Venture Capital and Private Equity

Session 6Professor 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)

Metapath Software

Professor Sandeep DahiyaGeorgetown University

OUTLINE

• What happened.• The broader themes:– The interplay of terms.– Options in private equity.

WHAT HAPPENED (1)• The Company turned down Cell Tech:– Offering 30% of their capitalization

indicated that their base business had limited upside.

– Clearly there were ongoing financing risks and liquidity issues.

– The fit was not compelling.

• Cell Tech stock fell $9 --> $3– After 3 years and several acquisitions, it

rebounded.

WHAT HAPPENED (2)

• Accepted RSC Participating Preferred, later had to raise a $12mm Ser F Rd at $8/shr, had to keep participation.

• Merged with UK based MSI Dec ‘98:– 65% MSI, 35% Metapath, both private cos.– Grey area since preferred carried over to

merged company.–Mezzanine investors insisted on

participation.

WHAT HAPPENED (3)• Much rancor between late investors

and early investors plus Management:– Ser E (and Ser F) had defined “liquidation” to

include any change of control event. – Management maintained all rights could be

preserved in capitalization post-merger.– Late stage investors knew company worth more

than their ~$24mm liquidation preference, so were willing to vote down deal (votes were by class)--they won.

WHAT HAPPENED (4): Lessons Learned

• Metapath used too much money:– Despite continual progress, ran out of cash.

• Metapath too price focused:– $4/shr w/ no participation possible? – $4/shr still a good step up from $1.62.

• RSco and TCV fundamentally different kind of investor from BVP & Norwest:– Trading terms for price.– Good trade when you perform but leaves no

room for error!

THE INTERPLAY OF TERMS: Trading price for terms

• Trend in price/share often only outside gauge of company progress.

• Price/share affects employee options and morale.

• Fancy terms tend to put boundaries on the downside.

• Term-laden deals often play on entrepreneur's optimism (screening?).

THE INTERPLAY OF TERMS: Liquidation & Participation• A liquidation triggers participation.• In the Metapath case, formerly the

board could deem a change of control a liquidation, but it was not automatic.

• “Liquidation” was changed to include change of control in Ser E:– Implication not picked up by management,

early investors or company counsel.

THE INTERPLAY OF TERMS: Voting & Negative

Covenants• Negative Covenants outline what the

company can NOT do without special vote of preferred (e.g.: merge, sell, change business, liquidate etc.)

• Preferred previously voted as one class, or on an “as converted basis”.

• Voting class by class became part of deal when terms between classes significantly diverged.

BLACK-SCHOLES LOOKS AT THE LIMITING CASE

• Assumes continuous time--many branching points.

• Obtains complex formula as function of:– Time to maturity.– Standard deviation of stock.– Current stock price.– Exercise price.– Risk-free interest rate.

USING THE BLACK-SCHOLES FORMULA

• Black-Scholes EXCEL calculator.

ILLUSTRATION

• Switch from convertible to participating preferred is essentially “re-pricing” the call option of Series E holders:–Will begin sharing in equity above $11.75

million, rather than $87.75 million:• How much is this worth?• How lower share price should Hardy be willing

to accept to get rid of?– He had offered $5.50 without instead of $6 with.

BASIC STRUCTURE

• Look at what worth in current setting.

• Look at what worth with higher exercise price.

• Look at how much lower share price will equate.

ASSUMPTIONS

• Ten-year option life.• 30% volatility (guess).• $11.75 and $87.75 million exercise

prices.• Assume $87.75 valuation is right.• Interest rate of 6.21%.– Assume away complexity of IPO.

CALCULATION

• Value of option with $11.75 strike price is $81.4 million.– 13.4% of this is $10.7 million.

• Value of option with $87.75 strike price is $49.9 million.– 13.4% of this is $6.7 million.

• The participating feature represents about $4 million in value!

CALCULATION (2)

• Now look at how much larger share of the company (lower price) will equate:– 13.4% * $81.5MM = X * $49.9 MM.– X = 21.9%.

• Hardy would have been equally well off giving Series E holders 21.9% of company without participation:

• Share price of (13.4%/21.9%)*$6=$3.67!

Why do we see these features

• Convertible preferred• Participating Convertible Preferred• Liquidation Preferences • Full Ratchet/ Weighted Average

Ratchet• Registration rights

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 1.5 million Rex 49.95%

John Terrific Offers $2 million for the Company – What happens if Rex had

taken Common Stock?

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

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

How Do VCs Evaluate Potential Investments?

• How do you evaluate potential venture opportunities?

• How do you evaluate the venture’s prospective business model?

• What due diligence do you conduct?• What is the process through which funding

decisions are made? • What financial analysis do you perform?• What role does risk play in your evaluation?• How do you think about a potential exit

route?

Key Takeaways

• While hard to codify some key patterns are consistent

• Risk-Reward trade-off• Market is big factor – How much pain!– Who feels the pain!

• Acceptance that mistakes will be made but with a twist– Mistake when made the investment– Mistake when DID NOT make investment

• Intense desire for IPO worthy investment