Question

Consider the following case which illustrates a typical chain of equity investments in the startup and early growth of a venture that qualifies for venture capital:

Upon incorporation, the Board authorizes company stock amounting to 2,000,000 shares available to be issued to potential stockholders and immediately issues 1,000,000 shares. From this issued stock pool the three founders (F) are collectively granted 900,000 shares of $.01-value founder's stock, and the additional 100,000 shares are ordered to be held in reserve for future key employees (KE) at a share price of $.10. Over the next 6 months several key employees are hired and all the KE shares are distributed.

A)What fraction of the company is owned collectively by the founders at this point in time?

One year after incorporation, at the time of first-stage financing, the Board issues an additional 500,000 shares from the authorized total for purchase by the venture capital firm (VC) at $2.00 per share.

B)What fraction of the company is owned by the investors at this point in time? By the founders?

C)What is the company valuation at this point in time?

After six months passes, the Board issues additional shares from the authorized total to cover the $2,000,000 second stage financing and the VC acquires these at $4.00 per share.

D)What fraction of the company is owned by the investors at this point in time?

   E) What is the company valuation at this point in time?

Subsequently, the Board accepts an acquisition offer for the entire company at a P/E ratio of 20 based on the previous year's performance. During that year, the firm's sales were $30,000,000 and net profits represented 10% on sales.

   F) Compute the overall multiple earned by the venture capital firm (VC) on their invested money.

   G) Do you have enough information to compute an annualized rate of return for the investment? If not, what additional information would you need?

Answer 1

Company authorized stock = 2,000,000 shares

Issued stock = Founders 900,000 shares @ $0.01 = $ 9,000

Key Employees 100,000 shares @ $0.10 = $10,000

Total Issued Stock = 1,000,000 shares at value $ 19,000

A. Fraction of the company owned by the Founders = 900,000 shares / 1,000,000 shares i.e. 0.90

B. One year after incorporation shares issued to VC Firm = 500,000 shares @ $2.00 = $1,000,000

Total Issued stock one year after incorporation = 1,500,000 shares at value $1,019,000

  Fraction of the company owned by the Founders = 900,000 shares / 1,500,000 shares i.e. 0.60

  Fraction of the company owned by the Investors = 500,000 shares / 1,500,000 shares i.e. 0.33

C. Company Valuation one year after incorporation = $1,019,000 / 1,500,000 = $0.68 per share

D. After six months, further shares issued to VC Firm = 500,000 shares @ $4.00 = $2,000,000

Total Issued stock one year six months after incorporation = 2,000,000 shares at value $3,019,000

  Fraction of the company owned by the Investors = 1,000,000 shares / 2,000,000 shares i.e. 0.50

E. Company Valuation one year six months after incorporation = $3,019,000 / 2,000,000 = $1.51 per share

Acquisition offer at a P/E of 20.

Firm's Sales $30,000,000

Net Profits = 10% of Sales i.e. $30,000,000 x 0.1 = $3,000,000

Acquisition offer = $3,000,000 x 20 i.e. $60,000,000

Share of VC Firm = 0.50 of $60,000,000 i.e. $30,000,000

F. Overall multiple earned by the VC firm on their invested money = Share of Offer / Total Investment value

i.e. $30,000,000 / $3,000,000 = 10

G. To compute annualized rate of return on investment we would need the period of holding of the investment by the VC firm.