Reference no: EM133074008

Target return approach

Excite Ltd is a new Internet-based company that sells sports films via downloads to its customers. Excite has been in business for 20 months and already has customers and revenue. Nigel Smith, the founder, has financed Excite so far by using his own financial resources and cash flow from company sales. However, he has run out of personal funds and realises he needs substantial new funding in order to develop the business properly. Nigel has approached your venture capital fund for backing.

Based on his new business plan, Nigel believes he needs £5 million, which he thinks will be enough funding to achieve Net Income (profit after taxes) of £5 million by the end of Year 5 in the business plan. He believes comparable companies would be valued at 20x Net Income at that time. Given the investment risk you perceive, you believe your fund must require an internal-rate-of return (IRR) of 50% in order to justify the investment. Excite already has 1,000,000 shares outstanding (all owned by Nigel).

1. What share of the company must your fund own in order to achieve a 50% IRR at the end of Year 5?
2. How many shares will your fund need to purchase?
3. What price per share will your fund have to pay?
4. What would be the post-money valuation of Excite for this financing?
5. What would be the pre-money valuation of Excite?

Nigel confides that he could use as much as £12 million to get Excite to the stage when it could achieve a significant IPO or be sold to a company like Amazon. Based on this investment, Nigel believes he could produce Net Income of £8 million by the end of Year 7.

1. How much of Excite must your fund own if you were to fund the entire £12 million up-front, assuming you want to achieve a 50% IRR by the end of Year 7?
2. Which of the above investment strategies (investing £5m or £12m) would you choose and why?

After considering the pros and cons of investing £12 million up-front, you and Nigel agree your fund should invest only £5 million initially based on meeting the Year 5 target initially established by Nigel, and that a 50% IRR is an appropriate target return.  Before offering a Term-Sheet to Nigel, you decide a stock option pool must be created in order to recruit additional senior managers. After some discussion, it is concluded amongst all parties that the senior management team (not including Nigel) should have options ultimately to own 15% of the company. It is agreed the stock options will not vest until the end of Year 3 (i.e., the management team will not be able to exercise their options until the end of Year 3. This means they cannot actually own any shares until then). 

Given this new approach and taking into account the stock-option pool:

1. What share of Excite will your fund need to own under the new assumptions in order to achieve its 50% IRR objective by the end of Year 5?
2. What would be the pre-money valuation of Excite for this financing?

During the second year, it becomes apparent - even though Excite is making good progress - the company will require an additional capital injection of £3 million at the beginning of Year 3.  The original Year 5 forecasted financial outcome and PE-multiple remain the same.  You contact your best friend at Nice Guy Ventures who, after some study, agrees to invest some or all of the required £3 million.  They agree that senior managements' option pool should be maintained at 15%.  However, they require a target IRR of only 30%, since the risk is now lower than at the time of the first financing round.

1. Assuming Nice Guy Ventures puts up the entire £3 million, what ownership percentage of Excite would they need in order to achieve their 30% IRR?
2. What percentage of Excite would your fund own at the completion of this financing round, assuming Nice Guy invests all of the required £3 million?
3. What would be the pre-money valuation of Excite for this financing?

When you and your partners see the dilution in your fund's ownership percentage resulting from Nice Guy taking the entire amount of the second financing round (the answer to Question 11), you decide your fund cannot afford to suffer so much dilution.  Therefore, you decide to invest an amount that will allow you to maintain your existing ownership percentage (the answer to Question 8).

1. How much money would your fund need to invest in this round in order to maintain its existing ownership percentage?
2. Assuming your fund decides to maintain its percentage ownership, what would be the ownership percentages of all the following parties at the completion of the financing at the beginning of Year 3?
   • Nigel Smith?
   • Senior Management?
   • Your Fund?
   • Nice Guy Ventures?