Question

EBV is considering a $5M Series A investment in Newco. EBV proposes to structure the investment as 6M shares of convertible preferred stock. The employees of Newco have claims on 10M shares of common stock. Thus, following the Series A investment, Newco will have 10M common shares outstanding and would have 16M shares outstanding on conversion of the CP. EBV estimates a 25 percent probability for a successful exit, with an expected exit time in 5 years and an exit valuation of $500M. The $100M EBV fund has annual fees of 2 percent for each of its 10 years of life and earns 20 percent carried interest on all profits.

(a) What is your investment recommendation for EBV? (Show all steps.)

(b) How sensitive is this recommendation to different assumptions about the exit valuation and the probability of success?

(c) Given the evidence described in Chapter 7, do you think that 25 percent is an aggressive assumption about the probability of success for a first-round investment?

Answer 1

(a)

Initial investment by EBV = $ 5M

EBV's stake in Newco post CP conversion = 6/16 = 37.5%

Expected value of EBV's stake at the end of 5 years = 37.5%*25%*$ 500 M = $ 46.88 M

Annual return achieved over 5 years, on successful exit = (46.88/5)^(1/5)-1 = 56%

This is much higher than the cost and hurdle rate for the fund. Hence investment in NewCo is recommended.

(b)

Investment rationale is totally dependent on assumptions of exit valuation and success probability. If exit valuation is brought down below $ 350 and success probability below 10%, then hurdle rate of 20% will not be met, and the fund would be better off investing in other opportunities.

(c)

First round investments are done in completely new ventures with cash flow and market evidence yet to significantly kick-in. Hence success rate is very low in such cases. 25% success probability is indeed a very aggressive call in this case.