1. Venture Capital and Private Equity Session 4
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. 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…

4. 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.

5. After Next Investment of $250,000

6. After Option Pool Creation of 750,000 Shares

7. What if Mann is able to do a $3. 5 million round at 2
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)

8. 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

9. Term Sheets… Let us look at Trendsetter

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

11. 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
Check the Term Sheet!
Got a Term Sheet
Multiple Rounds, Multiple Tranches

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

13. Valuation (Cap Tables)

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

15. 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!

16. Exit Values

17. 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

18. 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

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

20. 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?

21. 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

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

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

24. 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

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