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)
Term Sheets …
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
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
(Pre-Money Value+Money in new round)
NCP 
(Total # of Shares after financing)
EXAMPLE: Suppose that Early Venture (EV) makes a
$8M Series A investment in Newco for 2M shares at
$4 per share on 1/1/1999. One year later, Newco
has fallen on hard times and receives a $10M Series
B financing from Late Venture (LV) for 5M shares at
$2 per share. The founders and the stock pool have
claims on 6M shares of common stock.
Consider the following cases:
• Case I: Series A has no antidilution protection.
• Case II: Series A has full-ratchet antidilution
protection.
• Case III: Series A has broad-base weighted-average
antidilution protection.
For each of these cases, what percentage of Newco
(fully diluted) would be controlled by EV, Founders
and LV following the Series B investment? What
would be the post-money and pre-money
valuations?
Initial Capitalization
1/1/1998
# of shares $ per share
$ total
6,000,000 $0.001
$6,000
Investor
Founders
Early VC
Later VC
Total For Round
Cumulative Total
6,000,000
$0.001
First Round
Second Round No Antidilution
1/1/1999
1/1/2000
% ownership # of shares $ per share
$ total
% ownership # of shares $ per share
$ total
% ownership
100%
6,000,000
$24,000,000
75.00%
6,000,000
$12,000,000
46.15%
2,000,000
$4.00
$8,000,000
25.00%
2,000,000
$2.00
$4,000,000
15.38%
5,000,000
$2.00
$10,000,000
38.46%
$6,000
100%
8,000,000
$4.00
$32,000,000
100%
5,000,000
13,000,000
$2.00
$2.00
$10,000,000
$26,000,000
38.46%
100%
Notice value of Early VC has fallen from 8 million to 4 million
This implies a “paper loss” of 8-4= 4 million!
Investor
Founders
Early VC
Later VC
Second Round Full Ratchet
1/1/2000
# of shares $ per share
$ total
% ownership
6,000,000
$12,000,000
40.00%
4,000,000
$2.00
$8,000,000
26.67%
5,000,000
$2.00
$10,000,000
33.33%
Second Round Partial Ratchet
1/1/2000
# of shares
$ per share
$ total
% ownership
6,000,000
$12,000,000
44.52%
2,476,190.5
$2.00
$4,952,381
18.37%
5,000,000
$2.00
$10,000,000
37.10%
Cumulative Total
15,000,000
13,476,190
3.23
$2.00
$30,000,000
100%
NCP
$2.00
$26,952,381
100%
Liquidation – Quick Review
• Deemed liquidation event
• Liquidation preference (2X, 3X, etc.)
– Non Participating
– Fully Participating
• 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!
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
(Implied Valuation= $15 Million, 15 million shares)
• Structure I: 5M shares of common;
• Structure II: RP ($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 OPP, QPO at $5 per share;
• Structure VI: RP ($4M Aggregate Purchase Price) +
5M shares of CP ($1M APP).
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
also 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
Structure VI, RP component
RP in Series A
4
4
$W
Structure VI, RP ($4M APP) + 5M
shares of CP ($1M APP).
Series A
5
4
5
7
$W
Structure VI, CP component
CP in Series A
1
4
5
7
$W
Exit Values
Alpha Ownership -40.49%
Mega Ownership -41.67%
Term Sheet Alpha
Enterprise
Value ($
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
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
Rex 49.95%
1.5 million
John Terrific Offers $2 million for the
Company – What happens if Rex had taken
Common Stock?
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
Securities used by VCs
• Common Stock
• Debt
• Preferred Stock
• Never – why
not?
• Never – why
not?
• Interestingwhy?
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
Tomorrow
• Metapath Software
– Try using Option Pricing Model Posted on
the website under Class Session 6
• Wrap up with discussion of “How VCs
Evaluate Potential VC Opportunities”
• HW 2 assignment will be posted under
Class Session 5 (Due on Wednesday)