A potential investor is seeking to invest $500,000 in a venture, which currently

Question

A potential investor is seeking to invest $500,000 in a venture, which currently has 1,000,000 shares held by its founders, and is targeting a 50% return five years from now. The venture is expected to produce half a million dollars in income per year at year 5. It is known that a similar venture recently produced $1,000,000 in income and sold shares to the public for $10,000,000.

a.    What is the percent ownership of our venture that must be sold in order to provide the venture investor’s target return?

b.    What is the number of shares that must be issued to the new investor in order for the investor to earn his target return?

c.    What is the issue price per share?

d.    What is the pre-money valuation?

e.    What is the post-money valuation?

Please show work.

Explanation / Answer

We are going to solve this problem by the “Venture Capital Method.” From the question it is given that the investors are eyeing 50 % annualized return for a period of 5 years.

Therefore first lets define in terms “X” what is the amount of return they are looking at e.g 1X, 2X,etc. So this becomes a FV (future value) problem. If I invest 1$ today (PV) at the rate of 50% every year what will be my investment worth in 5 years.

To find FV we will use excel. The excel syntax for FV is:

=FV(rate,nper,pmt,[pv],[type])

rate=annual interest rate=50%

nper= number of periods=5 years

pmt=yearly payments from the investment=0

pv=present value =$ 1

type= 0 or 1. 0 if payments are made at the beginning of the period, and 1 if payments made at end of the period. Since nothing is given in the question we take the default value of 0.

=FV (0.50,5,0,-1,0)

= 7.594

So the investors are looking at return of 7.594X.

Now lets find out the P/E (Price /Earning) ratio of the comparable company. The comparable company had $ 1,000,000 Mn in income (Earnings) and it sold shares to the public for $ 10,000,000 (Price). Therefore:

P/E=(10,000,000/1,000,000)

=10

The company that we are valuing we know will have $ 500,000 in earnings 5 years from now. Therefore, using a P/E ratio of 10 the value (P) of the company will be:

10=P/500,000

P=$ 5,000,000

a) We know that our investor is going to invest $ 500,000. Out of this $ 5,000,000 we know that our investor wants the value of his investment to be 500,000*7.594= $ 3,796,875 at the end of 5 years. Therefore, the investor must own (3,796,875/5,000,000)= 75.94% shares of the company to earn his target return.

b)New Shares Issued: Venture Capital Investments/Share Price

Share Price: Pre-money valuation/Number of Pre Money Shares

In question part d we have already discussed pre-money valuation. The pre-money valuation is $ 159,717.64. Number of shares outstanding 1,000,000.

Therefore,

Share Price: 159,717.64/1,000,000

                               =0.1597176 (rounded to 0.1580)

New Shares Issued: Venture Capital Investments/Share Price

500,000/0.1597176

=3,130,524.59

c)As discussed in part b the Share Price is 0.1597176

d) Since the venture needs $ 500,000 in investments and $ 500,000 represents 75.794% in the company the post money valuation will be:

(1/0.75794)*500,000

=$ 659,682.82

Therefore, pre-money valuation of the venture= Post money valuation- Investment:

                                                                                      =659,682.82-500,000

                                                                                      =$ 159,717.64

e) As discussed in part d the post money valuation is $ 659,717.64

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