equity venture capital part 2

Equity Venture Capital

Part 2

New ScenarioMulti Round VC Investment

• VCs can manage risk by investing in stages (rounds, series) as the firm meets business milestones

• In this investment scenario, all is the same except that the VC investments are made in three rounds and denoted as Series A, B, and Co After 0, 2, and 4 years at LeanTech

• The objective is to determine the fraction ownership before and after each round of investment so that after the third and last investment, the final ownership fractions and ROIs are achieved

2

Cash Flow Timeline

3

0 4 5i 2

EVCRound A

IA Round BIB

Round CIC

VC

Exit

Equity Allocation at VC Exit

4

Value at exit for each investment

Ownership faction at VC exit

Cash Flow Timeline

5

fA

rA

dA

fB

rB

dB

fC

rC

dC

0 4 5i 2

EVCRound A

IA Round BIB

Round CIC

VCExit d: initial ownership

fractionr: retention fractionf: final ownership fraction

Equity Allocation at VC Exit

6

7

Discussion

So the fraction of the equity owned by the venture capitalists at exit dropped from 71% to 41%. Why?

Initial Share Allocation

8

Retention ratio for each investment

Initial ownership faction

d: initial ownership fractionr: retention fractionf: final ownership fraction

Initial Share Allocation

9

Initial ownership faction

d: initial ownership fractionr: retention fractionf: final ownership fraction

10

VC Equity Fractions

Investment Cash Flow

11

pA

nsA

pB

nsB

pC

nsC

pFDR

nsFDR

0 4 5i 2

EVCRound A

IAnsA

Round BIB

DnsB

Round CIC

DnsC

VCExit

pexit

Equity Shares

12

Initial ownership fraction

d: initial ownership fractionns: number of shares

13

Equity Shares

Share Price

14

I: VC investment p: price of an equity sharens: number of common equity shares

Share Price

15

VC App

16

17

VC App

18

Summary

Including shares for management is covered in Part 3

19

Summary• Note that the VC’s ownership fraction is being diluted,

o But diluted down to the targeted ownership fraction at exit (IPO, M&A)

o And that the targeted ROI is achieved

• These are pro-forma financials o An updated expected exit value would change the

calculations for subsequent rounds

• VC investment shares are more typically issued as preferred convertible stocko Preferred shares are converted to common shares via a

conversion ratioo The financial calculations are the same if the conversion

ratio is 1:1

Summary• There may be contract terms that give investors the

opportunity to not be diluted • Note that in the two scenarios the founders retained 1M

shares and 29% and 59% of the equity respectivelyo The balance of risk between investors and founders was

scenario dependent• The founder’s raised capital, but in exchange they gave up

a fraction of their future earnings, dividends, and capital gainso This is a (rate) cost of capital to the founders – specifically an

opportunity cost

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Finance Concepts Introduced• Risk • Uncertainty• Risk management• Return and return rate• Equity valuation• Financial decision making• Expectation• Investment • Return on investment• Discount rate• Growth rate • Common and preferred equity• Public v. private equity

21

• Capital raising• Capital structure

o Equity structure • Cost of capital• Discounted cash flow • Present and future value• Price to earnings ratio • Pro-forma financial planning • Corporate governance • Principal – Agent issues • Share issuance and

repurchase

22

Homework 2

Your startup firms needs $3M in investment over the next 5 years to reach profitability and an exit point for the VCs.

The $3M is raised in multiple rounds at the start of years 1, 3, and 5. The capital raised in each round is 30%, 40%, and 30% of the $3M total.

Your firm is expected to initially sell in the market at 18x its expected EBIT of $3.6M at the end of year 5

Use the targeted rates of return of 40%, 30%, and 20%.

Calculate and present all information of interest.