Venture Capital and Private Equity Session 4 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)

Quick Review of Valuation Methodologies DCF – Estimate FCF (EBIAT+Dep-CapEx-ΔNWC) – Estimate WACC – Estimate Terminal Value (Perpetual growth g) – Discount FCF and TV to get Enterprise Value Multiples Based – Choose a set of Peers/Comprables – Choose the multiple(s) e.g. EV/EBIT, P/E – Estimate Median/Average Multiple – Apply to target Please Read “Note on Valuation in Private Equity Settings”

VC Method Flavor of both DCF and Multiples but is different. FCF is highly uncertain WACC is almost meaningless Multiples are hard to get by Most firms will NOT survive A few firms would have incredible growth

VC Method-Implied Valuation Information you would almost always have I – Amount being raised from VC X- Number of Shares currently owned by entrepreneur Information that requires judgment call R – VC’s required return (IRR) usually between 25% to 80% T – Time to exit (When VC gets money back) V – Value of the company at time of exit Numbers you need to calculate F – Fraction of company VC would need to get the return Post-Money Valuation – Value of company after funding is received Pre-money Valuation - Value of company before funding is received P – Price per share. Y – Number of shares to be issued to the VC

An Example Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. Company currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 50%? Exit Value = $4 x 25 = $100 million POST MONEY VALUATION = 100/(1+50%) 5 = million PRE MONEY VALUATION = – 5 = $8.169 million Since 1 million shares outstanding Price per share = $8.17 Alternatively VC must get 5/13.17 = 37.97% of the company Let us assume Y is the number of new shares that must be issued to the VC, X are the existing number of shares Y/(X+Y) = F =38% algebraic manipulation yields Y = 612,091 shares. Price per share = 5,000,000/612,091 = $8.17 What if VC required 30%? What if need was for $12 million?

An Example Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. Company currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 50%? Exit Value of Hoya.com = $4 x 25 = $100 million Exit Value of VC has to be =$5x(1+50%) 5 = million Fraction of Company Needed = 37.97/100=37.97% Implied POST MONEY Valuation=5/0.3797=13.17 million Implied PRE MONEY Valuation= =8.17 million Let us assume Y is the number of new shares that must be issued to the VC, X are the existing number of shares Y/(X+Y) = F =37.97%; algebraic manipulation yields Y = 612,091 shares. Price per share = 5,000,000/612,091 = $8.17 What if VC required 30%? What if need was for $12 million?

An Example Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. Comapny currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 30%? Exit Value = $4 x 25 = $100 million Value of VC’s 5 million investment at 30% = 5*(1+.30) 5 = $18.6 million VC would ask for 18.6/100 = 18.6% of the firm! How many shares if VC needs 50% return (would ask for 38% of the firm). X original number of Shares, Y new shares Y/(X+Y) =0.38, since X =1, Y=0.612 How many shares if VC needs 30% return (would ask for 18.6% of the firm). Y = X(F/1-F) = 1*(0.186/ ) Y = million shares

Multiple Rounds/ Exit Dilution Imagine that you need 15% of the company at the exit to get your mandated return. Simple case – 100 shares would want 15 shares What if along the way company issues another 50 shares (option/new investor) what happens to your stake? – New total shares = = 150 – You interest = 15/150 = 10%!! – you have been diluted You would insist on more than 15% today to end with 15% eventually – how to figure that out Expected dilution = 50/150 = Fraction needed today = Final ownership/(1-Dilution) =15%/( )= 22.5% implying 22.5 shares today Check>>> at the end 22.5/150 = 15%

Example Contd. Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? Need to reserve 15% of the firm in terminal year for the option pool for mangers. VC still needs to get $5 million*(1.5) 5 = million Only 85 million available after the option pool VC would want 37.97/85 = 44.67% of the company AT EXIT. 5 million for 44.67% of the company imply Post money valuation of 5/0.4467= million and pre-money valuation of =6.193 million New Shares to VC =5/6.193=0.807 million shares

Another Approach (easier). Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? Need to reserve 15% of the firm in terminal year for the option pool for mangers. VC still needs to get $5 million*(1.5) 5 = million At Exit Firm is Still Worth 100 Million VC still needs 37.97/100 = 37.97% of the Firm AT TIME OF EXIT! However what VC needs TODAY is higher since extra shares would be issued to the Option Pool causing dilution VC Current Ownership = /(1-0.15) = 44.67%

Multiple Rounds of Financing Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? Need to reserve 15% of the firm in terminal year for the option pool for mangers. Would need another $ 3 million at the beginning of year 3 – round 2 investors require 30% return Round 2 investor need 30% on its 3 million i.e. 3(1.30) 3 = 6.59 million Amount available after option pool is 85 million implying 6.59/85 = 7.75% Round 1 still needs $38 million to generate 50% but only has ( ) million to get it out of implying initial stake = 38/( )=0.485 or 48.5% stake.

Multiple Rounds of Financing Hoya.com is asking for $5 million, Projected income in year 5 is $ 4 million and expected exit multiple is 25x. What share of company would a VC require today if VC’s required return is 50%? Need to reserve 15% of the firm in terminal year for the option pool for mangers. Would need another $ 3 million at the beginning of year 3 – round 2 investors require 30% return Round 2 investor need 30% on its 3 million i.e. 3(1.30) 3 = 6.59 million Final value is still 100 million, Thus Round 2 investor need 6.59% of the company AT EXIT Implying that at time of investment it needs to own Round 2 VC need 0.659/(1-0.15)=7.75% Round 1 still needs 38% at the time of EXIT implying initial stake = 0.38/(1-( ))=0.485 or 48.5% stake. What is the Post and Pre Money Valuation at round 1? How many shares need to be issued to Round 1, Round 2 and option pool? 5/0.485=10.32; 5.32 Round 1 = 1x[0.485/( )] =941,748 Round 2 = x[0.0775/( )]=163,128 Option Pool =( )X[0.15/(1-0.15)]= 371,448

For Practice Recalcualte the numbers detailed in “The Basic Venture Capital Formula”

Quick Review of VC Valuation Method Remember - 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 business This process is made transparent by reporting of “Capitalization Table” or simply “Cap Tables” – Let us see how these are created…

Capitalization Tables Page 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 Happened Was 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 Software Did IPO in 2003 at $13.5 share ONSET owned 17% of the company at the time of IPO

Term Sheets… Let us look at Trendsetter

Term Sheet Getting first Term Sheet is MAJOR break through! – Validates entrepreneur/idea – Establishes a price – Can be shopped around (especially in later rounds)

Check the Term Sheet! Term Sheets in Venture Financing Critical Issues – Uncertainty – Asymmetric Information – Nature of Firm’s assets – Conditions of relevant financial and product markets Responses by investors –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 Got a Term Sheet Multiple Rounds, Multiple Tranches

Trendsetter is Lucky! If you were advising Trendsetter which offer would recommend? – Valuation – Liquidation Preference (and Antidilution) – Vesting – Corporate Governance

Valuation (Cap Tables)

Liquidation Deemed liquidation event Liquidation preference (2X, 3X, etc.) – Non Participating – Fully Participating Qualified public offering (QPO) Will See in Details Later

What Type of Security? Alpha – Convertible Preferred (CP) Stock Mega – Participating Convertible Preferred (PCP) Stock TYPE OF LIQUIDATION EVENT IS CRITICAL!

Exit Values

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 Price OCP= Old Conversion Price in effect immediately prior to new issue OB = Number of shares of shares outstanding immediately prior to this round NM = New Money received by the Corporation SI=Number of shares of stock issued in this round Another way of writing it

Why do we see these features? Convertible preferred Participating Convertible Preferred Full Ratchet/ Weighted Average Ratchet Registration rights

Challenges for VCs Private 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 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? Interesting- why?

VCs response #1– Security Design Redeemable Preferred (RP) Convertible Preferred (CP) - Forced Conversion Clause Participating Convertible Preferred (PCP) DO NOT WORRY! WILL DEVOTE TIME TO THESE LATER!!

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

Tomorrow Read AntiDilution Note Read Note on Private Equity Securities Read “How VCs evaluate potential Opportunities”