Equity venture capital pdf
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Equity Venture Capital
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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
++
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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
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Discussion
• What is a firm’s equity?
• How is a VC firm organized?
• Who are the general and limited partners?
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Reference For These Lectures
5
Students must obtain this ‘background note’ from HBSP We will follow that methodology and example
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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
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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’
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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]
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Discussion
• What is capital ? o Look at the balance sheet
9
Non-interest bearing liabilities Interest bearing liabilities Equity
Assets
Capital
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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
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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 = $26,578,125
EFDR: Expected value of founder’s equity at VC exit fFDR: Frac<on of equity owned by founders
time in years t=0 t=N beginning of end of Nth
first year (last) year
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Discussion
• Mean value is an average value of a sample, a population, an experiment, a measurement, etc.
• Expected value is a probability-weighted average of all possible values or outcomes
• The financial context is different from running an experiment or sampling a population repeatedly
• We may have a historical mean annual return rate and an expected return rate next year o Expected value of the net
profit in year 6, E[NP6] o Year 6 is not actually run
repeatedly to find the average value!
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Equity Shares
13
How many shares must LeanTech’s board approve for LeanTech’s treasury (under the CFO) to issue to the VC?
postvc
prepost
nsf ns
nsnsns
⋅=Δ
Δ+=
476,433,2 %)875.701(000,000,1%875.70ns
=−
⋅=Δ
476,433,3
476,433,2000,000,1
nsnsns prepost
=
+=
Δ+=
nspre
nspost
Δns
ns: number of shares Δns: number of new shares issued to the VC
)f1(nsf
ns
)nsns(ns
nsns f
vc
prevc
pre
postvc
−
⋅=Δ
Δ+
Δ=
Δ=
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Discussion
14
• How many shares of common stock does Netflix have ? o Authorized o Issued o Outstanding o Treasury shares
= Issued - Outstanding
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Discussion
• What is preferred and common stock?
• What is additional paid in capital?
• What are retained earnings?
• What is the top job in a company’s accounting department? In its financing department?
15
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Post-‐Money Equity Value
16
438.1$
476,433,2000,500,3$
nsIp
pnsI
post
post
=
=
Δ=
⋅Δ=
272,938,4$
438.1$476,433,3
pnsE postpostpost
=
⋅=
⋅=
p: Share price E: Equity value Δns: number of new shares issued
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Pre-‐Money Equity Value
17
272,438,1$
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
=$10.922
p: Share price E: Equity value ns: number of equity shares
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VC App
18
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Mul< Round Investment
• VCs can manage risk by inves<ng in stages as the firm meets business milestones
• In this investment scenario, all is the same except that the VC investments are made in three rounds and denoted as Series A, B, and C o A3er 0, 2, and 4 years at LeanTech o Crunchbase
• The primary objec<ve is to determine the frac<on ownership before and a3er each round of investment so that a3er the third and last investment, the final ownership frac<ons are achieved
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Cash Flow Timeline
20
fA
rA dA
fB
rB dB
fC
rC dC
0 4
5 i 2
FVC Round A
IA
Round B
IB
Round C
IC
VC
Exit
d: ini<al ownership frac<on r: reten<on frac<on f: final ownership frac<on
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Equity Alloca<on at VC Exit
21
)iN(iii )k1(IE −+⋅=
000,250,1$%)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
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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
=
−−=
−−−=
−=
=
++=
++=
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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
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Initial & Final Equity Fraction
24
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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
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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
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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
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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
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VC App
29
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VC App
30
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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
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Discussion
• How do employee incentive stock options work?
32
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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%
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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
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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
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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
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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
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VC App
38
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Investment Alternatives
39
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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
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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