AN INTRODUCTION TO THE CDVC APPROACH

A WORKSHOP PRESENTED BY THE COMMUNITY DEVELOPMENT VENTURE CAPITAL ALLIANCE

March 18, 2015 – Washington, D.C.

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NEGOTIATING AND STRUCTURING VENTURE CAPITAL INVESTMENTS

Christopher Reim

Managing Director, CDVCA Managing General Partner, Innovate NY Fund, LP

Tanmay Bhargava

Manager, Investments and Fund Programs, CDVCA

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SESSION GOALS

1. Discuss various types of venture capital investments

2. Clarify distinctions between debt and equity securities

3. Introduce key investment terminology

4. Briefly describe a range of debt, equity and near-equity investment structures

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A GREAT TRAINING TOOL APPROPRIATE FOR STAFF, BOARD MEMBERS, STATE AND LOCAL ECONOMIC DEVELOPMENT OFFICERS, LENDERS, AND COMMUNITY LEADERS.

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UNDERSTANDING ‘STRUCTURING’

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Business health/potential

Industry makeup

Magnitude of capital

Purpose of capital

Book & Market Value

Risk/Return profile

Time horizon

Cash burn and stability of EBITDA

Control issues

Payback

Target returns

Ability and willingness to repay

Which investment instrument? Which terms?

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UNDERSTANDING ‘STRUCTURING’ (CONTD.)

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INVESTEE

Uses

Duration

Cost of capital

Flexibility of payments

Management control

Collateral

Balance sheet

The ideal investment structure matches the needs of the investee to those of the investors

INVESTOR

Return expectations

Risk appetite

Cost of capital

Control

Exit opportunities

Valuation

Subsequent rounds

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FINANCING BUSINESS GROWTH

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Time

Positive

Cash

Flow

Negative

Startup

Early Stage

Growth

Stage

Expansion

Stage

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TYPES OF VENTURE CAPITAL INVESTMENTS

Debt Equity

Senior debt

Subordinated debt

Subordinated debt + warrants

Convertible debt

Debt + royalty

Preferred stock

Convertible preferred stock

Common stock

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Wages / Payables

Common Equity

Senior Debt

Preferred Equity

Subordinated Debt Increasing Risk,

Focus on Business Growth Higher Expected Return

Increasing Asset Security,

Focus on Repayment

The “Capital Stack”

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DEBT

For Investee Lower cost of capital (vs. equity)

No ownership dilution

No loss of management control

Less emphasis on growth potential

Reduces tax bill

Timely, often inflexible repayments

Collateral requirement

Demonstration of ability to service debt

Potential for insolvency or even bankruptcy

Restrictions on balance sheet

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PROS CONs

For Investor Security, less risk

Timely repayments; cash flow predictable and easy to plan for

Ease of credit assessment

Less expensive to structure

Covenants to discipline borrower

Limited upside; no or limited participation

in business’s success

Limits the scope in terms of types & sizes of businesses

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EQUITY

For Investee Flexibility to repay

No collateral requirement

Emphasis on growth rather than historical performance

Doesn’t strain bottom line

Ownership dilution

Loss of management control

High cost of capital (discount rate)

Pressure to exit

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PROS CONs

For Investor Unlimited upside, lockstep in

company’s success

Mgmt. control through board seat(s)

Versatility

High risk (of course!)

Most illiquid

Exit: external liquidity event required

Validation is hard (business and valuation)

Relatively expensive to negotiate and structure

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RISK-RETURN PROFILE

Debt • Fixed returns, even if

company performs well

• Low risk; borrower liable

Equity • Returns depends on

company performance and exit event; Potentially high

• High risk

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Debt

Equity

Returns

Risk

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COST OF CAPITAL

Debt

• Lower than equity

• Effected by various factors • Senior vs. subordinated

• Secured vs. unsecured

• Guaranteed vs. not guaranteed

• Fixed vs. variable

Equity

• Higher than debt

• Loss of ownership and potentially control 12

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RELATIONSHIP WITH MANAGEMENT/OWNER

Debt

• Minimal • Review of financial statements

• Compliance with loan covenants

• Lender liability issues

Equity

• Significant • Board seat

• Involvement in day to day business operations

• Investor brings more than money to the table

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REPAYMENT OR EXIT

Debt • Repayment of debt

from cash flow • Senior vs Sub • Refinancing

Equity • Sale to strategic or financial buyer • Sale to management/owners • Initial public offering • Put or repurchase option

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TYPES OF NEAR EQUITY INVESTMENTS

• Debt with Warrants:

Fixed income plus a right to buy into “upside”

• Convertible Debt:

Right (or requirement) to exchange fixed debt for equity

• Debt with Royalty

Fixed income with return enhancement from a share of the sales or profits

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DEBT WITH WARRANTS

• A loan with the option to purchase equity at a pre-negotiated price

• Principal repayment plus interest and warrant for additional return

• Warrant is the governing document

• Spells out the terms and conditions governing stock purchase

• Governs the process of exercising and registering the warrants

• Identifies the restriction and notification requirements of both the investor and the company

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KEY TERMS IN A WARRANT

• Exercise price

• Exercise period

• Number of shares

• Triggering events

• Legal protections

• Cash or Cashless exercise

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ADVANTAGES OF DEBT WITH WARRANTS

To the Investor To the Company

Low-cost access to upside with security of debt

Minimizes dilution of ownership

Current income from debt component

Lowers interest rate due to equity kicker

Put agreement provides method for liquidity

No impact on cash flow which can fuel future growth

Exercise of warrants can provide additional cash

Interest expense is tax deductible

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CONVERTIBLE DEBT

• A loan that is convertible into preferred or common equity

• Principal repayment with interest or ability to convert into equity

• Loan Agreement/Securities Purchase Agreement is governing document

• Spells out terms and conditions governing both the loan and its conversion to equity

• Details the rights, restrictions and notification requirements of both the investor and the company

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KEY TERMS: LOAN/SECURITIES PURCHASE AGREEMENT

• Conversion period

• Conversion price

• Conversion of the “security interest” • Common or preferred stock

• Triggering events

• Put option

• Legal protections

• Adjustments • Performance • Anti-dilution

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ADVANTAGES OF CONVERTIBLE DEBT

To the Investor To the Company

Potentially lower initial risk profile relative to equity-only investment

Does not require valuation exercise. Therefore, useful in Seed stage

Gives the investor time to decide whether to convert

Quicker and less expensive than equity investment

May have to give up less ownership and control

May be able to force conversion to avoid repayment

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DEBT WITH ROYALTY PARTICIPATION

• A loan with the right to a percentage of company sales or profits

• Principal repayment with interest and royalty payments for additional return

• Participation Agreement is governing document

• Defines whether royalty amount is based on profits or

revenues

• States whether royalty is tied to the total amount or to incremental growth in profits and revenues

• References due dates for sales or profit statements, as well as royalty payments

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ADVANTAGES OF DEBT WITH ROYALTY STRUCTURE

To the Investor To the Company To Both

Debt protections to mitigate risk

No equity dilution Does not require valuation exercise

Exit predetermined Less burden in lean periods

Debt-like structure easier to understand

Income from interest and royalty payments

Tax deductible interest and royalty payments

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TYPES OF EQUITY INVESTMENTS

• Preferred Stock Superior position to “founders’ equity”

• Convertible Preferred Stock “Transition” equity position

• Common Stock The primary form of equity interest

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KEY TERMS: PREFERRED STOCK

• Dividends

• Liquidation preference

• Voting provisions

• Board seat

• Redemption/put and call

• Adjustments • Performance

• Anti-dilution

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DIVIDENDS

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The “preferred” return:

• Mandatory vs. “as declared”

• Cumulative vs. non-cumulative

• Return Rate and timing

• The company would only offer dividends if it is reliably cash-flowing

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LIQUIDATION PREFERENCE

• Ranks ahead of common stock

• Sale of company is a “liquidation”

• In the event of bankruptcy, a senior claim after debt is satisfied

• Receives a minimum multiple of the preferred stock value in the event of a sale

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VOTING

• Right to elect director(s)

• Limits ability to change corporate documents without approval

• Control provisions

• Sale of company or assets

• Budgetary

• Change in senior management

• Changes in compensation

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REDEMPTION/PUT AND CALL

• Investors have “liquidity” if no sale arises

• Investor can force a company to repurchase its shares

• Price and timing conditions

• Provisions in the event of default

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ANTI-DILUTION

• “Price dilution” vs. “Percent dilution” • Protect the investor from “down rounds” of financing at a price

lower than they paid

• “best price available” guarantee

• Anti-Dilution can cause a pricing “death spiral”

• Future equity or equity-like issuances

• “Weighted average” vs. “Ratchet”

• “Pay to play” provisions • A Conditional Protection: only investors that participate in the

dilutive financing are entitled to the benefit of the anti-dilution formula in effect

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ADVANTAGES OF PREFERRED EQUITY

To the Investor To the Company

If regularly paid, dividends provide current income

Equity shores up balance sheet allowing greater leverage of debt

In liquidation event, preferred has preference over common shareholders

Protective features of preferred may permit concession by investor on level of equity ownership

Redemption feature may provide viable exit

Investor devotes time and expertise to help management build value

Conversion to common stock allows participation in upside

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KEY TERMS: COMMON STOCK

• Percentage ownership of business

• Voting provisions

• Board seat

• Redemption/put and call

• Adjustments

• Performance

• Anti-dilution

• Other Investor rights

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EQUITY INVESTOR RIGHTS

• Co-investment (if invested as an LP in a fund)

• “Drag-along” Right (protection for majority owner)

• “Tag-along” Right (protection for majority owner)

• Registration Rights (transferability, public trading)

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ASSESSING BUSINESS RISK

• Management risk

• Market risk

• Technology risk

• Production risk

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• Financial risk

• Exit risk

• Policy risk (regulation)

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METHODS OF VALUATION

• Comparable public company multiples

• Comparable M&A multiples

• Discounted Cash Flow

• Replacement Value

• Weighted Average of different methods

• Multiples • Sales

• Earnings (EBITDA, EBIT, Net Income)

• Industry “rules of thumb” multiples

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BUSINESS VALUATION CONSIDERATIONS

• What is the value of the intellectual property, patent, customer base, etc.?

• What is the size of the market and what percentage can the company capture?

• What is the upside opportunity and on what is it based?

• What other intangible asset values does the company have?

• Are there any government or tax incentives?

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MECHANICS OF INVESTING

• Identify the company and their need

• Perform preliminary due diligence

• Determine preliminary structure

• Propose and negotiate terms and conditions

• Perform additional due diligence

• Document and fund the investment

• Manage the investment

• Exit the investment

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COMMUNITY DEVELOPMENT IMPACT

Venture capital investing offers an opportunity to have a positive impact on community development issues

• Job creation

• Quality jobs

• Local revitalization

• Capacity-building for Low-income communities

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ELEMENTS OF SUCCESSFUL TRANSACTIONS

• Successful deal structuring involves balancing returns – social and financial – with the risk presented by a company and a particular investment

• A well-structured and documented deal affords the investor legal protection and is a critical step in the investment process

• There is no substitute for a good screening process (criteria), a complete and thoughtful due diligence review

• Post investment value creation, monitoring and mentoring program that tracks operating and financial performance is critical to a successful exit

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For more information, contact us at: creim@cdvca.org

Questions