Venture Capital Class 4 SD

Venture Capital and Private Equity Session 4Professor Sandeep DahiyaGeorgetown University

Course Road MapWhat is Venture Capital - IntroductionVC CycleFund raisingInvestingVC Valuation MethodsTerm SheetsDesign of Private Equity securitiesExitingTime permitting Corporate Venture Capital (CVC)

Quick Review of VC Valuation MethodRemember - 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 pre-money value of the businessThis process is made transparent by reporting of Capitalization Table or simply Cap Tables Let us see how these are created

Capitalization TablesPage 10 (Bottom) of ONSET ventures case describes the financing history of TallyUp. Onset offered to invest $750,000 at a price $1 per share in return for 31.6% of the company. Later, ONSET invested another $250,000 at the same price ($ 1 per share) when Reed Tausig as the CEO. Please draw up the capitalization tables, pre-money and post money valuations for tally before and after each round of financing.

After Next Investment of $250,000

After Option Pool Creation of 750,000 Shares

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)

TallyUp What HappenedWas 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 SoftwareDid IPO in 2003 at $13.5 shareONSET owned 17% of the company at the time of IPO

Term SheetsLet us look at Trendsetter

Term SheetGetting first Term Sheet is MAJOR break through!Validates entrepreneur/ideaEstablishes a priceCan be shopped around (especially in later rounds)

Term Sheets in Venture FinancingCritical IssuesUncertaintyAsymmetric InformationNature of Firms assetsConditions of relevant financial and product markets Responses by investorsActive Screening Stage financingSyndicationUse of Stock options/grants with strict vesting requirements Contingent control mechanisms Covenants and restrictionsStrategic composition of Board of DirectorsGot a Term SheetMultiple Rounds, Multiple Tranches

Trendsetter is Lucky!If you were advising Trendsetter which offer would recommend?ValuationLiquidation Preference (and Antidilution)VestingCorporate Governance

Valuation (Cap Tables)

Liquidation Deemed liquidation event

Liquidation preference (2X, 3X, etc.)Non ParticipatingFully Participating

Qualified public offering (QPO)

Will See in Details Later

What Type of Security?AlphaConvertible Preferred (CP) StockMegaParticipating Convertible Preferred (PCP) Stock

Exit Values

Anti-Dilution ProtectionsDown round

Full-ratchet vs. weighted average

Adjusted conversion price, adjusted conversion rateRead the Note on Anti-dilution provisions: Typology and Numerical Example

Broad-base weighted average anti-dilutionNCP = 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 roundAnother way of writing it

Why do we see these features?Convertible preferredParticipating Convertible PreferredFull Ratchet/ Weighted Average RatchetRegistration rights

Challenges for VCsPrivate Equity Partnerships (PEP) have become the dominant organization form as it addresses challenges faced by LPs (Investors) and GPs(VC, Buyout Firm).Are there issues between GPs and the portfolio companies?

Challenges of Venture FinancingCritical issues involved in financing young firmsUncertaintyAsymmetric InformationNature of Firms assetsConditions of relevant financial and product markets Responses by VCsActive Screening Stage financingSyndicationUse of Stock options/grants with strict vesting requirements Contingent control mechanisms Covenants and restrictionsStrategic composition of Board of Directors

Securities used by VCsCommon Stock

Debt

Preferred StockNever why not?Never why not?Interesting- why?

VCs response #1 Security DesignRedeemable Preferred (RP)Convertible Preferred (CP) - Forced Conversion ClauseParticipating Convertible Preferred (PCP)

DO NOT WORRY!WILL DEVOTE TIME TO THESE LATER!!

VCs response #2 VestingVesting creates Golden Handcuffs for key employeesIdea 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 CovenantsCovenantsPositive CovenantsExample Provide regular information Negative CovenantsExample Sale of assetsOthersMandatory redemptionBoard Seats

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