1. F317 – Venture Capital & Entrepreneurial Finance Capitalization Tables + Waterfalls

2. 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:

3. 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.

4. 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.

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

6. 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

7. 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).

8. 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

9. 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

10. 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)

11. 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.

12. 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

13. 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 > % Discount.
Upon conversion, the note goes away and the holder will own the same securities at the Investor that negotiated the round.

14. 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.

15. 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

16. 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

17. 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

18. Any questions up to this point?

19. Creating a Capitalization Table

20. 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

21. 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

22. 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%

23. 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
( )

24. 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%

25. Any questions on creating the
Cap Table?

26. Calculating the Waterfall

27. 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.

28. 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

29. 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

30. 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)

31. 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

32. Waterfall Calculation
Fourth, create the Final Payout Schedule

33. 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

34. 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?

35. 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

36. 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

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

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

39. 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, _____________________
Proceeds to Common > $3,050,000
Price Per Share > $.0871 (Proceeds / TS)

40. 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

41. 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

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