310 ENTREPRENEURSHIP
when. By breaking the outflows down by type according to risk level, the entrepreneur
segments the investor market and sells the investors the level of reward and risk that best
matches that investor’s profile.Segmenting the Investor Market
A simplified deal structure is presented in Figure 8.2.^23 To understand the figure, imag-
ine that the cash flows shown represent an investment and subsequent returns in a
biotech company that does genetic engineering. The entrepreneurs have calculated that
they need $2 million to found the venture at year 0. Figure 8.2 shows their final esti-
mate of cash flows for the project for each year through Year 5.
The internal rate of return(IRR) on the cash flows in Figure 8.2 is 59.46 percent.
The IRR is calculated by solving for the discount factor that makes the cash outflow
exactly equal to the cash inflow. An IRR of 59.45 percent can be deemed sufficient to
proceed with the analysis. The five-year projection is also sufficient and typical.
However, the example shows only the aggregated bottom-line numbers on the deal.
Segmenting the investor market means breaking these numbers down into their origi-
nal component parts to show the risk/reward attributes of each part of the cash flow.
Table 8.1 does this and indicates that for a $2 million investment, the project gener-
ates cash flows from three sources:- Tax incentives are positive in the first three years but become negative (tax pay-
ments) in Years 4 and 5. - Free cash flow (CF) from operations is positive throughout the five-year horizon,
rising from $200,000 in Year 1 to $1.2 million in Year 5. - The projected terminal value of the business is also a factor. In this example, it is
predicted to be $10,000,000. This is derived (hypothetically) by taking the free
cash flow for Year 5, subtracting the Year 5 tax liability ($1,200 -$200), and apply-
ing a price-earnings multiple of 10 to the result (10 x $1,000,000 = $10,000,000).
Note that the Total CF figure is the same as the one used in Figure 8.2.
We can also calculate the net present value of each of the sources of cash flow by dis-
counting the cash flows on any given line of Figure 8.2 by the internal rate of return on
FIGURE 8.2 Biotech Cash Flows Example ($thousands)
Year
0 1 2 3 4 5
Cash Flows (2,000) 600 600 800 800 11,000To calculate the IRR of this stream of cash flows, solve for k.IRR = (2,000) = 600 + 600 + 800 + 800 + 11,000(1 + k) (1 + k)^2 (1 + k)^3 (1 + k)^4 (1 + k)^5
This equation can be solved with financing programs or spreadsheets like Excel.