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Venture Capital and Private Equity Session 5

Venture Capital and Private Equity Session 5. Professor Sandeep Dahiya 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

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Venture Capital and Private Equity Session 5

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  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. Term Sheets …

  4. 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

  5. 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

  6. EXAMPLE: Suppose that Early Venture (EV) makes a $8M Series A investment in Newco for 2M shares at $4 per share on 1/1/1999. One year later, Newco has fallen on hard times and receives a $10M Series B financing from Late Venture (LV) for 5M shares at $2 per share. The founders and the stock pool have claims on 6M shares of common stock. Consider the following cases: Case I: Series A has no antidilution protection. Case II: Series A has full-ratchet antidilution protection. Case III: Series A has broad-base weighted-average antidilution protection. For each of these cases, what percentage of Newco (fully diluted) would be controlled by EV, Founders and LV following the Series B investment? What would be the post-money and pre-money valuations?

  7. Second Round Full Ratchet Second Round Partial Ratchet 1/1/2000 1/1/2000 Investor # of shares $ per share $ total % ownership # of shares $ per share $ total % ownership Founders 6,000,000 - $12,000,000 40.00% 6,000,000 - $12,000,000 44.52% Early VC 4,000,000 $2.00 $8,000,000 26.67% 2,476,190.5 $2.00 $4,952,381 18.37% Later VC 5,000,000 $2.00 $10,000,000 33.33% 5,000,000 $2.00 $10,000,000 37.10% Cumulative Total 15,000,000 $2.00 $30,000,000 100% 13,476,190 $2.00 $26,952,381 100% NCP 3.23 Notice value of Early VC has fallen from 8 million to 4 million This implies a “paper loss” of 8-4= 4 million!

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

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

  10. 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)

  11. Alternatives $ 5 million investment 1/3rd ownership (Implied Valuation= $15 Million, 15 million shares) • Structure I: 5M shares of common; • Structure II: RP ($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 OPP, QPO at $5 per share; • Structure VI: RP ($4M Aggregate Purchase Price) + 5M shares of CP ($1M APP).

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

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

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

  15. Structure III RP + 5M shares of common W = 3, W =5, W =8, W=11

  16. 15 Structure III(A) CP

  17. Structure III (Revisited) RP + 5M shares of commonalso called Participating Convertible Preferred (PCP) Notice the “Double Dipping”

  18. 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

  19. 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!

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

  21. Structure VI, RP component

  22. 4 Structure VI, RP ($4M APP) + 5M shares of CP ($1M APP).

  23. Structure VI, CP component

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

  25. Why do we see these features • Convertible preferred • Participating Convertible Preferred • Liquidation Preferences • Full Ratchet/ Weighted Average Ratchet • Registration rights

  26. 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?

  27. 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

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

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

  30. 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

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

  32. Tomorrow • Metapath Software • Try using Option Pricing Model Posted on the website under Class Session 6 • Wrap up with discussion of “How VCs Evaluate Potential VC Opportunities” • HW 2 assignment will be posted under Class Session 5 (Due on Wednesday)

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