Venture Capital Financing The Venture Capital Method B.G. Bisson

Valuation and Pricing Magnitude of investment Magnitude of investment Staging of investment Staging of investment Syndication Syndication Target IRR Target IRR Investment time horizon Investment time horizon Terminal value of firm Terminal value of firm % ownership required % ownership required Deal structure Deal structure Future financing and dilution – “The Venture Capital Method” Future financing and dilution – “The Venture Capital Method”

Magnitude of Investment Typically >$1.0 million for institutional Typically >$1.0 million for institutional Small deals too costly Small deals too costly Typically less than $10 million in Canada Typically less than $10 million in Canada Most deals $1.0-$3.0 Most deals $1.0-$3.0 Based on business plan pro formas Based on business plan pro formas Free cash flow (EBIAT, working capital, capital expenditures) Free cash flow (EBIAT, working capital, capital expenditures)

Investment Time Horizon 4-7 years 4-7 years How long will it take to create value? How long will it take to create value? Years to cash flow breakeven Years to cash flow breakeven

VC Investments and IRR

Target IRR % % Stage of company Stage of company Use of funds Use of funds Deal structure Deal structure

VC Target IRR Seed Seed Startup Startup First stage First stage Second stage Second stage Bridge Bridge Restart Restart IRR>80% IRR>80% 50-70% 50-70% 40-60% 40-60% 30-50% 30-50% 20-35% 20-35% ?? ??

The Venture Capital Method Step 1 Given the VC investment, the target IRR and the investment time horizon, determine the future value of the VC investment Given the VC investment, the target IRR and the investment time horizon, determine the future value of the VC investment FV = PV(1+i)^n FV = PV(1+i)^n i = target IRR i = target IRR N = time horizon to exit N = time horizon to exit Eg. FV = $1.0m(1+0.35)^5 = $4.5m Eg. FV = $1.0m(1+0.35)^5 = $4.5m

The Venture Capital Method Step 2 Given the projected earnings at exit and an appropriate Price Earnings ratio (PER) for the company, calculate the projected terminal value of the company at exit Given the projected earnings at exit and an appropriate Price Earnings ratio (PER) for the company, calculate the projected terminal value of the company at exit Eg. TV = $1.0m(15) = $15m Eg. TV = $1.0m(15) = $15m

The Venture Capital Method Step 3 Determine the % ownership required by dividing the required future value of the investment at exit by the projected terminal value of the company at exit Determine the % ownership required by dividing the required future value of the investment at exit by the projected terminal value of the company at exit Eg. FV= $4.5m/TV$15m = 30% Eg. FV= $4.5m/TV$15m = 30% Or divide the VC investment by the present value of the projected terminal value of the company at exit Or divide the VC investment by the present value of the projected terminal value of the company at exit Eg. PV=$15m/(1+0.35)^5=$3.33m ; $1.0m/$3.33m=30% Eg. PV=$15m/(1+0.35)^5=$3.33m ; $1.0m/$3.33m=30%

% Ownership Required

Magnitude of investment Magnitude of investment Duration of investment Duration of investment Target IRR Target IRR Terminal value of firm Terminal value of firm Room for future investment? Room for future investment? See spreadsheet (VC Investment Perspective) See spreadsheet (VC Investment Perspective)

The Venture Capital Method Step 4 Determine number of new shares (NS) to be issued to VC. Determine number of new shares (NS) to be issued to VC. Find number of shares outstanding before investment (old shares (OS) eg. 1.0m) Find number of shares outstanding before investment (old shares (OS) eg. 1.0m) VC % Ownership = NS/(NS +OS) VC % Ownership = NS/(NS +OS) Eg. 30% = NS/(NS + 1.0m) Eg. 30% = NS/(NS + 1.0m) NS= 430,000 NS= 430,000 Price per share = $1.0m/430,000 = $2.33 Price per share = $1.0m/430,000 = $2.33

The Venture Capital Method Step 5 Determine pre and post-money valuation Determine pre and post-money valuation If 30% of the company is acquired for a $1.0 VC investment, this implies a post-money valuation of $1.0/0.30 = $3.33m If 30% of the company is acquired for a $1.0 VC investment, this implies a post-money valuation of $1.0/0.30 = $3.33m Give a post-money valuation of $3.33m and an investment of $1.0m, the pre-money valuation is $2.33m Give a post-money valuation of $3.33m and an investment of $1.0m, the pre-money valuation is $2.33m Carried interest = (post-money valuation) x (% ownership post-money) Carried interest = (post-money valuation) x (% ownership post-money) Does this valuation make sense? Is it realistic? Does this valuation make sense? Is it realistic?

The Venture Capital Method Step 6 Assess future dilution due to issuance of additional shares prior to exit. Assess future dilution due to issuance of additional shares prior to exit. Shares to management, future investors Shares to management, future investors Estimate retention ratio = 100% - % of ownership issued to others in future Estimate retention ratio = 100% - % of ownership issued to others in future Eg. If a future investor negotiates a 10% ownership, the retention ratio is 100%- 10%=90% Eg. If a future investor negotiates a 10% ownership, the retention ratio is 100%- 10%=90%

The Venture Capital Method Step 7 Calculate adjustment to required ownership % due to expected future dilution Calculate adjustment to required ownership % due to expected future dilution Adjusted ownership % = % ownership without dilution divided by retention ratio Adjusted ownership % = % ownership without dilution divided by retention ratio Eg. Adjusted % = 30%/90% = 33.3% Eg. Adjusted % = 30%/90% = 33.3% If VC owns 33% after investment and gets diluted by 10% before exit, the final ownership % will be 30%, ie. the required ownership % to realize target IRR given projected terminal value If VC owns 33% after investment and gets diluted by 10% before exit, the final ownership % will be 30%, ie. the required ownership % to realize target IRR given projected terminal value

Sensitivity Analysis Due Diligence Terminal Value Terminal Value Future Earnings (Sales, Expenses, Profits) Future Earnings (Sales, Expenses, Profits) PER PER Target IRR Target IRR Risk Risk Deal Structure Deal Structure Liquidity Liquidity Dilution Dilution Future Rounds (Amounts, IRR, Horizon) Future Rounds (Amounts, IRR, Horizon) Management incentives Management incentives

Staging of Investment All up front All up front Two or three tranches Two or three tranches Contingent on meeting milestones/targest Contingent on meeting milestones/targest Option to abandon Option to abandon

Syndication Sharing the deal with other VC firms Sharing the deal with other VC firms Diversify the risk Diversify the risk Broaden the network Broaden the network Increase size of portfolio Increase size of portfolio