Case Scenario: Venture Cap Question
Susan Strickler, a bioengineer and founder of XL Biosystems Inc, together with two other co-founders invested a total of $300,000 from personal funds as seed financing when they launched their new venture in December 2003. Susan, who had the initial idea for XL and had invested the greatest amount of “sweat equity” to date, invested $100,000 and received 50,000 shares of XL common stock in return. The other two co-founders also invested $100,000 each and each received 25,000 shares. No other shares have been issued since. As of today (i.e., October 2004) they have successfully developed a working prototype of their revolutionary new system-on-a-chip for detecting hazardous biological agents using micro-electro-mechanical systems (MEMS) technology. Their MEMS biochip system has already attracted favorable attention from a number of security systems companies.
Carl Montgomery, a local angel investor with substantial experience in security technologies, has been introduced to Susan by a trusted acquaintance and is considering an investment in XL. Carl has reviewed XL’s business plan and has conducted enough due diligence to be comfortable with an investment in the company. XL’s business plan calls for two rounds of financing. Carl is planning to be the first-round investor, which is planned for December 2004 in the amount of $1,500,000. These funds will be used primarily for hiring development engineers, for further product development and market research, and for beta testing the prototype. The second round of financing is planned for December 2006 in the amount of $11,000,000 primarily for hiring production engineers and marketing personnel, for initiating marketing and distribution activities, and for launching production. Financial projections in the plan estimate annual sales revenues of $15,000,000 by the end of 2008 under a “success” scenario. The plan also anticipates that XL will be acquired by a strategic investor at the end of 2008, this being the exit strategy for its investors. Carl’s due diligence has determined that a typical price/revenue ratio for early growth biochip companies is about 3:1.
Carl has introduced Susan to Leslie Neal, a partner in Technology Ventures Corp. (TVC). TVC is a regional venture capital firm. Like Carl, Leslie has significant experience with security technologies and feels that XL would be an ideal complement to TVC’s portfolio of high-tech startups. TVC has expressed interest in funding the second round of XL’s financing plan, assuming that the venture continues to look promising and achieves its interim milestone targets. TVC intends to invest in XL through its new “TVC High-Tech III Fund” that includes funds from high net worth individuals and institutional investors. TVC’s objective is to earn an annual rate of return of 30% (compounded annually) on its investments to cover both their general partner fees and their investors’ target returns.
Question #1. If Carl’s targeted rate of return is 40% per annum (compounded), what share of XL (i.e., what % of the company) must he acquire in December 2004 if he funds the full $1,500,000 amount of the first round? How many new shares of XL stock should he acquire? What should be the price per share? What are XL’ pre-money and post-money valuations at this first round?
Question #2. If TVC funds the entire amount of the second round, what share of XL must TVC acquire in December 2006? How many new shares of XL stock should TVC acquire? What should be the price per share? What are XL’ pre-money and post-money valuations at the second round?
Question #3. At the planned “liquidity event” in December 2008, what will Susan Strickler’s shares in XL be worth? What annual rate of return (compounded) on her original $100,000 investment does this represent? What will each of the other co-founders’ shares be worth? What annual rate of return (compounded) on their original $100,000 investments does this represent? Explain the reason for any difference between the return earned by Susan and that earned by each of the other co-founders.
Question #4. Susan briefly considered the alternative of eliminating the second round and, instead, raising the total amount of $12,500,000 in the first round. Assuming the investors would require a 40% per annum (compounded) rate of return, how would this alternative change your answers to questions #1 and #3, above? Explain. Note: Susan does not pursue this alternative.
Question #5. Based on their prior experience, both Carl and Leslie believe that stock options will be needed as incentives to recruit a senior management team for XL. They convince Susan to plan for the future creation of a pool of new XL shares for incentive stock options equal, in total, to 12% of the company at the time of the liquidity event in 2008. Given this plan to create a future pool of incentive stock options, recalculate your answers to questions #1 and #2.
Question #6. Immediately before the second round, it becomes apparent that the liquidity event will be delayed two years until December 2010 and that an additional $2,000,000 (i.e., a total of $13,000,000) will be needed in the second round, still scheduled to occur in December 2006. Despite the delay, the estimated terminal value of XL remains unchanged. At the time when this delay becomes apparent, Carl’s investment is already a done-deal and cannot be renegotiated. The future stock option pool, as described above, is included in XL’s plans. How does this change your answers to question #5? Given this delay scenario, what compound annual rates of return are actually realized on the first and second round investments?
During TVC’s term sheet negotiations, it is agreed that TVC will receive convertible preferred XL stock in return for their investment in round two. The founders’ shares, Carl’s shares and the option pool shares remain common stock. The difference between common and preferred shares is that preferred shareholders receive a fixed annual dividend payment equal to a prescribed percentage of their investment. In this case, TVC negotiates for a cumulative non-cash non-compounding dividend of 8% per annum. At the time of the liquidity event in 2008, each preferred share is convertible into one new XL common share and the accumulated dividends are convertible into new XL common shares at the original price per share paid by TVC.
Question #7. TVC priced the XL deal assuming that it received non-dividend-bearing common stock and that an option pool would be created at the time of the liquidity event (i.e., the same assumptions used for Question #5, above). What compound annual rate of return will TVC realize on its Round 2 investment as a result of using convertible preferred stock? What effect does this have on the rate of return realized by Carl, who does not have convertible preferred stock? What is the effect on the cash distributions realized by the founders? (In answering this question, ignore the delay scenario of Question #6).
Question #8. During TVC’s term sheet negotiations, TVC also proposed using a hybrid security called participating preferred stock for its investment. This security is like the convertible preferred stock described above, but it has an additional benefit in that, at conversion (i.e., at the liquidity event) the entire original purchase price is also repaid to TVC on a priority basis before any other distributions are calculated. Susan and Carl reject this proposal. What compound annual rate of return would TVC have realized on its Round 2 investment as a result of using participating preferred stock? What compound annual rate of return would Carl have realized under this proposal? Compared to the deal outlined in Question #7, above, what effect would this proposal have had on the amount of cash distributed to Susan and each of the other co-founders at the time of the liquidity event? (In answering this question, ignore the delay scenario of Question #6).