hello this is dr. adam jae bok in this short audio presentation we're going to finish up our conversation about venture capital we've already talked a little bit about angels and VCs and now we're going to walk through a capitalization example so this is often referred to as the venture capital model it's a mechanism that helps understand how ventures raise multiple rounds of financing there's usually some assumption about there being an expected exit value and given what that looks like we can take we can clearly assess the based on the investment amounts what the likely deal prices are going to be for the current for a given round I want to be very clear about this although these kinds of models are developed carefully by venture capitalists there are often very complex quantitative spreadsheet models based on extensive assumptions and calculations it's important to recognize that ultimately each of these deals is negotiated on a one-off basis every deal is different every round of every deal is different and so it's less important that you have some you know in-depth understanding of the calculations in in particular it's unlikely that you have really deep familiarity with discounted cash flows or weighted average cost of capital or internal rates of return but you should understand that this is a fairly sophisticated process that is negotiated and ultimately usually negotiated based on these models but once those models are determined then the actual numbers and actual deal terms are negotiated as part of a qualitative process that's driven heavily by people so all of this begins with the point the reality that for a given venture capital portfolio there's a specific model that's required to make this work so when a venture capital firm invests in ten companies there's a basic assumption that probably around half of those companies are going to fail almost completely that is all of the money will be spent and nothing will be no root there will be no returns at all the venture capital firm will get no written nothing back on those investments or very very little back on those investments and that's just a reality of the fact that these kinds of companies have a lot of uncertainty and risk associated with them and the technology may not work out the way they expected the market might not develop the way they expect that or there could be completely other factors that simply no one could predict but many of these startups these tech startups in particular and high-growth startups are likely to fail and some of these companies won't completely fail but they just won't generate any returns either so for example in this model we have five companies failing completely two of these companies they're not successful but at least the venture capital firm or the other investors get their money back so $100 is invested and they get about $100 back a couple of firms do reasonably well so in here they're shown as Forex returns that is the investors put in $100 they get $400 back and then some of these companies are in this case scenario only one out of the ten is hugely successful and generates 15x and so this then shows a annualized return of about 20 20 percent so the idea here is that over five years the venture capital firm is trying to generate 20% or higher returns per year and this shows you what the profile of different company return expectations is what this means though is that if you are a startup company and there's no way that your opportunity has the potential to generate 15 times returns then there's no point in the venture capital firm even considering you as an investment because you don't fit this model and even if you say well I'm certain we'll make Forex that's not interesting to them because there's no way to guarantee that and they have to treat all these companies the same and so this is often very disappointing and frustrating for entrepreneurs because they really do think there's a good opportunity and there might be but it doesn't fit the overall venture capital model so we're gonna quickly walk through an illustration of what a capitalization might actually look like through four rounds the founder round plus three rounds of external funding so initially the there's a founder round and it is normal for founders to put money into their companies even if it's not very much and in this case we're talking about $10,000 0.01 million dollars and so the founders put that much in they get a hundred percent ownership and now they are ready to go out and raise money from perhaps angels and presumably they accomplished something at the very beginning they put together a business plan they get a patent they identify potential strategic partners or they create a prototype or something like that so that they can go to angel investors and say look this company is worth something now and we want you to invest so here's what that might look like maybe the investment is a half million dollars five hundred thousand dollars and we see in this case a pre-money valuation of 1 million dollars I'm gonna talk a little bit about pre-money valuation in just a moment but the basic idea is that when they go to the seed investors they're saying this company is worth 1 million dollars and we would like a half million dollars to keep moving the company forward and hopefully hit a specific milestone well the way we look at ownership here is the ownership of the new investors is their investment divided by the post-money valuation well post-money valuation equals pre-money plus the investment if you think about it it's pretty straightforward the company was worth a million dollars and then the investors put a half million dollars in well that means that the post-money valuation is 1 million plus a half million which is a million and a half and since the seed investors put a half million in there they own 1/3 so the founders still owned two-thirds but what's interesting is now you can look and see how the founders value has gone up initially they put in $10,000 which is all the company was worth now they own 2/3 of a million of worth a million and a half dollars which means their stake is theoretically worth a million dollars now they can't do anything with that this is an illiquid asset but this is really important because many entrepreneurs get caught up in this issue of o-mai ownership stake went down and it did it went from a hundred percent to sixty six point seven percent but the value of their stake went up and that's the thing that matters right so yes control is important and needs to be considered but ultimately what you're really trying to do is try to create value so then let's do an a round and the a round is going to be much bigger it's a five million dollar round but let's imagine that the terms are roughly the same we now argue that the company is worth ten million dollars before the investment I'm sorry the company is worth five million dollars before the investment is made but it's a ten million dollar a round I misspoke my apologies a ten million dollar investment well we can look through the same process the post-money valuation is fifteen million and here whereas in the seed round the company the founders retained two thirds here the new investors are getting two thirds that's pretty unusual you will almost never see deals happen like that most investors don't want to take a majority ownership in any given round of funding but for the sake of argument we've put this in here again we can now see how the percentage has changed the founders ownership drops by two-thirds from 66 percent down to 22 percent but their the value of their stake has gone up yet again so from 1 million dollars up to 3.3 million dollars so again they've now lost control of the company investors as a group now own majority control the company but the founders value has still gone up let's imagine now that this company is hugely successful and never has to do another round of funding and then is able to go to an initial public offering that's pretty unlikely but for the sake of argument let's pretend that that's what happens while the pre-money valuation is all the way up to a hundred million dollars the amount that's brought in through the IPO is 50 million that gives us a post-money valuation of 150 million dollars and the founders ownership stake drops again by a third because that's a what the investment was a third of the value and so again we can look at the founders ownership which is now up to 22 million dollars and you get that by simply multiplying their ownership stake 14.1 14.8% by the valuation 150 million dollars and so again it's really important to notice here that at this point in time the founders only own 15% of the company and you might think well that's disastrous they started with a hundred percent now the only own 15 percent well sure but at the beginning they owned a hundred percent of something that was worth ten thousand dollars and now they own fifteen percent of something that's worth a hundred and fifty million dollars which means their piece of it is worth twenty two million dollars and that can be sold now that it's a public company they can sell that stock on the public market and capture some of that value and this is this crucial element about dilution there's a difference between ownership dilution and value dilution right so the percentage stake may go down but your the value of your ownership stake goes up that's the ultimate goal in these Vout in these capitalization processes and so you can see that whereas the a round investors only made seven times their money the founders made more than 2000 times their money so this is a pretty important step to recognize in terms of how how these things play out it's the earlier you get in the more the higher or return you expect to get and presumably the higher risk that you take so the key question that then comes up is well where do we get those pre-money valuations anyway how do we value an early-stage company and the answer is of that very often you can't early-stage valuation is very much an art there's a number of things that you can do to try to get a handle on it you can think forward to a likely exit value usually that's based on comparables similar kinds of companies that have exited in the past you can look at how much you need from your investor and what their expected return is that will give you an indicator of what you're likely valuation is you can try to figure out based on what your ownership requirement is and how much money you need but you have to be very careful about that because that may be based on what your expectations are and not what the market will bear so again the two key calculations post-money valuation that is how much the company is worth after the money goes in is simply equal to the pre-money valuation plus the investment itself another useful calculation is that that post-money valuation is equal to the investment that's put in divided by the ownership stake the percent that the investors are going to get and you're usually going to triangulate with other methods so you might if you're more sophisticated use a discounted cash flow analysis of future projections of the company you might compare that with benchmarks from other deals that have been done and then also compare that with what you're expecting as far as long-term exit and investor return expectations so this is although there's a huge science behind this ultimately this also gets negotiated and depends on a lot of different factors this is an example provided here for you I know that this may for those of you who are not math enthusiasts this may look quite frightening it also may be completely unfamiliar to those of you who don't have any experience with internal rates of return or discounted cash flows I'm gonna explain it just in a moment but you are not expected to know this for AI think a quiz or a test for example so let's imagine for a moment that our pro forma projections that is our financial projections going forward suggest that we're hoping to exit in year 5 and we think that when we do exit in year 5 the company will be worth about 10 million dollars and we might have gotten that because there's 5 million in revenue and in this industry historically exits happen at about a value of 2 times the revenue so again here we are triangulating based on industry data let's assume that we are taking $100,000 investment at the start of year during year 0 so this is before this 5 year time frame begins and let's say our where believe our investors want a 60% rate of return we can then use that to calculate how much they need to get back in five years which is a hundred thousand times 1.6 which is our return rate to the fifth power and that gives us just over a million dollars so that then tells us what ownership stake that they're going to need in order to achieve that if they need to get back just over a million dollars in five years and we think the company is going to be worth 10 million dollars then they need to have 10.5% ownership because at 10 million dollar valuation they'll get just about 1.0 5 million dollars for their for their investment therefore their ownership piece and so then that would give us a pre-money valuation we can look at how what the post-money valuation would be which is we know that they're investing a hundred thousand dollars in the ownership piece they need to get is 10.5% so we can calculate the post-money valuation from that which comes out to be about nine hundred and fifty thousand dollars and since the they're investing a hundred thousand that means the pre-money has to be that post-money minus one hundred thousand dollars was about eight hundred and fifty thousand dollars so this is a way of backing out evaluation based on what our investors would expect again if you're not familiar with this we don't expect you to be able to do this on the quiz or a test it's a really useful thing to be aware of but it is just a little bit more sophisticated than would normally be relevant in this kind of course so hopefully this gives you some sense of what capitalization might look like for an example it's just an example all these numbers you know will vary dramatically based on the type of investor the stage of the company the sector you're in the growth opportunity and so on