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Document Sample
Venture Capital and Private
Equity
Session 5
Professor 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
Read the Note on
Anti-dilution provisions: Typology
and Numerical Example
• Down round
• Full-ratchet vs. weighted
average
• Adjusted conversion
price, adjusted
conversion rate
Broad-base weighted average
anti-dilution
NCP = OCP * (OB+(NM/OCP)) / (OB+SI)
NCP= New Conversion Price
OCP= Old Conversion Price in effect immediately prior
to new issue
OB = Number of shares of shares outstanding
immediately prior to this round
NM = New Money received by the Corporation
SI = Number of shares of stock issued in this round
Another way of writing it
(Pre-Money Value+Money in new round)
NCP
(Total # of Shares after financing)
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?
Initial Capitalization First Round Second Round No Antidilution
1/1/1998 1/1/1999 1/1/2000
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%
Notice value of Early VC has fallen from 8 million to 4 million
This implies a “paper loss” of 8-4= 4 million!
Second Round Full Ratchet Second Round Partial Ratchet
1/1/2000 1/1/2000
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
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
Commonn
W = 3, W =6, W =10
$W
Structure II RP ($5M APP);
5
RP
W = 3, W =6, W =10
5 $W
Exit Diagrams for RP and
Common
Redeemable
Preferred
WA
5
CP
Common Stock
W = 3, W =6, W =10
5 $W 15
Structure III
RP + 5M shares of common
Series A
5
W = 3, W =5, W =8, W=11
5
$W
Structure III(A) CP
5
CP
5 15 $W
Structure III (Revisited)
RP + 5M shares of common
also called Participating Convertible Preferred (PCP)
Series A
5
Notice the
“Double Dipping”
5
$W
Structure IV
PCP with participation as-if 5M shares
of common, QPO at $5 per share
PCP
28 1/3
25 Drop Mandatory
= 10/3
Conversion
1/3*75=25!
5
5 75
71 $W
If Liquidation is at 71 first 5 goes to PCP Holder
Rest (71-5=66) is shared 1/3*66=22
Total 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
Conversion Point
20
PCPC
5
4*5=20; 5+15!
5 50 60
$W
Structure V, continued
PCPC
20
5 Sell Call
option X=50 Buy Call X=60
5 50 60
$W
Buy Call Option X=5
Structure VI, RP component
4
RP in Series A
4 $W
Structure VI, CP component
1
CP in Series A
4 5 7
$W
Structure VI, RP ($4M APP) + 5M
shares of CP ($1M APP).
5
Series A
5 7 $W
4
Exit Values
Alpha Ownership -40.49% Mega Ownership -41.67%
Term Sheet Alpha Term Sheet Mega
Enterprise Liquidation IPO Liquidation IPO
Value ($ Owner/Employ Owner/Employ Owner/Employ
Million) VC Owner/Employees VC ees VC ees VC ees
5.00 5.00 0.00 5.00 0.00
7.50 6.01 1.49 7.50 0.00
10.00 7.02 2.98 8.54 1.46
15.00 9.05 5.95 10.63 4.37
20.00 11.07 8.93 12.71 7.29
25.00 13.10 11.90 14.79 10.21
29.69 15.00 14.69 16.75 12.94
30.00 15.00 15.00 16.88 13.12
35.00 15.00 20.00 18.96 16.04
37.04 15.00 22.04 19.81 17.23
40.00 16.20 23.80 21.04 18.96
45.00 18.22 26.78 23.13 21.87
50.00 20.25 29.76 25.21 24.79
55.00 22.27 32.73 27.29 27.71
60.00 24.29 35.71 24.29 35.71 29.38 30.62
100.00 40.49 59.51 40.49 59.51 46.04 53.96
200.00 80.98 119.02 80.98 119.02 87.71 112.29
240.00 97.18 142.82 97.18 142.82 104.38 135.62 100.01 139.99
500.00 202.45 297.55 202.45 297.55 212.72 287.28 208.35 291.65
$ 15 million maximum
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 • Responses by VCs
financing young firms – Active Screening
– Uncertainty – Stage financing
– Asymmetric – Syndication
Information – Use of Stock options/grants
– Nature of Firm’s assets with strict vesting
requirements
– Conditions of relevant
– Contingent control
financial and product mechanisms – Covenants and
markets restrictions
– Strategic composition of
Board of Directors
Securities used by VCs
• Common Stock • Never – why
not?
• Debt • Never – why
not?
• Preferred Stock • 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
• Wrap up with discussion of “How VCs
Evaluate Potential VC Opportunities”
• HW 2 assignment Due on Monday
