A small Article from Mark Davis from CFJ Gotham Ventures was explaining the needs to protect the investors money by adjusting the risk of a venture with the amount of equity needed to compensate the risk.

There is one exercise from the Harvard Busienss School case that shows the basics of how a startup is evaluated by a VC. (The name of the case is “Venture Capital Method – Valuation Problem Set”. There is the exercise and there is another file which is the solutions sheet).

Given that I can’t show the content of the PDF because of copyright issue. I am going to give a similar problem and how a VC can calculate how much equity he should take of a startup.

——————————– Chim’s example —————————–

Carlos, CEO of Fiction Co., needs to raise $ 2 million for his company. He projects that the net income will be $ 2 million in five years. He also knows that similar companies traded at a price earning ratio of 15X.

On the other hand, Leonardo, VC of BlueGreen Capital, wants to have a rate of return ranging from 30% to 50%. He wonders how many shares he needs for that rate of return.

** Solution **

We have:

- $ 2 million from Leonardo

- Value of the company in 5 years (this is an important assumption, the valuation of a company can very a lot according to the market situation):    2 M X 15 = $ 30 million

If Leonardo wants a return of 50% then:

$ 2 M (1.5)^5 = $15.18 M  >>> 50.6% of the company (of $ 30 M value of Carlos’ company)

Basic explanation of this calculation: 2 million is the money that Leornado is going to give to the company. The 1.5 is the rate of return of 50%. For example, if you give me 100 dollars with a expected return of 50% in one year, I will need to give you back 150 dollars back at the end of next year.

Now imagine, that this happens five times (five years), so we multiply 1.5 by 1.5 by 1.5 by 1.5 by 1.5. Easy job to calculate.

The result is basically the amount of money that the VC is expecting to get in five years from now.

If we know the expected value of the company in five years, then we will know what is the percentange of the company a VC needs to have today.

Now let’s see what is the percentage for a 30% of return.

$ 2 M (1.3)^5 = $ 7.42 M >>> 24.7% of the company (of $ 30 M value of Carlos’company in five years)

There is another issue for Leonardo. He knows what is the percentage he needs to have in the company, but he doesn’t know how many shares he needs to have.

For that we need to know the number of shares that the company currently has.

Carlos told us that his company has 5,000,000 shares outstanding.

Let’s see how many shares Leonardo needs to have with 50% of return rate.

Let X be the number of shares purchased by the VC.

Let’s figure out the TOTAL number of shares once Leonardo invested.

X / (5,000,000 shares + X) = VC’s share which is 50.6% of the company

A quick explanation: after the VC invested in the company, we will have the 5,000,000 shares and the VC’s shares of the company which we call it TOTAL now. Leonardo needs to have 50.6% of the TOTAL.

X = 0.506(TOTAL)  ,  TOTAL means 5,000,000 shares + X

X = 0.506(5,000,000 shares + X)

X  = 2,530,000 + 0.506X

X – 0.506X = 2,530,000

0.494X = 2,530,000

X = 5,121,457 shares

Leonardo needs to have 5,121,457 shares of the company. Actually, the company issues 5,121,457 new shares to get the $ 2 M.

Now, how should we calculate the price per share?

We need to assume that the shares do not gives dividends and we have a conversion of common stock of 1:1.

$ 2,000,000 / 5,121,457 shares = $ 0.39/ share

If Leonardo agrees with everything else, he will state in his contract that he will pay $0.39/share for 5,121,457 shares of the company. Carlos will issue 5,121,457 shares to have $ 2M.

Imagine that this deal was done and everyone is happy, how Carlos can brag how much his company was value at?

Carlos has 5,000,000 shares, just because he succeed in selling his new shares at $ 0.39, so his shares value at 5,000,000 X $ 0.39 = $ 1,950,000 - This is what we called pre-money valuation.

OK, it is not that much, but if he just had incorporated the company with $1000, he is actually getting a value of $ 1,949,000!

What is the value of the company after all of this calculations?

This is what we call it post-money valuation.

We add simply the pre-money valuation and the VC’s investment: $ 1,950,000 + $ 2,000,000 = $ 3,950,000

Fantastic! This is one of many ways a VC can value the company.

I challenge you: if Leonardo wants a rate of return of 30% instead of 50%, what is the amount of shares Carlos will need to issue and what is the price per share ? What are the pre-money and post-money valuations?

In the next post, I will give you the answer.