Examples Class I 2007

a) Give five criteria an investor might apply to a start-up proposal. [5 marks] b) What are the differences between debt and equity finance ? [5 marks] c) A software start-up company is developing computer games software. They believe their game will have potential market of a million units selling at a retail price of £ They have already raised £1M from Angel investors for 33% of the company, which has been mostly spent on development. They estimate they can complete development and become cash flow positive following initial marketing, but that this will cost a further £1M and take another year. They intend to raise this money by selling further equity. Price this issue [5 marks] d) They receive a letter of intent from a publisher confirming their market estimation and offering 10% royalty on the retail price with £500K recoupable but non- refundable advance (where the publisher will take the first £500k of royalty earned to recoup the advance, but will not demand a refund if the game fails to sell). Should the company take this offer and how does this affect the proposed share offer? [5 marks]

Give five criteria an investor might apply to a start-up proposal. [5 marks] Global, sustainable, under-served, market need Top Team Defensible Technological advantage Believable plans 60% IRR

What are the differences between debt and equity finance ? [5 marks] Equity finance, represented by shares, is where a proportion of the ownership of the company is sold to investors. They usually, but may not, include voting, dividend and other rights. There may be additional rights (“preference shares”) such as liquidation options, tag and drag provisions. Convertable shares may be converted to debt under specified conditions. Debt finance is a loan to the company, for example a debenture or a bond. It may be secured on additional assets. It may be accompanied by periodic interest payments (coupons), and may have conversion rights to shares in the company if the debt is not paid or under other conditions.

Example preference terms 1 Rights of Series A Preference shares 1.1 The Preferred Shares shall rank senior to all Ordinary Shares of the Company in right of receipt of dividends and other distributions and in right of redemption. 1.2 In the event of a merger, liquidation, sale of all or substantially all of the assets of the Company, or winding up of the Company, the holders of Preference Shares shall be entitled to receive, prior to the holders of Ordinary Shares, an amount equal to 1 (one) time the Purchase Price (as adjusted for stock splits, combinations and anti-dilution adjustment), plus any declared but unpaid Dividends. After such payment, the holders of Ordinary Shares and the holders of Preference Shares shall be entitled to any remaining proceeds on an as converted basis. This liquidation preference shall cease to exist should the returns to Investors exceed 25% IRR. 1.3 Holders of Preference Shares (“Holders”) acting as a group shall have the right to treat any merger which results in a change of control, where control shall mean more than 50% voting interest in the combined entity, reorganisation (including sale of substantially all assets of the Company) or other transaction in which control of the Company is transferred as a liquidation for purposes of the foregoing liquidation preference. 1.4 The Preference Shares may be redeemed (as adjusted for stock splits and combinations), at the option of the holder, anytime after 1/01/2011 but before 1/01/2013 if not converted. If the holder elects to have the Preference Shares redeemed, the Company shall redeem the Preference Shares in eight equal quarterly payments. Upon exercise of this right, such holders shall be entitled to a redemption price per share equal to the greater of: (i) the original Purchase Price, plus all accrued and unpaid Dividends from the date of purchase, or (ii) fair market value as determined by a 3rd party appointed by the Board of Directors at the time the redemption option is exercised. 1.5 No other shares of the Company are redeemable and/or purchasable prior to the Preference Shares without the prior written consent of holders of a 60% of the Preference Shares. 1.6 The Preference Shares are convertible into Ordinary Shares at any time at the option of the holder at a ratio of 1:1 (the “Conversion Ratio”), subject to adjustment in the event of stock splits, anti-dilution adjustments and combinations. 1.7 The Preference Shares shall automatically be converted into Ordinary Shares, at the Conversion Ratio, in the event of either (i) the closing of a firm commitment underwritten public offering of shares of the Company on an recognised exchange with an aggregate offering net proceeds to the public of not less than £10 million and at an offering price not less than 2 times the Purchase Price (as adjusted for stock splits and combinations) (a “Qualifying IPO”) or (ii) the election of the holders of at least 60% of the outstanding Preference Shares.

c) ) A software start-up company is developing computer games software. They believe their game will have potential market of a million units selling at a retail price of £ They have already raised £1M from Angel investors for 33% of the company, which has been mostly spent on development. They estimate they can complete development and become cash flow positive following initial marketing, but that this will cost a further £1M and take another year. They intend to raise this money by selling further equity. Price this issue [5 marks]

Liquidation/asset value: zero Cost to date: £1m Total market: £50M; say 10% achievable: £5M, less costs of £2M: £3M Previous round equity value: (£1M for 33%): £3M Rule of thumb say 33% per round, raising £1M: £2M pre money

Thus £1M for 33% of the company is defensible. However computer game development is a high risk area, with only something like 3 in 100 games being successful enough to earn royalties over and above advances and cost to develop, so the price of the issue will critically depend on the company being to show evidence of customer acceptance. Such evidence might be a ringing endorsement from a preview in a trade magazine, a successful beta test, past track record, or other industry endorsement

They receive a letter of intent from a publisher confirming their market estimation and offering 10% royalty with £500K advance, How does this affect the proposed share offer? [5 marks] A publisher offer is good evidence to reduce the apparent market risk. Even if the company do not take the offer it is confirmation of the potential market. A publisher also has established routes to market, which is more likely to make the game successful and reduce the company’s marketing spend. The publisher will add marketing prowess, marketing budget, established channels to market and the ability to “trade off” between titles in their portfolio to ensure that retailers take a new title. However there may be concerns over the timing of this income – the publisher will be in no hurry to pay over the royalty, and indeed delays of 6m to 12m from release before payment of royalties net of advances might be a serious concern to the company and its investors The deal suggests a total income of about £5M, but external cash need is now only £500K. The cash can be raised by the company later when development and market risk may be lower. Thus the expected income is £5M against costs of £1.5M, valuing the company at £3.5M, so £500K represents 14.2%. of the company. More radically, since the company is near income, with an assured publishing customer debt financing should be considered. £500K for 1 year would cost say £50K, which would be a cheaper option. Loans for this sort of development are possible from specialised media investment teams in the UK and EU, but they will usually require some lien over the technology IPR and the creative IP as well as substantial fees (which might approach 20% of the funds raised).

Taking the publisher’s offer reduces the risk and the cash need. However, it means the company does not establish an independent brand and distribution for its products, both of which are expensive and difficult, even online. Taking the offer may constrain future directions. In particular it may lessen the options for future acquisition. Limiting the scope, for example in time, or geographically, or to boxed product only may help. Whether to take the publisher’s offer depends to some extent on the ambition of the directors; however the independent route may take considerably more cash (and hence dilution) than they currently budget. For a first product it would be wise take the offer, but negotiate terms that allow the establishment of an independent brand at a future date. After all, if successful, the team would have £4.5M of cash on hand (£5M less £500k advance) with which to reward investors and invest in the next game.