Venture Capital and Private Equity Session 2 Professor Sandeep Dahiya Georgetown University.
Venture Capital and Private Equity Session 5 Professor Sandeep Dahiya Georgetown University.
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Transcript of 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)
Anti-Dilution Protections
• Down round
• Full-ratchet vs. weighted average
• Adjusted conversion price, adjusted conversion rate
Read the Note on Anti-dilution provisions: Typology
and Numerical Example
Read the Note on Anti-dilution provisions: Typology
and Numerical Example
Broad-base weighted average anti-dilution
NCP = 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
round
(Pre-Money Value+Money in new round)
(Total # of Shares after financing)NCP
Another way of writing it
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?
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%
Initial Capitalization1/1/1998
Second Round No Antidilution1/1/2000
First Round1/1/1999
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 $26,952,381 100%
NCP 3.23
Second Round Full Ratchet1/1/2000
Second Round Partial Ratchet1/1/2000
Notice value of Early VC has fallen from 8 million to 4 millionThis implies a “paper loss” of 8-4= 4 million!
Liquidation – Quick Review
• Deemed liquidation event
• Liquidation preference (2X, 3X, etc.)– Non Participating– Fully Participating
• Qualified public offering (QPO)
What Type of Security?
• Alpha– Convertible Preferred (CP) Stock
• Mega– Participating Convertible Preferred (PCP)
Stock
TYPE OF LIQUIDATION EVENT IS CRITICAL!
Many types of preferred stock
• Redeemable Preferred (RP)
• Convertible Preferred (CP)
• Participating Convertible Preferred (PCP)
• PCP with cap (=PCPC)
• Key threshold for PCP is a qualified public offering (QPO)
Alternatives$ 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 III (Revisited) RP + 5M shares of common
also called Participating Convertible Preferred (PCP)
$W
Ser
ies
A
5
5
Notice the “Double Dipping”
Structure IV PCP with participation as-if 5M shares
of common, QPO at $5 per share
$W
PC
P
5 75
Drop= 10/3
28 1/3
25
5
Mandatory Conversion1/3*75=25!
71
If Liquidation is at 71 first 5 goes to PCP HolderRest (71-5=66) is shared 1/3*66=22Total 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
$W
PC
PC
5 50 60
Conversion Point
20
5
4*5=20; 5+15!
Structure V, continued
$W
PC
PC
5 50 60
5
20
Buy Call Option X=5
Sell Call option X=50 Buy Call X=60
Exit Values
VC Owner/Employees VCOwner/Employees VC
Owner/Employees VC
Owner/Employees
5.00 5.00 0.00 5.00 0.007.50 6.01 1.49 7.50 0.00
10.00 7.02 2.98 8.54 1.4615.00 9.05 5.95 10.63 4.3720.00 11.07 8.93 12.71 7.2925.00 13.10 11.90 14.79 10.2129.69 15.00 14.69 16.75 12.9430.00 15.00 15.00 16.88 13.1235.00 15.00 20.00 18.96 16.0437.04 15.00 22.04 19.81 17.2340.00 16.20 23.80 21.04 18.9645.00 18.22 26.78 23.13 21.8750.00 20.25 29.76 25.21 24.7955.00 22.27 32.73 27.29 27.7160.00 24.29 35.71 24.29 35.71 29.38 30.62
100.00 40.49 59.51 40.49 59.51 46.04 53.96200.00 80.98 119.02 80.98 119.02 87.71 112.29240.00 97.18 142.82 97.18 142.82 104.38 135.62 100.01 139.99500.00 202.45 297.55 202.45 297.55 212.72 287.28 208.35 291.65
Enterprise Value ($ Million)
Term Sheet MegaLiquidation IPO
Term Sheet AlphaLiquidation IPO
$ 15 million maximum
Alpha Ownership -40.49% Mega Ownership -41.67%
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