VC Return Model Explanation –
Detailed Notes
1. Company Valuation
The model estimates the company's value at the time of exit (IPO or sale) in 2027.
It uses a Sales Multiple of 2x on the projected 2027 sales to estimate the Enterprise Value (EV).
From this EV, Net Debt is subtracted to get the Equity Value.
Net Debt = Total Debt - Cash
Now, this Equity Value is what needs to be split between different shareholders.
2. Adjustments Before Splitting Equity
Before common shareholders get anything, the following amounts are subtracted from the Equity
Value:
1. Accrued Preferred Dividends (3 years):
VC investors (preferred shareholders) are often promised annual dividends.
Even if not paid yearly, these dividends are accrued and need to be paid on exit.
These are taken out from Equity Value first.
2. Preferred Participation (3 years):
This means VCs can first get their investment back (and dividends), then ALSO share in the
remaining equity like common shareholders.
These payouts reduce what's left for others.
This gives us the Remaining Equity for common shareholders.
3. Capitalization Table & Share Counts
The Cap Table shows all types of shareholders: Founders, Option Pool, and Preferred (VC).
The number of shares each party owns is listed.
Ownership % is calculated using total shares, including a 15% option pool, which is an important
assumption.
This 15% is reserved for future employees.
Even if not all options are issued, they count toward dilution.
Convertible Preferred Terms
VC investment is made through “Convertible Preferred Shares”.
They have the option to either:
Take back their investment + dividends (preferred route), OR
Convert their shares into common shares if it's more profitable.
This is why the model compares both and uses the higher value (called "as converted" vs.
"liquidation preference").
Hurdle Rate / Discount Rate
A Discount Rate (12%) is used (calculated via CAPM Model) to calculate the Net Present Value
(NPV) of returns.
This shows what future returns are worth today.
Then Probability of success was assumed as 25%, 40%, 60%, 80%, and 100% from 2023-
2027.
The Hurdle rate formula is :
Hurdle rate=Discount Rate/Probability of success
This Hurdle Rate of each year used to discount the Equity Value
Then we subtracted Investment needed from it each year to get “Post-Money Equity Value”
From this Figure, the Equity Investment of each year was subtracted to get “Pre-money Equity
Value”
Pre-Money Equity Share Price
The Pre-Money Equity Value was divided with the “Number of shares in issue each year” to
get “Pre-money Price per share”.
This is the price at which the VC invests
Then the Ownership % of
1) Management
2) Option pool
3) Investor 1, 2 and 3
were calculated
Preferred Dividend rate was assumed at 6%
Participation feature was assumed to be YES.
The VC Investors get following as their return on Investment
1) Original Investment back
2) Preference Dividends
3) Participation feature
here Are Two Types of Preferred Shares:
1. Non-Participating Preferred
VC says:
🧑💼 “Give me either my promised return, OR let me convert into shares and get my % of the sale —
I’ll pick whichever is better.”
This one is more fair to founders.
2. Participating Preferred (what you're seeing in your file)
VC says:
🧑💼 “Give me my full promised return first, AND THEN also let me eat from the remaining pie 🍰.”
In short:
💸 “First I get my money back + my bonus (divs), THEN I also act like a shareholder.”
That’s why:
The VC gets paid back their money with a return (dividends).
THEN, they still own a % of the company.
So when the rest is divided, they get that % too.
🧠 Why Would a Founder Agree to This?
Because at the start:
You have nothing.
VC is taking big risk.
VC says “I’ll give you $1M, but if this hits, I want extra security.”
So you agree:
“Ok fine... if we exit big, you’ll get your money + a share of the profit.”
📉 The Tradeoff
Participating preferred = More downside protection for VCs, less upside for founders.
At IPO or sale:
VC takes their full return.
Then says, “Oh yeah, I still own 20%, gimme that too.”
Accrued Preferred Dividends
Think of this like this:
The investor (VC) said:
👉 “Until you grow big, I’ll wait, but when you sell the company — you owe me X money every year I
waited.”
So every year, a bit more builds up — like unpaid rent.
At the end (when company is sold), this amount is paid first to the VC before anyone else gets money.
Final Returns
After all payouts and conversions, the model shows:
How much each party gets
The Multiple on Invested Capital (MOIC)
The Internal Rate of Return (IRR)
Summary
This model shows how money flows at the exit.
VCs get first dibs via preferred terms.
Then, what remains is divided among common holders.
The cap table + assumptions (like option pool %, participation rights (YES or NO), dividend rate %
and discount rate %) impact everyone’s return.