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