The document discusses a venture capital investment in LeanTech, a startup software company. LeanTech has no revenue and needs $3.5 million in funding over the next 5 years. A venture capitalist wants to invest and targets a 50% annual return over 5 years. Using LeanTech's forecasted future earnings and typical industry valuation ratios, the expected value of LeanTech after 5 years is $37.5 million. For the venture capitalist to achieve a 50% annual return, they would need to invest $3.5 million and own 70.875% of LeanTech. This values LeanTech at $4.938 million immediately after the investment.

1. Equity Venture Capital
Part 1

2. Objective
Introduce the basic concepts of finance: risk,
return, and value, using venture equity capital
2

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

4. Discussion
• What is capital ?
o Its on the balance sheet
• What assets does LeanTech have ?
4
Liabilities
Equity
Assets
roic > cost of capital
Capital
‘Invested capital’
Non-interest bearing
Interest bearing

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

6. 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 ≈ 38% / yr
1=
10
(1+r)5
r =10
1
5
−1
r ≈ 58% / yr

9. 9
P
F
0 N

10. 10

11. 11

12. 12

13. 13

14. 14

15. 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 founders ?
15

16. Discussion
• So how much of the ownership and future earning
potential do the founders surrender ?
• How is a VC firm organized?
16

17. Reference For Example
17
Students are advised to obtain this ‘background note’ from HBSP
We will follow that methodology and example

18. Reference For Example
18
Venture valuation methods

19. Scenario
• LeanTech’s incorporation documents (state law) declared 1,000,000
shares of common equity stock (issued and outstanding) divided among
the three founders (and maybe their friends and family)
• LeanTech has no revenue and no debt
• Its fair value is unknown to the founders
• LeanTech needs $3.5M for costs and expenses over the next 5 years.
• The founders forecast that LeanTech will attain annual net income of
$2.5M during the 6th year
o Net income is same as net profit and net margin
19

20. Forecast Income Statement
This forecast was done at the start of year 1 or time =0
Each year (column) is a forecast for the following year
These financial forecasts are expected values
20

21. Discussion
• What is depreciation ?
• What’s the difference between a cost and an expense ?
• What is EBITDA ?
• How is the economic value of an entity or security
determined?
o Discounted future value
o Relative, multiple, or ratio estimate
• The Harvard teaching note uses a ratio of equity fair value to
net profit
o other ratios can be used including equity fair value to EBITDA or EBIT
21

22. Timeline
• What’s the cash flow timeline?
22
time 0 1 2 3 4 5 6
investment
VC
exit
$2.5M in net
Income

23. 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 committed 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 VC ‘exit strategy’
23
pe=
EquityN
Net ProfitN+1
=
Share priceN
Earnings per shareN+1

24. 24

25. 25
What’s the value of Ford ?

26. Discussion
• What’s the cash flow timeline?
26
time 0 1 2 3 4 5 6
investment
VC
exit
pe =
EN
E NPN+1
!" #$
=
E5
E[NP6]

27. Expected Value
27
000,500,37$15000,500,2$ peNP E ===
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 exit
k: Annualized VC return on investment, ROI
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

28. Equity Allocation
28
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]
VC Investment VC 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

29. Equity Shares
29
How many shares must LeanTech’s board approve for LeanTech’s treasury (under
the CFO) to issue to the VC?
Δns =
70.875%⋅1,000,000
(1−70.875%)
= 2,433,476
nspost = nspre + Δns
=1,000,000+2,433,476
= 3,433,476
ns: number of shares
Dns: number of new shares issued to the VC
fvc =
Δns
nspost
=
Δns
(nspre + Δns)
Δns =
fvc ⋅nspre
(1− fvc )
nspost = nspre + Δns
Δns = fvc ⋅nspost nspre nspost
Dns
Investment

30. Discussion
30
• How many shares of common stock does Netflix have ?
o Authorized
o Issued
o Outstanding
o Treasury shares
= Issued - Outstanding

31. Discussion
• What is preferred and common stock?
• What is a firm’s additional paid in capital?
• What are retained earnings?
o DRE = NP – DIV
• What is the top job in a firm’s accounting department?
• In its financing department?
• To what position do they report?
31

32. Equity Value: Post-Money
32
I = Δns⋅ppost
ppost =
I
Δns
=
$3,500,000
2,433,476
= $1.438
Epost = nspost ⋅ppost
= 3,433,476⋅$1.438
= $4,938,272
p: Share price
E: Equity value
Dns: number of new shares issued

33. Equity Value: Pre-Money
33
Epre = Epost −I
= $4,938,272− $3,500,000
= $1,438,272
ppre =
Epre
nspre
=
$1,438,272
1,000,000
= $1.438
pexit=
E
nspost
=
$37,500,000
3,433,476
=$10.922
p: Share price
E: Equity value
ns: number of equity shares

34. VC App
34

35. Discussion
35
• 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?

36. Homework 1
36
Prepare a markdown document for a single round of venture equity
capital financing.
Use the example data from class except that
• The VC targets making 5x in 5 years
• Firm value is estimated to be 18x its expected EBIT of $3.6M at the
end of year 5
All information should be described and output
All code should be echoed
Due in 1 week at the start of class