Steps to calculate the NPV of Venture Capital Investments

Let’s pretend you’re approached by a group of tech-savvy guys who have just completed product development, organized their operations, and now need additional capital to begin production and sales. The company’s management is asking you to consider a $4.5 million investment. How would you proceed? How do you determine if the investment merits your time and money? 

When you start putting pencil to paper you estimate that the company will be ready for IPO in 3 years, which would permit you to exit the investment with $31 million. 

Feeling the excitement of this newfound opportunity you begin to estimate the probability of success in each of the next 3 years: 60%, 75% and 90%, respectively. 

If investments with similar risk profiles require a 23% discount rate, how would you calculate the expected net present value of the investment? 

Here are the steps: 
The initial investment is $4.5 million. The probability of success after three years is: (.60)(.75)(.90) = 40.5%. Therefore, the probability of failure is: 1- .405 = 59.5%. 

The NPV of success can therefore be calculated as follows: 

NPVsuccess = Terminal Value/(1+r)t – Initial Investment 

$31 
--------- - $4.5 = $12.16 million 
(1.23)3*  *(raised to 3) 

Keep in mind that if the project fails the $4.5 million is lost. 

The expected overall NPV can then be calculated as follow: 

E(NPV) = [NPVsuccess x P(Success)] + [NPVfailure x P(Failure)] 

= $12.16(.405) - $4.5(.595) = $2.25 million 

This step would then be combined with any due diligence needed to further evaluate the project. The figures used above are only for illustration purposes and should not be relied on for investment decisions. The process and formula can be used to evaluate a variety of projects requiring an NPV decision.

5 Steps to Value Intangible Assets