The Venture Capital Method – Valuation Problem Set

(Based on Harvard Business School Note 9-396-090, prepared by Andrew S. Janower under the
supervision of Professor William A. Sahlman; reorganized by Hao LIANG (SMU))

Question 1.

Roger Harkel, CEO of Bestafer Inc., sought to raise $5 million in a private placement of equity in his
early stage dairy products company. Harkel conservatively projected net income of $5 million in year
five, and knew that comparable companies traded at a price earnings ratio of 20X.

a. 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%?
b. If the company had 1,000,000 shares outstanding before the private placement, how many
shares should the venture capitalist purchase? What price per share should she agree to pay

m
if her required rate of return was 50%? 30%? (Note: Assume investment is in standard

e r as
preferred stock with no dividends and a conversion rate to common of 1:1)

co
eH w
c. Roger feels that he may need as much as $12 million 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

o.
would he have to give up?
rs e
ou urc
Solution:

The first question to ask with any problem set is: What are the inputs? In this case, the inputs are:
o
aC s

- $5 million new money from VC

v i y re

- Value of company in 5 years: 5 × 20 = 100 million

a) Rate of return required by the investor:

$5 m × (1.5)5 = $37.97 m ≈ 38.0% (of $100 m value of Bestafer, Inc.)
ed d

$5 m × (1.3)5 = $18.56 m ≈ 18.6% (of $100 m value of Bestafer, Inc.)

ar stu

b) Answering this question requires consideration of existing pool of shares and consideration of
dilution of this pool.
Let X be # of shares purchased by VC.
sh is

(1) How many shares will there be after the VC invests?

Th

𝑥
= VC’s share = 38%
1,000,000 shares+ 𝑥

Solving for 𝑥:
𝑥 = 0.38 × (1,000,000 shares + 𝑥) = 0.38 𝑥 + 380,000 shares
0.62 𝑥=380,000 shares
380,000 shares
𝑥= =612,903 shares
0.62

(2) What price per share should the venture capitalist agree to pay?
$5,000,000
= $8.16/share
612,903 shares
Bonus question: What is the pre-money valuation of the firm?

This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00
https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
 1,000,000 shares × $8.16/share = $8.16 m

Bonus question: What is the post-money valuation?

General Answer: pre-money valuation + new money = post-money valuation
$8.16 m + $5 m = $13.16 m

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
What is the value of the company in 5 years? It is still $100 m.
How much does Roger need to give up?

$91.13 m
= 91.13%
$100 m
This explains why Roger does not raise all the money in this round. He hopes he can raise some

m
e r as
of the money at a higher valuation later as the company makes progress.

co
eH w
o.
Question 2. rs e
ou urc
Benedicta Jones of Gorsam Capital liked Harkel’s plan, but thought it naïve in one respect: to recruit
a senior management team, she felt Harkel would have to grant generous stock options in addition
to the salaries projected in his business plan. From past experience, she felt management should
o

have the ability to own at least a 15% share of the company by the end of year 5. Given her beliefs,
aC s

what share of the company should Benedicta insist on today if her required rate of return is 50%?
v i y re

30%?

Solution:
ed d

At the end of year 5, the senior management team owns 15% of the company. This means the share
ar stu

ownership in year 5 will get diluted by 15%.

What is the value of the company in year 5? Still $100 m (just like in Question 1).
sh is

So, the ‘value pie’ that investors own at the end of year 5 is:
Th

$100 m - $15 m = $85 m

So, Benedicta now needs to do her analysis based on a value in year 5 of $85 m.

The amount that Benedicta hopes to receive in year 5 on her $5 m investment is $38 m.

Thus the share of the company she needs to own now is $38 m/$85 m = 44.7%

So, how many shares does this translate into?

x
= 44.7%
1,000,000+x

x = 447,000 + 0.447x

This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00
https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
 0.553x = 447,000

447,000
x= = 808,318 shares
0.553

the price per share is $5,000,000/808,318 = $6.19 per share

Bonus Question: What is the pre-money valuation?

$6.19 × 1,000,000 = $6.19 m

Bonus Question: What is the post-money valuation?

$6.19 m + $5 m = $11.19 m

m
e r as
Question 3.

co
On further analysis and discussion, Benedicta and Roger agree that the company will probably need

eH w
another round of financing in addition to the current $5 million. Benedicta believes that Bestafer will

o.
need an additional $3 million in equity at the beginning of year 3. While the first round investors
rs e
(including herself) will require a 50% return, Benedicta feels that round 2 investors, in recognition of
ou urc
the progress made between now and then, will probably have a hurdle rate of only 30%. As before,
management should have the ability to own a 15% share of the company by the end of year 5.
o

a. Based on this new information, what share of the company should Benedicta seek today?
aC s

What price per share should she be willing to pay?

v i y re

b. What share of the company will the Round 2 investors seek? What price per share will they
be willing to pay?
c. Suppose it was apparent in the beginning of year 3 that Bestafer would meet its financial
ed d

targets, but not until the end of year 7. How would your answers to parts 3a and 3b change?
ar stu

If Benedicta took her pro-rata share of the round (e.g., to keep her percentage ownership of
the company the same after the offering as it was before), what overall internal rate of
return could she expect?
sh is

Solution:
Th

Now we have to think about 2 rounds of financing at different valuations. A general approach for
this type of problems is as follows:

- Step 1: What $ amount and share of the terminal value do round 1 investors expect?
- Step 2: What $ amount and share of the terminal value do round 2 investors expect?
- Step 3: What share of the terminal value do round 1 investors expect given the dilution by
round 2 investors?

a) Why would subsequent investors expect/accept a lower return?

o Because prospects of the company have (presumably) improved.

This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00
https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
 What is the value of the company to investors at the end of year 5?
o $85 m ($15 m goes to management)

What $ amount of the equity pie does Benedicta require at the end of year 5?
o $38 m (same answer as in question 1a.). That equals 38% after dilution by
management.

How much is that before dilution by management?

o 38%/0.85 = 44.7% before dilution by management (same answer as question 2.)

What $ amount of the equity pie does the group of round 2 investors require? (Round 2
investors expect an annual 30% return on their $3m investment for a period of 3 years)
o $3 m × (1.3)3 = $5.59 m. That equals 6.59% after dilution by management.

m
e r as
How much is that before dilution by management?

co
o 6.59%/0.85 = 7.75% before dilution by management

eH w
Now, what % of the $85 m will stage 1 investors require given the dilution by round 2

o.
investors?
rs e
ou urc
o Round 1 investors require 44.7% before management dilutes them (see above) and
44.7%/(1-7.75%) = 48.5% before round 2 investors dilute them.
o

So, how many shares do round 1 investors require?

aC s
v i y re

x
o = 48.5%
1,000,000+x
x = 485,000/0.515 = 941,747
ed d

What is the share price for round 1 investors?

ar stu

o $5,000,000/941,747 = $5.30 per share

Bonus Question: What is the pre-money valuation for round 1?

sh is

o $5.30/share × 1,000,000 = $5.3 m

Th

Bonus Question: What is the post-money valuation for round 1?

o $5.3 m + $5 m = $10.3 m
b) So what # of shares do round 2 investors need to buy? (Remember they need 7.75% of the
pie before dilution by management)?
# of shares issued before round 2 = 1,000,000 + 941,744 = 1,941,767

So, how many shares need to be issued to round 2 investors to get to 7.75% ownership (pre-
dilution by management)?
x
o = 7.75%  x = 163,128 shares
1,941,747+x

This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00
https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
 The share price of shares needed to be issued in round 2:
$3 m / 163,178 shares = $18.39 per share

Bonus Question: What is the pre-money valuation for round 2?

o 1,941,747 × $18.39/share = $35.71 m

Bonus Question: What is the post-money valuation for round 2?

o $35.7 m pre money + $3 m new money = $38.7 m

c) Suppose schedule slips 2 years. How do your answer to a) change?

Remember: Benedicta has already invested $5 m for a share of 48.5% of company (before
dilution by round 2 investors and management)

m
--> answer to a) would not change. Benedicta has already made the investment.

e r as
Her cash flow:

co
0 1 2 3 4 5 6 7

eH w
-5 0 0 -1.455 0 0 0 $85m ×

o.
rs e 0.485 =
$41.2m
ou urc
$3m × 0.485 = $1.455m (her pro-rata share of investment to keep her ownership share
constant)
o

--> her IRR: 33% (rather than 50% as expected) Note: Benedicta’s IRR can be calculated with
aC s

any standard financial calculator.

v i y re

How do your answer to b) change?

Round 2 investors know at the time of their investment that schedule will slip by two years,
ed d

so they require a larger share than in the original scenario. What share do they require?
ar stu

$3 m × (1.3)5 = $11.14 m. So round 2 investors require 11.14% after dilution by

management.

How much do Round 2 investors require before dilution by management?

sh is

o 11.1%/0.85 = 13.06% required by stage 2 investors

Th

x
= 13.05%  x = 291,597 shares
1,941,747+x
Price per share for round 2:
o $3m / 291,597 = $10.29 per share

Bonus Question: What is the pre-money valuation of round 2?

1,941,747 shares × $10.29/share = $19.9 m (Note: this is lower than the valuation if schedule
had not “slipped” (see question 3b))

Bonus Question: What is the post-money valuation of round 2?

$19.9 m × $3 m = $22.9 m

This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00
https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
 Question 4.

In her term sheet, Benedicta has proposed using a hybrid security called participating preferred
stock. Participating preferred acts in part like standard preferred, in that at conversion common
stock is issued at a previously agreed upon conversion rate, and in part like debt, in that at
conversion the entire original principal amount is also repaid to the holder of the security. As far as
Roger can tell, Benedicta has also priced the deal assuming only one round of financing would be
required and as if standard preferred stock with a 50% required rate of return were used (as
described in Question 1a).

a. What effect does using the security Benedicta proposed have on her effective rate of return?
De facto, how much of the company does Benedicta own?
b. If Roger agrees to use the participating preferred security, what terms (e.g., price per share

m
e r as
and number of shares) should he propose in his counter-offer? What percentage of the

co
company should he be prepared to give up in order to still meet Benedicta’s 50% required

eH w
rate of return?
c. How does utilizing participating versus standard preferred change Roger and Benedicta’s

o.
rs e
perceptions of the risk and reward profile of this deal?
ou urc
Solution:

This question is comparable to question 1 a) except for the fact that participating preferred stock is
o

used.
aC s
v i y re

a) Terminal value: $100 m - $5 m (principal repaid to Benedicta) =$95 m

Benedicta’s share of terminal value: 38% × $95 m = $36.1 m
Return to Benedicta at the end of year 5: $5 m + $36.1 m = $41.1 m
ed d

Benedicta’s de-facto claim on the company at the end of year 5: $41.1 m/$100 m = 41.1%
ar stu

Benedicta’s cash flow:

0 1 2 3 4 5
-5 0 0 0 0 41.1
--> IRR = 53% (note: this is higher than the 50% annual return that Benedicta achieved in the
sh is

scenario in Question 1)
Th

b) What counter offer should Roger propose?

If Roger agrees to use the participating preferred stock, he should make a counter-offer
which accounts for the fact that Benedicta will receive $5 million first and then participate
pro rata in the remaining value of the firm. Under the base-case ($100 m enterprise value -
$5 m return of principal = $95 m equity value) this implies that Benedicta would meet her
required return with a reduced equity stake.
The payback that Benedicta requires in 5 years: 5 × (1.5)5 = 38 m

The nature of the payback: 1. $5 m cash (payback of principal); 2. $33 m in shares

The equity value in year 5: $100 m (enterprise value) - $5 m (debt) = $95 m

This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00
https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
 The share of the equity this requires: $33 m / $95 m = 34.7%

# of shares that Benedicta requires:

x
= 34.7%  solve for x, x = 531,393 shares
1,000,000+x

The share price: $5 m/531,393 shares = $9.41/share

--> Roger should offer Benedicta 531,393 shares at $9.41/share

The pre-money valuation: 1,000,000 shares × $9.41 =$9.4 m

The post-money valuation: $9.41 m + $5 m = $14.41 m

m
e r as
co
c) Utilizing participating preferred enhances the return to the investor and shifts risk from the

eH w
investor to the founders, particularly if the company is only modestly successful. The

o.
effective percentage of the company owned by Benedicta if she uses a participating
rs e
preferred depends on the total terminal value of the company as illustrated below:
ou urc
Company Value To Investor To Founder
$4MM 100% 0%
o

5 100% 0%
aC s

10 69% 31%
v i y re

20 54% 47%
30 48% 52%
40 46% 54%
50 44% 56%
ed d

100 41%* 59%

ar stu

150 40% 60%

* Scenario under Question 4a.
sh is
Th

https://www.coursehero.com/file/21532210/EF-VC-method-exercise-w-solution/
This study source was downloaded by 100000843521291 from CourseHero.com on 12-02-2024 15:11:22 GMT -06:00

https://www.coursehero.com/file/35316033/Validation-ProblemSet-answerspdf/
Powered by TCPDF (www.tcpdf.org)