Question

You are the founder of a start-up.  You incorporated a C corporation and currently own 1,000,000 shares as the founder. You raised $500,000 from friends and family using a convertible note, which will convert into equity if and when there is a “valuation event”, that is if and when your start-up manages to attract funds from a venture capital fund (at which point a valuation will be assigned to the company). The note provides that when the principal of the note ($500,000) converts into equity, the conversion will be done on the basis of a company valuation that may not exceed a total of $5 million (this is a “valuation cap” clause, meaning, friends and family get shares on the basis of the same valuation as the fund unless it is in excess of $5 million, in which case friends and family get shares on the basis of a $5 million valuation).

Your start-up is doing well. You are finally generating revenue and pitching to potential investors, including a VC fund “VC”. At this point you need VC to invest $10 million in your company in order to grow – if you secure this investment, you do not expect the company to produce any earnings for five years (though the company generates revenue, it still has negative earnings), but at the end of year 5 you anticipate to turn profitable and generate net income of about $16 million. VC knows that a firm comparable to yours with current earnings of $10 million was just sold for $100 million.

1. VC is concerned that you may need more than $10 million to get to the result where the company is generating net income of $16 million at the end of year 5. They introduce language in the investment agreement to be protected against any potential dilution of their interest in the event of subsequent funding rounds. If another funding round is needed at the end of year 3, in the amount of $12 million, what ownership percentage would the new investor insist upon if they wanted to get a 20% annual rate of return on their investment? How many new shares would need to be issued to this new investor? How many additional new shares would need to be issued to VC (to protect VC against dilution)? [hint: you need to first figure out total shares outstanding -- assume the dilution is shared with friends and family, meaning they just keep the shares they had]

2. Assuming that such additional funding round is indeed needed – what would happen to your ownership percentage, as the founder? How would this impact how much money you would make if the company were to eventually be sold for $200 million at the end of year 5?

Answer 1

Number of shares owned by the founder= 1,000,000

Number of shares owned by friends and family on the basis of their investment=$500000/$1

=500000

Total number of shares=1000,000+500,000=1,500,000

Percentage of shareholding of the founder=1,000,000/1,500,000=66.67%

Amount invested by VC to encourage growth for 5 years= $10,000,000

Present value of the expected return today at the rate of 20%= $10,000,000/2.9906=$3,343,797

Amount further invested by VC at the end of year 3= $12,000,000

Present value of the amount invested by the VC at the end of year 3 with an expected rate of return of 20%

=$12,000,000/2.1065

=$5,696,703

Expected earnings on Total investment made by the VC today= $(3,343,797+5,696,703)=$9,040,500

Total no. of shares to be issued to VC= $9040500/$1=9,040,500

Total shareholding after issue to VC= 1,500,000+9,040,500=10540500

Ans 1) OWNERSHIP PERCENTAGE of the new investor= 9040500/10540500=85.77%

ADDITIONAL shares to be issue to protect dilution=5,696,703

ANS 2) Revised ownership of the founder after dilution=(100-85.77)*66.67%=9.487%

Expected earnings at the end of 5 years= $16,000,000

Expected selling price of the company based on the trends of the similar company =$160,000,000

Selling price of the Company at the end of 5 years= $2,00,000,000

Additional income= $200,000,000-160,000,000=$40,000,000

Negative Impact on the profit of founder due to dilution=(66.67-9.487)*$40,000,000=$22,873,200