Venture Capital Method: Investment Scenarios

1. Basic Venture Capital Method

A venture capitalist is contemplating a $3.5 million investment in a company that expects

to require no further capital through year five. The company is expected to earn $2.5
million in year five and should be comparable to companies commanding price/earnings
ratios (PERs) of about 15. The venture capitalist expects to harvest his investment at that
point through sale of his stock to an acquiring company. Assume further that the venture
capitalist requires a 50% projected internal rate of return (IRR) on a project of this risk.
Assume there are 1 million shares outstanding before the investment. What is the share
price using these assumptions? (Price=$1.44)

2. Venture Capital Method with Sensitivity Analysis

How will the value of the company change if the assumptions are changed? The effect of
changing the following assumptions in the base model can be examined:

Variation 1: Reduce the terminal value by 10 percent

Variation 2: Increase time to exit by 10 percent
Variation 3: Increase IRR by 10 percent
Variation 4: Increase investment by 10 percent
Variation 5: Increase the number of existing shares

3. Venture Capital Method with Dilution

A first-round venture capitalist is contemplating a $1.5 million investment in a company

that expects to require an additional $1 million in years two and four. The company is
expected to earn $2.5 million in year five and should be comparable to companies
commanding price/earnings ratios (PERs) of about 15. The venture capitalist expects to
harvest his investment at that point through sale of his stock to an acquiring company.
Assume further that the first-round venture capitalist requires a 50% projected internal
rate of return (IRR) on a project of this risk. Since several rounds are required, in addition
to estimating the appropriate discount rate for the current round, the first-round VC must
also estimate the discount rates that are most likely to be applied in the following rounds,
which we will project for years two and four. Although a 50% rate is appropriate for year
zero, it is estimated that investors in this company will demand a 40% return in year two
and a 25% return in year four. Assume there are 1 million shares outstanding before the
investment. What is the terminal share price? (Price=$22.12)

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4. Venture Capital Method with Multiple Financing Rounds

A first-round venture capitalist is contemplating a $3 million investment in a company that

expects to require an additional $2 million in a second round. The assumed exit value is
$25 million. The venture capitalist expects to harvest his investment at that point through
sale of his stock to an acquiring company. Suppose that the discount rate is highest in the
early years and becomes lower after a while. For example, assume that the discount rate is
60 percent in the first year, stays at 50 percent in years two and three, and falls to 40
percent in the fourth year. In addition to determining the appropriate compound interest
rate for the current round, the first-round VC must also determine the compound interest
rate most likely to be applied in the second round. Suppose, for example, that the company
might be able to delay the timing of the second round until year four. Assume there are 1
million shares outstanding before the investment. What would be the wealth of the
entrepreneurs? (Wealth of Entrepreneurs=$7,080,000)

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