- LeanTech, a software startup, needed to raise $3.5 million in capital to fund costs over the next 5 years as it had no revenue. - A venture capitalist was interested in investing and targeted a 50% annual return over 5 years. - To achieve this return, the venture capitalist would receive a portion of LeanTech's equity and become a shareholder and board member, with the intent to exit via IPO or acquisition after 5 years. - The key terms of the venture capital deal, including LeanTech's valuation pre- and post-investment, the venture capitalist's expected return and ownership stake, and LeanTech's expected future value were calculated using standard venture capital models.

1. Equity Venture Capital
Part 1

2. Objective
• Introduce the basic principles of finance using
venture equity capital
o But only the core financial principles !
• What are the alternatives?
2

3. Scenario
• Three entrepreneurs founded a software
company, LeanTech, last year
• They have an alpha product currently and have
nearly depleted their savings
• The founders need to raise capital
• LeanTech has no revenue and its fair value is
unknown to the entrepreneurs
3

4. Discussion
• What is capital ?
o Its on the balance sheet
• What assets does LeanTech have ?
4
Liabilities
Non-interest bearing
Interest bearing
Equity
Assets
Capital
roa roc>

5. Sources of Capital
• Friends and family
• Credit cards ?
• Commercial banks
• Private equity
o Angels
o Venture capital
o ‘Private equity’
o Crowd sourcing
• Public equity
o Investment banks
o Primary offering
o Secondary offering
• Government programs
5

6. Venture Capital Deals
6

7. 7

8. 8
Return On Investment
Within five years, a portfolio company should be able to deliver five to ten
times the return on CenterPoint's investment, with CenterPoint retaining a
meaningful equity share of 10% or higher for its Limited Partners.
F = P×(1+ r)N
P =
F
(1+ r)N
1=
5
(1+ r)5
r = 5
1
5
-1
r » 40% / yr
1=
10
(1+ r)5
r =10
1
5
-1
r » 58% / yr

9. Discussion
• What is equity?
• How are present and future value related ?
o when there are no intermediate cash flows?
o when there are intermediate cash flows?
• Note the present and future value factors and
rates
• What is Centerpoint’s targeted rate of return on
its investment?
o Is there an equivalent cost to the company?
9

10. Discussion
• How is a VC firm organized?
• So how much of the ownership and future earning
potential do the entrepreneurs surrender ?
10

11. Reference For These Lectures
11
Students must obtain this ‘background note’ from HBSP
We will follow that methodology and example

12. Reference For These Lectures
12
Venture valuation methods

13. Scenario
• LeanTech’s incorporation documents (state law) declared
1,000,000 shares of common equity stock (issued and
outstanding) divided among the three founders
• LeanTech has no revenue yet and its fair value is unknown to
the founders
• LeanTech needs $3.5M for costs and expenses over the next 5
years.
• The company has no debt
• The founders expect that LeanTech will achieve annual net
income of $2.5M during the 6th year
13

14. Timeline
• What’s the cash flow timeline?
14
time 0 1 2 3 4 5 6
investment
VC
exit
$2.5M
in Net
Income

15. Forecast Income Statement
Each year (column) is a forecast for the upcoming year
What’s is depreciation ?
15

16. Discussion
• Mean value is an average value of a sample, a population,
an experiment, a measurement, etc.
• Expected value is a probability-weighted average of all
possible values or outcomes
16
X=
1
n
Xi
i=1
m
å
E[X]= pi × Xi
i=1
m
å

17. Scenario
• Companies in LeanTech’s industry have an average equity
value of 15 times forecasted annual earnings i.e., the price
earnings ratio, pe, is 15
• A venture capitalist is interested in investing in LeanTech. That
VC targets an ROI (a rate) of 50% annually – for funds tied up
for 5 years
• The VC becomes
o An equity investor and a shareholder
o A board member ?
• The VC intends to sell its equity to the public (IPO) or via
acquisition (M&A) after 5 years
o This is the ‘exit strategy’
17
pe=
EquityN
Net ProfitN+1
=
Share priceN
Earnings per shareN+1

18. Discussion
• What’s the cash flow timeline?
18
time 0 1 2 3 4 5 6
investment
VC
exit
pe =
EN
E NPN+1[ ]
=
E5
E[NP6 ]

19. Discussion
• What’s the difference between a cost and an
expense ?
• How is the economic value of an entity or security
determined?
o Discounted cash flow
o Relative, multiple, or ratio estimate of valuation
• The Harvard teaching note uses a ratio of equity fair
value to net profit, but other ratios can be used
including equity fair value to EBITDA or EBIT
19

20. Homework 1
20
Find the following values for ebay?
Use Yahoo Finance and year ending Dec 2014 or ttm
• Revenue
• COGS
• R&D expense
• SG&A expense
• EBITDA
• EBIT
• Interest expense
• Income tax expense
• Net profit
• Number of common shares outstanding
• Book value of the equity (total)
• Market value of the equity (total)
• Rate of return on assets
• Common equity at par
• Common equity additional
paid-in
• pe ratio

21. Expected Value
21
000,500,37$15000,500,2$peNPE 
The expected fair value of the equity after 5 years, E, is
The expected value of the VC’s share of the firm after 5 years, EVC, is
125,578,26$%)501(000,500,3$)k1(IE 5N
vc 
%875.70
000,500,37$
125,578,26$
E
E
f vc
vc



The fraction of the firm that the VC will own after the investment, fVC, is
I: VC investment
NP: annual net profit of company during Nth year
pe: price to earnings ratio (E/NP) in year N+1
N: Number of years to investment exit
k: Annualized VC return on investment
E: Equity (and total) value of company at end of N
years (future fair value)
fVC: Fraction of equity owned by VC
EVC: Value of VC equity at exit

22. Equity Allocation
22
fFDR = 1 – 70.875% = 29.125%
EFDR = $37,500,000 - $26,578,125 = $10,921,875
Pre-money period Post-money period pe E[NP]
Venture Capital
Investment
Venture Capital Exit
I = $3,500,000
EVC = $26,578,125
EFDR: Expected value of founder’s equity at VC exit
fFDR: Fraction of equity owned by founders
time in years t=0 t=N
beginning of end of Nth
first year (last) year

23. Equity Shares
23
How many shares must LeanTech’s board approve for LeanTech’s
treasury (under the CFO) to issue to the VC?
476,433,2
%)875.701(
000,000,1%875.70
ns




476,433,3
476,433,2000,000,1
nsnsns prepost



ns: number of shares
ns: number of new shares issued to the VC
)f1(
nsf
ns
)nsns(
ns
ns
ns
f
vc
prevc
pre
post
vc








postvc
prepost
nsfns
nsnsns


nspre nspost
ns
Investment

24. Discussion
24
• How many shares of common stock does Netflix have ?
o Authorized
o Issued
o Outstanding
o Treasury shares
= Issued - Outstanding

25. Discussion
• What is preferred and common stock?
• What is additional paid in capital?
• What are retained earnings?
o RE = NP – DIV
• What is the top job in a company’s accounting
department? In its financing department? To what
position do they report?
25

26. Equity Value: Post-Money
26
438.1$
476,433,2
000,500,3$
ns
I
p
pnsI
post
post





272,938,4$
438.1$476,433,3
pnsE postpostpost



p: Share price
E: Equity value
ns: number of new shares issued

27. Equity Value: Pre-Money
27
272,438,1$
000,500,3$272,938,4$
IEE postpre



438.1$
000,000,1
272,438,1$
ns
E
p
pre
pre
pre



pexit
=
E
nspost
=
$37,500,000
3,433,476
=$10.922
p: Share price
E: Equity value
ns: number of equity shares

28. VC App
28

29. Homework 2
29
Create a knitr file to compute and describe a single round of
venture equity capital financing. Print a pdf for for submission.
Use the information from the class case except
• VC targets making 5x in 5 years
• LeanTech value is estimated to be 18x its expected EBIT of $3.6M
at the end of year 5
The result should be prepared to be of value to you in the future
Key computations should ‘echo’ the code
Due September 15

30. Discussion
30
• What was LeanTech value ‘pre-money’ ?
• What was leanTech value ‘post-money’?
• What is LeanTech expected to be worth at the end of
year 5?
• What is the VC’s expected rate of return?
• What percent of the company will the VC own to achieve
that expected rate of return?
• What if LeanTech’s market value at the end of year 5 is
lower than expected? Higher than expected?

31. Homework 3
31
2 page essay
Describe Facebook’s IPO using as many course
concepts as possible. You will have to review several
articles to have the needed understanding.
Due September Sept 17

32. Discussion
32
What’s the value of Ford ?