Venture Capital and Private Equity

Session 4Professor 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)

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…

Capitalization TablesPage 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.

Before Financing After Intial 750,000 investment

Investor # of shares $ per share $ total%

ownership # of shares$ per share $ total

% ownership

Founders 1,625,000 $0.000 $0 100% 1,625,000 - $1,625,000 68.42%ONSET Ventures 750,000 $1.00 $750,000 31.58%Option Pool

Total For Round

Cumulative Total 1,625,000 $0.000 $0 100% 2,375,000 $1.00 $2,375,000 100%

Price Per Share$1

Pre-Money Valuation 1,625,000Cash Infusion 750,000Post-money Valuation 2,375,000

After Next Investment of $250,000

After Intial 750,000 investment After next 250,000 investment

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownership

Founders 1,625,000 - $1,625,000 68.42% 1,625,000 - $1,625,000 61.90%ONSET Ventures 750,000 $1.00 $750,000 31.58% 1,000,000 $1.00 $1,000,000 38.10%Option Pool

Total For Round 250,000 $1.00 $250,000 9.52%Cumulative Total 2,375,000 $1.00 $2,375,000 100% 2,625,000 $1.00 $2,625,000 100%

Price Per Share$1 $1

Pre-Money Valuation 1,625,000 $2,375,000Cash Infusion 750,000 250000Post-money Valuation 2,375,000 $2,625,000

After Option Pool Creation of 750,000 Shares

After next 250,000 investment After Option Pool

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownershi

p

Founders 1,625,000 - $1,625,000 61.90% 1,625,000 - $1,625,000 48.15%ONSET Ventures 1,000,000 $1.00 $1,000,000 38.10% 1,000,000 $1.00 $1,000,000 29.63%Option Pool 750,000 $1.00 $750,000 22.22%

Total For Round 250,000 $1.00 $250,000 9.52% 750,000 $0.00 $0 22.22%Cumulative Total 2,625,000 $1.00 $2,625,000 100% 3,375,000 $1.00 $3,375,000 100%

Price Per Share$1 $1

Pre-Money Valuation $2,375,000 $2,625,000Cash Infusion 250000 0Post-money Valuation $2,625,000 $3,375,000

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)After Option Pool Raise 3.5 Million Total at 2.5 Step Up

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownership

Founders 1,625,000 - $1,625,000 48.15% 1,625,000 - $4,062,500 34.03%ONSET Ventures 1,000,000 $1.00 $1,000,000 29.63% 1,400,000 $2.50 $3,500,000 29.32%Option Pool 750,000 $1.00 $750,000 22.22% 750,000 $2.50 $1,875,000 15.71%New VC 1,000,000 $2.50 2500000 20.94%

Total For Round 750,000 $0.00 $0 22.22% 1,400,000 $2.50 $3,500,000 29.32%Cumulative Total 3,375,000 $1.00 $3,375,000 100% 4,775,000 $2.50 $11,937,500 100%

Price Per Share$1 $2.50

Pre-Money Valuation $2,625,000 $3,375,000Cash Infusion 0 3,500,000Post-money Valuation $3,375,000 $11,937,500

TallyUp – What Happened

• Was able to raise 4 million in the next round at post-money value of $ 13 million (>2.5x step-up)

• Raised 4 more rounds – changed name to Callidus Software

• Did IPO in 2003 at $13.5 share• ONSET owned 17% of the company

at the time of IPO

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)

Check the Term Sheet!

Term Sheets in Venture Financing

• Critical Issues– Uncertainty– Asymmetric

Information– Nature of Firm’s assets– Conditions of relevant

financial and product markets

• 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

Got a Term Sheet

Multiple Rounds, Multiple Tranches

Trendsetter is Lucky!

• If you were advising Trendsetter which offer would recommend?– Valuation– Liquidation Preference (and Antidilution)– Vesting– Corporate Governance

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.)– Non Participating– Fully Participating

• Qualified public offering (QPO)

Will See in Details Later

What Type of Security?

• Alpha– Convertible Preferred (CP) Stock

• Mega– Participating Convertible Preferred (PCP)

Stock

TYPE OF LIQUIDATION EVENT IS CRITICAL!

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

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

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

Why do we see these features?

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

Ratchet• Registration rights

Challenges for VCs

• Private Equity Partnerships (PEP) have become the dominant organization form as it addresses challenges faced by LPs (Investors) and GPs(VC, Buyout Firm).

• Are there issues between GPs and the portfolio companies?

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

Securities used by VCs

• Common Stock

• Debt

• Preferred Stock

• Never – why not?

• Never – why not?

• Interesting- why?

VCs response #1– Security Design

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

Conversion Clause• Participating Convertible Preferred

(PCP) DO NOT W

ORRY!

WILL

DEVOTE TIM

E TO THESE

LATER!!

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