Venture Capital and Private Equity Session 4

1. Venture Capital and Private Equity Session 4 Professor SandeepDahiya Georgetown University

2. Course Road Map • What is Venture Capital - Introduction • VC Cycle • Fund raising • Investing • VC Valuation Methods • Term Sheets • Design of Private Equity securities • Exiting • Time permitting – Corporate Venture Capital (CVC)

3. Quick Review of VC Valuation Method • Remember - In venture capital all valuation is “implied valuation”. Simply put the value arises because VC(s) is(are) willing to finance the company! • The terms (amount invested, fraction of ownership received) fix the post-money and pre-money value of the business • This process is made transparent by reporting of “Capitalization Table” or simply “Cap Tables” – Let us see how these are created…

4. Capitalization Tables Page 10 (Bottom) of ONSET ventures case describes the financing history of TallyUp. Onset offered to invest $750,000 at a price $1 per share in return for 31.6% of the company. Later, ONSET invested another $250,000 at the same price ($ 1 per share) when Reed Tausig as the CEO. Please draw up the capitalization tables, pre-money and post money valuations for tally before and after each round of financing.

5. After Next Investment of $250,000

6. After Option Pool Creation of 750,000 Shares

7. What if Mann is able to do a $3.5 million round at 2.5 times step up (ONSET invests $1 million in this round)

8. TallyUp – What Happened • Was able to raise 4 million in the next round at post-money value of $ 13 million (>2.5x step-up) • Raised 4 more rounds – changed name to Callidus Software • Did IPO in 2003 at $13.5 share • ONSET owned 17% of the company at the time of IPO

9. Term Sheets…Let us look at Trendsetter

10. Term Sheet • Getting first Term Sheet is MAJOR break through! • Validates entrepreneur/idea • Establishes a price • Can be shopped around (especially in later rounds)

11. Term Sheets in Venture Financing • Responses by investors • Active Screening • Stage financing • Syndication • Use of Stock options/grants with strict vesting requirements • Contingent control mechanisms – Covenants and restrictions • Strategic composition of Board of Directors • Critical Issues • Uncertainty • Asymmetric Information • Nature of Firm’s assets • Conditions of relevant financial and product markets Got a Term Sheet Check the Term Sheet! Multiple Rounds, Multiple Tranches

12. Trendsetter is Lucky! • If you were advising Trendsetter which offer would recommend? • Valuation • Liquidation Preference (and Antidilution) • Vesting • Corporate Governance

13. Valuation (Cap Tables)

14. Liquidation • Deemed liquidation event • Liquidation preference (2X, 3X, etc.) • Non Participating • Fully Participating • Qualified public offering (QPO) Will See in Details Later

15. TYPE OF LIQUIDATION EVENT IS CRITICAL! What Type of Security? • Alpha • Convertible Preferred (CP) Stock • Mega • Participating Convertible Preferred (PCP) Stock

16. Exit Values

17. Anti-Dilution Protections Read the Note on Anti-dilution provisions: Typology and Numerical Example • Down round • Full-ratchet vs. weighted average • Adjusted conversion price, adjusted conversion rate

18. Broad-base weighted average anti-dilution NCP = OCP * (OB+NM/OCP) / (OB+SI) NCP= New Conversion Price OCP= Old Conversion Price in effect immediately prior to new issue OB = Number of shares of shares outstanding immediately prior to this round NM = New Money received by the Corporation SI = Number of shares of stock issued in this round Another way of writing it

19. Why do we see these features? • Convertible preferred • Participating Convertible Preferred • Full Ratchet/ Weighted Average Ratchet • Registration rights

20. Challenges for VCs • Private Equity Partnerships (PEP) have become the dominant organization form as it addresses challenges faced by LPs (Investors) and GPs(VC, Buyout Firm). • Are there issues between GPs and the portfolio companies?

21. Challenges of Venture Financing • Critical issues involved in financing young firms • Uncertainty • Asymmetric Information • Nature of Firm’s assets • Conditions of relevant financial and product markets • Responses by VCs • Active Screening • Stage financing • Syndication • Use of Stock options/grants with strict vesting requirements • Contingent control mechanisms – Covenants and restrictions • Strategic composition of Board of Directors

22. Securities used by VCs • Common Stock • Debt • Preferred Stock • Never – why not? • Never – why not? • Interesting- why?

23. VCs response #1– Security Design • Redeemable Preferred (RP) • Convertible Preferred (CP) - Forced Conversion Clause • Participating Convertible Preferred (PCP) DO NOT WORRY! WILL DEVOTE TIME TO THESE LATER!!

24. VCs response #2 Vesting • Vesting – creates “Golden Handcuffs” for key employees • Idea being that you have to “Earn” your share of the company! • Also keeps the option pool from being depleted if employees leave

25. VCs response #3 Covenants • Covenants • Positive Covenants • Example Provide regular information • Negative Covenants • Example Sale of assets • Others • Mandatory redemption • Board Seats