SECTION ONE
Question One
Assume as a VC that you want to establish a pre- and post-money valuation in support of the issuance of a term sheet.
In order to establish a discount rate, you’ve decided to use CAPM with the following inputs:
• Risk free rate of 4%
• Market return expectation of 10%
• Beta coefficient of 2.5
You are planning to invest $5mm in a lump sum based solely on the company’s success-based forecast as the basis for your operating cash flow (OCF) projections as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
OCF -$3mm -$1mm +$1mm +3mm +$5mm
Assume 5% annual growth after year 5.
At this point you perceive the most likely harvest to involve a M&A transaction. Recent transactions have occurred at the following operating cash flow multiples:
Transaction A: 8x Transaction B: 10x Transaction C: 11x Transaction D: 12x
The company currently has 1mm shares outstanding.
Propose an implied share price, a pre-money and post-valuation valuation for this venture.
Question Two
Based upon the following inputs, propose the optimal course of action for this venture:
• Probability of success: 30%; probability of failure: 30%; base case probability: 40%
• Cost of initial investment is $20mm
• Success NPV: $70mm; Base case NPV: $25mm
• Two upfront options:
- Staged investment of $10mm/stage; no impact on probabilities or scenario NPV but allows abandonment after first stage investment in case of anticipated failure
- Deferral of investment by 1 year to pursue $3mm feasibility study; decreases odds of failure by 10% and shifts odds evenly to success and base case
• Two midpoint options (assumes either success or base case scenario):
- Operate venture indefinitely and realize full NPV
- Reinvest for new market expansion under the same terms as the upfront option with the following changes:
- Chance of success is lowered by 5% and chance of failure is increased by 5%
- Upfront cost is higher by $5mm but PV of future cash flows remains unchanged
Keep in mind that the recommendation is being made today without the benefit of hindsight – specifically you do not know which scenario will come to pass.
Question Three
A growth stage venture that has received $6mm in venture financing and $1mm in angel financing is currently beginning the process of contemplating its harvest options. The CEO has requested that you, as CFO, perform a qualitative cost/benefit analysis of the following options:
• Acquisition
• Initial Public Offering (IPO)
• Leveraged Buyout / Management Buyout (MBO/LBO)
• Reverse Takeover of Public Company
It is imperative that you provide sufficient detail to support a number of key strategic decisions that will be made over the coming months.The existing venture investors expect harvest within 30 months.
SECTION TWO
Question One
Stratos Corporation is a privately held tablet semiconductor technology firm with bright growth prospects.The past 5 years has seen the firm evolve from a pure startup to a profitable firm with $30mm in annual revenues. The company’s executive team is currently focused on how to finance the next phase of the company’s growth strategy, specifically expansion into a new complementary smartphone circuit board design and expansion into the European OEM market.
Key financial considerations are as follow:
• Smartphone expansion will cost an estimated $15mm in investment capital and an additional $10mm of net working capital investment (primarily component and finished product inventory as well as some receivables). These funds will be required evenly in two stages over the 2-year launch period. This venture is expected to add $6mm/yr in annual after-tax gross marginand $0.5mm in additional annual costs beginning in two years. This venture is expected to have a 10 year life. Assume that the present value of the depreciation tax shield is $2mm.
• European expansion is expected to require $15mm in working capital primarily to finance new receivables and inventory. This capital will need to be available upfront in order to ensure that marketing efforts are not wasted and orders are unfulfilled. This opportunity would double the revenue of the current operations though incremental profit margins would be lower as a cost of entry to the tune of GM% at only 70% of the core business. This venture would be perpetual.
• Current operations generate $3mm in annual after-tax cash flow (assume capex = depreciation and no incremental working capital) and are expected to grow at a 15% compounded rate for the next five years with no incremental investment. Fixed non-manufacturing costs for the business are $8mm/yr and consist primarily of employee compensation, facilities costs, etc.
• The company is currently owned 40% by its management team, 40% by external investors (mainly VCs with a smattering of angel capital) and 20% is owned by an ESOP which is held in trust (though in practice controlled by management). The CEOhas a piggyback clause tied to VC exit which allows her to cash out her 10% ownership position, if desired, upon VC liquidation.
• Stratos currently has no long-term debt but does maintain a $10mm line of credit which generally remains drawn upon only during peak periods to the tune of $3-4mm.
• The VC investors wish to exit their investment within 3 years at the latest. The angel investors have no clear expectations in re: time to harvest.The IPO market is currently depressed with deal flow / valuations at multi-year lowsis but expected to recover within 2-3 years.
• Discussions with investment bankers have set the long-term debt target rate at 8% and set the existing business value at $125mm excluding any value associated with the new ventures.
• Marginal tax rate is 30%, cost of equity is 15% and current credit facility interest rate is 5%.
Propose two robust and well-reasoned potential financing plans for this company which takes into consideration all stakeholder expectations and a discrete evaluation of the new proposed expansions. A complete financial statement forecast is not required.
Question Two
Ginny Jones currently works as the VP-Product Strategy for a well-established enterprise software company. She and her friend, Tom Robinson, currently CFO at a competing firm (and someone who has taken two companies public), have spoken at length over the past 2 years about starting up a new company based on a complementary product concept that Ginny has been investigating on the side. Based on consultation with her lawyer, Ginny has a high degree of confidence that she is the sole owner of the intellectual property in question. With her current employment contract set to expire in 6 months, she wishes to decide now whether or not to begin the process of renegotiating her employment or to embark on a new venture.
Key facts:
• Including bonus, Ginny’s current annual compensation is $275,000; Tom’s is $300,000. Each believes that they would command salaries of 80% of current levels in the event of venture failure. Annual salary inflation is expected to be 5% into the future.
• If Ginny stays with her current company, she expects to be CEO within 6 years which would pay her $600,000/yr. By leaving the company she will forego this opportunity. Tom expects to leave corporate management at some point in the foreseeable future (assume 5 years) and work as a venture capitalist making at least $500,000/yr. This detour will have no effect in re: his career prospects.
• Tom & Ginny can each afford to invest up to $200,000 in the new venture and continue to maintain an adequate amount of portfolio diversification. Each commits to drawing no more than $125,000/yr in annual salary from the new venture for the first 5 years after which their salaries triple if they stay with the company.
• Tom has extensive VC contacts and has a rich uncle whose hobby is seeding new ventures.
• Total startup costs are expected to be $1mm with an additional $1mm in operating losses expected over the first two years of the venture.
• Based on a market survey and due to the depth of experience that Ginny & Tom bring to the venture, the expected VC equity financing cost for this venture is 35%
• The estimated market size for this new technology is $250mm/yr. Due to first mover advantage the team expects to be able to capture 60% of the market by the third year and command an operating margin of 30% in a success scenario, 35% of market at an operating margin of 20% in a base scenario. A failure scenario would result in a complete loss. Working capital requirements are expected to be negligible due to highly favourable supplier terms.
• Probability of failure is estimated at 25%, success at 25%.
• Personal and corporate income tax rate is 30%
• Overall market returns are 11%, risk free rate is 4% and venture beta is 2.5.
a) Should Ginny leave her current job to pursue this venture? Why?
b) Should Tom leave his job to pursue this venture? Why?
c) Whose opportunity cost of pursuing this venture is highest? Explain.
Question Three
You have been hired by Serge Brink and Larry Park to assist them in the evaluation of a recently issued term sheet from Global VC Partners.
The new venture is an Internet startup based on the pair’s doctoral research and each of the entrepreneurs are newly minted PhD graduates with minimal business experience. At this point, the valuation is not subject to debate but Serge & Larry are concerned about a number of the clauses referred to within the term sheet, specifically:
• Investor demand registration rights
• Reserved ESOP shares (30% of post-money shares)
• Investor liquidation preference of 250%
• Convertible preferred shares with full ratchet provision
• Fixed maturity date with investor put provision
Prepare a comprehensive professional style memo addressed to Serge & Larry that sufficiently explains each of the aforementioned items from both an investor’s and an entrepreneur’s perspective. You should also recommend any additional clauses that the entrepreneurs may wish to consider within their deal structure negotiations.