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Venture Capital and Private Equity Session 3

Venture Capital and Private Equity Session 3. 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 3

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  1. Venture Capital and Private Equity Session 3 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. Accel Partners VII

  4. Accel Partners – High Level Questions • How are VCs compensated? How does the compensation structure of VCs differ from CEOs or Fund managers • Why do we observe the partnership structure? • Why do GPs need to put down 1%? • Why not take down the entire capital at one go? • Why do we see the various restrictions on size and co-investment in previous deals?

  5. Accel Partners – More General Issues • How do Management Fee and Carry interact with Fund size? • $20 million fund with 2 partners(2.5% Mgmt fee) • $400 million fund with 4 partners (2.5% Mgmt fee)

  6. Accel Partners VII • Would you invest in Accel Partners VII • Would David Swensen invest ? • How they done in the past? • How are they likely to do in the future?

  7. Accel Partners Now • Did close Fund VII with 30% carry • Accel VIII – mother of all funds $1.6 BILLION proposed in 2000 scaled back to $950 million later • Accel IX 400 million • Accel X $520 million • No Idea how the funds are doing but was Series A investor in FACEBOOK.

  8. VC Method For Valuation Professor Sandeep Dahiya Georgetown University

  9. Quick Review of Valuation Methodologies • DCF • Estimate FCF (EBIAT+Dep-CapEx-ΔNWC) • Estimate WACC • Estimate Terminal Value (Perpetual growth g) • Discount FCF and TV to get Enterprise Value • Multiples Based • Choose a set of Peers/Comprables • Choose the multiple(s) e.g. EV/EBIT, P/E • Estimate Median/Average Multiple • Apply to target Please Read “Note on Valuation in Private Equity Settings”

  10. VC Method • Flavor of both DCF and Multiples but is different. • FCF is highly uncertain • WACC is almost meaningless • Multiples are hard to get by • Most firms will NOT survive • A few firms would have incredible growth

  11. 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

  12. An Example • Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. Company currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 50%? Analysis based on value TODAY ! Exit Value = $4 x 25 = $100 million POST MONEY VALUATION = 100/(1+50%)5 = 13.169 million PRE MONEY VALUATION = 13.169 – 5 = $8.169 million Since 1 million shares outstanding Price per share = $8.17 Alternatively VC must get 5/13.17 = 37.97% of the company Let us assume Y is the number of new shares that must be issued to the VC, X are the existing number of shares Y/(X+Y) = F =38% algebraic manipulation yields Y = 612,091 shares. Price per share = 5,000,000/612,091 = $8.17

  13. An Example • Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. Company currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 50%? Analysis based on value at EXIT DATE! Exit Value of Hoya.com = $4 x 25 = $100 million Exit Value of VC has to be =$5x(1+50%)5 = 37.97 million Fraction of Company Needed = 37.97/100=37.97% Implied POST MONEY Valuation=5/0.3797=13.17 million Implied PRE MONEY Valuation= 13.17-5=8.17 million Let us assume Y is the number of new shares that must be issued to the VC, X are the existing number of shares Y/(X+Y) = F =37.97%; algebraic manipulation yields Y = 612,091 shares. Price per share = 5,000,000/612,091 = $8.17

  14. An Example • Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. Comapny currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 30%? Exit Value = $4 x 25 = $100 million Value of VC’s 5 million investment at 30% = 5*(1+.30)5 = $18.6 million VC would ask for 18.6/100 = 18.6% of the firm! What fraction does VC need if $ 12 Million is needed and VC needs 50% IRR How many shares if VC needs 30% return (would ask for 18.6% of the firm). Y = X(F/1-F) = 1*(0.186/1-0.186) Y = 0.2285 million shares Value of VC at Exit =12x(1.5)^5 =91.125!!!

  15. 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%

  16. 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 Only 85 million available after the option pool VC would want 37.97/85 = 44.67% of the company today so that at exit its share is 37.97%. 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

  17. Another Approach (easier). • 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%

  18. 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 Amount available after option pool is 85 million implying 6.59/85 = 7.75% Round 1 still needs $38 million to generate 50% but only has (100-6.59-15) million to get it out of implying initial stake = 38/(100-6.59-15)=0.485 or 48.5% stake.

  19. 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

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

  21. 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…

  22. Tomorrow • How Do VCs Evaluate Investments • Term sheet for Trendsetter

  23. VC Framework • 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

  24. 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.

  25. After Next Investment of $250,000

  26. After option pool creation of 750,000 Shares

  27. 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)

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