equity venture capital pdf
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Equity Venture Capital
2
Return On Investment Within 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.
N=5$years5$times$the$investmentPV=1FV=5
5$$=$$1⋅(1+k%)5 $$k=38.0%
5"years10"times"the"investment
10""=""1⋅(1+k%)5 ""k=58.5%
FV=PV ⋅(1+k)N ++
PV= FV(1+k)N
++
Discussion
• What is Centerpoint’s targeted rate of return on its investment?
• How are present and future value related when there are no intermediate cash flows?
• Define the following o Future value rate and future value factor o Discount rate and discount factor
3
Discussion
• What is a firm’s equity?
• How is a VC firm organized?
• Who are the general and limited partners?
4
Reference For These Lectures
5
Students must obtain this ‘background note’ from HBSP We will follow that methodology and example
Scenario
• Three entrepreneurs founded a so3ware company, LeanTech, last year. • LeanTech’s incorpora<on documents (state law) declared 1,000,000
shares of common equity stock (issued and outstanding) divided among the three founders
• LeanTech has no revenue yet and its fair value is unknown to the founders • LeanTech needs $3.5M for expenses and costs over the next 5 years. • The company has no debt
• The founders expect that LeanTech will achieve annual net profits (NP) of
$2.5M during the 6th year
6
pe=EquityN
Net+ProfitN+1
Scenario (Continued)
• Companies in that industry have an average equity value of 15 <mes annual earnings i.e., the price earnings ra<o, pe, is 15
• A venture capitalist is interested in inves<ng. The VC targets an ROI (a rate) of 50% annually
• The VC becomes o An investor o An equity investor o A shareholder
• The VC intends to sell its equity to the public (IPO) or via acquisi<on (M&A) a3er 5 years o This is the ‘exit strategy’
7
Discussion
• How is the economic value of an entity or security determined? o Discounted cash flow o Relative and multiples valuation
• Where are debt, equity, and net profits in the financial accounting statements?
• What’s the cash flow timeline?
8
time 0 1 2 3 4 5 6
investment VC exit
pe=EN
NPN+1=
E5E[NP6]
Discussion
• What is capital ? o Look at the balance sheet
9
Non-interest bearing liabilities Interest bearing liabilities Equity
Assets
Capital
Expected Value
10
000,500,37$15000,500,2$ peNP E =⋅=⋅=
The expected value of the equity after 5 years, E, is
The expected value of the VC’s 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 vc
vc
=
=
=
The fraction of the firm that the VC will own after the investment, fVC, is
I: VC investment NP: annual net profit of company during Nth year pe: price to earnings ra<o (E/NP) in year N+1 N: Number of years to investment exit k: Annualized return on investment E: Equity (and total) value of company at end of N
years (future value) fVC: Frac<on of equity owned by VC EVC: Value of VC equity at exit
Equity Alloca<on
11
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]
Venture Capital Investment
Venture Capital Exit
I = $3,500,000
EVC = $26,578,125
EFDR: Expected value of founder’s equity at VC exit fFDR: Frac<on of equity owned by founders
time in years t=0 t=N beginning of end of Nth
first year (last) year
Discussion
• Mean value is an average value of a sample, a population, an experiment, a measurement, etc.
• Expected value is a probability-weighted average of all possible values or outcomes
• The financial context is different from running an experiment or sampling a population repeatedly
• We may have a historical mean annual return rate and an expected return rate next year o Expected value of the net
profit in year 6, E[NP6] o Year 6 is not actually run
repeatedly to find the average value!
12
Equity Shares
13
How many shares must LeanTech’s board approve for LeanTech’s treasury (under the CFO) to issue to the VC?
postvc
prepost
nsf ns
nsnsns
⋅=Δ
Δ+=
476,433,2 %)875.701(000,000,1%875.70ns
=−
⋅=Δ
476,433,3
476,433,2000,000,1
nsnsns prepost
=
+=
Δ+=
nspre
nspost
Δns
ns: number of shares Δns: number of new shares issued to the VC
)f1(nsf
ns
)nsns(ns
nsns f
vc
prevc
pre
postvc
−
⋅=Δ
Δ+
Δ=
Δ=
Discussion
14
• How many shares of common stock does Netflix have ? o Authorized o Issued o Outstanding o Treasury shares
= Issued - Outstanding
Discussion
• What is preferred and common stock?
• What is additional paid in capital?
• What are retained earnings?
• What is the top job in a company’s accounting department? In its financing department?
15
Post-‐Money Equity Value
16
438.1$
476,433,2000,500,3$
nsIp
pnsI
post
post
=
=
Δ=
⋅Δ=
272,938,4$
438.1$476,433,3
pnsE postpostpost
=
⋅=
⋅=
p: Share price E: Equity value Δns: number of new shares issued
Pre-‐Money Equity Value
17
272,438,1$
000,500,3$272,938,4$
IEE postpre
=
−=
−=
438.1$
000,000,1272,438,1$
nsE
ppre
prepre
=
=
=
pexit=E
nspost
++++++=$37,500,0003,433,476
=$10.922
p: Share price E: Equity value ns: number of equity shares
VC App
18
Mul< Round Investment
• VCs can manage risk by inves<ng in stages as the firm meets business milestones
• In this investment scenario, all is the same except that the VC investments are made in three rounds and denoted as Series A, B, and C o A3er 0, 2, and 4 years at LeanTech o Crunchbase
• The primary objec<ve is to determine the frac<on ownership before and a3er each round of investment so that a3er the third and last investment, the final ownership frac<ons are achieved
19
Cash Flow Timeline
20
fA
rA dA
fB
rB dB
fC
rC dC
0 4
5 i 2
FVC Round A
IA
Round B
IB
Round C
IC
VC
Exit
d: ini<al ownership frac<on r: reten<on frac<on f: final ownership frac<on
Equity Alloca<on at VC Exit
21
)iN(iii )k1(IE −+⋅=
000,250,1$%)251(000,000,1$ E
000,744,2$%)401(000,000,1$ E
625,390,11$%)501(000,500,1$ E
)45(C
)25(B
)05(A
=+⋅=
=+⋅=
=+⋅=
−
−
−
%333.3000,500,37$000,250,1$ f
%317.7000,500,37$000,744,2$ f
%375.30000,500,37$625,390,11$ f
C
B
A
==
==
==Value at exit for each investment
Ownership fac<on at exit
Equity Alloca<on at VC Exit
22
%974.58 %333.3%317.7%375.30
fff%100 f%100 f
%026.41 %333.3%317.7%375.30
fff f
CBA
VCFDR
CBAVC
=
−−=
−−−=
−=
=
++=
++=
Ini<al Share Alloca<on
23
rA #=100%(fB(fC=100%(7.317%(3.333%=89.349%
rB #=100%(fC=100%(3.333%=96.667%
rC=100%
fA=33.996%# ⋅ #(1(7.570%)# ⋅ #(1(3.333%)#=#30.375%%333.3
%100%333.3
rf
d
%570.7%667.96%317.7
rf d
%996.33%349.89%375.30
rfd
C
CC
B
BB
A
AA
===
===
===
Reten<on ra<o for each investment Ini<al ownership fac<on
d: ini<al ownership frac<on r: reten<on frac<on f: final ownership frac<on
Initial & Final Equity Fraction
24
Investment Cash Flow
25
pA
nsA
pB
nsB
pC
nsC
pFDR nsFDR
0 4
5 i 2
FVC Round A
IA
ΔnsA
Round B
IB
ΔnsB
Round C
IC
ΔnsC
VC
Exit
pexit
Equity Shares
26
055,515,1055,515000,000,1nsnsns
055,515%)996.331(000,000,1%996.33
)d1(nsd
ns
AFDRA
A
FDRAA
=+=Δ+=
=−
⋅=
−
⋅=Δ
131,639,1077,124055,515,1nsnsns
077,124%)570.71(055.515,1%570.7
)d1(nsd
ns
BAB
B
ABB
=+=Δ+=
=−
⋅=
−
⋅=Δ
653,695,1522,56131,639,1nsnsns
522,56%)333.31(131,639,1%333.3
)d1(nsd
ns
CBC
C
BCC
=+=Δ+=
=−
⋅=
−
⋅=Δ
%333.3 d
%570.7 d
%996.33 d
C
B
A
=
=
=
Ini<al ownership frac<on
d: ini<al ownership frac<on ns: number of shares
Share Price
27
692.17$522,56000,000,1$
nsI
p
060.8$077,124000,000,1$
nsI
p
912.2$055,515000,500,1$
nsI
p
C
CC
B
BB
A
AA
==Δ
=
==Δ
=
==Δ
=
115.22$653,695,1000,500,37$pexit ==
055,515,1ns
055,515ns
A
A
=
=Δ
131,639,1ns
077,124ns
B
B
=
=Δ
653,695,1ns
522,56ns
C
C
=
=Δ
I: VC investment p: price of an equity share ns: number of common equity shares
Discussion
• Note that the VC’s ownership fraction is being diluted, but diluted down to their targeted ownership fraction at exit (IPO, M&A)
• The VC’s targeted ROI is achieved
28
VC App
29
VC App
30
Management Shares
• Consider another alterna<ve: o Note the sec<on en<tled “Op<ons” on the last page of the HBS
teaching note o The founders and the VC’s decide that 5% of the equity should be
allocated for future key managers and employees o These shares may back employee incen<ve stock op<ons
• All else is the same as the mul<-‐round scenario • The VCs targeted ROI does not change • Unlike the HBS teaching note, we’ll treat management shares
as a share issuance a3er Series C for simplicity
31
Discussion
• How do employee incentive stock options work?
32
33
Final Alloca<ons From Slide 21
fA #####=$11,390,625$37,500,000
=30.375%
fB #####=$2,744,000$37,500,000
=7.317%
fC #####=$1,250,000$37,500,000
=3.333%
and#now
fM #####=#5.000%
Reten<on & Ini<al Alloca<on
34
rA #=100%(fB(fC (fM####=100%(7.317%(3.333%(5.000%####=84.349%
rB #=100%(fC (fM###=100%(3.333%(5.000%###=91.667%
rC #=100%(fM####=95.000%
rM #=100.000%
dA #=fArA##=30.375%
84.349%=36.011%
dB #=fBrB##= 7.317%
91.667%=7.983%
dC #=fCrC####=3.333%
95%=3.509%
dM#=fMrM####= 5.000%
100.000%=5.000%
Reten<on rate for each round Ini<al ownership fac<on
d: ini<al ownership frac<on r: reten<on frac<on f: final ownership frac<on M: management
Share Issuance
35
ΔnsA=dA ⋅nsFDR(1+dA)
------- = 36.011% ⋅1,000,000(1−36.011%)
=562,767
nsA=nsFDR+ΔnsA=1,000,000+562,767=1,562,767
ΔnsB=dB ⋅nsA(1)dB)
+++++++=7.983% ⋅1,562,767(1)7.983%)
=135,570
nsB=nsA++ΔnsB=1,562,767+135,570=1,698,338
dA ##=36.011%
dB ##=7.983%
dC ##=3.509%
dM##=5.000%
Ini<al ownership fac<on
d: ini<al ownership frac<on ns: number of shares
Share Issuance
36 36
ΔnsC=dC ⋅nsB(1)dC)
+++++++=3.509% ⋅1,698,338(1)3.509%)
=61,757
nsC=nsB+ΔnsC=1,698,338+61,757=1,760,095
dA ##=36.011%
dB ##=7.982%
dC ##=3.508%
dM##=5.000%
Ini<al ownership fac<on
d: ini<al ownership frac<on ns: number of shares
ΔnsM=dC ⋅nsC(1)dC)
+++++++ = 5.000% ⋅1,760,074(1−5.000%)
=92,636
nsEXIT=nsC +ΔnsM=1,760,095=1,852,732
Share Price
37
pA =IA
ΔnsA=$1,500,000562,767
=$2.665
pB=IB
ΔnsB=$1,000,000135,570
=$7.376
pC =IC
ΔnsC=$1,000,00061,757
=$16.192
pM =$16.194
pEXIT =$37,500,0001,852,732
=$20.240
ΔnsA =562,767nsA =1,562,767
ΔnsB=135,570
nsB=1,698,338
ΔnsC=61,757
nsC=1,760,095
I: VC investment p: price of a share ns: number of common equity shares
ΔnsM=92,636
nsEXIT=1,852,732
VC App
38
Investment Alternatives
39
Final Note
• VC investment shares are more typically issued as preferred conver<ble stock o Preferred shares are converted to common shares via a conversion ra<o o The financial calcula<ons are the same if the conversion ra<o is 1:1
• There may be terms that give investors the opportunity to not be diluted o In our example the investors get diluted (reduced ownership frac<on) but meet
their expected ROI • These are pro-‐forma financials
o The financial plan will very likely require upda<ng as expecta<ons change • Note that in the three scenarios the founders retained 1M shares and 29%, 59%,
54% of the equity respec<vely o The balance of risk between investors and founders was scenario dependent
• The founder’s raised capital, but in exchange they gave up a frac<on of their future dividends and capital gains o This is a (rate) cost of capital – specifically an opportunity cost
40
Finance Concepts Introduced
• Risk • Uncertainty • Risk management • Return and return rate • Equity valua<on • Financial decision making • Expecta<on • Investment • Return on investment • Discount rate • Growth rate • Common and preferred equity • Public v. private equity
41
• Capital raising • Capital structure
o Equity structure
• Cost of capital • Discounted cash flow • Present and future value • Price to earnings ra<o • Pro-‐forma financial planning • Corporate governance • Principle – agent issues • Incen<ve pay (stock op<ons) • Share issuance • Shares of common equity
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