VC Notes - 2012

Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle

Introduction to Venture CapitalThe Venture Capital Cycle & Industry Statistics

Professor David Wessels ©2012

The Wharton School of the University of Pennsylvania

3620 Locust Walk, Philadelphia PA 19104

1

1


Institutional Investor

(LP)

Venture Fund/Firm

Portfolio Company

Public Markets

The Venture Capital Cycle

Professor David WesselsThe Wharton School of the University of Pennsylvania

Capital Call

Institutional investors are accredited if they have more than $5 million of assets. These generally include government or company pensions, charitable organizations or financial institutions. Accredited individuals must have individual income over $200,000 or net worth over $1 million. (Rule 501, Regulation D, 1933 Securities Act)

Secondary transactions are limited to Qualified Institutional Buyers (QIBs), whose assets under management (AUM) must exceed $100 million. No individuals.(Rule 144A, 1933 Securities Act)

Public capital markets. While the IPOmay be the most glamorous type of exit for the venture capitalist, most successful exits of venture investments occur through a merger or acquisition of the company by either the original founders or another company.

Portfolio companies are typically young, privately held companies in high growth industries, such as technology or health care. Revenues are expected to reach $25 million within five years.

Venture Capital firms typically comprise of 3-20 partners (and an equal number of associates) who screen potential investment opportunities in high-growth industries. Venture capitalists are typically active investors.

Direct InvestmentExit

Distribution

Other: PIPEs and Buyouts

Exceptions:Evergreen FundsRecycle Provisions

2


The Investor’s Choice• The typical limited partner (LP) is looking to diversify across investment

opportunities. Diversification mitigates portfolio volatility. Many argue that access to alternatives provides exposure to “alpha.”


‐ Pension Funds ‐ Endowements

Source: Wessels, 2010

Private Equity

Seed

Early Stage

Veture Capital

Late Stage

Super Angels

Private EquityAlternatives

Leveraged Buyouts

Real Estate

Distress

Commodities

Treasuries

Institutional InvestorsCorporate Bonds

Growth Equity

Hedge FundsPublic Equities

Mezzanine

Qualified Investors

Venture Capital

Investors Asset Classes "Alternatives"

1. How are venture capital partnerships structured?

2. Does venture capital (in aggregate) outperform other asset classes on a risk reward basis?

3. Do particular VCs outperform their peers – and is this performance persistent?

4. How does a “portfolio perspective” alter a VC’s perspective on risk and investment?

Core Issues

3


Venture Capital versus Growth EquitySuper Angels.

• Super angels, who typically are successful technology entrepreneurs or former tech executives, have begun adding to their own investments by raising funds from outside investors. Unlike traditional angels, they also take a hands-on role in helping their start-ups. Like most angels, however, they still deal in relatively small sums of money, often investing $25,000 to $250,000 in a start-up. WSJ, 2010.

• Besides First Round, these "super angels," as they're called in the industry, include Baseline Ventures, Maples Investments, and Felicis Ventures. They're pushing ahead and financing startups even as big-name venture firms cut back and conserve capital until the economy improves. First Round Capital has quietly become the country's most active seed-stage investor, outpacing such marquee names as Sequoia Capital and Kleiner Perkins Caufield & Byers. BusinessWeek 2009.

Growth Equity.

• Growth equity investors focus on rapidly growing companies with proven business models. Unlike venture capital firms, they generally avoid investing in early-stage companies with unproven ideas. Growth equity investors also differ from buyout specialists in that they seek to earn returns from growing the business, rather than through financial engineering, restructuring or cutting costs. Summit Partners, 2010.

• Unlike late-stage VC, growth equity investments are traditionally done in companies that haven’t taken prior institutional investment and don’t require future institutional investment. Volition Capital, 2010.


Private Equity Veture Capital

Super AngelsSeed

Venture CapitalEarly Stage

Growth EquityLate Stage

4


Venture Capital under Management• Venture Capital steadily grew during the 1980s and 1990s, exploding in the late 1990s.

Opinion differs among long term observers as to whether the industry has reached an optimal size or is still too large for the amount of investment and exit opportunities.


Source: National Venture Capital Association, U.S. Federal Flow of Funds

0

75

150

225

300

375

1980

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$ billion

s

Total Capital Under Management

0%

1%

2%

3%

4%

1980

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2006

2008

2010

Venture Capital as a % of Non‐Financial U.S. Equities

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Venture Capital: Capital Commitments• Venture capital fundraising peaked during the internet boom (of 2000) at $105 billion.

The number dramatically fell, only to rise steadily again between 2002 and 2006. In 2011, roughly $18 billion was committed to new venture funds.


0

10,000

20,000

30,000

40,000

50,000

60,000

1980

1982

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2002

2004

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2008

2010

Venture Capital Commitments1980 ‐ 2011

0%

25%

50%

75%

100%

1980

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2000

2002

2004

2006

2008

2010

Venture Capital as % of Private EquityDollars Committed

Buyouts

Venture Capital

6


Venture Capital: Typical Fund Size• Venture capital funds are smaller than buyout funds, averaging $80 million in 2010

(versus $280 million for buyouts). Still, some “VC funds” are quite large. Insight Venture Partners (IV) raised $1.25 billion in 2007.


How much capital managed by partner?

7


Funds Under Management per Partner

• During the 1990’s, the average funds under management per partner grew from $5 to $10 million.

• Today, the average funds under management is approximately $25 million. At a 2% fee level, how much does each partner generate in management fees?


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30

1980

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$ millions

Average Funds Under Managementper Partner ($ million), 1980 ‐ 2011

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Sources of LP Capital by Type

• Public, private, and union-based pension funds comprise nearly half the funding for venture capital.

– What are the positive trends leading to greater availability of venture capital?

– What are the negative trends leading to less potential capital?


Source: Venture Economics, Tuck Private Equity Center

9


Characteristics of LP Capital• The percentage allocated to private equity is correlated to assets under

management (AUM). The same holds true for VC, but the results are not statistically significant.


0%

1%

2%

3%

4%

5%

0 500 1,000 1,500 2,000 2,500 3,000

Assets under Management (AUM) in $ millions

Percent Allocated to Private Equity by LP Size

Public employee plans

Union plans

Venture Capital Only

Regresson of Percent Allocated to Private Equity by LP Size

Private Equity Venture Capital Only

Constant ‐8.21 Constant ‐1.55Log size 1.24 * Log size 0.26Corporate 2.36 * Corporate 0.46Public 1.25 Public 0.24

* Base type is union

Source: "The Determinants of Investment in Private Equity and Venture Capital: Evidence from American and Canadian Pension Funds" by Gilles Chemla, UBC

US pension fund asset allocation data from Pensions and Investments magazine. The 1,000 pension funds in the data have total assets of US$3,611 billion in defined benefit plans.

10



Capital “Calls” from LPs to Fund• Capital calls (also know as

drawdowns or takedowns) occur frequently during the fund’s early years.

• Traditionally, capital contributions were made in three equal installments. Today, capital contributions are timed with investment needs.

• During significant downturns, many funds either “return” or “release” capital.

Source: Anonymous VC Annual Report

(100)

(80)

(60)

(40)

(20)

0

20

40

60

80

100

‐1 0 1 2 3 4 5 6$ millions

Years since "Official Closing"

Capital Drawdowns$400 million Fund

Significant market downturncausing fund to temporarilyreturn capital

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Failing to Meet the Capital Call• Capital calls generally must be fulfilled within 10 days.

• If necessary, LPs can borrow short-term:

– According to Larry Allen, the managing member of NYPPEX (a specialist in secondaries), one investment bank made advances of $1.5 billion for delinquent capital calls through its funds-of-funds programs between 2000 and 2002. The total extent of capital-call delinquencies was around $7 billion to $10 billion, Allen estimated.

• “The penalty for refusing so-called capital calls can include forfeiting half (to all) of the money already invested”, according to Bon French, CEO of Chicago-based Adams Street Partners LLC.


12


WaMu Defaults on Capital CallBankrupt holding company Washington Mutual Inc. (WMI) is looking to sell its interests in 10 venture capital funds after being penalized for not meeting a $700,000 capital call from one of the funds. Washington Mutual Inc.’s subsidiary, WMI Investment, has committed $36.5 million to 10 funds, and has to date contributed $27.8 million, according to court documents.

The funds are ARCH Venture Fund V; Arrowpath eCommerce Fund II; Digital Partners III; Financial Technology Ventures; Financial Technology Ventures II; Financial Technology Ventures III; Madrona Venture Fund I-A; Madrona Venture Fund III; Maveron Equity Partners 2000 and Northwest Venture Partners III.

WMI is in default on its fund commitment to Financial Technology Ventures III, which issued a $700,000 capital call on 1 October 2008. The fund is run by San Francisco-based FTVentures, a growth capital firm that invests in business services and software companies. The firm recently committed $30 million to Mu Sigma, a provider of analytical decision support services. WMI committed $10 million to the fund in March 2007, and has so far contributed $3.3 million. WMI has not fulfilled the capital request from FTVentures and is being penalized with an 18 percent default interest accrual on the amount of the capital call, according to court documents. In the event of continuing failure to meet the capital request, WMI will forfeit 25 percent and 50 percent of contributed capital on 6 December 2008, and 6 February 2009, respectively.

WMI has notified Financial Technology Ventures that the accrual of default interest on the capital request is a violation of bankruptcy law and should not be applied. ARCH Venture Fund also issued a $30,000 capital call on 29 September, but has yet to inform WMI that it is in default, the company said. WMI committed $3 million to the fund in 2000 and has contributed about $2.9 million.

“While [WMI] believes that the imposition of default interest. . . is a violation of [bankruptcy law], out of an abundance of caution and to avoid any disputes, [WMI] is requesting approval of the sales procedure,” the company said. Judge Mary Walrath, of the bankruptcy court in Wilmington, Delaware, must approve the auction process of the fund interests. A hearing is set for 16 December. – Private Equity OnLine, Christopher Witkowsky, 2008.


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Direct Investment• Venture capital investments typically are:

– Young. The company has a proven concept but lacks the infrastructure and professional management to grow successfully.

– High Growth. Venture capital is used to fund internal growth, primarily intangible investments – such as development (not research) and marketing. Rarely is venture capital used to provide liquidity.

– Big Potential. Given the high failure rate of start-ups, venture capital funds generate a good portion of their returns from the “home-run”

– Privately Held. Highly illiquid and difficult to value, venture capital is not for the faint of heart!



Venture Fund

Portfolio Company

Public Markets

Capital Call


Distribution

Monitor & Advise

How many investments per year?

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Number of Investments & Investment Size• In 2010, approximately 3,300 companies received an average of $6.7

million in venture financing.


0

1,000

2,000

3,000

4,000

5,000

6,000

1980

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2010

Companies Receiving Financing1990 ‐ 2011

0

3

6

9

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15

1980

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$ millions

Average Investment Size 1990 ‐ 2011

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High-Profile Investments (KPCB)


• Led by high-profile investors John Doerr and Brook Byers, Kleiner Perkins Caufield & Byers funds promising companies, helps them grow, and then actively grooms them for purchase or public offering. Since its inception in 1972, KPCB has invested more than $3 billion in more than 475 companies.

• The firm focuses its investments in four main areas: information technology, life sciences, pandemic and bio-defense, and green technology. The company current holds approximately 100 portfolio companies.

16


Typical Investments (KPCB)


• Information Technology– Zettacore: develops new memory

capabilities by using unique molecules in electronics

• Life Sciences– Invuity: develops technologies to

improve visualization in surgeries

• Pandemic and Bio-defense– Hx Diagnostics: diagnostics

company, focusing on seasonal and emerging infectious diseases

• Greentech– Altra: develops renewable energy,

focusing on ethanol

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“Stages” of Venture Capital


Stage% of Capital(2011)

% of Deals(2011)

Definition

Seed/Startup Stage 3% 11% The company has a concept or product under development, but is probably not fully operational. Usually, the company has been in existence for less than 18 months.

Early Stage 29% 39% The company’s product or service is in testing or pilot production. In some cases, the product may be commercially available. The company may or may not be generating revenues. Usually, the company has been in business for less than three years.

Expansion Stage 34% 27% The company’s product or service is in production and commercially available. The company demonstrates significant revenue growth, but may or may not be showing a profit. Usually, the company has been in business for more than three years.

Later Stage 33% 23% The company’s product or service is widely available. The company is generating ongoing revenue and is probably cash-flow positive. It is more likely to be profitable, but not necessarily.

Source: NVCA (2011) and MacMillan, Roberts, Livada, Wang (2008)

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Investments by Stage• Prior to 1995, nearly 40% of

all VC investment dollars went into seed or early stage companies.

• By 2002, the percent of investment dollars going into seed or early stage companies fell below 25%.

• VCs have been moving into later stage deals, where more capital per deal can be invested.


What percent do you get for Series A?

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Dollar Investments by Stage1980 to 2011

Later

Expansion

Early

Seed

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Industry Data on Ownership and Capital, Q4 2011• “We do not invest strictly based on discounted cash flow or a terminal value.

Our primary goal is to invest in companies that will become a lasting and strong presence in very large markets.” – High Profile VC.


Source: Wilson Sonsini Entrepreneurs Report, 2012. WSGR Database.

ImpliedValuation

20.0%

18.9%

10.2%

Series A

Series B

Series C and later

Percent Ownership

Post‐Money Ownership

2.3

3.5

8.5

Series A

Series B

Series C and later

$ millions

Median Amount of Capital Raised

20


Investments by Industry

• Venture capital is highly concentrated in “hot” industries.

• Today, approximately 60% of venture capital is invested in four industries:

– Biotechnology

– Software

– Medical devices

– Industrial / Energy


What percent of startups are from CA?

21


Investments by (US) State in 2011


Google MapsSource: NVCA (2012) More on ecosystems:

http://techcrunch.com/2012/04/10/startup-genome-compares-top-startup-hubs/

22


Venture Exits

• Depending on the investment focus and strategy of the venture firm, it will seek to exit the investment in the portfolio company within three to seven years of the initial investment.

• While the IPO may be the most glamorous type of exit for the venture capitalist, most successful exits of venture investments occur through a merger or acquisition of the company by either the original founders or another company.



Venture Fund

Portfolio Company

Public Markets

Capital Call

Direct Investment

Exit

Distribution

Monitor & Advise

23


Venture Exits• The number of liquidity events rebounded from 280 in 2009 to 500 in 2011.

• The average age has risen from a low of 4 years to nearly 9 years, as buyers (in the public and strategic buyer markets) become wary of uncertainty.


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Liquidity Events (M&A & IPO)

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Years

Median Age of Company prior to IPO

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Valuation Multiples

• Two-thirds of first-round investments fail to return original capital, and nearly half are total write-offs.

• Slightly under 30% of companies return between 1x and 10x the initial investment.

• Only 5% percent of companies return more than ten times (commonly known as the “home run”)


0%

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100%

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0.25

to 0.5

0.5 to 1

1 to 1.5

1.5 to 2

2 to 3

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10 to

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20 to

50

50 to

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>100

Gross Value Multiples All First‐Round Investments

Less Than 100% of Original Capital Returned

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Valuation Multiples: IPO versus M&A

• The gross value multiple for IPOs is higher than for M&A.

• For IPOs, few companies go public at a gross value multiple (GVM) less than 1x.

• For M&A, the distribution of gross value multiples is quite wide, with nearly 40% of gross value multiples at less than 1x.


What percentage of exits are IPOs?

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

<0.25 0.25to 0.5

0.5 to1

1 to1.5

1.5 to2

2 to 3 3 to 5 5 to10

10 to20

20 to50

50 to100

>100

Gross Value Multiples for IPOs and Acquisitions

IPOs

Acquisitions

26


Venture Exits: M&A and IPO• There has been a gradual shift from IPO exits to M&A exits for venture

investments. According to the NVCA, this is “a capital markets crisis for the start-up community.”


Source: Thomson Reuters & NVCA

0%

25%

50%

75%

100%

1980 1985 1990 1995 2000 2005 2010

VC‐Backed Exit by Type1980 ‐ 2010

M&A Exits

IPOs

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Why the Crisis?

• According to Dixon Doll, NVCA Chair,

• “While we clearly recognize that the IPO drought is being driven largely by a weak economy, there are other systemic factors that are making the IPO exit less attractive for high quality venture-backed companies.”


NVCA Survey, July 2008

12%

14%

15%

18%

57%

64%

77%

Lack of company interest

Reduction in investment banks

Poor IPO candidates

Lack of analyst coverage

Sarbanes‐Oxley

Credit Crunch

Skittish investors

Factors Causing IPO DroughtNVCA Survey, 660 Responses

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An Alternative Exit: Secondary Directs?Industry Ventures Closes $265 Million Fund V

Oversubscribed Secondary Fund Focused on Venture Capital Increases Fund Size

SAN FRANCISCO, CA -- (MARKET WIRE) -- Mar 23, 2009 -- Industry Ventures, L.L.C., a leading secondary firm focused on acquiring venture portfolios, limited partnership interests and other private equity investments, today announced the close of its oversubscribed fifth fund, Industry Ventures Fund V, L.P. with $265 million in committed capital from over twenty institutional investors. Originally targeting $200 million, the firm was granted approval by its limited partners to increase its fund size due to investor demand and overall market growth. Industry Ventures will actively deploy the new capital in the secondary market consistent with its previous strategy focused on acquiring positions in high quality venture backed companies through positions in venture capital funds and secondary direct transactions.

"The strength of the secondary market is one of the few bright spots in these challenging economic times," said Hans Swildens, principal and founder of Industry Ventures. "As markets dried up in 2008 and the global financial crisis spread, we began to see a proliferation of diverse sellers in the market as the need for early liquidity increased. This increased deal flow coupled with the secondary market's unique ability to steadily deploy capital resulted in significant investor demand and an oversubscribed fund that was larger than originally intended."

In 2008, Industry Ventures completed over 40 acquisitions -- which included secondary direct investments in private companies and limited partner interests --compared to 27 acquisitions the previous year. Some of the transactions involved the nation's high-profile venture-capital funds, as well as successful growth stage private companies, said Swildens. "Since last quarter, we have seen the volume of secondary deals grow more than 25% and we estimate there is more than $5 billion for sale in the secondary venture capital market. This vibrant market is providing an important liquidity option for entrepreneurs, sellers of venture funds and financial institutions and is contributing to the stabilization of the venture capital and financial markets," concluded Swildens.

Industry Ventures is planning to invest its Fund V over a period of two to three years through new acquisitions of direct investments and limited partnership interests typically ranging in size from $1 million to $25 million each. The firm also has a co-investment capability in Fund V that enables the firm to acquire larger special situation transactions with its limited partners larger than $25 million in size.


29


Cash is King: Distributions• The final segment of the venture capital

cycle is returning capital to the limited partners.

• Most venture capital firms have “20% carry,” which means they first return committed capital, but then keep 20% of all distributions above committed capital.

• Distributions primarily come in two forms:

– Cash

– Distribution In Kind: To avoid capital gains taxes, venture capital firms will return IPO shares to limited partners.



Venture Fund

Portfolio Company

Public Markets

Capital Call


Distribution

Monitor & Advise

30


Distributions versus Investments• Although distributions occur years after capital is raised, the aggregate amount

moves in tandem, as investors tend to “chase returns.”

• Why compare total investments versus distribution (on a gross basis) and not committed capital?


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Investments and Distributions by Year1995‐2011

Invested

Distributions

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Cumulative Investments and DIstributions 1980‐2011

Invested

Distributions

5‐Year LaggedDistributions

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Typical Carry Distribution “Waterfall”

1. Limited partner receives capital commitment (or alternatively invested capital), known as the return of capital.

2. Limited partner receives compounded hurdle rate (typically 8%), known as the preferred return.

3. General partner receives catch-up. Catch-up goes x% to general partner and (1-x%) to limited partner until general partner has received 20% of the profits. Note: Catch-up eliminates the hurdle return.

4. Both partners receive traditional 80/20 split, once GP is “caught up”

Professor David WesselsThe Wharton School of the University of Pennsylvania 32

32

Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner

Private Equity Funds: Organizational StructureGeneral Partners, Limited Partners, and “the Fund”




2

33


Organizational Structure & Compensation1. Outline the organizational structure of a venture capital “fund” – who

runs the fund (general partners) and who are the investors (limited partners)?

– Various stakeholders desire different ownership structures

2. What are the critical components in a contract written between limited and general partners?

– An in-depth discussion of compensation (fees, carry, and partial ownership). What actions do they incentivize?

– How is compensation split among key principals and what happens if key principals leave the fund before its conclusion?


34


Organizational Structure• Most venture capital “funds” are actually limited liability partnerships,

consisting of both general and limited partners. Limited partners contribute capital, general partners contribute capital, effort, and knowhow.


Portfolio Company

Limited Partners

Fund LP

Management Company

General Partners

Tom Robertson

Patrick Harker

ThomasGerrity

capital

effort andknowhow

fees

Accel Internet Fund IV, L.P.

Accel Partners LLC

35


General Partnership Agreements

Partnership Granted

Screening, Investment,

and Monitoring

The Disagreement

The Initial Public

OfferingThe Lawsuit


An example of a “smooth” transition: Vinod Khosla left Kleiner Perkins gradually, taking on a smaller role in early 2004, but not officially launching his new firm until March 2006. He declined to be a GP on new funds KPCG was launching, but remained a GP on older funds to avoid triggering key man provisions.

36


Organizational Structure• Most venture capital “funds” are actually limited liability partnerships,

consisting of both general and limited partners. Limited partners contribute capital, general partners contribute capital, effort, and knowhow.


Portfolio Company

Limited Partners

Fund LP

Management Company

General Partners

Tom Robertson

Patrick Harker

ThomasGerrity

capital

effort andknowhow

fees


Accel Partners LLC

37


An Example: Accel Partners (Palo Alto)


• Accel has raised ten separate primary funds and another eight specialized funds. The specialized funds have been focused on international investments, telecommunications, and the internet.

“The Firm” “The Fund”

Year Fund Name Amount Year Fund Name Amount1983 Accel Capital L.P. 64 1984 Accel Capital L.P. (Intl) 281989 Accel III, L.P. 100 1985 Accel Telecom L.P. 401993 Accel IV L.P. 1361996 Accel V L.P. 150 1996 Accel Internet Fund 201998 Accel VI L.P. 275 1998 Accel Internet Fund II L.P. 351999 Accel VII L.P. 480 1999 Accel Internet Fund III L.P. 1202000 Accel VIII L.P. 815 2000 Accel Internet Fund IV 2752004 Accel IX L.P. 4002007 Accel X, L.P. 520 2001 Accel Europe, L.P. 5092011 Accel XI, L.P. 475 2005 Accel London II, L.P. 450

2008 Accel London III, L.P. 525

2008 Accel Growth Fund 4802011 Accel Growth Fund II 875

2011 Accel India III 155

2011 Accel Big Data Fund (Set Aside)

Total ($ millions) 3,415 Total ($ millions) 3,513

SpecializedTraditional

Note: Does not include IDG-Accel joint venture funds.

38


The “Bulge Bracket”


• With hundreds of VC firms, there is no traditional bulge bracket. The top firms however account for the majority of capital raised (for instance, 80% of capital in 2Q 2012 was raised by just five funds).

Venture Capital Fund Raising Venture Capital Fund RaisingUnited States, 2011 ‐ Q2 2012 Rest of World (i.e. China!)

Rank Fund Firm $ mil Rank Fund Firm $ mil 1 New Enterprise Associates 14, L.P. New Enterprise Associates 14 2,075.9 1 RRJ Capital Asia Fund II RRJ Capital Fund 3,000.0

2 Bessemer Venture Partners VIII Bessemer Venture Partners 1,600.0 2 Tencent Collaboration Fund Tencent Collaboration Fund 1,531.2

3 Andreessen Horowitz Fund III, L.P. Andreessen Horowitz 1,500.0 3 Zhongxinjian China Merchants Equity Investment Fund

China Merchants Kunlun Equity Invest Management Co., Ltd.

1,156.0

4 Sequoia Capital 2010, L.P. Sequoia Capital 1,343.0 4 Shanghai Ruili Emerging Industry Investment Fund

Shanghai Ruili Investment Fund Management Co., Ltd.

1,095.6

5 J.P. Morgan Digital Growth Fund, L.P. J.P. Morgan Chase & Co. 1,217.5 5 China Culture Industry Capital Fund China Culture Industry Capital Fund Management Co., Ltd.

927.8

6 Khosla Ventures IV, L.P. Khosla Ventures 1,050.0 6 Northstar Equity Partners III PT Northstar Pacific Capital 825.0

7 Institutional Venture Partners XIV, L.P. Institutional Venture Partners 1,000.0 7 Guangdong Guangdian Fund Guangdong Zhongguang Investment Management Co., Ltd.

786.5

8 KPCB Digital Growth Fund LLC Kleiner Perkins Caufield & Byers 932.3 8 YR Delta Fund Y.R. Delta Fund Management Co., Ltd.

776.2

9 Accel Growth Fund II, L.P. Accel Partners 875.0 9 Guangdong Small & Medium Enterprise Equity Investment Fund

Bank of China Finance Equity Investment Fund Management

762.1

10 Lightspeed Venture Partners IX, L.P. Lightspeed Venture Partners 675.0 10 Shanghai Shipping Industry Fund Shanghai Shipping Industry Funds Management Co., Ltd.

759.7

39



Organizational Structure: The Limited Partner• Most venture capital funds are actually limited liability partnerships, consisting

of both general and limited partners. Limited partners contribute only capital.

How do Limited Partners Differ from General Partners?

Limited partners can not have a management role. Their liability is

limited to initial investment.

Why 1% of capital? Before the IRS began allowing a

“check-the-box” declaration of partnership in 1996, a 1%

capital interest was required to avoid corporate taxation.

Portfolio Company

Limited Partners

Fund LP

Management Company

General Partners

capital

effort andknowhow

fees


Accel Partners LLC

40


Examples of LP Capital: Public Pensions• Public pension funds are a major contributor to venture capital, and as the data

shows below, can be quite aggressive in the allocations.


Limited Partners

Assets under management ($

millions)

Target allocation to

PE (in %)

Last Year's Commitments

($ millions)

Oregon State Treasury 64,000 16 3,200Pennsylvania State Employees’ Retirement System 36,400 14 1,480City of Philadelphia Board of Pensions & Retirement 5,250 12 173San Francisco Employees’ Retirement System 16,700 12 575

Pennsylvania Public School Employees’ Retirement System 67,500 11 5,000Massachusetts Pension Reserves Investment Management Board 54,000 10 1,541New Mexico Educational Retirement Board 9,400 10 260

Indiana Public Employees’ Retirement Fund 17,600 8 670National Pension Reserves Fund (Ireland) 31,000 8 500Teacher’s Retirement System of the State of Illinois 42,000 8 1,400

Los Angeles County Employees’ Retirement Association 42,000 7 635Los Angeles City Employees’ Retirement System 11,480 5 1,000YMCA Retirement Fund 5,400 5 90

State Retirement & Pension System of Maryland 40,000 2 428

Sample of funds recently announcing calls for investment proposals…

41


New Limited Partners in Private EquityNew Mexico Educational Retirement Board

$9.4 billion AUM

New Mexico Education Retirement Board is ramping up its appetite for private equity rapidly. The system originally approved a 5% target allocation in 2006, and has already doubled that to 10%, freeing up some $400 million to commit during the calendar year.

The pension, with adviser Aldus Equity Partners, devised a plan that calls for it to allocate 62% of its PE bucket to buyouts, 18% to special situations, and 10% each to venture capital and mezzanine.

So far, New Mexico Educational Retirement Board has shown a willingness to champion newer firms, particularly spin offs, including Lion Capital, HM Capital, Newstone Capital Partners, Goode Partners, GF Capital and Industrial Opportunity Partners.


More information about : New Mexico Education Retirement Board

More information about: Aldus Equity Partners

Does due diligence matter? Yes.

42


Raising LP Capital: The Fundraising Process

1. Preparing offering materials (the investment memorandum)

• Strategy & scope of fund; if necessary, the economics of the space

• Partner experience in VC and more broadly, investment (not advisory)

• Historical performance of previous funds

• High profile exits (grandstanding)

• High profile LPs (herding)

2. Identifying and meeting with appropriate and compatible investors and their professional advisors

3. Responding to LP due diligence requests (background of partners)

4. Negotiating the partnership agreement (terms of the LP commitment).


43


Limited Partner Concerns

• Limited partners are highly focused on incentives – and somewhat price sensitive.

– Do the general partners have sufficient capital at stake?

– Do they split carried interest in an equitable way, or does one partner dominate?

• The level of management fees is more important to LPs than the level of carry.

• Be prepared to discuss these issues before meeting with limited partners!


Source: Private Equity Investors Survey, : Probitas Partners

52%

42%

42%

39%

35%

24%

23%

18%

9%

Level Of General Partner Financial Commitment to the Fund

Distribution Of Carried Interest Between the Senior Investment Professionals

Structure or Inclusion of a Key Man Provision

The Overall Level Of Management Fees

Maximum Fund Size

Level of Carried Interest

Transaction Fee Splits

Carry Distribution Waterfalls

Structure or Inclusion of a No Fault Divorce Clause

Percent of Limited Partners Concerned About:

44


Hot Topic: The Key ProfessionalsStaff Exits Roil Liquid Realty

Three senior executives have resigned from Liquid Realty, throwing a wrench into plans for the shop’s next fund. Chief investment officer Jeffrey Giller, the No. 2 executive to Liquid founder Scott Landress, will leave by year end. Two other top managers left Sept. 30: Joshua Cleveland, who led efforts to find investments, and due-diligence head Brendan MacDonald.

The departures left some limited partners upset with Liquid, whose funds buy interests in real estate vehicles on the secondary market. In a contentious conference call in August, investors in the San Francisco firm’s most recent fund said they felt betrayed that the departures were coming so early in the life of that 2007-vintage entity, Liquid Realty Partners 4.

The official line is that Giller, Cleveland and MacDonald have no specific plans. However, some market players believe the departing executives intend to start their own investment shop. In either case, the trio would almost certainly be subject to non-compete provisions for a time. As for Liquid’s next fund, the firm started informal talks with investors late last year with theidea of setting out to raise $750 million to $1 billion once Fund 4 had deployed most of its $570 million of equity. But withFund 4’s portfolio building up slower than expected, Liquid has yet to distribute marketing materials for the follow-up.

The departure of three senior executives will clearly complicate Liquid’s fund-raising plans, market players said, adding that agenerally tough environment for soliciting capital could force the shop to reduce its equity goal. Fund 4, meanwhile, is about two-thirds deployed and is considering a large deal that would exhaust the uncommitted equity. But if Giller departs before the position is added, it could trigger a “key-man” provision that would allow limited partners to block the investment. One source said Giller offered to stay on until the fund is fully invested. But limited partners suggested it might be better for him to leave soon.


45


Private Equity Funds: Organizational StructureWhy Structure Matters and Experienced Attorneys are Critical

Professor David Wessels © 2012



46


Organizational Structure: Fund LP• Why is the fund structured at a limited partnership and not a traditional

corporation? Answer: To avoid taxation at the fund level.

• If the portfolio company earns profits, it will be taxed at the corporate income tax rate. Why not structure the portfolio company as a LLC also?Answer: To avoid unrelated business taxable income, commonly known as UBTI. UBTI includes income “which is not substantially related to the organization’s exempt purpose.”


Portfolio Company

Institutional Investors Fund LP

Limited Partnership C-Corp

47


Why Structure Matters: Stakeholder Conflicts• To prevent UBTI, limited partners demand that the portfolio company be

structured as a C-Corp, with the fund purchasing shares.

• A few years pass and the founder decides to sell to a strategic buyer. Assume the original investment is $10 million and the company is worth $50 million. Corporate income is taxed at 35%, dividends at 15% (39.6% post-2012), and long-term capital gains at 15% (20% post-2012).

• Two primary alternatives exist:


Stock Sale• Seller friendly, elimination of ALL

liabilities• Sale taxed at long-term capital gains

rate.

Asset Sale• Buyer friendly, only agreed

liabilities are transferred.• Gains and losses are recognized as

corporate income, and then liquidating dividend paid.

48


Tax Implications (post 2012)• Assume the capital is $10 million and the company is worth $50

million. Corporate income is taxed at 35%, dividends at 15% (39.6% post-2012), and long-term capital gains at 15% (20% post-2012).


Asset Sale of C-Corp Asset Sale of LLC

Company

Founder

Limited Partner

49


Why Entrepreneurs Need Experienced Attorneys!

• Consider the ownership structure proposed by Professor Borghese:


“Blocker”Corp

Institutional Investors Fund LP

Limited Partnership C-Corp

Entrepreneur

Portfolio Company

Limited Liability Company

If portfolio company earns profit, then distribution will need to be paid to Blocker Corp to cover tax burden.

50


The Knock on LLCs• In most transactions, the entrepreneur does not think through the impact of

organizational structure, but if they do…

• Professional investors will rarely accept a blocker C structure for the following reasons:

– Administrative costs: Pass through organizations are more difficult to administer. The Blocker-C must be administered (and funded) by the professional investor, not the entrepreneur. Any income generated in the LLC creates an unfunded tax burden for the LLC.

– Employee Options. Employees (or others) who receive options are treated similar to members, and are given information rights that employees typically don’t have.

– Cultural inertia: Nonstandard terms are always met with skepticism. One lawyer writes, “Every LLC I have worked on for high growth company has had some kind of problem.”


51

Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation

Partnership Agreements & GP CompensationThe Economics of Contracting




3

52


Typical Partnership Agreement1. Fund Size: $100 million

2. Term of Agreement: Following the tenth anniversary of the initial closing, the term of the partnership will expire on December 31 unless extended for up to two consecutive one year periods at the discretion of the general partner. This is to permit orderly dissolution, and no management fees will be charged during any such extension.

3. Commitment Period: Following the fifth anniversary of the initial closing, all partners will be released from any further obligation with respect to their unfunded commitments on December 31, except to the extent necessary to cover expenses and obligations of the partnership (including management fees) in an aggregate amount not to exceed unfunded commitments.

4. Management Fees: The annual contributions will equal 2.0 percent of committed capital for the first ten years of the fund. These contributions will be paid quarterly.

5. Distributions: distributions in respect of any partnership investment will be made in the following order of priority:

• 100% to the Limited partners until they have received an amount equal to their invested capital.

• 80% to the Limited partners and 20% to the general partners.

6. Diversification and Investment Limits: The Fund may not invest more than 25% of aggregate commitments in any single portfolio company.

7. No Fault Divorce Clause: By vote, limited partners are permitted to remove the general partner of a fund and either terminate the Partnership or appoint a new general partner.


53


General Partner Compensation

• The fund compensates the general partners through fees and carry. The typical compensation rule for venture capital is 2/20, meaning 2% fees and 20% carry.

• But 2% and 20% of what? The LP contract will state the “basis,” such as committed capital, contributed capital, etc. Let’s discuss each in detail.


54


Cost Basis & Portfolio Value

• When fees and carry are computed on “net invested capital,” they are computed on the cost basis, not the net cash flow invested.

• For instance, what is the fund’s cost basis each year, for fund that makes four investments?


Portfolio Companies Year 1 Year 2 Year 3 Year 4

Company A -10 20

Company B -15 15

Company C -25 35

Company D -20 40

Fund Financials: Year 1 Year 2 Year 3 Year 4

Capital call -10 -40 -20 0

Distribution 0 20 15 75 IRR

Net cash flow -10 -20 -5 75 41%

Cost Basis:

55


Management Fee Negotiation• Split up into pairs. One person should act as the LP. Another should

act as the general partner. Both have equal power and would like to work together.

• You must design a fee contract that uses either committed capital, net invested capital, or a combination of both.

• How would you argue your position? Do NOT argue the other person’s position! Imagine you are working on behalf of your organization.


56


Potential Fee Schedules1. Level fee structure - e.g. 2% of committed capital. Assuming a 10 year

fund, only 80% of capital is “investable”. The remaining capital is pledged towards fees.

2. Declining percentage– e.g. 2% of committed capital for the first five years (the investment period), declining by 25 basis points per year.

3. Declining capital - The third type of fee schedule uses a constant rate, but changes the basis for this rate from committed capital (first five years) to net invested capital (last five years). Net invested capital equals gross investment less cost basis of exited investments.

4. Declining fee and committed capital.


57


43%

55%

16%

84%

45%

39%

% of funds changing fee basis after investment

period

% of funds changing fee level after investment

period

% of funds changing both basis and level

How Fees Changeafter Investment Period

Venture CapitalBuyouts

Typical Fee Structures


• The typical VC firm charges 2% of committed capital and 70% lower the fee basis from committed capital to net invested capital after the investment period.

• Does lowering the fee basis make sense?

Key insight: Why the

difference?

10%

51%47%

41%43%

8%

Venture capital Buyouts

Initial Fee Level by Fund Type

> 2%

= 2%

< 2%

58


Hot Topic: Fees on Uninvested CapitalTPG Plans to Return $20 Million in Fund Fees

The war on private-equity fees is heating up. TPG, one of the world's largest private-equity firms, told investors at its annual conference this week that it would refund $20 million in fees paid this year on its $18.8 billion flagship investment fund. The gesture is TPG's second concession this year, as it tries to shore up its relationships with investors who have committed billions of dollars with the private-equity firm but have seen little in the way of new deals or positive investment returns.

The move could ratchet up pressure on other buyout shops to reduce their fees or the size of their funds. Last week Sun Capital Partners reduced its $6 billion fund by $1 billion, an acknowledgement that there is too much money chasing too few deals. It also comes at a time moment when investors in private-equity funds have begun agitating for lower fees on their own.

At the market peak, large private-equity firms raised billions of dollars in anticipation of striking dozens of new deals. But as the credit markets closed, they found themselves with immense cash hordes and no way of spending them. At the same time, the buyout funds have also been collecting annual management fees, typically 1% to 2% of the assets raised. Originally designed to cover firm overhead, the fees now represent significant sources of revenue on their own – some $150 million for 1% of a $15 billion fund.

Last December TPG became the first U.S. buyout fund to cut the size of its fund, ultimately reducing it by $1 billion to $18.8 billion. Still, as the firm's deal activity remained limited throughout this year -- roughly 85% of the fund remains uninvested -- some of the firm's large clients, including the Government of Singapore Investment Corp. and California State Teachers Retirement System, urged the firm to consider other moves, according to people familiar with the discussions.


59


Carried Interest• “Carried interest or carry is a share of the profits of a successful

partnership that is paid to the manager of a private equity fund or hedge fund as a form of compensation that is designed as an incentive to the manager to maximize performance of the investment fund.”

• “In order to receive (keep) carried interest, the manager must first (eventually) return all capital contributed by the investors and in certain cases the fund must also return a previously agreed upon rate of return (the hurdle rate) to investors”


60


Distribution Structure: Carried Interest

• Carry level - The carry level refers to the percentage of “profits” distributed to the general partner (e.g. 20% of profits)

• Carry basis - The carry basis refers to how “initial investment” (and subsequently profits) is measured (e.g. commitment capital or investment capital).

• Carry timing - Finally, carry timing, not surprisingly, refers to the set of rules that govern the timing of carried interest distributions (e.g. does all committed capital need to be returned before profits are declared – or is it done on a per-deal basis).

– Clawback provision dictates that “excess distributions” will be returned (i.e. if future deals go bad)

• Carry hurdle - The carry hurdle refers to whether a GP must provide a “preferred return” to LPs before collecting carried interest and, if so, the rules about this preset return.

– Contracts that include hurdles typically come with “catch-up” provisions, described in two slides.


61


Distribution Structure: Carry Timing

• Traditional contracts require that committed capital (and potentially preferred return) must be distributed to LPs before GPs are paid carry.

• “European” carry allows for carried interest to be paid once all contributedcapital (to date) is returned.

• “American” carry allows for carried interest to be paid once the contributed capital for realized deals is returned.


VentureCarry

“European” Carry

“American”Carry

Conservative (LP Friendly)

Aggressive (GP Friendly)

62


Carried Interest Timing• Imagine a GP collects carry on the first few

transactions, but then writes off the remaining investments a few years later. In an extreme case, the GP can generate carry even without generate aggregate profits!

• To prevent carry without profits, two additional contracts terms are common:

– Clawback. LPs have the right to demand a return of carry if the fund does not earn a profit. Clawbacks can lead to ugly discussions between GP/LP.

– Fair-value test. LPs can restrict carry to paid only when cumulative unrealized investments exceed 120% of their cost basis.


63


Carry Hurdle: Payout Diagram• Suppose LPs invest $100 in a 10-

year fund. Assume payouts are made in year 10 (unrealistic, but assumed for simplicity).

• If the fund pays 20% carried interest to the GP, draw the payout diagram for:

1. Straight carry (venture)

2. True preferred return of 8%, with no catch-up

3. Compounded hurdle rate of 8% with 100% catch-up (buyouts)


0

10

20

30

40

50

60

70

0 100 200 300 400 500

Carry ($ millions)

Distributions ($ millions)

General Partner Carried Interest

)216)(1()100(51

xx

64


Typical Carry Distribution “Waterfall”

1. Limited partner receives capital commitment (or alternatively invested capital), known as the return of capital.

2. Limited partner receives compounded hurdle rate (typically 8%), known as the preferred return.

3. General partner receives catch-up. Catch-up goes x% to general partner and (1-x%) to limited partner until general partner has received 20% of the profits. Note: Catch-up eliminates the hurdle return.

4. Both partners receive traditional 80/20 split, once GP is

“caught up”


[ ]

[ ]

[ ]

[ ]

65


Do Hurdles Matter for VC?VCs argue hurdles are irrelevant when 10x is the goal. Should LPs fight for preferred returns?

• Take the University of California Retirement System (UCRS), a prominent institutional investor. More than one in ten venture funds failed to return 8%, and nearly one in five would have received less carry if a hurdle rate mechanism were used.

• David Toll, Private Equity Partnership Terms And Conditions, Dow Jones, (2008);


66


Carry Hurdle: An Example• Consider an $80 million fund with an 8% hurdle.

• Contract states “hurdle rate is paid on committed capital until cumulative distributions exceed hurdle. Once the hurdle is exceeded, General Partner will receive 100% of all distributions until 20% of profits are held by General Partner. Once General Partner holds 20% of profits, all future distributions are split at 80% to limited partner and 20% to the general partner.”


Venture Fund Cash Flows

$ millions Year 1 Year 2 Year 3 Year 4 Year 5

Capital call (Jan 1st) 20.0 40.0 20.0 0.0 0.0

Gross invested capital 20.0 60.0 80.0 80.0 80.0

Distribution (Dec 31st) 0.0 25.0 60.0 45.0 50.0

Required hurdle

67


Catch-Up Calculation


• The most difficult calculation occurs the year in which the hurdle rate is exceeded.

• The catch-up can be determined using the formula first presented with the payout diagram.

Step Component Value

Step 1 Distribution 45.0

Step 2: Hurdle requirement 108.8

Cumulative distributiont‐1 85.0

Return of Hurdle 23.8

Step 3: Remaining distribution (after hurdle) 21.2

Step 4: Break‐even threshold (formula) 116.0Hurdle requirement 108.8Catch‐up 7.2

Step 5: Remaining distribution (after catch‐up) 14.0

Step 6: Portion to LP 11.2Portion to GP 2.8

68


Carry using Contributed Capital


European WaterfallPayout Structure

$ millions Year 1 Year 2 Year 3 Year 4 Year 5Capital call (Jan 1st) 20.0 40.0 20.0 0.0 0.0Distribution (Dec 31st) 0.0 25.0 60.0 45.0 50.0

Drawdown 1 Distribution 0.0 21.6Cumulative distribution 0.0 21.6Hurdle 20.0 21.6

Drawdown 2Distribution 3.4 39.8Cumulative distribution 3.4 43.2Hurdle 40.0 43.2

Drawdown 3Distribution 20.2 45.0 50.0Cumulative distribution 20.2 65.2 115.2Hurdle 20.0 n/a n/a

Compensation Total LP Return of Capital 0.0 25.0 59.80 0.0 0.0 84.8LP Profits 0.16 36.0 40.0 76.2GP Profits 0.04 9.0 10.0 19.0Total distributions 0.00 25.00 60.00 45.0 50.0 180.0

• In a European Carry structure, the fund needs to return the hurdle on a drawdown-by-drawdown basis.

• Does the European carry lead to higher or lower distributions than the traditional method?

69


Typical Carry Structure• The typical fee structure is 2% of committed capital plus 20% of profits once

original capital is returned. Nearly all funds use committed capital as the basis. Hurdle rates are common in buyouts, but mixed in VC.


* Real estate fund typically charge 1.5% with a 20% carry. Real estate funds have a preferred return of 9% with a 60/40 catch-up.

92%

48%

84%

93%

% of funds using committed capital as

base (i.e. fees included)

% of funds that include a hurdle rate

Characteristics of Typical Carry Contracts

Venture CapitalBuyouts

4% 0%

95% 100%

1% 0%

Venture capital Buyouts

Carry Percentage by Fund Type

> 20%

= 20%

< 20%

70


Incentives Related to Carry• Carry: “the GP wins only when the LP wins,” but… Consider three investment

opportunities.


• If the probability of “up” is 50% and the cost of capital is 10%:what is the “NPV” of investment A? What is the present value of carry?

Carry

130 8

90

90 0

Time 0 Time 1

Portfolio Company A

71


Incentives Related to Carry

• Now consider two alternative investments, A versus B and A versus C. If only one of the two can be made, is A the optimal investment?


Carry Carry Carry

130 8 140 10 150 12

90 90 90

90 0 100 0 40 0

Time 0 Time 1 Time 0 Time 1 Time 0 Time 1

Portfolio Company A Portfolio Company B Portfolio Company C

72


Drivers of Option Value• Does carry (which is a call option) encourage the VC to invest in portfolio

companies with better returns? Yes, as the underlying asset value (S) rises, so does call option value. But there are four other drivers of option value!


Driver Conflict? Implication

Stock price S OK

Strike price K OK

Volatility Potential conflict

Time to maturity T Potential conflict

Risk free rate R Not applicable

73


Are you Willing to Pay a Higher Carry?• Nearly 2/3 of limited partners would be willing to raise the percent

carry in exchange for return hurdles and lower management fees.


Source: Private Equity Investors Survey: Probitas Partners

65.8%

27.1%

7.1%

Willing to Change the Carry Structure?

No way, 20% is too high!

No way, 20% is adequate

Potentially

42.2%

33.3%

29.0%

11.0%

Only over specific return hurdles

Only for those with a long track record

In exchange for limits on

management fees

In exchange for limits on fund size

% of Limited Partners Willing to Raise Carry

74


Appendix

Articles on Performance Contracts


75


Venture Funds Sweetening the Terms: Firms Cut Fees to Lure Investors After Decade of Mediocre Returns; 30% 'Deal Stopper'

Venture-capital funds are cutting fees as they scrounge for cash amid a bruising fund-raising environment. Battery Ventures, Draper Fisher Jurvetson and Opus Capital are among venture-capital firms that have dangled lower costs in front of investors in the past few months. Some are cutting fees outright, while others are building performance-based hurdles into fee structures. The moves mark the first retreat by the venture-capital industry since the dot-com bust, which forced many firms to cut fees in hopes of luring back investors. Before the latest downturn, fees were steady for several years at venture-capital funds.

Lower fees will hit venture capitalists in their wallets. Most funds charge a 2% annual management fee based on total assets in the fund. Such fees can add up to $1 million a year for some venture-capital partners, says Jon Holman, a recruiter for the venture-capital industry. Venture-capital firms get their biggest money from "carried interest," or profits reaped when the companies in which funds invest go public or are sold. Fees on carried interest usually are about 20%, with some funds charging higher carried-interest fees, dubbed "premium fees," of as much as 30%. The inflow from such fees has been scarce since the financial crisis shrank the pipeline of initial public offerings and sales of venture-capital-backed companies. Now, the fees themselves are heading south.

Opus, based in Menlo Park, Calif., and trying to attract investors to a new $250 million fund, recently cut its carried-interestfee for the fund to 20%. The firm's previous fund charged 25%. "Better fee terms can certainly make a difference to investors," says Kirk Dizon, a managing director at Hall Capital Partners LLC, which invests in venture-capital funds. These days, carried-interest fees of 30% would be a "deal stopper.“

The softening stance follows the venture-capital industry's decade of poor returns. The average return for venture-capital funds fell to 14% for the 10 years ended June 30, down from 34% for the 10 years ended June 30, 2008, largely because the venture returns generated in the first half of 1999 dropped out of the calculation, according to research firm Cambridge Associates LLC.


76


Venture Funds Sweetening the Terms: Firms Cut Fees to Lure Investors Continued

As a result, many investors are reluctant to put more money into venture capital, especially amid the liquidity crunch from last year's market turmoil. Some venture-capital funds have scaled back their size ambitions or abandoned efforts to drum up cash, particularly with so many rivals competing for capital.

This year, 435 venture-capital funds have hit the road to raise money, compared with 452 for all of 2008 and 445 in 2007, according to research firm Preqin. Out of that field, just 134 new venture-capital funds had completed their fund raising and closed to investors as of early November, down from the full-year totals of 309 funds in 2008 and 363 in 2007.The newcomers raised just $20.4 billion in total capital, down 65% from $58.2 billion in all of 2008, according to Preqin.

David Sze, a general partner at Greylock Partners, says the San Mateo, Calif., firm allotted more time than usual to fund raising because of the uncertain market, but ended up raising money for a new $575 million fund in four to six weeks.One reason investors boosted the fund above its $500 million target: Greylock's management fee is based on a yearly budget that investors must approve, instead of the 2% industry norm. Investors "appreciate" that kind of fee transparency, Mr. Sze says. According to a person familiar with the matter, Greylock, an investor in social-networking site FacebookInc., is charging a premium carried-interest fee on the new venture-capital fund.

Battery Ventures is incorporating a performance hurdle into the new $750 million venture-capital fund being raised by the firm. The fund will charge a carried-interest fee of 20%, down from the previous 25%, until it returns three times its capital. After that, the fee will climb to 30%. Highland Capital Partners LLC, which recently closed on a $400 million fund, also is incorporating a performance-based hurdle into its carried-interest fee, says a person familiar with the matter. Draper Fisher Jurvetson, which backed hits such as Skype and Hotmail and is raising a fund targeted at $400 million, sent a letter to prospective investors this year that said the firm would charge a premium carried-interest fee only if the fund meets certain performance targets. Investors would pay a 20% carried-interest fee until the fund returns 2.5 times its committed capital, according to the letter, a copy of which was reviewed by The Wall Street Journal. The fee would increase after that.


77

Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups

The Cost of Equity for VC-backed Start-UpsHow the CAPM applies to VC & Founders




4

78



Session Overview

• In this session, we estimate the opportunity cost of capital for limited partners, venture capitalists, and entrepreneurs.

• Many believe the limited partner’s cost of capital is quite high for start-ups (i.e. greater than 30%), as technological uncertainty is extreme and poor results often lead to business failure. This view, however, is inconsistent with:

– The theory of the CAPM, in that only systematic risk is rewarded.

– The empirical evidence, which shows that historical VC returns average less than 15% and when properly measured, abnormal returns are indistinguishable from zero.

• In this session, we derive the algebraic expressions for risk and return. We use these derivations to test how an opportunity’s risk can differ across investors.

79


Thinking about Risk & Return• Today, we examine risk and return from the investors perspective and test how

it differs from the manager/founder’s perspective. To get started, let’s analyze the following risky project:


• You are the program manager at the Baikonurcosmodrome in Kazakhstan. You have been approached by DirecTV to launch their new series 10 satellite.

• Because the rocket must be modified to fit the satellite, you are uncertain about success. Your engineers place probability of a successful launch at 75%.

• If the launch is successful, DirecTV will compensate the cosmodrome $200 million. If the launch fails, your organization must reimburse DirecTV $100 million – for the lost satellite.

80


Thinking about Risk & Return

• With a 25% probability of failure and a potential downside of $100 million cash outflow, you are nervous about accepting the project without good financial analysis.


1 s 2(p )CF (1 p )CFPV1 R

s

• Where ps equals the probability of launch success, CF1 equal the cash inflow from success and CF2 equals the cash outflow from failure.

• How much is the contract worth? What discount rate would you use? Use judgment, NOT formulas!

13.1%

9.2%

8.0%

7.2%

6.2%

6.0%

SmallCap growth stocks

Hedge funds

International stocks

Large stocks (S&P 500)

Corporate bonds

Real estate

Asset Returns by Class

1990 ‐ 2010

81


Risk & Return of Various Asset Classes• The limited partner (portfolio manager) has a number of asset classes to choose

from, including equities, debt, and alternatives. Below are summary statistics for 14 asset classes using monthly returns.


Risk and Return by Asset Class2001 ‐ 2010

Asset ClassExpected

returnHistorical average

Standard deviation

Expected return

Historical average

Standard deviation

1 LargeCap Value 10.0% 2.1% 16.3% 0.8% 0.2% 4.7%2 LargeCap Growth 7.2% 0.5% 18.3% 0.6% 0.0% 5.3%3 SmallCap Value 14.4% 21.0% 55.0% 1.2% 1.7% 15.9%4 SmallCap Growth 11.1% 5.9% 23.3% 0.9% 0.5% 6.7%5 NASDAQ 8.4% 3.6% 24.0% 0.7% 0.3% 6.9%6 MSCI Europe 8.2% ‐1.6% 16.9% 0.7% ‐0.1% 4.9%7 MSCI Asia 9.8% 15.1% 25.3% 0.8% 1.3% 7.3%8 MSCI Latin America 9.9% 20.5% 28.7% 0.8% 1.7% 8.3%9 Core Bond 4.1% 6.2% 4.5% 0.3% 0.5% 1.3%10 High Yield 3.8% 5.7% 7.3% 0.3% 0.5% 2.1%11 Real Estate 14.0% 6.8% 24.5% 1.2% 0.6% 7.1%12 Commodities 7.3% 12.5% 24.7% 0.6% 1.0% 7.1%13 Crude Oil 8.3% 17.6% 32.3% 0.7% 1.5% 9.3%14 Hedge Funds 4.6% 7.1% 5.6% 0.4% 0.6% 1.6%

Source: Bloomberg

Annual Statistics Monthly Statistics

82



Plotting Risk and Return

• A helpful tool for visually evaluating individual assets, asset classes, and portfolios of asset classes is the mean volatility plot.

• The goal of the limited partner is to target the highest return for the lowest amount of risk.

LargeCap Value

SmallCap Growth

High Yield

Commodities

0%

3%

6%

9%

12%

15%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return

Volatility of Returns

Mean‐Volatility Plot

83



The Limited Partner: Portfolio Optimization• The goal of the portfolio manager is to get the highest return for the

lowest risk. Rather than focus on both goals simultaneously, let’s give the portfolio manager a target return, and minimize risk.

• The mathematical expression for this concept is,

p

N

1iii

N

1iiix

RR~xEsuch thatR~xVarmin

• Rather than focus on the mathematical expression, let’s examine the portfolio manager’s task graphically…

84



Find an “Efficient” Portfolio

• The goal of the limited partner is to target the highest return for the lowest amount of risk.

• If higher rates of return mean higher risk of loss, what rate of return would you target for retirement?

LargeCap Value

SmallCap Growth

High Yield

Commodities

0%

3%

6%

9%

12%

15%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return



85



The Efficient Frontier

• A Markowitz Efficient Portfolio is one where no incremental diversification can lower the portfolio's risk for a given return expectation

• The Markowitz Efficient Frontier is the set of all portfolios that will give the highest expected return for each given level of risk.

LargeCap Value

SmallCap Growth

High Yield

Commodities

0%

5%

10%

15%

20%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return



Note: This efficient frontier was built using Fama-French expected returns, historical covariances, and no short-selling of individual portfolios.

86


LargeCap Value

SmallCap Growth

High Yield

Commodities

0%

3%

6%

9%

12%

15%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return




The Risk Free Rate and Portfolio Theory

• A risk free asset (for instance, treasury bills) has a standard deviation of zero.

• When we combine a risk free asset with a risky portfolio using various weights, we get a straight line.

• Should we create a portfolio of a riskless bond and a singlestock?

Portfolios comprised of commodities and the 10-

Year treasury

87


LargeCap Value

SmallCap Growth

High Yield

Commodities

Tangency Portfolio

0%

5%

10%

15%

20%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return




The Capital Market Line (CML)

• We can adjust the portfolio line such that it is tangent to the efficient frontier. The place where the line touches the efficient frontier is known as the tangency portfolio.

• The tangent line is known as the capital market line.

Portfolios comprised of the tangency portfolio

and the 10-year treasury

88



The Tangency Portfolio & The Market Portfolio

Key Assumptions:

1. What if returns are normally distributed?

2. What if every investor preferred high return and low volatility? (reasonable assumption)

3. What if every investor agreed on the risk and return of individual securities? (strong assumption).

Which portfolio would they choose?

LargeCap Value

SmallCap Growth

High Yield

Commodities

Tangency Portfolio

0%

5%

10%

15%

20%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return



89



Which Portfolio Would You Prefer?• Based on Sharpe’s work, assume the limited partner holds a well diversified

market portfolio. If the following opportunities were available, would you recommend adjusting the portfolio?

90


Risk and Return: An Experiment to Guide Us• You are a sophisticated limited partner, attempting to maximize risk

and return. You have been given the opportunity to increase your allocation percentage towards venture capital.

• You ask your data analysis team to answer two questions:

1. How will this new allocation affect our potential return?

2. How will this new allocation affect our potential risk?


91



Step 1: Increasing Your Portfolio’s Expectation• What if you held the market portfolio and decided to buy a small

amount of venture capital, financed by borrowing at the risk free rate? Let the “small amount” equal $y dollars.

fvcmlp yRR~yR~R~

)yRR~yR~E()R~E( fvcmlp

fvcmlp yR)R~yE()R~E()R~E(

• The new portfolio’s expectation would be calculated as follows

92



Step 1: Increasing Your Portfolio’s Expectation

• How does the expectation of our portfolio change when we increase y?

fvclp R-)R~E(

y)R~E(

• From the last slide:

fvcmlp yR)R~yE()R~E()R~E(

• As we purchase a small amount ($y) of venture capital, our portfolio’s expectation increases by E(Rvc) – Rf.

93



Step 2: Increasing Your Portfolio’s Variance• What if you held the market portfolio and decided to buy a small

amount of venture capital, financed by borrowing at the risk free rate? Let the “small amount” equal $y dollars.

fvcmlp yRR~yR~R~

)yRR~yR~Var()R~Var( fvcmlp

vcmlp R~y)(R~(1)Var)R~Var(

• The new portfolio’s variance would be calculated as follows

94



Step 2: Increasing Your Portfolio’s Variance• To determine the variance of our portfolio, we use the portfolio

variance formula, substituting x = 1.

)R~,R~2yCov()R~Var(y)R~Var()R~Var( vcmvc2

mlp

• How does the variance of our portfolio change when we increase y?

)R~,R~2Cov()R~2yVar(y

)R~Var(vcmvc

lp

)R~,R~Cov(2)R~Var()R~Var()R~Var( 2122

12

p xyyx

becomes

95



Step 2: Increasing Your Portfolio’s Variance

• From the last slide we have the following relation.

• For extremely small investments in venture capital (i.e. as the incremental investment approaches zero), the marginal variance equals venture capital’s covariance with the market.

)R~,R~2Cov()R~2yVar(y

)R~Var(mvcvc

lp

)R~,R~2Cov(y

)R~Var(lim mvc

lp

0y

96


Case Study: When Volatility Lowers Risk

• You have been approached by the board of directors at General Mills. The company manufactures and distributes ready-to-eat cereals, refrigerated yogurt, microwave popcorn, and frozen pizza.

• Given the low risk associated with the company, a prominent director believes employee’s defined contribution (DC) plans should hold only General Mills stock.

• You have countered that holding General Mills stock in isolation is actual high risk, and that adding a stock such as Google to the portfolio would actually lower the portfolio’s risk. But how is this possible? Google is a highly volatile security!


97


The Risk of General Mills versus Google• The board is concerned about Google volatility and plans to vote against

diversification using Google. As can be in Google’s stock return chart, the stock has fluctuated wildly.

• Based on portfolio theory, what do you think?


0

10

20

30

40

50

60

Dec‐06 Dec‐07 Dec‐08 Dec‐09 Dec‐10 Dec‐11

Adjusted Stock Price (Adjusted for Splits and Dividends)

General Mills

0

100

200

300

400

500

600

700

800

Dec‐06 Dec‐07 Dec‐08 Dec‐09 Dec‐10 Dec‐11

Adjusted Stock Price (Adjusted for Splits and Dividends)

Google

98


The Efficient Frontier for Two Stocks

• As long as two securities have a reasonably low correlation, adding a second security will lower volatility of the portfolio through diversification, even if it has high volatility!

• If too much of the second security is added however, volatility trumps diversification and portfolio volatility rises.


10%

11%

12%

13%

14%

0% 10% 20% 30% 40%

Expe

cted

Return

Standard Deviation

Efficient Frontier

New Project

Investor's Portfolio

99


Thinking about Risk & Return• Today, we examine risk and return from the investors perspective and

test how it differs from the manager/founder’s perspective. To get started, let’s analyze the following risky project:


• You are the program manager at the Baikonur cosmodrome in Kazakhstan. You have been approached by DirecTV to launch their new series 10 satellite.

• Because the rocket must be modified to fit the satellite, you are uncertain about success. Your engineers place probability of a successful launch at 75%.

• If the launch is successful, DirecTV will compensate the cosmodrome $200 million. If the launch fails, your organization must reimburse DirecTV $100 million – for the lost satellite.

100


Student Perceptions

• The general “perception” of cost of capital, both in the classroom and in the field, is that risky ventures should earn 20-30%.

• But what does “earn” really mean, and should this rate be used as the discount rate / hurdle rate to value ventures?


0

5

10

15

20

25

30

35

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% More

Kazakhstan Launch Venture Frequency of Selected Discount Rates

101



Step 3: Marginal Risk – Reward Ratios• We can now combine our two elements, marginal expectation and

marginal risk into a single risk-reward ratio:

fvclp R-)R~E(

y)R~E(

)R~,R~2Cov(

y)R~Var(

mvclp

)R,2Cov(RR-)R~E(

RiskReward

mvc

fvc

Marginal Reward Marginal Risk

The risk-reward ratio for a small incremental investment

in venture capital, while primarily holding the well-diversified market portfolio.

102



Sharpe’s Insight: No Deviation at Equilibrium• In an efficient market, where investors can buy and sell asset classes, each asset

class should have the same risk return ratio. Therefore, if we can assess risk by asset class, we should be able to predict the asset class’s return.

All portfolios have risk-reward of 3.5x

103



Marginal Benefit = Marginal Cost• In the 1960s, Bill Sharpe hypothesized that the risk-reward ratio for all assets

or any combination of assets(including the market portfolio) must be equal, otherwise investors would flow into the higher risk/reward asset class.

)R,2Cov(RR-)R~E(

)R,2Cov(RR-)R~E(

mm

fm

mvc

fvc

Venture Capital Market Portfolio

)Var(RR-)R~E(

)R,Cov(RR-)R~E(

m

fm

mvc

fvc • which can be rearranged,

• and simplified,

)Var(RR-)R~E()R,Cov(RR)R~E(

m

fmmvcfvc

104



A Risk-Reward Model• As long as a particular investment is a small part of an investor’s portfolio, then

covariance drives portfolio volatility, NOT the investment's variance.

• If the investor holds the market, what drives return is covariance with the market!

Expected returnof venture

capital

The risk reward ratio of the market

portfolio

Risk free rate

The risk of a particular asset

class

)R~Var(R]R~E[)R~,R~Cov(R]R~E[

m

fmmvcfvc

105



The Marginal Risk of a Portfolio• The big picture: If investors care about lowering the variance of their

portfolio (i.e. the market portfolio), then what’s important is not an individual asset’s variance, but its covariance with the market.

• A small covariance will raise the variance of the market portfolio less than a large covariance will. Subsequently, investments with a higher covariance must offer a higher return.

• This logic has been formalized by Sharpe and Traynor as the CAPM:

fmm

mvcfvc R]R~E[

)R~Var()R~,R~Cov(R]R~E[

106


Appendix

Incremental Portfolio Variance: Two Assets


107


Incremental Variance: Two Assets• In this lecture note, we increased our holdings in venture capital by borrowing

money. This allows us to examine the components of risk and derive the CAPM.

• In the assignment, we transferred holdings from a safe stock to a risky stock. Therefore, the mathematics is slightly different. The variance of the portfolio is as follows:


)R~,R~Cov()1(2)R~Var()R~Var()1()R~Var( 2122

12

p yyyy

)R~,R~Cov()42()R~Var(2)R~Var()1(2y

)R~Var(2121

p yyy

• Similar to before, we examine how the portfolio’s variance changes as we increase our holdings in the second asset:

108


Incremental Variance: Two Assets• From the previous page:


)R~,R~Cov(2)R~Var(2y

)R~Var(lim 211

p

0y

0y

)R~Var(lim p

0y

)R~Var()R~,R~Cov( 121 when

)R~,R~Cov()42()R~Var(2)R~Var()1(2y

)R~Var(2121

p yyy

• Next, determine the incremental variance at y equal to zero:

• The derivative will be negative (i.e. portfolio variance will drop) when the covariance of the two assets is less than the variance of the primary asset.

when)R~σ()R~σ()R~,R~ρ(

2

121

Using the definition of

correlation (p):

)R~σ()R~σ()R~R~Cov()R~,R~ρ(

21

2121

)R~(σ)R~Var( 12

1

109

Venture Capital & the Finance of Innovation Lecture 5 – The Founder’s Perspective on Required Return

The Cost of Equity for VC-backed Start-Ups

The Founder’s Perspective




5

110


The Founder’s Investment Choice

• An entrepreneur you know has developed a set of revolutionary processes to manufacture silicon wafers, solar cells, and other critical ingredients for solar power generation.

– The first production technology, polysilicon, has limited competition and strong expected IRRs.

– The second production technology, silane, has similar expected IRRs, but much greater uncertainty.

• If both technologies are available to the entrepreneur/founder, should the entrepreneur “put their life” into either of them?


Financial Assessment

Polysilicon Silane

production production

Projected IRR 21% 18%

Risk Metrics

Comparable beta 1.8 0.8

Comparable volatility 45% 60%

Market Metrics

Risk free rate 4% 4%

Market risk premium 5% 5%

Market volatility 17% 17%

111


LargeCap Value

SmallCap Growth

High Yield

Commodities

0%

5%

10%

15%

20%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return



Entrepreneurial Opportunities & the Efficient Frontier

• Although professionals are quick to use the CAPM to evaluate opportunities, this is not appropriate for an undiversified founder.

• From a financial perspective, the founder should compare the opportunity versus a levered efficient portfolio on the capital markets line (CML).

• Unlike a professional investor, the founder must also consider non-financial benefits of starting an enterprise.


New silaneproduction

process

New polysilicon production technology

112


LargeCap Value

SmallCap Growth

High Yield

Commodities

Tangency Portfolio

0%

5%

10%

15%

20%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

Return




A Financial Threshold for Entrepreneurs• The equation for any line equals:

Y = a + bX• The intercept for the capital market

line (CML) equals the risk free rate.

• The slope for the capital market line can be computed as rise over run. Therefore the entrepreneur’s cost of capital equals:

fmm

if R]R~E[

)R~σ()R~σ(RHurdle Financial

New silaneproduction

process

New polysilicon production technology

113



Additional Insight into Beta• We can use the definition of covariance to rearrange beta.

)R~Var()R~,R~Cov(b

m

mvcvc

can be rewritten as: )R~(

)R~(ρbm

vcvc

• Individual securities tend to have much higher volatilities than the diversified market portfolio. Thus, for highly correlated stocks, the beta is greater than one. For assets uncorrelated with the market, their beta is zero.

• As can be seen by the second equation, the market has a beta of one.

vc m

vc m

Cov(R ,R )ρσ(R )σ(R )

114



CAPM Betas versus Entrepreneur Betas• GT Solar International is a beacon along the path of the solar power supply chain. Its key

products include photovoltaic wafer fabrication machinery, silicon furnaces, and optical scanning systems. The company also provides solar module assembly services.

• If the risk free is 4% and the market risk premium is 5%,

• What is the limited partner’s cost of capital

• What is the founder’s cost of capital?

Market PricingManual Calculation

Statistics GTAT‐US S&P 500Historical average 3.6% 1.5%Standard deviation 18.2% 5.3%

Correlation 33.4%Covariance 0.31%

Date GTAT‐US S&P 500 GTAT‐US S&P 500Dec‐11 7.60 1,277.81 ‐6.2% 1.0%Nov‐11 8.10 1,264.87 ‐5.9% ‐0.2%Oct‐11 8.61 1,267.67 16.8% 10.9%Sep‐11 7.37 1,142.77 ‐42.5% ‐7.0%Aug‐11 12.82 1,229.18 ‐10.5% ‐5.4%Jul‐11 14.32 1,299.79 ‐15.8% ‐2.0%Jun‐11 17.01 1,326.77 27.0% ‐1.7%May‐11 13.39 1,349.26 14.2% ‐1.1%

Adjusted Stock Price ($) Monthly Returns

115



The Cost of Capital versus Expected Return• Based on the CAPM & its modifications, the cost of capital for the

startup’s limited partners is 9.7%. The cost of the capital for the founders is 21.2% (assuming they are fully invested).

Critical question:

• If the founder invests $1 million to start the company, does this mean the founder will earn 21.2% on average? i.e. if they started 100 companies with identical characteristics, would the average investment earn 21.2%?

116



Correlation & Volatility by Industry• Cross-sectional variation in beta is driven by relative volatility and correlation

with the market portfolio. If Internet companies have high volatility, but low correlation with the market, what does this mean for the founder/LP relationship?

1.0

1.6

2.4

2.6

2.9

3.9

4.3

4.3

4.8

5.8

6.3

Water Utility

Food Wholesalers

Average

Specialty Chemical

Aerospace & Defense

Drug

Software and Services

Biotechnology

Computer Peripherals

Semiconductors

Internet

Relative Volatility by Industry

26.2%

29.0%

29.1%

29.4%

30.9%

33.4%

36.7%

38.1%

41.0%

43.0%

55.1%

Internet

Drug

Computer Peripherals

Biotechnology

Software and Services

Food Wholesalers

Semiconductors

Specialty Chemical

Aerospace & Defense

Average

Water Utility

Market Correlation by Industry

Industry data via Compustat and Aswath Damodaran.

What is the cost of capital by type for

Internet companies and water utilities?

117


The Cost of Equity for VC-backed Start-Ups

Concluding Perspectives




118



The CAPM and Uncertainty: An Example• You work for a biotechnology company,

entirely financed with venture capital. The company is on the edge of a major breakthrough, although the probability of success is gauged at just 20%.

• If clinical tests are successful, Merck will contract/license the drug for $10 million per year forever. Conversely, failure kills the project completely.

• If the risk free rate is 5% and Merck’s cost of capital is 15%, should the company spend $15 million to proceed with the clinical trials?

119



Why such a High Cost of Capital in VC?• In the previous example, we assumed

the clinical tests were uncorrelated with the market. Therefore, a cost of capital of 5% was appropriate (assuming Merck is unlikely to default on its obligations).

• A venture capitalist is likely to incorporate risk into the denominator, not into the numerator.

• What is the net present value of the “win” scenario discounted at 20%, 25%, 30%. Which is theoretically correct?

NPV15% =

NPV25% =

NPV35% =

120



S. Korean satellite misses orbitGOHEUNG, South Korea: SouthKorea launched its first space rocketyesterday but failed to put a satelliteinto its planned orbit, in a setbackfor the country's nascent spaceprogram.The payload separated from thesecond-stage booster about eightminutes after liftoff but did not enterits targeted orbit, project officialssaid at the space center on Oenaro

Island, about 465 km south of Seoul."The first-stage engine and thesecond-stage kick motor operatednormally and the satellite separated,but it did not put it precisely in thetarget orbit," said Science MinisterAhn Byong-man. "We cannot spotthe satellite in its orbit, where it issupposed to be."The satellite reportedly separated 36km higher than its target position.

Officials could not immediatelyexplain what went wrong or whatwould happen to the satellite, butthey said it did not have a booster tocorrect its trajectory.

121

Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance

Venture Capital PerformanceAre High Hurdle Rates Justified? Empirical Evidence




6

122


Venture Capital Performance• Over the past 30 years, venture capital has (slightly) outpaced returns of both the S&P

500 and the NASDAQ composite index. Performance continued after the dot-com meltdown of 2001-2003.

• Between 1980 and 2010, VC has earned 11.9% versus 11.6% for the S&P 500.


Source: Cambridge Associates, Bloomberg

1

10

100

1981 1984 1988 1992 1996 1999 2003 2007 2011

Venture Capital Performance (1981‐2011)

CambridgeAssociates

Nasdaq

S&P 500

0.0

0.5

1.0

1.5

2.0

2003 2004 2005 2006 2007 2008 2009 2010 2011


CambridgeAssociatesNasdaq

S&P 500

123



Venture Capital Indices• Sand Hill Econometrics (SH) began by combining the databases of the two

main industry-trackers, VentureOne and VentureEconomics, supplemented with other industry sources. The database includes over 20,000 companies and more than 70,000 financing rounds and is produced monthly.

– The gross returns from 1988-2008 are 12.8% (versus 7.9% for NASDAQ).

• Cambridge Associates (CA) U.S. Venture Capital Index includes more than 75 percent of the dollars raised by VC funds since 1981. CA is an investment consultant to endowments (etc) that serves as a gatekeeper for potential LPs.

– The net returns from 1988-2008 are 16.2% (versus 7.9% for NASDAQ).

124


Gross versus Net Returns• Sand Hill Economics uses “gross returns.” Gross returns are raw returns, computed

without management fees or carry.


Limited Partner Venture Fund Limited Partner

Venture Fund Portfolio Company Venture Fund

• Cambridge Associates uses “net returns.” Net returns are computed after subtracting management fees and carry.

Capital Call Distribution

Investment Exit Proceeds

Why is the CA index higher than SHE? By its construction, CA is subject to severe survivorship bias (funds must be successful to raise additional capital). SHE is too conservative because it only computes proportional ownership and ignores embedded optionality.

125



Is a High Hurdle Rate Justified?• So, what is the cost of capital for Venture Capital? We know the probability

of failure for start-ups is high, but does this translate to priced risk? ? i.e. does the CAPM explain returns?

• To test this question, we regress excess venture returns against excess market returns. If the CAPM holds, what do you expect the values of alpha and beta to be?

)R](E[RBR-]E[R fmifi −+=α

Sand Hill Index® (monthly) and the

CA Index (quarterly)

CRSP Value Weighted Stock Index less short-

term bills

126



Unexplained VC-Performance• Early results are impressive. Abnormal performance (i.e. performance

unexplained by beta) is equal to 6% per year. Note, how beta is remarkably low. Are VC investments really this uncorrelated with the market?

CoefficientMonthly Data from

Sand Hill EconometricsQuarterly Data from

Cambridge Associates

Alpha (in % per year) 4.92**** 6.10

Market Beta 0.76*** 0.56***

Adjusted R2 72% 19%

Gross or Net Returns? Gross Net

Sample Period Jan 1989 to Dec 2008(240 monthly observations)

Q2 1981 to Q4 2008(111 quarterly observations)

• Is this really superior performance? Or perhaps the CAPM fails to measure risk appropriately. Let’s examine two alternative pricing models, Fama-French and Pastor-Stambaugh.

127



The Effect of Stale Prices• Many GPs report valuations based on the most recent round of financing, even if a

company’s outlook had changed significantly since that time.

• During the post-boom period, LPs complained old valuations significantly overstated the value of the portfolios, which made it difficult for LPs to properly assess their holdings.

The Solution?Lagged Beta

‐15%

‐10%

‐5%

0%

5%

10%

15%

20%

‐10% ‐5% 0% 5% 10% 15%Fund

Returns

Market Returns

Monthly Fund Returns versus Market Returns

Market Fund ReturnsMonth Returns Actual Reported

1 ‐4.5% ‐5.8% 0.0%2 3.9% 5.1% 0.0%3 1.3% 1.7% 0.0%4 3.8% 5.0% 0.0%5 ‐2.1% ‐2.7% 3.3%6 ‐6.7% ‐8.7% 0.0%7 ‐6.6% ‐8.6% 0.0%8 3.5% 4.6% ‐12.7%9 5.8% 7.5% 0.0%10 1.5% 1.9% 0.0%11 2.5% 3.2% 0.0%12 ‐1.4% ‐1.8% 0.0%

128



Fama-French 3-Factor Models• Many academics believe beta is a poor measure of risk. Instead, many use the

Fama and French (1993) three factor model to determine the risk of an asset class:

)R(Rλ)R(Rλ)r(RλαrR LH3BS2fM1fp −+−+−+=−

• According to Fama & French (data), three factors drive investment returns:

– The performance of economy as a whole, as measure by a traditional market beta

– A premium for companies that have returns correlated with small companies. Small companies have outperformed large companies by 24 basis points per month, or 3.0% per year.

– A premium for companies that have returns correlated with companies with high book-to-market values. High B/M companies have outperformed their counterparts by 38 basis points per month, or 4.6% per year.

129


Fama-French Portfolio Returns• Many have proposed theories to explain the higher returns associated with small

companies and low book-to-market values, but none have gained wide acceptance. Regardless, the data are robust and any “excess” performance must be tested.


0

1

2

3

4

5

6

7

8

Jun‐26 Jun‐36 Jun‐46 Jun‐56 Jun‐66 Jun‐76 Jun‐86 Jun‐96 Jun‐06

Portfolio Returns: Long Small, Short Large Companies1926‐2011

0

5

10

15

20

25

30

35


Portfolio Returns: Long High BM, Short Low BM1926‐2011

130


Fama-French Factor Loadings by Asset Class• Although equity indices each have similar exposure to the market, they have

different exposures to the other two Fama-French Factors.


Risk and Return by Asset Class2002‐ 2011

Asset ClassExpected

returnHistorical average

Standard deviation

Expected return

Historical average

Standard deviation HML beta SMB beta

Market beta

‐1 MSCI Index 9.0% 6.2% 17.5% 0.8% 0.5% 5.0% 0.02 ‐0.11 1.050 S&P 500 8.7% 2.2% 15.9% 0.7% 0.2% 4.6% 0.04 ‐0.15 1.001 LargeCap Value 9.3% 2.7% 16.7% 0.8% 0.2% 4.8% 0.23 ‐0.14 0.952 LargeCap Growth 8.4% 2.6% 16.3% 0.7% 0.2% 4.7% ‐0.18 ‐0.06 1.063 SmallCap Value 11.7% 6.4% 20.8% 1.0% 0.5% 6.0% 0.21 0.78 0.914 SmallCap Growth 11.5% 6.3% 22.1% 1.0% 0.5% 6.4% ‐0.24 0.91 1.145 NASDAQ 9.9% 4.9% 20.2% 0.8% 0.4% 5.8% ‐0.27 0.33 1.196 MSCI Europe 8.5% ‐0.9% 16.6% 0.7% ‐0.1% 4.8% 0.07 ‐0.06 0.887 MSCI Asia 9.9% 12.3% 24.3% 0.8% 1.0% 7.0% ‐0.14 0.18 1.198 MSCI Latin America 10.1% 18.4% 28.6% 0.8% 1.5% 8.3% ‐0.23 ‐0.19 1.529 Core Bond 4.1% 5.9% 4.5% 0.3% 0.5% 1.3% 0.02 0.01 0.0010 High Yield 3.8% 5.5% 7.3% 0.3% 0.5% 2.1% ‐0.03 ‐0.11 0.0611 Real Estate 11.9% 6.7% 25.1% 1.0% 0.6% 7.3% 0.61 0.46 0.8212 Commodities 6.3% 16.6% 24.8% 0.5% 1.4% 7.2% ‐0.20 0.09 0.5713 Crude Oil 6.9% 21.5% 32.6% 0.6% 1.8% 9.4% ‐0.25 0.30 0.5914 Hedge Funds 5.2% 6.4% 5.8% 0.4% 0.5% 1.7% ‐0.09 0.05 0.27

Source: Bloomberg Average monthly returns:0.3% 0.2% 0.4%

Annual Statistics Monthly Statistics Regression Coefficients

131



Handling Illiquidity: the Pastor-Stambaugh Model

• For venture capital applications, the most important innovation is the measurement of liquidity risk developed by Pastor and Stambaugh (2003). Many practitioners feel that venture capital should earn a higher return because the investments are illiquid.

• The Pastor-Stambaugh model (PSM) allows us to estimate this premium using data on VC returns by adding a liquidity factor to Fama & French (1993)

)R(Rλ)R(Rλ)R(Rλ)r(RλαrR LiqIlliq4LH3BS2fM1fp −+−+−+−+=−

• In the 1966 to 2004 period, the average return to the liquidity factor was 3 percent per year. Since 1980, however, the returns have been almost 6 percent per year. Liquidity data can be found in WRDS.

132



The Cost of Venture Capital• Using a lagged beta model to compute regression coefficients for the Pastor

Stambaugh model leads to:

Total Coefficient Monthly Data (SHE Index) Quarterly Data (CA Index) Risk Premium

Alpha (in % per year) – 2.11 0.13

Market Beta 1.63*** 2.04*** 5.0%

Size Beta – 0.09 1.04*** 2.5%

Value Beta – 0.68*** –1.46*** 3.5%

Liquidity Beta 0.26** 0.15 5.0%

Adjusted R2 83% 55%

Sample Period Jan 1989 to Dec 2008(240 monthly observations)

Q2 1981 to Q4 2008(111 quarterly observations)

Source: Metrick (2010)

• Based on these statistics, what is the cost of capital for the typical venture fund? Does the typical venture capital fund “beat” the market?

133

Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance

Choosing Amongst Venture Capital Firms Measuring Fund Performance & Manager Persistence




7

134


Session Overview• Over the last 30 years, venture capital has failed to statistically outperform

either a Fama-French adjusted set of indices. But can you “beat” the VC index by investing in particular VCs, and if so, can you reliably find which ones?

• During this session, we examine how to measure historical performance on a fund-by-fund basis. We will examine three metrics in particular: times-money-earned (investment multiple), internal rate of return (IRR), and discounted times-money earned.

• Venture capital managers exhibit persistence. Therefore, historical performance is a helpful selector. But how strong is persistence? More specifically, should you be willing to pay higher fees and carry for a manager with strong historical performance?


135


Venture Capital as an Asset Class

• Over the last 30 years, venture capital has failed to statistically outperform either a stock index, or a Fama-French adjusted set of indices.

• But can you “beat” the VC index by investing in particular VCs, and if so, can you reliably find which ones?


Source: Cambridge Associates, Bloomberg

1

10

100

1981 1984 1988 1992 1996 1999 2003 2007 2011


CambridgeAssociates

Nasdaq

S&P 500

136


Variation Across VC Funds


• Between 1978 and 2010, the University of California invested $2.4 billion in 124 venture funds, the most recent being Insight Venture Partners VII.

• With an average return of 15.3%, UC performed better than the VC index of 12.7%, but given the enormous variation of fund performance (standard deviation equals 43%), picking the “right fund” really matters.

• How should we measure individual fund performance?

Source: University of California, Office of the President,

0

2

4

6

8

10

12

14

16

18

20

‐30% ‐20% ‐10% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%Freq

uency

Internal Rate of Return

Distribution of VC Annual ReturnsUniversity of California Holdings

Five venture funds had IRRs greater

than 100% per year

137


University of California VC Returns• The University of California has made investments in more than 100 venture capital

funds. To report fund performance, UC records an unrealized value multiple and the net internal rate of return:


Venture Capital Fund Vintage YearUC

Commitment Cash In Current NAV Cash OutCash Out +

Current NAVInvestment

Multiple Net IRR1 Brentwood Associates II, L.P. 1978 3,000.0 (3,000.0) 0.0 4,254.0 4,254.0 1.42x 5.5%2 InterWest Partners I, L.P. 1979 3,000.0 (3,000.0) 0.0 6,681.0 6,681.0 2.23x 18.5%3 Alta Company 1980 3,000.0 (3,000.0) 0.0 6,655.0 6,655.0 2.22x 13.8%4 Golder, Thoma Fund I 1980 5,000.0 (5,000.0) 0.0 59,349.0 59,349.0 11.87x 32.1%5 Kleiner Perkins Caufield & Byers II 1980 7,500.0 (7,500.0) 721.0 31,521.0 32,242.0 4.30x 50.6%6 Welsh, Carson, Anderson & Stowe II 1980 4,000.0 (4,000.0) 0.0 8,670.0 8,670.0 2.17x 14.2%7 Alta II, L.P. 1981 3,000.0 (3,000.0) 0.0 5,300.0 5,300.0 1.77x 7.0%8 Mayfield IV, L.P. 1981 5,000.0 (5,000.0) 0.0 13,158.0 13,158.0 2.63x 26.1%9 Sequoia Capital III 1981 4,000.0 (4,000.0) 30.0 7,232.0 7,261.0 1.82x 11.3%10 InterWest Partners II, L.P. 1982 4,000.0 (4,009.0) 0.0 6,972.0 6,972.0 1.74x 8.4%11 Kleiner Perkins Caufield & Byers III 1982 7,832.0 (7,832.0) 0.0 13,596.0 13,596.0 1.74x 10.2%

117 DCM VI, L.P. 2009 25,000.0 (3,125.0) 2,712.0 0.0 2,712.0 0.87x NM118 Khosla Ventures Fund III, L.P. 2009 60,000.0 (31,800.0) 35,961.0 0.0 35,961.0 1.13x NM119 Khosla Ventures Seed, L.P. 2009 17,143.0 (6,171.0) 6,477.0 0.0 6,477.0 1.05x NM120 Caduceus Private Investments IV, L.P. 2010 25,000.0 (2,550.0) 2,365.0 0.0 2,365.0 0.93x NM121 Insight Coinvest II, L.P. 2010 13,000.0 0.0 0.0 0.0 0.0 NA NA122 Insight Venture Partners VII, L.P. 2010 50,000.0 0.0 0.0 0.0 0.0 NA NA123 Polaris Venture Partners VI, L.P. 2010 20,000.0 0.0 0.0 0.0 0.0 NA NA124 The Column Group II, L.P. 2010 20,000.0 0.0 0.0 0.0 0.0 NA NA

Source: University of California, Office of the President,

138


UC Regent Definitions


Term Definition

Vintage Year Represents the year each partnership commenced investment activities. This may be different than the year in which The Regents committed to invest in the partnership.

UC Commitment

Represents the total commitment made by The Regents to each partnership, adjusted for any subsequent reductions to partnership commitments by the General Partners.

Cash In Represents the total portion of The Regents’ commitment that has been contributed to the partnership from inception through the most recent year-end.

Current NAV Represents the net asset value of The Regents’ interest in each partnership as determined by the General Partners in financialstatements.

Cash Out Represents the total distributions received by The Regents from inception through the most recent year-end.

Cash Out + Current NAV

Represents the sum of distributions received by The Regents from inception through the most recent year-end and the net assetvalue of The Regents’ interest in each partnership as determined by the General Partners in financial statements.

Investment Multiple

Represents each partnership’s total value as a multiple of invested capital; the multiple is calculated by dividing Cash Out +Current NAV by Cash In.

Net IRR Represents the cash-on-cash return net of fees, expenses, and carried interest from inception through the most recent year-end aswell as the net asset value of The Regents’ interest in each partnership as determined by the General Partners in financialstatement.

Source: UC Regents

• How is the data reported? The UC Regents use the following definitions:

139


Measuring Performance• Investment Multiple / Times money earned (TME)

– An “Investment Multiple” is computed by dividing cumulative distributions by contributed (and eventually committed) capital. Can be computed with or without the value of unrealized investments.

• Internal rate of return (IRR)– The internal rate of return is solved by setting the NPV of cash flows

equal to zero. IRR is computed using “= IRR(range)”

• Discounted Investment Multiple.– Rather than compute a raw multiple, discount cash flows at an appropriate

cost of capital.


140


Measuring Performance: Cash Flows

• Your boss, the Alternative Investments manager at the New Mexico Education Retirement Fund is considering an investment in either the Alpha Partners or Beta Capital:

– Alpha Partners raised a $500 million dollar fund in 2002.

– Beta Capital raised an identically sized fund in the same year.

• At the end of each fund’s life, what is the net value multiple? How do we determine IRR?


Drawdown

Distributions

Alpha Partners Beta CapitalYear

2002 ‐500 ‐500

2003 50 0

2004 40 0

2005 0 0

2006 140 50

2007 80 0

2008 600 0

2009 0 300

2010 400 0

2011 0 800

2012 650 1600

141


Which is Fund is Better?

• Your boss, the Alternative Investments manager at the New Mexico Education Retirement Fund is considering an investment in either the Alpha Partners or Beta Capital.

• Which fund manager has better historical performance?


Performance Metrics

Times Internal Money Rate of

Fund Earned Return

Alpha Partners 3.9 22.5%

Beta Capital 5.5 20.6%

142


Measuring Performance: Investment Multiples

• The fund multiple grows over time as distributions are made.

• Alpha partners made early distributions, whereas beta capital made late distributions.

• What is the problem with investment multiples?


0

1

2

3

4

5

6

1 2 3 4 5 6 7 8 9 10

Investmen

t Multip

le

Fund Year

Alpha & Beta Return Multiples

Alpha Partners

Beta Capital

143


Measuring Performance: Internal Rate of Return

• A common alternative to showing an investment multiple is to compute an internal rate of return.

• Internal rate of return is solved by setting the NPV of cash flows equal to zero.


1042 IRR)(1600...

IRR)(1140

IRR)(120-5000

+++

++

++=

• Based on each fund’s IRR, which fund is superior?

20.6%

22.5%

10% 15% 20% 25%

Beta Capital

Alpha Partners

Internal Rate of Return

144


The Theory: Internal Rate of Return

• The internal rate of return is an extremely popular method to evaluate capital budgeting projects.

• IRR separates positive NPV projects from negative NPV projects.

• The theory dictates that you “select projects whose IRR is greater than the cost of capital”


(200)

(100)

0

100

200

300

400

500

10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%$ millions

Present Value of LP Cash Flows

Alpha Partners

145


Pitfalls of Internal Rate of Returns

• But the internal rate of return separates positive from negative projects, it can not be used to compare projects.

• The same holds true for funds. Even if two funds have the same initial investment and the same risk, IRR fails to measure performance consistently.


(300)

(200)

(100)

0

100

200

300

400

500

600

700

10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%

$ millions


Beta Capital

Alpha Partners

146


The Extreme: Multiple Rates of Return!


• Each time the cash flow pattern changes sign, a real root is possible.

• Since distributions can occur before capital commitments, negative can be followed by positive, by negative again!

• Consequently, multiple rates of return are possible!

‐150

‐100

‐50

0

50

100

150

0% 20% 40% 60% 80% 100%

$ millions

Discount Rate


Guess IRR0% 1%

10% 15%80% 86%

147


Other Practical Drawbacks of IRR

• A typical fund will make a set of capital calls immediately preceding investments. This process is imperfect – and subsequently, the fund will sometimes hold cash.

• What will holding cash do to a fund’s IRR? Is this penalty appropriate?


148


Distribution of Investment Multiples• The University of California reports investment multiples for each of its

investments. The average investment multiple was 2.6x (after fees and carry), but the median fund was only 1.1x. What does this imply?


0

5

10

15

20

25

0.0 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6 4.0 4.4 4.8

Freq

uency

Unrealized Investment Multiple

Distribution of VC Investment MultiplesUniversity of California Holdings

Nine venture funds had investment multiples

greater than 5x

Venture Capital FundVintage

YearInvestment

Multiple Net IRR

Kleiner Perkins Caufield & Byers VII 1994 32.51x 121.7%

Kleiner Perkins Caufield & Byers VIII 1996 17.00x 286.6%

Sequoia Capital VII 1995 16.39x 174.5%

Sequoia Capital VI 1992 15.67x 110.4%

Golder, Thoma Fund I 1980 11.87x 32.1%

Institutional Venture Partners VII, L.P. 1996 6.71x 96.2%

Institutional Venture Partners VI, L.P. 1994 5.82x 64.6%

Merrill, Pickard, Anderson & Eyre V, L.P. 1989 5.49x 46.1%

Sequoia Capital V 1989 5.30x 39.6%

Kleiner Perkins Caufield & Byers X‐A, L.P. 2000 0.59x ‐17.5%

Sequoia Capital X 2000 0.55x ‐31.0%

Google

149


Gross Versus Net Multiples/IRRs


• Gross returns are raw returns, computed without management fees or carry. Net returns are computed after subtracting management fees and carry. Consider the following two venture funds:

• You are considering investing in one of the two venture funds. Which metric would you use to make a decision? Why? Can anything be learned from Gross IRRs?

Gross Net Gross Net

Fund Multiple Multiple IRR IRR

Capital Partners 4.7 3.9 25.0% 19.0%

Delta Ventures 4.5 4.2 23.0% 22.0%

150


Realized &Unrealized Multiples/IRRs


• What are the realized, unrealized, and total value multiples for the fund below? If you were an LP evaluating the fund for the next capital raise, which multiple would you use?

Portfolio Valuation$ millions

Liquidation Unrealized TotalCompany Investment value value value Source / MethodologyCompany 1 3.0 7.5 0.0 7.5 M&A Company 2 5.0 0.0 20.0 20.0 Series C at $4.00 per shareCompany 3 3.0 36.0 0.0 36.0 IPO at $15.00 per shareCompany 4 3.5 0.0 0.0 0.0 Write‐offCompany 5 4.0 0.0 0.0 0.0 Write‐offCompany 6 4.5 13.5 0.0 13.5 M&A Company 7 5.0 0.0 30.0 30.0 Series D at $5.50 per shareCompany 8 4.0 0.0 12.0 12.0 Series B at $1.75 per shareCompany 9 3.0 0.0 3.0 3.0 CostCompany 10 5.0 0.0 5.0 5.0 CostTotal 40.0 57.0 70.0 127.0

151


Realized versus Unrealized Multiples/IRRs


• Your boss is considering an investment in either Evergreen Partners or Foundation Ventures. Both funds have only one prior fund, both in their fifth year.

• Which metric would you use to make a decision? Why? How would this influence your due diligence interview?

Realized Total Realized Total

Fund Multiple Multiple IRR IRR

Evergreen Partners 1.2 3.1 14.0% 29.0%

Foundation Ventures 1.6 2.8 18.0% 26.0%

152


The Impact of FAS 157 on Unrealized MultiplesFair value reporting for illiquid investments: Ready or not here it comesFor many years, private equity funds (both venture and buy-out) carried illiquid portfolio companies at cost for at least a year or more unless a subsequent financial transaction supported a different valuation, says Roger Mulvihill, a partner at law firm Dechert.In some cases, cost basis valuations continued until liquidity. This approach, often justified as conservative, tended to understate the actual performance of privately held portfolio companies in strong markets and overstate performance in weak markets. In the most extreme example, it took some years for the full impact of the internet bubble collapse to flow through to the financial statements of some limited partners. Although generally accepted accounting principles require that investments be valued at “fair value”, and most general partners are required to furnish GAAP financials to their limited partners, private equity funds and their auditors could plausibly argue for many years that cost approximated fair value for many private companies, partly because there was little guidance from the Financial Accounting Standards Board. In September 2006, the FASB issued FAS #157, which outlined specific methodologies for valuing illiquid investments and the accompanying required disclosures. Compliance with FAS #157, which is generally effective for financial statements issued for fiscal years beginning after November 2007 and interim periods within those years, could lead to much greater volatility in reported results of private equity funds and, at a minimum, will require significantly more attention to valuations by general partners. In general, FAS #157 and the Updated PEIGG Guidelines seek to have all portfolio investments reported at fair value on a consistent, transparent, and prudent basis. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The objective is to estimate the price at which a hypothetical willing marketplace participant would agree to transact in the principal market or, lacking a principal market, the most advantageous market.


153


Sample Presentation


154


Sample Presentation


155


Persistency of Venture Capital Performance

Professor David Wessels



156


Persistence by Asset ClassMutual Funds

• “Persistence in mutual fund performance does not reflect superior stock-picking skill. Rather, common factors in stock returns and persistent differences in mutual fund expenses and transactions costs explain almost all predictability in mutual fund returns. Only the strong, persistent underperformance by the worst-return mutual funds (bottom decile) remains anomalous.” On Persistence in Mutual Fund Performance, Mark Carhart, Journal of Finance.

Hedge Funds

• “Using parametric (regression) and non-parametric (binary) methods, we examine persistence in the performance of hedge fund managers. We find a reasonable degree of persistence which seems to be attributable more to the losers continuing to be losers instead of winners continuing to be winners. … In particular, we find that there are more LLs than WWs in every quarter.” On Taking the 'Alternative' Route: Risks, Rewards, Style and Performance Persistence of Hedge Funds, VikasAgarwal and Narayan Naik, Journal of Alternative Investments


157


Persistence of Venture Capital• When investment managers consistently perform above (or below) other

managers over multiple periods, this is known as persistence.

• Kaplan and Schoar (2005) find:– Returns persist strongly across funds raised by individual private equity partnerships.

– Returns improve with partnership experience.

• Both coefficients are significant at the 95% level. The standard deviation of the noise term (e) is quite large: 22.5%


F 1 F 2IRR(F) Year Fixed Effect (.36) IRR (.42) IRR ε− −= + + +

Steven N. Kaplan & Antoinette Schoar, 2005. "Private Equity Performance: Returns, Persistence, and Capital Flows," Journal of Finance, American Finance Association, vol. 60(4), pages 1791-1823, 08

Note: Because KS includes year fixed

effects, past IRR’s are demeaned by their

vintage year returns.

158


How Reliable is Persistence?• Your boss, the Alternative Investments manager at the

New Mexico Education Retirement Fund is considering an investment in either the Wharton Ventures VI fund or the HBS Financial Institutions Fund IV.

• The historical returns on the two funds have been:


Vintage Year

Number of Funds IRR

1980 22 23%1981 24 13%1982 29 5%1983 65 14%1984 74 15%1985 59 23%1986 61 13%1987 97 14%1988 71 12%1989 79 18%1990 45 21%1991 24 20%1992 50 23%1993 67 23%1994 68 23%1995 70 18%1996 67 19%1997 109 13%

Source: Kaplan & Schoar (2005)

Performance CharactersticsBy Fund

FundVintage

Year IRRWharton Ventures IV 1993 27%Wharton Ventures V 1997 20%

HBS Skilling Fund VI 1991 17%HBS Skilling Fund VII 1996 13%

159


How Reliable is Persistence?

• Using the estimates of Kaplan and Schoar and excess fund returns from the previous slide, what is the probability that the IRR of Wharton VI will exceed the IRR of HBS VIII? Assume the error term e is normally distributed, has a standard deviation of 22.5%, and the two fund’s returns are uncorrelated.

• What is the expected return of Wharton VI?

• What is the expected return of Harvard VI?

• True/False: Since VC performance is persistent, Wharton Ventures VI will have a higher IRR than HBS Financials Fund VIII.


160


Converting Expectation to Probability

• The fund with the higher expectation has a greater probability of outperforming the alternative fund. But what is the probability of outperformance? To determine this, we need to compute a t-stat:

• To determine the standard deviation of the difference: use the tools from portfolio theory, such that x = 1 and y = -1, covariance between the two funds equals zero.


)BCov(A,2)Var(By)Var(Ax)R~Var( 22p xy++=

B)σ(AB)E(Astatt

−−

=−

161


Determining Probability of OutperformanceRequired Steps:

1. Using the KS equation, compute each funds predicted performance.

2. Determine a t-statistic by dividing the difference by the standard deviation of the difference. To determine the standard deviation of the difference, use the portfolio rule introduced in a past lecture!

3. Use the PDF table found in every statistics book to determine the probability that the difference will be positive.


Standard Normal (Z) TableProbability (Random Variable > Cutoff)

Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.090.0 0.500 0.504 0.508 0.512 0.516 0.520 0.524 0.528 0.532 0.5360.1 0.540 0.544 0.548 0.552 0.556 0.560 0.564 0.568 0.571 0.5750.2 0.579 0.583 0.587 0.591 0.595 0.599 0.603 0.606 0.610 0.6140.3 0.618 0.622 0.626 0.629 0.633 0.637 0.641 0.644 0.648 0.6520.4 0.655 0.659 0.663 0.666 0.670 0.674 0.677 0.681 0.684 0.6880.5 0.692 0.695 0.699 0.702 0.705 0.709 0.712 0.716 0.719 0.7220.6 0.726 0.729 0.732 0.736 0.739 0.742 0.745 0.749 0.752 0.7550.7 0.758 0.761 0.764 0.767 0.770 0.773 0.776 0.779 0.782 0.7850.8 0.788 0.791 0.794 0.797 0.800 0.802 0.805 0.808 0.811 0.8130.9 0.816 0.819 0.821 0.824 0.826 0.829 0.832 0.834 0.837 0.8391.0 0.841 0.844 0.846 0.849 0.851 0.853 0.855 0.858 0.860 0.8621.1 0.864 0.867 0.869 0.871 0.873 0.875 0.877 0.879 0.881 0.8831.2 0.885 0.887 0.889 0.891 0.893 0.894 0.896 0.898 0.900 0.9021.3 0.903 0.905 0.907 0.908 0.910 0.912 0.913 0.915 0.916 0.9181.4 0.919 0.921 0.922 0.924 0.925 0.927 0.928 0.929 0.931 0.9321.5 0.933 0.935 0.936 0.937 0.938 0.939 0.941 0.942 0.943 0.9441.6 0.945 0.946 0.947 0.948 0.950 0.951 0.952 0.953 0.954 0.9551.7 0.955 0.956 0.957 0.958 0.959 0.960 0.961 0.962 0.963 0.9631.8 0.964 0.965 0.966 0.966 0.967 0.968 0.969 0.969 0.970 0.971

1.9 0.971 0.972 0.973 0.973 0.974 0.974 0.975 0.976 0.976 0.9772.0 0.977 0.978 0.978 0.979 0.979 0.980 0.980 0.981 0.981 0.982

162


Persistence does not Guarantee Performance


‐54%

‐48%

‐42%

‐36%

‐30%

‐24%

‐18%

‐12% ‐6% 0% 6% 12%

18%

24%

30%

36%

42%

48%

54%

60%

66%

72%

78%

84%

90%

WhartonForecasted

IRR = 16.2%

HarvardForecasted IRR = 8.6%

Standard Deviation of

Fund Returns = 22.5%

163


But Why Does Persistence Occur in VC?• If mutual fund performance is not persistent, why is venture capital persistent?

Compare the mutual fund investment process to the venture capitalist.


Make investment

•How does the search process work?

•At what price is the security purchased?

Hold the investment

•What occurs during the holding period?

Liquidate the investment

•How does the liquidation process work?

•At what price is the security liquidated?

• Wharton’s David Hsu (JF 2004) studies a sample of companies that receive multiple VC offers, and finds that offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10–14% discount!

David Hsu, 2004. “What Do Entrepreneurs Pay for Venture Capital Affiliation?” Journal of Finance, American Financial Association 59: 1805-1844.

164


Can “Skilled” VCs Captures Greater Wealth?

• Imagine a company with a great product, such as an exciting new game for the Nintendo Wii. How would a smart entrepreneur increase shareholder/personal wealth?

• How is a venture capitalist different? Should they capture greater wealth in the same way as a traditional business?

• Why not grow? Why not charge more?


165


The Haves and the Have-NotsCRV raises $375 million for new fundby Dan Primack, March 2012.

Charles River Ventures today will announce that it has closed its fifteenth fund with $375 million incapital commitments. The bi-coastal firm originally went out with a $300 million target just over twomonths ago, and was oversubscribed well beyond what it ultimately accepted.

CRV still has some dry powder remaining in the $320 million fund it raised in early 2009, so don't expectCRV XV to be tapped until the end of Q2 or early Q3. Recent IPOs for CRV portfolio companies includeRPX Corp. (RPXC), Broadsoft (BSFT) and The Active Network (ACTV). TechCrunch has more info.

This close – both its size and speed – fits into the VC market's larger narrative of haves and have-nots. Agroup of around two dozen firms seems able to raise what they want, when they want. The rest spendmonths, if not years, begging and pleading for a few LP crumbs. As the stratification continues to harden,it will be interesting to see how many new firms are able to break through – and if any of the current"haves" will fall out of LP favor…


166


End of Section 1Valuing High Growth Companies


167

Venture Capital & the Finance of Innovation

Screening New Venture Opportunities




8

Lecture 8 – Screening Opportunities

168


Best Practice versus Actual Practice


EHarmonyHot Or Not

Guy Kawasaki: The Art of Raising Venture Capital

“Raising venture capital is like dating. There are two kinds of dating sites in the world. One is “hot or not.” There is a picture of a person and you decide whether the person is hot or not, that’s it. At the other extreme is e-harmony. You create a psychographic. I am interested in long walks on the beach, I drive a Prius…

“Venture capital is “hot or not.” In the first five, ten or fifteen seconds, people decide – and that has important consequence. Many entrepreneurs spend the first fifteen minutes describing the background of the founders. Until I know what they do, I could care less about their background.”


169


Screen the Opportunity• An entrepreneur enters your office. What makes the opportunity

interesting? Use five minutes to structure your criteria – for instance, use three main “categories.”



170


A Fourth Dimension: Later Stage Deals



171

Venture Capital & the Finance of Innovation Lecture 9 – Key Value Drivers

Key Value Drivers




9

172



Session Overview• Traditional rules of thumb about valuation can be misleading, and in some

cases harmful. We start our discussion by demonstrating why EBITDA & Earnings Per Share (EPS) often fail to measure value

• In the second part of our discussion, we demonstrate how the value of a company can be traced to four key value drivers, core operating profit, return on capital, cost of capital, and organic revenue growth

– Value creation & the practice of finance is about tradeoffs. Although an action can lead to an improvement in one metric (such as worker productivity), it may have an adverse impact on other metrics, such as growth or capital required.

– Every business, product category, customer group, channel, must be thoroughly evaluated for the potential of growth and return on capital.

173



Two Simple Companies• Company A earns $100 million a year in after-tax profit. Part of the profit

will be reinvested in the business, the remainder distributed to investors.

EBIT (1-T)= $100

Reinvestedin business

Returnedto investors

$50

$50

Reinvestment Rate (IR) = 50%

Payout Rate = 50%

Financial Term

EBITDA= $180

$80

174



A Model of Two Simple Companies

• Assume the company plans to reinvest $50 million at a 10% rate of return.

• This investment leads to an extra $5 million in profits.

• For simplicity, we assume all ratios, investment rate etc, never change.

Company A

Reinvestment rate (IR) 50%

Return on new investment 10%

Growth in profits 5%

Year 1 Year 2 Year 3

After‐tax operating profit 100.0 105.0 110.3

Net Investment (50.0) (52.5) (55.1)

Free cash flow 50.0 52.5 55.1

175



Which Company is Worth More?• Both Company A and Company B have a starting profit of $100 million

and expected growth in profits of 5%.

• If both companies have 100 million shares outstanding, what would each company’s E.P.S. and E.P.S. growth rate be?

Company A Company B

Reinvestment rate (IR) 50% Reinvestment rate (IR) 25%

Return on new investment 10% Return on new investment 20%

Growth in profits 5% Growth in profits 5%

Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

After‐tax operating profit 100.0 105.0 110.3 After‐tax operating profit 100.0 105.0 110.3

Net Investment (50.0) (52.5) (55.1) Net Investment (25.0) (26.3) (27.6)

Free cash flow 50.0 52.5 55.1 Free cash flow 75.0 78.8 82.7

176



EPS Growth: Only Part of the Story!Boston Scientific 3rd-quarter loss narrowsBill Berkrot, Reuters

NEW YORK, Oct 21 (Reuters) - Boston Scientific reported a smaller third-quarter net loss on Tuesday as increased sales of implantable defibrillators helped to offset charges and a decline in sales of its drug-coated stents.

The company's adjusted profit of 18 cents per share topped Wall Street expectations by 2 cents, according to Reuters Estimates. Total net sales for the quarter fell to $1.98 billion from $2.05 billion, but that was in line with Wall Street expectations.

"It was kind of an on-target quarter and right now with Boston Scientific, not falling below the range of expectations is a good thing," said Phillip Nalbone, an analyst with RBC Capital Markets.

Source: Wall Street Journal

Boston Scientific

Source: Yahoo! Finance

177



The Drivers of Profit Growth• Before we value the two companies, let’s examine a general relation between

IR (reinvestment rate), ROIC (return on invested capital), and g (growth).

Growth = Reinvestment * Rate of Return

G = IR * ROIC

Company A

Reinvestment Rate (IR) 50%

Return on New Investment 10%

Growth in Profits 5%

Company B

Reinvestment Rate (IR) 25%

Return on New Investment 20%

Growth in Profits 5%

Company A: 5% = 50% * 10%

Company B: 5% = 25% * 20%

178



Session Overview• Traditional rules of thumb about valuation can be misleading, and in some

cases harmful. We start our discussion by disavowing two rules of thumb.

– Lesson 1: Value is driven by growth, but not all growth is created equal

– Lesson 2: EBITDA & Earnings Per Share (EPS) often fail to measure value

• The value of a company can be traced to four key value drivers, core operating profit, return on capital, cost of capital, and organic revenue growth

– Value creation & the practice of finance is about tradeoffs. Although an action can lead to an improvement in one metric (such as worker productivity), it may have an adverse impact on other metrics, such as growth or capital required.

– Every business, product category, customer group, distribution channel, must be thoroughly evaluated for the potential of growth and profitability.

179



The Growing Perpetuity Formula• A company is worth the present value of its future free cash flow. For example,

Company A can be valued as:

.........WACC)(1

FlowCashWACC)(1

FlowCashWACC)(1

FlowCashValue 33

221

gWACCCashflowValue 1

.........10).(1

55.1(1.10)

52.510).(1

50Value 32

• In our simple example, cash flows grow forever at a constant rate. Therefore, we can use the growth perpetuity formula to value each company.

via the Growing

PerpetuityFormula

180



What Drives Value?

As Cash Flow rises, what happens to value?

As WACC rises, what happens to value?

As growth rises, what happens to value?

gWACCFlowCashValue 1

But what

determines cash flow?

181



Deriving the Key Value Driver Formula• In order to develop the key value driver formula, we will rely on two

simple substitutions.

gWACCROIC

g1Profit

gWACCIR)Profit(1

gWACCFlowCashValue 1

Substitution #1

Cash Flow = Profit (1 – IR)

Substitution #2

Growth = IR x ROIC

182



The Key Value Driver Formula

gWACCROIC

g1ProfitValue

Company A

Company B

Terminology used by Consulting Firms

Profit – After-tax Operating Profit (NOPAT/NOPLAT )

ROIC - Return on Invested Capital (ROI/RONIC/ROCE/RONA)

WACC - Weighted Average Cost of Capital (Hurdle Rate)

g – Long term growth in profit and cashflows

183


Driving Value through Organic Growth• You sit in corporate headquarters evaluating international expansion proposals.

Algeria (whose characteristics mirror company A) and Belgium (whose characteristics mirror company B) are presenting their proposals.

• Algeria can increase projected growth from 5% to 8% while Belgium can increase it from 5% to 6%. If both countries require the same resources to accelerate growth and headquarters can only fund one plan, which should it choose?


Algeria

Value = 1000, Value =

Belgium

Value = 1500, Value =

20

184



What Drives Value?

As starting Profit rises, what happens to value?

As ROIC rises, what happens to value?

As WACC rises, what happens to value?

As growth rises, what happens to value?

gWACCROIC

g1ProfitValue

185



• As we will show later, if the spread between ROIC and WACC is positive, new growth creates value.

• The market value of a company, with a starting Profit of $100 million, and a 10% cost of capital, is as follows:

The Growth/Value Matrix

7.5% 10.0% 12.5% 15.0%

2% $917 1,000 1,050 1,083

Growth 4% 778 1,000 1,133 1,222

6% 500 1,000 1,300 1,500

ROIC

186



How Growth Drives Value• In 1995, two Fortune 500 companies had $20 billion in revenue. Since then

one company has grown dramatically. Which company is the high-growth company? A or B?

0

20

40

60

80

1995 1998 2001 2004 2007 2010

$ billion

s

Aggregate Revenues 1995‐2010

10.0%

4.4%

Company AMarket Capitalization ($ billions) 146.6Enterprise Value ($ billions) 158.4Forward P/E (FYE '11) 18.1PEG Ratio (3‐year expected): 1.5ROIC (via Thomson First Call): 21.0%

Company BMarket Capitalization ($ billions) 31.7Enterprise Value ($ billions) 34.0Forward P/E (FYE '11) 21.8PEG Ratio (5 yr expected): 1.2ROIC (via Thomson First Call): 9.6%

Source: Thomson First Call, Jan‐11

187



The Value of Alternative Strategies

• Assume your company earns a 15% return on invested capital, while growing at 2%. The new CEO has argued the company should grow faster, even if it means some sacrificing financial performance. What do you think?

• Assume your company earns a 10% return on invested capital, while growing at 6%. The new CEO has argued the company should focus on higher profit customers, even if it means reducing growth. What do you think?

7.5% 10.0% 12.5% 15.0%

2% $917 1,000 1,050 1,083

Growth 4% 778 1,000 1,133 1,222

6% 500 1,000 1,300 1,500

ROIC

188



• As long as the spread between ROIC and WACC is positive, new growth creates value. In fact, the faster the firm grows, the more value it creates.

• If the spread is equal to zero, the firm creates no value through growth. The firm is growing by taking on projects which have a net present value of zero!

• When the spread is negative, the firm destroys value by taking on new projects. If a company can not earn the necessary return on a new project or acquisition, its market value will drop (and often does).

Creating Value: To Review

189

Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities

Evaluating High-Growth OpportunitiesAn Analysis of AtriCure




10

190


Finance of Innovation


• Value Creation: A Focus on Key Value Drivers. A company / project’s value is driven by organic revenue growth and return on capital. For new opportunities with great uncertainty, a top-down focus on critical value drivers is more insightful than a detailed line-by-line valuation.

– What are the long-run economics (margins, etc) of this business in this industry?

– How quickly will the company move from its current performance to long-run economics

• Cash Burn: Value Drivers Also Drive Cash Burn. Unlike established companies with easy access to capital, high growth companies must focus on value creation and cash burn. When revenue growth outstrips return on capital, the company will typically consume cash.

191



What Drives Value?

gWACCROIC

g1ProfitValue

• A company’s value is driven by:

• Its ability to earn healthy margins, as represented by its core operating profit

• An ability to generate strong returns on capital, through good margins and high capital efficiency

• A well-engineered cost of capital, through the efficient use of debt and equity.

• The ability to grow. Growth can come through selecting high growth markets, stealing share from others, and acquisitions – but each comes with its own return characteristics!

The “Zen” of Corporate Finance

192



Dynamic Value Driver Framework: ROIC

• A company / project’s value is driven by organic revenue growth and return on capital.

• For new opportunities with great uncertainty, a top-down focus on critical value drivers is more insightful than a detailed line-by-line valuation.

• Start by assessing how, why, and when ROIC will exceed the cost of capital.

-10%

0%

10%

20%

30%

0 5 10 15 20

Time

ROIC and WACC Projections

CapitalUnitsx

UnitsCost)(RevenueROIC

193


An Example: Amgen

• When companies are not earning the cost of capital, you must assess two questions:

– How long will it take before the company starts creating value?

– How large will the initial investments (or losses) be?

• Amgen failed to earn its cost of capital until Epogen, its blockbuster drug, was approved by the FDA.

Professor David Wessels The Wharton School of the University of Pennsylvania

Percent

ROIC at Amgen (1984- 2003)ROIC measured as 3-year rolling average

194


An Example: Intel

• Two distinct periods of value creation have occurred at Intel Corporation: Memory chips in the 1970s and Microprocessors in the 1990s.

• Although an early leader in memory chips, new foreign competition lowered prices, driving down ROIC.

• In the 1990s, Intel reestablishes a competitive advantage through its reinvention as the “brains” of the personal computer.


ROIC at Intel Corporation (1973- 2003)ROIC measured as 3-year rolling average

Percent

195


ROIC Decay Rates• ROIC demonstrates a pattern of mean reversion. Companies earning high

returns tend to gradually fall over the next fifteen years and companies earning low returns tend to rise over time.


ROIC Percent

>2015-2010-15

5-10<5

Number of years following portfolio formation

Median ROIC of portfolio*

At time “zero”, companies are grouped

into one of five portfolios, ranked by their current ROIC

Source:Compustat; McKinsey & Company’s corporate performance database

196



Dynamic Model of Value Creation

Core OperationsReturn on Capital

Time

Making the InvestmentHow large is the necessary investment?

Are investments tangible or intangible?

How long will it take to “get to market?”

Capturing the ReturnWhat is the maximum return on investment the business can provide?

Is the product differentiable?

Is the ROI driven by price premiums or financial discipline?

Protecting the ReturnAre there barriers to entry? How quickly can competition duplicate our efforts?

197



Dynamic Value Driver Framework: Growth

• To value a new opportunity, you must size the addressable market and project adoption rates.

• Market sizing can be done top-down (through filters) or bottom-up (through channel aggregation).

• A helpful tool is Everett Rogers’ Innovation ACCORD model, which examines the product or service from the customer’s perspective:

– Relative (A)dvantage to what it replaces

– Compatibility with current behaviors / systems

– Complexity of communicating the benefits

– Observability of the products benefits

– Risk of product failure

– Divisibility or trialability.

0

20

40

60

80

100

0 5 10 15 20$

mill

ions

Time

Revenue Projections

Initial investment

Liquidity event

198


Market Sizing: A Momentum Perspective• Knowing the size of an end market is a great start. But how quickly can companies

grow? We examined the growth rates of 100 publically traded technology start-ups between 1995 and 2008.


Years 1-4 Years 5-8 All Years

Upper Quartile 89.0% 17.8% 49.3%

Median 52.4% 16.3% 33.1%

Lower Quartile 32.0% 13.8% 22.6%

Average Growth Rates by Period

0

50

100

150

200

250

300

1 2 3 4 5 6 7 8 9

$ millions

Revenue for Public Technology Start‐Ups after Reaching the $10 million Threshold

199


Market Sizing: A Momentum Perspective


Source: New York Times

• With advances in distributional channels and the improved availability of external funding, time to full penetration has dwindled. Whereas, the computer took 50 years to capture 60% share, the Internet accomplished 60% share in fifteen years.

200



ROIC vs. DCF Valuations

Core OperationsCash Flow Projections

Time0

requires consistency


Time

• Measuring how cash flows through the firm is simple and cash flow is difficult to game. Consequently, DCF is a favorite among academics.

• ROIC-based valuation, however, tie much more closely to corporate strategy, competitive positioning, barriers to entry, etc. Both provide benefits!

201


An Analysis of AtriCure




202


AtriCure: The Product


AblationIn medicine, ablation is the removal of a part of biological tissue, usually by surgery. Surface ablation in the skin (also called resurfacing, because it induces regeneration) can be carried out by chemicals (peeling) or by lasers.

AF (Atrial Fibrillation)AF is the fibrillating (i.e., quivering) of the heart muscles of the atria, instead of a coordinated contraction.

The atria are the chambers in which blood enters the heart, as opposed to the ventricle, where blood is pushed out to the organs.

203


AtriCure: The Founder

• AtriCure was founded by Mike Hooven in West Chester, Ohio (outside of Cincinnati).

• Not well known as a capital of innovation, why would a founder choose West Chester, Ohio to headquarter a company?


West Chester, Ohio

AtriCure

204


AtriCure: The Founder• AtriCure was founded by Mike Hooven in 2001. Prior to launching

AtriCure, Hooven was director of new product development for Ethicon Endo-Surgery, a Johnson & Johnson operating company located in the Cincinnati suburbs. "I told my superiors right from the start that I wanted to work here for about five years, get the experience, and make the contacts so I could start my own business and sell products back to the J&J's of the world”

• Based on Hooven’s work experience, what are the positives associated with his background? What are the negatives?


RIM

205


AtriCure: The Investors• In its first outside investment, the company issued

2,182,521 shares of Series A Preferred Stock at $2.39 per share to U.S. Ventures. In exchange for the Series A Preferred Stock, the Company received $4,025,000 in cash and converted a $1,150,000 promissory note and the related accrued interest of $49,958.

• In the second round, AtriCure issued 3,829,499 shares of Series B Preferred Stock at $5.43 per share. In exchange for the Series B Preferred Stock, the Company received $17,274,500 in cash and converted a $3,500,000 note and the related accrued interest of $35,000. Second round financed by Camden Partners, Charter Ventures, Foundation Medical Partners.


20 1,766

9,792

19,157

30,957

Founding Year 2 Year 3 Year 4 Current

AtriCure Revenues in $ thousands

Series A Series B

206


U.S. Ventures (USVP)


• Since 1981, USVP has invested more than $1.8 billion in over 350 companies. More than 70 companies achieved IPO. Many others have realized positive merger outcomes

• Bill Bowes, who has 50 years of venture investment experience, was also the founder of Amgen, a $70 billion pharmaceutical company.

• The firm’s investment interests include components, software, systems, services, and life sciences. Areas of current focus include semiconductors, software as a service, networking solutions for storage, wireless data, the Internet version 2.0, biomedical devices and new drugs with profound social benefits.

207


Due Diligence: Value Creation• Imagine you are taking a meeting with the founder of AtriCure. Using the value

creation framework we developed earlier in class, take notes on pertinent information. At the end of the video, be prepared to present your thoughts.


208


A Note on Technical Expertise• The benefits of this procedure are the immediate confirmation of a

transmural ablation line as exhibited by the presence of an entrance and exit block. The disappearance of the excitation from the ganglionic plexi and the removal of the left atrial appendage. 5:39.


209


Innovation and the Status Quo

• Drug Therapies. Currently available drugs are often ineffective, not well-tolerated and may be associated with severe side effects. For these reasons, drug therapy for AF fails for as many as 50% of patients within one year. Of those who initially respond to drug therapy, only approximately 25% of patients can continue to be managed with drugs after five years.

• Implantable Devices. Implantable devices, such as defibrillators and pacemakers, can be effective in reducing the symptoms and frequency of AF episodes, but neither device is intended to treat AF. Patients may continue to experience the adverse effects of AF as well as some of the symptoms and complications, including dizziness, fatigue, palpitations and stroke, because the AF continues.

• Catheter-Based Treatment. A catheter ablation is an ablation procedure that is typically performed by an electrophysiologist. The ablations are made from the inside of the heart using a flexible catheter. The heart is reached via a blood vessel, most commonly through the femoral vein. Catheter-based AF treatments are often technically challenging, can be associated with serious complications and have been known to yield inconsistent results. In proportion to the prevalence of AF, only a small number of catheter-based AF treatments are performed each year in the United States.

• Cut and Sew Maze. The cut and sew Maze procedure is a highly invasive open-heart surgical procedure that involves the use of a heart-lung bypass machine and cutting and sewing back together sections of the heart in order to block the abnormal electrical impulses causing AF. Although this procedure is highly effective at treating AF, it is rarely performed because it requires extensive open-heart surgery, is technically challenging and is typically associated with long recovery times. For these reasons, only a limited number of these procedures have been performed by a small number of cardiothoracic surgeons.


According to AtriCure:

210


Value Creation: Analyzing Magnitude• Assessing the level of innovation is subjective and requires synthesis of

multiple points of information. For instance, consider the analysis presented by “our” expert (Wharton graduate and physician) Aman Kumar:


Option How Invasive

Local or General Anesthetic

Op Time Time in Hospital

Success Rate

Drug Therapy 1 - - - 50-80%

DC Cardioversion 2 LA + sedation ½ hr <1day <50%

Catheter Ablation 4 LA + sedation 2hrs <1day 70%

Pacemaker 5 LA 1-2hr 1day 99%

ThorascopicAblation

8 GA 2-3hrs 3-4 days 80-85%

Cox-Maze(III)Procedure

10 GA 2-4hrs 5-7 days >95%

211


Customer Need: Who is the Customer?• The end customer is clearly the patient. But many others will influence

the purchase decision, and subsequently the ability for AtriCure to generate revenue. Who are the “influencers?”


Patient

212


Status Quo: The Doctor’s Perspective


Source: Manual of Intensive Care, Irwin and Rippe

While the consumer has some clout in the treatment process, the key decision maker is the doctor. The current decision process for the treatment of Atrial Fibrilation is outlined below:

Synchronized DC

cardioversion

Atrial Fibrilation

Consider possible underlying causesHemodynamically stable/less severe

symptomsHemodynamicallyunstable or severe

symptoms attributable to atrial fibrilation; angina, heart failure

Rate control β‐blocker

Calcium Channel BlockerDigoxin

Amoidarone

Duration of AF < 48 h

Duration of AF > 48

h or uncertain

Pharmacologic cardioversion (class Ia, Ic, or class III agent)

orElective DC cardioversion

or Long‐Term Strategy of rate control

and anticoagulation

Coumadin (warfarin) with INR 2‐3 for 3 weeks before and 4

weeks after elective DC cardioversion

orTEE to exclude left atrial

thrombus, IV heparin, early DC cardioversion followed by

>4 weeks warfarinor

Long‐term strategy of rate control and anticoagulation

Long term coagulation if recurrent AF and moderate or high risk. Consider long‐term antiarrhythmic or rate

control therapy if recurrent

What Does it Mean in English?

• Hemodynamically stable – normal circulation of blood, normal blood pressure.

• Coumadin (warfarin) - a controversial drug initially used as a pesticide against rats and mice, now used to prevent blood clots from forming (anticoagulant). A common side effect is hemorrhage (internal bleeding), which is the method used to kill rodents and by which it adversely affects many patients.

• Cardioversion - medical procedure by which an abnormally fast heart rate is converted to a normal rhythm by using electricity or drugs.

213


Due Diligence: Market Sizing


• What opportunities generate excitement among venture capitals and senior executive teams alike? Those that open the doors to large market opportunities. For AtriCure, how large is the market for RF ablation?

Infiniti Medical LLC

Addressable Market

Largest Possible Market

1.

2.

3.

4.

5.

6.

7.

Subset

214


Market Sizing as a Roadmap to Growth• A good market sizing analysis can lead not just to an appropriate market size, but also a

road map for growth plateaus. Once a plateau is reached, the company can release the next filter point to generate new growth.


Affordability

Proper Diagnosis

0

50

100

150

200

250

300

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

$ millions

Forecast Year

PortfolioCo Revenue Projections

Affordability

Proper Diagnosis

215


Market Sizing: Academic Research• From four large recent population-based surveys, we estimated the overall age- and gender-specific

prevalence of AF. These estimates were applied to the recent US census data to calculate the number of men and women with AF in each age group. There are an estimated 2.2 million people in the United States with AF, with a median age of about 75 years. The prevalence of AF is 2.3% in people older than 40 years and 5.9% in those older than 65 years. Approximately 70% of individuals with AF are between 65 and 85 years of age1.

• The number of patients with AF is increasing throughout the industrialized world as the population ages. In the United States, the prevalence of AF is expected to grow 2.5-fold to 5.6 million by 2050, and over half of those afflicted will be age 80 or older. As the burden of this disorder grows, increased emphasis will be placed on developing more effective ways to treat AF to reduce its associated morbidity and mortality2.

1. Feinberg WM, Blackshear JL, Laupacis A, Kronmal R, Hart RG. Prevalence, age distribution, and gender of patients with atrialfibrillation. Arch Intern Med. 1995;155:469-473.

2. Go AS, Hylek EM, Phillips KA, Chang Y, Henault LE, Selby JV, Singer DE. Prevalence of diagnosed atrial fibrillation in adults: National implications for rhythm management and stroke prevention: the AnTicoagulation and Risk Factors in Atrial Fibrillation (ATRIA) study. JAMA. 2001;285:2370-2375.


216


Appendix


217


The Story behind AtriCure• The traditional notion is that entrepreneurs are born and not bred-either you've got that risk-taking spirit in your core and you can deal with the

uncertainties that go along with start-up culture, or you don't. For Mike Hooven, founder, president and CEO of West Chester, Ohio-based AtriCure Inc., there was never any doubt about which group he fell into. Prior to launching AtriCure, Hooven was director of new product development for Ethicon Endo-Surgery, a Johnson & Johnson operating company located in the Cincinnati suburbs. "I told my superiors right from the start that I wanted to work here for about five years, get the experience, and make the contacts so I could start my own business and sell products back to the J&J's of the world," Hooven explains.

• For Hooven, the entrepreneurial itch was so strong that when, true to his plan, he left Ethicon in April 1994 to found his own company, Enable Medical Inc., it was without the slightest notion of what kind of technology or what clinical area Enable would focus on. One of the first things Hooven set out to do was meet with physicians in an effort to come up with an unmet clinical need for which he could develop a new product. Dan Smith, MD, a surgeon who had recently joined the faculty of the University of Cincinnati Medical Center from the Mayo Clinic, was among the first clinicians Hooven met with, and when Hooven told Smith he had just started a medical device company, Smith said, "OK, show me what you've got." Hooven handed Smith his business card and said, "That's it.“

• Hooven used his contacts with physicians like Smith and his own device background to look at a range of technologies and clinical applications, and initially drew upon his background at Ethicon in radio-frequency (RF) energy devices to set the product development path in motion at Enable. The company developed a variety of instruments for endoscopic and minimally invasive surgery (MIS) that were sold both as OEM and branded devices. After employing this strategy for five years at Enable, Hooven got some unsolicited advice from his mentor and Enable investor, Norm Weldon. "I told him, 'None of us is ever going to make any real money unless we can concentrate on a single, high value, large market opportunity,'" Weldon recalls. At that point, Hooven came under the tutelage of Enable board member, Donald Harrison, MD, former chief of cardiology at the Stanford University Medical Center, then at the University of Cincinnati, who helped Hooven explore potential market opportunities. Based on those discussions, Hooven came up with an idea for an atrial fibrillation (AF) device. While that initial device proved unsuccessful, Hooven realized that he had found the major opportunity he'd been after, and in November 2000, spun AtriCure out of Enable to focus exclusively on AF. Atrial fibrillation, once thought of as a benign condition affecting a relatively small patient population, has recently been found to be a major contributor to stroke and congestive heart failure (CHF), and to afflict a much larger patient pool, particularly as the population ages, making AF one of the largest unmet cardiovascular clinical opportunities.


218


The Story behind AtriCure• AtriCure's proprietary RF ablation technology will be used either as an adjunct to a cardiothoracic procedure or as a stand-alone minimally

invasive procedure. The significance of this technology is that it provides surgeons with an elegant device that ensures the creation of transmural lesions (completely penetrating tissue), which have been shown, through a complex surgical procedure, to be the only way to cure AF. All other current available means of treating AF are palliative, not curative. The curative surgical procedure is a traumatic surgery called the Maze procedure, which because it is so hard on the patient and complex for the surgeon, is rarely performed. Palliative treatments are limited to drug regimens that are often ineffective and can produce serious side effects, or electrophysiology (EP) and cardiac rhythm management procedures that are only used for a relatively small number of patients since they only offer temporary relief.

• Clearly the size of the AF market offers a tremendous opportunity for a start-up like AtriCure, even in its initial ability to address only a segment of the total AF patient pool. But this opportunity does not come without challenges. Cardiovascular surgeons are notoriously slow adopters of new technology. AtriCure claims that initial surgeon reaction to its device has been extremely positive because it is very easy to use and requires no significant learning curve. And the company also knows that, with surgeons losing increasing numbers of potential bypass surgery candidates to interventional cardiologists, a trend that only looks to continue with the advent of drug-coated stents, a device that may open up a new patient population for surgeons may be welcomed.

• But every major cardiovascular device company is looking to enter the AF space, as are many start-ups, utilizing a variety of energy sources and both surgical and interventional approaches. The question for AtriCure is whether its first-mover advantage in generating transmurallesions, which is likely to result in the company's device being used initially by surgeons for the adjunctive treatment of AF, can provide the company with the momentum that will enable it to drive more broad-based adoption aimed at the ultimate goal of treating AF as a stand-alone procedure. Phrased differently: can AtriCure establish itself as a technology leader in this market in time to withstand the inevitable stampede of competition that is likely not far behind, or will it ultimately remain a niche player?


219

Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn

Value Creation: Value Drivers and Cash Burn




11

220


The Finance of Innovation


• Value Creation: A Focus on Key Value Drivers. A company / project’s value is driven by organic revenue growth and return on capital. For new opportunities with great uncertainty, a top-down focus on critical value drivers is more insightful than a detailed line-by-line valuation.

– What are the long-run economics (margins, etc) of this business in this industry?

– How quickly will the company move from its current performance to long-run economics

• The Link between Value Drivers and Cash Burn. Unlike established companies with easy access to capital, high growth companies must focus on value creation and cash burn. When revenue growth outstrips return on capital, the company will typically consume cash.

221



A Growing Company• How quickly a company can grow depends on four key variables: operating

margin, capital efficiency, cash buffer (leverage), and investor payout.

Key DriversOperating margin =

Capitalturnover =

Cash reserves = 30%

Investor payout rate = 15%

Revenue growth =

CashBurn CoFinancial Statements

Item Amount Net Assets Debt and Equity

Revenues 2,000 Operating capital 1,200 Debt 0

Operating expenses (1,800) Cash reserves 360 Equity 1,560

After‐tax profit 200 Total funds invested 1,560 Total funds invested 1,560

Item Amount Assets Liabilities

Revenues 2,245 Operating capital Debt

Expenses Cash reserves Equity

After‐tax profit Total funds invested Total funds invested

Operating capital equals operating assets (inventory, PP&E, etc) less operating l iabil ities (payables, etc)

Balance Sheet ‐ 2011

Balance Sheet ‐ 2012E

Income Statement ‐ 2011

Income Statement ‐ 2012E

222



An Example of a Cash Shortfall

Key DriversOperating margin = 10%

Capitalturnover = 1.67

Cash reserves = 30%


Revenue growth = 30%

• If revenue growth is too high, the project/company will run out of cash. To prevent this, profitability needs to improve, capital efficiency must rise, or the company must raise capital.







Revenues 2,600 Operating capital Debt

Expenses Cash reserves Equity

After‐tax profit Total funds invested Total funds invested


Income Statement ‐ 2011 Balance Sheet ‐ 2011

Income Statement ‐ 2012E Balance Sheet ‐ 2012E

223



The Sustainable Growth Rate: Derivation

d)(1POCE

SOCS

OCE

SOCS 2

1

1

1

11

2

2

2

22

d)(1POCE

SOCSS 212

• As a general rule, a company’s current equity equals its previous equity plus reinvested profit. Reinvested profit equals after-tax operating profit less after-tax interest and dividends. We proxy for interest and dividends, by using a “investor” payout rate (d).

• Next we multiply both sides by “Sales / Sales” and “Operating Capital / Operating Capital” to create ratios which contain the inverse of capital turnover and financial leverage:

• Next, we assume that capital turnover and the cash buffer won’t change. Thus, we eliminate the subscripts and rearrange:

d)(1PEE 212

224


The Sustainable Growth Rate: Derivation


d)(1POC

CashOCS

OCSS 212

d)(1POC

Cash1S

OCSS 212

d)(1SPS

OCCash1

SOC

SSSS

2

22

1

121

• Next, multiply the left side by “S1/S1“ and the right side by “S2/S2”.

• Simplify the term the third term:

• From the previous slide, convert equity (E) into OC + Cash. Note, this assumes the start-up has no debt. For companies that can raise debt, substitute D + E for Operating Capital (on the last slide).

225



The Sustainable Growth Rate: Derivation• Move S1, asset turns, and financial leverage to the right.

• Given that “g = (S2 – S1)/ S1”, and “1+g = S2 / S1”,

OCCash1

d)(1OCS

SP

SSg

1

2

• We are close, but have the following “ugly” equation:

xg1

g

OCCash1

d)(1OCS

SP

g1g

x-1xg

226



The Sustainable Growth Rate• Given a fixed (1) return on invested capital, (2) financial leverage ratio, and (2) re-

investment rate, the sustainable sales growth is pre-determined.

• Revisit Cashburn Co from earlier in this note. Based on the characteristics of this company, what is the company’s sustainable growth rate?

(1 payout)step1 margin capital productivity

1 cash cushion

step 1sustainable growth1 - step 1

ROIC Financial Flexibility

227



The Sustainable Growth Rate: No New Equity• How quickly a company can grow depends on four key variables: operating

margin, capital efficiency, cash reserves, and investor payout.








Expenses (2,020) Cash reserves 404 Equity 1,751



Income Statement ‐ 2011 Balance Sheet ‐ 2011

Income Statement ‐ 2012E Balance Sheet ‐ 2012E

Key DriversOperating margin = 10%

Capitalturnover = 1.67

Cash reserves = 30%


Revenue growth = 12.2%

228



The Need to Raise Additional Capital• When growth occurs too quickly, i.e. actual growth exceeds return on

capital x leverage x payout, there will be a cash shortfall.

• To avoid raising additional capital, ROIC needs to improve, payout must drop, the firm must borrow beyond expected levels. Otherwise, additional capital will need to be raised.

* Traditional research, as reported in Smith and Smith (2003) and Higgins (2006), uses net income and total assets to determine the sustainable growth in equity. Our definition focuses on operating profit, operating capital, and growth in sales.

ROIC x Financial Flexibilityg1 - ROIC x Financial Flexibility

actual growth sustainable growth

For startups, financial flexibility equals (1-d) / (1+cusion).

For companies with debt, financial flexibility equals (1-d) x (1 + D/E).

229



Start-Ups: No Payout or Cash Cushion• Given a fixed (1) return on invested capital, (2) financial leverage ratio, and (2) re-

investment rate, the sustainable sales growth is pre-determined.

• For the typical startup, payout = 0 and the cash cushion can be drained to zero. In this case:

cushioncash1payout)(1typroductivi capitalmarginx

ROICtyproductivi capitalmarginx

ROICROIC-1

ROICg

230


ROIC & Growth Drive Cash Burn• Overlaying the two key value drivers, we can determine when a company will

need to raise additional capital. This is consistent with startups requiring capital and mature companies generating significant cash.


‐30%

‐20%

‐10%

0%

10%

20%

30%

40%

50%

0 5 10 15 20

Year

Key Value DriversValue Creation

‐30%

‐20%

‐10%

0%

10%

20%

30%

40%

50%

0 5 10 15 20

Year

Key Value DriversCash Burn Rates

The value of a company should not depend on the methodology used. So why do the areas look so different?

231


The Discipline of Capital Markets

• In this class, we are focused on the early years of value creation. Interesting dynamics happen in the later years as well.

• If you were on the board of directors of the company on the right, what would you recommend to the board in year 15?


‐15%

‐5%

5%

15%

25%

0 5 10 15 20

Year

Key Value DriversValue Creation

232


An Example: CashBurn Co• You project the revenue growth and return on capital for CashBurn Co, a high-growth

start-up. The company has $4 million in cash reserves generated from a Series A financing.

• Based on the projections below, when will it need another round of financing?


0

5

10

15

20

25

1 2 3 4 5 6 7 8 9

$ millions

Years since Series A Round

CashBurn CoRevenue Projections

‐30%

‐20%

‐10%

0%

10%

20%

30%

40%

1 2 3 4 5 6 7 8 9

Years since Series A Round

CashBurn CoReturn on capital

233


CashBurn Co: Cumulative Cash Needs• When ROIC is below revenue growth, cash is consumed. Therefore, the

company will need funding through year 5. According to the cash burn calculations, the original financing will finance only 3 years under the current projections.


‐40%

‐20%

0%

20%

40%

‐4

‐3

‐2

‐1

0

1

2

3

4

1 2 3 4 5 6 7 8 9

$ millions

Years since Series A round

CashBurn Co Cash Flow Projections

Revenuegrowth

Annualcash burn 0.1

1.7

4.3

7.0

8.57.9

5.7

2.6

‐1.0‐2

0

2

4

6

8

10

1 2 3 4 5 6 7 8 9

$ millions

Years since Series A round

CashBurn CoCumulative Cash Burn

234


CashBurn Co: Financial Data


CashBurn CoCash Burn using Key Value Drivers

$ millions Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9Revenue 1.00 3.50 7.88 12.80 16.80 19.42 20.94 21.76 22.18Cost of sales (1.10) (3.82) (8.35) (13.05) (16.29) (17.48) (18.01) (18.17) (18.41)After‐tax profits (EBITA) (0.10) (0.32) (0.47) (0.26) 0.50 1.94 2.93 3.59 3.77

Incremental capital n/a (1.25) (2.19) (2.46) (2.00) (1.31) (0.76) (0.41) (0.21)Free cash flow (0.10) (1.57) (2.66) (2.72) (1.50) 0.63 2.17 3.18 3.56

Supplemental Calculations:Operating capital 0.50 1.75 3.94 6.40 8.40 9.71 10.47 10.88 11.09Cumulative cash needs ‐0.10 ‐1.67 ‐4.33 ‐7.04 ‐8.54 ‐7.91 ‐5.74 ‐2.55 1.00

Key Value Drivers

percent Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9Revenue growth 500% 250% 125% 63% 31% 16% 8% 4% 2%

After‐tax operating profit ‐10% ‐9% ‐6% ‐2% 3% 10% 14% 17% 17%Capital turnover 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0Return on capital ‐20% ‐18% ‐12% ‐4% 6% 20% 28% 33% 34%

235

Venture Capital & the Finance of Innovation Lecture 12 – Mapping Value Drivers to DCF

Venture Capital Valuation: Mapping Value Drivers to DCF




12

236


A Practical Perspective on VC Valuation• Many venture capitalists have their own “sweet spot” for ownership percentages and

funding amounts for Series A investments. What implication does this have for valuation? How should the founder respond?


25% 27% 29% 31% 33% 35% 37% 39% 41% 43% 45%

RedCap VenturesOwnership Percent (Series A)

2.00 2.25 2.50 2.75 3.00 3.25 3.50

RedCap VenturesAmount Invested (Series A)

$ millions

Reluctance Reluctance Reluctance Reluctance

237


Industry Data on Ownership and Capital, Q3 2011• “We do not invest strictly based on discounted cash flow or a terminal value.

Our primary goal is to invest in companies that will become a lasting and strong presence in very large markets.” – High Profile VC.


Source: Wilson Sonsini Entrepreneurs Report, 2011. WSGR Database.

ImpliedValuation

238


Financial Analysis of AtriCure


• The key value driver formula relied on a perpetuity – which assumes the company has reached a steady state. For Atricure, neither growth rates or margins are stable. Therefore, we rely on a five-year forecast model, combined with a reasoned exit multiple.

• In this VC valuation model:

– The first five years of cash flows are projected and discounted

– The terminal value is determined using a “intermediate” or “steady-state” competitor multiple (i.e. a competitor who is at steady-state today).

239



Basic Valuation FrameworkAtriCure IncHybrid DCF Valuation

$ thousands Today Year 1 Year 2 Year 3 Year 4 Year 51 Revenues 30,957 39,006 48,367 59,492 72,580 83,467

2 EBITDA (10,643) (11,312) 2,805 5,949 10,887 20,867Depreciation (160) (202) (250) (308) (375)Operating profit (EBITA) (10,803) (11,513) 2,555 5,641 10,512

3 Operating taxes 4,030 (894) (1,975) (3,679)After‐tax operating profit (7,484) 1,661 3,667 6,833

4 Incremental investment (1,730) (2,012) (2,391) (2,814) C.V.Free cash flow (9,214) (352) 1,276 4,019 166,934 5

6 Discount factor 1.09 1.19 1.30 1.41 1.41Discounted cash flow (8,453) (296) 985 2,847 118,260

Key Value DriversRevenue growth 26.0% 24.0% 23.0% 22.0% 15.0%Cash operating margin ‐29.0% 5.8% 10.0% 15.0% 25.0%Capital turnover 4.7 4.7 4.7 4.7 4.7

Forecast

240



Quantifying Value Drivers

• A good historical analysis might give some insights concerning revenue growth and capital productivity, but is unlikely to tell you much about margins.

• To create a meaningful valuation, you must bound reasonable estimates of:

Key Inputs

1. Revenue growth. How fast is the aggregate market growing? How fast is the company capturing relevant share?

2. Operating margin. What do established companies in the field generate in margins?

3. Operating tax rate. Does the company have tax loss forward to shield future taxes?

4. Required investment. How much investor capital is required to grow the business?

5. Terminal value. What is the appropriate terminal multiple? Examine industry multiples company by company to understand differences.

6. Discount rate. For venture funded companies, the discount rate should be determined by the CAPM, not arbitrary rates!

241


Revenue Projections• The most critical aspect of valuing a venture opportunity is sizing the

relevant market. A top down forecast, starts with the global population and narrows the market size by relevant discriminators.


37 4254

6887

103122

148

178

AtriCureFounding

Year 3 Year 5 Year 7 Year 9

Aggregate Surgical AF MarketRevenue Forecast

$ millions

Global Population

Heart Conditions

Atrial Fibrillation

Geographic Screen

Proper Diagnosis

SeveritySource: Rodman & Renshaw Projections

242


Competitive Landscape• The most critical aspect of valuing a venture opportunity is sizing the

relevant market. How fast is the market growing, who are the major players? Why are they gaining or losing share?


Aggregate Surgical AF MarketRevenue share by competitor

Market share Year 2 Year 3 Year 4 Current Year 6 Year 7 Year 8 Year 9Medtronic 58.3% 55.5% 47.1% 41.3% 37.5% 37.0% 36.7% 36.0% 35.2%AtriCure 0.1% 4.2% 18.1% 28.1% 35.7% 37.2% 39.5% 40.3% 41.0%Getinge 16.2% 15.3% 12.9% 11.2% 9.7% 9.5% 9.4% 9.1% 8.9%CryoCath 14.1% 14.4% 13.1% 12.0% 11.0% 10.9% 4.3% 0.0% 0.0%ATS 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 5.3% 10.3% 11.2%Other 11.3% 10.5% 8.7% 7.3% 6.1% 5.5% 4.9% 4.3% 3.8%Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

AtriCure 0.0 1.8 9.8 19.1 31.1 38.3 48.2 59.6 73.0

Source: Rodman & Renshaw Projections

AtriCureFounding

243



A Side Note on Revenue: “Quality”Some Due Diligence:• Aehr (pronounced "air“) with $30 million in revenue, makes gear that tests

logic and memory semiconductors to weed out defective devices. Its burn-in systems test chips' reliability under stress by exposing them to high temperatures and voltages.

• Sales to the Company's five largest customers accounted for approximately 85%, 85%, and 95% of its net sales in fiscal 2011, 2010 and 2009, respectively.

– During fiscal 2011, Spansion Inc., or Spansion, and Texas Instruments Incorporated accounted for approximately 61% and 11%, respectively, of the Company's net sales.

– During fiscal 2010, Spansion, Micronas Semiconductor Holding AG and Texas Instruments Incorporated accounted for approximately 55%, 12% and 11%, respectively, of the Company's net sales.

244


Moving from Accounting to Economic Profits


• The second most critical element of high-growth valuation is to develop a perspective on margins.

• From an accounting basis, the company is losing money. Why might the losses be overstated?

• How could we adjust after-tax profits to account for investments in intangible assets?

AtriCure IncIncome Statement

$ thousands Year 2 Year 3 Year 4 CurrentRevenues 20 1,766 9,792 19,157 30,957Cost of revenues (8) (681) (2,612) (5,202) (8,057)Gross profit 12 1,085 7,180 13,955 22,900

Research and development (1,838) (2,721) (2,501) (4,422) (9,109)Selling and general expenses (1,314) (4,026) (8,036) (15,169) (24,594)Loss from operations (3,140) (5,662) (3,357) (5,636) (10,803)

Preferred stock interest (469) (2,563) (3,905) (3,905) (2,332)Other income (expense) 13 (806) 154 106 499Loss before income taxes (3,596) (9,031) (7,108) (9,435) (12,636)

Income tax expense 0 0 0 (17) (47)Net income (loss) (3,596) (9,031) (7,108) (9,452) (12,683)

AtriCureFounding

245


Calibrating Sustainable Profits

• Efficient markets (with limited barriers to entry) dictate that long run returns will approach the cost of capital.

• Consequently, profits should equal the cost of capital x capital? But can we measure capital effectively?



Time

246


Typical SG&A to Gross Margin Levels• To remain competitive, companies must “right-size,” selling (advertising and

promotion) and support (R&D, administrative) expenses. This proves challenging when a product mix changes cause a decline in gross margin.

REGRESSION OUTPUT

Regression StatisticsMultiple R 0.83R Square 0.69Adjusted R Square 0.69Standard Error 0.09Observations 416

ANOVAdf SS MS

Regression 1 7.6 7.6Residual 414 3.4 0.0Total 415 11.0

Coefficients Standard Error t StatIntercept ‐1.7% 1.0% ‐1.8X Variable 1 65.0% 2.1% 30.3

0%

20%

40%

60%

80%

0% 20% 40% 60% 80% 100%

SG&A / Re

venu

es

Gross margin

SG&A Expense vs. Gross MarginStandard & Poors 500


247


Estimating Intangibles Investment• There is no reliable method to estimate investment in intangibles, either inside

or outside the company. As a “calibrating” point, we can assume any selling and research expense above comparable averages are investments.


AtriCure Inc

Intangibles

$ thousands Year 2 Year 3 Year 4 Current

Intangible expenses 3,152 6,747 10,537 19,591 33,703 Normalized

Normalized intangibles (8) (723) (4,787) (9,304) (15,267) intantibles 66.7%

Excess intangible expenses 3,144 6,024 5,751 10,288 18,436

Balance Sheet:

Starting intangible assets 0 3,144 8,853 13,719 22,634

Add: Excess intangible expenses 3,144 6,024 5,751 10,288 18,436 Amortization

Deduct: Amortization of intangib 0 (314) (885) (1,372) (2,263) schedule 10

Ending intantibles 3,144 8,853 13,719 22,634 38,807

AtriCureFounding

248


Amortization Schedules

• When capitalizing expenses, it is easy to become consumed by estimates of the amortization period.

• As long as the period is longer than five years, the choice does not lead to dramatic differences.


42%

23%

17%

14%

13%

12%

12%

0% 10% 20% 30% 40% 50%

None

2

4

6

8

10

12

Return on Capital

Amortization Pe

riod

Efffect of Amortization Period on Return on Capital

5% ofRevenue

15% ofRevenue

249


Operating Margin• The second most critical element of high-growth valuation is to

develop a perspective on margins. Established players provide some guidance. But what about JNJ? Should they be included?


79.0%

78.7%

75.5%

84.9%

50.0% 60.0% 70.0% 80.0% 90.0%

Medtronic, Incorporated

Johnson & Johnson

St. Jude Medical, Inc.

Boston Scientific Corporation

Atricure, Inc.

Gross Margin

30.5%

22.3%

24.3%

14.0%

‐38.6%

‐60.0% ‐40.0% ‐20.0% 0.0% 20.0% 40.0%

Medtronic, Incorporated

Johnson & Johnson

St. Jude Medical, Inc.

Boston Scientific Corporation

Atricure, Inc.

Operating MarginBoston Scientific’s

acquisition of Guidant has lowered margins by

7.7% in amortization

250



Capital Requirements: Defining Invested Capital

Operating Assets

Operating liabilities

Non-Operating

Assets

Debt & Debt

Equivalents

Equity & Equity

Equivalents

PayablesCustomer advancesWarranty reserves

Traditional debtPension liabilities

Environmental reservesExcess cash

Short-term investmentsStrategic investments Deferred taxes

Common stockRetained earnings

ReceivablesInventoriesFixed assets

Goodwill

Assets Liabilities & Equity

251


Atricure: Capital Requirements• Using the principles of invested capital, what is the company’s current

operating capital? How does this differ from total assets? Is operating capital growing as quickly as total assets?


AtriCure IncBalance Sheet

$ thousands Year 4 Current $ thousands Year 4 Current Notes: Year 4 CurrentCash and cash equivalents 5,175.2 27,432.9 Accounts payable 733.4 1,243.4 Accrued commissions 791.6 987.6Short‐term investments 0.0 6,369.2 Accrued liabilities 2,572.3 4,131.6 Accrued bonus 236.3 600.8Accounts receivable 3,520.6 4,865.1 Current maturities of long‐term debt 0.0 398.0 Accrued vacation 175.7 469.0Inventories, net 1,087.4 2,135.1 Total current liabilities 3,305.8 5,773.0 Other accrued liabilities 1,368.7 2,074.2Other current assets 112.7 845.3 Total accrued liabilities 2,572.3 4,131.6Total current assets 9,895.9 41,647.7 Long‐term debt 0.0 1,084.0

Property and equipment, net 2,410.1 3,359.5 Series A, 2,182,521 shares 7,979.4 0.0Deferred offering costs (legal) 412.0 0.0 Series B, 3,829,499 shares 28,776.7 0.0Intangible assets 0.0 986.8 Total redeemable preferred stock 36,756.1 0.0Goodwill 0.0 3,840.8Other assets 12.6 205.5 Common stock, 12,086,482 shares 1.9 12.1Total assets 12,730.6 50,040.4 Additional paid‐in capital 3,281.4 86,107.5

Unearned compensation (981.6) (599.6)Accumulated deficit (29,633.0) (42,336.6)Liabilities and shareholders’ equity 12,730.6 50,040.4

252



Investments & FCF

• In our simple valuation model, we defined free cash flow as after-tax operating profit less the increase in invested capital.

• To best understand why this measure works, let’s first examine the definition of “investment,” such as capital expenditures.

253



Alternative Definitions of Free Cash Flow• The traditional definition of free cash flow is:

FCF =After-taxoperating

profit+ Non-cash

expenses

Investments in invested

capital-

Capex = Increase in Net PP&E + Depreciation

FCF =After-taxoperating

profit

Increase in invested capital

-

• As shown earlier, investment is defined as:

• Therefore, free cash flow can also be defined as:

254


Terminal Value: Transaction Multiples

Precedent Transactions

• Dublin-based Medex has reached an agreement with Ethicon Endo-Surgery, a Cincinnati-based subsidiary of Johnson & Johnson, to buy its catheter business. Ethicon Endo-Surgery is a worldwide health-care company with 5,000 employees. The portion of the business involved in the sale makes catheters for injecting into veins.

• The company has 1,000 employees worldwide; 150 permanent and 350 temporary employees work at 6250 Shier-Rings Rd., the site of the corporate headquarters and a manufacturing plant.

• Medex makes plastic parts -- including pumps, tubes, valves, and syringes -- used to supply fluids and medicine intravenously to patients.


Source: Worldscope, Thomson Financial, Wharton Analysis

0.0%

25.0%

50.0%

75.0%

100.0%

0

10

20

30

40

50

60

70

80

90

100

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Distribution of EV‐to‐EBITDAS&P SmallCap Index

255



A Review: Fundamental Valuation Framework

AtriCure IncHybrid DCF Valuation

$ thousands Today Year 1 Year 2 Year 3 Year 4 Year 51 Revenues 30,957 39,006 48,367 59,492 72,580 83,467

2 EBITDA (10,643) (11,312) 2,805 5,949 10,887 20,867Depreciation (160) (202) (250) (308) (375)Operating profit (EBITA) (10,803) (11,513) 2,555 5,641 10,512

3 Operating taxes 4,030 (894) (1,975) (3,679)After‐tax operating profit (7,484) 1,661 3,667 6,833

4 Incremental investment (1,730) (2,012) (2,391) (2,814) C.V.Free cash flow (9,214) (352) 1,276 4,019 166,934 5

6 Discount factor 1.09 1.19 1.30 1.41 1.41Discounted cash flow (8,453) (296) 985 2,847 118,260

Key Value DriversRevenue growth 26.0% 24.0% 23.0% 22.0% 15.0%Cash operating margin ‐29.0% 5.8% 10.0% 15.0% 25.0%Capital turnover 4.7 4.7 4.7 4.7 4.7

Forecast

Analyst Projections

Estimated using capital turns at 4.7x

256



So Why Such Complex Valuations?• Complex valuation tools

are especially useful when analyzing mature companies.

• Consider Lockheed Martin. Is the company creating value?

• Computing raw EBITA leads to extremely misleading results. A complex model is required to uncover true economic performance.

(in $ millions) 2001 2002 2003Service cost (1) 523 565 640 Amortization of prior service cost (2) 64 72 79 Interest cost (3) 1,357 1,401 1,453 Expected return on plan assets (4) (2,177) (2,162) (1,748)Recognized net actuarial losses (gains) (117) (33) 62 Amortization of transition asset (6) (4) (3) (2)Total net pension expense (income) (354) (160) 484

Source: Lockheed Martin 10-K, 2003

(in $ millions) 2001 2002 2003Revenue 23,990 26,578 31,824

EBITA 1,787 1,949 1,976Add: Interest cost (3) 1,357 1,401 1,453Subtract: Return on plan assets (4+5+6) (2,298) (2,198) (1,688)Adjusted EBITA 846 1,152 1,741

EBITA / Revenues (raw) 7.4% 7.3% 6.2%EBITA / Revenues (adjusted for pension) 3.5% 4.3% 5.5%

Lockheed Martin - EBITA Pension Adjustment

Non-Operating

Lockheed Martin 10-K, Note on Retirement Plans

Operating

257


Using Multiples Effectively

Triangulating Today’s Value and Determining Exit Valuation




13

Lecture 13 - Using Multiples Effectively

258


Today’s Discussion1. What are multiple (comparables) and how are they computed? To

determine a “multiple,” each company’s market valuation is normalized by earnings, invested capital, or some other measurement. This allows us to easily compare valuations across companies of different size.

2. What drives the difference in multiples across companies? Enterprise-value multiples are driven by incremental ROIC and growth. Thus, not all multiples within an industry will be identical!

3. Which multiple is appropriate and why? Most investment bankers use the enterprise-value-to-EBITDA multiple, but certain circumstances dictate using EV-to-Sales or EV-to-EBITA multiples.



259



What are Comparables/Multiples?• Multiples such as the Enterprise-Value-to-Revenue and Enterprise-Value-to-

EBITDA are used to compare companies.

• A multiple “size-adjusts” a company’s market value using revenues, profits, book values, or nonfinancial statistics. Consider the standard banking “comps” table:


Medical DevicesEnterprise Value Comparables AnalysisNov‐10

Debt NetMarket net of enterprise

Ticker Company Price cap cash value Revenue EBITDA EBITABDX‐N Becton, Dickinson And Company 77.54 18,000.6 621.4 18,622.0 2.40 8.0 9.8BSX‐N Boston Scientific Corporation 6.92 10,518.9 5,128.0 15,646.9 2.00 8.6 10.4COV‐N Covidien Plc 41.73 20,929.8 1,910.0 22,839.8 2.03 7.8 8.8MDT‐N Medtronic, Incorporated 35.35 38,174.0 3,385.0 41,559.0 2.43 6.6 7.1STJ‐N St. Jude Medical, Inc. 38.69 12,667.2 1,497.8 14,165.0 2.75 8.7 9.7SYK‐N Stryker Corporation 52.43 20,821.0 (2,860.0) 17,961.0 2.47 8.0 8.7ZMH‐N Zimmer Holdings, Inc. 51.81 10,229.5 349.9 10,579.4 2.52 6.8 8.1

Note: Debt includes unfunded pension liabilities Industry Mean 2.37 7.8 8.9Industry Median 2.43 8.0 8.8Std Dev /Mean 11.3% 10.5% 12.7%

One‐Year Forward Multiples

260


Step 1: Computing the Multiple

• If next year’s Medtronic's EBITDA is forecasted at $6.0 billion, how do we compute the enterprise-value-to EBITDA multiple?

• How is “enterprise-value” defined on Wall Street? What constitutes a “consistent” multiple?


How does our language differ from Wall Street’s language?


38.8

4.0 2.8

45.5

7.3

0.1

38.2

0

10

20

30

40

50

Coreoperatingvalue

Excesscash

Othernon‐operating

assets

Grossenterprise

value

Short and long‐term debt

Unfunded retirement

Equityvalue

$ billion

s

Medtronic, IncorporatedEquity Valuation

261


Requirements of a Robust Multiple• Although multiples appear simple to calculate, they fall prey to accounting and

economic pitfalls.

1. Is the multiple “consistent” given the organizational structure of the company? How did you compute the multiple on the previous page?

2. For multiples that are calculated in a consistent manner, does the multiple commingle assets with different economics? For instance, could we compute the multiple as gross enterprise value divided by EBITDA plus interest income?



262


Step 2: Using Multiple to Determine Continuing Value

• To determine continuing value, multiply the forecast of EBITDA by the enterprise value multiple.

• Use comparables that best approximate where the company will be financial by year five.

• If you use a forward multiple, make sure to discount by only four years.



AtriCure IncHybrid DCF Valuation

$ thousands Today Year 1 Year 2 Year 3 Year 4 Year 5Revenues 30,957 39,006 48,367 59,492 72,580 83,467

EBITDA (10,643) (11,312) 2,805 5,949 10,887 20,867Depreciation (160) (202) (250) (308) (375)Operating profit (EBITA) (10,803) (11,513) 2,555 5,641 10,512

Operating taxes 4,030 (894) (1,975) (3,679)After‐tax operating profit (7,484) 1,661 3,667 6,833

Incremental investment (1,730) (2,012) (2,391) (2,814) C.V.Free cash flow (16,698) 1,309 4,943 10,852 166,934

Discount factor 1.09 1.19 1.30 1.41 1.41Discounted cash flow (15,319) 1,102 3,817 7,688 118,260

Forecast

263








264



Part II: What Drives Multiples?

gWACCROIC

g1T)(1

EBITAValue

gWACCROIC

g1ProfitValue

gWACCROIC

g1T)-EBITA(1Value

We know after-tax profits equal EBITA x (1-T), where T is the operating tax rate. Therefore, we can make the substitution.

Start with the key value driver formula.

Divide both sides by EBITA, and we are left with a very popular multiple that bankers use to value companies.

This multiple is known as an

“enterprise value” multiple.


265



ROIC & Growth Drive Multiples

When ROIC > WACC, higher growth leads to higher EV/EBITA Ratio

Note how different

combinations of growth and ROIC

can lead to the same multiple!

Enterprise value to EBITA*

Return on invested capital

6% 9% 15% 20% 25%Long-term growth rate

7.8

7.8

7.8

7.8

7.8

10.3

10.9

11.7

12.7

14.0

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n/a

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4.5%

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6.0%

Increasing Growth

Rate

Increasing ROIC

Enterprise value to EBITA*

Return on invested capital

6% 9% 15% 20% 25%Long-term growth rate

7.8

7.8

7.8

7.8

7.8

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12.7

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2.9

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n/a

11.8

12.8

14.0

15.6

17.7

4.0%

4.5%

5.0%

5.5%

6.0%

Increasing Growth

Rate

Increasing ROIC


266


Careful: So Do Short-Term Downturns• Integral Systems designs satellite command and control, data processing, flight

simulation, integration and test, and signals analysis systems.



Integral Systems Inc45810H107

$ millions 2005 2006 2007 2008 2009 2010E 2011E 2012ERevenues 97.7 116.5 128.7 160.2 159.9 171.3 195.0 222.0EBITDA 15.5 22.2 20.3 27.7 4.4 8.9 19.8 35.0EBITDA margin 15.9% 19.1% 15.7% 17.3% 2.8% 5.2% 10.2% 15.7%

Net enterprise valueMarket capitalization 197.0 255.7 218.2 207.8 150.1Short and long‐term debt 0.0 0.0 0.0 0.0 10.5Gross enterprise value 197.1 255.7 218.2 207.8 160.6

Excess cash (57.5) (62.8) (24.5) (15.0) (5.7)Net enterprise value 139.6 192.9 193.7 192.8 154.9

Enterprise value to Revenues 1.43 1.66 1.51 1.20 0.97Enterprise value to EBITDA 9.01 8.68 9.56 6.97 34.95

<‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ Historical ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐> <‐‐‐‐‐‐‐‐‐‐‐‐ Forecast ‐‐‐‐‐‐‐‐‐‐‐>

267


The Limitations of Multiples• You are trying to value a well-established medical devices company. You

have built a well-structured DCF model, that implicitly leads to a 15x forward-looking EBITDA multiple. What do the following comparables tell you about your work?



Medical DevicesEnterprise Value Comparables AnalysisNov‐10

Debt NetMarket net of enterprise

Ticker Company Price cap cash value Revenue EBITDA EBITABDX‐N Becton, Dickinson And Company 77.54 18,000.6 621.4 18,622.0 2.40 8.0 9.8BSX‐N Boston Scientific Corporation 6.92 10,518.9 5,128.0 15,646.9 2.00 8.6 10.4COV‐N Covidien Plc 41.73 20,929.8 1,910.0 22,839.8 2.03 7.8 8.8MDT‐N Medtronic, Incorporated 35.35 38,174.0 3,385.0 41,559.0 2.43 6.6 7.1STJ‐N St. Jude Medical, Inc. 38.69 12,667.2 1,497.8 14,165.0 2.75 8.7 9.7SYK‐N Stryker Corporation 52.43 20,821.0 (2,860.0) 17,961.0 2.47 8.0 8.7ZMH‐N Zimmer Holdings, Inc. 51.81 10,229.5 349.9 10,579.4 2.52 6.8 8.1

Note: Debt includes unfunded pension liabilities Industry Mean 2.37 7.8 8.9Industry Median 2.43 8.0 8.8Std Dev /Mean 11.3% 10.5% 12.7%


268








269



Which Multiple?• Although we have so far focused on enterprise-value multiples based on EBIT , other multiples

can prove helpful in certain situations.

– EV/EBITDA Multiple. The most common multiple bankers use to value companies (and probably the best financial multiple) is EV/EBITDA. Using EBITDA is popular because the statistic more closely resembles forward-looking free cash flow than EBIT, which includes D&A costs that are sunk.

– EV/EBITA Multiple. Although D&A is sunk, future investments in working capital and capital expenditures are not. EBITA ratios are superior when reinvestment rates are expected to be difference.

– EV/Revenue Multiple. As we will show, an enterprise-value-to-sales multiple imposes an additional important restriction beyond the EV/EBITA multiple: similar operating margins on the company’s existing business. For most industries, this restriction is overly burdensome. But for start-ups, companies may not be profitable, and only the EV-Sales ratio is available.


270


Distribution of Enterprise Value Multiples

As of year-end 2010:

The median enterprise value to one-year forward EBITDA ratio for the S&P SmallCap index was 7.6x.


Source: Worldscope, Thomson Financial, Wharton Analysis


0.0%

25.0%

50.0%

75.0%

100.0%

0

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30

40

50

60

70

80

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100

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Distribution of EV‐to‐EBITDAS&P SmallCap Index

S&P SmallCap 600, 2009Summary Statsticics

Statistic Revenue EBITDA EBITAMedian 0.98 7.61 10.40Average 1.34 8.33 11.00Std Dev 1.27 3.65 4.37

271



When EBITA is Better than EBITDA• Many financial analysts use multiples of EBITDA, rather than EBIT, because

depreciation is a noncash expense, reflecting sunk costs, not future investment.

• EBITDA multiples have their own drawbacks. To see this, consider two companies, who differ only in outsourcing policies. Because they produce identical products at the same costs, their valuations are identical ($150).

Depreciation

EBITA

Revenues

Raw materials

Operating costs

EBITDA

Comp B

Company B outsourcesmanufacturing to another company

Incurs depreciation cost indirectly through an

increase in the cost of raw material)(5)

20

100

(35)

(40)

25

Comp A

(30)

20

100

(10)

(40)

50

Company A manufactures

product with their own equipment

Incurs depreciation cost directly


272


When EBITA is Better than EBIT


• Consider three identical companies that only differ in size. Consequently, prior to M&A activity, all three companies trade at the same multiple. If B purchases C and must amortize “intangibles” over five years, what happens to the EBIT multiple?


$ millions Comp A Comp B Comp C Comp A Comp B+CRevenues 500 375 125 500 500Cash Costs (200) (150) (50) (200) (200)Depreciation (100) (75) (25) (100) (100)Amortization 0 0 0 0 (25)Operating Profit 200 150 50 200 175

Book Capital 1,000 750 250 1,000 1,125Market Value 1,500 1,125 375 1,500 1,500

EV/EBITDA 5.0 5.0 5.0 5.0 5.0EV/EBIT 7.5 7.5 7.5 7.5 8.6

B Acquires C

Problems with EV/EBIT

Pre‐Acquisition

273



The Revenue Multiple

g(1-T) 1-Value ROIC= Margin x

Revenues WACC-g

The key value driver formula.

Enterprise value divided by revenue can be disaggregated into two driving ratios, note how revenues cancels.

Value EBITA ValuexRevenues Revenues EBITA

EBITA / revenues equals pre-tax margin and thus, the value to revenue multiple is a function of the enterprise-value-to-EBITA multiple times margin!


274



Revenue Multiples: Software Companies• Revenue multiples are most commonly used to value high-growth start-ups. Still used

today to evaluate software companies, the multiple fails to normalize for operating margins. Note how EBIT industries multiples are tightest.

• Why does Oracle trade at nearly twice Intuit?

Software CompaniesEnterprise Value Comparables Analysis

Market Net EnterpriseTicker Company Price Cap Debt Value Revenue EBITDA EBITA EBITADBE Adobe Systems Incorporated 21.10 11,057.2 (1,669.2) 9,387.9 2.8 6.4 7.6 7.7BMC Bmc Software, Inc. 29.66 5,561.4 (1,338.4) 4,223.0 2.2 5.6 6.6 7.0CA Ca, Inc. 18.65 9,676.9 (214.0) 9,462.9 2.2 6.4 8.9 7.2INTU Intuit Inc. 22.97 7,351.8 171.7 7,523.5 2.3 7.4 7.7 8.1MSFT Microsoft Corporation 19.09 169,720.8 (23,662.0) 146,058.8 2.4 6.1 6.1 6.7ORCL Oracle Corporation 17.72 89,418.3 193.0 89,611.3 3.8 7.8 8.4 8.4SAP Sap Ag 37.12 44,071.2 (4,192.7) 39,878.5 2.5 9.0 9.2 9.8

Mean 2.6 6.9 7.8 7.8Median 2.4 6.4 7.7 7.7Std Dev /Mean 21.1% 16.7% 14.5% 13.5%



275



Revenue Multiples: Software Companies• The revenue multiple fails to normalize for operating margin. Note how operating

margins are 45% at Oracle, but only 28% at Intuit! Thus you can not use a revenue multiple to value a company, when it’s “comparable” has different margins.

• Using EBITDA to control for margins, both companies trade at the same multiple.

Software CompaniesFinancial Drivers of Enterprise Multiples

Projected3‐Year

Ticker Company Revenue EBITDA EBITA Margin GrowthADBE Adobe Systems Incorporated 2.8 6.4 7.6 37.2% 3.9%BMC Bmc Software, Inc. 2.2 5.6 6.6 32.1% 3.5%CA Ca, Inc. 2.2 6.4 8.9 30.7% 1.7%INTU Intuit Inc. 2.3 7.4 7.7 28.4% 5.5%MSFT Microsoft Corporation 2.4 6.1 6.1 35.5% 2.9%ORCL Oracle Corporation 3.8 7.8 8.4 44.9% 4.4%SAP Sap Ag 2.5 9.0 9.2 25.9% 5.7%



276


Distribution of S&P SmallCap Revenue Multiples• Unlike the EBITDA multiple, revenue multiples for the S&P SmallCap index have a wide

distribution. This distribution is mirrored by an similar distribution for S&P 500 pre-tax operating margins. The median forward looking revenue multiple is 1.7x.



0%

10%

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30%

40%

50%

60%

70%

80%

90%

100%

0

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5.00

Distribution of EV‐to‐RevenuesS&P SmallCap Index

0

10

20

30

40

50

60

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

17.5%

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22.5%

25.0%

27.5%

30.0%

32.5%

35.0%

37.5%

40.0%

42.5%

45.0%

47.5%

Distribution of EBITDA MarginS&P SmallCap Index

277


0

1

2

3

4

5

6

5% 15% 25% 35% 45%

EV / Re

venu

es

EBITDA Margin

Revenue Multiples vs. Operating MarginsS&P SmallCap 600, 2009

Revenue Multiples & Operating Margins• By regressing revenue multiples against pre-tax operating margins, we find a

1% increase in pre-tax operating margin leads to a .064 increase in the enterprise value to revenue multiple.


Are companies above the line overvalued?


Regression Output

Regression StatisticsMultiple R 0.613R Square 0.376Adjusted R Square 0.375Standard Error 1.000Observations 462

ANOVAdf SS MS F

Regression 1 277.7 277.7 277.6Residual 460 460.1 1.0Total 461 737.8

Coefficientsandard Err t Stat P‐valueIntercept 0.42 0.07 5.92 0.00EBITDA Margin 6.36 0.38 16.66 0.00

278


NonFinancial MultiplesUsing Operating Data to Value Companies





Time Permitting

279



Non-Financial Multiples• Does financial information and/or non-financial information impact

the valuations of high-growth, money-losing investments?

• During the euphoria of the late 1990s, many argued, the “more you lose” the “higher your stock price will be!”

• Whether or not you agree with the previous statement, it is clear that valuing an industry with little history is extremely difficult. How do you justify these extraordinary prices? For instance, at their peak:

– Yahoo! had a P/E of 580

– eBay had a P/E of 1,945

– Amazon.com traded at a multiple to revenue of 13.5.


280



The Drivers of Value• To test the impact of financial information, academics often start with Ohlson’s (1995)

model of “residual income,” which practitioners know as the Stern Stewart MVA model, to value each internet firm,

1iiit

tt r)(1)E(RIBVMV

• In their research, Trueman, Wong, and Zhang (2000) decompose earnings into gross profit, operating expenses, and net non-operating expenses,

1i t

it

t

it

t

it

t

iti

t

t

BVNonOp

BVD&R

BVA&SG

BVGPE

r)(111

BVMV

• But how do we measure future profitability? For high-growth start-ups, are current earnings good predictors of future earnings, like they are for established firms?


281



Testing What Drives Value• The most interesting test would be to compare how future earnings affect valuation. Since

future earnings are difficult to measure/predict for start-ups, we instead ask whether current earnings are related to a start-up’s valuation:

• Next, if we decompose net income into gross profits, support expenses, and/or current operating statistics, such as website usage, do we see a clearer relation with valuation?

• Do current support expenses consist or business-building activities?

• Does current website usage predict demand for future revenues?

• To test these questions, we run the following regression:

t

t4

t

t3

t

t2

t

t1

t

t

BVFinancial-Nonb

BVD&Rb

BVA&SGb

BVGPba

BVMV

t

t1

t

t

BVNIba

BVMV


282



Using Non-Financial Data• To test the impact of non-

financial information, we need data from an external data source. For this study, Trueman et al use data from Media Metrix.

– Unique Visitors are the estimated number of different individuals who visit the firm’s web site during a particular month.

– Pageviews are the estimated number of pages viewed by those individuals visiting the firm’s websites during the month.


283



Non-Financial Valuation Multiples• Unlike stable mature companies,

there was no relation between Internet startups and net income. A simple price to earnings ratio fails to capture value.

• Valuation, was however, correlated with web traffic to the companies site. Both unique visitors and page views were predictors of value.

• Why would firm size (as measured by book equity) be a predictor of market-to-book?

Regressions based on 95 portal companies and “e-tailers.” A portal company would be CareerBuilder.com versus Amazon.com, who is an e-tailer.

Variable Reg1 Reg2 Reg3Intercept 20.1 11.2 8.9

6.0 3.1 3.1

Net Income (12.0) (13.8) (24.3)(1.2) (1.4) (2.9)

Unique Visitors 252.55.2

Page Views 3.910.7

Firm Size (1/BV) (99.1) (246.5) (68.9)(0.8) (2.0) (0.7)

Source: Trueman, Wong, & Zhang (2000)

Regression of Market to Book on:


284



Financial Versus Non-Financial Multiples

• When net income is broken into components, we see that different components have different effects.

• Gross profits have a positive affect on value, whereas marketing expenses are negative. Perhaps this implies marketing expenses are not treated by investors as investments.

• When disaggregating net income in the regression, unique visitors are no longer robust predictors of value.

Variable Reg4 Reg5 Reg6Intercept (0.9) (1.3) (4.6)

(0.3) (0.5) (1.9)

Gross Profit 302.2 296.0 185.111.1 10.2 6.9

Marketing (46.5) (44.8) (37.9)(2.4) (2.3) (2.3)

R&D 103.3 102.8 292.21.2 1.2 3.8

Other Expenses 3.7 3.4 7.20.4 0.3 0.8

Unique Visitors 23.80.6

Page Views 2.78.9

Firm Size (1/BV) (73.2) (88.1) (89.4)(0.8) (1.0) (1.2)



285



Segmenting By Business Type• In the previous slides, we examined

regressions based on all internet companies.

• What if we segmented the sample by business type? i.e. separated the sample into “e-tailers” versus portal & content providers.

• Notice how gross profit is extremely important for e-tailers. And how unique visitors matter for only portal/content providers, not for e-tailers.

Variable E P/C E P/CIntercept 3.2 6.3 (2.2) 5.3

0.6 2.4 (0.6) 2.1

Gross Profit 475.1 124.7 313.9 88.79.7 5.0 7.3 3.4

Marketing (44.7) (41.8) (2.2) (38.9)(1.4) (1.7) (2.0) (1.7)

R&D (174.5) 56.7 181.0 121.0(1.3) 0.7 1.5 1.6

Other Expenses (1.1) 2.1 3.2 25.5(0.1) 0.1 0.3 1.1

Unique Visitors 40.5 91.60.4 3.3

Page Views 2.9 1.87.2 4.7

Firm Size (1/BV) (560.3) (38.3) (457.7) (7.7)(2.1) (0.6) (2.3) (0.1)

Source: Trueman, Wong, & Zhang (2000)



286



Closing Thoughts on Multiples• A multiples analysis that is careful and well reasoned will not only provide a

useful check of your DCF forecasts but will also provides critical insights into what drives value in a given industry. A few closing thoughts about multiples:

– Similar to DCF, enterprise value multiples are driven by the key value drivers, return on invested capital and growth. A company with good prospects for profitability and growth should trade at a higher multiple than its peers.

– A well designed multiples analysis will focus on operations, will use forecasted profits (versus historical profits), and will concentrate on a peer group with similar prospects.


287


AppendixScreening New Venture Opportunities




Appendix – Screening Opportunities

288


Screen the Opportunity• There is no one complete, well structure list, but consider the following attempt…


The Market The Product The Management Team

Is the customer need clearly defined and understood by the management team?

How does the product solve the customer problem? How innovate is the solution versus the status quo?

Does the management team understand the product market, its customers, and competitors? Experience?

How large is the opportunity? Will the product open a door to new, larger markets?

How can the solution be protected? Is there clear IP ownership?

Does the management team have technical expertise to create an effective product? Experience?

How strong is the competitors? Are they also focused on the customerneed? Is there an alternative solution to the problem?

Is the product complete? What additional investments are required to get the product suitable for launch? Can the product scale without additional investment?

Does the management team believe in the company and demonstrate an enthusiasm that will attract new talent?

• The framework above focuses on the market and product. In the next discussion, we will examine the key success factors for a robust business model.


289


The Bucket List at BessemerIn short, my theory is that you must make generalizations. This is a tough pill to swallow. Learn to quickly place companies in assigned “buckets” as they’re evaluated. The case-by-case model is simply unworkable. Yes, you’ll be wrong sometimes. Hindsight and adjustment are part of the game.

There are many different types of buckets, I’m including the ones I find myself most frequently using in making evaluations. At risk of stating the obvious, many other VCs have significantly more experience and a more fine-tuned way of thinking about businesses than I do. The point is to provide context for thinking through your own beliefs about what makes a good investment opportunity. Form evaluations, try to justify them across the spectrum of companies you’re considering, and adjust your opinions and expectations as you’re proven wrong and right

• Teams: Evaluating team members is often cited as the most challenging and important part of venture investing. As John Doerr says, “Ideas are easy. Teams win.” Especially with early stage companies, where the barriers to entry are non-existent, a team that brings a competitive advantage is essential. Prior experience, technical talent and proprietary industry relationships are some examples of great qualities a team can bring to the table.

• Market: Size matters. I’m only interested in businesses that attack multi-billion dollar revenue opportunities. How many potential customers are there? How much can you charge them? Multiply. Exogenous variables: Are there external risks which threaten the viability of a business model? For instance, consider the regulatory and industry risks faced by music companies. Composition: Is the market competitive or commoditized? What are the barriers to entry?

• Technology: Complexity. Is the product hard to build? I like to consider early stage companies that have a spectacular team and/or are solving a very challenging technical problem. Otherwise, there’s no reason to think they’ll win over the next person who thinks of the idea or copies them. Website: If this is a consumer facing company, or one which makes sales online, a poorly constructed website implies inattentiveness to user needs or laziness.

• Business Model: It must be transaction-oriented. Does the product involve a transaction which can eventually be monetized? Advertising: Very few technology businesses have scaled efficiently with an ad-based model. I usually ignore them unless they collect very high quality user-interest data which makes them uniquely capable of ad-targeting. Recurring revenue. Is the product priced on a subscription basis or as a perpetual license? Recurring revenue businesses have smoother growth curves, as they simply need to add more customers than they lose to experience temporal growth.


Rahul Jaswa, Bessemer Venture Partners


290


End of Section 2Analyzing and Valuing High Growth Companies


Section 2: Valuing High Growth Companies

291

Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet

Capital Structure in VC-Backed FirmsThe Term Sheet




14

292


Term Sheets: Pick Your Battles• According to Matt Blumberg, CEO of Return Path, “focus on terms that matter. A

typical VC term sheet will have at least 20 terms spelled out in it. There are only a few that really matter in the end, although you should at least make sure your lawyer is comfortable that the others are reasonable and somewhat standard.”

• “Spend time on valuation, the option pool, the type of security (preference and conversion), board composition (voting), and your /their rights (registration rights, drag-along rights, etc).”


Closing Date: As soon as practicable following the Company’s acceptance of thisTerm Sheet and satisfaction of the Conditions to Closing (the“Closing”).

Term Sheet

293



Issue 1: Valuation• The financial issues related to venture capital are no different than

those of a traditional finance class. Theories and predictions related to discounted cash flow, multiples, contingent claims, options, capital structure, and Modigliani & Miller, still hold.

• But the differences in language used can be daunting. Consider how valuation is described:

– “I’ll put in $4 million based on six pre-money”

– “I’m looking for two-fifths of the company post, and for that I’ll put up the four”

– “It’s worth six pre-money, and I want to own 40% after we close.”

294



Translating VC Language to Capital Structure

• Your company current has three million shares outstanding (no price is available). Prior to the transaction, there has never been a discussion of valuation.

• How does: “It’s worth ten post, and I want to own 40% after we close,”

• Let’s translate to the pre-money valuation, the number of shares to be issued, and the share price?

Pre-Money Valuation

+ New Money

= Post-Money Valuation

ValuationMoney -PostMoney New Ownership %

SharesNew Shares Old

SharesNew Ownership %

295


Corporate Valuation meets Venture Capital

• You have just completed a discounted cash flow (DCF) valuation for a potential investment. Excited about the opportunity, you are ready to negotiate a term sheet with the company. You believe the company is worth $40 million (using DCF) but desperately needs $20 million to launch the product.

• In venture capital “speak” is the $40 million DCF a “pre-money” or “post-money” valuation?

– What ownership percentage does a $40 million pre-money valuation imply?

– What ownership percentage does a $40 million post-money valuation imply?

• To be fairly compensated, what ownership percentage should the VC demand?


Take 10 minutes…

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Value of Core Operations• To value a company, estimate the value of core operations. To determine core

operating value, determine free cash flow using forecasts of revenues, margins, capital intensity, and a terminal value.

• At a 15% cost of capital, the company is valued at $40 million.


Discounted Cash Flow Assessment

$ million Today Year 1 Year 2 Year 3Free cash flow (10.0) (10.0) 85.6Discount factor 1.15 1.32 1.52Discounted cash flow (8.7) (7.6) 56.3

Enterprise valueValue of operatons 40.0Excess cash 20.0Enterprise value 60.0

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Pre or Post-Money?

• Discounted cash flow clearly points to a $40 million valuation. But is the $40 million valuation pre-money or post money?

• To determine the ownership each implies, use the pre/post money formulas:


Pre & Post Money Valuation

$ million Method 1 Method 2Pre‐Money 40.0 20.0New Money 20.0 20.0Post‐money 60.0 40.0

Implied ownership: 33.3% 50.0%(new money / post‐money)

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Venture Capitalist Performance

• To determine, the venture capitalist’s expected performance, we use internal rate of return (IRR).

• Regardless of the ownership structure, $20 million is invested today.

• The venture capitalist than receives nonoperating income from unused cash and eventually liquidation.


Venture Capital Performance at 33% Ownership

Internal rate of return:

$ million Today Year 1 Year 2 Year 3Company dividends 3.0 1.5 85.6Venture capital flow (20.0) 1.0 0.5 28.5

Internal rate of return 15.0%

Venture Capital Performance at 50% Ownership

Internal rate of return:

$ million Today Year 1 Year 2 Year 3Company dividends 3.0 1.5 85.6Venture capital flow (20.0) 1.5 0.7 42.8

Internal rate of return 32.4%

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Issue 2: Employee Option PoolsOption Pool Shuffle

You have successfully negotiated a $4M investment on a $6M pre-money valuation by pitting the famous RedCap Ventures versus Blue Shirt Capital. Triumphant, you return to your company’s tastefully decorated loft to tell the team that their hard work has created $6M of value.

Your teammates ask what their shares are worth. You explain that the company currently has 3M shares outstanding so the investors must be valuing the company’s stock at $2/share:

$6M pre-money ÷ 3M existing shares = $2/share.

Later that evening you review the term sheet from RedCap. It states that the share price is $1.50. This must be a mistake! Reading on, the term sheet states, “The $6 million pre-money valuation includes an option pool equal to 15% of the post-financing fully diluted capitalization.”

You call your lawyer and your lawyer explains that the so-called pre-money valuation always includes a large unallocated option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am I going to explain this to the team?”

- Adapted from VentureHack


Title Range (%)

Chief Executive Officer 5‐10%Senior Executives 2‐5%

Vice Presidents 1‐2%Independent Board Member 1%

Director 0.4 ‐ 1.25%Lead Engineer 0.5 ‐ 1%5+ years experience Engineer 0.33 ‐ 0.66%Manager or Junior Engineer 0.2 ‐ 0.33%

Typical Silicon Valley Grants (Series A)

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Adding Employee Options to the Mix• Most venture capital deals include a

“reservation” for future shares to be purchased by or granted to employees. Investors typically demand between 15% and 30% of the share count.

• What is the post-money valuation and share price if an extra one million shares are allocated before financing?

• What would be the typical option strike price? Would the options have value?

Pre-Money Valuation

+ New Money

= Post-Money Valuation

ValuationMoney -PostMoney New Ownership %

SharesNew Shares Old

SharesNew Ownership %

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Employee Options: IssuesHow are total shares determined if the share grants (or options) are:

• Unissued and Unvested? When the term sheet is written to include future share grants and options, the shares are yet to be issued. Since ownership is based on currently issued shares, the venture capitalist would own 2.67 million of 5.67 million issued shares or 47.1% (even thought they originally negotiated for 40% ownership) in the case of immediate liquidation! Should the shares revert to the founder? Why or why not?

• Issued, butUnvested? Depends on the original option plan. (1) Most plans require options to be converted into options on the buyer’s stock – but still unvested. Alternatively, they may have a provision that states if the acquirer does not assume the option plan or proposes to modify the plan, options vest immediately prior to the close of the merger. This is known as “accelerated vesting.” Or there may be nothing stated!

• Issued and Vested? In the case of a liquidation event, employees will receive consideration for their shares.


Entrepreneurs:Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.

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Employee Options: Issued but Unvested

• Many companies write their employee option plans with the assumption that they will not be acquired. In fact, company are acquired, even if they are publically traded. One of the most common, and costly, areas of options lawsuits is what happens when there is an acquisition. Will options immediately vest and become fully exercisable or be cancelled? -- National Center for Employee Ownership

• From a specialist in the M&A group at Intel:

– “When conducting a “trade sale” of an Angel-backed company at Intel, we request that all unvested but issued shares are immediately vested for employees. Our intention is to reward employees rather than the investors. For lockup, we use earn outs and grant Intel stock options (with vesting) for all employees (as they are typically tagged as key employees).”


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Option Pools: Bridge Financing• Any bridge financing that contains convertible promissory notes or warrants,

known as “equity sweeteners” must also be set aside.

• For instance, to avoid a formal investment “round,” some venture capital companies will loan the portfolio company money to be paid back at the time of next official financing, plus “escalating” warrants (note, the loan will be rolled into the next financing).

– RedCap lends the portfolio company $1 million at a rate of 8% per year, plus 1% “warrant coverage” per month. The warrants give the holder $10,000 of stock for each month the bond is outstanding (1% of face per month).

– VC “warrants” typically specify a dollar amount (via percentage), not a share amount, and this has important valuation implications, which we discuss in the Angel Financing note.


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The Capitalization Table• The term sheet will also contain a pre- and post-financing capitalization table.

In the first round, the capitalization is relatively straight-forward. As we add multiple rounds of financing, the table can become quite complex.

Security # of Shares % # of Shares %

Common – Founders 3,000,000 75.0% 3,000,000 45.0%

Common – Employee Options

Issued 500,000 12.5% 500,000 7.5%

Unissued 500,000 12.5% 500,000 7.5%

Series A Preferred: Redcap Ventures 2,666,667 40.0%

Total 4,000,000 100.0% 6,666,667 100.0%

Pre-Financing

Capitalization Table

Post-Financing

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Closing Date: As soon as practicable following the Company’s acceptance of thisTerm Sheet and satisfaction of the Conditions to Closing (the“Closing”).

Investors: RedCap Ventures: [ ] shares ( %)

Amount Raised: $[ ], [including $[ ] from the conversion of principal [and interest] on bridge notes].[1]

Price Per Share: $[ ] per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).

Pre-Money Valuation: The Original Purchase Price is based upon a fully-diluted pre-moneyvaluation of $[ ] and a fully-diluted post-money valuation of$[ ] (including an employee pool representing [ ]% of thefully-diluted post-money capitalization).

Offering Terms

Source: NVCA, http://www.nvca.org/model_documents/Term_Sheet.doc

Representation in the Term Sheet

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Issue 3: The Type of Security

“Shortly after a recent exit sale, a CEO called his lead venture capital backer to complain that while he had thought his management team owned 34% of the company, they had

received only 5% of the sale proceeds.

"How did we get such a bum deal?" he asked. The VC patiently explained: liquidation preferences.”

The capitalization table can be misleading…

Liquidation Preferences: What You May Not KnowBy Colin Blaydon and Michael Horvath

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VC Ownership: Preferred Stock

How Preferred Stock differs from Common Stock:

• For liquidation events: Preferred Stocks have a liquidation preference which provides that upon liquidation or dissolution of the company, the preferred shareholders must be paid “x times face” before the common shareholders are paid anything.

• With no liquidation event: Some venture capitalists will ask for redemption rights, i.e. the right to force the company to repurchase the preferred stock at “x times face” plus cumulative dividends. Option becomes available in [5] years.

• Dividends on preferred stock: Typically, the preferred stock earns dividends at some modest rate if/when declared by the company’s board of directors.

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Liquidation PreferencesVenture capitalists are often maligned for the liquidation preference and other partialities. VCs do this to avoid the “Stanley Whiplash” and “Dudley Do-Right” problems.

– Stanley Whiplash, a founder who put a year into a biotech company, could raise $10 million for 50% ownership and then immediately sell the company for cash to a similar company pocketing $5 million. 1x liquidation prevents this.

– Dudley Do-Right, a founder who believes in his company, wants to raise $2 million, for 50% ownership. Dudley, has some confidence in the company, but knows the company’s not worth much more than $5 million. 2.5x liquidation prevents this deal from occurring.

Source: Kevin Laws, VentureBlog

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Advanced Equities & Pixelon


LAUNCH PARTY: Betting on One Big NightBy Dan Goodin

The masses of gamblers hunched in front of slot machines provided Pixelon.com, which hopes to hit the jackpot by bringing television-quality video to the Net, with a potent reminder: Las Vegas is where suckers go to strike it big.

That didn't stop the 3-year-old startup from coming to town to throw itself a grand-opening party Oct. 29 that featured performances by such glittering acts as the Who, Kiss, Brian Setzer, Tony Bennett and the Dixie Chicks. The San Juan Capistrano, Calif., firm, which has raised $23 million, insisted the $10 million launch party made perfect sense.

"This space is a horse race," Michael Fenne, the company's founder and chairman, says. "You're either fast and big or you're dead." Fenne, a 31-year-old former concert roadie turned computer programmer, won't get any arguments there.

Pixelon plans to become an online content factory, serving up 50,000 channels. "Since we're not a Time Warner (TWTC) with a content library a mile long, we had to be skilled ... in our execution," Fenne says.

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The Dark Side of EntrepreneursPixelon, which once raised $40 millionon the strength of its Internet videoplayer, is now down to a handful ofmanagers working without pay, thecompany confirmed Friday.

A top executive also said thecompany's founder, who later wasrevealed to be a fugitive from justicewith a false identity, didn't actuallycreate the software for the player andfaked a key demonstration last August.

Paul Ward, Pixelon's chairman andchief executive, said the layoffs weredesigned to save money while thecompany fights a bankruptcy petitionbrought by creditors seeking more than$1 million.

"If you have a bankruptcy pendingagainst us, we're going to havedifficulty

raising money from investors, so weare going to have limited funds in thefuture," Ward said. "I'm trying toconserve our capital, like anybusinessman would do."

Russell Reeder, vice president ofproduct development, painted a darkerpicture: "(The money's) gone. We don'thave money to pay salaries. We don'thave money to pay creditors. I thinkthat's the definition of bankrupt."

Reeder added that employees had notbeen paid for a month before thelayoffs. Those who are staying, hesaid, are trying to recoup theirinvestments, or are remaining out ofloyalty. Reeder said he himself hadinvested $100,000.

-- Orange Country Register

• But consider Advanced Equities Inc, a Chicago venture-capital firm that sank about $40 million into Pixelon.

• Pixelon became famous when they threw a Las Vegas bash costing $15 million (The Who was the featured band!)

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Issue 4: Board Composition• “At the initial closing, the Board shall consist of [ ] members comprised of

– (i) [Name] as [the representative designated by [ ], as the lead investor,

– (ii) [Name] as the representative designated by the remaining investors,

– (iii) [Name] as the representative designated by the founders,

– (iv) the person then serving as the Chief Executive Officer, and

– (v) [ ] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors].”

• Naval Ravikant CEO of Epinions.com writes,

– “Valuation is temporary, control is forever.”

• Ravikant’s rules of thumb: “Make the board composition proportional to ownership, be wary of independents (typically pro-investor), control is a one-way street: from common to preferred.”


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Issue 5: Your (Entrepreneur) Rights

• Registration rights allow the venture capitalist to force the company to register the company’s securities with the SEC so that it can be sold in the public markets. Major issue: Will the founder be ready to cede control?

• Drag Along rights allow the venture capitalist to demand that “holders of greater than 1%” be required to “vote their shares” in favor of a deemed liquidation event. Similar to registration right, but forcing sale.

• Typically there is a provision that reads “Matters Requiring Investor/Director Approval.” Investors, even holding minority positions, can restrict day-to-day operations including the ability to hire & fire key positions.

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The Dark-Side of Venture CapitalistsAlthough privately held, the story of FilmLoop leaked from multiple sources close to the company. Here’s a rough timeline of what appears to have happened

• May 2006: FilmLoop raises $7 million from venture firm ComVentures. Roland Van de Meer joins the board of directors.

• November 2006: ComVentures, under pressure from its own limited partners to clean up its portfolio, meets with FilmLoop management to tell them that they must find a buyer by the end of the year. The FilmLoop founders argue that they thought they had a good chance at success and did not want to sell. However, ComVentures’ ownership percentage, plus certain rights they have (called “drag along rights”), can force the company founders to sell.

• December 2006: ComVentures proposes Fabrik, another one of their portfolio companies, as the acquirer. Fabrik acquires FilmLoop for little more than the cash ($3 million) that FilmLoop has remaining in its bank account. Due to liquidation preference rights, the founders and all employees walk away with nothing.

One day, the founders and employees of FilmLoop had a viable company with $3 million in the bank. The next day they had no stock, no job, and no company. - Michael Arrington, TechCrunch


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AOL, MySpace bosses’ bloody VC mergerVenture capitalists sell themselves as friends to entrepreneurs, and talk about how they're going into business together. Isn't it useful to know how they treat the people they're actually in business with? The tale of the formation of Velocity Interactive Group is instructive in that regard. Former AOL CEO Jonathan Miller and ex-News Corp. executive Ross Levinsohn, who oversaw MySpace, raised eyebrows when they switched VC teams last December. The full story is even more cutthroat than we imagined.

When Microsoft set Facebook's value at $15 billion last fall, Miller and Levinsohn's plans to acquire four startups and roll them into one blog publishing company suddenly got a lot more expensive. Too expensive. So much so that funding partner General Atlantic dropped out. That turn of events left Miller and Levinsohn ready to listen to ComVentures cofounder Roland Van der Meer. Van der Meer offered them spots on a five-man team leading a new venture capital firm focused on digital media. Miller and Levinsohn agreed to join. Problem was: There were already five ComVentures partners. Two would have to go. Van der Meer decided to ax Michael Rolnick and Jeb Miller.

On the morning of December 17, the ComVentures partners gathered for their usual Monday morning meeting. Rolnick and Miller took their seats, coffees in hand, according to PEHub. Then Van der Meer told them they were out. "They were blindsided," one VC told PEHub. "There was no reason to treat people that way... Rolnick had been there nine years. This isn't a giant company doing layoffs, it's a small partnership. It was simply wrong.“ That's just business, right? Well, according to PEHub, investors aren't happy about how the shakeup went down either. They feel it makes the firm seem unstable.

One investor said:Levinsohn and Miller are impressive guys, but it's tough for me even if I want to invest with them. To do so, I have to believe that this entire team is going to still be together in five years, and I just can't trust that. Either Levinsohn and Miller will decide to leave because they aren't VCs at heart, or Roland will fire them for some reason or another. Either way, it's too risky.


http://fusecapital.com/investment-team

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Appendix

Article on the Founder Experience


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What I learned in selling mycompany for $100 million

Charlie Crystle

My software company ChiliSoftsold for $100 million in 2000. Or$70 million. Or $28 million.

It depends on the date you choose,the built-in triggers, and ego.Notably, from December 1999 toMay 2000, my stake dropped from40% to 15% when the deal closed.Most employee stakes dropped aswell -- but not all employees.

My point at the end of this story willbe something like this: sweat thedetails.

Some context: I started ChiliSoft in1996 in Lancaster, Pa. I had nomoney, and Dad had passed awayjust days before. It was a tough time,but I saw this huge opportunity foradding functionality to Web servers,so I took the deep plunge.

I tried raising money nearby, but inthose days there wasn't a firm inPennsylvania that really got the


space, so I headed to the West Coastwith a credit card, deeply believingin our mission to take over theworld. Tip: Try to take over theworld.

To save money, I slept on myattorney Ben's floor as I bouncedaround Silicon Valley trying to getmeetings and raise money. Benfinally got me a meeting withDraper Fisher Jurvetson, one of theleading venture-capital firms in thefield, and a few months later theyproduced a term sheet. Tip: Floorsare cheaper than hotel rooms.

I signed the term sheet for $1.4million at 11 p.m. on a Sunday nightat a bar in a casino in Las Vegas --completely emblematic, it seemed.

But I was out of debt. DFJ saved mylife, in a way. Tip: Try not to runup debt -- it's unlikely you'll besaved by Series A.

The second financing round, SeriesB, was nuts -- $3.7 million on $19million pre-money valuation, and acap on the liquidation preference.

That meant if we sold for more than$42 million, those who invested inthe Series B round simply got theirshare back -- and everyone would bethrilled. Tip: Don't create thewrong incentives.

Over the next year and a half, wefired the CEO, and I ended uptaking the CEO job back. I wasn't apopular guy with investors for that,but my gut (informed intuition) saidthat we needed to cut the bullshitand sell software. I figured they'lllike us when we win. Tip: They'lllike you when you win.

The chill set in, so I focused thecompany on sales, and kept sendingreports to the board. We increasedrevenue in that next quarter by threetimes the prior one, and thingsthawed. Tip: Communicationmatters with investor relationships.

I started a CEO search; I reallydidn't want to run the company, butalso didn't want to see someone runit into the ground. A few monthslater, we had our guy. Tip: Run the

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had a number of large ISP partners,like PSI and ATT, and that kind ofdistribution at the time was a bigwin.

Somewhere in the conversations thetalk turned to a merger -- Cobalt sawour application server as a strategicedge, and admired our traction withmajor customers like Excite.

And that's where it gets murky forme; I had been focused on launchinga suite of small business apps on topof ChiliSoft, and the talks went onwithout me.

A month later I got a voicemailfrom Ben: "Just make it easy, acceptthe severance, you'll make a lot ofmoney in the sale ...”

I sat down in the CEO's office, actedlike I didn't know anything, andtalked about how excited I wasabout the company, and how he wasdoing so well, and... he could haveat least had the balls to tell mehimself. Tip: You won't always beindispensable.

company, get help with ops.

At the same time, we were lower oncash than was comfortable, and Ihad the choice of cutting from 55people to 9, or bringing on the CEOand making sure he had cash in thebank. DFJ and another firm offeredan onerous bridge: monthlyescalating warrants, and acontrolling board seat. I didn't reallygrok the meaning of the warrants.Tip: Sweat the details.

I didn't want to send people homeand our pipeline was strong, so Ichose to keep the ride rolling and gowith it. Everyone was surprisedwhen I wasn't fired right away, butthere I was, still employed.

The Prospect

That fall a great sales/biz dev guy,Brian Pavicic, asked me to attend aconference with him. He wasincredibly excited about apotentially big licensing deal withCobalt Networks, which madeLinux servers for ISPs. ChiliSoft

I imagine they wanted me outbecause I was dogmatic about thedirection of the company. I wantedto make the engine free and sellapps into it, like the CRM system Iwas building. They wanted to getthe company sold and get liquid.Besides, CRM wasn't going to bebig or anything.

But I was difficult, admittedly.

The Deal

The deal was struck at $100 millionin January 2000.

But the VCs insisted on fixing thenumber of shares, not the value ofthe deal. A month later, they lookedlike geniuses: the deal was worth$135 million. The next month, it fellto $70 million. It closed in May at$28 million, 72% down from thedeal price. Tip: Fix the price, not thestock.

The management team threatened toquit if they didn't get an additional10% of the deal.

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From my perspective, they alreadyhad better than average stock optionallocations, and I didn't believe theywould walk. But at that point Ibasically decided to stop payingattention to the details and just get itdone, after a threatening call fromthe Cobalt CFO. Fun stuff.

The Drop

So how did my stock drop by 62%in 6 months? Three things:escalating warrants, managementshakedown, and the timing of one ofthe dips in Cobalt's wild ride in2000.

The deal closed at $28 million --below the $42 million threshold,which triggered more magic. Themanagement shakedown tookanother 10%. Tip, again: sweat thedetails.

And the escalating warrants? Let'sjust say it made DFJ very happy.They made (I think) more than 15times their original investment, witha big boost coming from the bridgedeal. Overall I owe a lot to those

guys -- learned a lot, made a lot, anddon't regret much of it. Tip: Youdon't have to accept a bad deal – atleast try to negotiate.

Some final tips: Run your company--you'll figure it out. Get goodadvisors, but follow your gut. Don'ttouch anything with escalatingwarrants. Be generous withemployee options and make themmeaningful.

And once you close your acquisitionand get your stake? Don't let it ride,especially in a bubble.

I did. Then Sun bought Cobalt andthe stock dropped 97% in value. Isold enough stock to invest in a fewstartups and support some greatnonprofits, but it was a huge, hugehit. Founders love to take risks, butwe're notorious for taking stupidrisks with our own money.

My Next Big Thing? Somethingnew around search. I'm raisingcapital and building a team, andwould love to hear your thoughts onit.

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Venture Capital & the Finance of Innovation Lecture 15 – Anti-Dilution Provisions

Term SheetsIntermediate Rounds: Anti-Dilution Protection




15

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Beware: The Danger of Dilution• Through this point we have focused on liquidation values at the time of exit. But what if

intermediate financing is done at a lower value? Consider the “evil entrepreneur” where a majority owner (i.e. 53% ownership) issues 100 million additional shares to another company he/she owns at one cent per share (versus 2.67 million shares at $1.50 in the Series A round). After the transaction, who “owns” the company?

…

Right of First Refusal: Investors who purchase at least [ 5% ] shares of Series A Preferred (a “Major Investor”) shall have the right in the event the Company proposes to offer equity securities to any person (other than the shares (i) reserved as employee shares described under “Employee Pool” below, (ii) etc… to purchase [ x times ] their pro rata portion of such shares…

Restrictions on Sales:The Company’s Bylaws shall contain a right of first refusal on all transfers (sales) of Common Stock by common shareholders, subject to normal exceptions (such as employees transferring shares in their estate). If the Company elects not to exercise its right, the Company shall assign its right to the Investors.”

Co-Sale Agreement (Take-me-Along Provision)The shares of the Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange their stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis.

Term SheetNote: Not every

investor receives each

right

VC can buy the shares being sold

by the founder

VC can sellshares to third

party along with the founder

VC can buy the shares being

issued to a third party

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Anti-Dilution Provisions• The right to purchase shares in the new round will protect the VC from a complete

transfer of ownership at an artificially low price. This right will not however protect the VC’s original investment. To protect the original investment, the VC needs additional anti-dilution provisions:


…

Anti-dilution Provisions: In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be reduced to the price at which the new shares are issued.”

…

Term Sheet

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Anti-Dilution: No Protection (1)• In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money

valuation for 50% fully-diluted ownership. If no anti-dilution provisions were in the original contract, what would happen to Redcap Venture’s ownership position?

• What is the pre-money valuation? How does this compare to last round’s post money valuation?

Shares New SharesMoney -Pre

Shares New p+

=

SharesMoney Prep)(1

p Shares New −−

=

With No Dilution Provision, Use Original Formulas

Pre‐Financing

Security # of Shares % # of Shares % # of Shares %

Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 3.8%

Unissued 500,000 12.5% 500,000 7.5% 500,000 3.8%

Series A Preferred: Redcap Ventures 2,666,667 40.0% 2,666,667 20.0%

Series B Preferred: Sand Hill VC 6,666,667 50.0%

Total 4,000,000 100.0% 6,666,667 100.0% 13,333,333 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000

Price Per Share (in $) 1.50 1.50 0.90

No ProtectionSeries A Series B


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Anti-Dilution: Full Ratchet (2)• In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money

valuation for 50% fully-diluted ownership.

• A full ratchet enables early round investors to preserve a portion of their initial ownership percentage in a down round. Full Ratchet protection multiplies the number of shares held by RedCap by [prior-round price / current-round price].

Step 1At a price of $0.90, the full

ratchet anti-dilution provision would add how many shares?

Step 2If RedCap is awarded this many shares, will Sand Hill still own

50%?

Step 3With RedCap’s new shares and Sand Hill’s new shares will the

share price remain at $0.90?

Pre‐Financing


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 3.7%

Unissued 500,000 12.5% 500,000 7.5% 500,000 3.7%



Total 4,000,000 100.0% 6,666,667 100.0% 13,333,334 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000



Full RatchetSeries A Series B

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Full Ratchet (post iteration)• Technically, there is only one unknown: how many shares will be issued to RedCap. Once

RedCap shares are known, all other figures quickly become apparent.

• Since the algebraic solution is complex, the easiest way to determine the effect of anti-dilution provisions is to use iteration via Excel’s Goal Seek function.

From the VCs perspective, why could a full ratchet be harmful?

RedCap SharesRedCap shares will be

determined via iteration.

Sand Hill Shares Sand Hill shares are

determined by the traditional new money equation.

Pre‐Financing


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 12.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 2.1%

Unissued 500,000 12.5% 500,000 7.5% 500,000 2.1%



Total 4,000,000 100.0% 6,666,667 100.0% 24,000,000 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000



Full RatchetSeries A Series B

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The Language of VC: Adjusted Conversion Price

• In the full-ratchet example, our capitalization table implied Redcap Ventures shares owned would rise from 2.67 million to 7.98 million.

• In actuality, Redcap would receive no new shares, but instead their conversion rate would change from a 1:1 conversion (comnmon:preferred) to a 3:1 to conversion rate.

The Legal Language

• Assume the “original purchase price” was set at $1.50, i.e. “$1.50 of preferred” is convertible into “$1.50 of common”.

• Under full ratchet, the adjusted conversion price for Series A would be $1.50 / 3 or $0.50. Thus, the adjusted conversion price of “$0.50 of preferred” is convertible into “$1.50 of common” i.e. 1 share to 3 shares.

• The conversion price for Series B would be $.50 of preferred to $.50 of common.


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Anti-Dilution: Weighted Average Ratchets• The NVCA defines narrow-based and broad-based weighted average anti-

dilution as follows:


SharesVCSharesalHypothetic

SharesVCSharesNew FactorAdjustmentBased-NarrowA

A

++

=

SharesPreMoneySharesalHypothetic

SharesPreMoneySharesNew FactorAdjustmentBased-Broad+

+=

• Weighted-average anti-dilution provides less protection to venture capitalists than the full ratchet provision. Iteration is still required…

Hypothetical shares equals the number of shares that would have been issued to Sand Hill Ventures at the last round’s price (or if applicable, last round’s adjusted conversion price).

(pre-money excluding

unissued options)

328



Anti-Dilution: Narrow-Based (3)• In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money


• A narrow-based weighted-average ratchet:

Pre‐Financing


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 3.8%

Unissued 500,000 12.5% 500,000 7.5% 500,000 3.8%



Total 4,000,000 100.0% 6,666,667 100.0% 13,333,333 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000




329



Narrow-Based (post iteration)• In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money


• A narrow-based weighted-average ratchet, following full iteration:

Pre‐Financing


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 17.8%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 3.0%

Unissued 500,000 12.5% 500,000 7.5% 500,000 3.0%



Total 4,000,000 100.0% 6,666,667 100.0% 16,888,889 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000



Narrow‐BaseSeries A Series B

330


Comparison of Various Method


Prior Round Priceleft-side Current Price

=

Post Money Current Priceleft-side Post-MoneyPrior Round Price

−=

A

A

New Shares + VCmultiplier= Hypothetical Shares + VC

• Start with the anti-dilution multiplier.

• Replace new shares and hypothetical shares with their respective definitions.

• Divide both the numerator and denominator by post-money.

… which equals the full ratchet multiplier!

331


Comparative Statics• The weighted average anti-dilution provision is a weighted average between

full ratchet and 1. As the new round increases relative to VCA, does the Series A protective multiplier become larger or smaller?


A

A

New Shares + VCmultiplier= Hypothetical Shares + VC

Prior Round PriceM Current Price

= M 1 =

332



Anti-Dilution: Broad-Based (4)• In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money


• A broad-based weighted-average ratchet:

Pre‐Financing


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 3.8%

Unissued 500,000 12.5% 500,000 7.5% 500,000 3.8%



Total 4,000,000 100.0% 6,666,667 100.0% 13,333,333 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000




333



Broad-Based (post-iteration)• In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money


• A broad-based weighted-average ratchet, following full iteration:

Pre‐Financing


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 19.7%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 3.3%

Unissued 500,000 12.5% 500,000 7.5% 500,000 3.3%



Total 4,000,000 100.0% 6,666,667 100.0% 15,229,630 100.0%

Valuation (in $) 6,000,000 10,000,000 12,000,000



Broad‐BasedSeries A Series B

334


Comparison of Anti-Dilution Methods

• Full ratchet provisions provide the most protection, but as discussed earlier are typically unenforceable (64% of down rounds waive protection).

• For those contracts with anti-dilution protections, only 27% have full ratchet. The remaining contracts used weighted average anti-dilution protection.


33.3%

26.3%

23.6%

20.0%

Full ratchet

Narrow‐based

Broad‐based

Noprotection

Effect of Various Anti‐Dilution Provisions

Value$4.00

$3.15

$2.83

$2.40

335


Empirical Evidence


• Venture capitalists understand the ex-post incompatibility of full ratchet protection.

• Consequently, it is rarely used, even though it provides the VC with the most downside protection.

Anti‐Dilution ProtectionWilson Sonsini

Protection Type 2010 Q1 Q2 Q3 Q4

Weighted average - Broad 91% 82% 91% 93% 82%

Weighted average - Narrow 3% 7% 4% 3% 1%

Full ratchet 3% 4% 1% 0% 6%

Other (including blend) 3% 7% 5% 4% 11%

Source: Wilson Sonsini

2011

336


Closed-Form Solution• Define x as the VCA multiplier.

• Define the following variables as:

1. Define “p” as the percentage of ownership Series B is requesting

2. F equals the # of founder shares

3. VCA equals the # of Series A shares

4. VCB equals the # of Series B shares

5. H equals the number of shares that would have been issued to Series B at the last round’s price.

• Define AD as either zero (full ratchet), the number of VCA shares (narrow base) or the first round shares (broad base) excluding unissued options.


Full Ratchet Narrow Base Broad Base

( )( )( ) ApVCADHp-1

ADp-1pFx−+

+=

( )AB xVCFp-1

pVC +=

(pre)xVC(post)VC AA =

337


Pay-to-Play Provision• Anti-dilution provisions do not provide a “free ride” to old investors. If an old

investor does not participate in the new round, they will be immediately converted to common. Conversion to common means the investor will lose their liquidation preference and their anti-dilution multiplier on prior round shares?


…

Pay-to-Play:In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated above under "Right of First Refusal" below will be converted into Common Stock.

Term Sheet

338


Appendix


339



A

AB

VCHVCVCx

++

=

( ) ABA VCVCVCHx +=+

( ) ( ) AAA VCxVCFp-1

pVCHx ++=+

(definition of narrow-based)

Appendix: Proof of Narrow-Based

Pre-money Shares(including anti-dilution)

p = Series B Ownership %

• Define x as the VCA multiplier.







340



( )( ) ( ) AAA VCp-1)xVCp(FVCHp-1x ++=+

( )( ) ( ) AAA VCp-1pFpxVCVCHp-1x +=−+

( )( )( ) AA

A

pVCVCHp-1VCp-1pFx−+

+=

( ) ( ) AAA VCxVCFp-1

pVCHx ++=+

Appendix: Proof of Narrow-Based

• Define x as the VCA multiplier.







341

Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms

Term Sheets: Security Design and Capital Structure in VC-Backed Firms




16

342



A Review of the “RedCap Ventures” Transaction

• During this session, we discuss the payoff structure for various capital structures related to venture capital financing.

• In our original example, “Redcap Ventures” purchased 2.67 million Series A shares at $1.50 per share. (for an aggregate purchase price of $4 million).

• How these shares eventually payout, depends on contractual terms. Let’s examine a few…


Common – Founders 3,000,000 75.0% 3,000,000 45.0%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5%

Unissued 500,000 12.5% 500,000 7.5%

Series A Preferred: Redcap Ventures 2,666,667 40.0%

Total 4,000,000 100.0% 6,666,667 100.0%

Valuation (in $) 10,000,000

Price Per Share (in $) 1.50

Pre‐Financing


Post‐Financing

343



Redeemable Preferred - Exit Diagram (RP)

• “Redcap Ventures” purchased 2.67 million shares at $1.50 per share for an aggregate purchase price (APP) of $4 million.

• If the stock is deemed preferred with a 2x liquidation preference, what is the payoff diagram upon liquidation.

• For now, assume no conversion is allowed and no common stock is issued – stock can only be redeemed at 2x initial stock price.

• How does redeemable prefer compare to traditional debt? How is it the same? How is it different?

0

2

4

6

8

10

12

0 5 10 15 20 25 30Preferred stock payoff

Enterprise value ($ millions)

Exit Diagram for Redeemable Preferred (no conversion)

344



Aggregate Purchase Price (APP)• Early transactions in venture capital were done

with a mixture of redeemable preferred and common stock.

• If two securities comprise a single investment round, it is necessary to split the new money into each security. For instance, assume RedCappurchases:

– Redeemable preferred (RP) with an “aggregate purchase price” of $2 million

– Common shares for $2 million, such that common shares comprised 40% of aggregate common shares.

• If the RP has a 2x liquidation preference, what does the payoff diagram for common look like?

0

2

4

6

8

10

12

0 5 10 15 20 25 30Preferred stock payoff


Exit Diagram for RP + Common Stock

345



Features of Preferred Stock: ConversionRedeemable Convertible Preferred (RCP):

• VCs are not banks – instead, they focus on upside. Therefore, preferred stock is convertible into common shares at the original purchase price. Once preferred stock is converted it loses any preference provisions.

Term Sheet…

Liquidation Preference:In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows: First pay [ X ] times the Original Purchase Price plus accrued dividends on each share of Series A Preferred. The balance of any proceeds shall be distributed to holders of Common Stock.

Optional Conversion:The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”

Either

Or

346



Redeemable Convertible Preferred Stock• “Redcap Ventures” purchased 2.67

million shares at $1.50 per share for an aggregate purchase price (APP) of $4 million.

• With this purchase, Redcap acquired the rights to 40% of the common stock upon conversion. What would the payoff for straight conversion look like?

• When would RedCap redeem its preferred? When would it chose to convert preferred into common?

0

2

4

6

8

10

12

0 5 10 15 20 25 30

Preferred stock payoff


Exit Diagram for Redeemable Convertible Preferred

347



Participating Convertible Preferred Stock(PCPS)

• In half of all transactions examined by Kaplan & Stomberg (2003), convertible preferred was participating.

• "Participating" preferred refer to securities that participate in excess earnings with the common stock over and above their preferred dividend.

• One of the most important features of these securities is that they allocate different cash flow rights depending on whether exit occurs through a Trade Sale(TS) or an Initial Public Offering (IPO).

Liquidation Preference:In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

First pay one times the Original Purchase Price on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis.

A merger or consolidation and a sale, lease, transfer or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above.

Corporate Charter

348



Participating Convertible Preferred Stock• If Redcap Ventures shares are convertible at 40% of total common stock, but are

designated as participating preferred (at 2x) in a liquidation event, what would the exit diagram look like?

0

2

4

6

8

10

12

0 5 10 15 20 25 30




0

2

4

6

8

10

12

0 5 10 15 20 25 30



Exit Diagram for Participating Convertible Preferred

349


Voluntary versus Mandatory Conversion• In a “deemed liquidation event,” such an acquisition, the preferred shareholders

can convert into common if they so choose (a voluntary conversion).

• To complete an IPO, all preferred shares will be converted into common stock. This is known as automatic conversion. In this case, PCSP no longer has value…


Term Sheet…

Mandatory Conversion:Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a [firm commitment] underwritten public offering with a price of [___] times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $[_______] (a “QPO”), or (ii) upon the written consent of the holders of [__]% of the Series A Preferred.

…

350



Acquisition versus an IPO• Most venture capital agreements

provide for mergers or trade sale as a liquidation event, in which case the venture capitalist is entitled to participation preferred rights.

• Why is there a difference? Think of the VC now as the informed investor (versus the entrepreneur).

• From a purely financial standpoint, what will the VC prefer? What non-financial considerations does a VC have?

0

4

8

12

16

20

0 5 10 15 20 25 30




Trade Sale or Liquidation

Qualified Public Offering

Exercise: Which is worth more to the VC? A $20

million acquisition or a $25 million IPO?

351


What does a QPO prevent?


352


Mandatory Conversion for RCP?

• An investment banker will be no more likely to support a redeemable convertible than a participating convertible in an IPO.

• So why is there no mandatory conversion clause for RCP securities?


0

2

4

6

8

10

12

0 5 10 15 20 25 30




Trade Sale or Liquidation

Qualified Public Offering

353



PCPS With Cap• When combined with a multiple times

liquidation preference, the double-dipping of “participating” stock appears over-reaching, especially for large payouts.

• Therefore, many VCs will cap their preferred rights at some level, even in the cast of an acquisition or liquidation.

• A cap can be found either described explicitly in the liquidation preference, or implicitly in a provision on mandatory conversion.

Liquidation Preference:In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

First pay one times the Original Purchase Price on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis until the holders of Series A Preferred receive an aggregate of [ ] times the Original Purchase Price.

354



PCPS With Cap: Exit Diagrams

• “Redcap Ventures” purchased 2.67 million shares at $1.50 per share for an aggregate purchase price (APP) of $4 million.

• Redcap Ventures shares are convertible at 40% of total common stock, but are designated as participating preferred (at 2x) in a liquidation event.

• If the participating preferred is capped at 3x (which is typical) what do the payout diagrams look like?

Note: Pro-entrepreneur attorneys will fight for 1x liquidation preference and 2x cap on participating, arguing that VC always can convert to common.

0

4

8

12

16

20

0 10 20 30 40Preferred stock payoff


Exit Diagram for Participating Convertible Preferred with Cap

355



VC Hybrid Securities: A Summary• Long gone are the days of simple common stock.

Today, venture capitalists use a variety of preferred stock contracts to limit the problems caused by information asymmetries, both between the entrepreneur & VC as well as between the VC and the stock market. Preferred stock includes:

– Redeemable Preferred (RP)

– Redeemable Convertible Preferred (RCP)

– Redeemable Convertible Participating Preferred (PCP)

– Redeemable Convertible Participating Preferred with cap (PCP with CAP)

Payoff Diagrams

356

Venture Capital & the Finance of Innovation Lecture 17 – Fundamentals of Option Pricing

Fundamentals of Options Pricing




17

357



Venture Capital & Contingent Claims• To value a company, we use

traditional valuation techniques such as discounted free cash flow (using probabilities) or transaction multiples.

• Because the payoff structures in venture capital are not linear functions of enterprise value, traditional methods are unreliable.

• Instead, use option pricing modelsto convert enterprise value into preferred stock value.

0

2

4

6

8

10

12

0 5 10 15 20 25 30




358



Derivatives / Contingent Claims

• In this lecture, we review the fundamentals of option pricing.

• These valuation techniques were pioneered by Black, Merton, and Scholes during the early 1970s.

• The valuation of contingent claims (such as options and other derivatives) is unique because if the underlying security is traded, it does not require probability assessments, nor an estimate of the cost of capital.

0

30

60

90

120

150

0 50 100 150 200

Call Option Payoff

Stock Price

Exit Diagram for a Call Option

359



Contingent Claims Valuation: Binomial Trees

• Let’s value a contingent claim in a one period, two state world. For exposition, we start with a two state model and then we generalize to multiple periods.

• What is the value of a stock that can either rise to $130 or fall to $90 with equal probability? The cost of equity equals 10%

• What are the payoffs and DCF value for a call option with a strike price (K) of $100?

S0 = ?

The Underlying Asset

Su = 130

Sd = 90

C0 = ?

The Contingent Claim

Cu = max(S1- K, 0) =

Cd = max(S1- K, 0) =

360



The Replicating Portfolio: An Example• To value the call option, we can not use discounted cash flow, since we can not

properly measure the option’s cost of capital. Instead, we use replicating portfolios.

• Since there are two states of the world, we need two assets to replicate the payoff structure of the option. The first is the underlying asset (in this case a stock). The second is a risk free bond, that pays B regardless of the future state.

• Assume the risk free bond pays 5%, regardless of end state.

N(130)+ B = 30

N(90)+ B = 0

Payoff in up state

Payoff in down state

361



Pricing the Option

• To replicate the call payoffs perfectly, we need to purchase 0.75 shares (N) and borrow $64.29 dollars (present value of B). Let’s verify the portfolio payoff, and then value this portfolio in order to value the call option.

(.75)(130) – (67.50) =

(.75)(90) – (67.50) =

Payoff inup state

Payoff in down state

Verify the Portfolio Payoff Value the “Portfolio”

f0 r1

BNS C

Law of One Price:

362


Arbitrage Portfolios• You are discussing option theory with a group of Harvard MBAs, who

are still using traditional DCF to value options. They offer to buy/sell options on the stock at $13.64. If you can trade the underlying asset seamlessly, how can you profit from the offer?


• In 2008, who played the role of the Harvard MBA? Why did the arbitrage trades fail? Who backed up the trades?

363



Contingent Claims Valuation: Key Insights

• Discounted cash flow can be used to value the call option, but ONLY if you know the appropriate cost of capital. Since we know the option value, we can back out the cost of capital. Is the cost of capital higher or lower than the underlying asset (which was 10%)?

C0 = ?


C1 = max(S1- K, 0) =

C2 = max(S1- K, 0) =

Key InsightA call option is

identical to a levered stock position

364


Binomial Pricing – Generalized Formula

• Building a replicating portfolio to value each option can be insightful, but quite time consuming!

• Therefore, we use general terms and a touch of algebra to determine an option’s price with a single formula.

• The key determinants of option are S, u & d, rf, and Cu & Cd. The number of shares (N) and required borrowing (B) are intermediate steps.


S0 = ?

The Underlying Asset

S1 = 130 = uS0

S1 = 90 = dS0

C0 = ?


C1 = max(S1- K, 0) = Cu

C2 = max(S1- K, 0) = Cd

365



Binomial Pricing: Derivation• We have just shown a specific example of how to price a call option

(or any contingent claim) using binomial option pricing. Let’s generalize our results.

uC BN(uS)

dC BN(dS)

)C-(C d)S-N(u du0

0

du

d)S-(u)C-(C N

u0 C B)N(uS

)N(uSC B 0u

f0 r1

BNS C

366


Binomial Pricing: Derivation

• To derive a robust “DCF” based model for option pricing, we start with the price of the replicating portfolio.

• Using our solution for the number of shares (N) and risk free borrowing (B), we can use algebra to rearrange the equation.

• The algebra is available in the appendix of this presentation.


f0 r1

BNS C

N(uS)C)rNS(1)r(1

1 C uff

0

du0 Cd-u

d-r)(11Cd-u

d-r)(1r)(1

1 C

duf

0 C*p1C*p)r(1

1 C

And now simplify with a tremendous amount of nasty

algebra!

367



Binomial Pricing – Generalized Formula

• Economists call this formula “risk-neutral pricing.” Call options are not risk-free, rather the risk has been incorporated within in the probabilities (p*) and not the traditional cost of capital.

duf

0 C*p1C*p)r(1

1 C

d-ud-)r(1 p* f

such that )r(1

*pp|CE Cf

10

• Economists call these probabilities risk-neutral probabilities.

• Note how the underlying asset’s cost of capital and original probabilities (p) are not required to solve for the call price!

Using the formula, what is the value of

our call option?

368



Valuation of Any Security

Risk neutral valuation works for any payoff:

• What is the value of a call option on a stock trading at $100 with a strike price of $110? Assume u = 1.3, d = 0.9, and the risk free rates equals 5%.

• What is the value of stock, trading at $100. Assume u = 1.3, d = 0.9, and the risk free rate equals 5%.

duf

0 C*p1C*p)r(1

1 C

d-ud-)r(1 p* f

such that

369


The Risk Neutral World: Minority Report


• Do you remember the movie minority report? I was writing a paper about option pricing when it came out.

• In the movie, Tom Cruise was able to spin and move pictures at will. If only we had this technology for option pricing…

370


The Risk Neutral World: Algebraic Transformation


• Different call options have different hedge & leverage ratios, so why can we use just one set of probabilities? Because the stock and bond now have the same expected rate of return. So leveraging the portfolio does not change the expected rate of return!

0%

10%

20%

30%

40%

50%

0% 20% 40% 60% 80% 100% 120% 140% 160%

Expe

ctged Re

turn

Annual Volatility

Mean Variance Plot: Actual

0%

10%

20%

30%

40%

50%

0% 20% 40% 60% 80% 100% 120% 140% 160%

Expe

ctged Re

turn

Annual Volatility

Mean Variance Plot: Risk Neutral World

371



Discrete Models Becoming Continuous

• Clearly a one period, two state world is very realistic.

• What if we, however, took the length of each intermediate period to be very small? And used many one period models stacked upon another to create a price diffusion process.

• We could then use recursive valuation (from back to front) to value a derivative security.

Time 1 Time 2 Time 3 Time 4 Time 5

S0 = 100

S5 = 130

S5 = 90

What happens if we take the length of each time period towards zero?

372



Black-Scholes Option Pricing Model• To value a call option, we can use

multiple binomial trees, starting at the end and working backwards.

• Fischer Black and Myron Scholes used the concept of arbitrage free portfolios of two assets, but instead worked in continuous time.

• They argued a call could be replicated through a continuously updated leveraged position in the stock.

T-r2010

fe)KN(d - S)N(d C

becomes…

Tσ

T2σ r

KSln

d

2

f0

1

Tσd d 12

such that

f0 r1

BNS C

373



Black Scholes: An Example

• What is the value of a call option on a stock trading at $100 with a strike price of $100. Assume the time to expiration is one year, the risk free rate is 5%, and the annualized volatility is 20%.

EUROPEAN CALL

European Call Calculation

stock price S= $100.00strike price X= $100.00standard deviation (annualized) 20.00%riskfree interest rate r= 5.00%time until expiration T= 1Call Option Value $10.45

Source: VCV

All inputs in consistent

time periods

374



Limitations in Practice• Black-Scholes is an extremely powerful

model, and can help to bound option valuations. A few drawbacks exist, however, for the Black Scholes model:

– Black Scholes requires a constant interest rate and a constant volatility .

– Cochrane (2005), however, argues the perceived drop in volatility following investment rounds is not reliably found in VC-based data.

– Black Scholes requires that the underlying asset be liquid. Otherwise, the replicating portfolio is merely a theoretical construct.

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%


Annualized VolatilityAmazon.Com vs S&P 500

Measured using2‐years of historical returns

375



The Determinants of Option Value

• There are five primary determinants of an option’s value: the stock price, the exercise price, the stock’s volatility, the time to maturity, and the interest rate.

Symbol Value Driver Current Value Effect on Call Value

Stock Price $90

Exercise Price $100

The Stock's Volatility 18%

Time to Maturity 3 months

Interest Rate 5%

376



Sensitivity Analysis: Stock & Strike Prices• What happens to the value of a call option, as the stock price increases?

• What happens to the value of a call option, as the strike price drops?

Probability of Positive PayoffWith Low Stock

0

10

20

30

40

50

60

0 50 100 150

Stock Price

Payo

ff

Probability of Positive PayoffWith Valuable Stock

0

10

20

30

40

50

60

0 50 100 150

Stock Price

Payo

ff

377



The Value of Uncertainty• The greater the volatility, the more opportunities for high payoff.

Therefore, options are the most valuable when the underlying asset is highly volatile.

Probability of Positive PayoffWith Low Variance

0

10

20

30

40

50

60

0 50 100 150

Stock Price

Payo

ff

Probability of Positive PayoffWith High Variance

0

10

20

30

40

50

60

0 50 100 150

Stock Price

Payo

ff

378



The Determinants of Option Value

• There are five primary determinants of an option’s value: the stock price, the exercise price, the stock’s volatility, the time to maturity, and the interest rate.

Symbol Value Driver Current Value Effect on Call Value

Stock Price $90

Exercise Price $100

The Stock's Volatility 18%

Time to Maturity 3 months

Interest Rate 5%

379


Appendix

Binomial Pricing Derivations




380



Binomial Pricing: Derivation• We have just shown a specific example of how to price a call option

(or any contingent claim) using binomial option pricing. Let’s generalize our results.

uC BN(uS)

dC BN(dS)

)C-(C d)S-N(u du0

0

du

d)S-(u)C-(C N

u0 C B)N(uS

)N(uSC B 0u

f0 r1

BNS C

381




Substitute the equation for B from the previous page into the last formula. Rather than keep (1+r) attached to B, move it outside the brackets.

f0 r1

BNS C

N(uS)C)rNS(1)r(1

1 C uff

0

uf

0 Cu)-rNS(1)r(1

1 C

d-ud)-(uCu)-r(1

d-uC-C

r)(11 C udu

0

The value of a call option equals the value of the tracking portfolio, where N equals the number of shares, and B equals the debt borrowed.

Combine the two terms which are a function of N and S into a single term.

Substitute the equation for N from the previous page into the last formula. Multiply Cu by one.

382




du0 C

d-uu-r1C

d-ud-uu-r1

r)(11 C

du0 C

d-ur)1(uC

d-ud-r)(1

r)(11 C

du0 C

d-udr)1(d-uC

d-ud-r)(1

r)(11 C

du0 Cd-u

d-r)(11Cd-u

d-r)(1r)(1

1 C

Start with the last equation from the previous page.

d-ud)-(uCu)-r(1

d-uC-C

r)(11 C udu

0

Separate Cu from Cd and then combine like terms.

Cancel u with itself, and rearrange -(1 + r –u) into u - (1+r).

Add and subtract d in the second term.

Cancel u-d in numerator and denominator of the second expression and we are done!

383



Binomial Pricing – Generalized Formula• Economists call this formula “risk-

neutral pricing.” Call options are not risk-free, rather the risk has been computed within in the probabilities (p*) and not the traditional cost of capital. du

f0 C*p1C*p

)r(11 C

d-ud-)r(1 p* f

such that

)r(1*pp|C EC

f0

• Economists call these probabilities risk-neutral probabilities.

• Note how the cost of capital and original probabilities are not necessary!

384

Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims




18

Valuation of Venture Capital ClaimsUsing VCV

385


Session Overview• A preferred share can be replicated by a series of call options. To determine

the appropriate portfolio of call options, first build a payoff diagram.

• Rather than compute the value of each option one-by-one, use the VCV Excel model, built by Wharton alumni.

– The VCV model uses a modified version of Black-Scholes to value each call option, summing the resulting values.

– The primary modification to the Black-Scholes valuation is the time to expiration. Rather than use a fixed time, the model uses a series of probability-weighted times.

• Dividends will affect the payoff diagrams and consequently the valuation. VCV has the capability to handle dividends.


386



Venture Capital & Contingent Claims

• To value the portfolio company, use traditional valuation techniques such as discounted free cash flow (using scenarios and probabilities) or multiples.

• Because the payoff structures in VC-backed companies are not a simple linear functions of enterprise value, use options models to convert enterprise value into preferred stock value.

0

2

4

6

8

10

12

0 5 10 15 20 25 30




387



Constructing Tracking Portfolios: Redeemable• Earlier, “Redcap Ventures” purchased 2.67 million shares at $1.50 per share in

Series A financing (for an aggregate purchase price of $4 million).

• If preferred stock is redeemable at 2x but not convertible, how can we construct a portfolio of stocks and options?

0

2

4

6

8

10

12

0 5 10 15 20 25 30




0

2

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6

8

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0 5 10 15 20 25 30




388



Constructing Tracking Portfolios: Convertible• If preferred stock is redeemable at 2x and convertible into 40% of

common, how can we construct a portfolio of stocks and options?

0

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12

0 5 10 15 20 25 30




0

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389



Valuation of Preferred Stock• If the stock is redeemable at

2x and also convertible into 40% of common, we can value the claim as follows:

20)(0.4)C(at8)C(atEntValPS 00

• Supposedly, we purchasing 40% of a $10 million company for $4 million. But how much is the VC claim really worth?

390



Sensitivity: Increased Volatility

A few questions:

• What happens to the value of the company if the volatility of cash flows rises, but expected cash flow and covariation with the economy remains at historical levels?

• What happens to the value of preferred stock when volatility rise?

391



Negotiations: The Counter Proposal• Your VC firm is considering an investment in iPet.com. You estimate iPet’s

enterprise value at $20 million. The volatility of enterprise value is estimated at 90% per year.

• You propose making an investment of $5 million in participating redeemable convertible preferred. The liquidation preference will equal 2x, and the security in convertible into 25% of the common stock. What is the payoff diagram? What is the security worth? Should you make the investment?

• What if the founder balks at “double-dipping?” What percentage of common would you counter with, for straight redeemable convertible preferred? Continue to assume the 2x liquidation preference?

392



Exit Diagrams• Build the payoff diagram for each preferred share type:

0

4

8

12

16

20

0 10 20 30 40




0

4

8

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16

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0 10 20 30 40




393



Original Valuation: Participating

0

4

8

12

16

20

0 10 20 30 40




394



Valuation & the Counter Proposal

0

4

8

12

16

20

0 10 20 30 40




395


Negotiation: Interesting Issues• How will the “Post-Money” valuation change?

– In the original offer, you propose a $5 million investment for 25% of a $20 million post-money valuation. The participation feature made the security quite valuable.

– In the response, you propose RCP with a greater percentage ownership. How does this change the post-money valuation? Should we change the VCV model to reflect the new post-money valuation?

• Does security choice matter?– As the venture capitalist, you have designed two securities with identical economic

values ($8.78 million).

– You offer both contracts to the entrepreneur. Even with identical economic values, why should you care which security the entrepreneur chooses? How can you use this information ex-ante?


396


Valuation of Venture Capital ClaimsVCV: How the Model Works




397


Why the Need to Press Calculate?• European Call Options have a fixed expiration date. For VC-based

preferred stock, when do the imbedded options expire? They do not! So how do we handle random expiration (RE)?


Value (T =1) = 4.5 million

Value (T = 2) = 4.9 million




A Black-Scholes valuation based on a (1) particular underlying asset price, (2) strike price, (3) volatility, (4) interest rate, and (5) time to expiration of three years.

398



RE Calls versus European Calls

• Random expiration calls require numerical approximation because the normal function N(d1) within the valuation equation is impossible to integrate.

• The same inputs as a traditional call are still required, except now we model time as the 50% threshold of expiration.

EUROPEAN CALL

European Call Calculation

stock price S= $100.00strike price X= $100.00standard deviation (annualized) 35.00%riskfree interest rate r= 5.00%time until expiration T= 1Call Option Value $16.13

399



Why the Need to Press Calculate?• A traditional call option give its holder the right to purchase the underlying

asset (such as a stock) for a set period of time. The option holder can choose when to exercise (American options).

• Venture capital options are unlike to traditional call options, as the holder can be forced to close out their position at any time (Random Expiration).

• We value random expiration by taking the expected value of multiple call options:

T

1t

rt-201RE )KeN(d - )SN(dp(t)C

Probability thatoption will be exercised

on date t

Value of the option

400


The Exponential Distribution• The exponential distribution is the most common distribution for (theoretically) measuring

wait times, such as the time it takes before the next phone call arrives to a call center or the time until default (on payment to company debt holders) in credit risk modeling.

• The exponential distribution is described by a single parameter (denoted by lambda or q).


0%

25%

50%

75%

100%

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Exponential DistributionCumulative Distribution Function

q = 0.5

q = 1.5

q = 1.0

0.00

0.25

0.50

0.75

1.00

1.25

1.50

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Exponential DistributionProbability Density Function

q = 0.5

q = 1.5

q = 1.0

q1Exp[t]

qtqePDF[t]

401



Probability of Conversion: The Distribution• Various probability density functions are available to model random expiration, but to

be consistent with other theoretical models (such as component failure probabilities), we choose the exponential distribution.

• The exponential function is continuous, allows for any possible time to conversion, but decays at a reasonable rate.

1x)KeN(d - )SN(dqeCmonths 120

0t

rt-201

qtRE

probability value

• In VCV (module 2):

Do While counter < numPeriods…revar = revar + (qvar * Exp(-qvar * (counter / 15) / 24) * BS(svar, xvar, (counter / 15) / 24, vvar, rvar))....Loop

VCV is the work-product of many alumni, which has led to “less than desirable” coding.

For instance, the model started with bi-monthly time periods, and has now moved to daily

time periods…

The program uses “Simpson's rule” integration.

402


Exponential Distribution: Measuring Q• How should we think about the distribution? Currently the model uses expected holding

period to determine “q”, which is the “best” unbiased statistic if you are estimating using historical exits. If you are conceptualizing exits with no data, than perhaps median would be a better statistic…


0%

25%

50%

75%

100%

0 1 2 3 4 5 6 7 8Time in Years

Cumulative Probability of Mandatory ConversionUsing Exponential Distribution

q = 0.1

q = 0.2

q = 0.15q1Exp[t]

qln(2)Median[t]

Summary Statistics

Note: The ln(2) equals 0.7, so Median = (0.7) Expectation

403


Modeling Dividends• Preferred stock can include a cumulative dividend. Typically, this dividend does not pay

in cash; instead, it adds to the redeemable value of the preferred and is paid upon exit.


Alternative 1: Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and if paid on the Common Stock

Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, participation with Common Stock on an as-converted basis.

Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.

• In some cases, accrued and unpaid dividends are payable on conversion as well as upon a liquidation event. Most typically, however, dividends are not paid if the preferred is converted. Another alternative is to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value. The latter are referred to as “PIK” (payment-in-kind) dividends.

404


Valuation with Dividends: Payoff Diagrams


• The payoff diagram will depend on dividends. This occurs because dividends will change the redemption value.

• Draw the payoff diagram for a company that pays 2x the liquidation preference, plus a cumulative (but non-compounding) dividend of 8%. What is the payoff diagram in the fifth year?

0

2

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6

8

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12

0 5 10 15 20 25 30




0

2

4

6

8

10

12

0 5 10 15 20 25 30




Payoff at Time Zero

405



Dividends & RE Calls• Preferred stock can include a cumulative dividend. This dividend does

not pay in cash; instead, it adds to the redeemable value of the preferred and is paid upon exit.

• Including dividends in our analysis is more complex than the inclusion of a liquidation preference, because the strike price is changing over time. But this is easily handled in a random expiration call.

dtqe)K(t)eN(d - )SN(dC qt

0t

rT-201RE

probability

The strike (K )is a function of time as well

(DivRate)tKeK(t) suchthat

Since the RE option already requires us to compute a separate Black-Scholes formula at every point in time, the model can easily handle changing strike prices caused by dividends.

406

Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments

Valuation of Series B Preferred




19

407


Round 2: Series B Financing• In the Series B financing, our portfolio company raises $6 million for 30% of

the fully-diluted share count. The shares are redeemable at a 2x liquidation preference.


Questions:How many shares will be issued, and what happens to Redcap's fully-diluted ownership percentage?

Is Round 2 an “up round” or a “down round”?


Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 31.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 5.3%

Unissued 500,000 12.5% 500,000 7.5% 500,000 5.3%



Total 4,000,000 100.0% 6,666,667 100.0% 9,523,810 100.0%

Valuation (in $) 6,000,000 10,000,000 20,000,000


Pre‐Financing Series A Series B


408


Series B Liquidation Preferences: New Money First

• The Series B has preference over earlier rounds and the founder. Assuming no conversion (i.e. only redeemable preferred) and Series B has preference to Series A, draw the payoff diagram for each investor:


0

5

10

15

20

25

30

0 5 10 15 20 25 30

Pref

erre

d St

ock

Payo

ff

Enterprise Value ($ millions)

Exit Diagram for Redeemable Preferred

(Series B)

0

5

10

15

20

25

30

0 5 10 15 20 25 30

Pref

erre

d St

ock

Payo

ff



(Series A)

0

5

10

15

20

25

30

0 5 10 15 20 25 30

Com

mon

Sto

ck P

ayof

f


Exit Diagram for Common Stock

(Founder)

409


Liquidation Preference “Overhang”

• One downside of an aggressive liquidation preference (or multiple rounds with preferences) is known as liquidation preference “overhang.”

– In an overhang situation, common stock holders (and others subordinated in the capital structure) have no incentive to provide effort or capital.

• If overhang becomes a motivation issue, the company can create a “bonus pool” for key employees that will share in the liquidation, paripassu.


In one nasty negotiation, management demanded the elimination of the liquidation preference, i.e. a “cram down.” They threatened to de facto transfer assets to a new company. VC countered with threat to sue on grounds of “illegal conveyance.”

410


Series B Liquidation Preferences: Pari Passu• If liquidation preferences are “pari passu” then A & B share pro-rate on either

a share count basis, or a proportional liquidation preference.

• For instance, what if liquidation preferences are paid on a proportional basis? What would be the payoff diagrams look like?


0

5

10

15

20

25

30

0 5 10 15 20 25 30

Pref

erre

d St

ock

Payo

ff



(Series B)

0

5

10

15

20

25

30

0 5 10 15 20 25 30

Pref

erre

d St

ock

Payo

ff



(Series A)

0

5

10

15

20

25

30

0 5 10 15 20 25 30

Com

mon

Sto

ck P

ayof

f



(Founder)

411


Optimal Conversion with Multiple Rounds1. Compute the optimal conversion point for each investor (i.e. at what

valuation will investor convert versus redeem) , assuming the other investors do NOT convert.

– Compute Series A optimal conversion, assuming Series A does not convert.

– Compute Series B optimal conversion, assuming Series B does not convert.

2. Using the optimal conversion points, rank them from lowest to highest.

3. Assuming lowest converts first, rerun conversion points for investments with higher conversion points.


412


Series A Optimal Conversion

• In addition to demanding 30% at $20 post-money, Sand Hill also demands a 2x liquidation preference to all prior financings.

• Assuming Series B does not convert, at what point would Series A convert? How is the fully diluted ownership of Series B determined?


8)12tVal(40.0%)(En Assume Series

B does not convert

Fully diluted ownership of

Series A

Redemption value of Series B

Redemption value of Series A

413


Series B Optimal Conversion

• In addition to demanding 30% at $20 post-money, Sand Hill also demands a 2x liquidation preference to all prior financings.

• Assuming Series A does not convert, at what point would Series B convert? How is the fully diluted ownership of Series B determined?


Assume Series A does not

convertFully diluted ownership of

Series B

Redemption value of Series A


414


Series B: Adjusted Conversion • The optimal conversion point for Series A is $32.0 million and Series

B is $36.8 million. Therefore, Series A would convert before Series B.

• Assumes Series A converts at $32.0, what would the adjusted Series B conversion rate be?


12tVal)(30.0%)(En Assume Series A converts!


Series B

Series A no longer redeems


415


Series B Payoff Diagram

• With each investment’s conversion point calculated, draw the payoff diagram for Series B.

• Since Series B has the highest conversion point, it look similar to a traditional Series A convertible preferred investment.


0

5

10

15

20

25

30

0 10 20 30 40 50 60

Pref

erre

d St

ock

Payo

ff



(Series B)

416


Series A & Founder• The Series A and founder payoffs are tricky. Each conversion point with drive

a change in slope. Assuming each investor converts optimally, draw the following payoff diagrams:


0

5

10

15

20

25

30

0 10 20 30 40 50 60

Pref

erre

d St

ock

Payo

ff



(Series A)

0

5

10

15

20

25

30

0 10 20 30 40 50 60

Com

mon

Sto

ck P

ayof

f



(Founder)

417


Valuation of Founder’s Position


418


Valuation of Series A


419


Valuation of Series B


420


Which Valuation is Appropriate?• Using the fully-diluted share count, the Series A valuation rises from

$4.0 million (2.67 x $1.50) to $5.6 million (2.67 x $2.10). But what happens to economic value?


• How is this possible?

Fully Economic Fully EconomicDiluted Value Diluted Value

Founder 6.00 4.62 Founder 8.40 6.27Series A 4.00 5.38 Series A 5.60 5.11Series B n/a n/a Series B 6.00 8.62

10.00 10.00 20.00 20.00

Round 2Round 1

421


Negotiation: Force 1x Liquidation Preference

• The aggressive 2x liquidation preference for Series B caused the Series A to drop in economic value.

• If the liquidation preference is dropped to 1x, Series B will convert first, and the Series A threshold is calculated as:


8al)(28%)(EntV

How does this new valuation compare to the Series A valuation in Round 1?

422

Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments

Valuing Later-Round InvestmentsSeries C & Beyond




20

423


A Review: Series B Financing• In the Series B financing, our portfolio company raised $6 million at a post-

money valuation of $20 million, with a 2x liquidation preference.



Common – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 31.5%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 5.3%

Unissued 500,000 12.5% 500,000 7.5% 500,000 5.3%



Total 4,000,000 100.0% 6,666,667 100.0% 9,523,810 100.0%

Valuation (in $) 6,000,000 10,000,000 20,000,000


Pre‐Financing Series A Series B


424


A Review: Conversion Order1. Compute the optimal conversion point for each investor (i.e. at what

valuation will investor convert versus redeem) , assuming the other investors do NOT convert.

– Compute Series A optimal conversion, assuming Series B does not convert.

– Compute Series B optimal conversion, assuming Series A does not convert.

2. Using the optimal conversion points, rank them from lowest to highest.

3. Assuming lowest converts first, rerun conversion points for investments with higher conversion points.


425


Conversion Order: A General Formula• For investor i, let VCi equal their number of shares, LPi equal their liquidation

preference (in $), and Trigger Pointi equal their exit value conversion threshold, assuming no other investors convert. Let F equal the number of shares of common stock (held by the founder and employees).


iix

xii

i LPLPPointTrigger FVC

VC

Assume all other rounds

do not convert


Series i, assuming NO other rounds

convert.

The cumulative liquidation

preference of all other rounds, except Series i

Liquidation preference of

Series i

426


Conversion Order Rearranged

• We start with the equation on the previous page, which determine the trigger point for venture capitalist i.

• Next, using a set of algebraic changes (shown in the appendix), we rearrange to solve for the venture capitalist i’s conversion point.


iix

xii

i LPLPPointTrigger FVC

VC

iiii

ii LPLPLPVC

FLPTrigger

ii

ii LP

VCLPFTrigger

ix

ixii

i LPLPLPPointTrigger FVC

VC

And now simplify with a some nasty

algebra!

427


Conversion Order: Rearranged• In the appendix, the formula on the last slide is rearranged to solve for Trigger

Pointi, the enterprise value at which Series i converts.


ii

ii LP

VCLPFPointTrigger

• Since the number of founder shares and the sum of liquidation preferences are identical across classes, they do not affect the rank ordering of the “Trigger Points”. Only the ratio of LP to VC (liquidation preference in $ divided by the number of VC shares) affects the rank ordering.

• The ratio of liquidation preference to VC shares is known as Redemption Value Per Share (RVPS)

Note: This equation assumes only venture

capitalist i is considering conversion. All others

redeem.

428


A Conversion Short Cut• A critical component to drawing an accurate payoff diagram is the

order of conversion (i.e. $32 million for A, $40 million for B, etc)

• The method outlined earlier is somewhat cumbersome. A simpler method is to compute the redemption value per share (RVPS):


Series A: $8 million / 2.67 million shares =

Series B: $12 million / 2.86 million shares =

• Conversion will occur from lowest RVPS to highest RVPS

429


Series C & Beyond• To value a portfolio company’s shares that has had multiple financing

rounds, use the following steps:

1. Build the fully-diluted capitalization table

2. Using redemption values per share (RVPS), determine the conversion order for each series.

3. Starting with the lowest RVPS, determine the conversion point for each series, using the method from the last lecture note.

4. Build the payoff diagrams to determine the appropriate portfolio of replicating options.

5. Use the VCV valuation model to price the shares.


430


Round 3: Series C Financing• In round three, our portfolio company is able to raise a Series C financing with

Back Bay Partners. Back Bay demands 25% fully-diluted ownership at a post-money valuation of $50 million, with a 1x liquidation preference.

• How many shares will be issued, and what is the new share price, and what are the fully-diluted valuations of each investor?


Pre‐Financing Series A Series B Series C Fully‐dilutedSecurity # of Shares % # of Shares % # of Shares % # of Shares % ValuationCommon – Founders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 31.5% 3,000,000 23.6%


Issued (strike at 1.50) 500,000 12.5% 500,000 7.5% 500,000 5.3% 500,000 3.9%

Unissued 500,000 12.5% 500,000 7.5% 500,000 5.3% 500,000 3.9%

Series A Preferred: Redcap Ventures 2,666,667 40.0% 2,666,667 28.0% 2,666,667 21.0%

Series B Preferred: Sand Hill VC 2,857,143 30.0% 2,857,143 22.5%

Series C Preferred: Back Bay Partners 3,174,603 25.0%

Total 4,000,000 100.0% 6,666,667 100.0% 9,523,810 100.0% 12,698,413 100.0%

Valuation (in $) 6,000,000 10,000,000 20,000,000 50,000,000

Price Per Share (in $) 1.50 1.50 2.10 3.94


431


Step 2: What is the Conversion Order?• The conversion order can be determined by ranking RVPS from lowest

to highest. Using the data from the Series C capitalization table, determine the conversion order for Series A, B, and C.


Conversion Table:

Liquidation Redemption Share Conversion Conversion

New money preference (x) value count RVPS1 order threshold

4,000,000

Seres A 4,000,000 2 8,000,000 2,666,667 3.00 1 50,000,000

Seres B 7,500,000 2 15,000,000 2,857,143 5.25 3 66,666,667

Seres C 15,000,000 1 15,000,000 3,174,603 4.73 2 61,500,000

1 RVPS = Redemption value per share.

432


Step 3: What are the Conversion Points?• Series A will convert first. At what valuation point does Series A

convert? Remember, Series B and Series C do not convert!


8.0)5.24tVal(40.0%)(En Fully diluted ownership of

Series A

Cumulative liquidation preference of Series B

and Series C


Series A

• Series C will convert second. At what valuation point does Series C convert? Remember, Series A converts, but Series B does not! Series B will convert third.

• What are the conversion points?

433


Step 4: What are the Payoff Diagrams?

• After you estimate the conversion points for each series, build the corresponding payoff diagrams.

• Use the payoff diagrams to determine the portfolio of options that will replicate the security.


0

5

10

15

20

25

30

0 15 30 45 60 75 90

Pref

erre

d st

ock

payo

ff



(Series A)

434


Step 5: What is the Series A Valuation?


435


Economic versus Capitalization Table• In Round 2, the Series A investor was punished by losing the power of

their liquidation preference.

• In Round 3, the liquidation preference for Series C was small (1x) and the higher post-money valuation drove an increase in investment value.


Fully Economic Fully Economic Fully EconomicInvestor Diluted Value Investor Diluted Value Investor Diluted ValueFounder 6.00 4.62 Founder 8.40 6.27 Founder 15.75 13.66Series A 4.00 5.38 Series A 5.60 5.11 Series A 10.50 9.65Series B n/a n/a Series B 6.00 8.62 Series B 11.25 11.79Series C n/a n/a Series C n/a n/a Series C 12.50 14.90

10.00 10.00 20.00 20.00 50.00 50.00

Round 1 Round 2 Round 3

436


RVPS With Dividends• Assume the company negotiated Series A and B without dividend, but

Series C requires an 8% dividend rate paid on money in, accumulated in the event of redemption. Assume dividends are not compounded.

• How does this affect conversion at liquidation?


Conversion Table:

Liquidation Redemption Share Conversion Conversion

New money preference (x) value count RVPS1 order threshold

4,000,000

Seres A 4,000,000 2 8,000,000 2,666,667 3.00 1 44,500,000

Seres B 6,000,000 2 12,000,000 2,857,143 4.20 3 53,333,333

Seres C 12,500,000 1 12,500,000 3,174,603 3.94 2 50,750,000

1 RVPS = Redemption value per share.

437


Appendix

RVPS Proof


438


Appendix: RVPS Proof• Rank ordering the redemption value per share (RVPS) leads to the same order as

computing the conversion points manually.

• For Investor I, let VCi equal their number of shares, LPi equal their liquidation preference (in $), and wi equal their conversion point. Let F equal the number of shares of the Founder.


iix

xii

i LPLPwFVC

VC

Assume all other rounds

do not convert


Series i, assuming NO other rounds

convert.

The cumulative liquidation

preference of all other rounds, except Series i


Series i

439


Appendix: RVPS Proof


ixii

i LPLPwFVC

VC

ix

iiii

ii LPLPLP

VCFVCw

iiii

ii LPLPLPVC

FLPw

ii

ii LP

VCLPFw

ix

ixii

i LPLPLPwFVC

VC

1. Start with the conversion point equation from the pervious slide.

2. Include LPi in the negative summation and add LPi separately. Adding and subtracting identical amounts equals zero.

3. Multiply both sides by (VCi + F) / VCi. Move the summation of LPx and LPi to the right side.

4. Separate VCi from F. VCi / VCi equals one.

5. Cancel LPi with negative LPi.

440


Appendix: RVPS Proof• The conversion point for each Series can be rearranged as:


ii

ii LP

VCLPFw

• Since the number of founder shares and the sum of liquidation preferences are identical across classes, they do not affect the rank ordering of w.

• Only the ratio of LP to VC (liquidation preference in $ divided by the number of VC shares) affects the rank ordering.

441

Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt

Angel FinancingThe Mechanics of Convertible Debt Financing




21

442


Angel versus Professional Capital• Angels tend to invest in companies at a very early stage, where uncertainty is greatest,

and information asymmetries are highest.

• Consequently, one would expect that Angels would demand higher equity stakes and better investor protections than venture capital, but instead we find the exact opposite! Angel contracts are notoriously simple!

• For instance,

– Angel investors tend not to stage investments. Most Angels invest all proceeds in the first round, with no expectation of participating in future rounds.

– Angel investors tend not to take board seats. One study of software companies found that less than 20% of angel financing including the granting of a board seat.

– Angel investors tend not to have “veto rights” over management decisions, such as hiring, mergers, asset sales, etc. One study found less than 5% of investments have veto rights.

– Angel investors tend not to have “exit rights,” forcing a sale or liquidation.


Legend has it that Andy Bechtolsheim simply handed Google’s founders a $100,000 check after they made a short

presentation!

443


Justifying Limited Protection: Follow On Financing

• Angels are the first, but not the last, source of outside funding for start-ups. According to Jeffrey Leavitt, “Angels generally invest with the expectation that, should the company progress as planned, one or more venture capital (‘VC’) firms will subsequently invest.” Venture capital is needed for a start-up to have any realistic chance at an IPO or even a high-dollar sale to a larger company.

• A venture capitalist might reject a funding proposal because of an overreaching Angel. A start-up marred by a complicated angel round is unattractive to venture capitalists because it requires them to “unwind” the non-standard angel preferences in order to strike the venture capitalists’ standard deal. Will the Angel unwind preferential terms?

• A survey by Stanco & Akah found that although more than 90% of venture capitalists consider Angels beneficial to the start-up industry roughly half of VCs found angel-backed start-ups to be unattractive candidates for funding since Angels took “unnecessarily complex terms.”


Source: Darian Ibrahim, Vanderbilt Law Review

444


Justifying Limited Protection: Reputation and Knowledge

• Angel investing is highly localized, relationship-driven, and industry-specific. Angels like to invest in start-ups where they know either the entrepreneur or the substantive area (e.g., biotechnology or e-commerce), and preferably both – limiting information asymmetries.

• Investment opportunities come to Angels from a network of trusted business associates.This “network of trust” serves an important screening and sorting function by funneling high-quality deals to Angels while excluding low-quality deals.

• Conversely, venture capitalists must make more investments to generate timely returns for fund investors, and this pressure inevitably forces venture capitalists to sacrifice some of the intimacy and familiarity with start-ups that Angels without downstream pressure enjoy.


Source: Darian Ibrahim, Vanderbilt Law Review

445


Justifying Limited Protection: Transaction Costs

• Given the small amounts associated with Angel financing, the Angel must be extremely careful about transaction costs. According to well-known Wilson Sonsini attorney Yokum Taku:

• The legal fees for a simple note (loan) are typically much lower than the legal fees for a preferred round, which are typically $50,000. For instance, on a $500,000 investment, what percent is $50,000?


“Convertible debt documents are generally much moresimpler to draft and read than equity financing documents, soI typically recommend convertible debt for companiesraising below around $750K.”

446


The Modern Angel Contract

SUMMARY OF PROPOSED TERMS FOR CONVERTIBLE PROMISSORY NOTE FINANCING

Amount: $1,000,000 in aggregate principal amount of convertible promissory notes (the “Notes”).

Maturity Date: Principal and unpaid accrued interest on the Notes will be due and payable 18 months from the date of the issuance ofthe first Note (the “Maturity Date”).

Interest: Simple interest will accrue on an annual basis at the rate of 7% per annum based on a 365-day year.

Conversion to Equity:

Automatic Conversion in a Qualified Financing: If the Company issues equity securities (“Equity Securities”) in atransaction or series of related transactions resulting in aggregate gross cash proceeds to the Company of at least$1,000,000 (i.e., not including the conversion of the Notes or any other debt obligations) (a “Qualified Financing”),then the Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity securities issuedpursuant to the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the per share price paid bythe purchasers of such equity securities in the Qualified Financing or (ii) the price obtained by dividing $6,000,000 bythe aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initialclosing of the Qualified Financing (assuming full conversion or exercise of all convertible and exercisable securitiesthen outstanding other than the Notes).


• Much of today’s angel financing is done with convertible debt, which means the Angel can force the company into repayment without an exit. But how realistic is this?

447


Conversion at “Market Price”• “The Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity

securities issued pursuant to the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the per share price paid by the purchasers of such equity securities.

• As an Angel, you plan to invest $1,000,000 in convertible notes. You are considering two startups:

– Start-up A: You expect the Series A investor to purchase 30% of the company at a post-money value of $10 million. Based on the current shares outstanding, this would equate to issuing 3 million new shares at $1 per share.

– Start-up B: You expect the Series A investor to purchase 30% of the company at a post-money value of $20 million. Based on the current shares outstanding, this would equate to issuing 3 million new shares at $2 per share.


APxdPrincipalShares Angel

APxSharesAngelValuation

Start-up A Start-up B

Which company is the most financiallyattractive to Angel?

Now try start-up

B…

448


Security Types• To avoid transaction costs, many Angels use convertible debt.

• The Angel’s convertible debt appears to have characteristics similar to traditional convertible debt, but since the conversion price is to be determined later, “convertibility” is quite misleading…


Angel: Convertible DebtNote convertible into common stock at future Series A price

(discounted).

Traditional Convertible DebtNote convertible into common

stock at a pre-specified price (e.g. $20 per share).

VC: Redeemable ConvertibleA stock which can either be

redeemed or converted into a pre-specified percentage of company

(e.g. 40%)

vs.

vs.

449


Purchase at the “Market” Price• The company receives a convertible note at time zero, which is convertible into shares at

the Series A price.


Company is acquired at

P(2)

T = 2

Company receives Series A financing at

P(1)

Company receives convertible note with “no price”

T =1T =0

• But what is the “expected return” between time 1 and 2? If the expected return is a CAPM fair return then what is the convertible’s option really worth?

• Implication: Are you really betting on the quality of company? Or are you betting on the quality of the VC?

450


The Convertible Note: Potential Outcomes

• With no cap, there are three potential outcomes. Either the company (1) fails, (2) the convertible is (partially) repaid, or (3) the note is converted at the Series A price.

• Since the option is only the “right to participate” at a discount, what is the value of the option?

• How can Angel actively work for “better” returns?


Investment($1 million)

Failure

Funding: $1.25 million of Series A stock at Series A price, i.e. right to participate!

Low-growth company:Company repays note with interest

451


Convertible Share Count: An Example• Prior to the Series A round, your company has 4 million fully-diluted shares outstanding

(non-inclusive of the convertible). Houston Capital offers to purchases 40% fully-diluted at a $15.0 million post-money valuation.



Common – Founders 3,000,000 75.0% 3,000,000


Issued (strike at 1.50) 500,000 12.5% 500,000

Unissued 500,000 12.5% 500,000

Convertible bond: $1,000,000

Series A Preferred: Houston Capital 40.0%

Total 4,000,000 100.0%


Price Per Share (in $)


Pre-Financing Round 1

Step 1Compute a price based on prior round’s

share count

Step 2Determine the number of convertible shares, based on the temporary price.

Step 3Determine the number of shares for the

Series A holder

Step 4Compute new price and start over!

452


Tricky Share Count

• Although the valuation is straight-forward, determining the resulting share count is tricky. This is because the conversion shares depend on the share price and share price depends on the converted shares!

• Define the following variables:

1. Define C as the # of convertible shares

2. Define Face Value as the principal of the note

3. Define EntValue as the post-money valuation offered by Series A

4. Define d as the Angel’s discount to Series A price

5. Define F as the # of founder shares (including options)

6. Define VCA as the # of Series A shares issued in offering

7. Define “p” as the percentage of ownership Series A is requesting


Pricex dValueFaceC

SharesTotalEntValuex d

Value FaceC

)VCC(FEntValuex d

ValueFaceC A

C)(F

p1pCF

EntValue x dValueFaceC

C)(F

p11

EntValue x dValueFaceC

C)(Fp1

1EntValue x d

ValueFaceC

453


Tricky Share Count

• In step 1, define the following variables:

1. Define Face Value as the principal of the note

2. Define d as the Angel’s discount to Series A price

3. EntValue as the post-money valuation offered by Series A

4. Define “p” as the percentage of ownership Series A is requesting

• In step 2, define the following variables:

1. Define C as the # of convertible shares

2. Define F as the # of founder shares (including options)


F#1 Step1

#1 StepC

p11

EntValue x dValueFace#1Step

C)(Fp1

1EntValue x d

ValueFaceC

C)(F x #1StepC

with some additional algebra…

454


Convertible Share Count: An Example• Prior to the Series A round, your company has 4 million fully-diluted shares outstanding

(non-inclusive of the convertible). Houston Capital offers to purchases 40% fully-diluted at a $15.0 million post-money valuation.



Common – Founders 3,000,000 75.0% 3,000,000


Issued (strike at 1.50) 500,000 12.5% 500,000

Unissued 500,000 12.5% 500,000

Convertible bond: $1,000,000

Series A Preferred: Houston Capital 40.0%

Total 4,000,000 100.0%


Price Per Share (in $)


Pre-Financing Round 1

455


Resulting Convertible Valuation• Without a “cap”, the convertible valuation is unaffected by the eventual post-

money valuation. The only upside is the discount (typically 20%) and the post-financing performance of the shares.


Series A ConvertiblePost‐Money ($) Founder Convertible Series A Total Price ($) Value ($) Step #1

3,000,000 4,000,000 9,090,909 8,727,273 21,818,182 0.14 1,250,000 0.6944,000,000 4,000,000 4,347,826 5,565,217 13,913,043 0.29 1,250,000 0.5215,000,000 4,000,000 2,857,143 4,571,429 11,428,571 0.44 1,250,000 0.4176,000,000 4,000,000 2,127,660 4,085,106 10,212,766 0.59 1,250,000 0.347

Key Variables 7,000,000 4,000,000 1,694,915 3,796,610 9,491,525 0.74 1,250,000 0.298Face value 1,000,000 8,000,000 4,000,000 1,408,451 3,605,634 9,014,085 0.89 1,250,000 0.260

9,000,000 4,000,000 1,204,819 3,469,880 8,674,699 1.04 1,250,000 0.231Discount 80% 10,000,000 4,000,000 1,052,632 3,368,421 8,421,053 1.19 1,250,000 0.208Series A 40% 11,000,000 4,000,000 934,579 3,289,720 8,224,299 1.34 1,250,000 0.189

12,000,000 4,000,000 840,336 3,226,891 8,067,227 1.49 1,250,000 0.174Founder 13,000,000 4,000,000 763,359 3,175,573 7,938,931 1.64 1,250,000 0.160Shares 4,000,000 14,583,333 4,000,000 666,667 3,111,111 7,777,778 1.87 1,250,000 0.143

15,000,000 4,000,000 645,161 3,096,774 7,741,935 1.94 1,250,000 0.13916,000,000 4,000,000 598,802 3,065,868 7,664,671 2.09 1,250,000 0.13017,000,000 4,000,000 558,659 3,039,106 7,597,765 2.24 1,250,000 0.12318,000,000 4,000,000 523,560 3,015,707 7,539,267 2.39 1,250,000 0.11619,000,000 4,000,000 492,611 2,995,074 7,487,685 2.54 1,250,000 0.11020,000,000 4,000,000 465,116 2,976,744 7,441,860 2.69 1,250,000 0.104

Share Count

456


The “Cap”: An Equity Sweetener• “The Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity

securities issued pursuant to the Qualified Financing at a conversion price equal to the lesser of (ii): the price obtained by dividing $6,000,000 by the aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initial closing of the Qualified Financing.

• The legal language above can be converted into a minimum share count for the convertible:


SharesMoney -PreCap""Pmin

minPFace(C) Shares of #Min

The Angel no longer converts at the Series A price, but potential

a better (lower) price.

This guarantees a minimum number of shares in the new

financing.

457


Convertible with a Cap: Resulting Payoffs• To determine the convertible share count, use the maximum between the share

count with no cap and the computed share count on the previous page. Upside is created by the “cap,” creating a synthetic RCP contract.


Series A ConvertiblePost‐Money ($) Founder Convertible Series A Total Price ($) Value ($)

3,000,000 4,000,000 9,090,909 8,727,273 21,818,182 0.14 1,250,0004,000,000 4,000,000 4,347,826 5,565,217 13,913,043 0.29 1,250,0005,000,000 4,000,000 2,857,143 4,571,429 11,428,571 0.44 1,250,0006,000,000 4,000,000 2,127,660 4,085,106 10,212,766 0.59 1,250,0007,000,000 4,000,000 1,694,915 3,796,610 9,491,525 0.74 1,250,0008,000,000 4,000,000 1,408,451 3,605,634 9,014,085 0.89 1,250,0009,000,000 4,000,000 1,204,819 3,469,880 8,674,699 1.04 1,250,00010,000,000 4,000,000 1,052,632 3,368,421 8,421,053 1.19 1,250,00011,000,000 4,000,000 934,579 3,289,720 8,224,299 1.34 1,250,00012,000,000 4,000,000 840,336 3,226,891 8,067,227 1.49 1,250,00013,000,000 4,000,000 763,359 3,175,573 7,938,931 1.64 1,250,00014,583,333 4,000,000 666,667 3,111,111 7,777,778 1.87 1,250,00015,000,000 4,000,000 666,667 3,111,111 7,777,778 1.93 1,285,71416,000,000 4,000,000 666,667 3,111,111 7,777,778 2.06 1,371,42917,000,000 4,000,000 666,667 3,111,111 7,777,778 2.19 1,457,14318,000,000 4,000,000 666,667 3,111,111 7,777,778 2.31 1,542,85719,000,000 4,000,000 666,667 3,111,111 7,777,778 2.44 1,628,57120,000,000 4,000,000 666,667 3,111,111 7,777,778 2.57 1,714,286

Share Count

458


0

400,000

800,000

1,200,000

1,600,000

2,000,000

0 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000

Convertible Payoff

Convertible with a Cap: Resulting Payoffs

• Upside is created by the “cap,” which creates a synthetic RCP contract.

• The slope equals the ownership that results from the cap, which is a function of the face value, the cap, and the Series A ownership percent (p).

• For the current offer, what is the trigger point and ownership slope?


Cap

Face1Cap

Facep1Slope

Note: the proof of the slope and trigger

points are in the appendix.

dFaceCap

p11PointTrigger

459


Avoiding a Valuation?• Many claim the purpose of convertible notes is to avoid having to determine a post-

money valuation. One professional investors writes:


“Here's one option to consider when trying to value your company for a seed-roundinvestment. Avoid it altogether; after all, it doesn't make sense and can only present apotential liability down the road. Instead of offering equity, offer debt that can be convertedinto equity at some point in the future. This strategy avoids the problem of applying animproper valuation too early in the life of the company.”

• But is this accurate? Just because there is no term sheet, cap table or share price, can the Angel really avoid having a perspective on the company’s enterprise valuation?

Contract AInvest $1 million with at a 20% discount and a cap of $6 million. Assume Series A will take 1/3

Contract BInvest $1 million with at a 25% discount and a cap of $8 million. Assume Series A will take 1/3.

We can even come up with a fully

diluted valuation!

If we are investing $1 million to get

into 8.3%, what is the fully-diluted

valuation?

460


Assignment: Which is Worth More?• As an angel, you are considering two contracts. The first contract is at

a 20% discount and $6 million cap. The second contract is at a 25% discount and $8 million cap. If you believe the value of the company is $4 million, what is the value of each contract?


0

400,000

800,000

1,200,000

1,600,000

2,000,000

0 5,000,000 10,000,000 15,000,000 20,000,000

Convertible Payoff

0

400,000

800,000

1,200,000

1,600,000

2,000,000

0 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000

Convertible Payoff

461


Comparative Statics• As the discount gets bigger (for instance from 80% to 70%), what happens to

the value of the convertible note?


• As the cap rises (for instance from $6 million to $20 million), what happens to the value of the convertible note?

APxdPrincipalShares Angel

APxSharesAngelValuationd

PrincipalValuation

minPFaceC

SharesMoney -PreCapPmin

SharesMoneyPrexCapFaceC

462


Convertible Notes: Survey Data• Median amount raised $662,500

• Median size of future financing in which note converts: $1,000,000

• Percentage of deals in which valuation on conversion is capped: 83%

• Percentage of deals that convert at a discount to the next equity round valuation: 67%.

• Median initial discount: 20%

• Percentage of deals with discount in which discount increases over time: 25%

• Treatment of note if company is acquired prior to an equity financing:

– Receive return of investment plus a premium: 50%

– Median premium: 0.75x original principal amount

• Median interest rate: 6.0%

• Median term: 18 months

• Percentage in which investors received a board seat: 8.3%


Source: Fenwick and West

463


Appendix


464


Proof: Conversion into Ownership (Slope)

• For every dollar increase in exit value, the convertible’s value increases by the number of conversion shares divided by the total shares.

• Replace the number of VCA shares with the rearranged percentage formula (p)

• Combine terms and take the reciprocal of 1-p (to place in the numerator). Next, use the definition of the number of convertible shares (see the comparative statics slide for derivation).

• Insert the number of conversion shares into the slope formula and

• Simply by removing F (the founder shares) and we are done!


AVCCFCSlope

C)(F

p1pCF

CSlope

p1CF

CSlope

FxCapFaceC

p1FCap

FaceF

FCapFace

Slope

Cap

Face1Cap

Facep1Slope

465


Proof: Trigger Point


Cap

Face1Cap

Facep1Slope

Slope1

dFacePointTrigger

Face/CapCap

Face1

p11

dFacePointTrigger

Cap

Face1 d

Capp1

1PointTrigger

dFaceCap

p11PointTrigger

• Start with the slope slide from the previous page.

• The trigger point equals the bond value divided by the slope from the previous page (as it is with RCP).

• Inert the slope formula from the previous page.

• Simplify by cancelling the Face value in the numerator and the denominator . Move CAP from the denominator of a denominator into the numerator.

• Distribute CAP into the parenthesis and we are done!

466


Thank You!

• I hope you found this lecture note (and our class) helpful.

• Just remember, innovation never sleeps. Best of luck in finding (or funding) that next great idea!


Final Slide

467

VC Notes - 2012

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