Securing Investors and Structuring the Deal 313Risk Sharing
The previous example is intentionally simplified to show that investors have different
risk/reward preferences and that entrepreneurs who can identify these needs have an
advantage in securing financing.^25 If the entrepreneurs in the example had gone directly
to the venture capitalists, they would have had to part with 79.9 percent of the equity
to secure the entire $2 million.^26
The example assumed that the venture capitalists would take common stock and pro-
vide their entire investment up front, at the beginning of the initial period. These
assumptions are relaxed in the example that follows.Risk Sharing: Some Examples. Table 8.3 presents a simplified set of cash flows for a
deal.^27 In an all-equity deal with a 40-percent required rate of return for the venture cap-
italist, the NPV of the set of flows is $1,204. (Readers should calculate this for them-
selves). The venture capitalist will demand 83 percent of the equity ($1,000/$1,204) for
this investment, leaving 17 percent for the entrepreneurs. The net present value for the
investors is $0, since 83 percent of this set of cash flows exactly equals the investment
of $1,000, and the NPV for the entrepreneurs is $204.
However, the real world is not quite so neat. In a more typical scenario, both future
cash flows and the appropriate discount rate are undetermined, and the parties to the
deal will disagree about the amount and timing of the cash flows and the appropriate
discount rate. The investors and entrepreneurs will disagree about interpretation of laws,
regulations, and the tax treatment of certain events. There will be conflicts of interest
between the investors and founders, each group seeking to protect its interests at the
expense of the other.
If just one assumption is relaxed—if a definite $500-per-year cash flow becomes an
expected$500 per year cash flow—the actual amount will be known only over time.
How does this change the rewards and risks of the deal? The top portion of Table 8.4
shows the effects of this change on a common stock deal of proportional sharing.
Given an equal probability that the returns will be $450 or $550 (with the expected
value still at $500), the investor will receive $373 (.83 x $450) in a bad year and $456
(.83 x $550) in a good year. The expected annual return is the average of the two
($415). The standard deviation (a measure of risk) of the PV to the investor is 83 per-
cent of the total deal’s NPV standard deviation of $102, or $85. The investor in this sce-Period 0^1 2 3 4 5TABLE 8.3 A Series of Cash Flows
Investment ($1,000)
Cash flow $500 $500 $500 $500 $ 500
Terminal value 1,000
Net cash flow ($1,000) $500 $500 $500 $500 $1,500SOURCE: From “Aspects of Financial Contracting,” Journal of Applied Corporate Finance, 1988: 25–36. Reprinted by permission
of Stern Stewart Co., New York, NY.