Dollinger index

Securing Investors and Structuring the Deal 315

Staged Financing

Few deals require all the money up front. Most new venture development occurs in

stages, so most deals allow for staged (phased) financing. Let’s say that the entrepre-

neurs need $20 million and are willing to sell 75 percent of the firm for this capital

investment. Table 8.5 shows one possible way to stage, or phase, the financing. Often,

first-stage financing is used for market studies, development of prototypes, and early

organizational costs. The amounts are relatively small and are used to prove the venture

viable. In this scenario, $1 million goes to pay for these development and start-up costs

and buys 50 percent of the venture. The implied valuation, therefore, is $2 million.

As the venture succeeds in its initial efforts, it becomes more valuable. At the second

stage, money may be needed to purchase plant and equipment for a small manufactur-

ing facility that will enable the firm to test engineering concepts and design and to pro-

duce for a test market. Four million dollars is needed at this stage. The $4 million buys

33.3 percent of the firm. Because the investors already own 50 percent, they end up

owning 66.7 percent at the end of this round. Now the company is more valuable: Its

implied valuation is now $12 million ($4 million x 3).

If the venture is on track and succeeding as planned, third-stage financing will be

needed for a full production ramp-up. If this requires $15 million, investors can be

brought up to the originally determined 75 percent ownership by purchasing another

25 percent of the company. The post-investment valuation of the firm is now $60 mil-

lion. At each stage, the investor is purchasing a smaller piece of the firm at a higher price.

Why is the investor willing to do this? As the entrepreneurs meet their goals and mile-

stones, risk is reduced. The continued success makes the venture more valuable and less

risky.

The Option to Abandon

Not all staged-financing deals proceed as smoothly as the one depicted in Table 8.5. If

things go wrong and the deal turns sour, investors will not want to put additional money

in, especially at the $4-million and $15-million levels. That is, they want the option to

abandon. The example in Tables 8.3 and 8.4 shows what happens in staged financing if

Implied

Valuation

(post money)

TABLE 8.5 Phased Investment Scheme

Round of

Financing

First round

Second round

Third round

Amount

Invested

This Round

$ 1,000,000

4,000,000

15,000,000

Percent

Received

This Round

50.0%

33.3

25.0

VC’s

Share

50.0%

66.7

75.0

Founder’s

Share

50.0%

33.3

25.0

Formula for the second round: 50% + (33.3%) (1.50) = 66.7%

Formula for the third round: 66.7% + (25%) (166.7) = 75.0%

SOURCE: From “Aspects of Financial Contracting,” Journal of Applied Corporate Finance, 1988: 25–36. Reprinted by permission
of Stern Stewart Co., New York, NY.

$ 2,000,000

12,000,000

60,000,000