Lecture 4: How VC funds work | Adv. Venture Capital-FINAN 6310 | Chad Jardine, University of Utah, 2008–

Venture Capital: FINAN 6310
Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners.
Venture Capital: FINAN 6310
Lecture 3

Advanced Venture Capital: FINAN 6310
Time-Value of Money
VC Power Law
VC Fund Structure
Convertible Notes
Agenda

Venture Capital: Financing for New Ventures: FINAN 6300
Thinking Like A Venture Capitalist: Know Your Audience

Investors approach a deal from the
perspective that
• Money is time that is monetized—i.e.,
inventory that must be turned.
• ROI versus the dollars and risk of the
investment.

Thinking Like A Venture Capitalist
$10 million
Invested
$20 million
Return
Good Deal?

Depends on time.
1-year = 100% IRR
7-years = 12.25% IRR

Venture Capital: Financing New Ventures: FINAN 6300
P/E Ratio

Time-Value of Money
VC Power Law
VC Fund Structure
Convertible Notes
Agenda
✓

“The biggest secret in
venture capital is that the
best investment in a
successful fund equals or
outperforms the entire
rest of the fund
combined.”
Photo Credit: Forbes
The VC Power Law
—Peter Thiel
Cofounder and former CEO of Paypal.
Author of Zero to One

You mean most VC investments are losers?

“You can only make money
by being right about
something that most
people think is wrong.”
—Bill Gurley
General Partner, Benchmark
The VC Power Law

Time-Value of Money
VC Power Law
VC Fund Structure
Convertible Notes
Agenda
✓
✓

Venture Capital is a subset of Private Equity
Invest in private companies/shares rather
than public.
Private Equity Structure
VC vs. Private Equity
Venture Capital Private Equity
Target Company Startup Mature/Underperforming/
Undervalued
Ownership Minority Control
Exit IPO LBO

VCs normally only have a token
amount of their own money in
their fund to invest.

Tim Ferriss
Author, Podcaster, Investor
Basics of how
venture capital is
structured

Member/Manager
LLC
NewCo
ENT–2
ENT–1
INV–1 INV–2 TRUST
INV–3
REIT
INV–4
Sub Sub Sub Sub
Accredited Investors: High net-worth individuals & institutions such as:
pension funds, insurance companies, family offices, endowments,
sovereign wealth funds, foundations, etc.
GP LP
LP
LP LP
30%
70%
Investment Portfolio: All
the companies invested
in by the fund.
Y/N Investment Fund
1–3%
Mgt. Fee
MGT
20/80 profit
distribution
“carry”
P.Ag.
LLC
VC Firm/
Brand/MGT Co
LP
“2–20” is the cliche
VC structure
LLC
VC–2
VC–1 VC–3
VC Principals/Sponsors
Fund II
Fund III

Time-Value of Money
VC Power Law
VC Fund Structure
Convertible Notes
Agenda
✓
✓
✓

EQUITY
VALUATION
FINANCING ROUND
Price per Share (PPS)
Bootstrap
$0.003
Angel
$1.00
Seed
$1.25
Series A
$2.00
Series B
$5.00
IPO
$13.00
EOPP
Founder
Accredited
Investor
Employees Seed VC or
Super Angel
A-VC
B-VC
Public
2.9M
$10K
100K
$100K
$0
350K
$1M
800K
$5M
2.5M
$17.5M
3.5M
5.5M
Options are growing for
what happens here
(especially in tech)

How do you raise money when
you’re too early to have any
revenue or earnings?

Photo Credit: Business Insider
“It’s harder to make
money in the venture
business, given the
valuation environment
that exists today.”
—Fred Wilson
Managing Partner, Union Square Ventures
Founder, Flatiron Partners

–Paul Graham
Cofounder Y-Combinator

Convertible Notes 
A loan (i.e., debt) that can convert to
equity when a subsequent equity
round is raised.

Convertible Notes 
Need an interest rate and a term
Intend that it convert to equity, but
can be repaid.
May include a cap
Common for
A. Early seed rounds
B. Smaller interim cash infusions

Calculating Convertible Notes
Terms:
Investment: The amount raised
using the convertible note
Discount Rate: Discount to
subsequent round PPS
Valuation Cap: Max valuation at
which note converts
Interest Rate: Interest (accrues to
principal)
Maturity Date: Date the note must
be repaid if unconverted
Pre-Money Valuation: Valuation
before next round of investment
Price per Share (PPS): PPS at the
next round of investment

Convertible Note Example
Seed Round Convertible Note
Raise $750,000 using a CN.
10% interest rate.
$5M cap and 20% discount.
Series A triggers conversion (2 years later)
$4M investment
$2 per share (2M shares)
$10M pre-money valuation
$14M post-money valuation
What happens to the Seed investor?

Principal grows due to interest rate
$750,000(1+.1/1)2
= $907,500
New Principal Amt. $907,500

Calculate PPS using the cap
Formula: (Cap/Pre-money) x Series A PPS
$5M/$10M = 0.5 x $2 PPS = $1 CN PPS
$907,500/$1 =
907,500 shares
(Same amount into Series A would yield 453,750 shares)

Calculate PPS using the discount
Formula: Series A PPS - Discount = Conversion PPS
$2 - 20% = $1.60
$907,500/$1.6 =
567,187 shares
(Same amount into Series A would yield 453,750 shares)

Noteholder Converts at Lowest PPS
Cap Yields 907,500 shares at $1 PPS
Discount Yields 567,187 shares at $1.60 PPS
Noteholder gets 907,500 shares
For the price of 453,750

SAFE 
Simple Agreement for Future Equity
Turns out California has a lot of
regulations about loans.

Time-Value of Money
VC Power Law
VC Fund Structure
Convertible Notes
Agenda
✓
✓
✓
✓

Lecture 4: How VC funds work | Adv. Venture Capital-FINAN 6310 | Chad Jardine, University of Utah, 2008–

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Lecture 4: How VC funds work | Adv. Venture Capital-FINAN 6310 | Chad Jardine, University of Utah, 2008–