Venture Capital and Private Equity Session 6

1. Venture Capital and Private Equity Session 6 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. Metapath Software Professor Sandeep Dahiya Georgetown University

4. OUTLINE • What happened. • The broader themes: • The interplay of terms. • Options in private equity.

5. WHAT HAPPENED (1) • The Company turned down Cell Tech: • Offering 30% of their capitalization indicated that their base business had limited upside. • Clearly there were ongoing financing risks and liquidity issues. • The fit was not compelling. • Cell Tech stock fell $9 --> $3 • After 3 years and several acquisitions, it rebounded.

6. WHAT HAPPENED (2) • Accepted RSC Participating Preferred, later had to raise a $12mm Ser F Rd at $8/shr, had to keep participation. • Merged with UK based MSI Dec ‘98: • 65% MSI, 35% Metapath, both private cos. • Grey area since preferred carried over to merged company. • Mezzanine investors insisted on participation.

7. WHAT HAPPENED (3) • Much rancor between late investors and early investors plus Management: • Ser E (and Ser F) had defined “liquidation” to include any change of control event. • Management maintained all rights could be preserved in capitalization post-merger. • Late stage investors knew company worth more than their ~$24mm liquidation preference, so were willing to vote down deal (votes were by class)--they won.

8. WHAT HAPPENED (4): Lessons Learned • Metapath used too much money: • Despite continual progress, ran out of cash. • Metapath too price focused: • $4/shr w/ no participation possible? • $4/shr still a good step up from $1.62. • RSco and TCV fundamentally different kind of investor from BVP & Norwest: • Trading terms for price. • Good trade when you perform but leaves no room for error!

9. THE INTERPLAY OF TERMS: Trading price for terms • Trend in price/share often only outside gauge of company progress. • Price/share affects employee options and morale. • Fancy terms tend to put boundaries on the downside. • Term-laden deals often play on entrepreneur's optimism (screening?).

10. THE INTERPLAY OF TERMS: Liquidation & Participation • A liquidation triggers participation. • In the Metapath case, formerly the board could deem a change of control a liquidation, but it was not automatic. • “Liquidation” was changed to include change of control in Ser E: • Implication not picked up by management, early investors or company counsel.

11. THE INTERPLAY OF TERMS: Voting & Negative Covenants • Negative Covenants outline what the company can NOT do without special vote of preferred (e.g.: merge, sell, change business, liquidate etc.) • Preferred previously voted as one class, or on an “as converted basis”. • Voting class by class became part of deal when terms between classes significantly diverged.

12. BLACK-SCHOLES LOOKS AT THE LIMITING CASE • Assumes continuous time--many branching points. • Obtains complex formula as function of: • Time to maturity. • Standard deviation of stock. • Current stock price. • Exercise price. • Risk-free interest rate.

13. USING THE BLACK-SCHOLES FORMULA • Black-Scholes EXCEL calculator.

14. ILLUSTRATION • Switch from convertible to participating preferred is essentially “re-pricing” the call option of Series E holders: • Will begin sharing in equity above $11.75 million, rather than $87.75 million: • How much is this worth? • How lower share price should Hardy be willing to accept to get rid of? • He had offered $5.50 without instead of $6 with.

15. BASIC STRUCTURE • Look at what worth in current setting. • Look at what worth with higher exercise price. • Look at how much lower share price will equate.

16. ASSUMPTIONS • Ten-year option life. • 30% volatility (guess). • $11.75 and $87.75 million exercise prices. • Assume $87.75 valuation is right. • Interest rate of 6.21%. • Assume away complexity of IPO.

17. CALCULATION • Value of option with $11.75 strike price is $81.4 million. • 13.4% of this is $10.7 million. • Value of option with $87.75 strike price is $49.9 million. • 13.4% of this is $6.7 million. • The participating feature represents about $4 million in value!

18. CALCULATION (2) • Now look at how much larger share of the company (lower price) will equate: • 13.4% * $81.5MM = X * $49.9 MM. • X = 21.9%. • Hardy would have been equally well off giving Series E holders 21.9% of company without participation: • Share price of (13.4%/21.9%)*$6=$3.67!

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

20. 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?

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)

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

26. How Do VCs Evaluate Potential Investments? • How do you evaluate potential venture opportunities? • How do you evaluate the venture’s prospective business model? • What due diligence do you conduct? • What is the process through which funding decisions are made? • What financial analysis do you perform? • What role does risk play in your evaluation? • How do you think about a potential exit route?

27. Key Takeaways • While hard to codify some key patterns are consistent • Risk-Reward trade-off • Market is big factor • How much pain! • Who feels the pain! • Acceptance that mistakes will be made but with a twist • Mistake when made the investment • Mistake when DID NOT make investment • Intense desire for IPO worthy investment