Venture Capital and Private Equity Session 4

Venture Capital and Private Equity Session 4 Professor SandeepDahiya Georgetown University

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)

VC Method-Implied Valuation Information you would almost always have • I – Amount being raised from VC • X- Number of Shares currently owned by entrepreneur Information that requires judgment call • R – VC’s required return (IRR) usually between 25% to 80% • T – Time to exit (When VC gets money back) • V – Value of the company at time of exit Numbers you need to calculate • F – Fraction of company VC would need to get the return • Post-Money Valuation – Value of company after funding is received • Pre-money Valuation - Value of company before funding is received • P – Price per share. • Y – Number of shares to be issued to the VC

Multiple Rounds/ Exit Dilution • Imagine that you need 15% of the company at the exit to get your mandated return. • Simple case – 100 shares would want 15 shares • What if along the way company issues another 50 shares (option/new investor) what happens to your stake? • New total shares = 100+50= 150 • You interest = 15/150 = 10%!! – you have been diluted • You would insist on more than 15% today to end with 15% eventually – how to figure that out • Expected dilution = 50/150 = 0.333 • Fraction needed today = Final ownership/(1-Dilution) • =15%/(1-0.333)= 22.5% implying 22.5 shares today • Check>>> at the end 22.5/150 = 15%

Example Contd. • Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? • Need to reserve 15% of the firm in terminal year for the option pool for mangers. VC still needs to get $5 million*(1.5)5 = 37.97 million At Exit Firm is Still Worth 100 Million VC still needs 37.97/100 = 37.97% of the Firm AT TIME OF EXIT! However what VC needs TODAY is higher since extra shares would be issued to the Option Pool causing dilution VC Current Ownership = 0.3797/(1-0.15) = 44.67%

Example Contd. • Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? • Need to reserve 15% of the firm in terminal year for the option pool for mangers. 5 million for 44.67% of the company imply Post money valuation of 5/0.4467= 11.193 million and pre-money valuation of 11.19 -5=6.193 million New Shares to VC =5/6.193=0.807 million shares

Multiple Rounds of Financing • Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? • Need to reserve 15% of the firm in terminal year for the option pool for mangers. Would need another $ 3 million at the beginning of year 3 – round 2 investors require 30% return Round 2 investor need 30% on its 3 million i.e. 3(1.30)3 = 6.59 million Final value is still 100 million, Thus Round 2 investor need 6.59% of the company AT EXIT Implying that at time of investment it needs to own Round 2 VC need 0.659/(1-0.15)=7.75% Round 1 still needs 38% at the time of EXIT implying initial stake = 0.38/(1-(0.0659+0.15))=0.485 or 48.5% stake. What is the Post and Pre Money Valuation at round 1? How many shares need to be issued to Round 1, Round 2 and option pool? 5/0.485=10.32; 5.32 Round 1 = 1x[0.485/(1-0.485)] =941,748 Round 2 = 1.941748x[0.0775/(1-0.0775)]=163,128 Option Pool =(1.942+0.163)X[0.15/(1-0.15)]= 371,448

For Practice • Recalcualte the numbers detailed in “The Basic Venture Capital Formula”

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…

Capitalization Tables Page 10 (Bottom) of ONSET ventures case describes the financing history of TallyUp. “…Onset invested $750,000 to purchase preferred shares (at $1 each), in return for 31.6% of the company, based on a $2,375,000 post-money valuation. The agreement was structured so that ONSET would later invest an additional $250,00 – at the same $1 per share price…” Please draw up the capitalization tables, pre-money and post money valuations for tally before and after each round of financing.

Hiring of Reed Taussig as CEO.. Page 12 (Bottom) of ONSET Venture case describes the follow up financing. “…Once Taussig was hired, ONSET invested the additional $250,000 they had planned to put in, raising TallyUp’s (post-money) valuation to $2,625,000…”.

Option Pool ! Page 13 (Bottom) of ONSET Venture case describes the creation of Option Pool. “…First, TallyUp had decided to set aside a portion of shares used as stock options for new employees hires. The value of these options would likely be $750,00 (750,000 shares at $1 per share), which would increase TallyUp’s valuation by the same amount…”.

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)

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) Paper Gain $2 MM investment now worth(???) $3.5 MM!

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

Fund Raising versus Fund Investing • We saw how GPs and LPs can have conflicting interests – the solution that has emerged is the PEP agreement that we saw first in ONSET case and also in ACCEL Partners case. • Now let us turn our attention to conflict of interest between the VCs and the entrepreneurs they finance

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!!

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

TYPE OF LIQUIDATION EVENT IS CRITICAL! Security Design - What Type of Security? VCs NEVER take Common Stock • Common Stock • Stands Last • Preferred Stock • Before Common Stock in case of LIQUIDATION

Challenges for VCs • Joe Flash and Rex Finance do a deal John Terrific Offers $2 million for the Company – What happens if Rex had taken Common Stock?

Many types of preferred stock • Redeemable Preferred (RP) • Convertible Preferred (CP) • Participating Convertible Preferred (PCP) • PCP with cap (=PCPC) • Key threshold for PCP is a qualified public offering (QPO)

Alternatives $ 5 million investment 1/3rd ownership (OPP $1.00 per share) (Implied Valuation= $15 Million, 15 million shares) • Structure I: 5M shares of common; • Structure II: Redeemable Preferred ($5M APP); • Structure III: RP + 5M shares of common; • Structure III(A): 5M Convertible Preferred (CP) exchange ratio 1:1. • Structure IV: PCP with participation as-if 5M shares of common, QPO at $5 per share; • Structure V: PCPC with participation as-if 5M shares of common, with liquidation return capped at four times Original Purchase Price (OPP), QPO at $5 per share;

Structure I - 5M shares of common W = 3, W =6, W =10

Structure II RP ($5M APP); W = 3, W =6, W =10

W A 5 CP Common Stock 5 15 $W Exit Diagrams for RP and Common Redeemable Preferred W = 3, W =6, W =10

Series A 5 5 $W Structure III RP + 5M shares of common W = 3, W =5, W =8, W=11

15 Structure III(A) CP

Structure III (Revisited) RP + 5M shares of commonsimilar to a structure called Participating Convertible Preferred (PCP) Notice the “Double Dipping”

Structure IV PCP with participation as-if 5M shares of common, QPO at $5 per share Mandatory Conversion 1/3*75=25! 71 If Liquidation is at 71 first 5 goes to PCP Holder Rest (71-5=66) is shared 1/3*66=22 Total Payoff = 5+22= 27

Structure V PCPC with participation as-if 5M shares of common, with liquidation return capped at four times Original Purchase Price, QPO at $5 per share 4*5=20; 5+15!

Sell Call option X=50 Buy Call X=60 Buy Call Option X=5 Structure V, continued

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

Other Term Sheet Features • Vesting • Covenants • Anti-Dilution Protection • Board Seats • Please read the Note on Private Equity Securities and the “Trendsetter” Case for class on Thursday

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

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

Tomorrow • Discussion of Trendsetter Case • Read AntiDilution Note • Read Note on Private Equity Securities • Read “How VCs evaluate potential Opportunities”

Venture Capital and Private Equity Session 4