PARTIAL VALUATION II: PARTIAL VALUATION II: PCP STOCK, PCP STOCK,

IMPLIED VALUATION IMPLIED VALUATION & COMPLEX & COMPLEX STRUCTURESSTRUCTURESProf.Stephen OngProf.Stephen Ong

BSc(Hons)Econs (LSE), MBA (Bradford)BSc(Hons)Econs (LSE), MBA (Bradford)

Visiting Professor, Shenzhen UniversityVisiting Professor, Shenzhen UniversityAcademic Fellow, Entrepreneurship & Innovation,Academic Fellow, Entrepreneurship & Innovation,

The Lord Ashcroft International Business School, The Lord Ashcroft International Business School, Anglia Ruskin University Cambridge UKAnglia Ruskin University Cambridge UK

MSC TECHNOPRENEURSHIP : MSC TECHNOPRENEURSHIP : VENTURE CAPITAL FINANCINGVENTURE CAPITAL FINANCING

Today’s Overview Today’s Overview

LEARNING OBJECTIVESLEARNING OBJECTIVES

To understand the features of To understand the features of Participating Convertible Participating Convertible Preferred stock;Preferred stock;

To understand the methods for To understand the methods for implied valuation;implied valuation;

To discuss complex structures.To discuss complex structures.

1.Participating Convertible Preferred Stock

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Example 1Example 1

Suppose that EBV offers the Suppose that EBV offers the employees of Newco a bonus pool of employees of Newco a bonus pool of $5M upon any exit where firm value $5M upon any exit where firm value exceeds $200M. Currently, the firm exceeds $200M. Currently, the firm value of Newco is $40M, and base-case value of Newco is $40M, and base-case option pricing assumptions (Series A) option pricing assumptions (Series A) apply. apply.

ProblemProblem What is the current value of this bonus What is the current value of this bonus

incentive?incentive?

Example 2Example 2

EBV considering $6M Series A EBV considering $6M Series A investment in Newcoinvestment in Newco

PCP ($6M APP) for 5M shares, with a PCP ($6M APP) for 5M shares, with a QPO threshold at $6 per share.QPO threshold at $6 per share.

Pre-money shares = 10MPre-money shares = 10M

Question: What is the breakeven Question: What is the breakeven valuation?valuation?

Example 3Example 3Talltree is considering a $12M Series B Talltree is considering a $12M Series B

investment in Newcoinvestment in Newco5M shares of PCP, with a QPO at $12 per 5M shares of PCP, with a QPO at $12 per

share.share.Employee shares = 10MEmployee shares = 10MEBV (Series A) has 5M shares of PCPC EBV (Series A) has 5M shares of PCPC

($6M APP) a $6 per share QPO, and a 4X ($6M APP) a $6 per share QPO, and a 4X cap.cap.

Questions: Questions: 1) What is the exit diagram for the Series A?1) What is the exit diagram for the Series A?2) What is the breakeven valuation?2) What is the breakeven valuation?

Example 4Example 4XYZ ventures is considering a $20M Series F in Newco for XYZ ventures is considering a $20M Series F in Newco for

10M shares of PCP with a QPO threshold of $6 per share.10M shares of PCP with a QPO threshold of $6 per share. Employees have claims on 20M shares of commonEmployees have claims on 20M shares of common Series A: 10M shares of CP ($6M APP)Series A: 10M shares of CP ($6M APP) Series B: 10M shares of CP ($10M APP)Series B: 10M shares of CP ($10M APP) Series C: 10M shares of CP ($4M APP and 3X liquidation Series C: 10M shares of CP ($4M APP and 3X liquidation

preference)preference) Series D: 10M shares of PCPC ($10M APP) with 3X cap Series D: 10M shares of PCPC ($10M APP) with 3X cap

and $5 QPOand $5 QPO Series E: 10M shares of CP ($10M APP)Series E: 10M shares of CP ($10M APP) All venture investors have $250M committed capital and All venture investors have $250M committed capital and

$50M in lifetime fees.$50M in lifetime fees.QuestionsQuestions1)1) What is the exit diagram for the Series D PCPC.What is the exit diagram for the Series D PCPC.2)2) What is the breakeven valuation?What is the breakeven valuation?

2.Implied Valuation

Implied post-valuation, Series A

Employees

Series A LP Valuation

Series A GP Valuation

When Series A LP Valuation = Series A LP Cost, then the value of the whole pie = breakeven valuation = implied valuation = IVpost

Implied pre-valuation, Series B

Employees

Series A LP Valuation

Series A GP Valuation

Series B LP Valuation

Series B GP Valuation

IVpre = IVpost – Series B GP implied valuation – Series B LP implied valuation

= IVpost – (1 / (1 – GP%) )* Series B LP cost

Walnut, revisitedWalnut, revisited

Considering a $2M Series A investment in Considering a $2M Series A investment in RBS for RP (1.8M APP) and CP (converts RBS for RP (1.8M APP) and CP (converts to 55,556 shares), with 8% accrued cash to 55,556 shares), with 8% accrued cash dividends.dividends.

Fully-diluted share count = 200KFully-diluted share count = 200KPrior “round” of investment was $400K for Prior “round” of investment was $400K for

10% of the common stock. 10% of the common stock.

ProblemProblem

What is IVWhat is IVprepre? How does it compare to ? How does it compare to

O’Connor’s (CEO) expectations?O’Connor’s (CEO) expectations?

Example

Talltree invests $10M in Series B for 8M shares of CP.

Other investors are EBV (Series A), with 6M shares of CP ($6M APP) and employees (with 10M shares of common).

ProblemsWhat is IVpost and IVpre?

What the LP implied valuation of the Series A?

Down rounds?

What is the proper way to assess a down round?Usually, the contract is explicit, and we can just

compare the conversion prices across rounds. What if the new round does not have a conversion

price? Or, what if we really want to get it “right”?

Example

Same Setup as previous example. One year later, and Owl invests $12M for RP ($2M

APP with 5X liquidation preference) and 8M shares of common.

Problems

What is IVpost and IVpre?

What the LP implied valuation of the Series B? Do you think this really represents a down round for

the Series B?

MetapathMetapath Series A: Securicor Telesciences, Jan 95: 600K RP with cash dividend Series A: Securicor Telesciences, Jan 95: 600K RP with cash dividend

(LIBOR + 1%) (LIBOR + 1%)

Series B: Bessemer Venture Partners (BVP), Jan 95: 1M RP with Series B: Bessemer Venture Partners (BVP), Jan 95: 1M RP with cash dividend (8% simple starting Jan 2000)cash dividend (8% simple starting Jan 2000)

Series C: BVP, Sept 1995, 1M CP ($1.05 OPP, 950K shares), same div Series C: BVP, Sept 1995, 1M CP ($1.05 OPP, 950K shares), same div as Series Bas Series B

Series D: BVP, USVP, Norwest, April 96: 7M CP ($1.62 OPP, 4.32M Series D: BVP, USVP, Norwest, April 96: 7M CP ($1.62 OPP, 4.32M shares), same div as Series Bshares), same div as Series B

12.66M total shares prior to Series E12.66M total shares prior to Series E

Series E: Omega, TCV, and others:Series E: Omega, TCV, and others: Structure 1: 11.75M PCP at OPP of $6 (1.96M shares) (assume QPO Structure 1: 11.75M PCP at OPP of $6 (1.96M shares) (assume QPO

at $15 per share)at $15 per share) Structure 2: 11.75M CP at OPP of $5.50 (2.14M shares)Structure 2: 11.75M CP at OPP of $5.50 (2.14M shares)

Assume total valuation = $115M + $11.75M = $126.75M as base caseAssume total valuation = $115M + $11.75M = $126.75M as base case

Series E vs. Merger?Series E vs. Merger?

Cell Tech (not real name) Cell Tech (not real name) offering $115M in stock.offering $115M in stock.

How should BVP and How should BVP and Metapath compare this offer to Metapath compare this offer to the Series E? the Series E?

3.Complex Structures

Management Carve-OutManagement Carve-Out Newco has received four rounds of investments (Series A, Newco has received four rounds of investments (Series A,

B, C, and D) for a total of 40M shares of CP plus 10M B, C, and D) for a total of 40M shares of CP plus 10M shares of common claimed by the employees. shares of common claimed by the employees.

$12M Series E investment with Vulture Ventures (VV) for $12M Series E investment with Vulture Ventures (VV) for 50M shares of CP and a 3X liquidation preference. 50M shares of CP and a 3X liquidation preference.

As part of this agreement, all previous investors (Series A As part of this agreement, all previous investors (Series A through Series D) give up all their preferred rights and through Series D) give up all their preferred rights and are converted to common stock, so the capital structure of are converted to common stock, so the capital structure of Newco is now 50M shares of common plus the Series E Newco is now 50M shares of common plus the Series E CP. CP.

As part of the investment, Vulture creates a carve-out: As part of the investment, Vulture creates a carve-out: management will receive 10 percent of all exit proceeds, management will receive 10 percent of all exit proceeds, with a value of this carve-out capped at $5M. Vulture with a value of this carve-out capped at $5M. Vulture Ventures has $250M of committed capital, $50M of Ventures has $250M of committed capital, $50M of lifetime fees, and 20 percent carried interest.lifetime fees, and 20 percent carried interest.

What is the implied valuation of the management carve-out?What is the implied valuation of the management carve-out?

Management Carve-Out (2)

Same setup as in the previous example, but this Same setup as in the previous example, but this time with a different structure for the time with a different structure for the management carve-out. Now, following the $12M management carve-out. Now, following the $12M Series E investment from Vulture Ventures (50M Series E investment from Vulture Ventures (50M shares of CP with a 3X liquidation preference), shares of CP with a 3X liquidation preference), management is promised the following incentives: management is promised the following incentives: If Newco has an exit of at least $50M, then If Newco has an exit of at least $50M, then Vulture will transfer $5M to the employees. If Vulture will transfer $5M to the employees. If Newco has an exit of at least $80M, then Vulture Newco has an exit of at least $80M, then Vulture will transfer an additional $5M to the employees. will transfer an additional $5M to the employees. The earlier investors have 40M shares of The earlier investors have 40M shares of common, and the employees have claims on a common, and the employees have claims on a further 10M shares.further 10M shares.

What is the implied valuation of the management What is the implied valuation of the management carve-out?carve-out?

Dealing with PartnersDealing with Partners EBV makes a $10M Series A investment in Newco for EBV makes a $10M Series A investment in Newco for

10M shares of CP. 10M shares of CP. The employees of Newco have claims on 10M shares of The employees of Newco have claims on 10M shares of

common stock. common stock. At the same time as this transaction, Newco enters into a At the same time as this transaction, Newco enters into a

transaction with Techco to obtain licenses for some transaction with Techco to obtain licenses for some Techco patents. As consideration for providing these Techco patents. As consideration for providing these licenses, Techco receives an option to purchase 10M licenses, Techco receives an option to purchase 10M shares of common stock for $1.50 a share, but this option shares of common stock for $1.50 a share, but this option can only be exercised upon an exit above $150M. (Assume can only be exercised upon an exit above $150M. (Assume that this $150M would be adjusted for any future dilution, that this $150M would be adjusted for any future dilution, so that the threshold is effective for the proceeds owed to so that the threshold is effective for the proceeds owed to the current shareholders.) EBV is aware of the deal with the current shareholders.) EBV is aware of the deal with Techco at the time that they make their Series A Techco at the time that they make their Series A investment.investment.

What is the implied valuation of Techco’s options?What is the implied valuation of Techco’s options?

Putting it all togetherPutting it all togetherNewco at the time of the Series F:Newco at the time of the Series F: Employees have claims on 20M shares of commonEmployees have claims on 20M shares of common Series A: 10M shares of CP ($6M APP)Series A: 10M shares of CP ($6M APP) Series B: 10M shares of CP ($10M APP)Series B: 10M shares of CP ($10M APP) Series C: 10M shares of CP ($4M APP and 3X liquidation Series C: 10M shares of CP ($4M APP and 3X liquidation

preference)preference) Series D: 10M shares of PCPC ($10M APP) with 3X cap and $5 QPOSeries D: 10M shares of PCPC ($10M APP) with 3X cap and $5 QPO Series E: 10M shares of CP ($10M APP)Series E: 10M shares of CP ($10M APP) Series F: 10M shares of PCP ($20M APP) with QPO at $6 per share.Series F: 10M shares of PCP ($20M APP) with QPO at $6 per share. Management carve-out for 20% of the first $50M in proceeds. (at Management carve-out for 20% of the first $50M in proceeds. (at

time of Series F)time of Series F) Acquisition of Subco for 20M shares plus upside bonus of 10M shares Acquisition of Subco for 20M shares plus upside bonus of 10M shares

of common for exits above $1B. (at time of Series F)of common for exits above $1B. (at time of Series F) All venture investors have $250M committed capital and $50M in All venture investors have $250M committed capital and $50M in

lifetime fees.lifetime fees.

QuestionsQuestions1)1) What is the implied valuation for the management carve-out?What is the implied valuation for the management carve-out?2)2) What is the implied valuation for the Subco stake?What is the implied valuation for the Subco stake?

Further ReadingFurther Reading

Metrick, Andrew and Yasuda, Ayako (2011) Venture Capital & the Finance of Innovation. 2nd Edition. John Wiley & Sons.

Lerner,Losh, Hardymon, Felda and Leamon, Ann (2012). Venture Capital and Private Equity : A Casebook. 5th Edition. John Wiley & Sons.

Dorf, R.C. and Byers, T.H. (2008) Technology Ventures – From Idea to Enterprise 2nd Edition, McGraw Hill

QUESTIONS?