Venture Capital and Private Equity Session 5

1. Venture Capital and Private Equity Session 5 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. 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 • Preferred Stock • Use of Stock options/grants with strict vesting requirements • Contingent control mechanisms – Covenants and restrictions • Strategic composition of Board of Directors Got a Term Sheet Multiple Rounds, Multiple Tranches READ THE TERM SHEETS!!

4. How do VCs address these problems • Security Design • Vesting Provisions • Covenants

5. VCs response #1– Security Design • Redeemable Preferred (RP) • Convertible Preferred (CP) - Forced Conversion Clause • Participating Convertible Preferred (PCP)

6. 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

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

8. Other Term Sheet Features • Vesting • Covenants • Liquidity Preferences • Anti-Dilution Protection • Board Seats • Please read the Note on Private Equity Securities

9. Liquidation – Quick Review • Deemed liquidation event • Liquidation preference (2X, 3X, etc.) • Non Participating • Fully Participating • Qualified public offering (QPO)

10. FACEBOOK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Conversion Each share of Series A, Series B, Series C, Series D, and Series E preferred stock is convertible, at the option of the holder thereof, at any time after the date of issuance of such share, into such number of fully paid and non-assessable shares of Class B common stock as is determined by dividing the applicable original issue price by the conversion price applicable to such share in effect on the date of conversion. The conversion price of each series of preferred stock may be subject to adjustment from time to time under certain circumstances. The convertible preferred stock issued to date was sold at prices ranging from $0.004605 to $7.412454 per share, which, in all cases, exceeded the then most recent reassessed fair value of our Class B common stock. Accordingly, there was no intrinsic value associated with the issuance of the convertible preferred stock through December 31, 2011, and there were no other separate instruments issued with the convertible preferred stock, such as warrants. Therefore, we have concluded that there was no beneficial conversion option associated with the convertible preferred stock issuances. Each share of Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall automatically be converted into fully paid, non-assessable shares of Class B common stock immediately upon the earlier of: (i) the sale by us of our Class A common stock or Class B common stock in a firm commitment underwritten public offering pursuant to a registration statement under the Securities Act of 1933, as amended (Securities Act), the public offering price of which results in aggregate cash proceeds to us of not less than $100 million (net of underwriting discounts and commissions), or (ii) the date specified by written consent or agreement of the holders of a majority of the then-outstanding shares of preferred stock, voting together as a single class on an as-converted basis, provided, however, that if (a) the holders of a majority of the then-outstanding shares of Series D convertible preferred stock do not consent or agree or (b) the holders of a majority of the then-outstanding shares of Series E convertible preferred stock do not consent or agree, then in either such case the conversion shall not be effective as to any shares of preferred stock until 180 days after the date of the written consent of the majority of the then-outstanding shares of preferred stock. Liquidation Preferences In the event we liquidate, dissolve, or wind up our business, either voluntarily or involuntarily, the holders of our Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall be entitled to receive, prior and in preference to any distribution of any of our assets to the holders of Class A common stock or Class B common stock, an amount per share equal to $0.004605, $0.0570025, $0.2871668, $7.412454, and $4.54158 per share (as adjusted for stock splits, stock dividends, reclassifications, and the like), respectively, plus any declared but unpaid dividends. If, upon the occurrence of any of these events, the assets and funds distributed among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then our entire assets and funds legally available for distribution shall be distributed ratably among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock in proportion to the preferential amount each such holder is otherwise entitled to receive. If there are any remaining assets upon the completion of the liquidating distribution to the Series A, Series B, Series C, Series D, and Series E convertible preferred stockholders, the holders of our Class A common stock and Class B common stock will receive all our remaining assets. The merger or consolidation of us into another entity in which our stockholders own less than 50% of the voting stock of the surviving company, or the sale, transfer, or lease of substantially all our assets, shall be deemed a liquidation, dissolution, or winding up of us. As the “redemption” events are within our control for all periods presented, all shares of preferred stock have been presented as part of permanent equity.

11. Facebook Cap Table

12. Biggest VC Success Story Angel Round? ACCEL? Peter Thiel 500,000 turned into 2.5% of 100 Billion = 2.5 Billion YES BILLION!!!

13. 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

14. Dilution • A owns 100% of the company which is 1 million shares for which she had paid $2 per share • Company issues another 1MM shares and raises 2 MM from B • A is now 50% owner -- she has been diluted! • But A did NOT suffer any ECONOMIC DILUTION – Company now is worth $ 4 million and A’s stake is still $2 million! • Similarly, If company reserves 1 MM shares for option pool again the company receives future services from the employees for that option pool again there is no ECONOMIC DILUTION. • What is investor B pays $1 per share for its $2 million investment? • Now there are 3 Million share post financing and A only owns 33.3% • A’s investment declines from $2MM to $1MM • ECONOMIC DILUTION!!!

15. Antidilution • Company XYZ raised $12 Million from Early Ventures (EV) in Round A financing. EV received 6 million shares (at a $2.00 per share price). The Founders had 4 million shares after Round A. Subsequently the firm falls on hard times and has to raise another $ 10 million. It appears that investors are unlikely to offer more than $1.00 per share valuation. How would the Cap Tables look if (a) EV had NO antidilution protection (b) EV had Full Ratchet Protection (c) EV had Broad Weighted Average antidilution Protection

16. Regular Round What happens when the new round for $ 10 Million is raised at $1.00 Per share?

17. Series A Series B (No AntiDilution) % % Investor # of shares $ per share $ total ownership # of shares $ per share $ total ownership Founders 4,000,000 $2.00 $8,000,000 40.00% 4,000,000 $1.00 $4,000,000 20.00% Key Ventures 6,000,000 $2.00 $12,000,000 60.00% 6,000,000 $1.00 $6,000,000 30.00% Series B VC 10,000,000 $1.00 $10,000,000 50.00% Total For Round 6,000,000 12,000,000 10,000,000 10,000,000 Cumulative Total 10,000,000 $2.00 $20,000,000 100% 20,000,000 $1.00 $20,000,000 100% Price Per Share $2.00 $1.00 Pre-Money Valuation 8,000,000 10,000,000 Cash Infusion 12,000,000 10,000,000 Post-money Valuation 20,000,000 20,000,000 No Antidilution Protection

18. Series A Series B (Full Ratchet) % % Investor # of shares $ per share $ total ownership # of shares $ per share $ total ownership Founders 4,000,000 $2.00 $8,000,000 40.00% 4,000,000 $1.00 $4,000,000 15.38% Key Ventures 6,000,000 $2.00 $12,000,000 60.00% 12,000,000 $1.00 $12,000,000 46.15% Series B VC 10,000,000 $1.00 $10,000,000 38.46% Total For Round 6,000,000 12,000,000 10,000,000 10,000,000 Cumulative Total 10,000,000 $2.00 $20,000,000 100% 26,000,000 $1.00 $26,000,000 100% Price Per Share $2.00 $1.00 Pre-Money Valuation 8,000,000 16,000,000 Cash Infusion 12,000,000 10,000,000 Post-money Valuation 20,000,000 26,000,000 Full Ratchet Protection • Early Round VC simply demands that the NEW down round price be used for the Money he had invested in the earlier round! • First round  $12 Million was invested – New price is $1 – Early VC would say his total number of shares must be 12 million, since he already has 6 million shares he would have to be given extra 6 million shares! • Notice what happens to the shareholding of Late round investor IF there is anti-dilution protection!

19. 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

20. Series A Series B (Wtd Avg Ratchet) % Investor # of shares $ per share $ total ownership # of shares $ per share $ total % ownership Founders 4,000,000 $2.00 $8,000,000 40.00% 4,000,000 $1.00 $4,000,000 18.18% Early Venture 6,000,000 $2.00 $12,000,000 60.00% 8,000,000 $1.00 $8,000,000 36.36% Late Venture 10,000,000 $1.00 $10,000,000 45.45% Total For Round 6,000,000 12,000,000 10,000,000 10,000,000 Cumulative Total 10,000,000 $2.00 $20,000,000 100% 22,000,000 $1.00 $22,000,000 100% Price Per Share New conversion Price for EV 1.50 $2.00 $1.00 Pre-Money Valuation 8,000,000 12,000,000 Cash Infusion 12,000,000 10,000,000 Post-money Valuation 20,000,000 22,000,000 Weighted Average Anti-Dilution NCP = OCP * (OB+(NM/OCP)) / (OB+SI) NCP= $2 * (10MM+($10MM/$2)) / (10MM+10MM)=30MM/20MM=$1.5 New Number of Shares due to Series A= $12MM/1.5=8MM (implying an extra 2MM shares that would be issued because of antidilution protection)

21. 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

22. Term Sheets…Let us look at Trendsetter

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

24. Trendsetter • If you were advising Wendy and Jason and you could not change any of the terms, which term sheet would you recommend?

25. Some Questions • How much money are VCs putting in? • What is the implied pre-money and post-money valuation? • When will the “Option Pool” be created? • Focus on Mega: So how much are Wendy and Jason worth? • How is “Liquidation Preference” differ across two term sheets?

26. How much money – what fraction of the company? • Let us look at Mega first • Pre-Money • Founders own Shares • Option Pool Shares • Post-Money • Mega owns Shares • Total # of Shares • What if the options were never mentioned and Mega had said we give you 7 million Pre-money and 12 million post? 4,500,000 64.28% 35.72% 2,500,000 Founders 37.50% Option Pool 20.83% VC 41.67% 5,000,000 12,000,000

27. How much money – what fraction of the company? • Now let us look at Alpha – Assuming no release from the escrow account • Pre-Money • Founders own Shares • Option Pool Shares • Post-Money • Alpha owns Shares • Total # of Shares • Founder Ownership $7,350,000 Implying $1.05 Per share 4,000,000 3,000,000 $ 12,350,000 4,761,905 Ownership 40.49% Total shares 11,761,905 34.01%

28. Valuation (Cap Tables)

29. Liquidation • Deemed liquidation event • Liquidation preference (2X, 3X, etc.) • Alpha • Mega • Qualified public offering (QPO)

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

31. Who gets how much: Liquidation Waterfall Charts • If Alpha 40.49% ; If Mega 41.67% • Liquidation values • 5 million • 7.5 million • 20 million • 30 million • 40 million Alpha 5 Mega 5 Alpha 5 +40.49% of (7.5-5) = 6.01; Mega 7.5 Alpha 11.07; Mega 7.5 +(20-7.5)x41.67%=12.71 Alpha 15.12; Mega 16.88 Alpha 15 ; Mega 21.04 Alpha will convert 40.49% of 40= 16.20!

32. What about IPO? • Remember in both cases the total number of shares outstanding after financing were ~12 million • How valuable must the company become to meet the QPO • How much does Mega get for $500 million sale of the company versus an IPO that values the company for $500 million?

33. Exit Values Alpha Ownership -40.49% Mega Ownership -41.67% $ 15 million maximum

34. Broader discussion of terms • What terms did you like in one but not in other term sheet? Why? • What terms did you dislike in both terms sheets? Why?

35. Alpha • Hurdle • Tricky • 3MM • CP • NoCum • 3x • Low • WtAvg • 60% • Same?? • Two VCs Mega • $7 MM • Plain • 2.5MM • PCP • Cum • 1.5x • High • Full? • ??? • Same • One VC • Key Issues • Valuation • Pre and Post • Option Pool • Type of security • Dividend • Liquidation • QPO • Antidilution • Voting Rights • Founder’s vesting • VC Syndicate

36. Trendsetter • If you were advising Wendy and Jason and you could ask for change in any of the terms, which terms would you try to renegotiate?

37. Alpha • Hurdle • Tricky • 3MM • CP • NoCum • 3x • Low • WtAvg • 60% • Same?? • Two VCs Mega • $7 MM • Plain • 2.5MM • PCP • Cum • 1.5x • High • Full? • ??? • Same • One VC • Key Issues • Valuation • Pre and Post • Option Pool • Type of security • Dividend • Liquidation • QPO • Antidilution • Voting Rights • Founder’s vesting • VC Syndicate Remember – Term sheet is “proposal” nothing is cast in stone yet. You need to know what to negotiate and why?

38. A framework for analyzing termsheets • Economics • Original Purchase Price (OPP) aka “proposed ownership percentage)” on a “fully diluted basis” • Liquidation Preference (1x, 2x etc. • Participation (Note: on top of liquidation preference) • Conversion (QPO) • Antidilution • Dividends • Control • Board of Directors • Voting Rights/Protective Provisions • Conversion (QPO) • Founders stock/vesting • Transfer Restrictions • Registration Rights???

39. Term sheet Check list • Green Flags • Simple Terms • VC willing to take the downside risk (1x liquidation preference; no antidilution) • Plain convertible Preferred • Yellow Flags • Milestone heavy • Complex terms • Terms left vague • Future option pool to come out of founders’ share • Red Flags • Extremely milestone heavy • Length exclusivity • Complex due diligence requirements • Clauses that shift control from founders to VCs

40. Why do we see these features? • Convertible preferred • Participating Convertible Preferred • Full Ratchet/ Weighted Average Ratchet • Vesting provisions

41. 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

42. Recap • Hopefully you are better placed to appreciate the importance of terms. • As an entrepreneur try to avoid “fancy” term sheets with lots of “gingerbread” • Try not to raise money WHEN you need it – try to do it with 6 months of cash burn cushion