Reference no: EM132262655
You are the founder of a start-up. You incorporated a C corporation and currently own 1,000,000 shares as the founder. You raised $500,000 from friends and family using a convertible note, which will convert into equity if and when there is a “valuation event”, that is if and when your start-up manages to attract funds from a venture capital fund (at which point a valuation will be assigned to the company). The note provides that when the principal of the note ($500,000) converts into equity, the conversion will be done on the basis of a company valuation that may not exceed a total of $5 million (this is a “valuation cap” clause, meaning, friends and family get shares on the basis of the same valuation as the fund unless it is in excess of $5 million, in which case friends and family get shares on the basis of a $5 million valuation).
Your start-up is doing well. You are finally generating revenue and pitching to potential investors, including a VC fund “VC”. At this point you need VC to invest $10 million in your company in order to grow – if you secure this investment, you do not expect the company to produce any earnings for five years (though the company generates revenue, it still has negative earnings), but at the end of year 5 you anticipate to turn profitable and generate net income of about $16 million. VC knows that a firm comparable to yours with current earnings of $10 million was just sold for $100 million.
1. How would VC estimate the present value of your venture if it wants a 40 percent annual rate of return on the investment?
2. Assuming that VC is investing on the basis of this valuation, what percentage of the company would be owned by, respectively (i) friends and family (converting the $500,000 note into shares) and (ii) VC?
3. How much of the company percentage wise would you retain as the founder?
4. How many shares would be issued to friends and family and to VC? What share price would each be paying?