Essentials of Entrepreneurship: A Practical Approach

Assume that an entrepreneur is forming a new business and is seeking venture capital to finance it. What relative ownership shares should the entrepreneur and the venture capitalist have.

Assumptions:

1. There will be only two owners of the business, the entrepreneur and the venture capitalist.
2. The entrepreneur will supply his/her effort ("sweat equity") and the venture capitalist  will supply the required funding to get business to the point where it can be "harvested" (sold or taken public).
3. A business plan has been prepared projecting the funding needs of the business and pro forma revenues, profits, and cash flows.
4. The entrepreneur and the venture capitalist agree to the assumptions and resulting projections in the business plan.
5. The venture capitalist invests or earns cash flows each period up to including the harvest period.

Solution:

1.

                


2.

Where:

X  is the share of the business owned by the venture capitalist

Y  is the share of the business owned by the entrepreneur

C_t  is a cash flow invested (+) or (-) at period t.

i    is the required compounded annual rate of return expected by the venture capitalist for investments with the risk character of this investment

n  is the final return (investment) period anticipated (e.g. "harvest time")

V  is the value of the enterprise at harvest time

Numerical example:

A venture capitalist invests $1,000,000 today in a new enterprise. She invests no additional dollars in the future and receives no cash flow return until the harvest 5 years from now. At the harvest, the company will be sold for ten times after-tax earnings which are projected to be $1,200,000. The venture capitalist requires a 40% compounded annual return (pre-tax) on her investment. The relative ownership share (X) for the venture capitalist would be:

              (1,000,000)(1+.4)⁵
                (10)(1,200,000)

     =  5,378,249/12,000,000 = 44.8%

and the relative ownership (Y) for the entrepreneur would be:

      1 - X = (1 - .448) = .552 or 55.2%

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