Venture Capital: Capitalization Example

Overview

• Venture capital models help understand how ventures raise multiple rounds of financing.
• Expected exit value is a key consideration.
• Deals are negotiated individually despite quantitative models.

Venture Capital Portfolio Model

• Assumption: 50% of invested companies may fail completely.
• Return expectation varies:
  • Complete failure: no returns.
  • Break-even: get initial investment back.
  • Successful: May have 4x return.
  • Highly successful: Can achieve 15x return.
• VC firms expect a 20% annualized return over 5 years.

Startup and Investment Suitability

• VC firms seek high return potential (e.g., 15x returns).
• Companies without potential for high returns may not fit VC models.

Capitalization Example: Multiple Rounds

• Founder Round
  • Founders invest $10,000.
  • Ownership: 100% founders.
• Seed Round
  • Investment: $500,000.
  • Pre-money valuation: $1 million.
  • Ownership: 1/3 investors, 2/3 founders.
• A Round
  • Investment: $5 million.
  • Pre-money valuation: $5 million.
  • Ownership: 1/3 founders, 2/3 new investors.
• IPO Scenario
  • Pre-money valuation: $100 million.
  • Investment: $50 million.
  • Post-money valuation: $150 million.
  • Founders' ownership: 14.8% valued at $22 million.

Valuation and Dilution

• Ownership vs. Value Dilution
  • Ownership percentage decreases but value increases.
• Pre-Money and Post-Money Valuation
  • Key calculations involve pre-money plus investment.
  • Post-money = investment / ownership stake required.

Early-Stage Valuation

• Valuation is often an art rather than science.
• Methods include:
  • Comparables (similar companies).
  • Investor required returns.
  • Ownership requirements.
• Triangulation with discounted cash flow analysis and benchmarks.

Example Calculation

• Scenario: $100,000 investment, exit in 5 years at $10 million valuation.
• Investor expects 60% return.
• Ownership stake calculated through expectations.

Conclusion

• Capitalization processes vary greatly by investor type, company stage, and industry sector.
• Understanding these processes, even at a basic level, is crucial for working with venture capital.