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 Method

Step 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 Method

Step 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 Method

Step 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 Method

Step 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 Method

Step 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 Method

Step 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 Method

Step 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 Analysis
Due Diligence

Terminal Value

Target IRR

Future Earnings (Sales, Expenses, Profits)

PER

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