Financial Services-MBA-BM

Session 4-5

• Venture Capital Funds

• Theoretical Framework:
• Venture Capital is a way in which investors support new entrepreneurial talent,
primarily with finance to exploit potential market opportunities, with an objective to
earn high capital gains in the medium to long term.

• In addition to finance, the VC may also provide some value addition in the form of
management and strategic advice

• Some Famous VC stories in US

• Apple :
• Facebook :
• FedEx, Intel, Sun Microsystems are some of the other popular success stories with VC
funding .

• See this for top 50 potential success stories in US:

– http://online.wsj.com/news/articles/SB1000142405274870413220457619064423790
5576

• Venture Capital Scenario in India :

• Before 1985, the development financial institutions ( DFIs) had been partially playing
the role of venture capitalists by providing financial assistance to pre public issue
ventures.

• Around 1985, the creation of a venture capital fund on an experimental basis was
announced by the Ministry of Finance.
– The concept was operationalized in the fiscal budget for 1987-88, by incorporating a
cess of upto 5% on all technology import payments to create a pool of funds.

• VCs in India belong primarily to four different categories :

– VCFs promoted by the central govt. owned development financial institutions :
Risk Capital and Technology Finance Corporation of India ltd.( RCTFC) by IFCI
and Risk capital Fund by IDBI .
– VCFs promoted by State Govt. owned developmental financial institutions like
Gujarat Venture Finance Company Limited (GVFCL) by Gujarat Industrial
Investment Corporation, Andhra Pradesh Venture Capital limited (APVCL) by
Andhra Pradesh State Finance Corporation.
– VCFs promoted by public sector banks such as Canfina by Canara Bank and SBI
Caps by SBI.
– VCFs promoted by private companies and banks such as Grindlay’s India
Development funds, IL&FS Venture Corporation Ltd etc.

Dr. Soumya G Deb, XIMB Page 1

 Financial Services-MBA-BM

• The SEBI Venture Capital Regulation Act was put in place in 1996 which laid down
rules and code of conduct regarding registration of the VCs, investment conditions and
restrictions etc.

• Venture Capital Funding in India : recent happenings

• Some most active VC firms in India in recent times :
• Helion venture Partners:
– Startups Funded: Yepme, MakemyTrip, NetAmbit, Komli, TAXI For Sure,
PubMatic.
• Accel Partners :
– Startups Funded :Flipkart, BabyOye, Freshdesk, Book My Show, Zansaar, Probe,
Myntra, CommonFloor.
• Sequioa Capital India :
– Startups Funded: JustDial, Knowlarity, Practo, iYogi, bankbazaar.com

• Top 47 most active VC firms in India

• Some recent news about VC :

– http://inc42.com/resources/top-47-active-venture-capital-firms-india-startups/
– http://timesofindia.indiatimes.com/business/india-business/72-increase-in-
venture-capital-funding-in-solar-energy-sector/articleshow/38376904.cms
– Venture capital firms pour money into India's niche e-commerce companies( Dec,
2013)
– http://www.vcpost.com/articles/20159/20131226/venture-capital-firms-pour-
money-indias-niche-ecommerce-companies.htm
– List of Venture capital Firms in India :
– http://en.wikipedia.org/wiki/List_of_venture_capital_companies_in_India
– Indian Venture Capital Association :
– http://en.wikipedia.org/wiki/Indian_Venture_Capital_Association

• Structure of a VC fund
• Venture capital firms are typically structured as partnerships consisting primarily of
– the general partners who serve as the managers of the firm and will serve as
investment advisors to the investors .
– The limited partners who are only investors of capital in the firm .This group
comprises both high net worth individuals and institutions with large amounts of
available capital.
• Stages of Financing in a VC set up
• Seed Financing :
• Start up financing :
– After seed stage
• First stage financing :
• Second Stage Financing :

Dr. Soumya G Deb, XIMB Page 2

 Financial Services-MBA-BM

• Bridge Financing :
• Restart or turnaround financing :
.
• Pricing and Valuation

• VC setting are often characterized by negative cash flows and earnings initially, and highly
uncertain but potentially substantial future rewards.

• With practically little information available, ( particularly in early stages of funding)

extracting and individually assessing each soft factor is a vital prerequisite :
• 1) The company itself :
– The business model :
– the company’s Current position/condition :
• ?

• 2) Management
– one of the most relevant key success drivers within any organization.
• 3) Market :

• 4) Product and Technology

• 5) Financing stage
•
• Methods of Valuation :
• 1) Discounted Cash Flow (DCF)
CF1 CF2 CF3 CFn
PV = + + + ................. +
(1 + r ) (1 + r ) (1 + r )
1 2 3
(1 + r ) n
• PV = Calculated Present value
• CF = Cash Flow ( Free cash flow typically)
• r = Discount rate (typically = WACC: Weighted average cost of capital)

•
• 2) rNPV( Risk Adjusted NPV) or eNPV( expected NPV) :
– NPV accounts for all risk by the discount rate, while rNPV includes risk by
multiplying the cash flows with their respective probability before discounting
them – with a different ( much lower ) discount rate than NPV.

– rNPV is the standard method within pharma and biotech companies.

•
3) Comparable/Multiplier method
– Most commonly used particularly for early stage funding :
• P/E
• P/B
• P/Revenues

Dr. Soumya G Deb, XIMB Page 3

 Financial Services-MBA-BM

• Value/EBITDA
• Important terms that are used are the following :
– Point of exit
– Terminal value
– Post money valuation
– Premoney valuation
– Retention ratio/dilution
– IRR

• Step I: Finding the terminal Value

P
P(Final Value) =   × Earnings Forecasted future
•  E  obtained from comparable
firms in the industry

• Step II : finding the present value of the terminal value

• The terminal value is then discounted at a very high discount rate ( to justify the high risk
and effort involved in the investment) typically between 35% to 80% per year to obtain the
present value.
Terminal Value
PV(Terminal Value) =
(1 + RRR) no of years toexit

• Sometimes instead of using a discount rate concept :

– the terminal value is divided by a flat “ no of times “ to arrive at a PV
– Most conservative investors plan to get a 10x-30x the initial investment
– while aggressive investors may hope for up to 70x
•
• post-money valuation = value immediately after funding

• pre-money valuation = post money value – VCs fund

• Step III :Finding VC’s share :

• The VC then uses this present value ( post money value) and its desired investment
quantum to find out its share in the business.
– For example if the discounted terminal value is $10 million and the VC wants to
make an investment of $5 million then it will want a 50% stake in the business.

– This is the present value approach. Sometimes an alternate but equivalent IRR
approach is also followed .

Dr. Soumya G Deb, XIMB Page 4

 Financial Services-MBA-BM

• IRR approach to find VC’s share( assuming no dilution )

Example :
• Consider a situation of a VC who is about to make an investment of Rs. 35 million in a
company which is not expected to raise any further capital till year 5. The company
XYZ enterprises is expected to earn Rs. 25 million in year 5 and should be
comparable to companies commanding a PE ratio of about 15. The VC expects to
realize his investment at that point through sale of his stock to an acquiring company.
Assume that the VC requires a 50% projected rate of return on a project of this risk.
– What fraction of the company should the VC ask for now ?
– How many shares will he be issued ?
– What price should he pay now for a stock in the company ?

• Now the VC must own enough of the company in year 5 to realize a 50% annual return on
the investment. Thus at that time his shares must be worth :

• Required future value of the investment =(1+IRR)5 x Investment = 1.505 x Rs. 35 million =
Rs. 266 million

• Now at that point the company as a whole will be worth :

• Total terminal value = PE x terminal earnings= 15 x Rs. 25 m = Rs. 375 m

• For the VC to receive the required Rs. 266 million out of the total Rs. 375 m terminal value
, he will have to own a corresponding portion of the company’s stock.
•
• Therefore the required percent ownership at that time must be 266/375 = 70.9%
•
• Since there are no further stock issues expected between now and year 5, if the VC buys
70.9% now he will own 70.9% then.
• Thus, Required FutureValue(Investment)
Final Ownership Reuired =
Total terminal Value

• Computing Shares to Issue and Share Price :

• When the VC invests in the company , additional shares are issued, diluting the ownership
of the previous investors, who are usually the founders /promoters of the company.
•
• Now, the percent ownership refers to the portion of the total stock that is owned post
money i.e after the new shares are issued.
new shares
% Ownesrhip acquired =
• old shares + new shares
•
•
% ownership
or, new shares = × old shares
1 − (% ownership)

Dr. Soumya G Deb, XIMB Page 5

 Financial Services-MBA-BM

• Thus if the VC must own 70.9% of XYZ, and there are say 1,000,000 shares outstanding
before the VC came in, then new shares to be issued =
• [70.9%/(1-70.9%)]*1,000,000= 2436426 shares.

• The price at which each share is to be issued is = Investment / no of shares =

• 35 m/2436426= Rs. 14.40 per share.
• IRR approach ( assuming no dilution ) … contd…

• Post Money and Pre Money valuation :

• In the case of XYZ the Post money valuation is thus = 35m /70.9% = Rs.49.4 m
• Pre Money valuation = Post Money valuation –Investment = 49.4m -35m =Rs. 14.4 m
• These numbers should also be equal to :
• Post Money valuation = Share Price x Total no of shares Post money = Rs. 14.4 x
(1000,000+ 2436426)= 49.4 m ( approx)
• Pre Money valuation = Share price x Total no of shares Pre money =Rs. 14.4 x (1000,000)=
Rs. 14.4 m

• Practice problem 1

• A Boston based Venture Capital firm is planning to invest $5 million in a start up bio
technology venture and must decide what share of the company it should demand for
his investment. Projections he developed with company managements show net
income in year seven of $20 million. The few profitable bio technology companies are
trading at an average PE ratio of 15 currently. The company currently has 500,000
shares outstanding. The VC believes that the target rate of return of 50% is required
for a venture of this risk. Find out the number of new shares to be issued to the VC
firm and the price of such shares. Find also the pre money and post money valuations
of the bio technology firm.

199026 shares @ $25.12 per share

Pre money value = 12.56 m and Post money valuation =17.56 m

Carried Interest :
• The carried Interest of a given shareholder or group in a Venture Capital scenario is the
valuation of that portion of the company owned by that party after the financing .

• Thus the total post money valuation of the company can be broken down into the ‘carried
interest’ portions of the various parties.
• Under this definition
– the carried interest for the VC in the example is 35 m
– and that of the founders is 14.4 m .

• Another definition of carried interest

• subtracts a shareholder’s previous investments from his post money valuation.

Dr. Soumya G Deb, XIMB Page 6

 Financial Services-MBA-BM

– For example if in the XYZ example, the founders invested Rs. 1m as their initial
equity, then their carried interest after the VC enters would be Rs. (14.4m -1m ) =
Rs. 13.4 m .

• This should represent the amount by which the valuation of a shareholder’s portion
increase post financing by the VC in the latest round…
– Under this definition, if an investor had bought in at a price higher than the current
round’s price, then his carried interest could also be negative.

• Valuation assuming future Dilution

• As new stocks are issued to later stage to new investors or to new key employees, the early
round investors can expect to suffer dilution , a loss of ownership due to the issuance of
additional shares.

• To protect themselves from this happening

– the early round investors will have to make an estimate of the number of future
rounds of financing that may happen and

– Ask for a higher ownership percentage initially so that even after dilution a
given terminal or final ownership can be achieved after all future financing
rounds.

• What are the steps involved in the analysis ?

• Steps :
• 1) Estimate The future pie ( value) of the company i.e estimating the terminal value:
The process and issues have already been discussed . In our XYZ example this value if Rs.
375m (= 15 * 25 m )

• 2) carving up the future pie : For doing this the VC ( first round) has to estimate the
following :
• The number of rounds of financing to happen in future
• The timing and quantum of those financings
• The required rate of return by each investor in each round

• Suppose in our XYZ example the VC decides to distribute the total 35 m investment into
three installments :
– 15 m at time 0,
– 10 m at the end of year 2 and
– 10 m at the end of year 4 the later rounds may be by him or by other VCs.

• He also estimates that

– the required return for the first round investment is still 50%

Dr. Soumya G Deb, XIMB Page 7

 Financial Services-MBA-BM

– but those of the second round and the third round should be respectively 40%
and 25% given that the prospects of the company will be somewhat apparent at that
time and the risk reduced to some extent.

Round 1 investors
Future Value (Investment) (1 + 50%) 5 ×15m
Final target % = = = 30.4%
terminal value Company 15 × 25m
(1 + 40%)3 × 10m
Round 2 = = 7.3%
15 × 25m
(1 + 25%)1 × 10m
Round 3 = = 3.3%
15 × 25m
• Retention Percent:
• Now we will have to adjust for ‘dilution’. For that we need to know something called a
Retention % or a Retention ratio which is defined as the ratio of the % ownership a
given investor will hold as of the terminal year of a project to the % ownership he holds as
of the current year of investment.

Final % ownership
retention % =
Current % ownership

The reduction in ownership over time is caused by the sale of new shares to new investors
or the award of additional options to the management .
– For example an investor’s retention % will be 75% , if a second round investor is
awarded 25% of the final company .
– For example suppose a VC invests in first round and is issued 100 shares while the
promoters had originally 50 shares. So VCs initial share becomes 2/3 and promoters
1/3. Now in a second round another VC comes and is issued 50 shares. So total
shares becomes 200 and the new VCs share becomes 25%. What is the first VC’s
share now ? = 100/200 = ½. So what is his retention % : ½ /2/3 = 75% which is
same as (1-new VCs share in the enhanced firm) = 1-25% =75%.

In general
Retention % = 1-(total of future final % ownership by other investors )

In our previous example, as the second and third round investors will hold 7.3% and
3.3% of the final ownership respectively,
– the first round investors will retain only 1-(7.3%+3.3%)=89.3% of original
holding.

The second round investors will retain 1-3.3% = 96.7% of original holding

And the third round investors will retain 100% since there will not be any further
investment and hence dilution till the final year.

Dr. Soumya G Deb, XIMB Page 8

 Financial Services-MBA-BM

Then percent ownership each investor should purchase at the time of financing is
calculated as follows :
Final % ownership
current % ownership =
retention %
So, for the
30.4%
Round 1 VC : current % = = 34%
89.3%
7.3%
Round 2 VC : current % = = 7.6%
96.7%
3.3%
Round 2 VC : current % = = 3.3%
100%

Using the formula presented earlier,

% ownership
new shares = × old shares
1 − (% ownership)
34%
So for the first round, new shares = × 1,000,000 = 515,055
1 − (34% )
7.6%
second round, new shares = ×1,515,055 = 124,077
1 − (7.6% )
3.3%
third round, new shares = × 1,639,131 = 56,522
1 − (3.3% )

• The price per share for the different VCs can thus be calculated as follows :
Investment Made
Share price =
New shares issued
• 15,000,000
• For , Round 1 VC : share price = = 29.12
515,055
•
10,000,000
• round 2 VC : share price = = 80.60
• 124,077
• 10,000,000
• round 3 VC : share price = = 176.90
56,522
•
• The terminal or final year share price can also be calculated as follows :
– There will be (1,639,131 + 56,522)=1,695,653 shares outstanding after the third
round. And total terminal value is 25 x 15 = 375m
– Thus the price per share at the time of exit should be 375m/ 1,695,653= 221 (
approx)

Dr. Soumya G Deb, XIMB Page 9

 Financial Services-MBA-BM

• To check whether this price is consistent with the assumed discount rates /IRR note that,
– (1+50%)^5 *29.1=221
– (1+40%)^3 *80.6=221
– (1+25%)^1*176.9=221

• Retention Vs dilution :

• Many VCs work with dilution % which is the ratio of future additional shares to the
current shares. This is typically used when

– instead of the future final ownerships of all rounds of investors , the dilution % at
each round is known which is based on the existing number of shares at the
beginning of that round

• Let us define the following terms first :

– Current shares : no of shares outstanding at the end of the current financing round
– Final shares : no of shares outstanding at the terminal year.
– New shares : no of additional shares purchased by the VC in the current round.
Then,
future additional shares
dilution % =
current shares
current + additional shares
1 + dilution% =
current shares
final shares/new shares
=
current shares/new shares

new share / current share current ownership % 1

= = =
new share / final share final ownesrship % retention %
 1 
Therefore, retention % =
 (1 + dilution %) 

In case of Multiple rounds of financing the retention % is given by

1
retention % =
(1 + dilution%)1 × (1 + dilution%) 2 .......etc

Dr. Soumya G Deb, XIMB Page 10

 Financial Services-MBA-BM

• Exit routes …

Principal disinvestment channels for (equity) investments made by VC are :

− Firm going public ( IPO)
− Sale of shares to entrepreneurs themselves
− Sale of shares to a new investor/VC
− Liquidation ( in case the venture is a failure)

• Term Sheet
A term sheet generally refers to a document outlining the material terms and
conditions of a business agreement with the VC.
– Term sheets are very similar to letters of Intent (LOI) in that they are both
• preliminary,
• mostly non-binding documents
• meant to record two or more parties' intentions to enter into a future
agreement based on specified terms

• Within the context of venture capital funding, a term sheet typically includes
conditions for financing a start up .

• The key offering terms in such a term sheet include

– (a) amount raised,
– (b) price per share,
– (c) pre-money valuation,
– (d) liquidation preference,
– (e) voting rights,
– (f) anti-dilution provisions. etc.

• More about term sheets and sample term sheet :

– https://en.wikipedia.org/wiki/Term_sheet
– http://www.investopedia.com/terms/t/termsheet.asp
– http://www.businessinsider.com/a-plain-english-term-sheet-venture-capitalist-2013-6
– http://www.marsdd.com/mars-library/term-sheet-template-for-angel-or-venture-
capital-investors/

• Practice Problem 2
• In problem 1 suppose the Venture capital firm is of the opinion that three more
senior staff will be needed to be hired. In its experience this number of top caliber
recruits would require options amounting to 10% of the common stocks. Additionally
the VC firm also believes that at the time the firm goes public, additional shares
equivalent to 30% of the common stock will be sold to the public. How will the
previous calculations regarding number of new shares to be issued to itself and the
price of such shares, be amended with this information in place ? Use both dilution %
and retention % approaches.
• $14.56 (approach 1: dilution % )
• $11.07 ( approach 2: retention % )

Dr. Soumya G Deb, XIMB Page 11

 Financial Services-MBA-BM

• Practice problem 3
The CEO of Millenium Dairy Product, a small venture among 10 partners each
having 100,000 shares, sought to raise an additional Rs.5 crore in a private
placement of equity in his early stage dairy product company. The CEO
conservatively projected net income of Rs.5 crore in year 5, and knew that the
comparable companies traded at a price earning ratio of 20X. She approached SBI
caps a venture capitalist with her proposal to seek funds.
a. What share of the company would SBI caps require today if their required rate of
return was 50%?
b. If the company had 1000,000 shares outstanding before the private placement ,how
many shares should SBI caps purchase ? What price per share should she agree to
pay if her required return was 50%? What are the pre money and post valuations ?
Carried interest of the VC ? Carried Interest of the promoters ?
c. The CEO feels that he may need as much as Rs.12 crores in total outside financing to
launch his new product. If he sought to raise the full amount in this round, how much
of his company would he have to give up? What price per share would SBI caps ask
for if their required rate of return was 50%? Pre money and post money valuations?
Carried Interests ?

*****************************************************************************

Dr. Soumya G Deb, XIMB Page 12