1. Venture Capital and Private Equity Session 5
Professor Sandeep Dahiya
Georgetown University

2. 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)

3. 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
Preferred Stock
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
READ THE TERM SHEETS!!

4. How do VCs address these problems
Security Design
Vesting Provisions
Covenants

5. Securities used by VCs Common Stock Debt Preferred Stock
Never – why not?
Interesting- why?

6. VCs response #1– Security Design
Redeemable Preferred (RP)
Convertible Preferred (CP) - Forced Conversion Clause
Participating Convertible Preferred (PCP)

7. 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

8. VCs response #3 Covenants
Positive Covenants
Example Provide regular information
Negative Covenants
Example Sale of assets
Others
Mandatory redemption
Board Seats

9. Other Term Sheet Features
Vesting
Covenants
Liquidity Preferences
Anti-Dilution Protection
Board Seats
Please read the Note on Private Equity Securities

10. Liquidation – Quick Review
Deemed liquidation event
Liquidation preference (2X, 3X, etc.)
Non Participating
Fully Participating
Qualified public offering (QPO)

11. FACEBOOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Conversion
Each share of Series A, Series B, Series C, Series D, and Series E preferred stock is convertible, at the option of the holder thereof, at any time after the date of issuance of such share, into such number of fully paid and non-assessable shares of Class B common stock as is determined by dividing the applicable original issue price by the conversion price applicable to such share in effect on the date of conversion.
The conversion price of each series of preferred stock may be subject to adjustment from time to time under certain circumstances. The convertible preferred stock issued to date was sold at prices ranging from $ to $ per share, which, in all cases, exceeded the then most recent reassessed fair value of our Class B common stock. Accordingly, there was no intrinsic value associated with the issuance of the convertible preferred stock through December 31, 2011, and there were no other separate instruments issued with the convertible preferred stock, such as warrants. Therefore, we have concluded that there was no beneficial conversion option associated with the convertible preferred stock issuances.
Each share of Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall automatically be converted into fully paid, non-assessable shares of Class B common stock immediately upon the earlier of: (i) the sale by us of our Class A common stock or Class B common stock in a firm commitment underwritten public offering pursuant to a registration statement under the Securities Act of 1933, as amended (Securities Act), the public offering price of which results in aggregate cash proceeds to us of not less than $100 million (net of underwriting discounts and commissions), or (ii) the date specified by written consent or agreement of the holders of a majority of the then-outstanding shares of preferred stock, voting together as a single class on an as-converted basis, provided, however, that if (a) the holders of a majority of the then-outstanding shares of Series D convertible preferred stock do not consent or agree or (b) the holders of a majority of the then-outstanding shares of Series E convertible preferred stock do not consent or agree, then in either such case the conversion shall not be effective as to any shares of preferred stock until 180 days after the date of the written consent of the majority of the then-outstanding shares of preferred stock.
Liquidation Preferences
In the event we liquidate, dissolve, or wind up our business, either voluntarily or involuntarily, the holders of our Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall be entitled to receive, prior and in preference to any distribution of any of our assets to the holders of Class A common stock or Class B common stock, an amount per share equal to $ , $ , $ , $ , and $ per share (as adjusted for stock splits, stock dividends, reclassifications, and the like), respectively, plus any declared but unpaid dividends.
If, upon the occurrence of any of these events, the assets and funds distributed among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then our entire assets and funds legally available for distribution shall be distributed ratably among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock in proportion to the preferential amount each such holder is otherwise entitled to receive.
If there are any remaining assets upon the completion of the liquidating distribution to the Series A, Series B, Series C, Series D, and Series E convertible preferred stockholders, the holders of our Class A common stock and Class B common stock will receive all our remaining assets. The merger or consolidation of us into another entity in which our stockholders own less than 50% of the voting stock of the surviving company, or the sale, transfer, or lease of substantially all our assets, shall be deemed a liquidation, dissolution, or winding up of us. As the “redemption” events are within our control for all periods presented, all shares of preferred stock have been presented as part of permanent equity.

12. Facebook Cap Table

13. Biggest VC Success Story
Number of Shares
Price paid
Amount Invested
Series A
133,055 $
612.72
Series B
224,273 $
12,784.12
Series C
91,410 $
26,249.92
Series D
50,590 $
374,996.05
Series E
44,038 $
200,002.10
Angel Round?
ACCEL?
Peter Thiel 500,000 turned into 2.5% of 100 Billion = 2.5 Billion YES BILLION!!!

14. Anti-Dilution Protections
Read the Note on
Anti-dilution provisions: Typology
and Numerical Example
Down round
Full-ratchet vs. weighted average
Adjusted conversion price, adjusted conversion rate

15. Dilution
A owns 100% of the company which is 1 million shares for which she had paid $2 per share
Company issues another 1MM shares and raises 2 MM from B
A is now 50% owner -- she has been diluted!
But A did NOT suffer any ECONOMIC DILUTION – Company now is worth $ 4 million and A’s stake is still $2 million!
Similarly, If company reserves 1 MM shares for option pool again the company receives future services from the employees for that option pool again there is no ECONOMIC DILUTION.
What is investor B pays $1 per share for its $2 million investment?
Now there are 3 Million share post financing and A only owns 33.3%
A’s investment declines from $2MM to $1MM
ECONOMIC DILUTION!!!

16. Antidilution
Company XYZ raised $12 Million from Early Ventures (EV) in Round A financing. EV received 6 million shares (at a $2.00 per share price). The Founders had 4 million shares after Round A. Subsequently the firm falls on hard times and has to raise another $ 10 million. It appears that investors are unlikely to offer more than $1.00 per share valuation. How would the Cap Tables look if
(a) EV had NO antidilution protection
(b) EV had Full Ratchet Protection
(c) EV had Broad Weighted Average antidilution Protection

17. Regular Round
What happens when the new round for $ 10 Million is raised at $1.00 Per share?

18. No Antidilution Protection
Series A
Series B (No AntiDilution)
Investor
# of shares
$ per share
$ total %
ownership
Founders
4,000,000
$2.00
$8,000,000
40.00%
$1.00
$4,000,000
20.00%
Key Ventures
6,000,000
$12,000,000
60.00%
$6,000,000
30.00%
Series B VC
10,000,000
$10,000,000
50.00%
Total For Round
12,000,000
Cumulative Total
$20,000,000
100%
20,000,000
Price Per Share
Pre-Money Valuation
8,000,000
Cash Infusion
Post-money Valuation

19. Full Ratchet Protection
Series A
Series B (Full Ratchet)
Investor
# of shares
$ per share
$ total %
ownership
Founders
4,000,000
$2.00
$8,000,000
40.00%
$1.00
$4,000,000
15.38%
Key Ventures
6,000,000
$12,000,000
60.00%
12,000,000
46.15%
Series B VC
10,000,000
$10,000,000
38.46%
Total For Round
Cumulative Total
$20,000,000
100%
26,000,000
$26,000,000
Price Per Share
Pre-Money Valuation
8,000,000
16,000,000
Cash Infusion
Post-money Valuation
20,000,000
Early Round VC simply demands that the NEW down round price be used for the Money he had invested in the earlier round!
First round  $12 Million was invested – New price is $1 – Early VC would say his total number of shares must be 12 million, since he already has 6 million shares he would have to be given extra 6 million shares!
Notice what happens to the shareholding of Late round investor IF there is anti-dilution protection!

20. 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

21. Weighted Average Anti-Dilution
Series A
Series B (Wtd Avg Ratchet)
Investor
# of shares
$ per share
$ total %
ownership
% ownership
Founders
4,000,000
$2.00
$8,000,000
40.00%
$1.00
$4,000,000
18.18%
Early Venture
6,000,000
$12,000,000
60.00%
8,000,000
36.36%
Late Venture
10,000,000
$10,000,000
45.45%
Total For Round
12,000,000
Cumulative Total
$20,000,000
100%
22,000,000
$22,000,000
Price Per Share
New conversion Price for EV
1.50
Pre-Money Valuation
Cash Infusion
Post-money Valuation
20,000,000
NCP = OCP * (OB+(NM/OCP)) / (OB+SI)
NCP= $2 * (10MM+($10MM/$2)) / (10MM+10MM)=30MM/20MM=$1.5
New Number of Shares due to Series A= $12MM/1.5=8MM (implying an extra 2MM shares that would be issued because of antidilution protection)

22. 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

23. Term Sheets… Let us look at Trendsetter

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

25. Trendsetter
If you were advising Wendy and Jason and you could not change any of the terms, which term sheet would you recommend?

26. Some Questions How much money are VCs putting in?
What is the implied pre-money and post-money valuation?
When will the “Option Pool” be created?
Focus on Mega: So how much are Wendy and Jason worth?
How is “Liquidation Preference” differ across two term sheets?

27. How much money – what fraction of the company?
Let us look at Mega first
Pre-Money
Founders own Shares
Option Pool Shares
Post-Money
Mega owns Shares
Total # of Shares
What if the options were never mentioned and Mega had said we give you 7 million Pre-money and 12 million post?
4,500,000
64.28%
35.72%
2,500,000
Founders 37.50%
Option Pool 20.83%
VC %
5,000,000
12,000,000

28. How much money – what fraction of the company?
Now let us look at Alpha – Assuming no release from the escrow account
Pre-Money
Founders own Shares
Option Pool Shares
Post-Money
Alpha owns Shares
Total # of Shares
Founder Ownership
$7,350,000
Implying $1.05 Per share
4,000,000
3,000,000
$ 12,350,000
4,761,905
Ownership 40.49%
Total shares 11,761,905
34.01%

29. Valuation (Cap Tables)

30. Liquidation Deemed liquidation event
Liquidation preference (2X, 3X, etc.)
Alpha
Mega
Qualified public offering (QPO)

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

32. Who gets how much: Liquidation Waterfall Charts
If Alpha 40.49% ; If Mega 41.67%
Liquidation values
5 million
7.5 million
20 million
30 million
40 million
Alpha 5 Mega 5
Alpha % of (7.5-5) = 6.01; Mega 7.5
Alpha 11.07; Mega 7.5 +(20-7.5)x41.67%=12.71
Alpha 15.12; Mega 16.88
Alpha 15 ; Mega 21.04
Alpha will convert 40.49% of 40= 16.20!

33. What about IPO?
Remember in both cases the total number of shares outstanding after financing were ~12 million
How valuable must the company become to meet the QPO
How much does Mega get for $500 million sale of the company versus an IPO that values the company for $500 million?

34. Exit Values $ 15 million maximum Alpha Ownership -40.49%
Mega Ownership %
$ 15 million maximum

35. Broader discussion of terms
What terms did you like in one but not in other term sheet? Why?
What terms did you dislike in both terms sheets? Why?

36. Key Issues
Valuation
Pre and Post
Option Pool
Type of security
Dividend
Liquidation
QPO
Antidilution
Voting Rights
Founder’s vesting
VC Syndicate
Alpha
Hurdle
Tricky
3MM CP
NoCum 3x
Low
Wt Avg
60%
Same??
Two VCs
Mega
$7 MM
Plain
2.5MM
PCP
Cum
1.5x
High
Full?
???
Same
One VC

37. Trendsetter
If you were advising Wendy and Jason and you could ask for change in any of the terms, which terms would you try to renegotiate?

38. Key Issues Valuation Pre and Post Option Pool Type of security
Dividend
Liquidation
QPO
Antidilution
Voting Rights
Founder’s vesting
VC Syndicate
Alpha
Hurdle
Tricky
3MM CP
NoCum 3x
Low
Wt Avg
60%
Same??
Two VCs
Mega
$7 MM
Plain
2.5MM
PCP
Cum
1.5x
High
Full?
???
Same
One VC
Remember – Term sheet is “proposal” nothing is cast in stone yet. You need to know what to negotiate and why?

39. A framework for analyzing termsheets
Economics
Original Purchase Price (OPP) aka “proposed ownership percentage)” on a “fully diluted basis”
Liquidation Preference (1x, 2x etc.
Participation (Note: on top of liquidation preference)
Conversion (QPO)
Antidilution
Dividends
Control
Board of Directors
Voting Rights/Protective Provisions
Conversion (QPO)
Founders stock/vesting
Transfer Restrictions
Registration Rights???

40. Term sheet Check list Green Flags Yellow Flags Red Flags Simple Terms
VC willing to take the downside risk (1x liquidation preference; no antidilution)
Plain convertible Preferred
Yellow Flags
Milestone heavy
Complex terms
Terms left vague
Future option pool to come out of founders’ share
Red Flags
Extremely milestone heavy
Length exclusivity
Complex due diligence requirements
Clauses that shift control from founders to VCs

41. Why do we see these features?
Convertible preferred
Participating Convertible Preferred
Full Ratchet/ Weighted Average Ratchet
Vesting provisions

42. 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

43. Recap
Hopefully you are better placed to appreciate the importance of terms.
As an entrepreneur try to avoid “fancy” term sheets with lots of “gingerbread”
Try not to raise money WHEN you need it – try to do it with 6 months of cash burn cushion