19: Venture Capital Problem Set

This Venture Capital Problem Set is due Thursday, March 27th, in addition to a regular assignment posted for that day. This takes a considerable amount of time to complete so you are advised not to put it off until the last minute. Submit your document as a PDF or Excel file on Canvas prior to the beginning of class. Be sure all work is shown and that your answers are clearly identified. Credit will not be given for answers where all work is not shown. You should feel free to discuss the Venture Capital Method as it applies to this Problem Set with other students; however, when you work out the answers to the Problem Set, all work must be your own, subject to the University’s Code of Academic Integrity, and not the product of a collaborative effort. As you work on the Problem Set, you may find it helpful to refer to your class notes and the Note on Venture Capital Method which covers each step of the in-class example and is posted in Canvas Files.

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VENTURE CAPITAL PROBLEM SET

Kenneth Cook, founder of XL Microdevices, together with two other co-founders invested a total of $50,000 from personal funds as seed financing when they launched their new venture in March 2024. Ken, who had the initial idea for XL and had invested the greatest amount of “sweat equity” to date, invested $30,000 and received 350,000 shares of XL common stock in return. The other two co-founders each invested $10,000 and each received 75,000 shares.

When the company was launched in March 2024, the founders also secured the backing of Cathy Strickler, a local angel investor with substantial and relevant experience in computer hardware. Cathy invested $400,000 in XL with a post-money SAFE. Terms of the SAFE included: (i) a conversion discount of 20% tied to the Series A share price; (ii) a $1,000,000 minimum future financing threshold to trigger conversion of the SAFE; (iii) a post-money valuation cap of $4,000,000 for the SAFE; and, (iv) if XL is acquired prior to a Series A financing, Cathy would receive 150% of the SAFE’s principal investment amount.

Now, as of the spring of 2025, XL has successfully developed a working prototype of their advanced solid-state disk (SSD) drive product and has attracted favorable attention from a number of portable computer manufacturers.

Cathy recently introduced Ken to Gerald (Jerry) Montgomery, a partner in Technology Ventures Corp. (TVC). TVC is a regional venture capital firm. Like Cathy, TVC has significant experience with computer hardware devices and feels that XL would be an ideal complement to their portfolio of high-tech startups. TVC has reviewed XL’s business plan and has conducted enough due diligence to be comfortable investing in the company. TVC intends to invest in XL through its new “TVC High-Tech IV Fund” that includes funds from high-net-worth individuals and institutional investors. They may also form a syndicate and include other venture capital firms in this investment opportunity.

XL’s business plan calls for three rounds of financing. Series A is planned for March 2025 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. Series B is planned for March 2027 in the amount of $7,000,000 primarily for hiring production engineers and marketing personnel, for initiating marketing and distribution activities, and for launching production. Series C is planned for March 2028 in the amount of $8,500,000. This third-round investment is primarily intended to fund expansion of the company. Financial projections in the plan estimate annual earnings of $750,000 on sales revenues of $6,500,000 by the spring of 2030 under a “success” scenario. The plan also anticipates that XL will be acquired by a strategic investor in March 2030, this being the exit strategy for its investors. TVC’s due diligence has found that a typical price/revenue ratio for similar early growth companies is about 14:1.

TVC’s objective is to earn a rate of return of 50% per annum (compounded) on their Series A investment, a 40% p.a. compounded return on their Series B investment, and a 30% p.a. compounded return on their Series C investment. These targeted returns would also pertain to other venture capital investors who may participate in the syndicate TVC may form.

Question #1a. What share of XL (i.e., what % of the company) must TVC or its syndicate acquire in March 2025 if they fund the $1,500,000 amount of the Series A round? How many new shares of XL stock should they acquire? What should be the price per share? What are XL’s pre-money and post-money valuations at this first round?

Question #1b. If TVC or its syndicate funds the Series B and Series C rounds, what share of XL must they acquire in each round? How many new shares of XL stock should they acquire in each round? What should be the price per share in each round? What are XL’s pre-money and post-money valuations at the Series B and Series C rounds, respectively?

Question #2. At the planned “liquidity event” in March 2030, what will Ken Cook’s shares in XL be worth? What annual rate of return (compounded) on his original $30,000 investment does this represent? What will both of the other co-founders’ shares be worth? What annual rate of return (compounded) on their original $10,000 investments does this represent? What will Cathy’s converted shares be worth? What annual rate of return (compounded) on her original $400,000 investment does this represent? Finally, explain any difference between the rate of return earned by Ken and that earned by each of the other co-founders.

Question #3. Ken briefly considered the alternative of eliminating the Series B and Series C rounds and, instead, raising the total amount of $17,000,000 in the initial Series A round. He assumed investors in this priced round would require a 50% per annum (compounded) rate of return. After analyzing this alternative, Ken did not pursue it. Why did he decide this?

Question #4. Based on their prior experience, Cathy and Jerry believe that stock options will be needed as incentives to recruit a management team for XL. They convince Ken to plan for the future creation of a pool of new XL shares for incentive stock options equal, in total, to 10% of the company at the time of the liquidity event in 2030. Given this plan to create a future pool of incentive stock options immediately prior to the liquidity event, recalculate your answers to questions #1a, #1b and #2.

Question #5. Immediately before the Series B round, it becomes apparent that the liquidity event will be delayed two years until March 2032 and that an additional $2,000,000 (i.e., a total of $10,500,000) will be needed in the scheduled Series C round. Although the liquidity event will be delayed two years, the Series B and Series C rounds of investments remain scheduled for March 2027 and March 2028, respectively. Despite the delay, the estimated terminal value of XL remains unchanged. At the time this delay becomes apparent, TVC’s Series A 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 #4? Given this delay scenario, what compound annual rates of return are realized on the Series A, B and C investments?

Question #6. When answering this Question #6, ignore the delay scenario of Question #5 but include the option pool of Question #4. Without adjusting the number of shares they would acquire for their Series A, B and C investments as calculated in Question #4, TVC proposed using a hybrid security called *participating preferred* stock for their Series B and C, but not Series A, shares. This security has an additional benefit in that, at the time of the 2030 liquidity event, an amount equal to their original Series B and C investments would be paid to TVC from the liquidation proceeds on a priority basis before any distributions based on shareholdings are calculated. What compound annual rates of return would TVC realize on their Series B and C investments, respectively, as a result of using this *participating preferred* stock? What compound annual rate of return would then be realized in Series A under this proposal? How much cash would then be distributed to the founders and to Cathy at the time of the liquidity event?

Rev. March 2025

Rubric

VCPS Grading Rubric (1)

This criterion is linked to a Learning Outcome

Deduct no points for an error carry-forward from the previous question.

Criteria	Ratings	Pts
Questions 1a & 1bQ#1a & b Grading (50 points). These questions must be answered together because the retention calculation in Q#1a depends on the answers to Q#1b.	60 pts	60 pts
Question 2Q#2 Grading (20 points).	20 pts	20 pts
Question 3Q#3 Grading (10 points).	10 pts	10 pts
Question 4Q#4 Grading (35 points).	35 pts	35 pts
Question 5Q#5 Grading (30 points).	30 pts	30 pts
Questions 6Q#6 Grading (15 points).	15 pts	15 pts
Total Points: 170