Reference no: EM13197629

January 1, 2000 was not a party day for the three founders of SpiffyTerm, Inc. Annabella Labella, Krishnuvara Ramakrishna, and Bob Sledge were MBA students at a prestigious West Coast business school that was known for its beautiful red-roof-tiled buildings and for its hardworking MBAs. Instead of joining the futile celebrations for a turn of the millennium that was really just a counting mistake, they decided to focus on the on-going negotiation that they had had with a number of venture capitalists. The three students had founded the new company on the basis of an idea that had come to them while munching burritos in the school's famous cafeteria. They were convinced that the recent Internet boom had missed the real opportunities offered by this new technology. They wanted to explore the Internet's true potential by doing something that I would like to tell you about, but I would have to shoot you if I did. All I can say is that their idea involved living creatures on Mars, a really cool Web site, and lots of chocolate chip cookies for the company party.

What preoccupied the founders most was a term sheet they had recently received from their contact partner-a curious individual by the name of Wolf C. Flow-at a well-known Sand Hill venture capital firm called Vulture Ventures (Exhibit 1). As far as the founders of SpiffyTerm, Inc. were concerned, this term sheet was so incomprehensible that it could have been in written in Swahili. So instead of celebrating the new millennium, the founders decided to use this day to understand the term sheet, and, most important, to determine what valuation and other terms they should be bargaining for. 

section 1: basic valuations

The founders of SpiffyTerm, Inc. wanted to begin by calculating what they thought would be an appropriate valuation. Annabella suggested they read "A Note on Valuation of Venture Capital Deals" (Stanford GSB Case Study E-95) that one of her young and brilliant professors had written up in a moment of utter lucidity. This method required that the owners take account of the current as well as anticipated future financing rounds. The founders thought they needed to raise $4 million at this time. Currently they had allocated 5 million shares to themselves, and they wanted to put aside an option pool of 1.5 million shares for future hires. The founders also believed that they would need to raise an additional $2 million after two years.

Wolf C. Flow had offered to invest $4 million at a price of $1 per share, but the founders were not convinced that this was a fair valuation. Instead, they wanted to model what an appropriate valuation might look like. They were quite confident that SpiffyTerm, Inc. would be able to do an IPO after four years, at a valuation of about $80 million. But they realized that there were risks in their venture, so they thought that everybody would apply a discount rate of 45 percent.

Question 1a: What valuation do these assumptions suggest?

Question 1b: The founders also wanted to do some sensitive analysis with their assumptions. They wanted to know how the valuations would change if the second round of financing required $3 million? And what would the valuation be if they raised $6 million up front with no further round thereafter?

Obviously, these valuations differed from the one proposed by Wolf C. Flow. The founders thought that Wolf C. Flow had worked off the same base assumptions, but that he used maybe a different discount rate, or maybe a different IPO value. 

Question 1c: If Vulture Ventures used the above valuation model, and indeed used a 45 percent discount rate, what implicit valuation after 4 years must they have used?

Question 1d: If Vulture Ventures used the above valuation model, and believed the IPO value of $80 million, what implicit discount rate must they have used?

Question 1e: A friend of Bob, called Wuz, was convinced that the investors were using the assumption of 1d, but he reasoned as follows: If Vulture Venture wants to pay only $1 per share, maybe the founders could simply increase their initial number of shares from 5 million to 10 million, and the option pool from 1.5 million to 3 million? This way everybody would win: the founders get more shares, and the investors get the price per share that they want. Based on this reasoning, should Wuz get an honorary MBA degree?

Question 1f: The analysis so far implicitly assumes that the investors are holding straight equity. Under the term sheet proposed by Vulture Ventures, is this a valid assumption?