# Venture Capital

Document Sample

```					Venture Capital and Private
Equity
Session 4
Professor Sandeep Dahiya
Georgetown University
• 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)
VC Method-Implied Valuation
Information you would almost always have
• I – Amount being raised from VC
• X- Number of Shares currently owned by entrepreneur
Information that requires judgment call
• R – VC’s required return (IRR) usually between 25% to 80%
• T – Time to exit (When VC gets money back)
• V – Value of the company at time of exit
Numbers you need to calculate
• F – Fraction of company VC would need to get the return
• Post-Money Valuation – Value of company after funding is
• Pre-money Valuation - Value of company before funding is
• P – Price per share.
• Y – Number of shares to be issued to the VC
Multiple Rounds/ Exit
Dilution
• Imagine that you need 15% of the company at the exit
• Simple case – 100 shares would want 15 shares
• What if along the way company issues another 50
shares (option/new investor) what happens to your
stake?
– New total shares = 100+50= 150
– You interest = 15/150 = 10%!! – you have been diluted
• You would insist on more than 15% today to end with
15% eventually – how to figure that out
• Expected dilution = 50/150 = 0.333
• Fraction needed today = Final ownership/(1-Dilution)
• =15%/(1-0.333)= 22.5% implying 22.5 shares today

• Check>>> at the end 22.5/150 = 15%
Example Contd.
• Hoya.com is asking for \$5 million, Projected income in year 5
is \$ 4 million and expected exit multiple is 25x. What share of
company would a VC require today if VC’s required return is
50%?
• Need to reserve 15% of the firm in terminal year for the option
pool for mangers.
VC still needs to get \$5 million*(1.5)5 = 37.97 million
At Exit Firm is Still Worth 100 Million
VC still needs 37.97/100 = 37.97% of the Firm AT TIME OF EXIT!
However what VC needs TODAY is higher since extra shares would
be issued to the Option Pool causing dilution
Final Ow nership%
Retention% 
Current Ow nership%
Retention%  (1  Dilution%)  (1  Later Ow ner's Final%)
Final Ow nership%        Final Ow nership%
Current Ow nership%                     
Retention%       (1  Later Ow ner's Final%)
VC Current Ownership = 0.3797/(1-0.15) = 44.67%
Example Contd.
• Hoya.com is asking for \$5 million, Projected income in year 5
is \$ 4 million and expected exit multiple is 25x. What share of
company would a VC require today if VC’s required return is
50%?
• Need to reserve 15% of the firm in terminal year for the option
pool for mangers.

5 million for 44.67% of the company imply Post money
valuation of 5/0.4467= 11.193 million and pre-money
valuation of 11.19 -5=6.193 million
New Shares to VC =5/6.193=0.807 million shares

F1
New Number of Shares Y  X
(1-(F 1  OP ))
0.3797
Y 1                        0.807 million shares
(1-(0.3797  0.15))
Multiple Rounds of Financing
•   Hoya.com is asking for \$5 million, Projected income in year 5 is \$ 4
million and expected exit multiple is 25x. What share of company
would a VC require today if VC’s required return is 50%?
•   Need to reserve 15% of the firm in terminal year for the option pool
for mangers. Would need another \$ 3 million at the beginning of
year 3 – round 2 investors require 30% return
Round 2 investor need 30% on its 3 million i.e. 3(1.30)3 = 6.59 million
Final value is still 100 million, Thus Round 2 investor need 6.59% of the
company AT EXIT Implying that at time of investment it needs to own
Round 2 VC need 0.659/(1-0.15)=7.75%
Round 1 still needs 38% at the time of EXIT
implying initial stake = 0.38/(1-(0.0659+0.15))=0.485 or 48.5% stake.
5/0.485=10.32;
What is the Post and Pre Money Valuation at round 1?         5.32
How many shares need to be issued to Round 1, Round 2 and option pool?

Round 1 = 1x[0.485/(1-0.485)] =941,748
Round 2 = 1.941748x[0.0775/(1-0.0775)]=163,128
Option Pool =(1.942+0.163)X[0.15/(1-0.15)]= 371,448
For Practice
• Recalcualte the numbers detailed in
“The Basic Venture Capital Formula”
Quick Review of VC Valuation
Method
• Remember - In venture capital all valuation
is “implied valuation”. Simply put, the value
arises because VC(s) is(are) willing to
finance the company!
• The terms (amount invested, fraction of
ownership received) fix the post-money and
• This process is made transparent by
reporting of “Capitalization Table” or simply
“Cap Tables” – Let us see how these are
created…
Capitalization Tables
Page 10 (Bottom) of ONSET ventures case describes the financing
history of TallyUp. “…Onset invested \$750,000 to purchase
preferred shares (at \$1 each), in return for 31.6% of the company,
based on a \$2,375,000 post-money valuation. The agreement was
structured so that ONSET would later invest an additional \$250,00
– at the same \$1 per share price…” Please draw up the
capitalization tables, pre-money and post money valuations for
tally before and after each round of financing.
Before Financing                                     After Intial 750,000 investment

%                      \$ per                        %
Investor               # of shares     \$ per share      \$ total   ownership # of shares     share        \$ total      ownership
Founders                 1,625,000       \$0.000           \$0        100%     1,625,000        -        \$1,625,000      68.42%
ONSET Ventures                                                                 750,000      \$1.00       \$750,000       31.58%
Option Pool

Total For Round
Cumulative Total       1,625,000         \$0.000           \$0        100%     2,375,000      \$1.00      \$2,375,000           100%

Price Per Share
\$1
Pre-Money Valuation                                                                                       1,625,000
Cash Infusion                                                                                               750,000
Post-money Valuation                                                                                      2,375,000
Hiring of Reed Taussig as CEO..
Page 12 (Bottom) of ONSET Venture case describes the follow up
financing. “…Once Taussig was hired, ONSET invested the
(post-money) valuation to \$2,625,000…”.

After Intial 750,000 investment                     After next 250,000 investment

\$ per                        %                      \$ per                  %
Investor               # of shares     share        \$ total      ownership # of shares     share      \$ total  ownership
Founders                1,625,000        -        \$1,625,000      68.42%    1,625,000        -      \$1,625,000 61.90%
ONSET Ventures            750,000      \$1.00       \$750,000       31.58%    1,000,000      \$1.00    \$1,000,000 38.10%
Option Pool

Total For Round                                                              250,000       \$1.00     \$250,000      9.52%
Cumulative Total       2,375,000       \$1.00      \$2,375,000       100%     2,625,000      \$1.00    \$2,625,000     100%

Price Per Share
\$1                                              \$1
Pre-Money Valuation                                  1,625,000                                      \$2,375,000
Cash Infusion                                          750,000                                          250000
Post-money Valuation                                 2,375,000                                      \$2,625,000
Option Pool !
Page 13 (Bottom) of ONSET Venture case describes the creation of
Option Pool. “…First, TallyUp had decided to set aside a portion of
shares used as stock options for new employees hires. The value of
these options would likely be \$750,00 (750,000 shares at \$1 per
share), which would increase TallyUp’s valuation by the same
amount…”.
After next 250,000 investment                 After Option Pool
%
\$ per                  %                      \$ per                ownershi
Investor               # of shares     share      \$ total  ownership # of shares     share       \$ total      p
Founders                1,625,000        -      \$1,625,000 61.90%     1,625,000        -       \$1,625,000 48.15%
ONSET Ventures          1,000,000      \$1.00    \$1,000,000 38.10%     1,000,000      \$1.00     \$1,000,000 29.63%
Option Pool                                                             750,000      \$1.00      \$750,000   22.22%

Total For Round         250,000        \$1.00     \$250,000      9.52%    750,000      \$0.00         \$0       22.22%
Cumulative Total       2,625,000       \$1.00    \$2,625,000     100%    3,375,000     \$1.00     \$3,375,000    100%

Price Per Share
\$1                                             \$1
Pre-Money Valuation                             \$2,375,000                                     \$2,625,000
Cash Infusion                                       250000                                              0
Post-money Valuation                            \$2,625,000                                     \$3,375,000
What if Mann is able to do a
\$3.5 million round at 2.5 times
step up (ONSET invests \$1
million in this round)
After next 250,000 investment                 After Option Pool
%
\$ per                  %                      \$ per                ownershi
Investor               # of shares     share      \$ total  ownership # of shares     share       \$ total      p
Founders                1,625,000        -      \$1,625,000 61.90%     1,625,000        -       \$1,625,000 48.15%
ONSET Ventures          1,000,000      \$1.00    \$1,000,000 38.10%     1,000,000      \$1.00     \$1,000,000 29.63%
Option Pool                                                             750,000      \$1.00      \$750,000   22.22%

Total For Round         250,000        \$1.00     \$250,000      9.52%    750,000      \$0.00         \$0       22.22%
Cumulative Total       2,625,000       \$1.00    \$2,625,000     100%    3,375,000     \$1.00     \$3,375,000    100%

Price Per Share
\$1                                             \$1
Pre-Money Valuation                             \$2,375,000                                     \$2,625,000
Cash Infusion                                       250000                                              0
Post-money Valuation                            \$2,625,000                                     \$3,375,000
What if Mann is able to do a \$3.5
million round at 2.5 times step up
(ONSET invests \$1 million in this
round)
After Option Pool                 Raise 3.5 Million Total at 2.5x Step Up

# of      \$ per                   %                         \$ per                  %
Investor                shares      share       \$ total  ownership # of shares        share      \$ total ownership
Founders               1,625,000      -       \$1,625,000  48.15%      1,625,000         -       \$4,062,500 34.03%
ONSET Ventures         1,000,000    \$1.00     \$1,000,000  29.63%      1,400,000       \$2.50     \$3,500,000 29.32%
Option Pool              750,000    \$1.00      \$750,000   22.22%        750,000       \$2.50     \$1,875,000 15.71%
New VC                                                                1,000,000       \$2.50     \$2,500,000 20.94%

Total For Round         750,000      \$0.00        \$0        22.22%     1,400,000       \$2.50    \$3,500,000     29.32%
Cumulative Total       3,375,000     \$1.00    \$3,375,000     100%      4,775,000       \$2.50   \$11,937,500      100%

Price Per Share
\$1.00                                            \$2.50
Pre-Money Valuation                            \$2,625,000                                       \$8,437,500
Cash Infusion                                           0                                        3,500,000
Post-money Valuation                           \$3,375,000                                      \$11,937,500

Paper Gain \$2 MM investment now worth(???) \$3.5 MM!
TallyUp – What Happened
• Was able to raise 4 million in the next
round at post-money value of \$ 13
million (>2.5x step-up)
• Raised 4 more rounds – changed name
to Callidus Software
• Did IPO in 2003 at \$13.5 share
• ONSET owned 17% of the company at
the time of IPO
Fund Raising versus Fund
Investing
• We saw how GPs and LPs can have
conflicting interests – the solution that
has emerged is the PEP agreement
that we saw first in ONSET case and
also in ACCEL Partners case.
• Now let us turn our attention to
conflict of interest between the VCs
and the entrepreneurs they finance
Challenges of Venture Financing

• Critical issues involved in • Responses by VCs
financing young firms         – Active Screening
– Uncertainty                – Stage financing
– Asymmetric                 – Syndication
Information               – Preferred Stock
– Nature of Firm’s assets    – Use of Stock options/grants
with strict vesting
– Conditions of relevant
requirements
financial and product
– Contingent control
markets
mechanisms – Covenants and
Got a Term                        restrictions
Sheet                        – Strategic composition of
Board of Directors
Multiple Rounds,
Multiple Tranches                    READ THE TERM SHEETS!!
problems
• Security Design

• Vesting Provisions

• Covenants
Security Design - What Type
of Security?
• Common Stock                          VCs
NEVER
take
– Stands Last                       Common
• Preferred Stock                      Stock

– Before Common Stock in case of
LIQUIDATION

TYPE OF LIQUIDATION EVENT IS
CRITICAL!
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?
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 (OPP \$1.00
per share)
(Implied Valuation= \$15 Million, 15 million shares)
• Structure I: 5M shares of common;
• Structure II: Redeemable Preferred (\$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 Original Purchase Price (OPP), QPO at
\$5 per share;
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
similar to a structure 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

5                     50                 60
\$W

VCs response #1– Security
Design
• Redeemable Preferred (RP)
• Convertible Preferred (CP) - Forced
Conversion Clause
• Participating Convertible Preferred
(PCP)
Other Term Sheet Features
•   Vesting
•   Covenants
•   Anti-Dilution Protection
•   Board Seats
Securities and the “Trendsetter” Case
for class on Thursday
VCs response #2 Vesting
• Vesting – creates “Golden Handcuffs”
for key employees
• Idea being that you have to “Earn”
• 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
•   Discussion of Trendsetter Case