Venture Capital

Arushi Bhandari, CPA, MBA

Agenda 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 EquityCrowdfunding

What 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 Capitalists vs.

Angel Investors

Angel Investors

Venture Capitalists

Investment Own money. Money raised from

investors (LPs).

Board Seats

Typically do not take a Board seat

Typically take a Board seat

VC Fund StructureConsists of 3 entities

Management 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 Workflow

Ideas

FoundersAngel Investors (FFF)

BusinessPlan

Venture Capitalists

TermSheet

DueDiligence

Series A,Series B,Bridge …

Seed Capital

Investments

Due diligence Term Sheet

BusinessPlan

DueDiligence

Due 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 diligence

Term 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 provisions

Pre-money vs. Post-money valuation

Pre-money valuation:Company’s deemed value prior to financing Usually appears on the first page of the term

sheet

Post-money valuation: Value of the company after the financing

Relationship: Pre-money Valuation + Investment = Post-money

Valuation

Price/Share and Protective Provisions

Price/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 dividend

Excerpt of Liquidation Preference

Sample Term Sheet ( source: www.nvca.org)

Template of a Term Sheet (Source: NVCA)

Dilution & Cap TableDilution:

Decrease in an owner’s percentage interest in the company.

Example: 4 million shares outstanding AND founder holds 1 million sharesFounder’s % ownership = 25% (1m/$4m).Company issues another 1 million shares, Founder’s 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 company’s securities before and after venture capital financing.

Cap Table Sample

Example: Cap TableAt the time company is founded:• Authorized shares = 10m• Authorized 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.• VC’s ownership percentage is 33.33% ($5m/ $15m).• Founder’s 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%) and

• Number of shares in the employee pool = 3,857,143 (19,285,714* 20%)

Funding Options: Convertible Debt vs. Equity

Convertible 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 Debt

An investor A’s 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 A’s 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.

Example: Convertible EquityIssued and outstanding shares = 1,000,000

Pre-money valuation =$1,000,000 Investor’s 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 dealers web portals

3rd party intermediaries register with SEC and subject to FINRA rules

Additional disclosure requirements for companies and 3rd party intermediaries

Crowdfunding Disclosure

RequirementsFor companies:

Name of officers and directorsHow raised money will be used If money raised > $ 500,000 provide audited

financial statements

For intermediaries:Provide investors with educational materialCannot solicit or provide investment advice

Caps on CrowdfundingFor entrepreneurs:

raise up to $1M in a 12-month period

For investors:Net income < $100,000, individual invest greater

of i. 5% of net income or ii. $2,000

Net income > $100,000, individual invest greater of

i. 10% of net income orii. $100,000

THANK YOU