1. Venture Capital and Private Equity Session 5
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. Term Sheets …

4. 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

5. 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

6. EXAMPLE: Suppose that Early Venture (EV) makes a $8M Series A investment in Newco for 2M shares at $4 per share on 1/1/1999. One year later, Newco has fallen on hard times and receives a $10M Series B financing from Late Venture (LV) for 5M shares at $2 per share. The founders and the stock pool have claims on 6M shares of common stock.
Consider the following cases:
Case I: Series A has no antidilution protection.
Case II: Series A has full-ratchet antidilution protection.
Case III: Series A has broad-base weighted-average antidilution protection.
For each of these cases, what percentage of Newco (fully diluted) would be controlled by EV, Founders and LV following the Series B investment? What would be the post-money and pre-money valuations?

7. Notice value of Early VC has fallen from 8 million to 4 million
This implies a “paper loss” of 8-4= 4 million!
Investor
# of shares
$ per share
$ total
% ownership
Founders
6,000,000 -
$12,000,000
40.00%
44.52%
Early VC
4,000,000
$2.00
$8,000,000
26.67%
2,476,190.5
$4,952,381
18.37%
Later VC
5,000,000
$10,000,000
33.33%
37.10%
Cumulative Total
15,000,000
$30,000,000
100%
13,476,190
$26,952,381
NCP
3.23
Second Round Full Ratchet
1/1/2000
Second Round Partial Ratchet

8. Liquidation – Quick Review
Deemed liquidation event
Liquidation preference (2X, 3X, etc.)
Non Participating
Fully Participating
Qualified public offering (QPO)

9. 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!

10. Many types of preferred stock
Redeemable Preferred (RP)
Convertible Preferred (CP)
Participating Convertible Preferred (PCP)
PCP with cap (=PCPC)
Key threshold for PCP is a qualified public offering (QPO)

11. Alternatives $ 5 million investment 1/3rd ownership
(Implied Valuation= $15 Million, 15 million shares)
Structure I: 5M shares of common;
Structure II: RP ($5M APP);
Structure III: RP + 5M shares of common;
Structure III(A): 5M Convertible Preferred (CP) exchange ratio 1:1.
Structure IV: PCP with participation as-if 5M shares of common, QPO at $5 per share;
Structure V: PCPC with participation as-if 5M shares of common, with liquidation return capped at four times OPP, QPO at $5 per share;
Structure VI: RP ($4M Aggregate Purchase Price) + 5M shares of CP ($1M APP).

12. Structure I - 5M shares of common
W = 3, W =6, W =10

13. Structure II RP ($5M APP);
W = 3, W =6, W =10

14. Exit Diagrams for RP and Common$W CP 5 15 W A
Redeemable Preferred
Common Stock
W = 3, W =6, W =10

15. Structure III RP + 5M shares of common
W = 3, W =5, W =8, W=11

16. Structure III(A) CP 15

17. Structure III (Revisited) RP + 5M shares of common also called Participating Convertible Preferred (PCP)
Notice the
“Double Dipping”

18. Structure IV PCP with participation as-if 5M shares of common, QPO at $5 per share71
Mandatory
Conversion
1/3*75=25!
If Liquidation is at 71 first 5 goes to PCP Holder
Rest (71-5=66) is shared 1/3*66=22
Total Payoff = 5+22= 27

19. Structure V PCPC with participation as-if 5M shares of common, with liquidation return capped at four times Original Purchase Price, QPO at $5 per share
4*5=20; 5+15!

20. Structure V, continued Sell Call option X=50 Buy Call X=60
Buy Call Option X=5
Sell Call option X=50

21. Structure VI, RP component

22. Structure VI, RP ($4M APP) + 5M shares of CP ($1M APP).

23. Structure VI, CP component

24. Exit Values $ 15 million maximum Alpha Ownership -40.49%
Mega Ownership %
$ 15 million maximum

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

26. 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 million
Rex 49.95%
John Terrific Offers $2 million for the Company – What happens if Rex had taken Common Stock?

27. 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

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

29. VCs response #1– Security Design
Redeemable Preferred (RP)
Convertible Preferred (CP) - Forced Conversion Clause
Participating Convertible Preferred (PCP)

30. 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

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

32. Tomorrow Metapath Software
Try using Option Pricing Model Posted on the website under Class Session 6
Wrap up with discussion of “How VCs Evaluate Potential VC Opportunities”
HW 2 assignment will be posted under Class Session 5 (Due on Wednesday)