- The startup needs $3M total investment over 5 years, raised in 3 rounds at the start of years 1, 3, and 5 - The rounds are 30%, 40%, and 30% of total needed, so $0.9M, $1.2M, and $0.9M respectively - The startup expects $3.6M EBIT and 18x P/E ratio at exit, valuing the startup at $64.8M - Target rates of return are 40%, 30%, 20% for each round - The ownership percentages and ROI for each round must be calculated to meet

1. Equity Venture Capital
Part 2

2. New Scenario
Multi Round VC Investment
• VCs can manage risk by investing in stages (rounds, series) 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 After 0, 2, and 4 years at LeanTech
• The objective is to determine the fraction ownership before and after each
round of investment so that after the third and last investment, the final
ownership fractions and ROIs are achieved
2

3. Cash Flow Timeline
3
0 4 5i 2
EV
C
Round A
IA Round B
IB
Round
C
IC
VC
Exit

4. Equity Allocation at VC Exit
4
Value at exit for each
investment
Ownership faction at VC exit

5. Cash Flow Timeline
5
fA
rA
dA
fB
rB
dB
fC
rC
dC
0 4 5i 2
EVC
Round A
IA Round B
IB
Round
C
IC
VC
Exit
d: initial ownership fraction
r: retention fraction
f: final ownership fraction

6. Equity Allocation at VC Exit
6

7. Discussion
7
So the fraction of the equity owned by the venture capitalists at
exit dropped from 71% to 41%. Why?

8. Initial Share Allocation
8
Retention ratio for each investment Initial ownership faction
d: initial ownership fraction
r: retention fraction
f: final ownership fraction

9. Initial Share Allocation
9
Initial ownership faction
d: initial ownership fraction
r: retention fraction
f: final ownership fraction

10. VC Equity Fractions
10

11. Investment Cash Flow
11
pA
ns
A
pB
nsB
pC
nsC
pFDR
nsFDR
0 4 5i 2
EVC
Round A
IA
nsA
Round B
IB
DnsB
Round
C
IC
DnsC
VC
Exit
pexit

12. Equity Shares
12
Initial ownership
fraction
d: initial ownership fraction
ns: number of shares

13. Equity Shares
13

14. Share Price
14
I: VC investment
p: price of an equity share
ns: number of common equity shares

15. Share Price
15

16. VC App
16

17. VC App
17

18. Summary
18
Including shares for management is covered in Part 3

19. Summary
• Note that the VC’s ownership fraction is being diluted,
o But diluted down to the targeted ownership fraction at exit (IPO,
M&A)
o And that the targeted ROI is achieved
• These are pro-forma financials
o An updated expected exit value would change the calculations for
subsequent rounds
• VC investment shares are more typically issued as preferred
convertible stock
o Preferred shares are converted to common shares via a conversion
ratio
o The financial calculations are the same if the conversion ratio is 1:1
19

20. Summary
• There may be contract terms that give investors the opportunity to
not be diluted
• Note that in the two scenarios the founders retained 1M shares
and 29% and 59% of the equity respectively
o The balance of risk between investors and founders was scenario
dependent
• The founder’s raised capital, but in exchange they gave up a
fraction of their future earnings, dividends, and capital gains
o This is a (rate) cost of capital to the founders – specifically an
opportunity cost
20

21. Finance Concepts Introduced
• Risk
• Uncertainty
• Risk management
• Return and return rate
• Equity valuation
• Financial decision making
• Expectation
• Investment
• Return on investment
• Discount rate
• Growth rate
• Common and preferred equity
• Public v. private equity
21
• Capital raising
• Capital structure
o Equity structure
• Cost of capital
• Discounted cash flow
• Present and future value
• Price to earnings ratio
• Pro-forma financial planning
• Corporate governance
• Principal – Agent issues
• Share issuance and repurchase

22. Homework 2
22
Your startup firms needs $3M in investment over the next 5
years to reach profitability and an exit point for the VCs.
The $3M is raised in multiple rounds at the start of years 1,
3, and 5. The capital raised in each round is 30%, 40%,
and 30% of the $3M total.
Your firm is expected to initially sell in the market at 18x its
expected EBIT of $3.6M at the end of year 5
Use the targeted rates of return of 40%, 30%, and 20%.
Calculate and present all information of interest.