A Teaching Note on Deal Structure and the Use of Capitalization Tables

Abstract

This note provides an overview of the deal structuring process between company founders and venture capital firms. Specifically, the note: (1) reviews the use of the venture capital method to value venture investment opportunities and structure the financing arrangement between the founders of the entrepreneurial firms and the venture investors, (2) illustrates the use of capitalization tables to plan for multiple rounds of venture financing, and (3) emphasizes the importance of arriving at a realistic value estimate for the entrepreneurial firm that does not over-value the firm. The last point refers to the fact that initial valuations used to structure venture financing contracts can be too high. Excessive valuations in earlier rounds can lead to severe dilutions of founder and even early round investor shares in subsequent financing rounds. In the extreme, the dilution can be so severe as to jeopardize the continued existence of the firm.

Keywords: Venture capital, capitalization tables

JEL Classification: G19, G29, G39