Question

You are an inventor with a great business idea but no money. You have approached a venture capitalist (VC), asking for a $100 million investment in your company. You explain that you expect the initial $100 million investment to earn a 40% annual rate of return forever. You plan to reinvest all of the project's earnings in Years 1 and 2, and you expect that these additional investments will also earn a 40% annual rate of return forever. After Year 2, you plan to invest no more in the company, except to maintain assets, so your company's annual earnings should remain constant forever from Year 3 onward. The appropriate discount rate for your business is 25%. If the capital market were perfectly efficient, what ownership share in the company should the VC receive in exchange for the $100mil. investment? In other words, what would be the ownership percentage VC should require if market is efficient? (Write the answer in percentage term with two decimal points i.e., 10.25%).

Answer 1

From the question it is clear that the inventor is out of money and is completely dependant of the venture capitalist. The entire 100 million investment is made by the VC and no investment comes out of the inventor into the business. Since, the project budget is 100 millions and is invested by the venture capitalist, they are required to have the major portion of ownership of the business even though additional investments are raised by the inventor.

To calculate the ownership percentage =

$100million-(annual rate of return)*2/25%*3

= 12%