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- Venture Capital- Angel Investors vs Venture Capital- Venture Capital Firm Structure- Cap Table- Dilution- Convertible Debt vs. Convertible Equity- Crowdfunding

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Venture Capital

Venture Capital Arushi Bhandari, CPA, MBA 1Agenda What is Venture Capital?Venture Capital vs. Angel InvestorsVC StructureDue DiligenceTerm Sheet and its offering termsPre-money vs. Post-money valuationImpact of dilution on a Cap TableFunding Options Convertible Debt and EquityCrowdfunding2What is Venture Capital?Financial capital provided to startups.Raised mostly from investors, Limited Partners, which are entities like banks, large corporations, institutional investors and high net-worth individuals.Typical investment made after seed funding.VCs invest in return for preferred stock.

Venture Capital is financial capital provided to early-stage startups. companies.A Venture Capital investment usually occurs after seedcapital funding. In this, the venture capital fund invests in the startup and in turn owns equity orpreferred stock in return for their investment. These investors are a variety of entities like banks, large corporations, institutional investors and high net-worth individuals3Venture Capitalists vs. Angel Investors Angel Investors

Venture CapitalistsInvestment Own money.Money raised from investors (LPs).Board SeatsTypically do not take a Board seatTypically take a Board seatInstead of investing their own money, which the angel investors typically do, VCs raise moneyfrom their investors who become limited partners in the VC firm. 4VC Fund StructureConsists of 3 entitiesManagement CompanyVenture Capital FundGeneral Partnership

Details:Management Company, incorporated as LLC or LP, is the franchise of the VC firm and employs the staff and pays day-to-day expenses.Venture Capital Fund, incorporated as LP, is the entity which basically consists of a big pool of capital made by the individual investors and then invests this money in different privately-held companies.General Partnership is the legal entity which serves as General Partner to Venture Capital Fund providing investment advice and in return receives carried interest.

Typical Investment WorkflowIdeas

Founders

Angel Investors (FFF)BusinessPlan

Venture CapitalistsTermSheetDueDiligenceSeries A,Series B,Bridge

Seed CapitalInvestmentsDue diligenceTerm SheetBusinessPlanDueDiligence7Due DiligenceProcess by which VC or an investor determines whether s/he should invest in a startup ensures worthiness of the deal.Due Diligence process enlists documents which need to be completed Due Diligence Checklist.Details depend on how long the company has been in business and also involves:Legal and Financial diligenceTechnology diligenceReference checksCorporate diligenceIf the VC has a keen interest in the entrepreneurs company and wants to make an investment, (s)he will begin the process of due diligence. Due diligence is a rigorous process which determines whether the investor/VC will invest in the startup. It basically means that the VC will research the startup to ensure worthiness of the deal. A typical due diligence process enlists a list of documents, which need to be completed Due Diligence Checklist. The details of documentation usually depend upon how long the company has been in business. There are VC firms who sign the term sheet after the due diligence process is complete, while others may perform due diligence after signing the term sheet but before closing the deal.8Term SheetDocument which outlines terms of investment, both legal and financial, in a startup.Key offering terms in a term sheet:valuation (pre-money or post-money)price/shareprotective provisionsliquidation preferencesanti-dilution provisionsTerm sheet is a document, which outlines the terms of investment, both legal and financial,in a startup by an investor. Some of the key offering terms in a term sheet are pre-money valuation, price/share, liquidation preferences, anti-dilution provisions and protective provisions. Protective provisions are veto rights that investors have on certain actions by the company.An example of protective provisions is unless investor agrees the following cannot be done:1. Change terms of stock owned by investor2. Issue other kind of stock3. Pay or declare dividend9Pre-money vs. Post-money valuationPre-money valuation:Companys deemed value prior to financing Usually appears on the first page of the term sheetPost-money valuation: Value of the company after the financingRelationship:Pre-money Valuation + Investment = Post-money ValuationPrice/Share and Protective ProvisionsPrice/Share Pre-Money valuation / Pre-Financing Fully Diluted CapitalExample: Common stock held by founders = 1,400,000, Option pool = 600,000 (10% of outstanding shares)Pre-money valuation = $2mPrice/Share =$1/share ($2m/2m)Protective Provisions : Veto rights that investors have on certain actions by the company.Example: Unless investor agrees the following cannot be done:1. Change terms of stock owned by investor2. Issue other kind of stock3. Pay or declare dividendExcerpt of Liquidation Preference Sample Term Sheet ( source: www.nvca.org)Template of a Term Sheet (Source: NVCA)

A template of a term sheet can be found at NVCA(National Venture Capital Association). There are other templates too on the NVCA website stock purchase agreement, certificate of incorporation and others. You can check it out at www.nvca.org.12Dilution & Cap TableDilution: Decrease in an owners percentage interest in the company.Example: 4 million shares outstanding AND founder holds 1 million sharesFounders % ownership = 25% (1m/$4m).Company issues another 1 million shares, Founders new ownership percentage to 20% ($1m/$5m)Ownership diluted on the issuance of new shares.Cap Table: Summarizes major shareholders and their pro-rata ownership of the companys securities before and after venture capital financing.

Cap Table SampleExample: Cap TableAt the time company is founded:Authorized shares = 10mAuthorized issued shares to founders at $0.01/share are 9m shares for a purchase price of $90,000 (9m*$0.01)Authorized unissued shares (option pool) = 10m - 9m = 1m At the time of Series A, Pre-money valuation = $10m, Investment by Venture Capital firm = $5m, Term sheet requirement to create a new option pool 20% of the total shares outstanding.Example contd..Calculations:Post-money valuation = $10m+$5m =$15m.VCs ownership percentage is 33.33% ($5m/ $15m).Founders new ownership percentage is 46.67% (100% - 33.33% - 20%) and it is represented by 9m shares previously owned.Total outstanding shares =19,285,714 shares (since Total outstanding shares *46.67% = 9,000,000)Preferred shares owned by VC = 6,428,571(19,285,714 * 33.33%) andNumber of shares in the employee pool = 3,857,143 (19,285,714* 20%)Funding Options: Convertible Debt vs. EquityConvertible Debt:(Principal/investment + interest) either paid off or automatically converted to equity at maturity or upon the closing of a round of financing. Must have interest rates at the Applicable Federal Rates (AFR) published by the IRS monthly at AFR Rates.Bridge notes/loans are an example of convertible debt.Convertible Equity:Investment at the expiration/maturity of the agreement is converted to common stock generally at the set valuation cap.

Example: Convertible DebtAn investor As investment = $300,000 convertible note with terms:10% discount and automatic conversion after a financing of $1,000,000. Financing of $1.5m and price/share= $1 for the current round of funding. Other investors get share(s) for $1Investor As purchase price = $.90 ($1 *90%) i.e. at a10% discount. Shares received by investor A for $300,000 investment = $300,000/$0.90 = 333,333 shares.(Note: The discount is appropriate as it is a reward for early investors to invest in a startup, which has no or little funding). Let us assume there was a financing of $1.5m and the share price is $1 for the current round of funding. While others get share(s) for $1, the investor gets it for $.90 ($1 *90%) since there is a 10% discount. Shares received by angel investor for $300,000 investment = $300,000/$0.90 = 333,333 shares.

18 Example: Convertible EquityIssued and outstanding shares = 1,000,000 Pre-money valuation =$1,000,000 Investors investment = $250,000Price/Share = $1 ($1m pre-money valuation /1m outstanding shares) Investor receives 250,000 shares at expiration of convertible equity agreement.Percentage ownership of investor = $250,000/$1,250,000 = 20%Post-money valuation = $ 1,250,000 (Pre-money valuation + Investment)CrowdfundingRaising money from general public (also known as unaccredited investors) Sale of equity/security through 3rd party intermediaries:registered brokers and dealersweb portals3rd party intermediaries register with SEC and subject to FINRA rulesAdditional disclosure requirements for companies and 3rd party intermediaries

Crowdfunding Disclosure RequirementsFor companies:Name of officers and directorsHow raised money will be usedIf money raised > $ 500,000 provide audited financial statements

For intermediaries:Provide investors with educational materialCannot solicit or provide investment adviceCaps on CrowdfundingFor entrepreneurs:raise up to $1M in a 12-month period

For investors:Net income < $100,000, individual invest greater of 5% of net income or $2,000Net income > $100,000, individual invest greater of 10% of net income or$100,000

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