Dollinger index

312 ENTREPRENEURSHIP

How much would the wealthy investor be willing to pay for this cash stream? That

can be determined by discounting the tax cash flow by the investor’s required rate of

return. In this case, we arrive at a present value of $492,155. The investor must see this

investment of $492,155 as equivalent to the cash flows from the tax benefits. After a

modest amount of convincing, the entrepreneurs hope to receive a commitment from

the investor, so they may point out that the tax benefits could be even larger if the firm

loses more money in its early years.

With some money now in hand, the entrepreneurs are ready to approach a lending

institution such as a commercial bank. Banks are not interested in tax benefits; few of

them make enough money to pay very much in taxes anyway. They are interested in the

firm’s ability to generate cash for interest payments and the repayment of principal.

Although the free cash flows of the firm are relatively risky, some portion of them should

be considered safe by conservative lending officers. For our example, assume that

$100,000 (see Table 8.2) is considered fairly safe in any given year. If the entrepreneurs

can find a bank inclined to accept an interest payment of $100,000 each year and a

repayment of principal in Year 5 with an interest rate of 10 percent, they can borrow $1

million.^24 Added to the $492,000 from the wealthy investor, the entrepreneurs need only

$508,000 to complete the deal.

Selling Equity. There are few alternative sources for the remaining $508,000, so the

entrepreneurs are forced to sell equity in their business to a venture capital firm. Venture

capitalists are interested in the riskiest portion of the deal, the terminal value. In

exchange for this risk, they demand the highest returns (upwards of 50 percent). The

management team can use the residual pricing method (see Chapter 7) to determine just

how much equity must be sold to raise $508,000 at a required rate of return. To calcu-

late this, they determine the remaining cash flows not previously committed to the

wealthy individual or bank (see Table 8.3), then discount it by the venture capitalist’s 50

percent required rate of return. This gives a residual value of $1,796,707. The amount

of the proposed venture capital investment is $508,000, 28.3 percent of $1,796,707. So

the entrepreneurs offer the venture capitalists 28.3 percent of the common equity in

their business for $508,000. If the venture capitalists accept the offer, the entrepreneurs

have completed their $2-million financing and have kept 71.7 percent of the firm for

themselves. In fact, the entrepreneurs are creating value for themselves any time they

raise money at less than the total internal rate of return (IRR) for the project (59.5 per-

cent).

TABLE 8.2 Partitioned Cash Flow Structure by Investor ($000)

Source of Investment Year 0

-$2,000

-$2,000

Year 1

$600

400

100

$100

Year 2

$600

100

100

$100

Year 3

$800

100

100

$600

Year 4 Year 5

Total CF

>Wealthy investor

>Lending

institution

=Remaining CF

$ 800

-200

100

$ 900

$11,000

-200

1,100

$10,100