Understanding a Basic Venture Capital Formula to acquire stake in a company


 “The best reason to start an organization is to make meaning; to create a product or service to make the world a better place.” 
-Guy Kawasaki, venture capitalist, CEO of Garage Technology Ventures
Understanding a Basic Venture Capital Formula to acquire stake in a company
The table below illustrates a simple example of how a Venture Capital/PE firm will value the firm, arrive at the current and future stock price, and deduce the % of shares to be acquired in order to meet the expectations of the investment.
It is based on expected rate or return (in this case 50%), number of years (5 yrs), investment amount ($3.5 mn), expected PE ratio of the firm in 5 years (based on comparables), expected cash flows of the firm  in 5 years.

Required IRR (%) — a 50.00%
Investment ($) — b 35,00,000
Term (Yrs.) — c 5
Year 5 revenue ($) — d 25,00,000
PE ratio (Year 5) — e 15
# of shares outstanding before investment — f 10,00,000
Terminal value of the firm ($) — (d * e) — g 3,75,00,000
Required future value of  investment ($) — Expected Future Value of Investment — h 2,65,78,125
Final ownership required= h/g=i 70.88%
# of shares to be acquired = f/(1-i)*i=j 24,33,476
New share price ($)=b/j=m 1.44
Post-money value of the firm @ t0 ($)=b/i=k 49,38,272
Pre-money value of the firm ($)=k-b 14,38,272
Share value at exit, for given discount rate=Expected Future Value of Current Share Price 10.92
Firm value at the end of each round = Post Money Valuation 49,38,272
RoI 659.38%

The above basic calculation is done assuming only one round of funding & no further dilution (i.e. no second/third round.. in which case the % of stake would obviously rise).
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