Personal and corporate income tax rate, Electrical Engineering

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Ginny Jones currently works as the VP-Product Strategy for a well-established enterprise software company. She and her friend, Tom Robinson, currently CFO at a competing firm (and someone who has taken two companies public), have spoken at length over the past 2 years about starting up a new company based on a complementary product concept that Ginny has been investigating on the side. Based on consultation with her lawyer, Ginny has a high degree of confidence that she is the sole owner of the intellectual property in question. With her current employment contract set to expire in 6 months, she wishes to decide now whether or not to begin the process of renegotiating her employment or to embark on a new venture.

Key facts:

  • Including bonus, Ginny's current annual compensation is $275,000; Tom's is $300,000. Each believes that they would command salaries of 80% of current levels in the event of venture failure. Annual salary inflation is expected to be 5% into the future.
  • If Ginny stays with her current company, she expects to be CEO within 6 years which would pay her $600,000/yr. By leaving the company she will forego this opportunity. Tom expects to leave corporate management at some point in the foreseeable future (assume 5 years) and work as a venture capitalist making at least $500,000/yr. This detour will have no effect in re: his career prospects.
  • Tom & Ginny can each afford to invest up to $200,000 in the new venture and continue to maintain an adequate amount of portfolio diversification. Each commits to drawing no more than $125,000/yr in annual salary from the new venture for the first 5 years after which their salaries triple if they stay with the company.
  • Tom has extensive VC contacts and has a rich uncle whose hobby is seeding new ventures.
  • Total startup costs are expected to be $1mm with an additional $1mm in operating losses expected over the first two years of the venture.
  • Based on a market survey and due to the depth of experience that Ginny & Tom bring to the venture, the expected VC equity financing cost for this venture is 35%
  • The estimated market size for this new technology is $250mm/yr. Due to first mover advantage the team expects to be able to capture 60% of the market by the third year and command an operating margin of 30% in a success scenario, 35% of market at an operating margin of 20% in a base scenario. A failure scenario would result in a complete loss. Working capital requirements are expected to be negligible due to highly favourable supplier terms.
  • Probability of failure is estimated at 25%, success at 25%.
  • Personal and corporate income tax rate is 30%
  • Overall market returns are 11%, risk free rate is 4% and venture beta is 2.5.

a) Should Ginny leave her current job to pursue this venture? Why?

b) Should Tom leave his job to pursue this venture? Why?

c) Whose opportunity cost of pursuing this venture is highest? Explain.

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