Reading: Staged Capital Contribution (SCC)

Consider an entrepreneur who approaches a VC to finance a 6 million investment in his software company. In exchange for the investment, the entrepreneur offers a 40% ownership stake in the company. Consequently, the entrepreneur's valuation is as follows (please refer to the module Startup Valuation for a detailed discussion of how these valuations could come about):

Post-money valuation (Entrepreneur) = \( \frac{Investment}{\text{Ownership stake}} = \frac{6}{0.4} \) = 15 million.

Pre-money valuation (Entrepreneur) = Post-money valuation - Investment = 15 - 6 = 9 million.

The VC, however, thinks that this valuation is excessive. In her view, the current pre-money valuation is only 2 million, which brings the post-money valuation (according to her view) to 8 million. To break even the VC would therefore require an ownership stake of 75%:

Required ownership stake (VC) = \( \frac{Investment}{\text{Post-money valuation}_{VC}} = \frac{6}{8} \) = 75%

Consequently, while also the VC agrees that the firm is, in principle, a good investment, she would require a much higher ownership stake (75%) than what the entrepreneur is wiling to offer (40%). The reason for the disagreement can be easily identified: The entrepreneur is more optimistic about the business prospects than the VC. 

To address this issue, the VC could suggest to stage her capital contributions. To illustrate, let's assume the following:

• Today, the firm only needs capital of 0.5 million to further explore the idea.
• If the idea proves promising, the firm will need 2.0 million to prepare for market entry
• And if the market entry is successful, it will need the remaining 3.5 million to finance its growth plans.

Consequently, there are three rounds of financing that are tied to specific milestones the entrepreneur must reach. Let us further assume that there are currently 100'000 shares outstanding and that the pre-money valuation according to the VC evolves as follows:

• Round 1: 2.0 million (see above)
• Round 2: If the idea proves promising, the firm's pre-money valuation increases to 10 million
• Round 3: If market entry is successful, the firm's pre-money valuation increases to 31.5 million.

Based on all this information, the following table summaries the possible structuring of the staged capital contribution (without dilution protection for the VC). Also see the accompanying Excel file for details.

Let's go through the relevant numbers step by step (for a detailed discussion of how to get from the valuation to the issue price, see here).

Here is what happens in the first round of financing:

• From today's perspective, the pre-money valuation is 2 million.
• If the VC invests 0.5 million, the post-money valuation will be 2.5 million. Consequently, the VC will ask for an ownership stake of 20% today (=0.5/2.5) in exchange for her investment.
• Given that there are currently 100'000 shares outstanding, the firm will issue 25'000 shares to the VC, so that after the first round, there will be 125'000 shares outstanding, of which the VC owns 25'000, i.e., the desired 20% (=25'000/125'000).
• Finally, if the VC receives 25'000 shares in exchange for an investment of 0.5 million, the issue price today is 20 per share.

The mechanics of the second financing round are very similar:

• If the firm clears the predefined milestone (the idea is indeed promising), the pre-money valuation increases to 10 million, according to our assumptions. Since the capital requirements at this stage are 2 million, the post-money valuation will be 12 million and the VC will ask for an additional ownership stake of 16.67% (= 2/12).
• Before the capital increases, there are 125'000 shares outstanding (see above). Consequently, the firm will issue another 25'000 shares, so that after the second round, there will be 150'000 shares outstanding.
• The 25'000 new shares the VC receive account for the desired additional ownership stake of 16.67% (= 25'000/150'000) for round 2.
• After the second round of financing, the VC will own a total of 50'000 shares (25'000 from each round of financing). Her total ownership stake will, therefore, be 33% (=50'000/150'000).

Similarly, in the third round of financing, where the pre-money valuation goes up to 31.5 million, the VC will ask for an ownership stake of 10% in exchange for his investment of 3.5 million. This translates into 16'667 newly issued shares at a price of 210 each. 

In sum, the total capital invested by the VC is 6 million and she receives a total of 66'667 shares for this investment (25'000 in the first round, 25'000 in the second round, and 16'667 in the third round). Given that there will be 166'667 shares outstanding at the end of round three, her ownership stake will be exactly 40% (= 66'667/166'667). 

By moving from a lump-sum investment of 6 million to the staged investment plan, the entrepreneur can, therefore, reduce the ownership stake that he has to offer the VC in exchange for her investment from 75% to 40%.