Question

Question 1: Roger Harkel, CEO of Bestafer, Inc. seeks to raise $2 million in a private placement of equity in his early stage venture. Harkel conservatively projects net income of $5 million in year 5 and knows that comparable companies trade at a price earnings ratio of 20X.

What share of the company would a venture capitalist require today if her required rate of return was 50%?

What if her required rate of return was only 30%?

If the company had 1M shares outstanding before the private placement, how many shares should the venture capitalist purchase?

What price per share should she agree to pay if her required rate of return was 50%? 30%?

(Note: Assume investment is in standard preferred stock with no dividends and a conversion rate to common of 1:1)

Roger feels that he may need as much as $12M in total outside financing to launch his new product. If he sought to raise the full amount in this round, how much of his company would he have to give up?

What price per share would the venture capitalist be willing to pay if her required rate of return was 50%? 30%?

Question 2: Benedicta Jones of Gorsam Capital likes Harkel’s plan, but thinks it is naïve in one respect: to recruit a senior management team, she believes Harkel will have to grant generous stock options in addition to the salaries projected in his business plan. From past experience, she thinks management should have the ability to own at least 15% share of the company by the end of year 5.

Given her beliefs, what share of the company should Benedicta insist on today if her required rate of return is 50%? 30%?

Answer 1

New money from VC = $2 million
Value of company in 5 years: 5 × 20 = 100 million ( $5 million profits x p/e ratio)
a) Share of the company required by the investor:
1. If required rate of return is 50%:
$2 m × (1.5)^5= $15.19 million= 15.19% (of $100 m value of Bestafer, Inc.)
2. If required rate of return is 30%:
$2 m × (1.3)^5= $7.425 million = 7.425% (of $100 m value of Bestafer, Inc.)
b)Answering this question requires consideration of existing pool of shares and consideration of dilution of this pool.
Let X be the number of shares purchased by VC.
(1)How many shares will there be after the VC invests?
?? / 1,000,000 shares+ ??= VC’s share = 15.19%
Solving for ??:
??= 0.1519 × (1,000,000 shares + ??) = 0.1519??+ 151900 shares
0.8481x ??=151900 shares ; x = 179106
(2) What price per share should the venture capitalist agree to pay?
$2,000,000 /179106 shares= $11.17/share
c) What if $12 m was raised in this round, how much would Roger need to give up?
$12 m × (1.5)^5= $91.13 m
So, Roger would need to give up 91.13% (91.13 million / 100 million)
This explains why Roger does not raise all the money in this round.
He hopes he can raise some of the money at a higher valuation later as the company makes progress