Venture Capital and Private

Equity
Session 4
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)
Quick Review of VC Valuation
Method
Remember - In venture capital all valuation
is implied valuation. Simply put the value
arises because VC(s) is(are) willing to
finance the company!
The terms (amount invested, fraction of
ownership received) fix the post-money and
pre-money value of the business
This process is made transparent by
reporting of Capitalization Table or simply
Cap Tables Let us see how these are
created
Capitalization Tables
Page 10 (Bottom) of ONSET ventures case describes the financing
history of TallyUp. Onset offered to invest $750,000 at a price $1
per share in return for 31.6% of the company. Later, ONSET
invested another $250,000 at the same price ($ 1 per share) when
Reed Tausig as the CEO. Please draw up the capitalization tables,
pre-money and post money valuations for tally before and after
each round of financing.
Before Financing After Intial 750,000 investment
Investor # of shares $ per share $ total
%
ownership # of shares
$ per
share $ total
%
ownership
Founders 1,625,000 $0.000 $0 100% 1,625,000 - $1,625,000 68.42%
ONSET Ventures 750,000 $1.00 $750,000 31.58%
Option Pool
Total For Round
Cumulative Total 1,625,000 $0.000 $0 100% 2,375,000 $1.00 $2,375,000 100%
Price Per Share
$1
Pre-Money Valuation 1,625,000
Cash Infusion 750,000
Post-money Valuation 2,375,000
After Next Investment of
$250,000
After Intial 750,000 investment After next 250,000 investment
Investor # of shares
$ per
share $ total
%
ownership # of shares
$ per
share $ total
%
ownership
Founders 1,625,000 - $1,625,000 68.42% 1,625,000 - $1,625,000 61.90%
ONSET Ventures 750,000 $1.00 $750,000 31.58% 1,000,000 $1.00 $1,000,000 38.10%
Option Pool
Total For Round 250,000 $1.00 $250,000 9.52%
Cumulative Total 2,375,000 $1.00 $2,375,000 100% 2,625,000 $1.00 $2,625,000 100%
Price Per Share
$1 $1
Pre-Money Valuation 1,625,000 $2,375,000
Cash Infusion 750,000 250000
Post-money Valuation 2,375,000 $2,625,000
After Option Pool Creation of
750,000 Shares
After next 250,000 investment After Option Pool
Investor # of shares
$ per
share $ total
%
ownership # of shares
$ per
share $ total
%
ownershi
p
Founders 1,625,000 - $1,625,000 61.90% 1,625,000 - $1,625,000 48.15%
ONSET Ventures 1,000,000 $1.00 $1,000,000 38.10% 1,000,000 $1.00 $1,000,000 29.63%
Option Pool 750,000 $1.00 $750,000 22.22%
Total For Round 250,000 $1.00 $250,000 9.52% 750,000 $0.00 $0 22.22%
Cumulative Total 2,625,000 $1.00 $2,625,000 100% 3,375,000 $1.00 $3,375,000 100%
Price Per Share
$1 $1
Pre-Money Valuation $2,375,000 $2,625,000
Cash Infusion 250000 0
Post-money Valuation $2,625,000 $3,375,000
What if Mann is able to do a $3.5
million round at 2.5 times step up
(ONSET invests $1 million in this
round)
After Option Pool Raise 3.5 Million Total at 2.5 Step Up
Investor # of shares
$ per
share $ total
%
ownership # of shares
$ per
share $ total
%
ownership
Founders 1,625,000 - $1,625,000 48.15% 1,625,000 - $4,062,500 34.03%
ONSET Ventures 1,000,000 $1.00 $1,000,000 29.63% 1,400,000 $2.50 $3,500,000 29.32%
Option Pool 750,000 $1.00 $750,000 22.22% 750,000 $2.50 $1,875,000 15.71%
New VC 1,000,000 $2.50 2500000 20.94%
Total For Round 750,000 $0.00 $0 22.22% 1,400,000 $2.50 $3,500,000 29.32%
Cumulative Total 3,375,000 $1.00 $3,375,000 100% 4,775,000 $2.50 $11,937,500 100%
Price Per Share
$1 $2.50
Pre-Money Valuation $2,625,000 $3,375,000
Cash Infusion 0 3,500,000
Post-money Valuation $3,375,000 $11,937,500
TallyUp What Happened
Was able to raise 4 million in the next
round at post-money value of $ 13
million (>2.5x step-up)
Raised 4 more rounds changed name
to Callidus Software
Did IPO in 2003 at $13.5 share
ONSET owned 17% of the company at
the time of IPO
Term Sheets
Let us look at Trendsetter
Term Sheet
Getting first Term Sheet is MAJOR
break through!
Validates entrepreneur/idea
Establishes a price
Can be shopped around (especially in
later rounds)
Check the Term Sheet!
Term Sheets in Venture
Financing
Critical Issues
Uncertainty
Asymmetric
Information
Nature of Firms assets
Conditions of relevant
financial and product
markets
Responses by investors
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
Got a Term
Sheet
Multiple Rounds,
Multiple Tranches
Trendsetter is Lucky!
If you were advising Trendsetter which
offer would recommend?
Valuation
Liquidation Preference (and Antidilution)
Vesting
Corporate Governance
Valuation (Cap Tables)
Alpha Mega
Investor # of shares
$ per
share $ total
%
ownership # of shares
$ per
share $ total
%
ownership
Founders 4,000,000 $1.05 $4,200,000 34.01% 4,500,000 $1.00 $4,500,000 37.50%
VC 4,761,905 $1.05 $5,000,000 40.49% 5,000,000 $1.00 $5,000,000 41.67%
Option Pool 3,000,000 $1.05 $3,150,000 25.51% 2,500,000 $1.00 $2,500,000 20.83%
Total For Round 4,761,905 5,000,000 5,000,000 5,000,000
Cumulative Total 11,761,905 $1.05 $12,350,000 100% 12,000,000 $1.00 $12,000,000 100%
Price Per Share
$1.05 $1.00
Pre-Money Valuation 7,350,000 7,000,000
Cash Infusion 5,000,000 5,000,000
Post-money Valuation 12,350,000 12,000,000
Liquidation
Deemed liquidation event

Liquidation preference (2X, 3X, etc.)
Non Participating
Fully Participating

Qualified public offering (QPO)



Will See in
Details Later
What Type of Security?
Alpha
Convertible Preferred (CP) Stock
Mega
Participating Convertible Preferred (PCP)
Stock

TYPE OF LIQUIDATION EVENT IS
CRITICAL!
Exit Values
VC Owner/Employees VC
Owner/Employ
ees VC
Owner/Employ
ees VC
Owner/Employ
ees
5.00 5.00 0.00 5.00 0.00
7.50 6.01 1.49 7.50 0.00
10.00 7.02 2.98 8.54 1.46
15.00 9.05 5.95 10.63 4.37
20.00 11.07 8.93 12.71 7.29
25.00 13.10 11.90 14.79 10.21
29.69 15.00 14.69 16.75 12.94
30.00 15.00 15.00 16.88 13.12
35.00 15.00 20.00 18.96 16.04
37.04 15.00 22.04 19.81 17.23
40.00 16.20 23.80 21.04 18.96
45.00 18.22 26.78 23.13 21.87
50.00 20.25 29.76 25.21 24.79
55.00 22.27 32.73 27.29 27.71
60.00 24.29 35.71 24.29 35.71 29.38 30.62
100.00 40.49 59.51 40.49 59.51 46.04 53.96
200.00 80.98 119.02 80.98 119.02 87.71 112.29
240.00 97.18 142.82 97.18 142.82 104.38 135.62 100.01 139.99
500.00 202.45 297.55 202.45 297.55 212.72 287.28 208.35 291.65
Enterprise
Value ($
Million)
Term Sheet Mega
Liquidation IPO
Term Sheet Alpha
Liquidation IPO
Anti-Dilution Protections
Down round

Full-ratchet vs. weighted
average

Adjusted conversion
price, adjusted
conversion rate
Read the Note on
Anti-dilution provisions: Typology
and Numerical Example

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
(Pre-Money Value+Money in new round)
(Total # of Shares after financing)
NCP
Another way of writing it
Why do we see these features?
Convertible preferred
Participating Convertible Preferred
Full Ratchet/ Weighted Average
Ratchet
Registration rights

Challenges for VCs
Private Equity Partnerships (PEP) have
become the dominant organization
form as it addresses challenges faced
by LPs (Investors) and GPs(VC, Buyout
Firm).
Are there issues between GPs and the
portfolio companies?
Challenges of Venture Financing
Critical issues involved in
financing young firms
Uncertainty
Asymmetric
Information
Nature of Firms 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?
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
Covenants
Positive Covenants
Example Provide regular information
Negative Covenants
Example Sale of assets
Others
Mandatory redemption
Board Seats