F317 – Venture Capital & Entrepreneurial Finance Capitalization Tables + Waterfalls

10,000 FT View Last class, we learned how to value a start-up company and then translate it into an ownership percentage. Today, we are going to discuss Capitalization Tables + Waterfalls. First, a couple of principals:

Principal 1 – Cash vs. Time/Talent Most founding teams’ primary contribution to a project is time/talent/idea. Payment will be in the form of common equity. Because Investors’ contributions are cash, Professional Investors want to hold preferred securities, not common.

Last Money In, First Money Out Principal 2 – Last Money In, First Money Out Remember the Golden Rule??? (“He or She who has the gold, makes the rules”) One of those rules is that the last investors get paid back first…..then the previous investors…..etc. The founders get paid back last.

Different Types of Securities are utilized for the various contributors to a start-up End of Lecture

Types of Equity Founders’ Equity: Common Shares that are issued to the Founders of a Company at the launch of the business. Based on various contributions: Time Talent Ideas Money

Types of Equity Common Shares: Shares owned by non-Founders which entitles the holder to a share of the profits and share of the voting power…. usually Family & Friends investment rounds provide for common shares (if not a loan).

Types of Equity Preferred Shares: Shares that receive annual dividends and which have a return preference over the founders’ shares and common shares. The shares “do not” entitle owner to share of profits or voting power. Two types of preferred shares: Convertible Preferred Participating Preferred

Types of Equity Convertible Preferred Shares Preferred shares in which the owners of such shares have the option to convert their preferred shares to common shares (At a valuation negotiated with the Founders) Timing of Conversion? Will convert only when? Upon a Liquidation When it’s financially in their best interest

Types of Equity Participating Preferred Shares Preferred shares in which the owners of such shares get to both redeem their shares “and” participate as a common shareholder (at a valuation negotiated with the Founders)

Types of Equity Dividends Both Participating & Convertible Preferred shares typically come with an annual dividend (usually 8-12%). However, because early-stage companies don’t have the cash to pay the dividends each year, the dividends “accrue” as a liability on the balance sheet until liquidation. Called Cumulative Dividends.

Types of Equity Warrants & Stock Options Both give the holder the right to purchase equity (usually common stock) at a specific price and within a specific time. Warrants are usually issued to Investors, Advisors, etc. Stock Options are typically issued to employees. Both work the same way + and need to be represented on the Cap Table

Types of Equity Convertible Notes A loan made to the company that automatically converts into equity upon a future, qualified financing (i.e. Series A Round). The conversion rate is at a discount to the Pre-Money Valuation negotiated as part of that financing. Typically > 20-25% Discount. Upon conversion, the note goes away and the holder will own the same securities at the Investor that negotiated the round.

Types of Equity Convertible Notes For example, a $500,000 Convertible Note with a 25% Discount. If a Series A Investment later occurs at a Pre-Money valuation of $10MM, the Note holder will purchase the same equity as the Series A at a Pre-Money Valuation of $7.5MM.

Quick Lesson on Types of Entities Note: In order to offer Preferred Shares to investors, you have to be able to create different “classes” of ownership So – Quick Lesson on Types of Entities

Types of Entities There are only two entities that allow for the creation of different “classes” of stock ownership: C-Corporation Limited Liability Company S-Corporations only allow for a single class of ownership

Types of Entities Also, as an FYI, equity ownership in the two types of entities is characterized as: C-Corporation - Limited Liability Company - Shares Units

Any questions up to this point?

Creating a Capitalization Table

Capitalization Table A detailed summary of who has a claim to equity in a company including: Founders > Founder Shares Investors > Preferred Shares Employees > Stock Options Advisors > Warrants Board Members > Warrants Family & Friends > Common Shares A Cap Table is presented in order of liquidity Preference

Capitalization Table Event 1: It starts with issuing Founders’ Equity Once a company is Incorporated (C-Corp) or Organized (LLC), the first step in creating a cap table is issuing equity to the Founders. > How should you determine ownership among the founders? > How do should you structure distribution of the equity? Weight towards future contributions Vest

Capitalization Table Note: The initial number of shares/units created in the Founder Pool is arbitrary Founders Founder 1 20,000,000 57.14% Founder 2 10,000,000 28.57% Founder 3 5,000,000 14.28% Total Shares 35,000,000 100%

Capitalization Table 35,000,000 __________ - 35,000,000 = 8,750,000 Event 2: Suppose the company raises $1,500,000 in exchange for 20% ownership in the form of Participating Preferred Securities (with a 2x Return Preference and a 10% Cumulative Dividend) 35,000,000 __________ - 35,000,000 = 8,750,000 (1 - .20)

Capitalization Table Simply continue to follow this process whenever a new pool of equity is created. Investor Round Founder Round Security Type PP (2x) Common Investment $1,500,000 --- Founders 35,000,000 80% Investor 8,750,000 20% Total Shares 100%

Any questions on creating the Cap Table?

Calculating the Waterfall

Waterfall Calculation Whenever a company has a liquidity event (IPO, Acquisition, etc.), the Waterfall Calculation will allocated the proceeds to each of the contributors to the company: Founders Investors Advisors Employees Etc.

Waterfall Calculation Using the Cap Table from above, let’s suppose that the Company was acquired for $5,000,000 in cash precisely 3 Years after the the $1,500,000 Investment was made in the company

Waterfall Calculation First, understand the priority of the proceeds (after all debts have been repaid): Return Preferences (Last In / First Out) Accrued, Unpaid Dividends (Last In / First Out) Common Shares

Waterfall Calculation Second, determine the proceeds to the Common Shareholders and the Price Paid Per Common Share. Return Preferences > $3,000,000 (2x $1.5MM) Cumulative Dividends > $450,000 ($1.5MM*.1*3) _____________________ Proceeds to Common > $1,550,000 Price Per Share > $.0354 (Proceeds / TS)

Waterfall Calculation Third, multiply the price per share by the total number of shares for each of the Equity Holders. Common Shares PPS Payout Founder 1 20,000,000 $.0354 $708,571.43 Founder 2 10,000,000 $354,285.71 Founder 3 5,000,000 $177,142.86 Investor 8,750,000 $310,000.00

Waterfall Calculation Fourth, create the Final Payout Schedule

Waterfall Calculation You can see that the structure of the investment can drive allocation of the proceeds as much Valuation. Return Preference Dividends Payout on Common % Ownership Total Payout % of the Proceeds Founder 1 $0 $708,571.43 45.71% 14.17% Founder 2 $354,285.71 22.86% 7.09% Founder 3 $177,142.86 11.43% 3.54% Investor $3,000,000 $450,000 $310,000.00 20% $3,760,000.00 75.20% $1,550,000 100% $5,000,000

Waterfall Calculation Last Question > Instead of the Investor owning Participating Preferred Shares (with a 2x Return Preference), what if the Investor received Convertible Preferred Shares with a 1x Return Preference? How does this change the Waterfall?

Waterfall Calculation First, Investor has to “Make a Choice”: Redeem or Convert. Redeem > $1,500,000 (1x $1.5MM) Cumulative Dividends > $450,000 ($1.5MM*.1*3) _____________________ Total > $1,950,000

Waterfall Calculation First, Investor has to “Make a Choice”: Redeem or Convert. Convert > $1,000,000 (20%*$5MM) Cumulative Dividends > $450,000 ($1.5MM*.1*3) _____________________ Total > $1,450,000

Waterfall Calculation First, Investor has to “Make a Choice”: Redeem or Convert. Redeem > $1,950,000 Convert > $1,450,000 Investor will choose to?????

Waterfall Calculation Second, allocate the proceeds to the Common Shareholders based on their ownership percentage. Return Preferences > $1,500,000 Cumulative Dividends > $450,000 _____________________ Proceeds to Common > $3,050,000 Price Per Share > $.0871 (Proceeds / TS)

Waterfall Calculation Note: Since Investor didn’t Convert, Total Share Count (TS) reverts back to 35,000,000 Shares Return Preferences > $1,500,000 Cumulative Dividends > $450,000 _____________________ Proceeds to Common > $3,050,000 Price Per Share > $.0871 (Proceeds / TS)

Waterfall Calculation And look how much more favorable a Convertible Preferred Security (with a 1x Return Preference) is to the Founders Ownership of Company PPS Total Payout Founder 1 57.14% 20,000,000 $.0871 $1,394,285.71 Founder 2 28.57% 10,000,000 $697,142.86 Founder 3 14.28% 5,000,000 $348,571.43 Investor ----- Notice that when Investor Redeems, the Founders were no longer diluted by Investor

Waterfall Calculation And look how much more favorable a Convertible Preferred Security (with a 1x Return Preference) is to the Founders Return Preference Dividends Payout on Common % Ownership Total Payout % of the Proceeds Founder 1 $0 $1,394,285.71 57.14% 34.86% Founder 2 $697,142.86 28.57% 17.43% Founder 3 $348,571.43 14.28% 8.71% Investor $1,500,000 $450,000 0% $1,950,000 39% $1,550,000 100% $5,000,000

Cap Table + Waterfall Exercise Any Questions? Next Class: Cap Table + Waterfall Exercise End of Lecture