Venture Capital and Private Equity Session 6 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)

Professor Sandeep Dahiya Georgetown University Metapath Software Professor Sandeep Dahiya Georgetown University

OUTLINE What happened. The broader themes: The interplay of terms. Options in private equity.

WHAT HAPPENED (1) The Company turned down Cell Tech: Offering 30% of their capitalization indicated that their base business had limited upside. Clearly there were ongoing financing risks and liquidity issues. The fit was not compelling. Cell Tech stock fell $9 --> $3 After 3 years and several acquisitions, it rebounded.

WHAT HAPPENED (2) Accepted RSC Participating Preferred, later had to raise a $12mm Ser F Rd at $8/shr, had to keep participation. Merged with UK based MSI Dec ‘98: 65% MSI, 35% Metapath, both private cos. Grey area since preferred carried over to merged company. Mezzanine investors insisted on participation.

WHAT HAPPENED (3) Much rancor between late investors and early investors plus Management: Ser E (and Ser F) had defined “liquidation” to include any change of control event. Management maintained all rights could be preserved in capitalization post-merger. Late stage investors knew company worth more than their ~$24mm liquidation preference, so were willing to vote down deal (votes were by class)--they won.

WHAT HAPPENED (4): Lessons Learned Metapath used too much money: Despite continual progress, ran out of cash. Metapath too price focused: $4/shr w/ no participation possible? $4/shr still a good step up from $1.62. RSco and TCV fundamentally different kind of investor from BVP & Norwest: Trading terms for price. Good trade when you perform but leaves no room for error!

THE INTERPLAY OF TERMS: Trading price for terms Trend in price/share often only outside gauge of company progress. Price/share affects employee options and morale. Fancy terms tend to put boundaries on the downside. Term-laden deals often play on entrepreneur's optimism (screening?).

THE INTERPLAY OF TERMS: Liquidation & Participation A liquidation triggers participation. In the Metapath case, formerly the board could deem a change of control a liquidation, but it was not automatic. “Liquidation” was changed to include change of control in Ser E: Implication not picked up by management, early investors or company counsel.

THE INTERPLAY OF TERMS: Voting & Negative Covenants Negative Covenants outline what the company can NOT do without special vote of preferred (e.g.: merge, sell, change business, liquidate etc.) Preferred previously voted as one class, or on an “as converted basis”. Voting class by class became part of deal when terms between classes significantly diverged.

BLACK-SCHOLES LOOKS AT THE LIMITING CASE Assumes continuous time--many branching points. Obtains complex formula as function of: Time to maturity. Standard deviation of stock. Current stock price. Exercise price. Risk-free interest rate.

USING THE BLACK-SCHOLES FORMULA Black-Scholes EXCEL calculator.

ILLUSTRATION Switch from convertible to participating preferred is essentially “re-pricing” the call option of Series E holders: Will begin sharing in equity above $11.75 million, rather than $87.75 million: How much is this worth? How lower share price should Hardy be willing to accept to get rid of? He had offered $5.50 without instead of $6 with.

BASIC STRUCTURE Look at what worth in current setting. Look at what worth with higher exercise price. Look at how much lower share price will equate.

ASSUMPTIONS Ten-year option life. 30% volatility (guess). $11.75 and $87.75 million exercise prices. Assume $87.75 valuation is right. Interest rate of 6.21%. Assume away complexity of IPO.

CALCULATION Value of option with $11.75 strike price is $81.4 million. 13.4% of this is $10.7 million. Value of option with $87.75 strike price is $49.9 million. 13.4% of this is $6.7 million. The participating feature represents about $4 million in value!

CALCULATION (2) Now look at how much larger share of the company (lower price) will equate: 13.4% * $81.5MM = X * $49.9 MM. X = 21.9%. Hardy would have been equally well off giving Series E holders 21.9% of company without participation: Share price of (13.4%/21.9%)*$6=$3.67!

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

Challenges for VCs Joe Flash and Rex Finance do a deal Asset Liabilities and Shareholders’ Equity Joe’s Idea ??? Asset Liabilities and Shareholders’ Equity Joe’s Idea 1.5 million Joe 50.05% Cash 1.5 million Rex 49.95% John Terrific Offers $2 million for the Company – What happens if Rex had taken Common Stock?

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)

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 Positive Covenants Example Provide regular information Negative Covenants Example Sale of assets Others Mandatory redemption Board Seats

How Do VCs Evaluate Potential Investments? How do you evaluate potential venture opportunities? How do you evaluate the venture’s prospective business model? What due diligence do you conduct? What is the process through which funding decisions are made? What financial analysis do you perform? What role does risk play in your evaluation? How do you think about a potential exit route?

Key Takeaways While hard to codify some key patterns are consistent Risk-Reward trade-off Market is big factor How much pain! Who feels the pain! Acceptance that mistakes will be made but with a twist Mistake when made the investment Mistake when DID NOT make investment Intense desire for IPO worthy investment