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)
VC Method-Implied Valuation
Information you would almost always have
• I – Amount being raised from VC
• X- Number of Shares currently owned by entrepreneur
Information that requires judgment call
• R – VC’s required return (IRR) usually between 25% to 80%
• T – Time to exit (When VC gets money back)
• V – Value of the company at time of exit
Numbers you need to calculate
• F – Fraction of company VC would need to get the return
• Post-Money Valuation – Value of company after funding is
received
• Pre-money Valuation - Value of company before funding is
received
• P – Price per share.
• Y – Number of shares to be issued to the VC
Multiple Rounds/ Exit
Dilution
• Imagine that you need 15% of the company at the exit
to get your mandated return.
• Simple case – 100 shares would want 15 shares
• What if along the way company issues another 50
shares (option/new investor) what happens to your
stake?
– New total shares = 100+50= 150
– You interest = 15/150 = 10%!! – you have been diluted
• You would insist on more than 15% today to end with
15% eventually – how to figure that out
• Expected dilution = 50/150 = 0.333
• Fraction needed today = Final ownership/(1-Dilution)
• =15%/(1-0.333)= 22.5% implying 22.5 shares today
• Check>>> at the end 22.5/150 = 15%
Example Contd.
• Hoya.com is asking for $5 million, Projected income in year 5
is $ 4 million and expected exit multiple is 25x. What share of
company would a VC require today if VC’s required return is
50%?
• Need to reserve 15% of the firm in terminal year for the option
pool for mangers.
VC still needs to get $5 million*(1.5)5 = 37.97 million
At Exit Firm is Still Worth 100 Million
VC still needs 37.97/100 = 37.97% of the Firm AT TIME OF EXIT!
However what VC needs TODAY is higher since extra shares would
be issued to the Option Pool causing dilution
Final Ownership%
Current Ownership%
Ret ent ion% (1  Dilution%)  (1  Lat erOwner's Final%)
Ret ent ion%
Current Ownership%
Final Ownership%
Final Ownership%

Ret ent ion%
(1  Lat erOwner's Final%)
VC Current Ownership = 0.3797/(1-0.15) = 44.67%
Example Contd.
• Hoya.com is asking for $5 million, Projected income in year 5
is $ 4 million and expected exit multiple is 25x. What share of
company would a VC require today if VC’s required return is
50%?
• Need to reserve 15% of the firm in terminal year for the option
pool for mangers.
5 million for 44.67% of the company imply Post money
valuation of 5/0.4467= 11.193 million and pre-money
valuation of 11.19 -5=6.193 million
New Shares to VC =5/6.193=0.807 million shares
New Number of Shares Y  X
Y 1
F1
(1-(F 1  OP ))
0.3797
 0.807 million shares
(1-(0.3797  0.15))
Multiple Rounds of Financing
•
•
Hoya.com is asking for $5 million, Projected income in year 5 is $ 4
million and expected exit multiple is 25x. What share of company
would a VC require today if VC’s required return is 50%?
Need to reserve 15% of the firm in terminal year for the option pool
for mangers. Would need another $ 3 million at the beginning of
year 3 – round 2 investors require 30% return
Round 2 investor need 30% on its 3 million i.e. 3(1.30)3 = 6.59 million
Final value is still 100 million, Thus Round 2 investor need 6.59% of the
company AT EXIT Implying that at time of investment it needs to own
Round 2 VC need 0.659/(1-0.15)=7.75%
Round 1 still needs 38% at the time of EXIT
implying initial stake = 0.38/(1-(0.0659+0.15))=0.485 or 48.5% stake.
5/0.485=10.32;
What is the Post and Pre Money Valuation at round 1?
5.32
How many shares need to be issued to Round 1, Round 2 and option pool?
Round 1 = 1x[0.485/(1-0.485)] =941,748
Round 2 = 1.941748x[0.0775/(1-0.0775)]=163,128
Option Pool =(1.942+0.163)X[0.15/(1-0.15)]= 371,448
For Practice
• Recalcualte the numbers detailed in
“The Basic Venture Capital Formula”
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 invested $750,000 to purchase
preferred shares (at $1 each), in return for 31.6% of the company,
based on a $2,375,000 post-money valuation. The agreement was
structured so that ONSET would later invest an additional $250,00
– at the same $1 per share price…” Please draw up the
capitalization tables, pre-money and post money valuations for
tally before and after each round of financing.
Before Financing
Investor
Founders
ONSET Ventures
Option Pool
Total For Round
Cumulative Total
After Intial 750,000 investment
# of shares
1,625,000
$ per share
$0.000
$ total
$0
1,625,000
$0.000
$0
%
ownership # of shares
100%
1,625,000
750,000
100%
2,375,000
$ per
share
$1.00
$ total
$1,625,000
$750,000
%
ownership
68.42%
31.58%
$1.00
$2,375,000
100%
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$1
1,625,000
750,000
2,375,000
Hiring of Reed Taussig as CEO..
Page 12 (Bottom) of ONSET Venture case describes the follow up
financing. “…Once Taussig was hired, ONSET invested the
additional $250,000 they had planned to put in, raising TallyUp’s
(post-money) valuation to $2,625,000…”.
After Intial 750,000 investment
Investor
Founders
ONSET Ventures
Option Pool
Total For Round
Cumulative Total
# of shares
1,625,000
750,000
2,375,000
$ per
share
$1.00
$1.00
After next 250,000 investment
$ total
$1,625,000
$750,000
%
ownership # of shares
68.42%
1,625,000
31.58%
1,000,000
$ per
share
$1.00
%
$ total
ownership
$1,625,000 61.90%
$1,000,000 38.10%
$2,375,000
250,000
2,625,000
$1.00
$1.00
$250,000
$2,625,000
100%
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$1
1,625,000
750,000
2,375,000
$1
$2,375,000
250000
$2,625,000
9.52%
100%
Option Pool !
Page 13 (Bottom) of ONSET Venture case describes the creation of
Option Pool. “…First, TallyUp had decided to set aside a portion of
shares used as stock options for new employees hires. The value of
these options would likely be $750,00 (750,000 shares at $1 per
share), which would increase TallyUp’s valuation by the same
amount…”.
After next 250,000 investment
Investor
Founders
ONSET Ventures
Option Pool
# of shares
1,625,000
1,000,000
$ per
share
$1.00
Total For Round
Cumulative Total
250,000
2,625,000
$1.00
$1.00
After Option Pool
%
$ total
ownership # of shares
$1,625,000 61.90%
1,625,000
$1,000,000 38.10%
1,000,000
750,000
$ per
share
$1.00
$1.00
%
ownershi
$ total
p
$1,625,000 48.15%
$1,000,000 29.63%
$750,000
22.22%
$250,000
$2,625,000
$0.00
$1.00
$0
$3,375,000
9.52%
100%
750,000
3,375,000
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$1
$2,375,000
250000
$2,625,000
$1
$2,625,000
0
$3,375,000
22.22%
100%
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 next 250,000 investment
Investor
Founders
ONSET Ventures
Option Pool
# of shares
1,625,000
1,000,000
$ per
share
$1.00
Total For Round
Cumulative Total
250,000
2,625,000
$1.00
$1.00
After Option Pool
%
$ total
ownership # of shares
$1,625,000 61.90%
1,625,000
$1,000,000 38.10%
1,000,000
750,000
$ per
share
$1.00
$1.00
%
ownershi
$ total
p
$1,625,000 48.15%
$1,000,000 29.63%
$750,000
22.22%
$250,000
$2,625,000
$0.00
$1.00
$0
$3,375,000
9.52%
100%
750,000
3,375,000
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$1
$2,375,000
250000
$2,625,000
$1
$2,625,000
0
$3,375,000
22.22%
100%
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
Investor
Founders
ONSET Ventures
Option Pool
New VC
Total For Round
Cumulative Total
Raise 3.5 Million Total at 2.5x Step Up
# of
shares
1,625,000
1,000,000
750,000
$ per
share
$1.00
$1.00
%
$ total
ownership # of shares
$1,625,000
48.15%
1,625,000
$1,000,000
29.63%
1,400,000
$750,000
22.22%
750,000
1,000,000
$ per
share
$2.50
$2.50
$2.50
%
$ total ownership
$4,062,500
34.03%
$3,500,000
29.32%
$1,875,000
15.71%
$2,500,000
20.94%
750,000
3,375,000
$0.00
$1.00
$0
$3,375,000
$2.50
$2.50
$3,500,000
$11,937,500
22.22%
100%
1,400,000
4,775,000
29.32%
100%
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$1.00
$2,625,000
0
$3,375,000
$2.50
$8,437,500
3,500,000
$11,937,500
Paper Gain $2 MM investment now worth(???) $3.5 MM!
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
Fund Raising versus Fund
Investing
• We saw how GPs and LPs can have
conflicting interests – the solution that
has emerged is the PEP agreement
that we saw first in ONSET case and
also in ACCEL Partners case.
• Now let us turn our attention to
conflict of interest between the VCs
and the entrepreneurs they finance
Challenges of Venture Financing
• Critical issues involved in • Responses by VCs
financing young firms
– Active Screening
– Stage financing
– Uncertainty
– Syndication
– Asymmetric
– Preferred Stock
Information
– Use of Stock options/grants
– Nature of Firm’s assets
with strict vesting
– Conditions of relevant
requirements
financial and product
– Contingent control
markets
mechanisms – Covenants and
restrictions
Got a Term
Sheet
– Strategic composition of
Board of Directors
Multiple Rounds,
Multiple Tranches
READ THE TERM SHEETS!!
How do VCs address these
problems
• Security Design
• Vesting Provisions
• Covenants
Security Design - What Type
of Security?
• Common Stock
– Stands Last
• Preferred Stock
VCs
NEVER
take
Common
Stock
– Before Common Stock in case of
LIQUIDATION
TYPE OF LIQUIDATION EVENT IS
CRITICAL!
Challenges for VCs
• Joe Flash and Rex Finance do a deal
Asset
Liabilities and
Shareholders’ Equity
Joe’s Idea ???
0
Asset
Liabilities and
Shareholders’ Equity
Joe’s Idea 1.5 million
Joe 50.05%
Cash
Rex 49.95%
1.5 million
John Terrific Offers $2 million for the
Company – What happens if Rex had taken
Common Stock?
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)
Alternatives
$ 5 million investment 1/3rd ownership (OPP $1.00
per share)
(Implied Valuation= $15 Million, 15 million shares)
• Structure I: 5M shares of common;
• Structure II: Redeemable Preferred ($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 Original Purchase Price (OPP), QPO at
$5 per share;
Commonn
Structure I - 5M shares of
common
W = 3, W =6, W =10
$W
Structure II RP ($5M APP);
RP
5
W = 3, W =6, W =10
5
$W
Exit Diagrams for RP and
Common
Redeemable
Preferred
WA
CP
5
Common Stock
W = 3, W =6, W =10
5
$W
15
Series A
Structure III
RP + 5M shares of common
5
W = 3, W =5, W =8, W=11
5
$W
Structure III(A) CP
CP
5
5
15
$W
Series A
Structure III (Revisited)
RP + 5M shares of common
similar to a structure called Participating Convertible
Preferred (PCP)
5
Notice the
“Double Dipping”
5
$W
Structure IV
PCP
PCP with participation as-if 5M shares
of common, QPO at $5 per share
28 1/3
25
Drop
= 10/3
Mandatory
Conversion
1/3*75=25!
5
5
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
71
75
$W
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
Conversion Point
PCPC
20
5
4*5=20; 5+15!
5
50
60
$W
PCPC
Structure V, continued
20
5
Sell Call
option X=50
5
Buy Call Option X=5
50
Buy Call X=60
60
$W
VCs response #1– Security
Design
• Redeemable Preferred (RP)
• Convertible Preferred (CP) - Forced
Conversion Clause
• Participating Convertible Preferred
(PCP)
Other Term Sheet Features
•
•
•
•
•
Vesting
Covenants
Anti-Dilution Protection
Board Seats
Please read the Note on Private Equity
Securities and the “Trendsetter” Case
for class on Thursday
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
Tomorrow
•
•
•
•
Discussion of Trendsetter Case
Read AntiDilution Note
Read Note on Private Equity Securities
Read “How VCs evaluate potential
Opportunities”