Question

You started Max Inc., a seed stage web-oriented entertainment venture, with 10,000 shares. You do not expect to make a profit until year 4 when your net income is expected to be $4 million. An investor wants to invest $1.5 million in your venture. You and the investor agree that the required return on this investment is 40% and that the investor will exit at the end of year 4. Meanwhile, the common stock of TDC, a comparable firm, currently trades in the over the counter market at $10 per share. TDC’s net income for the most recent year was $300,000 and the firm has 150,000 shares of common stock outstanding. However, two years after this deal, it turns out that the venture needs an additional investment of $1 million. Another investor is willing to invest $1 million in your venture provided you give her 30% return. Calculate the percentage of ownership dilution suffered by the first-round investor after the second investment.                                                                                           

22.	FV investment1 = 1500000*1.4^4 =5,762,400.00
	FV Venture = 5x$4M = $20M
	% Investor 1 = 5,762,400.00/20M = 28.81%
	% Founder = 1-28.81% = 71.19%
	Total shares = 10,000/71.19% = 14,046.92
	Shares issued = 14,046.92– 10,000 = 4,046.92
	Second Round
	% Investor 2 = (1000000*1.30^2)/20M = 8.45%			8.45%
	% Founder and 1st Investor = 1-8.45% = 91.55%
	Total shares = 14,046.92/91.45%= 15.343.44			15343.44
	% Investor 1 = 4,046.92/15,236.92= 26.38%			26.38%
	%Dilution =(28.81%-26.38%)/28.81% = 8.45%			8.45%

Answer 1

1)Value of investment:-

As per the agreement, investor and founder has agreed that investor's rate of return from the investment is 40%p.a

Hence, his aggregate value of investment stretched for four years=1.5 Mns x 1.4^4

{The formulae works in similar line with compounding interest =Like you have invested 10,000 in a Fixed deposit @ 8 % return p.a for four years with annual compounding, hence after one year your value of investment will be =10000+8%=$10800(i.e 108 %of initial invt) or 1.08 times

now in 2nd year, he will get return of 8 % on 10800(because due to compounding his value of investment has increased to 10800. Similarly your value of investment will increase till 4 years . thus the formulae works like

10,000*108%*108%*108%*108%=i.e 10,000* 108%^4=$13604}

2) Value of venture=Here the method applied for calculating value of venture is called "profit multiplier method".

{in profit multiplier, the value of the business is calculated by multiplying its profit. For example, if your company’s adjusted net profit is $100,000 per year, and you use a multiple like 4(4 years), then the value of the business will be calculated as 4 x $100,000 = $400,000}

Hence above calculation is like = 5 years x 4 Millions (expected net income per year)=$20Mns.

{5 years=suppose venture started in 2013 , end of four means 2017 so it will be 5 years (i.e 2013,2014,2015,2016,2017)}

3)Hence proportion of investment of an investor = Value of investment by investment / Value of venture.

4)Percentage of founder = 100% minus proportion of investment by investor=100%-28.81%=71.19%

5)As founder of company is holding 71.19% i.e 10,000 shares

Shares by investor=10,000/71.19% *28.81%=4046.92 shares

6)Investment value of 2nd investor= As he is investing for 2 years with expectation of 30 % return, his value of investment= 1 Mns*1.30 ^2 =1.69 Mns

7)Proportion of investment b investor 2= Investment by investor 2/Value of venture= 1.69mns/20 mns=8.45%

8)Shares issued to 2nd investor=

(Total shares with founder & investor 1)/(proportion of invt in venture of founder & investor 1) x proportion of investment of 2nd investor= (10000+4046.92)/(100%-8.45%) x 8.45%=1296.51 shares

9)Proportion of investment by investor 1 (after investment by 2nd investor)=4046.92 shares/15236.92 shares=26.38%

10)Hence dilution in investment proportion=(28.81%-26.38%)/28.81%=8.45%