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 capital’Non-interest bearing

Interest bearing

Sources of Capital

• Friends and family

• Credit cards ?

• Commercial banks

• Private equity

o Angels

o Venture capital

o ‘Private equity’

o Crowd sourcing

5

• Investment banks

• Public equity

o Primary offering

o 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 Centerpoint’s 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

• LeanTech’s 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 ?

• What’s 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

• What’s the cash flow timeline?

22

time 0 1 2 3 4 5 6

investmentVC exit

$2.5M in net Income

Scenario

• Companies in LeanTech’s 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 priceN

Earnings per shareN+1

24

25

What’s the value of Ford ?

Discussion

• What’s the cash flow timeline?

26

time 0 1 2 3 4 5 6

investmentVC exit

pe = EN

E NPN+1!" #$

=E5

E[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 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: 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 founder’s 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 LeanTech’s board approve for LeanTech’s treasury (under the CFO) to issue to the VC?

Δns =70.875% ⋅1,000,000

(1−70.875%)

=2,433,476

nspost = nspre +Δns

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

=3,433,476

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

fvc =Δns

nspost

=Δns

(nspre +Δns)

Δns =fvc ⋅nspre

(1− fvc )

nspost = nspre +Δns

Δns = 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 firm’s additional paid in capital?

• What are retained earnings? o DRE = NP – DIV

• What is the top job in a firm’s accounting department?

• In its financing department?

• To what position do they report? 31

Equity Value: Post-Money

32

I= Δns ⋅ppost

ppost =I

Δns

=$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 VC’s expected rate of return?

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

• What if LeanTech’s 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