Venture Capital Venture

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					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

				
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