00:04Stanford University hello and welcome
00:09back to you 145 technology
00:11entrepreneurship this is the second
00:13video and the venture finance series and
00:16in this video I wanted to talk to you a
00:19bit more about the deal structure and so
00:22I'm going to be going over this fairly
00:23quickly so I encourage you to take a
00:26look at some of the recommended readings
00:28on the website for more detailed
00:31information if you're interested in
00:32delving in a bit deeper into this topic
00:34so the two key questions that you want
00:38to have in mind is the entrepreneur
00:39going into the deal or what percentage
00:42of the company do the investors receive
00:44for their cash and besides this
00:47percentage of ownership what are the
00:50special terms and conditions that are
00:52necessary to compensate them for the
00:54risks they're taking and so here we are
00:57back in our venture capitalist boardroom
00:59to think a bit more about while you're
01:01going through your pitch to the VC
01:04partners what's going through their
01:06heads in terms of venture finance so
01:08let's start with some simple examples so
01:13imagine that here we have Roma's hot
01:16startup and Rome is determined that she
01:20needs 10 million dollars in order to
01:22form her business and she expects from
01:25her business plan to earn about 10
01:27million dollars in the fifth year at
01:29least that's what she's pitching in her
01:30presentation Randy has a VC firm and
01:34he's listening to Roma's pitch he's
01:37reviewed the company's business plan and
01:39he believes that he is entitled to an
01:42annual 50% return on his investment or
01:45that's at least what he's he's expecting
01:48and perhaps what his institutional
01:50investors are expecting him to return in
01:52their fund so if he wants to make an
01:55annual 50 percent return on his
01:56investment he's thinking through what
01:59percentage he has to own in Roma startup
02:01if he's going to make an investment so
02:05he knows that publicly traded companies
02:08tend to trade approximately 15 times
02:12that's the price to earnings ratio
02:14there's also no material difference
02:16between these companies and Roma startup
02:18let's say so the question and there's
02:22one is what portion of the company
02:24should Randy's VC firm receive today so
02:27if he makes an investment how of this
02:30ten million dollars what percentage of
02:32the company does he need to own the
02:35second question is what's the post-money
02:37valuation of the company today after it
02:40receives the funding so you might think
02:43this little this is a little bit
02:44backwards the Randy's the VC should be
02:46thinking through what the current
02:48valuation of the company is and then how
02:51much money the company needs to raise
02:53and therefore as an outcome of these two
02:56numbers it will determine what the
02:58percentage ownership is but this is just
03:00to point out that sometimes the
03:02calculation is actually a bit different
03:04that we're working backwards from a
03:06percentage equity ownership to a current
03:09valuation that would that would give
03:11that percentage equity ownership so see
03:14if you can calculate ahead of time
03:17before I give you the answers what the
03:19value of this VC investment is going to
03:21be in year 5 so what formula do we need
03:24here what the startups valuation is
03:28going to be in year 5 and then what the
03:30VC firms share is today and then the
03:34post-money valuation
03:43okay so let's take a look okay so this
03:48is what you should have come up with
03:50that the value of the VC investment in
03:53year five has to be seventy six million
03:55this is because the investment in the
03:59beginning is ten million dollars and
04:01then this is the formula for calculating
04:03that there must be a 50% annual return
04:07on the investment over five years the
04:10startups value in year five is going to
04:13be the ten million dollar earnings times
04:16the industry p/e ratio of 15 so ten
04:21million dollars times earnings times the
04:23p/e ratio of 15 should yield a start-up
04:26valuation of one hundred and fifty
04:28million total the VC firms share today
04:32if the firm is going to be worth 150
04:36million the VC investment share is going
04:39to be 76 million that's approximately
04:4150% that they're going to own and so
04:45then the post-money valuation today is
04:49going to be the 10 million divided by 50
04:52percent a twenty million dollar post
04:53valuation and so in order for the VC
04:58investor to wind up owning 50 percent if
05:02they need to put in ten million dollars
05:04today then they're essentially giving a
05:07pre-money valuation of ten million and
05:10so then the post-money valuation is that
05:13ten million dollar pre-money valuation
05:15plus the ten million dollars that the VC
05:18is putting in so that yields a
05:20post-money valuation of 20 million
05:29so let's go through another example so
05:34this example is of the multiple stages
05:37of funding and dilution that the typical
05:41entrepreneurial firm goes through and so
05:44you might imagine a start-up going in
05:46has three founders and they're going to
05:50divide up the shares the equity
05:53ownership in the company into three
05:55million shares and so each founder is
05:58going to get exactly one-third of the
06:01ownership of the company so we can talk
06:04later about whether this might make
06:05sense for the owner for the founders to
06:07divide up the shares evenly but imagine
06:10everyone gets a million shares for each
06:12founder and so perhaps the valuation is
06:17currently three thousand dollars each
06:19one of the founders is put in a thousand
06:21dollars of evaluation of three thousand
06:23dollars total now let's say a little bit
06:26of time goes by they've reduced some
06:28risk they've created some value they
06:31want to bring in a CEO and also carve
06:34out part of the equity for stock options
06:38for for early employees so let's imagine
06:41now because they've reduced some risk
06:43and created some value the startup is
06:45now worth fifty thousand we create
06:48another 1 million shares each for the
06:52CEO and for the early employees so we're
06:56creating an additional two million
06:58shares total so now there's five million
07:01shares there's five million shares and
07:03the total valuation is fifty thousand
07:05each share instead of being worth a
07:08tenth of a penny each share is now worth
07:11a penny so let's imagine that the
07:13founders have now decided that they need
07:15to raise some venture capital and so
07:18they need to go out and they need to
07:19raise five million dollars so they're
07:21going to have to generate some more
07:22shares for the venture capital firm
07:24that's going to invest so let's say at
07:28this point the venture capital firm
07:30invest is five million dollars an
07:33additional five million shares are
07:35created so we have a total of ten
07:38million shares now and because some
07:41additional value has been
07:42additional risk has been reduced each of
07:45these shares is now worth a dollar piece
07:48and so even though the founders have
07:52gone from owning one-third of the shares
07:54each to 20% each and now at this stage
07:58each founder only owns 10% of the
08:02company the size of the pie has
08:05continued to grow because value has
08:07continued to be created and so for this
08:09founder even though he's been deluded to
08:12only owning 10% because the shares are
08:15now worth a dollar piece this founder
08:19their shares are now worth $1,000,000 as
08:22opposed to at the very beginning when
08:24they're 1 million shares were only worth
08:27about $1,000 so we're going to use some
08:31of this money from the VCS to conduct
08:33some additional Rd continue to develop
08:36the product maybe start to develop a
08:38second product let's see what happens so
08:43before we move on one key question here
08:45if the post-money valuation of the firm
08:49at this stage stage 3 is now 10 million
08:53dollars what was the pre-money valuation
08:57so this is very simple to answer because
09:00if the post-money valuation is 10
09:02million dollars and 5 million shares
09:05have been created the VCS now and 50%
09:10the pre-money valuation must have been 5
09:12million dollars and so in essence the
09:16value of the company increased from
09:18fifty thousand to five million dollars
09:20at this stage and then when the VCS
09:23decided to invest their money they
09:26essentially gave the startup firm a
09:28pre-money valuation of five million
09:30dollars they invested another five
09:32million so the post-money valuation is
09:3410 million dollars so this is all to get
09:36you into the habit of thinking about
09:38these terms that we tend to use in
09:40venture finance a pre-money valuation
09:42post-money valuation
09:47so let's imagine we move forward a
09:49couple of steps an additional round of
09:52funding was raised for marketing the
09:55valuation of the firm went up the size
09:57of the overall pie continues to grow but
10:00as we bring in a second round of VCS and
10:03generate additional shares for them the
10:05percentage equity ownership continues to
10:08get diluted for the founders we now
10:10reach the stage of an IPO this is an
10:13initial public offering to the general
10:16public in terms of the New York Stock
10:18Exchange or Nasdaq we're now going to
10:22generate another 5 million shares for
10:24sale to the public through the IPO and
10:28so the shares there's now a total of 20
10:32million shares and the shares are priced
10:34at $15 each in the IPO and when the
10:38shares go on sale the public has to pay
10:40$15 $15 each per share so 20 million
10:44shares at $15 each gives the company
10:46evaluation of 300 million dollars and so
10:50you can then calculate that even though
10:51the founders now only owned 5% of the
10:56company as opposed to starting out with
10:5833% their 5% share is now worth
11:03significantly more and so this is
11:07essentially the the trade off your
11:09trading giving up some percentage equity
11:11ownership in the company some control
11:13for additional resources that you need
11:16to continue to grow the overall size of
11:18the pie and so I just want to point out
11:24a little bit more about the language of
11:26venture finance there are three
11:27different ways that you can think about
11:28the overall market cap the overall
11:31valuation of the company you can think
11:34about it in terms of what's the net
11:35income of the company and then what's
11:38the typical price to earnings ratio in
11:40that industry so if you have a net
11:42income of 10 million and a price p/e
11:45ratio of 30 then the market cap the
11:48valuation of the company is going to be
11:49300 million similarly we could calculate
11:52this from the share price if we have a
11:54share price of $15 and there are 20
11:56million shares outstanding then 15 times
12:00under million dollar valuation then the
12:03third way is from the sales you might
12:08have you might have 100 million dollars
12:12in sales PS ratio of 3 which then gives
12:16a 300 million dollar valuation of the
12:18company so let me pause there and in the
12:26next video I want to dig in a bit more
12:28on the economics of the VC firm how VC
12:31firms are structured and how you should
12:33think about your pitch and the process
12:36of raising money from venture
12:37capitalists for more please visit us at
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