Venture Capital and Private Equity
Session 6Professor 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)
Metapath Software
Professor Sandeep DahiyaGeorgetown University
OUTLINE
• What happened.• The broader themes:– The interplay of terms.– Options in private equity.
WHAT HAPPENED (1)• The Company turned down Cell Tech:– Offering 30% of their capitalization
indicated that their base business had limited upside.
– Clearly there were ongoing financing risks and liquidity issues.
– The fit was not compelling.
• Cell Tech stock fell $9 --> $3– After 3 years and several acquisitions, it
rebounded.
WHAT HAPPENED (2)
• Accepted RSC Participating Preferred, later had to raise a $12mm Ser F Rd at $8/shr, had to keep participation.
• Merged with UK based MSI Dec ‘98:– 65% MSI, 35% Metapath, both private cos.– Grey area since preferred carried over to
merged company.–Mezzanine investors insisted on
participation.
WHAT HAPPENED (3)• Much rancor between late investors
and early investors plus Management:– Ser E (and Ser F) had defined “liquidation” to
include any change of control event. – Management maintained all rights could be
preserved in capitalization post-merger.– Late stage investors knew company worth more
than their ~$24mm liquidation preference, so were willing to vote down deal (votes were by class)--they won.
WHAT HAPPENED (4): Lessons Learned
• Metapath used too much money:– Despite continual progress, ran out of cash.
• Metapath too price focused:– $4/shr w/ no participation possible? – $4/shr still a good step up from $1.62.
• RSco and TCV fundamentally different kind of investor from BVP & Norwest:– Trading terms for price.– Good trade when you perform but leaves no
room for error!
THE INTERPLAY OF TERMS: Trading price for terms
• Trend in price/share often only outside gauge of company progress.
• Price/share affects employee options and morale.
• Fancy terms tend to put boundaries on the downside.
• Term-laden deals often play on entrepreneur's optimism (screening?).
THE INTERPLAY OF TERMS: Liquidation & Participation• A liquidation triggers participation.• In the Metapath case, formerly the
board could deem a change of control a liquidation, but it was not automatic.
• “Liquidation” was changed to include change of control in Ser E:– Implication not picked up by management,
early investors or company counsel.
THE INTERPLAY OF TERMS: Voting & Negative
Covenants• Negative Covenants outline what the
company can NOT do without special vote of preferred (e.g.: merge, sell, change business, liquidate etc.)
• Preferred previously voted as one class, or on an “as converted basis”.
• Voting class by class became part of deal when terms between classes significantly diverged.
BLACK-SCHOLES LOOKS AT THE LIMITING CASE
• Assumes continuous time--many branching points.
• Obtains complex formula as function of:– Time to maturity.– Standard deviation of stock.– Current stock price.– Exercise price.– Risk-free interest rate.
USING THE BLACK-SCHOLES FORMULA
• Black-Scholes EXCEL calculator.
ILLUSTRATION
• Switch from convertible to participating preferred is essentially “re-pricing” the call option of Series E holders:–Will begin sharing in equity above $11.75
million, rather than $87.75 million:• How much is this worth?• How lower share price should Hardy be willing
to accept to get rid of?– He had offered $5.50 without instead of $6 with.
BASIC STRUCTURE
• Look at what worth in current setting.
• Look at what worth with higher exercise price.
• Look at how much lower share price will equate.
ASSUMPTIONS
• Ten-year option life.• 30% volatility (guess).• $11.75 and $87.75 million exercise
prices.• Assume $87.75 valuation is right.• Interest rate of 6.21%.– Assume away complexity of IPO.
CALCULATION
• Value of option with $11.75 strike price is $81.4 million.– 13.4% of this is $10.7 million.
• Value of option with $87.75 strike price is $49.9 million.– 13.4% of this is $6.7 million.
• The participating feature represents about $4 million in value!
CALCULATION (2)
• Now look at how much larger share of the company (lower price) will equate:– 13.4% * $81.5MM = X * $49.9 MM.– X = 21.9%.
• Hardy would have been equally well off giving Series E holders 21.9% of company without participation:
• Share price of (13.4%/21.9%)*$6=$3.67!
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
How Do VCs Evaluate Potential Investments?
• How do you evaluate potential venture opportunities?
• How do you evaluate the venture’s prospective business model?
• What due diligence do you conduct?• What is the process through which funding
decisions are made? • What financial analysis do you perform?• What role does risk play in your evaluation?• How do you think about a potential exit
route?
Key Takeaways
• While hard to codify some key patterns are consistent
• Risk-Reward trade-off• Market is big factor – How much pain!– Who feels the pain!
• Acceptance that mistakes will be made but with a twist– Mistake when made the investment– Mistake when DID NOT make investment
• Intense desire for IPO worthy investment