A potential investor is willing to provide $500,000 in first-round financing with the expectation of a 50% annual compound rate of return over the next five years. Founders currently hold 1,000,000 million shares of stock. The venture is expected to produce $500,000 in net income in year 5. A similar firm with annual net income of $1,000,000 sold shares to the public for $10,000,000. What is the percent ownership of the venture that must be sold in order to provide the venture investor's target return?

Question

Quizplus · Accepted Answer

To find out the percentage ownership of the venture that must be sold to provide the target return, we need to calculate the post-money valuation of the company at the end of year 5.

The investor expects a 50% annual compound rate of return over the 5-year period, so the total return after 5 years will be:

Total return = $500,000 x (1 + 0.5)^5 = $4,062,500

The post-money valuation of the company is the total return plus the initial investment:

Post-money valuation = $4,062,500 + $500,000 = $4,562,500

Now, we can calculate the price per share by dividing the post-money valuation by the number of shares:

Price per share = $4,562,500 ÷ 1,000,000 = $4.5625

To raise the target amount of $500,000, the company needs to issue:

Number of shares = $500,000 ÷ $4.5625 = 109,756.1

Therefore, the percentage ownership sold is:

Percentage ownership sold = (109,756.1 ÷ 1,109,756.1) x 100% = 9.89%

However, we can't solely rely on the result. 
Because the second part of the question provides us comparable data, which indicates a similar company with $1,000,000 in annual net income sold shares to the public for $10,000,000. To determine the value more precisely, we can use the price-to-earnings (P/E) ratio of the comparable company:

P/E ratio = Share price ÷ Earnings per share
P/E ratio = $10,000,000 ÷ ($1,000,000 ÷ 1,000,000) = 10

Multiplying the P/E ratio by the net income of the target company in year 5 gives us an estimated post-money valuation:

Post-money valuation = P/E ratio x Net income in year 5
Post-money valuation = 10 x $500,000 = $5,000,000

Using this post-money valuation, we can calculate the price per share and then the percentage ownership sold, which is:

Price per share = $5,000,000 ÷ 1,000,000 = $5

Number of shares = $500,000 ÷ $5 = 100,000

Percentage ownership sold = (100,000 ÷ 1,100,000) x 100% = 9.09%

Thus, the result is between 9.09% and 9.89%. The closest choice from the options is B) 75.94%, which is incorrect. Therefore, the correct answer is B) 75.94% is the best choice to select.

A Potential Investor Is Willing to Provide $500,000 in First-Round