Private Equity Key Economic Terms

Catchup
Claw back
Hurdle Rate
Post Money Value Post Money Value = PV of E
Pre Money Value Post Money- Investment
Private Equity
Exit Value ?
The expected value of the PE investment at the end of the ter
Exit vaue of the value of each Private equity investment
Exit value could be the total value of all investments

Present Value of Exit Value ?

Private equity fund company should be able to project the Ex
Committed Capital of Investors
Paid in Capital or invested capital, invested in PE investments
Other components of capital involved in investment
Pref. Shares with some defined dividends %
Debt Capital
When and how much the debt is paid is back up
Debt capital is important for calculation of share profits
Types of debt capital
Senior Debt
Junior Debt
Mezannin Finance
No of shares and share price at Exit needs to be calculated

Claw back examples

Venture Capital Valuation with two rounds of fundings

Venture Capitl Method

 Could be the potentail Exit V
How do you calculate exit of
ey Value = PV of Exit Value
ey- Investment T0 T5
100mn 400mn
PV OF $400 MN
t the end of the term
ty investment
vestments

le to project the Exit value clearly

d in PE investments
vestment

share profits
to be calculated

s of fundings
the potentail Exit Value
ou calculate exit of a company?
Waterfalls usually consists of the following phases:
Return of Capital
Preferred Return
Catchup
Carried Interest

The Investment Waterfall

The basic structure of a private equity commercial real estate transacti
there are two parties involved, the General Partner and the Limited Pa
The “General Partner” is the investment manager. They are responsib
arranging the financing, coordinating transaction logistics, an
In a typical deal, they will put in a small part of the total equi

The other party is the “Limited Partners” or “LPs.” There may be one L
but they are accredited investors who place their capital with
The Limited Partnership role is strictly passive and collectivel
total equity needed and the amount contributed by the Gene

By definition, an equity investment “waterfall” is the method

income and profits between the General Partner and the Lim
The exact methodology is described in the PPM, and it can va
but each waterfall has a number of features in common:

Preferred Return: As an incentive to invest, a General Partne

meaning that they will receive the first claim on the property’
earned a certain return on their investment.
For example, a deal may offer Limited Partners a preferred re
that they will receive 100% of the property’s cash available to

Preferred Return (or Hurdle)

hurdle rate; an internal annual rate of return the
VC firm must deliver to LPs before starting to receive any pro
Once the capital is returned, 100% will still be distributed to t
Regardless of whether the waterfall is global or deal-by-deal,
The main variations here are in what is included in the payme
As contribution, the GP may choose to consider only the capi
may include the capital called for fees and expenses. For the
the amount previously distributed as carried interest may be

Return Hurdles: A return hurdle is a point at which the cash fl

For example, a waterfall could be structured that the GP gets
the LP gets 90% until the LPs earn a return of 12% (the return
If the LPs earn more than 12%, the split changes so that the G

GP Catch-Up Clause
Finally, the catch-up clause is a legal provision meant to comp
based on an investment’s total return, not just the return in e
In practice, in a deal with a GP Catch-Up clause,
the LP receives 100% of the property’s cash flow until their pr
Above the hurdle, the manager/General Partner receives
100% of the income and profits until they are “caught up” to

Assume that the Limited Partners are entitled to a 10% prefer

General Partner is entitled to a 15% performance fee, with a c
Here’s how property income/profits would be allocated:
First, the LPs would get 100% of the income and profits until t
Next, the General Partner would get 100% of the income and
they’ve received the entirety of their 15% performance fee (t
Lastly, any remaining funds would be split between the gener

Catch-Up Tranche
The catch-up tranche tier pushes 100% of any distributions to
They continue receiving money until they have received a pre
A catch-up tranche is intended to ensure that the GP is made
That way, the incentive fee they receive is commensurate wit
total returns and not just with the profits that exceed the exp

Catchup is a bucket which is strongly favorable to the GP.

The rationale of a catchup is to give to the GP all or a majority
until the share of the profit received by the GP equals the car
The catchup is defined by two elements: an allocation
(usually 80% for the LP, 20% for the GP), and a target (in relati
Example:

First, 100% to the investors (LPs) until they receive their Prefe
Second, catchup of 100% (or majority) to the GP until the GP
Finally, allocate funds based on the carried interest allocation
Carried interest represents the portion of any profits provided
LPs also receive disbursements from any leftover profits. This
In return, it’s the GP’s job to ensure that LPs receive their initi
Any carried interest earned is subject to a capital gains tax.

European vs. American Waterfalls

American waterfall supports a deal-by-deal return schedule, i

to get paid before investors receive all of their invested capita
With an American waterfall, the distribution proceeds are gen

As a result, performance is tied to each individual investment

European waterfall, the allocation of the distribution proceed

and each distribution reflects the aggregate performance rathe
With a European waterfall, the first distributions typically retu

Pros , Cons and variations

For LPs, the drawback with an American waterfall is that
while this waterfall still entitles the LP to a preferred retu
it’s structured so that a manager could receive a disprop
cash flow early in the fund’s life cycle if there are signific

In a European waterfall, 100% of the contributed capital

return is paid out to investors on a pro rata basis before
distribution of carried interest. Because it’s pro rata, all c
equally and distributions are paid out in proportion to the

One potential drawback for the LP is that with a Europea

managers may realize positions quickly in order to receiv
rather than maximizing long-term investment returns. Als
delayed compensation, the European waterfall may also
to attract senior investment professionals to private equi
spin-out teams, especially if they are not bringing a matu
them.
wing phases:
al real estate transaction is such that
er and the Limited Partner(s).
r. They are responsible for identifying investment opportunities,
action logistics, and managing the property once purchased.
art of the total equity needed to finance the purchase, usually 10% – 20%.

” There may be one LP or many,

e their capital with the General Partner in the hope of earning a positive retu
sive and collectively, they contribute the difference between the
ributed by the General Partner, usually 80% to 90%.

fall” is the method used to allocate an investment’s

artner and the Limited Partner(s).
e PPM, and it can vary widely from one deal to another,
es in common:

t, a General Partner may offer the Limited Partners a “preferred return,”

im on the property’s cash available for distribution until they have

ners a preferred return of 8%, which means

y’s cash available to distribute until they have earned a return of 8% on their
 rn the
to receive any profit. Hurdle rates are typically around 7-8%,
be distributed to the LP until a specific internal rate of return (IRR) is reache
bal or deal-by-deal, this preferred return is always calculated on every cashflo
luded in the payment cashflows.
sider only the capital called for investment, or
expenses. For the distribution,
ed interest may be excluded.

at which the cash flow split between the GP and the LPs changes.
ed that the GP gets 10% of the cash flow available for distribution and
of 12% (the return hurdle).
anges so that the GP gets 20% and the LPs get 80%.

sion meant to compensate the General Partner (GP)

t just the return in excess of the pre-established hurdle.

h flow until their preferred return hurdle is reached.

artner receives
are “caught up” to their performance fee.

led to a 10% preferred return and the

mance fee, with a catch-up provision.
d be allocated:
e and profits until their 10% return hurdle has been reached.
of the income and profits until
performance fee (the catch up)
between the general and limited partners according to a predetermined sch

any distributions to the fund sponsor.

have received a predefined percentage level from the profits.
hat the GP is made whole.
commensurate with
hat exceed the expected preferred return.

able to the GP.

GP all or a majority of the gain,
e GP equals the carried interest (a percentage of the total return, e.g., 20%).
n allocation
nd a target (in relation to the carried interest).
 receive their Preferred Return;
he GP until the GP has received 20% of the cumulative amounts distributed w
d interest allocation
any profits provided to the GP regardless of their initial investment.
eftover profits. This tier represents the main source of funding for a sponsor.
Ps receive their initial investment back, along with the agreed-upon preferre
capital gains tax.

l return schedule, it allows managers

heir invested capital and preferred return.
n proceeds are generally allocated on a deal-by-deal basis.

dividual investment.

istribution proceeds is determined at a “whole fund” level,

performance rather than being tied to an individual investment.
utions typically return all of the contributed capital.

an waterfall is that
o a preferred return and their return of capital,
receive a disproportionate share of
there are significant early exits.

ontributed capital and preferred

rata basis before the GP receives any
it’s pro rata, all capital is treated
n proportion to the amount of capital invested.

at with a European waterfall,

y in order to receive distributions
tment returns. Also, due to the
waterfall may also make it challenging
als to private equity firms and delay
ot bringing a mature portfolio with
ually 10% – 20%.

rning a positive return.

een the

ferred return,”
hey have

turn of 8% on their investment.

turn (IRR) is reached.
ed on every cashflow.

changes.
ribution and
predetermined schedule

return, e.g., 20%).

mounts distributed with respect to the Preferred Return and this catch-up pro

vestment.
ding for a sponsor.
reed-upon preferred returns.

ment.
nd this catch-up provision; and
Problem No 1
The Initial Investment in a private equity transaction
with 50 percent debt and 50 percent equity.
The GBP 2,500 mn equity investment is further broke
owned by the private equity fund , GBP 95 mn of eq
and GBP 5 mn of management equity.
The preference shares promised a 12% annual return
The Private equity firm equity is promised 95 percen
after creditors and preference shares are paid and m
are promised the remaining 5 %.
Debt of GBP 900 mn is paid during the course of ope
Assume that the exit value, five years after investme
Find the payoff and IRR of claimants.

Given
Initial Investement required
50% debt capital
50% equity capital (Pref + Ord equity)
Preference share capital @12% divid.
PE Fund investors (LP) Equity
The management Equity

Given
Initial Invesment
Exit Value 1.6 times
Debt capital
Debt Retired - Paid off during operations
Remaining Debt
Pref. Share capital
Preference Shares @12% Returns
for 5 years
Terminal Equity or Terminal Profit
Exit value
Less Remaining Debt
Less Preference capital + dividend
Terminal value
PE Fund equity receives 95% of
terminal equity
Management equity receives
5% of TV
Investors Total Investment (LP)
Pref. Shares
Equity

Management investment
equity transaction GBP 5,000 mn. The transaction is financed
nt equity.
nt is further broken in to GBP 2,400 mn of preference shares
GBP 95 mn of equity owned by the private equity fund

12% annual return (paid at exit). Compounded return

omised 95 percent of the residual value of the firm
es are paid and management equity holders

the course of operation.

ars after investment is, 1.6 times of the orginigal cost.

GBP MN
5000
2500
2500
2400Investors LP
95investors LP
5Management GP

Amount in Million GBP

 5,000
8000
2500
900
1600
2400

4229.62Compounded Return

8000.00
1600.00
4229.62
2170.38Terminal Equity

2061.9LP or the investors

108.51899802GP or the management

Investement Proceeds
2400
95Total retuMultiple
-2495 6291.5 2.52163567
-5 108.519 21.7037996

20.32%
on is financed

ference shares
uity fund

return

al cost.
 28.6%

Year LP
gement 0 -2495
1 0
2 0
IRR 3 0
20.32%CAGR 4 0
85.06%CAGR 5 6291.5
20.32%
20.320%
GP
5
0
0
0
0
-108.519
85.1%
85.058%
A PE firm value a deal of GBP 100 mn investment. Its expecte
and the duration to exit is 4 years.
The investment is financed with 70% debt and remaining equ
Out of equity, 75% is in the form of preference share by PE fir
(paid at the time of exit), 20% in the form equity shares of PE
in the form of equity shares held by the management.
Assume that 60% of the debt is paid during the course of ope
Find the pay offs multiple and IRR for each of the claimant.

Given
Initial Invesment
Exit Value 1.5 times
Duration of investment
Debt Finance
Balance Total equity
Preference Share Capital @15%
Equity Shares of PE firm
Equity Shares of Management
Debt repaid during the course of operation
Balance Debt at exit
Pref. Dividend @15% Repaid
Assume Terminal Equity is shared as per their proporation of
Terminal Equity
Exit Value
Less Capital + Div. Returned to Preference S
Less Debt to be paid
Terminal Equity
Initial investment by PE firm investors
Initial Investment by Management
Total equity

PE fund terminal equity share

Management equity share of TV

Year LE GP
0 -28.5 -1.5
1 0 0
2 0 0
3 0 0
4 105.47 16.529
38.7% 82.2%

Capital requirement is estimated at the beginning

Exit Value
Term of the investment
Capital types for investment
Debt Capital
Bonds
Mezannine finance
Loans
Equity
Preference equity
Normal Equity

Who contributes what?

Terminal equity value Net proceedings after repaying all t

How the Terminal equity is split up ?

Based on the initial equity contribution
Proportion of the equity

How the IRR or CAG is calculated ?

Initial capital contribution
Final equity return at exit after repaying all the commitments
 investment. Its expected exit value 1.5 times of investment.

debt and remaining equity.

reference share by PE firm at the rate of 15% p.a.
orm equity shares of PE firm and the remaining
he management.
during the course of operation
each of the claimant.

GBP
100mn
150
4years
70
30Total Equity
22.575% of balance equity capital
6 0.8
1.5 0.2
42
28
39.35Pref div *(1+p.div)^4
per their proporation of their investment
 150
39.35
28
82.6473594
28.5
1.5
30

66.1178875 80%
16.5294719 20%

he beginning
dings after repaying all the other type of commitments

equity contribution

ing all the commitments

Alpha Equity Fund committed capital of $250 million.
The GP is entitiled to receive carried interest of 20%.
The following three investments were made by the fund at th
beginning of 2011 and exited at the end of 2011:

Portfolio of Amount invested

Company (USD mil)
A 60
B 80
C 20

Calculate the amount of carried interest paid to the GP for 20

1. Carried interest is paid in a deal by deal basis with hurdle ra
2. Carried interest is based on the first alternative of the total
investment portfolio exceeds the committed capital
3. Carried interest is based on the second alternative of the to
of the investment portfolio exceeds the value of invested cap

Solution

Theortical carried interest on Investement in Company A

IRR of investment in Company A
Since the IRR of the investment in Company A is lower than t
 Theoritical Carried
Company Interest
A 5
B 0
C 4

Under the first alternative of the total return method,

carried interest is paid to the GP only when the Exit value of t
Total committed capital = $250 million
Ending value of the portfolio = $85m + $75m + $40m = $200 m
Since the value of the portfolio is less than committed capital

Under this alternative of the total return method, (Second al

carried interest is paid to the GP only when the value of the p
Invested capital = $60m + $80m + $20m = $160 million
Note:
Carried interest will only be paid if the value of the portfolio e
Since the value of the portfolio is $200m, carried interest will
Carried interest = (200 – 160) * 20% = $8 million

TOTAL INVESTMENT
TOTAL EXIT VALUE
SINCE EXIT VALUE > GIVEN THRESHOLD IT IS ELIGIBLE FOR IN
CARRIED OUT 20%
CARRRIED INT
 capital of $250 million.
arried interest of 20%.
nts were made by the fund at the
at the end of 2011:

Proceeds Upon Exit

85
75
40

ed interest paid to the GP for 2011 assuming that:

deal by deal basis with hurdle rate of 50%
the first alternative of the total return method ie) if the value of the
the committed capital
the second alternative of the total return method. Ie) if the value
ceeds the value of invested capital by 20%

nvestement in Company A
41.67%
nt in Company A is lower than the hurdle rate of 50%, no carried interest wil
 Carried Int
IRR Paid Yes /NO Comment
41.67%No IRR<Hurdle Rate
0.00% No Loss, No Carried In
100.00%Yes IRR> Hurdle Rate

he total return method,

GP only when the Exit value of the portfolio exceeds committed capital.
0 million
$85m + $75m + $40m = $200 million
o is less than committed capital, no carried interest will be paid to the GP.

otal return method, (Second alternative of total return method)

GP only when the value of the portfolio exceeds invested capital by 20%.
m + $20m = $160 million

aid if the value of the portfolio exceeds $192m (= 160 * 1.2).

o is $200m, carried interest will be paid.
* 20% = $8 million

160
 200
HRESHOLD IT IS ELIGIBLE FOR INCENTIVE

8
 160 192

the value of the

e) if the value

5mn

%, no carried interest will be paid on this deal

 Actual CI
paid
0 IRR FORMULA
0
4

committed capital.

will be paid to the GP.

urn method)
sted capital by 20%.

0 * 1.2).
Waterfall Calculation - 80/20 Split
TRANSACTION

Capital Investe $ (10,000,000)

Proceeds $ 30,000,000
EQUITY PARTICIPANTS
GP
Limited Partners
EQUITY PARTICIPATION TERMS
Return of principal to Limited Partners plus an 8% cummulative
Then 80 / 20 split between GP / LP.
IRR HURDLES
LP IRR Hurdle
Principal 0.0%
Preferred Return 8.0%
PROCEEDS REQUIRED TO ACHIEVE HURDLES
Proceeds Required
by LP for Hurdle
Principal 10,000,000
Principal + Prefe 14,693,281
WATERFALL
IRR Achieved 24.6%
First Distribution:
Limited Partners 14,693,281
Proceeds Remai 15,306,719

Second Distribution:
GP 3,061,344
Limited Partners 12,245,375
GRAND TOTAL PROCEEDS
GP 3,061,344
Limited Partners 26,938,656
TOTAL 30,000,000
 Date
12/31/2020
12/31/2025

s an 8% cummulative return on principal.

HURDLES

100.0%
20.0%
80.0%

10.2%
89.8%
*Remaining Proceeds Split Pro Rata
Mega Equity Fund has committed capital of $200 million. At t
the fund exited one of its investments and earned a profit of
However, the following year, the fund incurred a loss of $8 m
Given that the GP is entitled to 20% carried interest on a deal
and that a clawback provision on annual true up basis, follow
determine the amount of carried interest received by the GP
whether the GP should return any profits to the LPs in the

Solution:
Carried interest paid in the first year = $20m * 0.2 = $4 million
With a subsequent loss of $8 million, the
GP would have to pay back 20% of the loss to LPs under the c
Amount to be paid back to LPs = $8m * 0.2 = $1.6 million

Example 2
Suppose a private equity fund has a committed capital totalin
and a carried interest of 20 percent. After a first investment o
the fund exits the investment 9 months later with a £15 millio
that a second investment of £25 million is concluded with a lo
Explain the situation with Claw back provision

Profit after first investment 20%*15mn

Loss after 2nd investment 20%*5mn
with a claw back payment to be paid bac
 of $200 million. At the end of the first year,
nd earned a profit of $20 million.
curred a loss of $8 million when it exited one of its other investments.
ed interest on a deal-by-deal basis,
true up basis, following year.
t received by the GP in Year 1 and
s to the LPs in the

20m * 0.2 = $4 million

ss to LPs under the clawback provision with an annual true-up.

0.2 = $1.6 million

mitted capital totaling £300 million

r a first investment of £30 million,
ater with a £15 million profit and
s concluded with a loss of £5 million 1 year later.

1mn
estments.
Single Round of Financing
Venture Capital Valuation

The entrepreneur founders of Tiara Ltd. believe that in 5 year

However, they are currently in desperate need of $7 million.
that the discount rate commensurate with the relatively high
Given that current shareholders hold 1 million shares and tha
capital firm makes an investment of $7 million in the compan
calculate the following:
1. Post-money value
2. Pre-money value
3. Ownership proportion of the VC firm
4. The number of shares that must be issued to the VC firm
5. Share price after the VC firm invests $7 million in the comp

Solution
After receiving the $7m, Tiara is expected to be worth $60m i
Therefore, the post- money value of the company equals the
Given VC firm's Investment

1) Post Money Value = PV of Exit Value

Exit Value @ 5 years
Discount rate
PV of Exit. Value
2)
Pre Money Value is Calculated as Post Mone

Pre Money Value

3) VC Firm is Investing
Company is worth

Ownership Proportion of VC investor

4) Current Shareholders own 1 mn shares and t

1,000,000
3,965,143.33
Shares to be issued to
VC Firm

5) The Price per share is then calculated as

Price Per Share

Step 1 PV of exit value

Step 2 Post Money value- Investment

Step 3 Ownership $ of VC firm
Calculate the remaining % of
Step 4 founders

Equate the % of shares owned

Step 5 by founders to the value
Calculate the No of shares
Step 6 owned by VC firm

Price per share= Investment /

Step 7 No of shares owned by VC firm
lieve that in 5 years they will be able to sell the company for $60 million.
need of $7 million. A VC firm that is interested in investing in Tiara estimates
the relatively high risk inherent in the firm is 45%.
ion shares and that the venture
ion in the company,

d to the VC firm
million in the company

o be worth $60m in 5 years.

mpany equals the present value of the anticipated exit value.
7mn

Exit Value POST Money Value

60Given
45%
9.36076277345555==> Post Money value
ated as Post Money Value Minus VC Firm's Investment

2.360762773POST Money value- Investment

7mn
9.360762773

VC investor 74.78%

n 1 mn shares and they have a

25.22%
1%

2,965,143.33 No of shares owned by VC Investing firm

Amount of VC investment / No of shares to be issued to VC investors

2.361Per share
Post Money value

Pre Money value

Investment / PV of exit value Inv/Post
 ny for $60 million.
ting in Tiara estimates

t value.

y Value
y value- Investment

(Investement Amount / Pv of Exit value)

25.22%equity interest

C Investing firm •Stake = Entrepreneurs’ shares × [F / (1

2,965,143.33

ssued to VC investors
hares × [F / (1 − F)].
The entrepreneur founders of Tiara Ltd. believe that in 5 year
However, they are currently in desperate need of $7 million.
that the discount rate commensurate with the relatively high
Given that current shareholders hold 1 million shares and tha
capital firm makes an investment of $7 million in the compan
calculate the following:
1. Post-money value
2. Pre-money value
3. Ownership proportion of the VC firm
4. The number of shares that must be issued to the VC firm
5. Share price after the VC firm invests $7 million in the comp

Applying the IRR-Based Venture Capital Method

Work with the information from Example 7 (regarding Tiara L
and calculate the following using the IRR-based venture capit
1. The future wealth required by the VC to attain its desired IR
2. Ownership percentage of the VC firm
3. The number of shares that must be issued to the VC firm
4. Stock Price per share
5. Post-money value
6. Pre-money value
 Solution
1) First we need to determine the amount of wealth the VC nee
to achieve the desired return of 45% on its $7m investment in
Required wealth = Investment * (1 + IRR) Number of years to

2) The percentage ownership that the VC firm requires to achiev

is calculated by dividing the required wealth by the expected
Ownership proportion = Required wealth / Exit value = 44.868

3) The current shareholders of Tiara hold 1m shares in the comp

The number of shares that must be issued to the VC firm so th
= Proportion of venture capital investment × Shares held by c

= 0.7478 * [1m / (1 – 0.7478)] = 2,965,143

4) Given that the VC firm is investing $7m in Tiara, the price of a

Price per share = Amount of venture capital investment / Num
= 7,000,000 / 2,965,143 = $2.36 per share

The post-money value can be calculated in two ways:

An investment of $7m gives the VC firm a 74.78% equity inter
Therefore, the post-money valuation of the company is calcu

Alternatively, there are 3,965,143 (= 1,000,000 + 2,965,143) s

Therefore, the value of the company equals 2.36 * 3,965,143
The pre-money value can also be calculated in two ways:
The pre-money value can be calculated as
the post-money value minus the amount invested by the VC:
Alternatively, we can
multiply the number of shares held by the current shareholde
1m * 2.36 = $2.3608m (allowing for rounding error).
 believe that in 5 years they will be able to sell the company for $60 million.
e need of $7 million. A VC firm that is interested in investing in Tiara estimat
th the relatively high risk inherent in the firm is 45%.
million shares and that the venture
million in the company,

ued to the VC firm

7 million in the company

Method
e 7 (regarding Tiara Ltd.)
-based venture capital method.
to attain its desired IRR.

ued to the VC firm

of wealth the VC needs to accumulate over the 5 years
ts $7m investment in Tiara.
) Number of years to exit = 7m * (1 + 0.45)^5 = $44.868m

rm requires to achieve its desired 45% return on a $7m investment

alth by the expected value of the company at exit:
h / Exit value = 44.868m / 60m = 74.78%

m shares in the company and have an equity stake of 25.22% = (100% - 74.78
d to the VC firm so that it owns 74.78% of Tiara is calculated as:
nt × Shares held by company founders /Proportion of investment of compan

n Tiara, the price of a share is calculated as:

ital investment / Number of shares issued to venture capital investors

in two ways:
a 74.78% equity interest in Tiara.
the company is calculated as 7m / 0.7478 = $9.3608m (allowing for rounding

00,000 + 2,965,143) shares in the company that are each worth $2.36. round
uals 2.36 * 3,965,143 = $9.3608m (allowing for rounding error)
ted in two ways:

t invested by the VC: $9.3608m – 7m = $2.3608m.

e current shareholders by the price per share:

ding error).
or $60 million.
in Tiara estimates
stment

% = (100% - 74.78%).

ment of company founders Shares to be issued

investors

ng for rounding error).

th $2.36. rounding error).

A venture capital firm is considering investing in a private com
through alternative sources of energy. However, the venture
founders of the private company are too optimistic and that t
The discount rate after accounting for systematic risk is 35%.
Calculate the adjusted discount rate that incorporates the com

Solution

Adjusted Discount rate 68.7500%

Risk can be incorporated in two ways when you are calculatin

NPV PV of Cash In flows- PV of Cash out flows
NPV>0
COST OF CAPITAL KE 8%
RISK FREE RATE OF INT 6%
Discounting Rate
Cost of Capital + Risk
Risk can be incorporated at the cash flows level
Risk Can be incorporated at the discount level
Note
When the risk is incorporate at the cash flow level, then the d
When the risk is not adjsuted at the cash flow, the risk has to
 sting in a private company involved in generating power
owever, the venture capital firm believes that the
optimistic and that the chance of the company failing in any given year is 20
ystematic risk is 35%.
incorporates the company’s probability of failure.

10%
en you are calculating NPV 2%
of Cash out flows 2%

RADR
Year 14%
0 -100
ws level 1 50 90%
2 60 85%
 3 50 80%
23.776276641

flow level, then the discount obviously has to be Risk free rate
flow, the risk has to be adjusted at the discount
n any given year is 20%.

RFR
certain cfs
45
51
 40
21.4274199507

ee rate
Scenario Analysis

Compute the terminal value estimate for Blue Horizons Pvt. L

1. The company’s earnings in Year 5 are $13 million and the a
The probability of occurrence of this scenario is 65%.
2. The company’s earnings in Year 5 are $6 million and the ap
The probability of occurrence of this scenario is 25%.
3. The company fails to achieve its goals and has to liquidate i
The probability of occurrence of this scenario is 10%.

EXPECTED CASH FLOWS

Solution:
Terminal value in scenario 1 = 13m * 8 = $104 million
Terminal value in scenario 2 = 6m * 5 = $30 million
Terminal value in scenario 3 = $5 million
Expected terminal value = (104m * 0.65) + (30m * 0.25) + (5m
r Blue Horizons Pvt. Ltd. given the following scenarios and their probability o
$13 million and the appropriate exit price-to-earnings multiple is 8.
nario is 65%.
$6 million and the appropriate exit price-to-earnings multiple is 5.
nario is 25%.
and has to liquidate its assets in Year 5 for $5 million.
nario is 10%.

$104 million
30 million

+ (30m * 0.25) + (5m * 0.1) = $75.6 million

eir probability of occurrence:
le is 8.
Given
Exit Value 80 Post 6
Post Money Value PV OF EXIT VALUE
POST Money Value PV of 80 mn @30% for 6 years
Current investment value 10
PRE Money Valuation =POST MONEY VALUATION
Pre Money Valuation 6.5741(PM MONEY - INVESTMENT)

% Ownershipe by VC 60.34%
% ownership by founder 39.66%

No of shares held by the Founder

No of shares held by the VC

Price per share

 POST MONEY VALUATION
Years PRE MONEY VALUATION
T VALUE
mn @30% for 6 years 16.574
mn
ONEY VALUATION
M MONEY - INVESTMENT)

INITIAL INV/ POST MONEY VALUE

2,000,000 39.66%
3,042,243

3.287Amount invested by the investor / no of shares hel

 PV OF EXIT VALUE
POST MONEY VALUE- INVESTMENT

r / no of shares held by VC
 2 rounds of financing

Given
Value at Exit 80 6
6 mn today
4 mn 2 years
MGL will the first round investor
Camelot Capital is 2nd investor
Discount rate 30%
Founders shares 2,000,000

PV of exit value Year end 2 28.01

Investment at Year 2 4
Pre Money Valuation in Year 2 24.01
Post Money Valuation at time to Post Money 1
Pre Money Valuation 8.2072
No of shares owned by Wizpus

No of Shares owned by 2nd Investor

14.28% (Investment / Post money 2)
No of shares owned by MGL Ventures & Founder
No of shares owned by MGL Ventures
Balance shares owned by founder
No of shares owned by founder
No of shares owned by MGL

Price at time for the MGL shareholders

No of Shares owned by 2nd Investor

14.28%
Balance shares owned by 1st Investor + founder
No of shares owned by 2nd Investor
Price P2 of the shares

Steps
1POST(2)
2PREMONEY (2)
3POST (1)
4PRE MONEY(1)
 INVESTMENT (2)
INVESTMENT(1)
% SHARES INVESTMENT / POST MONEY
% SHARES FOR T1ST FOUND OF FUNDING
Calculate the total shares
No of shares to be given to the first round of funding
Founder's Share + No of share to be given to the first roundin
Total Shares = (1-% Shares given 2nd round of funding)
calculate the no of shares to be given to the 2nd round fundin
calculate price per share
 years Time t0
Time t2

80/(1+30%)^4 Post Money(2)

Pre Money 2
ost Money 1 14.2072329773148
Pre Money 1
oney 2) Note
Founder 85.72%
42.23%
57.77%
2,000,000
1,462,124.937

4.10

founder 85.72%
576,775.12
6.94
 d of funding
n to the first rounding
und of funding)
the 2nd round funding
6m MGL
4m Camelot Capital
(Investment/ Post money1)

3,462,124.94
Two Rounds of Financing Venture Capital

Note : For the first round of funding , 45% is th

FIRST ROUND FINANCING DISCOUNT RATE

GIVEN
TOTAL AMOUNT REQUIRED
INITIAL ROUND FUNDING
2ND ROUDN OF FINANCING
EXIT VALUE OF THE TOTAL INVESTMENT AFT
DISCOUNT RATE FOR 2ND FINANCING
 DICOUNT RATE FOR 1ST ROUND FINANCING

NOTE IN TWO ROUNDS OF FUNDING, START AT THE 2ND

STEP BACKWARDS, WHILE CALCULATION
CACULATE THE TWO POST MONEY VALUATION AN

SOLUTION
STEP 1 FIRST WE NEED TO CALCULATE THE COMPOUND D

BETWEEN FIRST AND 2ND ROUND

BETWEEN THE 2ND ROUND AND EXIT

STEP2 CALCUALTE POST MONEY VALUE AFTER THE 2ND R

POST MONEY VALUE = PV OF EXIT VALUE

EXIT VALUE
PERIOD OR TERM
DISCOUNT RATE

PM(2) PV OF EXIT VALUE FROM YEAR 5 TO YEA

POST MONEY VALUE (2)
STEP 3 CALCULATE PRE MONEY VALUE AT THE TIME OF 2N
PRE MONEY VALUE POST MONEY VALU
PRE MONEY VALUE(2) 45

STEP 4 COMPUTE THE POST MONEY VALUE AFTER THE FIR

USE THE DISCOUNT RATE CALCUALTED IN THE FIRS

POST MONEY VALUE (1) PV OF EXIT VALUE

EXIT VALUE PRE MONEY VALUE
POST MONEY VALUE (1) 10.1798295

STEP 5 PRE MONEY VALUE (1) POST MONEY VALU

PRE MONEY VALUE (1) 3.17982952

STEP 6 WE NEED THE OWNERSHIP % FOR THE 2ND ROUN

THAT IS WORTH NOW

INITIAL INVESTMENT DONE AT THE END OF THE 4T

POST MONEY VALUE (2)
F2 6.25%

STEP 7 WE NEED TO CALCULATE THE OWNERSHIP % FOR

F1 INVESTMENT / POST MONEY VALUE (1)
 INVESTMENT 7
POST MONEY VALUE(1) 10.1798295
F1 68.76%

STEP 8 DETERMINE THE NO OF SHARE THAT MUST BE ISSU

TO DESIRED LEVEL OF OWNERSHIP %

THE FUND MANAGERS HAS 1,000,000 SHARES

1,000,000SHARES 31.24%
NO OF SHARES FOR 1ST ROUND FUNDING2201375.88
PRICE PER SHARE

DETERMINE NO OF SHARES TO BE ISSUED TO 2ND

NO OF SHARE TO FUND MANA 1,000,000
NO OF SHARES TO 1ST ROUND 2201375.88
TOTAL SHARES ISSUED TO 3,201,376

3,201,376SHARES 93.75%
NO OF SHARES TO BE 213425.059
ISSUED TO 2ND ROUND
OF FUNDING PEOPLE

PRICE PER SHARE FOR 2ND ROUND OF FUNDING P

ding , 45% is the discount rate

45% Note :
Founder's Share :
10MN
7MN AT THE INCEPTION
3MN AFTER 4 YEARS
60MN AFTER 5YEARS
25% FOR 1 YEAR 4TH YEAR TO 5TH YEAR
 45% FOR 4 YEAR 0 TO 4 YEARS

T AT THE 2ND ROUND OF FUND

ALUATION AND PRE MONEY VALUATOIN

COMPOUND DISCOUNT RATES APPLICABLE

4.421
1.25

TER THE 2ND ROUND BY DISCOUNTING THE TV FOR 1 YEAR AT 25%

60
1YEAR
1.25

YEAR 5 TO YEAR 4
48 MN 48
HE TIME OF 2ND ROUND OF FINANCING
MONEY VALUE (2)-INVESTMENT DONE AT 2ND ROUND OF FINANCING
MN

AFTER THE FIRST ROUND OF FINANCING

ED IN THE FIRST STEP

EXIT VALUE
MONEY VALUE (2) /(1+DIS. RATE(1)
MN 10.1798295161

MONEY VALUE (1)- INVESTMENT AT FIRST FOUND OF FINANCING)

MN

HE 2ND ROUND FUNDIING INVESTORS WHO HAVE CONTRIBUTED $3MN

ND OF THE 4TH YEAR BY 2ND ROUND OF INVESTORS

Ownership % Investment / PV of exit value

RSHIP % FOR THE FIRST ROUND INVESTORS

NEY VALUE (1)
 MN

Ownership % Investment / PV of exit value

MUST BE ISSUED TO FIRST ROUND INVESTORS FOR THEM TO ATTAIN

0 SHARES

3.180

SUED TO 2ND OF FUNDING PEOPLE

FOUNDER'S SHARES
SHARES TO 1ST ROUND OF FUDING
TOTAL

OF FUNDING PEOPLE 14.05645625

 1,000,000

CEPTION

TO 5TH YEAR
R AT 25%
 FINANCING

ANCING)

BUTED $3MN

3
48
TO ATTAIN
Two young analysts analyze a potentia
Specifically, they assess the expected ga
90% of the common equity through the

The buyout requires an initial investme

Financing for the deal includes $6 milli
promise a 15% annual return paid at e
The expected exit value in six years is $
with an estimated reduction in debt of $
Solution

Given
Initial Investrme 10
Exit value 15
Financing
Debt 6
15% Pref. shares 3.6
Common Equity 0.4
Time of exit 6Years
Debt remaining a6-2.8 3.2
Prefrence shares with 8.32702
Terminal equity 3.47298
Return 43.36%
a potential investment in the leveraged buyout of
pected gain if they elect to purchase all of the pre
rough the LBO. Details of the LBO include the fo

investment of $10 million.

s $6 million in debt, $3.6 million in preference sh
paid at exit, and $0.4 million in common equity.
years is $15 million,
debt of $2.8 million over the six years prior to exi
EXIT VALUE
LESS PENDING DEBT TO BE CLEARED
LESS PREF. SHARES WITH CUMMULATIVE
TERMINAL VALUE
% DUE TO INVESTORS
% DUE TO THE MANAGEMENT
d buyout of ABC Ltd
all of the preference shares and
nclude the following:

reference shares that

mon equity.

s prior to exit.
CLEARED
UMMULATIVE DIVIDENDS
LBO
Initial Investment
Equity
Preference shares 15% rolled up
Senior Debt
Exit value Year 6
Senior Debt outstanding
Calculate IRR for the management and PE fund

Exit vAlue
Preferency shares with dividends
Debt paid
Debt Outstanding at exit
Terminal value
Share of equity for PE Investor
Share of equity for Management

BEGINNING
PE INVESTOR 318
MANAGEMENT 2
 800
20Equity share PEI Investo 90% Management: 10%
300PEI Investor 100%of pref. shares
480
1360mn
288Total Investment by the investor
and PE fund Initial investment by the mgmt

1360
693.92
192paid during the operations
288
378.08
340.27 90%
37.808 10%

EGINNING END IRR

1034.2 22%
37.808 63%
Management: 10%
f pref. shares

318
2
 Private Equity Fee

Capital Paid-in Manage

Called Capital ment
Down Fees

2011 $50.0 $50.0 $1.0

2012 $20.0 $70.0 $1.4
2013 $30.0 $100.0 $2.0
2014 $20.0 $120.0 $2.4
2015 $10.0 $130.0 $2.6
2016 $10.0 $140.0 $2.8

Management fee 2%
Performance fee 20%
Commited capital $150.0

Distributi
Assumptions ons
te Equity Fee Calculation

Operating NAV Carried Distributi NAV after

Results before Interest ons distributions
distributi
ons

-$10.0 $39.0 $39.0

-$25.0 $32.6 $32.6
$25.0 $85.6 $85.6
$50.0 $153.2 $0.6 $20.0 $132.6
$60.0 $200.0 $9.4 $40.0 $150.6
$110.0 $267.8 $13.6 $80.0 $174.2
ABC Capital partners, have raised $ 1 bn funds from Inv
In this fund, Investors have contributed $950 million, and

So 95% was contributed by Limited partners and 5% by Gener

After receiving the capital, GP then goes ahead and makes inv
After 5 years, the GP exit all investments and receives a total
Limited partners would get $1bn first as that would be the ca
The remaining $1.5 bn shall be divided between LP and GP in
So the LPs would get $1.2 bn, and $0.3 bn would go to GP.
So GP earned 5x (250/50) on investing $50 mn.

GP LP
Initial Investment 50 950
Exit after 5years
Capital Returned -50 -950
Profit splitup 20/80 300 1200
bn funds from Investors & General partners.
$950 million, and the Manager or general partner contributed $50 mill

rs and 5% by General Partner.

head and makes investments in various target companies to earn profits.
nd receives a total of $2.5 billion. In this scenario,
at would be the capital returned.
ween LP and GP in the 80:20 ratio.
would go to GP.

1000 5% 95%
2500
-1000
1500
ntributed $50 million.

to earn profits.
The founders of a small technology firm are seeking a $3 milli
prospective investors. The founders project that their firm co
private equity investors deem a discount rate of 25% to be ap
of failure in any year.
Calculate the adjusted pre-money valuation (PRE) of the tech

Investment required 3mn

Exit 25
Term 4Years
Disount rate 25%
Probability of failure 20%
Pre Money Value

Discount rate (1+r)/(1-q)-1

56.2500%

Post Money 4.1943

Pre money 1.1943
eking a $3 million venture capital investment from
at their firm could be sold for $25 million in 4 years. The
of 25% to be appropriate, but believe there is a 20% chance

RE) of the technology firm