Hi everybody. Last class, we assumed that one round of financing was sufficient until year five. However, it is more realistic that there are several rounds of financing. It can be new stocks issued to later round investors, or to new key employees. In that case, the early round investors can suffer dilution. In this class, we are going to learn what percent ownership should each investor purchase at the time of the financing in order to keep their final percent ownership. Suppose a start up requires financing of $1 million and it is raised in three rounds. The first round VC provides $0.5 million now and the discount rate is 50%. The first round VC's investment period is five years. The second round VC provides $0.25 million in year two. The second round VC's investment period is three years. The third round investor provides $0.25 million in year four, and the discount rate is 30%. The third round VC's investment period is one year. The start up is expected to earn $0.5 million in year five and should be comparable to companies with PE ratio of 20. What is the final ownership for the VC of each round? The final ownership is the percent ownership a given investor will hold as of the terminal year of a project. And it is the future value of investment divide by terminal value of the startup. In order to find the round one VC's final ownership, we need to know future value of investment in round one. Why don't you start Excel, and we will use FV function. Type in 50% for rate, type in 5 for NPER, type in 0 for PMT, and type in -500,000 for PV. The result is $3,796,875 which is future value of investment in round one. Next, we need to find terminal value of startup. This is calculated by multiplying expected earning for startup in year five, by comparable company's PE ratio, that is $0.5 million times 20. The result is $10 million. In order to find round one VC's final ownership, we need to divide $3.796 million by $10 million. Then the round one VC's final ownership would be 37.97%. Next, let's do the same process to find round two VC's final ownership. First, you have to find the future value of investment for second round VC. Type in equal FV, 40% for the rate, 3 for the period, 0 for the PMT and -250,000 for PV. The result is $686,000. We need to divide $686,000 by $10 million. The result is 0.0686. In other words the round two VC's final ownership would be 6.86%. The round three VC's final ownership can be calculated by the same way. First, find the future value of investment for third round VC. Which is FV(30%, 1, 0, -250,000) and then divide this number by future value of the startup, cell A2. The result is 0.0325, which means the round three VC's final ownership would be 3.25%. For VCs to have these final ownership percentages, the early round VC must purchase enough shares now, to make up for the dilution that will be caused by the future financings. The early round VC's retention rate is 1 minus total of future final percentage ownership. In this example, the Round 1 VC's retention ratio would be 1- 6.86%- 3.25% = 89.89%. The Round 2 VC's retention ratio is 1- 3.25% = 96.75%. The Round 3 VC's retention rate is 1- 0, so it is 100%. The VC's retention percentage is also the ratio of the percent ownership a venture capital will hold as of the terminal year of a project to the percent ownership he holds as of his investment. The percent ownership a venture capital will hold as the terminal year of a project is called the final ownership. And the percent ownership a VC holds as of VC's investment is called the current percent ownership. Then we can write investor's retention percent as the following. Retention percent is equal to final percentage ownership divided by current percent ownership. From this equation we know that current percent ownership is equal to final percent ownership divided by retention percent. Therefore in this example, the Round 1 VC's current percent ownership should be 37.97% / (1-6.86%-3.25%) = 37.97% / 89.89% = 42.24% The Round 2 VC's current percent ownership should be 6.86% / 1-3.25% which is 96.75%. The result is 7.09%. The Round 3 VC's current percentage ownership should be 3.25% / 1, so it is 3.25%.
