2. Financing Alternatives

For the purpose of valuation, let us go back to the example that we have discussed in the course section Division of Financial Returns. The basic characteristics of the deal were as follows:

  • Amount of Investment: 10 million
  • Expected time to exit: 4 years
  • Post-money valuation (according to the VC): 15 million
  • Pre-money valuation (according to the VC): 5 million
  • Current number of shares of common stock outstanding (including reserved shares): 15 million

 

For the purpose of our valuation, we also make two additional assumptions:

  • The risk-free rate of return is 5% p.a. (discrete compounding)
  • The volatility of the firm's return is 40% p.a.

  

Our task is now to structure a financing package such that the VC receives a value of (at least) 10 million in exchange for his investment.

 

Common Equity

In the preceding sections, we started out with common equity financing and have determined that the VC would require a share in capital of 66.7% in exchange for his investment.

 

Share in CapitalVC = \(\frac{Investment_{VC}}{\text{Post-money valuation}} = \frac{10}{15} \) = 66.7%.

 

Consequently, the firm would have to issue 30 million shares of common stock to the VC, at an issue price of 0.333 each.

 

Preferred Stock

Let us now look at the various alternative deal structures that we have considered, as well as their valuation implications. The following table summarizes the key elements of the deal structures from the course section on Preferred Returns:

 

Number of shares Liquidation preference ($) Additional participation Cap on participation ($) Convertibility
Straight preferred 10 million 17.1 million none none
Convertible preferred 10 million 15.1 million none 1:1
Participating preferred (full participation) 10 million 9.2 million pro-rata as converted no cap 1:1
Participating preferred (with cap) 10 million 10.0 million pro-rata as converted 30.0 million none
Convertible participating preferred (with cap) 10 million 9.5 million pro-rata as converted 30.0 million 1:1

  

Let us now value these alternative deal structures. To do so, we will rely on option pricing models, more specifically, the Black-Scholes model.  For a brief discussion of this model, and it's limitations in the context of firm valuation, please refer to the respective section in the course module Startup Valuation. The separate Excel file "Valuation of Alternative Deal Structures" contains the necessary calculations to value all these deal structures.