Exam 2 Review
Exam Rules and Format
Time – 1 hour and 45 minutes
Open notes – The path to answering every question on the exam can be found in the slides attached to this deck
No phones or computers
Bring a calculator
Practice is critical – make sure that you go over the examples and exercises that we covered in class
Format Similar to Exam I
Section I (50 points)
10 multiple choice questions worth 5 points each
Section II (50 points)
3 to 5 questions requiring computations
What’s on the exam?
While the exam is cumulative, we will primarily focus on Lectures 8 through 13
Systematic risk question from Exam I will be on this exam, in a slightly different form
Lecture 8 – Crowdfunding and Angel Investors
Lecture 9 – Sources of Financing (Venture Capital)
Lecture 10 – The Investment Process (perhaps 1 question about Due Diligence)
Lecture 11 – Term Sheets I
Lecture 12 – Term Sheets II
Lecture 13 – Exits
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Lecture 8 – Sources of Financing
Crowdfunding, Incubators, and Angels
Equity-based crowdfunding
Backer receives shares of a company in exchange of the money pledged
Crowdfunding platforms cannot make commissions on equity raising, so they have to make money by alternative means:
Flat rate listing fees
Premium services
Selling data
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SEC limits on Equity Crowdfunding
Equity crowdfunding is tantamount to the sale of equity securities to the public and is therefore regulated under Securities Act of 1933
Crowdfunding was severely limited until the Jumpstart Our Business Startups (JOBS) Act of 2012
Made major amendments to Rule 506 of Reg D and Rule 144A
Key requirements of SEC regulations issued under the Jobs Act:
Transactions must be conducted through an intermediary that is either a registered broker or an SEC approved funding portal
Issuer may sell up to $1 million of its securities, per 12 months
Individual investments in a 12-month period are limited based on annual income and net worth of the investor. Current range is $2,200 to $107,000, per investor per year.
Independent CPA reviewed financial statements for raises from $100,000 to $500,000 and Audited financial statements for raises from $500,000 to $1,000,000
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SEC limits on Crowdfunding Investors
| Annual Income | Net Worth | Calculation | 12-month Limit |
| $30,000 | $105,000 | greater of $2,200 or 5% of $30,000 ($1,500) | $2,200 |
| $150,000 | $80,000 | greater of $2,200 or 5% of $80,000 ($4,000) | $4,000 |
| $150,000 | $107,000 | 10% of $107,000 ($10,700) | $10,700 |
| $200,000 | $900,000 | 10% of $200,000 ($20,000) | $20,000 |
| $1,200,000 | $2,000,000 | 10% of $1.2 million ($120,000), subject to cap | $107,000 |
If either annual income or net worth is less than $107,000, then during any 12-month period, you can invest up to the greater of either $2,200 or 5% of the lesser of your annual income or net worth.
If both annual income and net worth are equal to or more than $107,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $107,000.
Source: US Securities and Exchange Commission, Investor Bulletin, May 5 2017
Examples from the SEC
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Angel Investor Definition
High net worth individuals who invest directly into entrepreneurial businesses in return for equity (or convertible debt)
Often successful, exited entrepreneurs or retired business persons
Typically invest in areas of professional expertise or interest
Accredited investors – SEC definition
E.g. net worth >$1M or annual income >$200K
Angels are the largest source of start-up capital
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Angels provide smart money
Many angels provide mentoring before and after investment
Often provide an advisory role for management team
Some serve as board members or observers
Some join venture as C-level executive for an interim period
Develop relationships with Venture Capital firms for expansion capital
Some angels are better than others…
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Super angels
Super angel: Set of very active, influential angel investors
E.g., have a portfolio of >20 companies and invest >$100 per company
Famous super angels: Aydin Senkut (former Google exec), Ron Conway (SV Angel), Chris Sacca (former Google exec), Mike Maples, Dave McClure (former Paypal exec)
Often co-invest alongside own fund or other VC firms
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Angel groups
Networks of angels who pool their resources and coordinate on leads, due diligence, contacts, and management advice and invest jointly
First Angel group “Band of Angels” founded in 1995 by Hans Severiens
In 2013, 400+ angel groups with an average of 42 members per group
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Lecture 9 – Sources of Financing
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Who invests in venture capital?
Accredited Investors Only
VC funds sell interests in “Private Transactions”
Not a public offering
Exempt from registration under the Securities Act of 1933.
Restrictions:
Investment manager cannot advertise the offering or broadly solicit investors
Offering is restricted to a small number of Accredited Investors
No more than 100 investors
Net worth > $1M or $200K annual income
Who invests in venture capital?
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Private placement memorandum (PPM)
Document which VC funds send to institutional investors to advertise fund investment opportunities
Includes
Fund’s investment strategy
Fund size, term, fees, minimum contribution, & GP commitment
GP’s background and expertise
Market opportunity
Other legal, tax, and regulatory matters
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Limited partnership agreement
Legal document that contains the terms that describe the control, management, financial investment, and distribution of returns for a fund
The PPM is the starting point for negotiation between LPs and GPs
Main goal: Alignment of LP and GP financial interests
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Limited partnership agreement
Structure of the funds
Minimum investment amount
Minimum and maximum size of the fund
“Takedown” schedule
Extreme conditions under which LPs can terminate their investment before the 10-year limit
Key man provisions (key GP exits)
Bankrupt
Majority of LPs vote that GPs are damaging the fund
Penalty on LPs failing to meet their capital commitments
Charge interest for late payments
Seize LP’s stake; Sue LP
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Limited partnership agreement
Management of the Fund
Activities of the General Partners
Types of Investments
Compensation
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What is a VC fund?
Each fund is structured as a Limited Partnership
Typically the fund life is 10 years with possible extensions
Life science funds are often established as 12-year funds
Invest in the first 3-5 years
Exit in the second half
Reality life of funds can be much longer than 10 years.
Typical fund consists of 12-24 investments
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What is a VC fund?
Funds typically have a stage or industry focus:
Stage: Seed/Early, Growth/Expansion, Later
Industry: Internet, healthcare, clean tech, etc.
A VC firm can manage several funds, which are typically raised a few years apart.
In 2008, KPCB raised its 13th fund: KPCB XIII, $700 mn
In 2012, KPCB raised its 15th fund of $525mn
Flow of funds: Fees & Carry
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Fund terminology
Committed capital: amount of money promised by LPs over the fund life
Only a portion (10-30%) of the committed capital is transferred to VC right after the fund closes
The rest will be called down as the need arises
Capital calls: Request from GP to LP for pledged capital
Typically, takes 2 weeks for capital to arrive from time of call
Lifetime fees: the total amount of fees paid over the lifetime of a fund
Fund terminology
Investment capital: committed capital – lifetime fees
Invested capital: cost basis for the investment capital of the fund that has already been deployed
Net invested capital: invested capital – cost basis of all exited and written-off investments
Investment period (commitment period): Period of time during which the fund can make new investments
Typically, the first 5 years
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Simple Example
ABC Ventures raised its first fund – ABC I
Committed capital: $100M
Management fees: 2% (level) of committed capital (basis) annually
Fund life: 10 years
What are the lifetime fees and investment capital of this fund?
Lifetime fees = 2% x 100M x 10 = $20M
Investment capital = $100M – $20M = $80M
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Slightly less Simple Example
ABC Ventures raised its first fund – ABC 1
Committed capital: $100M
Same management fee and carried interest
Invests $5M per company in 10 companies
Sells 2 companies for $200M a piece
What are the invested capital and net-invested capital of this fund?
Invested capital = $5M x 10 = $50M
Net-invested capital = $50M – $10M = $40M
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Practice problem
Greylock Partners raised its 15th fund in 2008
Committed capital of $400M
2% Management fee on committed capital
12 year fund life, 5-year commitment period
Greylock has made 10 investments of $30 million each by 2012, and
Greylock has exited 5 deals with a total cost basis of $150M
It is now 2015
Calculate:
Lifetime fees
Investment capital
Invested capital
Net-invested capital
Practice Problem Solution
| Formula | Calculation ($M) | |
| Step 1 | Lifetime fees: | |
| Committed Capital x Fee % x years | $400 x 2% x 12 = $96 | |
| Step 2 | Investment Capital | |
| Committed Capital – Lifetime fees | $400 – 96 = $304 | |
| Step 3 | Invested Capital | |
| Sum of all investments made to date | 10 investments x 30 = $300 | |
| Step 4 | Net Invested Capital | |
| Invested Capital – Cost basis of all exited or written off investments | $300 – 150 = $150 |
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Computation of fees in practice
Requires two values:
Level (%)
Variation among funds
Variation over fund life
Basis
Committed capital
Invested capital
Implication on VCs’ behaviors?
In roughly 40% of firms, management fee base changes from committed capital to net invested capital after 5 year investment period
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Practice problem #2
Fund XYZ has committed capital equal to $500M and is 7 years into its fund life of 10 years. Management fees for XYZ are 2% of committed capital during the first 5 years of the fund’s life, and 2% of net invested capital after its initial 5 year investment period. XYZ has invested $400M and has experienced 3 firm exits at the end of year 5 which totaled a cost basis of $125M.
Calculate fund XYZ’s lifetime fees assuming no more exits by year 10
Practice Problem #2 Solution
| Formula | Calculation ($M) | |
| Part 1 | Fees for the first 5 years: | |
| Committed Capital x Fee % x years | $500 x 2% x 5 = $50 | |
| Part 2 | Fees for last 5 years: | |
| Net Invested Capital x Fee % x years | ||
| 1 | Invested Capital | |
| Sum of all investments made to date | $400 | |
| 2 | Net Invested Capital | |
| Invested Capital – Cost basis of all exited or written off investments | $400 – 125 = $275 | |
| 3 | Calculate fees for last 5 years | |
| Net Invested Capital x Fee % x years | $275 x 2% x 5 = $27.5 | |
| Part 3 | Lifetime Fee | |
| Part 1 + Part 2 | $50 + $27.5 = $77.5 |
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Computation of carried interest
Carried interest (carry): portion of profit that goes to GPs
Carry = Carry percentage * Profit
Profit = Exit Proceeds – Carry Basis
Carry percentage: typically 20%
Carry Basis: Threshold that must be exceeded before GP can claim a profit
Committed capital (used by about 70% of funds)
Investment capital (i.e., committed capital – fee)
May include a hurdle rate
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Practice problem
Fund Z has carry percentage of 15% and a carry basis equal to committed capital.
If committed capital is equal to $100M how much will the GPs make after selling all the funds portfolio companies for
$250M?
GP carry = (250 – 100)*0.15 = 22.5
How much would the LPs make?
LP profit = 250 – 100 – 22.5 = 227.5
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Practice problem
Fund VII has committed capital equal to $350M. The carry percentage is 20% and the carry basis is equal to committed capital plus a 10% hurdle rate. At the end of the funds life exit proceeds equal
$560M.
Calculate the GPs carry.
Carry = (560 – (350 x 1.1)) x 0.2 = $35M
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Computation of carried interest
Timing of distributions:
Deal-by-deal (most popular)
Real-estate model — wait till LPs get their money back
Deal-by-deal: What could possibly go wrong?
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Lecture 10 – The Investment Process
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Due diligence
Due diligence: Investigation of a business or person prior to signing a contract
Rigorous process that determines whether or not the venture capital fund or other investor will invest in your company
Primary purpose is to confirm valuation and identify material risks.
The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity.
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Preliminary due diligence
For firms that successfully pass the pitch meeting, the next step is preliminary due diligence
Primarily focuses on an in-depth analysis of company’s management and market potential.
If other VCs are also interested in the firm, preliminary due diligence is short
If the results of the preliminary due diligence is positive, the VC prepares a term sheet that includes a preliminary offer.
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Warren Buffet due diligence
4 simple criteria:
Can I understand it? (Buffet defines “understanding a business” as “having a reasonable probability of being able to assess where the company will be in ten years”)
Does it look like it has some kind of sustainable competitive advantage?
Is the management composed of able and honest people?
Is the price right?
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Final due diligence
Further analysis of management, market, customers, products, technology, competition, projections, partners, burn rate of cash, legal issues etc.
Legal due diligence: “I’m interested in learning how well formed the company is, if there are skeletons in the closet like fired co-founders or large debts or consultants who are owed shares or pending lawsuits.”
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Lecture 11 – Term Sheets I
Term sheet
A term sheet is a non-binding agreement setting forth the basic terms and conditions under which an investment will be made
A term sheet is NOT a legal promise to invest, rather it’s a reference point in future negotiation
“Think of it as a blueprint for your future relationship with your investor” – Brad Feld, Foundry Group
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Term sheet
The primary goal of the term sheet is to outline the economic and control terms of the entrepreneur – investor relationship
Economic terms: Terms which determine how the money will be split between the entrepreneurs and investors when the firm is sold or goes public
Control terms: Terms which explain how the control of the start-up is split between the entrepreneurs and investors
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Timeline of a VC investment
Company presents business plan to VC
VC performs preliminary due diligence on company
Business model, management team, competition, technology, capital intensity, etc.
VC proposes a term sheet to the company
VC and company negotiate the terms of the term sheet
Company signs term sheet, exclusivity period starts (No- Shop provision)
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Timeline of a VC investment
VC performs legal due diligence on company
IP filing, customer and supplier contracts, organizational documents
VC prepares definitive investment documents (the “5 documents”) based on the signed term sheet
More negotiations
Things not addressed in term sheet
New information found in due diligence
Closing of the transaction
Both company and VC sign definitive investment documents
Transfer funds
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No Shop Provision
A term sheet is NOT a legal promise to invest
Once signed the only legally binding portion of the term sheet is the “No Shop Provision”
The No Shop Provision it requires the company to:
Keep the negotiations confidential
Stop looking for other investors for a period (say 30-60 days)
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Overall
The term sheet is critical and is much more than a simple letter of intent
It will provide the basis for your future relationship with your investor and will influence your ability to get future financing
Outlines trade-off between economic and control rights
The best way to negotiate higher valuation is to have multiple VCs interested in investing in your company
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Term sheet
Economic terms
Valuation—pre-money valuation
Liquidation preference
Anti-dilution provisions
Vesting
Option pool
Dividends
Control terms
Board of directors
Protective provisions
Drag-along agreement (M&A)
Conversion
Key negotiating points
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Key term sheet provisions for negotiation
Pre-money valuation
Key determinant of ownership structure
Size of unallocated employee option pool
Also impacts ownership structure
Governance provisions
Board Structure & Voting rights determine who controls the company
Ideal outcome is a balanced Board
Participating preferred
VC’s best friend when the business generates a sub-optimal outcome
Capitalization table
Outlines pre-money and post-money valuation
Ownership is recorded on a “fully diluted basis” – i.e., it assumes all preferred stock is converted and all options are exercised
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Pre-money and post-money valuation
Pre-money valuation is the company’s valuation before it accepts the new investment
Post-money valuation is the company’s valuation after the new investment.
Pre- and Post-money valuations are implied valuations
Post-money valuation =
$ investment / ownership percentage
Pre-money valuation =
Post-money valuation – $ investment
Example: $5M for 33.33% of firm
Post-money valuation = $5M/0.3333 = $15M
Pre-money valuation = $15M – $5M = $10M
Capitalization table
Term sheet states: $1M for 50%
Post-money = $1M/0.5 = $2M
Pre-money = $2M – $1M = $1M
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Pre-money vs. post-money
When a VC says, “I’ll invest $5 million at a valuation of
$20 million”
The smart entrepreneur says “Is that a pre- or post- money valuation?”
Why?
If $20 million is a pre-money valuation, then
VC owns 20% after financing (post-money, 5/25)
If $20 million is a post-money valuation, then
VC owns 25% of $20M post-money (5/20)
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Practice problem
Assume the following:
2,000,000 shares held by founders before investment
$10M pre-money valuation
$5M investment by VC
What % ownership does the VC have?
| Class | Shares | Price per share | Valuation | Percentage |
| Founders | 2,000,000 | A | ||
| Employee pool | B | 20.00% | ||
| VC | C | D | $5M | 33.33% |
| Total | E | D | $15M | 100.00% |
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Practice problem – Solution
A = 100% – 33.33% – 20% = 46.67%
E = 2,000,000/0.4667 = 4,285,408
B = E*0.2 = 4,285,408*0.2 = 857,081
C = E*0.3333 = 4,285,408*0.3333 = 1,428,326
D = 5,000,000/1,428,326 = $3.50 per share
| Class | Shares | Price per share | Valuation | Percentage |
| Founders | 2,000,000 | A | ||
| Employee pool | B | 20.00% | ||
| VC | C | D | $5M | 33.33% |
| Total | E | D | $15M | 100.00% |
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Option pool
Why?
Typically 10-20% of fully diluted shares following the new issuance to VC
The bigger the pool the better?
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Not necessarily…
Large pool unlikely to run out of available options, but
Large pool dilution, since pool is typically carved out of owners equity pre-financing
Negotiation strategies:
Try to trade off pool size for higher pre-money valuation,
Try to get pool added to the deal post-money
Entrepreneurs should come armed with an options budget (i.e., a list of all planned hires)
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Liquidation preference
Specifies which investors get paid first and how much they get paid when a liquidation event occurs
Liquidation event: when the firm is acquired, merges, or sells most of its assets, but NOT an IPO
An IPO is a funding event
Helps protect VCs from losing money by making sure they get their initial investments (plus profit) back before other parties
Especially important for VCs when company is sold for less than what they’ve invested
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Liquidation preference
Each series of preferred stock will have its own liquidation preference
This can get complicated when there are multiple rounds
Typically, latest-round investors get money back first
Two components that make up Liquidation preference:
The actual preference – who gets paid first
The participation – how much they get paid
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Participation
Three ways to structure liquidation preference for preferred stock:
Non-participating preference
Participating preference without a cap
Participating preference with a cap
1. Non-participating preference
The preference holder gets back its original investment (or multiple) plus, in some cases, unpaid accrued or declared dividends.
The non-participating preference is like an option.
At the time of liquidation, investor must choose to either:
Receive the liquidation preference, or
Share in the proceeds in proportion to his or her equity ownership after converting his or her preferred shares into common stock
Investor would choose whichever option provides the better return
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Non-participating preference example
Ali Corp is raising a $250K seed round at a $1M “pre-money valuation” through the issuance of preferred stock with non-participating liquidation preferences. Assuming $250K is raised, the seed investors would own 20% of the company ($250K / $1.25M).
Holding all else equal, what happens in each of the following scenarios if the company either does well and is acquired for $3M, is mediocre and sells for $2M, or performs worse-than-expected and sells for only $1M:
1X liquidation preference (most common)
1.5X liquidation preference
2X liquidation preference
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| Investor Exercises Liquidation Preference | |||
| Liquidation Preference | |||
| Exit Value | 1.0x | 1.5x | 2.0x |
| $3,000,000 | 250,000 | 375,000 | 500,000 |
| $2,000,000 | 250,000 | 375,000 | 500,000 |
| $1,000,000 | 250,000 | 375,000 | 500,000 |
| Investor Elects Return Based on Ownership | |||
| Exit Value | 1.0x | 1.5x | 2.0x |
| $3,000,000 | 600,000 | 600,000 | 600,000 |
| $2,000,000 | 400,000 | 400,000 | 400,000 |
| $1,000,000 | 200,000 | 200,000 | 200,000 |
2. Participating preference without a cap
Participating Liquidation Preferences are sometimes referred to as “Double-Dip Preferred” and are the most favorable preference to investors.
After the VC fund gets its original investment (or multiple), the VC fund then shares in the balance of the sale proceeds with the common stock holders on an as-converted basis (e.g. as if their preferred shares were converted to common stock).
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3. Participating preference with a cap
After the VC fund gets its original investment (or multiple), the VC fund then shares in the balance of the sale proceeds with the common stock holders on an as- converted basis up until their aggregate return reaches a pre-negotiated cap (usually some multiple of the original purchase price per share).
Note: The cap includes the original investment. For example, if the cap is at 15M and the original investment is $5M then the investors will participate until they receive an additional $10M
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Quick note: Conversion Provision
Preferred stock can convert to common stock at any time!!!
This is non-negotiable
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Liquidation preference example 1
Suppose only 1 round of financing equal to $5M at $10M pre-money VC owns 33.33%
Assume company has an offer to be acquired for $30M
| CASE | VC | Entrepreneur |
| 1) Non-participating | 33% = $10M | 67% = $20M |
| 2) Participating | First $5M, then 33%*$25M = $8.3M | 67% of $25M = $16.7M |
| 3) Participating w/ 3X cap | Won’t reach cap of $15M, so same as 2) | Same as 2) |
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Liquidation preference example 1
Suppose only 1 round of financing equal to $5M at $10M pre-money VC owns 33.33%
Assume company has a offer to be acquired for $100M
| CASE | VC | Entrepreneur |
| 1) non-participating | 33% = $33M | 67% = $67M |
| 2) Participating | First $5M, then 33%*$95M = $36.35M | 67% of $95M = $63.65M |
| 3) Participating w/ 3X cap | Series A makes better than 3X Convert shares, same as 1) | Same as 1) |
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Conclusions
Participation has a lot of impact at relatively low outcomes, but little impact at high outcomes
Which liquidation preference will start-ups prefer?
Non-Participating Preferred Stock
Which liquidation preference will VCs prefer?
Participating Preferred Stock without a cap
Middle ground: Participating Preferred Stock with a cap
about 25% of deals
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Liquidation preference practice problem
Suppose Company X receives 1 round of financing equal to $2M at a $10M pre-money valuation
The VC receives participating preferred stock without a cap
If the company is acquired for $50M how much will the VC receive?
Value of PS = 2 + (2/12)*(50 – 2) = $10M
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Terminology: Down round
A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the company by earlier investors.
Down rounds cause dilution of ownership for existing investors BAD!
Unfortunately, sometimes the only other option is going out of business. In this case down rounds are necessary and welcomed.
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Anti-dilution provision
Protects investor’s stake in down rounds
Two types:
Full ratchet anti-dilution: Earlier round preferred stock can only convert at new price
E.g. Series A 1000 shares at $2 per share, new share price $1 per share convert at $1 per share, get 2000 shares
Weighted-average anti-dilution: the number of shares issued at the reduced price are considered in the repricing of the Series A
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Participation rights
Investors have the right of first refusal to invest in future rounds, usually their pro rata portion of the new financing
Note: This is a market term and is in most every VC deal you will see
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Board of directors
Key control mechanism is the process for electing board of directors
Board of directors (Early stage, typically 5 members)
Founder
CEO
VC
A second VC
Outside board member (chosen by the board or by the common and preferred shareholders voting together as a single class)
Key: Balance of control
Later stage will have 7-9 board members
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What does the board of directors do?
Typical duties include:
Select, appoint, support, and review CEO
Set the salaries and compensation of company management
Establish broad policies and objectives
Ensure the availability of adequate financial resources
Approve annual budgets
Account to the stakeholders for the organization’s performance
Approve any transactions above an agreed upon threshold.
Your board is your judge, jury, and executioner all in one – so be careful who you choose to be on it!
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Board of directors
VC as board of director has fiduciary duty to the company
But,…
VC is also an investor
Conflict???
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Protective provisions
Veto rights that investors have on certain actions by the company:
Issuing new shares
Change the terms of the stock owned by VCs
Issue stocks senior or equal to VCs
Buy back common shares
Sell the company
Change the certification of incorporation or bylaws
Change the size of board of directors
Pay or declare a dividend
Borrow money in excess of a threshold (e.g., 100K)
Why do protective provisions exist?
Mandatory conversion
Most underwriters require outstanding preferred stock to convert before IPO
Rather than negotiate at time of IPO with preferred holders, Qualified Public Offering (QPO) provisions force conversion prior to IPO
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Qualified public offering (QPO)
QPO is an IPO surpassing:
Minimum offering price (e.g., X times original purchase)
Minimum offer amount
Minimum market cap (sometimes)
All convertible preferred stocks are subject to mandatory conversion in case of QPO
If a proposed IPO is not a QPO, mandatory conversion can still happen as long as a majority of preferred holders agree
In that case, preferred holders may be able to receive more common shares as an incentive for them to agree to convert
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How to negotiate QPO
What will entrepreneurs want?
Entrepreneur will want lower conversion thresholds to ensure more flexibility
What will the VC want?
VCs will want higher thresholds to give them more control over the timing and the terms of the IPO
VCs want to set the QPO requirement high enough to prevent founders from pushing the firm public too early
Minimum price: ensure a decent return for VC; a thinly traded stock makes it harder for VCs and their LPs to trade out of the stock.
Minimum offering amount: An IPO with small offering amount (i.e.,
$ raised in IPO) will not attract established underwriters, which can hurt the success of the IPO.
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Drag along rights
Allows subset of investors to force the other investors and the founders to agree to a sale or liquidation of a company
Prevent holdout problem (esp. when the sale value is below the liquidation preference)
Requires majority of preferred holders
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Negotiating drag along rights
Get the drag-along rights to pertain to the majority of the common stock, not the preferred;
The investors can convert some of their preferred to common stock to create a majority (which would lower the liquidation preference).
Negotiate a higher threshold (e.g. 2/3 instead of 51%) to trigger the drag-along rights
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Other terms of the Term Sheet
Redemption rights – Conditions under which investors may redeem their initial investment
E.g. prespecified length of time to reach milestones
Rarely exercised due to legal difficulties
Registration rights – Provide a contractual right for investors to demand that the company register their shares with the SEC. Following a registration, the investor can sell their shares on the public market.
Important since US law permits the company, but not the shareholder, to register company securities.
Ensures that liquidity is an option for the investor
Co-sale and Right of first refusal – Investors right to sell stock to the same buyer, at the same price and same percentage that a founder or other major holder sells to.
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Lecture 12 – Term Sheets II
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IPO process summary
Obtain Board of Directors re-approval to begin the formal process
Select underwriters, legal team, and auditor team
Prepare and file the registration statement with SEC, apply for stock exchange listing
SEC examines the registration during a 20-30 day waiting period and issues comments on registration statement
A preliminary prospectus, called a red herring, is distributed during the waiting period
If there are problems, the company is allowed to amend the registration and the waiting period starts over
Cap table practice problem
Sequoia Capital proposes to invest $3M in YouFace.com for 6M shares of Series A preferred stock
Assume that the three founders, Chad, Steve, and Carl each owns 3M shares of common stock
In addition, there are 3M shares of common stock for employee stock pool, of which 600,000 shares have been issued
Construct the capitalization table of YouFace for this transaction.
What is the pre- and post-money valuation?
What is Sequoia’s fully-diluted ownership after the investment?
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Cap table – Solution Steps
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Step 1 – Fill in pre-money shares and ownership percentages Fill in post-money shares for founders and option holders
Step 2 – Calculate the post-money shares: Pre-money shares + New shares = post-money shares
Step 3 – Calculate individual post-money ownership percentages: Individual shares / total post-money shares
Step 4 – Calculate the post-money valuation: New Investment / Series A ownership percentage
Step 5 – Calculate post-money individual ownership values ($) Post-money valuation x ownership percentage
Step 6 – Calculate the pre-money valuation Post-money valuation – investment
Step 7 – Calculate pre-money individual ownership values ($) Pre-money valuation x ownership percentage
Cap table practice problem – Solution
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| Pre-money | Post-money | |||||
| Shares | $ | % | Shares | $ | % | |
| Common – Founders | Step 1 | Step 7 | Step 1 | Step 1 | Step 5 | Step 3 |
| Common – Option pool | Step 1 | Step 7 | Step 1 | Step 1 | Step 5 | Step 3 |
| Issued | Step 1 | Step 7 | Step 1 | Step 1 | Step 5 | Step 3 |
| Unissued | Step 1 | Step 7 | Step 1 | Step 1 | Step 5 | Step 3 |
| Series A Preferred | 6.0 | Step 5 | Step 3 | |||
| Total | Step 1 | Step 6 | 100.0 | Step 2 | Step 4 | 100.0 |
Cap table practice problem Answer Sheet
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| Pre-money | Post-money | |||||
| Shares | $ | % | Shares | $ | % | |
| Common – Founders | ||||||
| Common – Option pool | ||||||
| Issued | ||||||
| Unissued | ||||||
| Series A Preferred | 6.0 | |||||
| Total |
Cap table practice problem – Solution
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| Pre-money | Post-money | |||||
| Shares | $ | % | Shares | $ | % | |
| Common – Founders | 9.0 | 4.5 | 75.0 | 9.0 | 4.5 | 50.0 |
| Common – Option pool | 3.0 | 1.5 | 25.0 | 3.0 | 1.5 | 16.7 |
| Issued | 0.6 | 0.3 | 5.0 | 0.6 | 0.3 | 3.3 |
| Unissued | 2.4 | 1.2 | 20.0 | 2.4 | 1.2 | 13.3 |
| Series A Preferred | 6.0 | 3.0 | 33.3 | |||
| Total | 12.0 | 6.0 | 100.0 | 18.0 | 9.0 | 100.0 |
Sequoia Capital proposes to invest $3M in YouFace.com for 6M shares of Series A preferred stock
Assume that the three founders, Chad, Steve, and Carl each owns 3M shares of common stock
In addition, there are 3M shares of common stock for employee stock pool, of which 600,000 shares have been issued
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A lesson for VC’s investing in common stock
VC is willing to invest $3M in founder’s idea for a new software company
Founder and VC agree on a 50.05/49.95 split, with founder holding the majority stake
Suppose the VC invests in common stock
On the day after closing, founder receives an offer of $4M to buy his company
Will the founder accept this offer?
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Will the founder accept the $4 million offer?
It depends on the founder
Simple valuation analysis might lead the founder to reject the offer
Prior to the $4 million offer, founder’s stake is worth $3 million (50.05% of a business valued at $6 million)
Is she accepts the new offer, she only gets $2 million.
Is a bird in the hand worth two in the bush?
The founder might accept the offer if any of the following are true:
The offer includes a lucrative compensation package for the founder to continue as CEO
Founder is uncertain about the future of her business or has other projects to pursue and wants the surety of $2 million in the bank.
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All possible outcomes for the VC are bad
If the contract provides for drag-along rights, the VC could be forced to sell and will quickly lose $1 million on its investment
If no drag-along rights, VC could refuse to sell which might kill the deal
Alternative would be to threaten or pursue litigation to block the sale.
Immediately file for a temporary injunction to halt sale until a final ruling on the merits of the case
Final outcome of litigation will depend on the whether the final agreements include minority shareholder protections
Litigation will destroy both the business and the relationship
Lose focus on running the business
Potential customers may walk away
Cash drain
Animosity
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How could the VC have avoided this disaster?
Invest in preferred stock
“money-back” feature
Liquidation preference
Ensures that VC gets fully paid back before any proceeds go to founder
Require super majority approval by investors on important decisions (such as sale of the company)
Reverse vesting provision
Founder must relinquish her shares and then re-earn them on a new vesting schedule
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Features of preferred stock
Liquidation preference
With or without participation
Capped or uncapped participation
Optional conversion provision
Mandatory conversion provisions
Qualified public offering
Anti-dilution protection (in the event of down rounds)
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Liquidation preference
All types of preferred stocks have this feature (downside protection)
Determines who gets paid first and how much is paid in the event of liquidation
Who gets paid first?
Preferred vs. common stockholders
Later round investors vs. previous rounds
How much is paid (redemption value)?
1X original investment
Majority of deals
> 1X original investment
“Excess liquidation preference”
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Types of preferred stock
Redeemable preferred (RP)
Non-convertible
Convertible preferred
without participating rights (CP)
with participating rights
Unlimited participating rights (PCP)
Capped participating rights (PCPC)
Exit diagrams allow us to compare the payoff of different types of securities
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Non-participating convertible preferred stock (CP)
Popular in 1980’s – more money around, more competitive VC industry, so the security needs to be more founder friendly
Liquidation preference offers downside protection
Convertible feature provides upside potential if the exit value is high enough
But in order to share the upside, need to convert to common stock
If converted to common stock, liquidation preference is lost
Cannot have both downside protection and upside potential
simultaneously
Non-participating convertible preferred (CP) stock exit diagram
Assume a $1M investment in CP stock with a 5X liquidation preference and a 1/3 ownership if converted to common stock
Voluntary conversion point: The exit value at which the investor is indifferent between converting or not converting.
$W (total exit)
Exit value of investment
Slope = 0
5
Slope = 1
5
Slope = 1/3
voluntary conversion point
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Common stock return,
Slope = 1/3
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Participating convertible preferred stock (PCP)
Popular in 1990’s – attract later rounds of investors
Liquidation preference offers downside protection
Participating feature allows the holder to share upside potential without converting
“Double dipping”— can have downside protection and upside potential (on an as-if-converted basis) simultaneously.
Participating convertible preferred (PCP) stock exit diagram
5
$W
PCP
Slope = 1/3
Slope = 1
Assume a $1M investment in PCP stock with a 5X liquidation preference and participation as if 1M shares of common stock (i.e., 1/3 ownership)
Exit value of
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investment
Does the VC have an incentive to voluntarily convert if she invests in PCP?
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Participating convertible preferred with a cap (PCPC)
PCPC is the same as PCP, except that it caps how much investors can receive.
Will the PCPC investor have the incentive to convert voluntarily?
For example, if the cap is low and the exit value is high enough.
The cap determines how long you can “double-dip”.
Participating convertible preferred with a cap (PCPC) stock exit diagram
PCPC
(Redemption value)
Assume a $1M investment in PCP stock with a 5X liquidation preference and participation as if 1M shares of common stock (33%) with a 7X cap
Exit value of
investment
PCP
PCPC
(Conversion value)
voluntary conversion point
$W (total exit)
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PCPC practice problem
Suppose that Sequoia invests $3M in YouFace.com for 1/3 ownership with their investment structured as follows:
PCPC with purchase price of $3M
1X liquidation preference,
and a liquidation cap of 6 times investment.
Questions:
Will Sequoia convert and how much will Sequoia get if the company is sold for
9 million
90 million
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PCPC practice problem
Suppose that Sequoia invests $3M in YouFace.com for 1/3 ownership with their investment structured as follows:
PCPC with purchase price of $3M
1X liquidation preference,
and a liquidation cap of 6 times investment.
Questions:
If there is no cap, will Sequoia convert and how much will Sequoia get if the company is sold for
9 million
90 million
If the firm went through IPO at an offer price of $3 per share, how much is Sequoia’s stake worth?
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Pre-money valuation isn’t everything…
Term sheet 1
$5m invested
VCs ask for 1/3 of the company
Pre-money = 15-5= $10m
Term sheet 2
$5m invested
VCs ask for 1/2 of the company
Pre-money = 10-5 = $5m
Should you choose TS 1 because of the higher pre-money value?
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Pre-money valuation isn’t everything…
Term sheet 1
$5m invested
VCs ask for 1/3 of the company
Pre-money = 15-5= $10m
Term sheet 2
$5m invested
VCs ask for 1/2 of the company
Pre-money = 10-5 = $5m
Should you choose TS 1 because of the higher pre-money value?
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(1) Liquidation preference
Assume both are convertible preferred
Term sheet 1 has 2x liquidation preference
Term sheet 2 has 1x liquidation preference
If the company is sold for 10m, how much goes to VC and how much to founders?
Term sheet 1: VC gets 10m, founders 0
Term sheet 2: VC gets 5m, founders 5m
For other scenarios, exit diagrams will help clarify.
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(2) Participating rights
Assume both have 1x liquidation preference
Term sheet 1 is participating convertible preferred
Term sheet 2 is non-participating
If the company is sold for 10m, how much goes to VC and how much to founders?
Term sheet 1: VC gets 5+1/3*(10-5)=6.67, founders 3.33
Term sheet 2: VC gets 5m, founders 5m
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(3) Participating with cap
Assume both are participating convertible preferred with 1x liquidation preference
Term sheet 1 participates with no limit
Term sheet 2 has a cap of 1.5x on participation
If the company is sold for 13m, how much goes to VC and how much to founders?
Term sheet 1: VC gets 5+1/3*(13-5)=7.7m, founders 5.3m
VC is capped at 1.5*5=7.5m, founders get 5.5m
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Anti-dilution provision
Anti-dilution provisions protect against a down round by adjusting the price at which the preferred stock converts into common stock
Conversion price and/or rate, of earlier round investors gets adjusted according to a pre-specified formula
Different types of conversion formulas:
Full ratchet
Weighted average
Broad-based
Narrow-based (Rarely used)
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Conversion rates
Full ratchet:
New conversion price = price of new stock sale
New conversion rate =
Old conversion price
New conversion price
Weighted Average – Broad-based method
New conversion price =
Old conversion price x shares outstanding before the new round + new investment)
Shares outstanding before the new round + shares issued in the new round)
New conversion rate =
Old conversion price
New conversion price
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End Game Comparison of the 3 Scenarios
Founders prefer no anti-dilution provision
Series A investors prefer the Full Ratchet provision
Series B investors prefer the Weighted Average provision or insist on a fixed ownership percentage
| No Anti-dilution protection | Full Ratchet Provision | Weighted Average Provision | |||||||
| Investor | Shares | $ | % | Shares | $ | % | Shares | $ | % |
| Founders | 3M | 1.5M | 25 | 3M | 1.5M | 20 | 3M | 1.5 | 23 |
| Series A | 3M | 1.5M | 25 | 6M | 3.0M | 40 | 4M | 2.0 | 31 |
| Series B | 6M | 3.0M | 50 | 6M | 3.0M | 40 | 6M | 3.0 | 46 |
| Total | 12M | 6.0M | 100 | 15M | 7.5M | 100 | 13M | 6.5 | 100 |
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How well do anti-dilution provisions work in practice?
Full-ratchet anti-dilution was popular during the last downturn
Misleading to take the mechanical security of full-ratchet (and other) anti-dilution protections at the face value
Why?
Everything is negotiable in the Series B round
New investors are not dumb
Who has bargaining power?
However, it is valuable to understand how anti-dilution works if only to understand each party’s negotiating leverage
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How well do anti-dilution provisions work in practice?
VCs are forced to waive anti-dilution protection in about 64% of applicable down rounds, and in the remaining 36% of cases protections don’t work as strongly as language suggests
Why?
Anti-dilution protection is only useful when the protected party is willing to walk away from the deal
E.g., if the company is doing poorly and the VC is willing to liquidate, then the anti-dilution provisions are useful
But if VC wants new financing, then it has little leverage to maintain the protections
New investors will insist on old investors waiving anti-dilution rights
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Lecture 13 – Exits
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IPO process summary
Obtain Board of Directors re-approval to begin the formal process
Select underwriters, legal team, and auditor team
Prepare and file the registration statement with SEC, apply for stock exchange listing
SEC examines the registration during a 20-30 day waiting period and issues comments on registration statement
A preliminary prospectus, called a red herring, is distributed during the waiting period
If there are problems, the company is allowed to amend the registration and the waiting period starts over
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IPO process summary
Find investors
Distribute preliminary prospectus (red herring) to investors during waiting period
Begin road show
Finalize the deal
File final registration statement with SEC, SEC declare offering effective
Obtain final Board of Directors approval
Set the final offer price, sign the underwriting agreement
Print tombstone ad
Offer date, begin trading
The Methods of Issuing New Securities
| Method | Type | Definition |
| Public Traditional Negotiated Cash Offer | Firm Commitment Cash offer | The company negotiates an agreement with an Investment Bank to underwrite and distribute new shares. A specified number of shares are bought by underwriters and sold at a higher price. |
| Best Efforts Cash Offer | The company has investment banks sell as many of the new shares as possible at an agreed-upon price. Underwriter does not guarantee how much cash will be raised. | |
| Dutch Auction Cash Offer | The company has investment banks auction shares to the determine the highest offer price obtainable for a given number of shares to be sold. |
Firm Commitment Underwriting
Issuer sells entire issue to the underwriting syndicate
The syndicate then resells the issue to the public
The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold
The underwriters buy stock from the issuer at a discount (typically 6-7% of the offering price) and then sell it to the public at the full price.
The syndicate bears the risk of not being able to sell the entire issue for more than the cost
Most common type of underwriting in the United States
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This is a good place to review the difference between primary and secondary market transactions. Technically, the sale to the syndicate is the primary market transaction, and the sale to the public is the secondary market transaction.
Note that the cost of the issue includes the price paid to the issuing company plus the expenses of selling the issue.
Best Efforts Underwriting
Underwriter must make its “best effort” to sell the securities at an agreed-upon offering price
The company bears the risk of the issue not being sold
The offer may be pulled if there is not enough interest at the offer price. In this case, the company does not get the capital, and they have still incurred substantial flotation costs
Not as common as it was back in the day
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Real-World Tip: “Corporate America is turning more fickle in choosing finance partners on Wall Street …[m]ore companies are ditching the Wall Street underwriters they had selected for initial public offerings and picking different investment banks when it comes time to complete follow-on stock sales.” So read the opening lines of an article in the December 19, 1996 issue of The Wall Street Journal. But why is this occurring? According to the article, the phenomenon is attributable in part to the fact that many offerings quickly rise above the offering price, leading issuers to feel that their shares were underpriced (and that they left millions of dollars “on the table” as a result).
Potential Exam Topic
Know the difference between Firm Commitment and Best Efforts underwriting
Who bears the risk?
Sample Question:
Big Bank agrees to underwrite the IPO of NewCo Under a firm commitment agreement, Big Bank agrees to purchase 2,000,000 shares of NewCO at a price of $10 per share and sell them to the public at $11 per share. When the issue comes to market, Big Bank can only find buyers for 1,800,000 shares at $9.50 per share. Does the deal need to move forward? If so, how much will Big Bank need to pay Newco?
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Real-World Tip: “Corporate America is turning more fickle in choosing finance partners on Wall Street …[m]ore companies are ditching the Wall Street underwriters they had selected for initial public offerings and picking different investment banks when it comes time to complete follow-on stock sales.” So read the opening lines of an article in the December 19, 1996 issue of The Wall Street Journal. But why is this occurring? According to the article, the phenomenon is attributable in part to the fact that many offerings quickly rise above the offering price, leading issuers to feel that their shares were underpriced (and that they left millions of dollars “on the table” as a result).
IPO Underpricing
It may be difficult to price an IPO because there isn’t a current market price available
Private companies tend to have more asymmetric information than companies that are already publicly traded
Underwriters want to ensure that, on average, their clients earn a good return on IPOs
Underpricing causes the issuer to “leave money on the table”
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Lecture Tip: More recent evidence (see “Underpricing, Overhang, and the Cost of Going Public to Preexisting Shareholders” by Dolvin and Jordan in the 2007 issue of Journal of Business Finance and Accounting) suggests that underpricing has little impact on owners, as very few preexisting shares are sold in IPOs.
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Money left on the table phenomenon
The share price is likely to increase for most IPOs:
TheGlobe.com jumped 900% on the first trading day (the dot- com boom)
Hyatt jumped 12% on the first trading day
Dollar General jumped 8%
These high returns on the first day of trading have been observed across many nations and time periods
IB with better reputation and more experienced VC investors are associated with reduced underpricing
Average initial return
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AVERAGE INITIAL RETURN VARIES BY COUNTRY. IN WELL ESTABLISHED MARKETS, IT IS THE 1-DAY RETURN.
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Why?
Compensation for information gaps
Investors may need a discount to buy a newly listed company with high risk and uncertainty
informed vs. uninformed investors
Momentum effect (retail investors rush in after price increases)
IB sets the price deliberately low to transfer wealth to bank’s clients in return for future business (“spinning”)
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Green shoe option
Investment bankers reserve the option to sell 15% more shares than the stated offering size—stabilizing the stock price in the period following the IPO (often 30 days)
If the offering was 1M shares, the bank will sell 1.15M shares
If the price goes up after IPO, the bank will declare that the offering was 15% larger than the size originally projected
If the price drops below the offering price, the bank will buy back the additional 15% of the shares, hoping to drive up the price. In the meantime, the bank also makes money.