Venture Capital and Private Equity

Session 5Professor 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

• Time permitting – Corporate Venture Capital (CVC)

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– Preferred Stock – Use of Stock options/grants

with strict vesting requirements

– Contingent control mechanisms – Covenants and restrictions

– Strategic composition of Board of Directors

READ THE TERM SHEETS!!

Got a Term Sheet

Multiple Rounds, Multiple Tranches

How do VCs address these problems

• Security Design

• Vesting Provisions

• Covenants

VCs response #1– Security Design

• Redeemable Preferred (RP)• Convertible Preferred (CP) - Forced

Conversion Clause• Participating Convertible Preferred

(PCP)

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

VCs response #3 Covenants

• Covenants– Positive Covenants

• Example Provide regular information

– Negative Covenants• Example Sale of assets

– Others• Mandatory redemption• Board Seats

Other Term Sheet Features

• Vesting • Covenants

• Liquidity Preferences• Anti-Dilution Protection• Board Seats• Please read the Note on Private

Equity Securities

Liquidation – Quick Review

• Deemed liquidation event

• Liquidation preference (2X, 3X, etc.)– Non Participating– Fully Participating

• Qualified public offering (QPO)

FACEBOOK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)  Conversion  Each share of Series A, Series B, Series C, Series D, and Series E preferred stock is convertible, at the option of the holder thereof, at any time after the date of issuance of such share, into such number of fully paid and non-assessable shares of Class B common stock as is determined by dividing the applicable original issue price by the conversion price applicable to such share in effect on the date of conversion.  The conversion price of each series of preferred stock may be subject to adjustment from time to time under certain circumstances. The convertible preferred stock issued to date was sold at prices ranging from $0.004605 to $7.412454 per share, which, in all cases, exceeded the then most recent reassessed fair value of our Class B common stock. Accordingly, there was no intrinsic value associated with the issuance of the convertible preferred stock through December 31, 2011, and there were no other separate instruments issued with the convertible preferred stock, such as warrants. Therefore, we have concluded that there was no beneficial conversion option associated with the convertible preferred stock issuances.  Each share of Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall automatically be converted into fully paid, non-assessable shares of Class B common stock immediately upon the earlier of: (i) the sale by us of our Class A common stock or Class B common stock in a firm commitment underwritten public offering pursuant to a registration statement under the Securities Act of 1933, as amended (Securities Act), the public offering price of which results in aggregate cash proceeds to us of not less than $100 million (net of underwriting discounts and commissions), or (ii) the date specified by written consent or agreement of the holders of a majority of the then-outstanding shares of preferred stock, voting together as a single class on an as-converted basis, provided, however, that if (a) the holders of a majority of the then-outstanding shares of Series D convertible preferred stock do not consent or agree or (b) the holders of a majority of the then-outstanding shares of Series E convertible preferred stock do not consent or agree, then in either such case the conversion shall not be effective as to any shares of preferred stock until 180 days after the date of the written consent of the majority of the then-outstanding shares of preferred stock.  Liquidation Preferences  In the event we liquidate, dissolve, or wind up our business, either voluntarily or involuntarily, the holders of our Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall be entitled to receive, prior and in preference to any distribution of any of our assets to the holders of Class A common stock or Class B common stock, an amount per share equal to $0.004605, $0.0570025, $0.2871668, $7.412454, and $4.54158 per share (as adjusted for stock splits, stock dividends, reclassifications, and the like), respectively, plus any declared but unpaid dividends.  If, upon the occurrence of any of these events, the assets and funds distributed among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then our entire assets and funds legally available for distribution shall be distributed ratably among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock in proportion to the preferential amount each such holder is otherwise entitled to receive.  If there are any remaining assets upon the completion of the liquidating distribution to the Series A, Series B, Series C, Series D, and Series E convertible preferred stockholders, the holders of our Class A common stock and Class B common stock will receive all our remaining assets. The merger or consolidation of us into another entity in which our stockholders own less than 50% of the voting stock of the surviving company, or the sale, transfer, or lease of substantially all our assets, shall be deemed a liquidation, dissolution, or winding up of us. As the “redemption” events are within our control for all periods presented, all shares of preferred stock have been presented as part of permanent equity.  

Facebook Cap Table

Biggest VC Success Story

  Number of Shares Price paid Amount Invested

Series A 133,055 $ 0.00460500                   612.72 

Series B 224,273 $ 0.05700250              12,784.12 

Series C 91,410 $ 0.28716680              26,249.92 

Series D 50,590 $ 7.41245400            374,996.05 

Series E44,038 $ 4.54158000            200,002.10 

Angel Round?

ACCEL?

Peter Thiel 500,000 turned into 2.5% of 100 Billion = 2.5 Billion YES BILLION!!!

Anti-Dilution Protections

• Down round

• Full-ratchet vs. weighted average

• Adjusted conversion price, adjusted conversion rate

Read the Note on Anti-dilution provisions: Typology

and Numerical Example

Read the Note on Anti-dilution provisions: Typology

and Numerical Example

Dilution• A owns 100% of the company which is 1 million shares for

which she had paid $2 per share• Company issues another 1MM shares and raises 2 MM from B

– A is now 50% owner -- she has been diluted! – But A did NOT suffer any ECONOMIC DILUTION – Company

now is worth $ 4 million and A’s stake is still $2 million!• Similarly, If company reserves 1 MM shares for option pool

again the company receives future services from the employees for that option pool again there is no ECONOMIC DILUTION.

• What is investor B pays $1 per share for its $2 million investment?

– Now there are 3 Million share post financing and A only owns 33.3%– A’s investment declines from $2MM to $1MM– ECONOMIC DILUTION!!!

Antidilution

• Company XYZ raised $12 Million from Early Ventures (EV) in Round A financing. EV received 6 million shares (at a $2.00 per share price). The Founders had 4 million shares after Round A. Subsequently the firm falls on hard times and has to raise another $ 10 million. It appears that investors are unlikely to offer more than $1.00 per share valuation. How would the Cap Tables look if

(a) EV had NO antidilution protection(b) EV had Full Ratchet Protection

(c) EV had Broad Weighted Average antidilution Protection

Regular RoundBefore Financing Series A

Investor # of shares $ per share $ total%

ownership # of shares $ per share $ total%

ownership

Founders 4,000,000 $0.000 $0 100% 4,000,000 $2.00 $8,000,000 40.00%

Early Venture 6,000,000 $2.00 $12,000,000 60.00%

Late Venture

Total For Round 6,000,000 12,000,000

Cumulative Total 4,000,000 $0.000 $0 100% 10,000,000 $2.00 $20,000,000 100%

Price Per Share

$2.00

Pre-Money Valuation 8,000,000

Cash Infusion 12,000,000

Post-money Valuation 20,000,000

What happens when the new round for $ 10 Million is raised at $1.00 Per share?

No Antidilution ProtectionSeries A Series B (No AntiDilution)

Investor # of shares $ per share $ total%

ownership # of shares $ per share $ total%

ownership

Founders 4,000,000 $2.00 $8,000,000 40.00% 4,000,000 $1.00 $4,000,000 20.00%Key Ventures 6,000,000 $2.00 $12,000,000 60.00% 6,000,000 $1.00 $6,000,000 30.00%Series B VC 10,000,000 $1.00 $10,000,000 50.00%

Total For Round 6,000,000 12,000,000 10,000,000 10,000,000

Cumulative Total 10,000,000 $2.00 $20,000,000 100% 20,000,000 $1.00 $20,000,000 100%

Price Per Share$2.00 $1.00

Pre-Money Valuation 8,000,000 10,000,000Cash Infusion 12,000,000 10,000,000Post-money Valuation 20,000,000 20,000,000

Full Ratchet Protection

• Early Round VC simply demands that the NEW down round price be used for the Money he had invested in the earlier round!

• First round $12 Million was invested – New price is $1 – Early VC would say his total number of shares must be 12 million, since he already has 6 million shares he would have to be given extra 6 million shares!

• Notice what happens to the shareholding of Late round investor IF there is anti-dilution protection!

Series A Series B (Full Ratchet)

Investor # of shares $ per share $ total%

ownership # of shares $ per share $ total%

ownership

Founders 4,000,000 $2.00 $8,000,000 40.00% 4,000,000 $1.00 $4,000,000 15.38%

Key Ventures 6,000,000 $2.00 $12,000,000 60.00% 12,000,000 $1.00 $12,000,000 46.15%

Series B VC 10,000,000 $1.00 $10,000,000 38.46%

Total For Round 6,000,000 12,000,000 10,000,000 10,000,000

Cumulative Total 10,000,000 $2.00 $20,000,000 100% 26,000,000 $1.00 $26,000,000 100%

Price Per Share

$2.00 $1.00

Pre-Money Valuation 8,000,000 16,000,000

Cash Infusion 12,000,000 10,000,000

Post-money Valuation 20,000,000 26,000,000

Broad-base weighted average anti-dilution

NCP = OCP * (OB+NM/OCP) / (OB+SI)NCP= New Conversion PriceOCP= Old Conversion Price in effect immediately

prior to new issueOB = Number of shares of shares outstanding

immediately prior to this roundNM = New Money received by the Corporation SI = Number of shares of stock issued in this

round

(Pre-Money Value+Money in new round)

(Total # of Shares after financing)NCP

Another way of writing it

Weighted Average Anti-Dilution

NCP = OCP * (OB+(NM/OCP)) / (OB+SI)NCP= $2 * (10MM+($10MM/$2)) / (10MM+10MM)=30MM/20MM=$1.5New Number of Shares due to Series A= $12MM/1.5=8MM (implying an extra

2MM shares that would be issued because of antidilution protection)

Series A Series B (Wtd Avg Ratchet)

Investor # of shares $ per share $ total%

ownership # of shares $ per share $ total % ownership

Founders 4,000,000 $2.00 $8,000,000 40.00% 4,000,000 $1.00 $4,000,000 18.18%

Early Venture 6,000,000 $2.00 $12,000,000 60.00% 8,000,000 $1.00 $8,000,000 36.36%

Late Venture 10,000,000 $1.00 $10,000,000 45.45%

Total For Round 6,000,000 12,000,000 10,000,000 10,000,000

Cumulative Total 10,000,000 $2.00 $20,000,000 100% 22,000,000 $1.00 $22,000,000 100%

Price Per Share New conversion Price for EV 1.50

$2.00 $1.00

Pre-Money Valuation 8,000,000 12,000,000

Cash Infusion 12,000,000 10,000,000

Post-money Valuation 20,000,000 22,000,000

Broad-base weighted average anti-dilution

NCP = OCP * (OB+NM/OCP) / (OB+SI)NCP= New Conversion PriceOCP= Old Conversion Price in effect immediately

prior to new issueOB = Number of shares of shares outstanding

immediately prior to this roundNM = New Money received by the Corporation SI = Number of shares of stock issued in this

round

(Pre-Money Value+Money in new round)

(Total # of Shares after financing)NCP

Another way of writing it

Term Sheets…Let us look at Trendsetter

Term Sheet

• Getting first Term Sheet is MAJOR break through!– Validates entrepreneur/idea– Establishes a price– Can be shopped around (especially in

later rounds)

Trendsetter

• If you were advising Wendy and Jason and you could not change any of the terms, which term sheet would you recommend?

Some Questions• How much money are VCs putting in?• What is the implied pre-money and post-

money valuation?• When will the “Option Pool” be created?• Focus on Mega: So how much are Wendy

and Jason worth?• How is “Liquidation Preference” differ

across two term sheets?

How much money – what fraction of the company?

• Let us look at Mega first – Pre-Money

• Founders own Shares• Option Pool Shares

– Post-Money• Mega owns Shares• Total # of Shares

– What if the options were never mentioned and Mega had said we give you 7 million Pre-money and 12 million post?

4,500,000

2,500,00064.28%35.72%

5,000,000 12,000,000

Founders 37.50%Option Pool 20.83%VC 41.67%

How much money – what fraction of the company?

• Now let us look at Alpha – Assuming no release from the escrow account– Pre-Money

• Founders own Shares• Option Pool Shares

– Post-Money• Alpha owns Shares

• Total # of Shares• Founder Ownership

$7,350,000

3,000,000

Ownership 40.49%

$ 12,350,000 4,761,905

Implying $1.05 Per share

4,000,000

Total shares 11,761,905

34.01%

Valuation (Cap Tables)Alpha Mega

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownership

Founders 4,000,000 $1.05 $4,200,000 34.01% 4,500,000 $1.00 $4,500,000 37.50%VC 4,761,905 $1.05 $5,000,000 40.49% 5,000,000 $1.00 $5,000,000 41.67%Option Pool 3,000,000 $1.05 $3,150,000 25.51% 2,500,000 $1.00 $2,500,000 20.83%

Total For Round 4,761,905 5,000,000 5,000,000 5,000,000Cumulative Total 11,761,905 $1.05 $12,350,000 100% 12,000,000 $1.00 $12,000,000 100%

Price Per Share$1.05 $1.00

Pre-Money Valuation 7,350,000 7,000,000Cash Infusion 5,000,000 5,000,000Post-money Valuation 12,350,000 12,000,000

Liquidation

• Deemed liquidation event

• Liquidation preference (2X, 3X, etc.)– Alpha– Mega

• Qualified public offering (QPO)

What Type of Security?

• Alpha– Convertible Preferred (CP) Stock

• Mega– Participating Convertible Preferred (PCP)

Stock

Who gets how much: Liquidation Waterfall Charts• If Alpha 40.49% ; If Mega 41.67%• Liquidation values

– 5 million– 7.5 million– 20 million– 30 million– 40 million

Alpha 5 Mega 5

Alpha 5 +40.49% of (7.5-5) = 6.01; Mega 7.5

Alpha 11.07; Mega 7.5 +(20-7.5)x41.67%=12.71

Alpha 15.12; Mega 16.88

Alpha 15 ; Mega 21.04

Alpha will convert 40.49% of 40= 16.20!

What about IPO?

• Remember in both cases the total number of shares outstanding after financing were ~12 million

• How valuable must the company become to meet the QPO

• How much does Mega get for $500 million sale of the company versus an IPO that values the company for $500 million?

Exit Values

VC Owner/Employees VCOwner/Employees VC

Owner/Employees VC

Owner/Employees

5.00 5.00 0.00 5.00 0.007.50 6.01 1.49 7.50 0.00

10.00 7.02 2.98 8.54 1.4615.00 9.05 5.95 10.63 4.3720.00 11.07 8.93 12.71 7.2925.00 13.10 11.90 14.79 10.2129.69 15.00 14.69 16.75 12.9430.00 15.00 15.00 16.88 13.1235.00 15.00 20.00 18.96 16.0437.04 15.00 22.04 19.81 17.2340.00 16.20 23.80 21.04 18.9645.00 18.22 26.78 23.13 21.8750.00 20.25 29.76 25.21 24.7955.00 22.27 32.73 27.29 27.7160.00 24.29 35.71 24.29 35.71 29.38 30.62

100.00 40.49 59.51 40.49 59.51 46.04 53.96200.00 80.98 119.02 80.98 119.02 87.71 112.29240.00 97.18 142.82 97.18 142.82 104.38 135.62 100.01 139.99500.00 202.45 297.55 202.45 297.55 212.72 287.28 208.35 291.65

Enterprise Value ($ Million)

Term Sheet MegaLiquidation IPO

Term Sheet AlphaLiquidation IPO

$ 15 million maximum

Alpha Ownership -40.49% Mega Ownership -41.67%

Broader discussion of terms

• What terms did you like in one but not in other term sheet? Why?

• What terms did you dislike in both terms sheets? Why?

• Key Issues– Valuation

• Pre and Post– Option Pool– Type of security– Dividend– Liquidation– QPO– Antidilution– Voting Rights– Founder’s vesting– VC Syndicate

Alpha•Hurdle

• Tricky– 3MM– CP– NoCum– 3x– Low– Wt Avg– 60%– Same??– Two VCs

Mega•$7 MM

• Plain– 2.5MM– PCP– Cum– 1.5x– High– Full?– ???– Same– One VC

Trendsetter

• If you were advising Wendy and Jason and you could ask for change in any of the terms, which terms would you try to renegotiate?

• Key Issues– Valuation

• Pre and Post– Option Pool– Type of security– Dividend– Liquidation– QPO– Antidilution– Voting Rights– Founder’s vesting– VC Syndicate

Alpha•Hurdle

• Tricky– 3MM– CP– NoCum– 3x– Low– Wt Avg– 60%– Same??– Two VCs

Mega•$7 MM

• Plain– 2.5MM– PCP– Cum– 1.5x– High– Full?– ???– Same– One VC

Remember – Term sheet is “proposal” nothing is cast in stone yet. You need to know what to

negotiate and why?

A framework for analyzing termsheets

• Economics– Original Purchase Price

(OPP) aka “proposed ownership percentage)” on a “fully diluted basis”

– Liquidation Preference (1x, 2x etc.

– Participation (Note: on top of liquidation preference)

– Conversion (QPO)– Antidilution– Dividends

• Control– Board of Directors– Voting Rights/Protective

Provisions– Conversion (QPO)– Founders stock/vesting– Transfer Restrictions– Registration Rights???

Term sheet Check list

• Green Flags– Simple Terms– VC willing to

take the downside risk (1x liquidation preference; no antidilution)

– Plain convertible Preferred

• Yellow Flags– Milestone

heavy– Complex

terms– Terms left

vague– Future option

pool to come out of founders’ share

• Red Flags– Extremely

milestone heavy

– Length exclusivity

– Complex due diligence requirements

– Clauses that shift control from founders to VCs

Why do we see these features?

• Convertible preferred• Participating Convertible Preferred• Full Ratchet/ Weighted Average

Ratchet• Vesting provisions

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

Recap

• Hopefully you are better placed to appreciate the importance of terms.

• As an entrepreneur try to avoid “fancy” term sheets with lots of “gingerbread”

• Try not to raise money WHEN you need it – try to do it with 6 months of cash burn cushion