equity venture capital part 2

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Equity Venture Capital Part 2

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Topic 2 part 1

Equity Venture Capital

Part 2

Banks make collateralized loans,Short term debt on your balance sheetYou want an equity investment Privet offering or public offering Secondary market Capital ?Claim on the company for which a return is expected Accounts buyableLoanBond Equity

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New ScenarioMulti Round VC InvestmentVCs 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 CAfter 0, 2, and 4 years at LeanTechThe 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

Not A & B shares 9/8/162

Cash Flow Timeline304

5i 2EVCRound AIA

Round BIB

Round CIC

VCExit

Total for allCould be three different or first particulates in all rounds 9/8/163

Equity Allocation at VC Exit4

Value at exit for each investment Ownership faction at VC exit

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Cash Flow Timeline5fArAdA

fBrBdB

fCrCdC

04

5i 2EVCRound AIA

Round BIB

Round CIC

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

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Equity Allocation at VC Exit6

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Discussion7So the fraction of the equity owned by the venture capitalists at exit dropped from 71% to 41%. Why?

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Initial Share Allocation8

Retention ratio for each investmentInitial ownership faction d: initial ownership fractionr: retention fractionf: final ownership fraction

Retention % is reduced by the percents that go to the next investors.The A investor could certainly be the round B and C investor or participate in the round9/8/168

Initial Share Allocation9

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

Retention % is reduced by the percents that go to the next investors.The A investor could certainly be the round B and C investor or participate in the round9/8/169

VC Equity Fractions 10

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Investment Cash Flow 11pAnsApBnsBpCnsCpFDRnsFDR04

5i 2EVCRound AIAnsA

Round BIBDnsB

Round CICDnsC

VCExit pexit

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Equity Shares12

Initial ownership fraction d: initial ownership fractionns: number of shares

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Equity Shares13

Share Price14

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

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Share Price15

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VC App16

VC App17

Summary18

Including shares for management is covered in Part 3

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SummaryNote that the VCs ownership fraction is being diluted,But diluted down to the targeted ownership fraction at exit (IPO, M&A)And that the targeted ROI is achieved

These are pro-forma financials An updated expected exit value would change the calculations for subsequent rounds

VC investment shares are more typically issued as preferred convertible stockPreferred shares are converted to common shares via a conversion ratioThe financial calculations are the same if the conversion ratio is 1:1

19

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SummaryThere 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 respectivelyThe balance of risk between investors and founders was scenario dependentThe founders raised capital, but in exchange they gave up a fraction of their future earnings, dividends, and capital gainsThis is a (rate) cost of capital to the founders specifically an opportunity cost20

Risk, return, ro9/8/1620

Finance Concepts IntroducedRisk UncertaintyRisk managementReturn and return rateEquity valuationFinancial decision makingExpectationInvestment Return on investmentDiscount rateGrowth rate Common and preferred equityPublic v. private equity

21Capital raisingCapital structureEquity structure Cost of capitalDiscounted cash flow Present and future valuePrice to earnings ratio Pro-forma financial planning Corporate governance Principal Agent issues Share issuance and repurchase

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Homework 222Your 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.

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