategic flexibility it provides. It allows venture capitalists to make incremental investments based on evolving information, thereby managing risk and capitalizing on potential growth opportunities in a highly uncertain environment.

Growth Option: Xstrata's series of acquisitions (Glencore’s coal assets, MIM, Tintaya, Cerrejon, Falconbridge) can be seen as exercising growth options. Each acquisition represented an opportunity to expand into new markets or commodities, thereby increasing the company's overall growth potential.

Option to Defer: Xstrata likely evaluated the timing of each acquisition, deferring some until the right opportunity presented itself. This strategic patience allowed them to capitalize on favorable market conditions or internal readiness, maximizing the value of each acquisition.

Option to Expand: Each acquisition was an exercise of the option to expand. By acquiring new assets, Xstrata increased its operational scale and diversified its portfolio, which is particularly crucial in the commodities market where diversification can mitigate risks associated with price fluctuations.

Option to Contract: While Xstrata's strategy was predominantly expansionary, the option to contract would have been implicit in their decision-making. This would involve divesting or scaling back certain operations if they became unprofitable or did not align with the company's strategic objectives.

Option to Abandon: Though not explicitly exercised in the cases mentioned, Xstrata would have retained the option to abandon any of its ventures if they turned out to be significantly unprofitable or if market conditions drastically changed.

Option to Temporarily Shut Down: In the volatile commodities market, Xstrata had the option to temporarily shut down operations in response to market downturns or price crashes. This flexibility would be particularly valuable in managing costs and maintaining financial stability during adverse periods.

Staged Financing: Although not a typical staged financing scenario like in venture capital, Xstrata’s acquisition strategy had elements of staged investment. Each acquisition could be seen as a stage where the company evaluated the success and integration of the previous acquisition before proceeding to the next.

In summary, Xstrata's serial acquisition strategy can be reevaluated as a series of strategic moves, each representing different real options. This perspective highlights the company's flexibility and strategic decision-making in navigating the uncertainties of the commodities market, leveraging opportunities for growth while maintaining the agility to adapt or reorient its strategy as needed.

3. Understanding Expanded NPV

What are the components of an expanded NPV of a platform acquisition?

The ENPV of a platform acquisition includes the traditional NPV calculation (based on existing assets' cash flows) and adds the value of strategic flexibility (real options), strategic value (including game theory insights), synergies, and strategic advantages, while also accounting for integration costs and risks, and adjusting for additional risks and uncertainties. This approach provides a more holistic and dynamic valuation of a platform acquisition, considering both its financial and strategic dimensions.

4. Calculating Present Value of Growth Opportunities

With the “market method” we can back out the market’s perception of strategic growth option value from share prices. Any value that is embedded in a company’s market value and cannot be reconciled for by the value of its assets in place represents the value of its growth opportunities. Suppose that the market value (share price multiplied by outstanding shares) of the company equals $80 billion. The value of assets in place of the company, estimated as the discounted value of earnings under a no-growth policy, equals $50 billion.

Estimate the strategic growth option value (also known as the present value of the growth opportunities, or PVGO) for this company.

Week #2