“The best reason to start an organization is to make meaning; to create a product or service to make the world a better place.”
-Guy Kawasaki, venture capitalist, CEO of Garage Technology Ventures
Understanding a Basic Venture Capital Formula to acquire stake in a company
The table below illustrates a simple example of how a Venture Capital/PE firm will value the firm, arrive at the current and future stock price, and deduce the % of shares to be acquired in order to meet the expectations of the investment.
It is based on expected rate or return (in this case 50%), number of years (5 yrs), investment amount ($3.5 mn), expected PE ratio of the firm in 5 years (based on comparables), expected cash flows of the firm in 5 years.
|Required IRR (%) — a||50.00%|
|Investment ($) — b||35,00,000|
|Term (Yrs.) — c||5|
|Year 5 revenue ($) — d||25,00,000|
|PE ratio (Year 5) — e||15|
|# of shares outstanding before investment — f||10,00,000|
|Terminal value of the firm ($) — (d * e) — g||3,75,00,000|
|Required future value of investment ($) — Expected Future Value of Investment — h||2,65,78,125|
|Final ownership required= h/g=i||70.88%|
|# of shares to be acquired = f/(1-i)*i=j||24,33,476|
|New share price ($)=b/j=m||1.44|
|Post-money value of the firm @ t0 ($)=b/i=k||49,38,272|
|Pre-money value of the firm ($)=k-b||14,38,272|
|Share value at exit, for given discount rate=Expected Future Value of Current Share Price||10.92|
|Firm value at the end of each round = Post Money Valuation||49,38,272|
The above basic calculation is done assuming only one round of funding & no further dilution (i.e. no second/third round.. in which case the % of stake would obviously rise).
More on VCPE here