PRICING OF FOLLOW-UP ROUNDS AND THE RIGHT OF FIRST REFUSAL

The founders had some further concerns about how the second round of financing would work out. To keep things more tractable, they decided to ignore issues of preferred equity and treat all securities on an "as-if converted" basis. On the assumption that they would take Wolf C. Flow's deal, there would be 10.5 million shares, 4 million shares owned by Vulture Ventures, 5 million shares owned by the founders, and 1.5 million shares owned by employees. For the second round of financing, Vulture Ventures had already mentioned that they would want to bring in another venture capital firm with the trust-inspiring name of Crow Capital.

Annabella wanted to see how prices would be set in the second round. She assumed that the total investment amount would be $2 million. However, she wasn't sure how much of this would be provided by Vulture Ventures or Crow Capital. She thought that Vulture Ventures would invest either $0.5 million or $1 million. After agreeing on the amount, she thought that the price of shares would be either $2 or $2.5 per share. There were thus four possible bargaining outcomes:

- Outcome 1: Vulture Ventures invests $0.5 million, Crow Capital invests $1.5 million, price per share is $2.
- Outcome 2: Vulture Ventures invests $0.5 million, Crow Capital invests $1.5 million, price per share is $2.5.
- Outcome 3: Vulture Ventures invests $1 million, Crow Capital invests $1 million, price per share is $2.
- Outcome 4: Vulture Ventures invests $1 million, Crow Capital invests $1 million, price per share is $2.5.

Annabella was indifferent about how Vulture Ventures and Crow Capital split the $2 million. But she wondered how this first choice of investment amounts would affect the subsequent choice of the price per share? Since she wasn't sure who would be setting the price, she envisioned three scenarios.

- In the first scenario, the founders would control to price.
- In the second scenario, Crow Capital would control the price.
- In the third scenario, Vulture Ventures would control the price.

Question a: For each of the four outcomes, calculate the pre- and post-money valuation of the firm, as well as the ownership stakes of all parties.

Question b: Now consider each of the three price-setting scenario. Suppose that Vulture Ventures invested $0.5 million. What price would you expect for each of the three scenarios? How does your answer change if Vulture Ventures invested $1 million?

Bob suggested that instead of investing $0.5 million for $1 per share, Vulture Ventures should invest according to the "right of first refusal" clause, in which the first round investor invested in the second round according to its pro rata share; i.e., Vulture Ventures should take up 4 / 10.5 38.10 percent of the second round, which would amount to approximately $0.76 million.

Question c: How does your answer to 5b change if Vulture Ventures made a pro-rata investment?