Transcript Venture Capital

Venture Capital and Private
Equity
Session 6
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)
Metapath Software
Professor Sandeep Dahiya
Georgetown 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!
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?
How Do VC Evaluate…
• Some discussion points
– What criteria would you use?
– How do VCs evaluate the business model?
– What about the founding team?
– How do VCs think about their exit?
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