Examples Class I
2007
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
£49.99. 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 nonrefundable 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 £49.99. 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
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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.