Chariot.com needs $500,000 in venture capital to bring a new Internet messaging
ID: 2779277 • Letter: C
Question
Chariot.com needs $500,000 in venture capital to bring a new Internet messaging service to market. The firm's management has approached Route 128 Ventures, a venture capital firm located in the high-tech startup mecca known as Route 128 in Boston, Massachusetts, which has expressed an interest in the investment opportunity. Chariot.com's management made the following EBITDA forecasts for the firm, spanning the next five years:
Route 128 Ventures believes that the firm will sell for six times EBITDA in the fifth year of its operations and that the firm will have $1.2 million in debt at that time, including $1 million in interest-bearing debt. Finally, Chariot.com's management anticipates having a $200,000 cash balance in five years. The venture capitalist is considering three ways of structuring the financing:
1. Straight common stock, where the investor requires an IRR of 45%.
2. Convertible debt paying 10% interest. Given the change from common stock to debt, the investor would lower the required IRR to 35%.
3. Redeemable preferred stock with an 8% dividend rate, plus warrants entitling the VC to purchase 40% of the value of the firm's equity for $100,000 in five years. In addition to the share of the firm's equity, the holder of the redeemable preferred shares will receive 8% dividends for each of the next five years, plus the face value of the preferred stock in year 5.
A) Based on the offering terms for the first alternative (common stock), what fraction of the firm's shares will it have to give up to get the requisite financing?
B) If the convertible debt alternative is chosen, what fraction of the firm's ownership must be given up?
C) What rate of return will the firm have to pay for the new funds if the redeemable preferred stock alternative is chosen?
Year EBITDA 1 - $175,000 2 75,000 3 300,000 4 650,000 5 1,050,000Explanation / Answer
Answer:-
Given data:-
Analysis of financing structure #1- Straight Common Stock
VC's required rate of return
Required $ return to VC Firm
Enterprise value of firm in year 5
Equity value in year 5
Part a. Alt #1. Required ownership"share"
45%
Analysis of financing structure #2--Convertible Debt
VC's required rate of return
35%
Coupon rate on debt
10%
Required $ year 5 return to VC Firm
Enterprise value of firm in year 5
Equity value in year 5
Part b. Alt #2. Required ownership"share"
Year
Cash to Conv Debt
Terminal cash flow
IRR (Conv Debt)
0
$(500,000)
1
2
4
5
Analysis of financing structure #3--Redeemable Preferred Plus Equity
VC's required ownership share
40%
Dividend rate on preferred stock
8%
Required $ year 5 return to VC Firm
Exercise price of warrants
Part c. Alt #3. Required rate of return
Alternate solution procedure for Alternative #3
Note: With redeemable preferred stock the value of the firm's
equity is reduced by the repayment of the face value of the
preferred stock when it is redeemed.
Given data:-
Capital needed $500,000 Projected EBITDA in year 5 $1,050,000 Exit year 5 EBITDA sales multiple in year 5 6.00 times Interest bearing debt in year 5 $1,000,000 Total debt in year 5 $1,200,000 Cash in year 5 $200,000Analysis of financing structure #1- Straight Common Stock
VC's required rate of return
Required $ return to VC Firm
Enterprise value of firm in year 5
Equity value in year 5
Part a. Alt #1. Required ownership"share"
45%
Analysis of financing structure #2--Convertible Debt
VC's required rate of return
35%
Coupon rate on debt
10%
Required $ year 5 return to VC Firm
Enterprise value of firm in year 5
Equity value in year 5
Part b. Alt #2. Required ownership"share"
Year
Cash to Conv Debt
Terminal cash flow
IRR (Conv Debt)
0
$(500,000)
1
2
4
5
Analysis of financing structure #3--Redeemable Preferred Plus Equity
VC's required ownership share
40%
Dividend rate on preferred stock
8%
Required $ year 5 return to VC Firm
Exercise price of warrants
Part c. Alt #3. Required rate of return
Alternate solution procedure for Alternative #3
Note: With redeemable preferred stock the value of the firm's
equity is reduced by the repayment of the face value of the
preferred stock when it is redeemed.