equity venture capital part 1

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Equity Venture Capital Part 1

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  • Equity Venture Capital

    Part 1

  • Objective

    Introduce the basic concepts of finance: risk, return, and value, using venture equity capital

    2

  • Scenario

    Three entrepreneurs founded a software company, LeanTech, last year

    They have an alpha product currently and have nearly depleted their savings and that of family and friends

    LeanTech has no revenue and its fair value is unknown to the entrepreneurs

    The founders need to raise capital

    3

  • Discussion

    What is capital ? o Its on the balance sheet

    What assets does LeanTech have ?

    4

    Liabilities

    Equity

    Assets

    roic > cost of capital

    Capital

    Invested capitalNon-interest bearing

    Interest bearing

  • Sources of Capital

    Friends and family

    Credit cards ?

    Commercial banks

    Private equityo Angelso Venture capital

    o Private equity

    o Crowd sourcing

    5

    Investment banks

    Public equityo Primary offeringo Secondary offering

    Government programs

  • 6

  • 7

  • 8

    Return On InvestmentWithin five years, a portfolio company should be able to deliver five to ten times the return on CenterPoint's investment, with CenterPoint retaining a meaningful equity share of 10% or higher for its Limited Partners.

    F =P (1+r)N

    P =F

    (1+r)N

    1=5

    (1+r)5

    r =515 1

    r 38% / yr

    1=10

    (1+r)5

    r =1015 1

    r 58% / yr

  • 9

    P

    F

    0 N

  • 10

  • 11

  • 12

  • 13

  • 14

  • Discussion

    What is equity?

    How are present and future value related ?o when there are no intermediate cash flows?

    o when there are intermediate cash flows?

    Note the present and future value factors and rates

    What is Centerpoints targeted rate of return on its investment?o Is there an equivalent cost to the founders ?

    15

  • Discussion

    So how much of the ownership and future earning potential do the founders surrender ?

    How is a VC firm organized?

    16

  • Reference For Example

    17

    Students are advised to obtain this background note from HBSPWe will follow that methodology and example

  • Reference For Example

    18

    Venture valuation methods

  • Scenario

    LeanTechs incorporation documents (state law) declared 1,000,000 shares of common equity stock (issued and outstanding) divided among the three founders (and maybe their friends and family)

    LeanTech has no revenue and no debt

    Its fair value is unknown to the founders

    LeanTech needs $3.5M for costs and expenses over the next 5 years.

    The founders forecast that LeanTech will attain annual net income of $2.5M during the 6th year

    o Net income is same as net profit and net margin

    19

  • Forecast Income Statement

    This forecast was done at the start of year 1 or time =0

    Each year (column) is a forecast for the following year

    These financial forecasts are expected values

    20

  • Discussion

    What is depreciation ?

    Whats the difference between a cost and an expense ?

    What is EBITDA ?

    How is the economic value of an entity or security determined?o Discounted future valueo Relative, multiple, or ratio estimate

    The Harvard teaching note uses a ratio of equity fair value to net profito other ratios can be used including equity fair value to EBITDA or EBIT

    21

  • Timeline

    Whats the cash flow timeline?

    22

    time 0 1 2 3 4 5 6

    investmentVC exit

    $2.5M in net Income

  • Scenario

    Companies in LeanTechs industry have an average equity value of 15 times forecasted annual earnings i.e., the price earnings ratio, pe, is 15

    A venture capitalist is interested in investing in LeanTech. That VC targets an ROI (a rate) of 50% annually for funds committed for 5 years

    The VC becomeso An equity investor and a shareholder

    o A board member ?

    The VC intends to sell its equity to the public (IPO) or via acquisition (M&A) after 5 yearso This is VC exit strategy

    23

    pe=EquityN

    Net ProfitN+1=

    Share priceNEarnings per shareN+1

  • 24

  • 25

    Whats the value of Ford ?

  • Discussion

    Whats the cash flow timeline?

    26

    time 0 1 2 3 4 5 6

    investmentVC exit

    pe = EN

    E NPN+1!" #$=

    E5E[NP6]

  • Expected Value

    27

    000,500,37$15000,500,2$peNPE ===The expected fair value of the equity after 5 years, E, is

    The expected value of the VCs share of the firm after 5 years, EVC, is

    125,578,26$%)501(000,500,3$)k1(IE 5Nvc =+=+=

    %875.70

    000,500,37$125,578,26$

    EEf vcvc

    =

    =

    =

    The fraction of the firm that the VC will own after the investment, fVC, is

    I: VCinvestmentNP: annualnetprofitofcompanyduringNthyearpe: pricetoearningsratio(E/NP)inyearN+1N: Numberofyearstoexitk: AnnualizedVCreturnoninvestment,ROIE: Equity(andtotal)valueofcompanyatendofN

    years(futurefairvalue)fVC: FractionofequityownedbyVCEVC: ValueofVCequityatexit

  • Equity Allocation

    28

    fFDR = 1 70.875% = 29.125%

    EFDR = $37,500,000 - $26,578,125 = $10,921,875

    Pre-money period Post-money period pe E[NP]

    VC Investment VC Exit

    I = $3,500,000EVC = $26,578,125

    EFDR: Expected value of founders equity at VC exit fFDR: Fraction of equity owned by founders

    time in years t=0 t=Nbeginning of end of Nth

    first year (last) year

  • Equity Shares

    29

    How many shares must LeanTechs board approve for LeanTechs treasury (under the CFO) to issue to the VC?

    ns =70.875% 1,000,000

    (170.875%)

    =2,433,476

    nspost = nspre +ns

    =1,000,000+2,433,476

    =3,433,476

    ns: number of sharesDns: number of new shares issued to the VC

    fvc =ns

    nspost

    =ns

    (nspre +ns)

    ns =fvc nspre(1 fvc )

    nspost = nspre +ns

    ns = fvc nspost nspre nspost

    Dns

    Investment

  • Discussion

    30

    How many shares of common stock does Netflix have ?o Authorized

    o Issued

    o Outstanding

    o Treasury shares = Issued - Outstanding

  • Discussion

    What is preferred and common stock?

    What is a firms additional paid in capital?

    What are retained earnings? o DRE = NP DIV

    What is the top job in a firms accounting department?

    In its financing department?

    To what position do they report? 31

  • Equity Value: Post-Money

    32

    I= ns ppost

    ppost =I

    ns

    =$3,500,000

    2,433,476

    = $1.438

    Epost = nspost ppost

    =3,433,476 $1.438

    = $4,938,272

    p: Share price E: Equity valueDns: number of new shares issued

  • Equity Value: Pre-Money

    33

    Epre = Epost I

    = $4,938,272$3,500,000

    = $1,438,272

    ppre =Epre

    nspre

    =$1,438,272

    1,000,000

    = $1.438

    pexit=E

    nspost

    =$37,500,000

    3,433,476=$10.922

    p: Share price E: Equity valuens: number of equity shares

  • VC App

    34

  • Discussion

    35

    What was LeanTech value pre-money ?

    What was leanTech value post-money?

    What is LeanTech expected to be worth at the end of year 5?

    What is the VCs expected rate of return?

    What percent of the company will the VC own to achieve that expected rate of return?

    What if LeanTechs market value at the end of year 5 is lower than expected? Higher than expected?

  • Homework 1

    36

    Prepare a markdown document for a single round of venture equity capital financing.

    Use the example data from class except that The VC targets making 5x in 5 years Firm value is estimated to be 18x its expected EBIT of $3.6M at the

    end of year 5

    All information should be described and output

    All code should be echoed

    Due in 1 week at the start of class