Venture Capital and Private Equity

Session 5Professor Sandeep Dahiya

Georgetown University

Course Road Map

• What is Venture Capital - Introduction• VC Cycle

– Fund raising– Investing

• VC Valuation Methods• Term Sheets• Design of Private Equity securities

– Exiting

• Time permitting – Corporate Venture Capital (CVC)

Term Sheets …

Anti-Dilution Protections

• Down round

• Full-ratchet vs. weighted average

• Adjusted conversion price, adjusted conversion rate

Read the Note on Anti-dilution provisions: Typology

and Numerical Example

Read the Note on Anti-dilution provisions: Typology

and Numerical Example

Broad-base weighted average anti-dilution

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

prior to new issueOB = Number of shares of shares outstanding

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

round

(Pre-Money Value+Money in new round)

(Total # of Shares after financing)NCP

Another way of writing it

EXAMPLE: Suppose that Early Venture (EV) makes a $8M Series A investment in Newco for 2M shares at $4 per share on 1/1/1999. One year later, Newco has fallen on hard times and receives a $10M Series B financing from Late Venture (LV) for 5M shares at $2 per share. The founders and the stock pool have claims on 6M shares of common stock.

Consider the following cases:• Case I: Series A has no antidilution protection.• Case II: Series A has full-ratchet antidilution

protection.• Case III: Series A has broad-base weighted-average

antidilution protection.For each of these cases, what percentage of Newco

(fully diluted) would be controlled by EV, Founders and LV following the Series B investment? What would be the post-money and pre-money valuations?

Investor # of shares $ per share $ total % ownership # of shares $ per share $ total % ownership # of shares $ per share $ total % ownership

Founders 6,000,000 $0.001 $6,000 100% 6,000,000 - $24,000,000 75.00% 6,000,000 - $12,000,000 46.15%Early VC 2,000,000 $4.00 $8,000,000 25.00% 2,000,000 $2.00 $4,000,000 15.38%Later VC 5,000,000 $2.00 $10,000,000 38.46%

Total For Round 5,000,000 $2.00 $10,000,000 38.46%Cumulative Total 6,000,000 $0.001 $6,000 100% 8,000,000 $4.00 $32,000,000 100% 13,000,000 $2.00 $26,000,000 100%

Initial Capitalization1/1/1998

Second Round No Antidilution1/1/2000

First Round1/1/1999

Investor # of shares $ per share $ total % ownership # of shares $ per share $ total % ownership

Founders 6,000,000 - $12,000,000 40.00% 6,000,000 - $12,000,000 44.52%Early VC 4,000,000 $2.00 $8,000,000 26.67% 2,476,190.5 $2.00 $4,952,381 18.37%Later VC 5,000,000 $2.00 $10,000,000 33.33% 5,000,000 $2.00 $10,000,000 37.10%

Cumulative Total 15,000,000 $2.00 $30,000,000 100% 13,476,190 $2.00 $26,952,381 100%

NCP 3.23

Second Round Full Ratchet1/1/2000

Second Round Partial Ratchet1/1/2000

Notice value of Early VC has fallen from 8 million to 4 millionThis implies a “paper loss” of 8-4= 4 million!

Liquidation – Quick Review

• Deemed liquidation event

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

• Qualified public offering (QPO)

What Type of Security?

• Alpha– Convertible Preferred (CP) Stock

• Mega– Participating Convertible Preferred (PCP)

Stock

TYPE OF LIQUIDATION EVENT IS CRITICAL!

Many types of preferred stock

• Redeemable Preferred (RP)

• Convertible Preferred (CP)

• Participating Convertible Preferred (PCP)

• PCP with cap (=PCPC)

• Key threshold for PCP is a qualified public offering (QPO)

Alternatives$ 5 million investment 1/3rd ownership(Implied Valuation= $15 Million, 15 million shares)• Structure I: 5M shares of common;• Structure II: RP ($5M APP);• Structure III: RP + 5M shares of common;• Structure III(A): 5M Convertible Preferred (CP)

exchange ratio 1:1.• Structure IV: PCP with participation as-if 5M

shares of common, QPO at $5 per share; • Structure V: PCPC with participation as-if 5M

shares of common, with liquidation return capped at four times OPP, QPO at $5 per share;

• Structure VI: RP ($4M Aggregate Purchase Price) + 5M shares of CP ($1M APP).

Structure I - 5M shares of common

$W

Co

mm

on

n

W = 3, W =6, W =10

Structure II RP ($5M APP);

$W

RP

5

5

W = 3, W =6, W =10

Exit Diagrams for RP and Common

$W

CP

5 15

WA5

Redeemable Preferred

Common Stock

W = 3, W =6, W =10

Structure III RP + 5M shares of common

$W

Ser

ies

A

5

5

W = 3, W =5, W =8, W=11

Structure III(A) CP

$W

CP

5

5

15

Structure III (Revisited) RP + 5M shares of common

also called Participating Convertible Preferred (PCP)

$W

Ser

ies

A

5

5

Notice the “Double Dipping”

Structure IV PCP with participation as-if 5M shares

of common, QPO at $5 per share

$W

PC

P

5 75

Drop= 10/3

28 1/3

25

5

Mandatory Conversion1/3*75=25!

71

If Liquidation is at 71 first 5 goes to PCP HolderRest (71-5=66) is shared 1/3*66=22Total Payoff = 5+22= 27

Structure V PCPC with participation as-if 5M shares of common, with liquidation return capped at four times Original Purchase Price, QPO at $5 per share

$W

PC

PC

5 50 60

Conversion Point

20

5

4*5=20; 5+15!

Structure V, continued

$W

PC

PC

5 50 60

5

20

Buy Call Option X=5

Sell Call option X=50 Buy Call X=60

Structure VI, RP component

$W

RP

in S

erie

s A

4

4

Structure VI, RP ($4M APP) + 5M shares of CP ($1M APP).

$W

Seri

es A

5 7

5

4

Structure VI, CP component

$W

CP

in

Seri

es A

4 5 7

1

Exit Values

VC Owner/Employees VCOwner/Employees VC

Owner/Employees VC

Owner/Employees

5.00 5.00 0.00 5.00 0.007.50 6.01 1.49 7.50 0.00

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

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

Enterprise Value ($ Million)

Term Sheet MegaLiquidation IPO

Term Sheet AlphaLiquidation IPO

$ 15 million maximum

Alpha Ownership -40.49% Mega Ownership -41.67%

Why do we see these features

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

Ratchet• Registration rights

Challenges for VCs

• Joe Flash and Rex Finance do a deal

Asset Liabilities and Shareholders’ Equity

Joe’s Idea ??? 0

Asset Liabilities and Shareholders’ Equity

Joe’s Idea 1.5 million Joe 50.05%

Cash 1.5 million Rex 49.95%

John Terrific Offers $2 million for the Company – What happens if Rex had

taken Common Stock?

Challenges of Venture Financing

• Critical issues involved in financing young firms– Uncertainty– Asymmetric

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

financial and product markets

• Responses by VCs– Active Screening – Stage financing– Syndication– Use of Stock options/grants

with strict vesting requirements

– Contingent control mechanisms – Covenants and restrictions

– Strategic composition of Board of Directors

Securities used by VCs

• Common Stock

• Debt

• Preferred Stock

• Never – why not?

• Never – why not?

• Interesting- why?

VCs response #1– Security Design

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

Conversion Clause• Participating Convertible Preferred

(PCP)

VCs response #2 Vesting

• Vesting – creates “Golden Handcuffs” for key employees

• Idea being that you have to “Earn” your share of the company!

• Also keeps the option pool from being depleted if employees leave

VCs response #3 Covenants

• Covenants– Positive Covenants

• Example Provide regular information

– Negative Covenants• Example Sale of assets

– Others• Mandatory redemption• Board Seats

Tomorrow

• Metapath Software– Try using Option Pricing Model Posted on

the website under Class Session 6

• Wrap up with discussion of “How VCs Evaluate Potential VC Opportunities”

• HW 2 assignment will be posted under Class Session 5 (Due on Wednesday)