Venture Capital and Private
Equity
Session 5
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)
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
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
Other Term Sheet Features
• Vesting
• Covenants
•
•
•
•
Liquidity Preferences
Anti-Dilution Protection
Board Seats
Please read the Note on Private Equity
Securities
Liquidation – Quick Review
• Deemed liquidation event
• Liquidation preference (2X, 3X, etc.)
– Non Participating
– Fully Participating
• Qualified public offering (QPO)
FACEBOOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Conversion
Each share of Series A, Series B, Series C, Series D, and Series E preferred stock is convertible, at the option of the holder thereof, at any time after the date of issuance of such
share, into such number of fully paid and non-assessable shares of Class B common stock as is determined by dividing the applicable original issue price by the conversion price
applicable to such share in effect on the date of conversion.
The conversion price of each series of preferred stock may be subject to adjustment from time to time under certain circumstances. The convertible preferred stock issued to date
was sold at prices ranging from $0.004605 to $7.412454 per share, which, in all cases, exceeded the then most recent reassessed fair value of our Class B common stock.
Accordingly, there was no intrinsic value associated with the issuance of the convertible preferred stock through December 31, 2011, and there were no other separate
instruments issued with the convertible preferred stock, such as warrants. Therefore, we have concluded that there was no beneficial conversion option associated with the
convertible preferred stock issuances.
Each share of Series A, Series B, Series C, Series D, and Series E convertible preferred stock shall automatically be converted into fully paid, non-assessable shares of
Class B common stock immediately upon the earlier of: (i) the sale by us of our Class A common stock or Class B common stock in a firm commitment underwritten public
offering pursuant to a registration statement under the Securities Act of 1933, as amended (Securities Act), the public offering price of which results in aggregate cash
proceeds to us of not less than $100 million (net of underwriting discounts and commissions), or (ii) the date specified by written consent or agreement of the holders of a
majority of the then-outstanding shares of preferred stock, voting together as a single class on an as-converted basis, provided, however, that if (a) the holders of a majority of the
then-outstanding shares of Series D convertible preferred stock do not consent or agree or (b) the holders of a majority of the then-outstanding shares of Series E convertible
preferred stock do not consent or agree, then in either such case the conversion shall not be effective as to any shares of preferred stock until 180 days after the date of the
written consent of the majority of the then-outstanding shares of preferred stock.
Liquidation Preferences
In the event we liquidate, dissolve, or wind up our business, either voluntarily or involuntarily, the holders of our Series A, Series B, Series C, Series D, and Series E convertible
preferred stock shall be entitled to receive, prior and in preference to any distribution of any of our assets to the holders of Class A common stock or Class B common stock, an
amount per share equal to $0.004605, $0.0570025, $0.2871668, $7.412454, and $4.54158 per share (as adjusted for stock splits, stock dividends, reclassifications, and the
like), respectively, plus any declared but unpaid dividends.
If, upon the occurrence of any of these events, the assets and funds distributed among the holders of the Series A, Series B, Series C, Series D, and Series E convertible
preferred stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then our entire assets and funds legally available for
distribution shall be distributed ratably among the holders of the Series A, Series B, Series C, Series D, and Series E convertible preferred stock in proportion to the preferential
amount each such holder is otherwise entitled to receive.
If there are any remaining assets upon the completion of the liquidating distribution to the Series A, Series B, Series C, Series D, and Series E convertible preferred stockholders,
the holders of our Class A common stock and Class B common stock will receive all our remaining assets. The merger or consolidation of us into another entity in which our
stockholders own less than 50% of the voting stock of the surviving company, or the sale, transfer, or lease of substantially all our assets, shall be deemed a
liquidation, dissolution, or winding up of us. As the “redemption” events are within our control for all periods presented, all shares of preferred stock have been presented as part
of permanent equity.
Facebook Cap Table
Biggest VC Success Story
Number of Shares
Series A
Series B
Series C
Series D
Series E
Price paid
Amount Invested
133,055 $ 0.00460500
612.72
224,273 $ 0.05700250
12,784.12
91,410 $ 0.28716680
26,249.92
50,590 $ 7.41245400
374,996.05
44,038 $ 4.54158000
200,002.10
Peter Thiel 500,000 turned into 2.5% of 100 Billion = 2.5
Billion YES BILLION!!!
Angel Round?
ACCEL?
Anti-Dilution Protections
• Down round
Read the Note on
Anti-dilution provisions: Typology
and Numerical Example
• Full-ratchet vs. weighted
average
• Adjusted conversion
price, adjusted
conversion rate
Dilution
• A owns 100% of the company which is 1 million shares for
which she had paid $2 per share
• Company issues another 1MM shares and raises 2 MM from B
– A is now 50% owner -- she has been diluted!
– But A did NOT suffer any ECONOMIC DILUTION – Company
now is worth $ 4 million and A’s stake is still $2 million!
• Similarly, If company reserves 1 MM shares for option pool
again the company receives future services from the
employees for that option pool again there is no ECONOMIC
DILUTION.
• What is investor B pays $1 per share for its $2 million
investment?
– Now there are 3 Million share post financing and A only owns 33.3%
– A’s investment declines from $2MM to $1MM
– ECONOMIC DILUTION!!!
Antidilution
• Company XYZ raised $12 Million from Early
Ventures (EV) in Round A financing. EV received 6
million shares (at a $2.00 per share price). The
Founders had 4 million shares after Round A.
Subsequently the firm falls on hard times and has
to raise another $ 10 million. It appears that
investors are unlikely to offer more than $1.00 per
share valuation. How would the Cap Tables look if
(a) EV had NO antidilution protection
(b) EV had Full Ratchet Protection
(c) EV had Broad Weighted Average antidilution
Protection
Regular Round
Before Financing
Investor
Founders
# of shares
4,000,000
Series A
$ per share
$ total
%
ownership
$0.000
$0
100%
Early Venture
$ per share
$ total
%
ownership
4,000,000
$2.00
$8,000,000
40.00%
6,000,000
$2.00
$12,000,000
60.00%
$2.00
$20,000,000
# of shares
Late Venture
Total For Round
Cumulative Total
6,000,000
4,000,000
$0.000
$0
100%
10,000,000
12,000,000
Price Per Share
$2.00
Pre-Money Valuation
8,000,000
Cash Infusion
12,000,000
Post-money Valuation
20,000,000
What happens when the new round for $ 10 Million is raised at $1.00 Per
share?
100%
No Antidilution Protection
Series A
Investor
Founders
Key Ventures
Series B VC
Total For Round
Cumulative Total
# of shares
4,000,000
6,000,000
6,000,000
10,000,000
Series B (No AntiDilution)
$ per share
$ total
%
ownership
$2.00
$2.00
$8,000,000
$12,000,000
40.00%
60.00%
$2.00
12,000,000
$20,000,000
100%
# of shares
4,000,000
6,000,000
10,000,000
10,000,000
20,000,000
$ per share
$ total
%
ownership
$1.00
$1.00
$1.00
$4,000,000
$6,000,000
$10,000,000
20.00%
30.00%
50.00%
$1.00
10,000,000
$20,000,000
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$2.00
8,000,000
12,000,000
20,000,000
$1.00
10,000,000
10,000,000
20,000,000
100%
Full Ratchet Protection
Series A
Investor
# of shares
Founders
Key Ventures
Series B VC
4,000,000
6,000,000
Total For Round
6,000,000
Cumulative Total
10,000,000
Series B (Full Ratchet)
$ per share
$ total
%
ownership
$2.00
$2.00
$8,000,000
$12,000,000
40.00%
60.00%
12,000,000
$2.00
$20,000,000
100%
# of shares
4,000,000
12,000,000
10,000,000
10,000,000
26,000,000
$ per share
$ total
%
ownership
$1.00
$1.00
$1.00
$4,000,000
$12,000,000
$10,000,000
15.38%
46.15%
38.46%
10,000,000
$1.00
$26,000,000
100%
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
•
•
•
$2.00
8,000,000
12,000,000
20,000,000
$1.00
16,000,000
10,000,000
26,000,000
Early Round VC simply demands that the NEW down round price be used for the
Money he had invested in the earlier round!
First round  $12 Million was invested – New price is $1 – Early VC would say
his total number of shares must be 12 million, since he already has 6 million
shares he would have to be given extra 6 million shares!
Notice what happens to the shareholding of Late round investor IF there is antidilution protection!
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
NCP 
(Pre-Money Value+Money in new round)
(Total # of Shares after financing)
Weighted Average AntiDilution
Series A
Investor
# of shares
Series B (Wtd Avg Ratchet)
$ per share
$ total
%
ownership
# of shares
$ per share
$ total
% ownership
Founders
4,000,000
$2.00
$8,000,000
40.00%
4,000,000
$1.00
$4,000,000
18.18%
Early Venture
6,000,000
$2.00
$12,000,000
60.00%
8,000,000
$1.00
$8,000,000
36.36%
10,000,000
$1.00
$10,000,000
45.45%
$1.00
$22,000,000
Late Venture
Total For Round
Cumulative Total
6,000,000
10,000,000
12,000,000
$2.00
$20,000,000
Price Per Share
22,000,000
10,000,000
New conversion Price for EV
$2.00
Pre-Money Valuation
10,000,000
100%
100%
1.50
$1.00
8,000,000
12,000,000
Cash Infusion
12,000,000
10,000,000
Post-money Valuation
20,000,000
22,000,000
NCP = OCP * (OB+(NM/OCP)) / (OB+SI)
NCP= $2 * (10MM+($10MM/$2)) / (10MM+10MM)=30MM/20MM=$1.5
New Number of Shares due to Series A= $12MM/1.5=8MM (implying an extra 2MM
shares that would be issued because of antidilution protection)
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
NCP 
(Pre-Money Value+Money in new round)
(Total # of Shares after financing)
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)
Trendsetter
• If you were advising Wendy and Jason
and you could not change any of the
terms, which term sheet would you
recommend?
Some Questions
• How much money are VCs putting in?
• What is the implied pre-money and postmoney valuation?
• When will the “Option Pool” be created?
• Focus on Mega: So how much are Wendy
and Jason worth?
• How is “Liquidation Preference” differ across
two term sheets?
How much money – what
fraction of the company?
• Let us look at Mega first
– Pre-Money
• Founders own 4,500,000 Shares 64.28%
• Option Pool 2,500,000 Shares 35.72%
– Post-Money
• Mega owns 5,000,000 Shares
• Total # of Shares 12,000,000
Founders 37.50%
Option Pool 20.83%
VC
41.67%
– What if the options were never mentioned
and Mega had said we give you 7 million
Pre-money and 12 million post?
How much money – what
fraction of the company?
• Now let us look at Alpha – Assuming
no release from the escrow account
– Pre-Money
$7,350,000
• Founders own 4,000,000 Shares
• Option Pool 3,000,000 Shares
Implying $1.05
Per share
– Post-Money $ 12,350,000
• Alpha owns 4,761,905 Shares Ownership 40.49%
• Total # of Shares Total shares 11,761,905
• Founder Ownership 34.01%
Valuation (Cap Tables)
Alpha
Investor
Founders
VC
Option Pool
Total For Round
Cumulative Total
# of shares
4,000,000
4,761,905
3,000,000
4,761,905
11,761,905
Mega
$ per
share
$1.05
$1.05
$1.05
$ total
$4,200,000
$5,000,000
$3,150,000
$1.05
5,000,000
$12,350,000
%
ownership
34.01%
40.49%
25.51%
# of shares
4,500,000
5,000,000
2,500,000
100%
5,000,000
12,000,000
$ per
share
$1.00
$1.00
$1.00
$ total
$4,500,000
$5,000,000
$2,500,000
$1.00
5,000,000
$12,000,000
Price Per Share
Pre-Money Valuation
Cash Infusion
Post-money Valuation
$1.05
7,350,000
5,000,000
12,350,000
$1.00
7,000,000
5,000,000
12,000,000
%
ownership
37.50%
41.67%
20.83%
100%
Liquidation
• Deemed liquidation event
• Liquidation preference (2X, 3X, etc.)
– Alpha
– Mega
• Qualified public offering (QPO)
What Type of Security?
• Alpha
– Convertible Preferred (CP) Stock
• Mega
– Participating Convertible Preferred (PCP)
Stock
TYPE OF LIQUIDATION EVENT IS
CRITICAL!
Who gets how much:
Liquidation Waterfall Charts
• If Alpha 40.49% ; If Mega 41.67%
• Liquidation values
– 5 million
– 7.5 million
– 20 million
– 30 million
– 40 million
Alpha 5 Mega 5
Alpha 5 +40.49% of (7.5-5) = 6.01; Mega 7.5
Alpha 11.07; Mega 7.5 +(20-7.5)x41.67%=12.71
Alpha 15.12; Mega 16.88
Alpha 15 ; Mega 21.04
Alpha will convert 40.49% of 40= 16.20!
What about IPO?
• Remember in both cases the total
number of shares outstanding after
financing were ~12 million
• How valuable must the company
become to meet the QPO
• How much does Mega get for $500
million sale of the company versus an
IPO that values the company for $500
million?
Exit Values
Alpha Ownership -40.49%
Mega Ownership -41.67%
Term Sheet Alpha
Enterprise
Value ($
VC
Million)
5.00
7.50
10.00
15.00
20.00
25.00
29.69
30.00
35.00
37.04
40.00
45.00
50.00
55.00
60.00
100.00
200.00
240.00
500.00
Liquidation
5.00
6.01
7.02
9.05
11.07
13.10
15.00
15.00
15.00
15.00
16.20
18.22
20.25
22.27
24.29
40.49
80.98
97.18
202.45
Owner/Employees
VC
0.00
1.49
2.98
5.95
8.93
11.90
14.69
15.00
20.00
22.04
23.80
26.78
29.76
32.73
35.71
59.51
119.02
142.82
297.55
$ 15 million maximum
IPO
Owner/Employ
ees
VC
24.29
40.49
80.98
97.18
202.45
35.71
59.51
119.02
142.82
297.55
Term Sheet Mega
Liquidation
IPO
Owner/Employ
Owner/Employ
ees
VC
ees
5.00
0.00
7.50
0.00
8.54
1.46
10.63
4.37
12.71
7.29
14.79
10.21
16.75
12.94
16.88
13.12
18.96
16.04
19.81
17.23
21.04
18.96
23.13
21.87
25.21
24.79
27.29
27.71
29.38
30.62
46.04
53.96
87.71
112.29
104.38
135.62
100.01
139.99
212.72
287.28
208.35
291.65
Broader discussion of terms
• What terms did you like in one but not
in other term sheet? Why?
• What terms did you dislike in both
terms sheets? Why?
• Key Issues
– Valuation
• Pre and Post
– Option Pool
– Type of security
– Dividend
– Liquidation
– QPO
– Antidilution
– Voting Rights
– Founder’s vesting
– VC Syndicate
Alpha
Mega
• Hurdle
• $7 MM
• Tricky
• Plain
– 3MM
– 2.5MM
– CP
– PCP
– NoCum
– Cum
– 3x
– 1.5x
– Low
– High
– Wt Avg
– Full?
– 60%
– ???
– Same??
– Same
– Two VCs
– One VC
Trendsetter
• If you were advising Wendy and Jason
and you could ask for change in any of
the terms, which terms would you try
to renegotiate?
• Key Issues
– Valuation
• Pre and Post
– Option Pool
– Type of security
– Dividend
– Liquidation
– QPO
– Antidilution
– Voting Rights
– Founder’s vesting
– VC Syndicate
Alpha
Mega
• Hurdle
• $7 MM
• Tricky
• Plain
– 3MM
– 2.5MM
– CP
– PCP
– NoCum
– Cum
– 3x
– 1.5x
– Low
– High
– Wt Avg
– Full?
– 60%
– ???
– Same??
– Same
– Two VCs
– One VC
Remember – Term sheet is “proposal” nothing is
cast in stone yet. You need to know what to
negotiate and why?
A framework for analyzing
termsheets
•
Economics
– Original Purchase Price
(OPP) aka “proposed
ownership percentage)” on
a “fully diluted basis”
– Liquidation Preference (1x,
2x etc.
– Participation (Note: on top
of liquidation preference)
– Conversion (QPO)
– Antidilution
– Dividends
•
Control
– Board of Directors
– Voting Rights/Protective
Provisions
– Conversion (QPO)
– Founders stock/vesting
– Transfer Restrictions
– Registration Rights???
Term sheet Check list
• Green Flags
– Simple Terms
– VC willing to
take the
downside risk
(1x liquidation
preference; no
antidilution)
– Plain
convertible
Preferred
• Yellow Flags
– Milestone
heavy
– Complex
terms
– Terms left
vague
– Future option
pool to come
out of
founders’
share
• Red Flags
– Extremely
milestone
heavy
– Length
exclusivity
– Complex due
diligence
requirements
– Clauses that
shift control
from founders
to VCs
Why do we see these features?
• Convertible preferred
• Participating Convertible Preferred
• Full Ratchet/ Weighted Average
Ratchet
• Vesting provisions
Challenges of Venture Financing
• Critical issues involved in • Responses by VCs
financing young firms
– Active Screening
– Stage financing
– Uncertainty
– Syndication
– Asymmetric
– Use of Stock options/grants
Information
with strict vesting
– Nature of Firm’s assets
requirements
– Conditions of relevant
– Contingent control
financial and product
mechanisms – Covenants and
markets
restrictions
– Strategic composition of
Board of Directors
Recap
• Hopefully you are better placed to
appreciate the importance of terms.
• As an entrepreneur try to avoid “fancy”
term sheets with lots of “gingerbread”
• Try not to raise money WHEN you need
it – try to do it with 6 months of cash
burn cushion