Venture Capital

Fact summary

Required rate of return RRI: 60%

Investment: $10mm

Term: 6

Year 6 net income: $9mm

Year 6 PER: 22

The Basic Venture Capital Formula (No Dilution)

This method is used to determine how much should the venture capitalist invest in a company to obtain a certain required rate of return RRI after long period of time.

Example:

Let us suppose that venture capitalist want to invest $10mm in company X that would not require any additional capital through 6 years and the company expect to earn $9mm dollar in year 6, and this company has commanding price / earnings (PER) equal to 22. The venture capitalist expect 60% required rate of return (RRI).

Required future value (investment) = (1 + IRR) years x (investment)

= (1 + .6)6 x ($10mm)

= $167.8 mm

So the venture capitalist's stocks value should be equal $167.8mm in year 6 to achieve 60% annual return.

Total Terminal Value = PER x Terminal Net Income

= 22 x $9mm

= $198mm

after 6 years the company as whole would worth $198mm.

Final ownership required =

Final ownership required = $167.8mm / $198mm = 84.34%.

The required percent ownership after 6 years should be 84.34%

"and it is equal to beginning percent ownership because the company doesn't require any additional capital through 6 years"

Computing Shares to Issue and Share Price

Usually Companies Issue additional stocks after period of time of venture capitalists investment, diluting the ownership of pervious investors.

So now if the company X has 800,000 shares outstanding and the VC must own 84.34% of company X, then the company should issue additional shares of amount:

New shares = x Old shares

New Shares = 84.34%/1-(84.34) x 800,000

= 4308557 Shares

Share price =

The Share price = 10,000,000 / 4308557 = $2.32.

Computing implied valuation

Post-money Valuation =

This valuation is applicable after the financing.

Post-money valuation for company X is $10mm / 83.34% = $11.98 million.

Pre-money valuation = (post-money valuation) – (new investment)

the valuation of Company's x stocks held by previous founder or investors:

= $11.98mm - $10 = $1.98 million.

Carried interests = (post-money valuation) x (% ownership post-money)

The founders' carried interest is $11.98mm x 16.57% = 1.98 which is equal to pre-money valuation.

Valuation assuming Future Dilution

when a company issuing additional stocks, early-round investors suffer dilution and a loss of ownership. As a result, the early-round investor will have to purchase a higher ownership percentage as of the financing, in order to achieve a given terminal or final ownership after future financings.

VC must estimate the amount of new stock that will be issued in the future, and