Understanding Venture Capital Formula for Equity Acquisition

Understanding a Basic Venture Capital Formula to Acquire Stake in a Company

“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

The table below illustrates a simple example of how a Venture Capital/Private Equity (VC/PE) firm values a company, determines the current and future stock price, and deduces the percentage of shares to be acquired in order to meet the expected return on investment (ROI). The formula is based on an expected rate of return (50%), the investment amount ($3.5 million), the expected PE ratio in five years, and the projected cash flow of the firm.

Variables Used in the Formula:

• a (IRR) = 50%

• b (Investment) = $3,500,000

• c (Term in Years) = 5

• d (Year 5 Revenue) = $25,000,000

• e (PE Ratio in Year 5) = 15

• f (Number of Shares Outstanding Before Investment) = 10,000,000

Step-by-Step Calculation:

1. Terminal Value of the Firm
   Formula: g = d × e
   Calculation: g = 25,000,000 × 15 = $375,000,000

2. Required Future Value of Investment
   Formula: h = (b × (1 + a)^c)
   Calculation: h = 3,500,000 × (1 + 0.50)^5 = $265,781,250

3. Required Ownership (Percentage of Shares to be Acquired)
   Formula: i = h / g
   Calculation: i = 265,781,250 / 375,000,000 = 70.88%

4. Number of Shares to be Acquired
   Formula: j = f / (1 – i) × i
   Calculation: j = 10,000,000 / (1 – 0.7088) × 0.7088 = 2,433,476 shares

5. New Share Price
   Formula: m = b / j
   Calculation: m = 3,500,000 / 2,433,476 = $1.44 per share

6. Post-Money Valuation
   Formula: k = b / i
   Calculation: k = 3,500,000 / 0.7088 = $4,938,272

7. Pre-Money Valuation
   Formula: k – b
   Calculation: 4,938,272 – 3,500,000 = $1,438,272

8. Share Value at Exit
   Formula: m × (1 + a)^c
   Calculation: m × (1 + 0.50)^5 = 1.44 × 7.59375 = $10.92 per share

9. Firm Value at the End of Each Round
   Formula: k
   Calculation: $4,938,272

Return on Investment (ROI):

Formula: ROI = (Exit Value – Investment) / Investment × 100
Calculation: ROI = (10.92 – 1.44) / 1.44 × 100 = 659.38%

Key Takeaways:

• One round of funding and no dilution assumptions have been used for this calculation. If there were subsequent funding rounds, the percentage of shares acquired would rise.

• The expected return on investment (ROI) is extremely high (659.38%), showing the potential for significant growth when making calculated, strategic investments in companies.

Conclusion

This venture capital formula demonstrates how a PE or VC firm evaluates an investment, sets expectations for returns, and determines the shares to acquire. The numbers and approach outlined above reflect a typical investment cycle in venture capital funding, with calculations that are key to understanding the financial potential of startup and growth-stage companies.