Venture Capital Financing

The Venture Capital Method

B.G. Bisson

Valuation and Pricing

Magnitude of investment

Staging of investment

Syndication

Target IRR

Investment time horizon

Terminal value of firm

% ownership required

Deal structure

Future financing and dilution – “The Venture Capital Method”

Magnitude of Investment

Typically >$1.0 million for institutional

Small deals too costly

Typically less than $10 million in Canada

Most deals $1.0-$3.0

Based on business plan pro formas

Free cash flow (EBIAT, working capital, capital expenditures)

Investment Time Horizon

4-7 years

How long will it take to create value?

Years to cash flow breakeven

VC Investments and IRR

Target IRR

25-80 %

Stage of company

Use of funds

Deal structure

VC Target IRR

Seed

Startup

First stage

Second stage

Bridge

Restart

IRR>80%

50-70%

40-60%

30-50%

20-35%

??

The Venture Capital MethodStep 1

Given the VC investment, the target IRR and the investment time horizon, determine the future value of the VC investment

FV = PV(1+i)^n

i = target IRR

N = time horizon to exit

Eg. FV = $1.0m(1+0.35)^5 = $4.5m

The Venture Capital MethodStep 2

Given the projected earnings at exit and an appropriate Price Earnings ratio (PER) for the company, calculate the projected terminal value of the company at exit

Eg. TV = $1.0m(15) = $15m

The Venture Capital MethodStep 3

Determine the % ownership required by dividing the required future value of the investment at exit by the projected terminal value of the company at exit

Eg. FV= $4.5m/TV$15m = 30% Or divide the VC investment by the present

value of the projected terminal value of the company at exit

Eg. PV=$15m/(1+0.35)^5=$3.33m ; $1.0m/$3.33m=30%

% Ownership Required

% Ownership Required

Magnitude of investment

Duration of investment

Target IRR

Terminal value of firm

Room for future investment?

See spreadsheet (VC Investment Perspective)

The Venture Capital MethodStep 4

Determine number of new shares (NS) to be issued to VC.

Find number of shares outstanding before investment (old shares (OS) eg. 1.0m)

VC % Ownership = NS/(NS +OS)

Eg. 30% = NS/(NS + 1.0m)

NS= 430,000

Price per share = $1.0m/430,000 = $2.33

The Venture Capital MethodStep 5

Determine pre and post-money valuation

If 30% of the company is acquired for a $1.0 VC investment, this implies a post-money valuation of $1.0/0.30 = $3.33m

Give a post-money valuation of $3.33m and an investment of $1.0m, the pre-money valuation is $2.33m

Carried interest = (post-money valuation) x (% ownership post-money)

Does this valuation make sense? Is it realistic?

The Venture Capital MethodStep 6

Assess future dilution due to issuance of additional shares prior to exit.

Shares to management, future investors

Estimate retention ratio = 100% - % of ownership issued to others in future

Eg. If a future investor negotiates a 10% ownership, the retention ratio is 100%-10%=90%

The Venture Capital MethodStep 7

Calculate adjustment to required ownership % due to expected future dilution

Adjusted ownership % = % ownership without dilution divided by retention ratio

Eg. Adjusted % = 30%/90% = 33.3%

If VC owns 33% after investment and gets diluted by 10% before exit, the final ownership % will be 30%, ie. the required ownership % to realize target IRR given projected terminal value

Sensitivity AnalysisDue Diligence

Terminal Value Future Earnings (Sales, Expenses, Profits) PER

Target IRR Risk Deal Structure Liquidity

Dilution Future Rounds (Amounts, IRR, Horizon) Management incentives

Staging of Investment

All up front

Two or three tranches

Contingent on meeting milestones/targest

Option to abandon

Syndication

Sharing the deal with other VC firms

Diversify the risk

Broaden the network

Increase size of portfolio