Strategy, Valuation, and Deal Structure
Chapter 13. Value Creation and Contract Design
Questions and Problems
1. Consider a venture to develop a new video game system for babies. The system is designed
to be installed in child-safety car seats. If everything goes according to the entrepreneur’s
plan, the venture can achieve sales of $10 million in four years. At that point, based on
market information for similar companies, the venture could be offered to the public at a
multiple of 6 times annual sales. To complete development of the venture, the entrepreneur
anticipates needing $1 million in capital immediately, $1.5 million in year 1, $2 million in year
2, and $3 million in year 3. Capital that is raised in advance of when it is needed can be
invested to earn an annual return of 5 percent.
a. Suppose the investor uses hurdle rates of 75 percent for current investment, 60
percent for year-1 investment, 45 percent for year-2 investment, and 30 percent for
year-3 investment. How much capital does the entrepreneur need if all of the
investment is provided now? How much of the equity would the investor require for
making such an investment?
b. Now, suppose the investor would make annual contributions of the needed amounts
of capital (in four stages). How much of the equity would the investor require at each
stage? Assuming that the venture is successful and that its projections are on target,
how much of the equity would the investor ultimately require?
c. Finally, suppose the venture survives but is significantly less successful than the
entrepreneur projects it to be. At the time of the year-1 investment, the revenue
projection is reduced to $9 million, at the time of the year-2 investment, it is reduced
to $7.5 million, and at the time of the year-3 investment, it is reduced to $6 million. All
other assumptions are unchanged. What fraction of the equity would the investor
2. Suppose that for the venture described in problem 1, the projected sales level in year 4 is of a
success scenario. It is equally likely that the venture will have sales of $2 million at that point.
Suppose the investor makes the entire cash commitment at time zero. The entrepreneur
plans to contribute $400,000 of human capital, from his total wealth of $1.5 million, and will
invest the balance in the market. The expected market return is 11 percent per year. The
market standard deviation is 20 percent per year. The correlation between the venture and
the market is .25. Suppose the investor and the entrepreneur both receive equity claims.
a. Assume the market for outside investment capital is highly competitive. How much