I met with Barry Pâquet and I was very impressed and amazed by his story of how he started up his company. He was working as a consultant for another software company and eventually, he had a great opportunity to come up with a product that was superior from the one his client was using. Then, from that one sales, he built his portfolio of clients and making money.

I always like to listen to how people become entrepreneurs and in my experience, most people became entrepreneurs serendipitously.

His company, Quantum Whisper, offers a nifty solution for product development teams scrambling around coding and user feedback. I used to funnel users feedback to the product team and I knew how messy things can get. From the product team perspective, the challenge is to link the user feedback to the specific code or feature in a solid way. Most of us just uses a kind of spreadsheet or paper to take notes between the bug and the code related to it. However, if the project gets too big, the paper or spreadsheet solution can become very overwhelming.

The solution he has is  a platform that links users feedback directly into the development side, so no programmer nor product manager has to do the dirty work of linking those two things every time. This is a great value proposition and I bet it is going to grow a lot.

Invest Now! - from Flickr

My last post from the Entrepreneurial Finance course is here.

Today, I want to share my summary of the Horizon Communications Corporation (A) case study.

This document basically shows the industry background of telecommunication in the 90′s. Basically, it highlights the Telecommunications Act of 1996 and how it changed the market.

With the Act, there was a new market opportunity for companies to provide transmission facility to customers. Basically, there was an opportunity for new companies to serve as a hub connecting a telecommunication facility for big clients to other local telecom providers and to long distance providers.

Along the case, it explains the who the founders are, what the Horizon’s operating strategy is and what the product and service are.

The case presents a serious of challenging questions to the Horizon’s management. It wants to students to think what amount of financing should they ask for and which venture capital firms they should approach.

Again, this case presents challenging questions for VCs and entrepreneurs.

Assignment from MIT OpenCourseWare:

Horizon Communications

1.Would you have started this company? Would you invest in this company? Why or why not? What do you think of the economics of the idea? Of the management team? How does this investment differ from that in Technical Data Corp.

2.What pre-money value would you place on the company? I.e., what value should the Horizon team place on the company when they try to raise money? How much money should they attempt to raise?

3.How should Horizon approach their fundraising process? Should Horizon go to a venture capital firm or to family and friends? If Horizon decides to go to a venture capital firm, which firm or firms should they target?

4.Can a venture capitalist add value to the Horizon team? How?

Assume:

. Horizon’s marginal tax rate is 36%
. Expected inflation is 3%.

Read the Case Study: Horizon Communications Corporation (A)

Please, add your answers in the comment section below!

Invest - from Flickr

I’ve started studying the Entrepreneurial Finance at MIT OpenCourseWare by myself a month ago. I wrote my first post about the first case study here (Technical Data Corporation Business Plan).

Until now, I think the selection of the case studies are awesome. It presents many cases where the student is put in the position of a venture capitalist and an entrepreneur. For instance, you have to learn how to valuate a business and decide if you want to invest in a specific company. Plus, you must provide your analysis to decide what you want to do next.

Today, I’m want to present my summary and my recommendations about the Centex Telemanagement, Inc. case study.

Centex Telemanagement, Inc.

- The case starts with the story of Sierra Ventures and its found Peter Wendell. Then, it talks about how Wendell met with Jeffrey Drazan. Drazan was a VC associate hired by Wendell. In this part of the case, it gave me a very interesting vision of how VC hires an associate to work with. Wendell wanted to invest in the telecommunication industry after the break-up of AT&T’s monopoly and he wanted to find a person with experience in telecommunication industry. Luckly, Drazan, who was in that industry, wanted to go to the VC industry. They had the chance to meet each other and the relationship developed.

- Later, it shows quickly the Centex Telemanagement formation, but the focus is how Drazan found and brought this opportunity to Wendell. Drazan worked with the Centex Telemanagement by acting as the CFO of the company. However, Centex and Sierra hadn’t formed any formal and legal relationship yet. Drazan was supporting the financial projections and planning the growth of the company. Everyone was expecting the Sierra would make an investment to Centex. When they were almost closing the details of the investment, the Sierra founders decided not to continue to the plan. Drazan was shocked because he dedicated an amount of effort to the company and it would ruined all his efforts. However, after some negotiation, they closed the deal in a staged/milestone-oriented approach to the deal.

- To get higher valuation, Centex would need to achieve some milestone, such as hiring the CEO and some other people in the senior management and also Centex would need to achieve an X amount of revenue by a deadline.

Assignment from MIT OpenCourseWare:

Centex Questions:

1. Sierra Ventures and Centex:

-Describe the deal structure:
-What role does Series C Preferred play?
-What value does right of first offer have?
-What valuation is Sierra offering to Centex? How can Sierra justify this valuation?

2. Private (initial) investors:

-How much dilution do the initial investors experience?
-How much dilution would the initial investors have experienced, if they had anti-dilution protection on their initial investment of $499,999? (Full ratchet? Weighted ratchet?)

Assume that by May 1985 the private placement offering has raised the full $499,999 for Centex at $2.25 per share

Read the Case Study: Centex Telemanagement, Inc. – 286059p2

Please, add your answers in the comment section!

The Technical Data Corporation Business Plan is the first case study from the Entrepreneurial Finance course from MIT OpenCourseWare. It is a business plan prepared by Jeffrey P. Parker in late 1980.

The case describes that Technical Data wants to raise $100,000 before the end of 1980 in the form of 20 Units. Each Unit would have 50 shares of common stock offered at $10 per share and a promissory note (debt) of $4500.

Technical Data Corporation: Business Plan

You can read the case study here: http://utopia.duth.gr/~gk7844/moustakis/M1-2007-08/business_plan_example_1.pdf

Then, in this lecture, there are some questions regarding about this case from the open course. I answered them in bold.

Technical Data Corporation: Business Plan The case contains excerpts from a business plan prepared in late 1980.

The entrepreneur, Jeff Parker, proposes to start a company that will supply information to professional investors in the bond market. Among the issues you might address are the following:

1. Should Parker enter the business?

Parker is asking for $100,000 to start up the company. He will create a business based on an existing market of Telerate customer. If he secures, as he stated, the deal of promotion to Telerate’s customer, he is able to attract customer to his financial product and earn a stable source of revenue through the monthly subscription of the service. So, he should enter the business.

2. Would you invest in this deal?

He structure his deal in a promissory note and a few shares of his company. This type of structure is not ideal for a venture capitalist nor private equity partner. First, there is no incentive of high payoff in the $4500 from promissory note even if the interest rate is 15%. Second, the percentage of ownership is small, thus the active investors do not have a great say in the company. Lastly, the company’s grow depends on the Telerate customer base, so there is not a huge or exponential growth rate for the business in the future.

3. How has the deal been structured? Why? (Note that Parker is selling equity for 10% of the company in the units. The two directors with 1.5% each are buying 3 units each.)

The deal is structured in this way:

- 20 Unit
- Each unit having $ 5000 in value
- $ 5000 X 20 = $ 100,000

Each Unit:
- 50 shares of common stock at $ 10 / share
- promissory note of $4500

This is a great exercice. The next case I’m studying is the Horizon Communications Corporation (A), this one is much harder.

15.431 Entrepreneurial Finance

There is an amazing course for people seeking to work in the private equity, venture capital industry and entrepreneurship. The Entrepreneurial Finance is an open course that focus on the finance of start-up ventures.

It addresses some of the important questions such as:

- how much money can and should be raised
- when should it be raised and from whom
- what is a reasonable valuation of the company
- how funding should be structured.

I am self-studying this course and it is great to read case studies that make me aware of the issues that I will be facing in the VC/PE industry.

You can read more about this open course here: http://ocw.mit.edu/OcwWeb/Sloan-School-of-Management/15-431Entrepreneurial-FinanceSpring2002/CourseHome/index.htm

Have fun with your friends!

If you want to read the whole Accel And Facebook case about valuation, please check the posts in this sequence.

A VC firm makes money – Accel and Facebook case – Part 1

A VC firm makes money – Accel and Facebook case – Part 2

A VC firm makes money – Accel and Facebook case – Part 3

A VC firm makes money – Accel and Facebook case – Part 4 (Final)

Have fun!

 

News about series funding or staged investments from venture capitalists

 In this third post, I’m going to explain why venture capital firms invest in stages and not in a one-time-big-investment and why Facebook is receiving rounds of investments.

Venture capitalists want to have some control in their investments. By staggering their investments in rounds, they can evaluate if the startup should receive more money or not. In this way, the VCs can monitor the entrepreneur’s progress and gather additional information to make a sound investment.

From the book “The Venture Capital Cycle – 2nd edition” on page 173, we have the Apple Computer’s story that illustrates this well:

“Apple Computer received three rounds of venture capital financing. In the first round, venture capitalists invested $518,000 in January 1978 at  a price of $0.09 per share. The company was doing well by the second round of venture financing in September 1978. Venture investors committed an additional $704,000 at a price of %0.28 per share, reflecting the progress the firm had made. A final venture capital infusion of $2.331 million was made in December 1980 at $0.97 per share. At each stage the increasing price per share and the growing investment reflected resolution of uncertainty concerning Apple’s prospects.”

Besides, these rounds of investments may have some names such as Series A round or B or C or even D rounds.

From the entrepreneur’s side, these round of investments may mean that they achieved a milestone event such as breakeven, getting their 1,000,000 customer, having the patent granted, having the drug trial phase IV passed, etc.

Back to the Facebook and Accel example:

“Facebook received its first investment of US$500,000 in June 2004 from PayPal co-founder Peter Thiel.[25] This was followed a year later by $12.7 million in venture capital from Accel Partners, and then $27.5 million more from Greylock Partners.[25][26] A leaked cash flow statement showed that during the 2005 fiscal year, Facebook had a net loss of $3.63 million.”

So, in this little paragraph, we see that Facebook had at least 3 rounds of investments until 2005.

- Peter Thiel: US$ 500,000
- Accel Partners: US$ 12.7 million (Accel invested probably because Facebook achieved some milestone)
- Greylock $27.5 million (Greylock invested probably because Facebook achieved some milestone, but probably it had to pay more for less share)

Much later, we had the Microsoft’s investment of $240 million.

Let’s pick up Accel’s investment and see how its investment increased in value.

“Among venture capitalists it’s a poorly kept secret that Facebook’s valuation came in just shy of $100 million. Assuming that’s true (Mr. Breyer declined to say), Accel paid a little more than $12 million for roughly a 15 percent share.”

Usually, when a company receives a round of fund with increasing value (a higher price-per-share), no previous investors requires more shares of the company. If the company has a “down-round” which means that the price-per-share of the latest round is lower than the previous one, usually the VCs requires more new shares to compensate for their loss in the valuation. I will explain this in other posts.

So, in later reports, Accel still has 11% of the company. This means at the time of Microsoft’s investment, Accel’s investment was valued from US$ 12.7 million to US$ 1.65 billion. That’s an increase of 130 times of their initial investment!

Other VCs and investors invest in Facebook because they hope that their shares will have a similar increase value of their investments.

You wonder if this is the way VC makes money. This is simply the value of their investment; however, they need to “transform” their shares of the company into money.

This transformation is what VCs call “exiting event”.

The “exiting event” can be divided into four types:

- Staying private

- IPO

- Bankrupt

- Acquired / Merger

In the part 4 of this post, I will show what would happen to Accel’s investment for each of the exits. Then, we conclude how VC firms make money.

The news that you saw from the image were taken from these pages:

Twitter Raises $35 Million Series C From Benchmark and IVP

MARINUS PHARMACEUTICALS RAISES $20 MILLION IN SERIES B FINANCING

Wozniak’s storage startup Fusion-io raises $47.5M more

Irvine Chip Startup WiSpry Nabs $10M Funding

Math is not as complex as it looks

Remember from the last post:

“At the end, we see that Peter Thiel got XXXX % (I can’t find the info, but this does not matter in our discussion of how a VC firm makes money rfom now) of Facebook with US$ 500,000 in June 2004,Accel Partners invested $ 12.7 million for 15 % (let’s say that New York Times is right) and Greylock Partners invested $27.5 million for XXXXX %.

Tomorrow, I will post the calculation of what is the percentage that Greylock Partners got with $ 27.5 million.”

So, today I will show how we can estimate the percentage of equity that Greylock had after investing $ 27.5 million.

US$ 27.5 million is Y% of the post-money valuation.

The post-money valuation was given from this news:

“Venture capital funding provided by Greylock Partners and other firms totaling $25 million placed a value of $525 million on Facebook, which reportedly turned down $750 million from Viacom.”

Chim’s comment: What I really want you to focus is the first paragraph. Greylock Partners and other firms valued the company at $525 million! This number is important to establish the pre-money and post-money valuation. With this info, we are able to estimate the approximate percentage of the company’s equity being sold.

So, we have $ 525 million of post-money and the new money is US$ 27.5 M.

This means that Greylock got probably  in exchange of 19% of Facebook.

Now, let’s see what is the pre-money valuation!

As you can remember, the pre-money + new money is post-money.

Pre-money (what Peter, Accel, founders, management, employees and other not-known investors) + $ 27.5M = $ 525 M

So, the pre-money valuation was at that time: $ 497.5 million, almost half a billion!

In the next post, I will tell you about the differences of Round A, B, etc rounds of investment. A startup usually receives more than one round of investment and that can affect the number of shares a VC needs to have. I will keep the explanations simple and in case I need to explain more, I will create more posts!

Background information:

Accel Partners is a private equity and venture capital firm. It invests in many industries such as Computing, Consumer Internet, Engergy, etc (there are 11 industries).

Increadibly, Accel has invested in 197 companies (I did not count one by one but I use a smarter way to count). It is based in Palo Alto, Californa and it also has in London, China and India. It was created on 1984 and there are some famous companies invested by them, Real Networks, Facebook, Veritas, Comscore, BitTorrent and Macromedia (the creator of Dreamweaver, Flash, etc.)

Also incredibly, Accel was able to raise almost 1 billing of dollar at the end of 2008, when the Global economic downturn started.

Read more at its website

Facebook is a social network website. Basically, it is a virtual place where people communicate and share their lives in an easy way. It was created by Mark Zuckerberg and his classmates in Harvard University in 2003.

You can read more about Facebook here.

Now we are ready to visualize how a VC firm can make money (I will need to write more than a post for this, be ready).

If you read from the Wikipedia page at the Financials section, you read that:

“Facebook received its first investment of US$500,000 in June 2004 from PayPal co-founder Peter Thiel.[25] This was followed a year later by $12.7 million in venture capital from Accel Partners, and then $27.5 million more from Greylock Partners.[25][26] A leaked cash flow statement showed that during the 2005 fiscal year, Facebook had a net loss of $3.63 million.”

We are not going to focus on the net loss this time. I may discuss this later posts.

Searching a little bit the Internet, we get:

From New York Time, Facebook and Venture Capital Firms

“Among venture capitalists it’s a poorly kept secret that Facebook’s valuation came in just shy of $100 million. Assuming that’s true (Mr. Breyer declined to say), Accel paid a little more than $12 million for roughly a 15 percent share.”

Chim’s comment: I added some other paragraph just to give you a glimpse of what was being discussed there. You can click the paragraph to the news directly.

As you can see, Accel paid, very probably (you can see from the last post that this is almost exactly what Accel had with the Microsoft valuation), $ 12M for 15% of Facebook that time.

“And back in 2006, social-network valuations sky-rocketed accordingly.

There was the $800 million acquisition offer from Yahoo that Facebook reportedly rejected, the $2 billion Facebook wanted and the $25 million in venture capital Facebook got from Greylock Partners in April. In September, RBC Capital markets analyst Jordan Rohan said MySpace might be worth $15 billion in three years. The same month, Google bought video-sharing site YouTube, with is social features such as profiles and friends lists, for $1.6 billion.”

Chim’s comment: Something is impressive here. Big companies, such as Yahoo!, were buying social networks for about $500 – $800 million at that time. This means that the value of social network sites were in this range price. One very interesting thing is the Jordan’s (from RBC Capital) comments “MySpace might be worth $ 15 billion in three years”. He missed, it was Facebook that was going to be valued at $ 15 billing in less than 3 years.

Venture Beat - Facebook and VC firms

“It has never been our intention to sell the company,” said Melanie Deitch, Facebook’s director of marketing, adding that the latest funding puts the rumors of such a sale to rest. Late last month, Business Week reported the company had turned down a buyout offer for $750 million and was looking for as much as $2 billion, citing analysts saying that Viacom, owner of MTV, might make a good match.

David Sze, the venture capitalist who led the investment for Greylock, said earlier statistics from comScore showing a decline in unique visitors in February were an aberration, and that the company’s internal statistics show continued robust growth. Indeed, the March statistics showed resumed growth on this metric too.”

Chim’s comment: As you can think, big companies were trying to buy Facebook for $750 M range. The second paragraph is interesting about the statistics from comScore. It is not the first time that comScore misreport numbers about visitors for a site. Sometimes, misleading news are spread to push negotiation… not in this case, I guess.

WebProNews - Facebook and VC firms

“Venture capital funding provided by Greylock Partners and other firms totaling $25 million placed a value of $525 million on Facebook, which reportedly turned down $750 million from Viacom.”

Chim’s comment: What I really want you to focus is the first paragraph. Greylock Partners and other firms valued the company at $525 million! This number is important to establish the pre-money and post-money valuation. With this info, we are able to estimate the approximate percentage of the company’s equity being sold.

Seattlepi.com - Facebook and VC firms

“New York-based News Corp., whose far-flung media properties include Fox Broadcasting and 20th Century Fox, spent $3.5 million for an undisclosed stake in Mountain View, Calif.-based SimplyHired. It bought MySpace.com last year for $580 million.”

Chim’s comment: So, on 2005, Fox bought MySpace for $580 million. Again, this reinforce the probable value range ($400M – $800 M) of a famous social network site.

At the end, we see that Peter Thiel got XXXX % (I can’t find the info, but this does not matter in our discussion of how a VC firm makes money rfom now) of Facebook with US$ 500,000 in June 2004, Accel Partners invested $ 12.7 million for 15 % (let’s say that New York Times is right) and Greylock Partners invested $27.5 million for XXXXX %.

Tomorrow, I will post the calculation of what is the percentage that Greylock Partners got with $ 27.5 million.

15 Billion - Facebook and Microsoft Case

Many of you remember that Microsoft paid $ 240 million for 1.6 percent of Facebook . That was a huge amount of money for a company that is not generating THAT much money for the valuation.

Sometimes, a company invest in a startup for strategic reasons.

Anyway, let’s use the Venture Capital Method to see what is the post-money valuation (don’t remember what’s post-money valuation? read my past article about it again.)

Information that we have:

- Microsoft paid $ 240 million for 1.6%

The math is very simple to calculate the post-money valuation: 1.6%(TOTAL) = $ 240 M then, TOTAL = $240M/0.016

We have a whooping $ 15 000 million or $15 billion post-money valuation! 

When a reporter says that the company was valued at $15 B, he was saying the post-money valuation.

In this case, we didn’t need to know the number of shares held by the existing shareholders because we know the percentage Microsoft got from this transaction which was 1.6%. However, we do not know the real number of shares.

I found another website that has more information about the percentage each of the shareholders has of Facebook.

“That’s obvious too with the $240 million cash investment (with more to come from other greedmonger private investors, of course, in another round now being arranged by Facebook) that bought Microsoft exactly 1.6% of Facebook.

That puts Microsoft behind Greylock Partners’ and Meritech Capital Partners’ 1.7%, Founders Fund’s 5% and Accel Partners’ 11%–Accel partner and Facebook board member Jim Breyer also has a personal 1% stake, now valued at $150 million–and Zuckerberg’s 20% (not the 30% that has been widely reported), which is now worth $3 billion.”

Organizing the information:

- Greylock Partners’ and Meritech Capital Partners’ 1.7%

- Founders Fund’s 5%

- Accel Partners’ 11% (Chim’s comment: pay attention to this, in the next posts I will show you why this number decrease from 15% to 11%, but they got a lot of money!)

- Accel partner and Facebook board member Jim Breyer also has a personal 1%

- Zuckerberg’s 20%

If the information is correct, then each of their pre-money valuation would be:

- Greylock Partners’ and Meritech Capital Partners’ 1.7% (of $ 15B) = $ 255M

- Founders Fund’s 5% = $ 750M

- Accel Partners’ 11% = $1.65B (Chim’s comment: again pay attention on this. They invested $XXXX amount and they ‘got’ this billion here, more info in the next posts.)

- Accel partner and Facebook board member Jim Breyer also has a personal 1% = $ 150M

- Zuckerberg’s 20% = $ 3B

Let me check for one thing: $240M + $255M + $750M + $1.65B + $150M + $3B = $ 6 billion.

Where or who is holding the remaining 9 billion? Who knows.

In the next post, I will share some findings about how VC makes money with concrete information.

Valuation: the money that you have

Remember from our last post. 

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

Leonardo wants 30% of return rate instead of 50%.

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 24.7% 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 24.7% of the TOTAL.

X = 0.247(TOTAL)  ,  TOTAL means 5,000,000 shares + X

X = 0.247(5,000,000 shares + X)

X  = 1,235,000 + 0.247X

X – 0.247X = 1,235,000

0.753X =  1,235,000

X = 1,640,106 shares

Leonardo needs to have 1,640,106 shares of the company. Actually, the company issues 1,640,106 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 / 1,640,106 shares = $ 1.22/ share

If Leonardo agrees with everything else, he will state in his contract that he will pay $1.22/share for 1,640,106 shares of the company. Carlos will issue 1,640,106 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 $ 1.22, so his shares value at 5,000,000 X $ 1.22 = $ 6,100,000 - This is what we called pre-money valuation.

OK, this is much better the valuation with 50% of rate of return from Leonardo! Remember that the pre-money was only $ 1,950,000!!!

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: $ 6,100,000 + $ 2,000,000 = $ 8,100,000

As you can see, the rate of return is extremely important for valuation purpose. The new value is double the amount of the last valuation.

This is one of the reason Finance skill is so important.

In the next posts, I will use some real world news and apply this Venture Capital method to see some “hidden” information.

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.