Venture Capital and Private Equity

Session 3Professor 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)

Accel Partners VII

Accel Partners – High Level Questions

• How are VCs compensated? How does the compensation structure of VCs differ from CEOs or Fund managers

• Why do we observe the partnership structure?

• Why do GPs need to put down 1%?• Why not take down the entire capital at

one go?• Why do we see the various restrictions on

size and co-investment in previous deals?

Accel Partners – More General Issues

• How do Management Fee and Carry interact with Fund size?– $20 million fund with 2 partners(2.5%

Mgmt fee)– $400 million fund with 4 partners (2.5%

Mgmt fee)

Accel Partners VII

• Would you invest in Accel Partners VII

• Would David Swensen invest ?• How they done in the past?• How are they likely to do in the

future?

Accel Partners Now

• Did close Fund VII with 30% carry• Accel VIII – mother of all funds $1.6

BILLION proposed in 2000 scaled back to $950 million later

• Accel IX 400 million• Accel X $520 million• No Idea how the funds are doing but

was Series A investor in FACEBOOK.

VC Method For Valuation

Professor Sandeep DahiyaGeorgetown University

Quick Review of Valuation Methodologies

• DCF– Estimate FCF (EBIAT+Dep-CapEx-ΔNWC)– Estimate WACC– Estimate Terminal Value (Perpetual growth g)– Discount FCF and TV to get Enterprise Value

• Multiples Based– Choose a set of Peers/Comprables– Choose the multiple(s) e.g. EV/EBIT, P/E– Estimate Median/Average Multiple– Apply to target

Please Read “Note on Valuation in Private Equity Settings”

VC Method

• Flavor of both DCF and Multiples but is different.

• FCF is highly uncertain• WACC is almost meaningless• Multiples are hard to get by• Most firms will NOT survive• A few firms would have incredible growth

VC Method-Implied Valuation

Information you would almost always have• I – Amount being raised from VC• X- Number of Shares currently owned by entrepreneurInformation 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 exitNumbers 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

An Example• Hoya.com is asking for $5 million, Projected income in year 5

is $ 4 million and expected exit multiple is 25x. Company currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 50%?

Exit Value = $4 x 25 = $100 million

POST MONEY VALUATION = 100/(1+50%)5 = 13.169 million

PRE MONEY VALUATION = 13.169 – 5 = $8.169 million

Since 1 million shares outstanding Price per share = $8.17

Alternatively VC must get 5/13.17 = 37.97% of the company

Let us assume Y is the number of new shares that must be issued to the VC, X are the existing number of shares

Y/(X+Y) = F =38% algebraic manipulation yields Y = 612,091 shares.

Price per share = 5,000,000/612,091 = $8.17

Analysis based on value TODAY !

An Example• Hoya.com is asking for $5 million, Projected income in year

5 is $ 4 million and expected exit multiple is 25x. Company currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 50%?

Exit Value of Hoya.com = $4 x 25 = $100 million

Exit Value of VC has to be =$5x(1+50%)5 = 37.97 million

Fraction of Company Needed = 37.97/100=37.97%

Implied POST MONEY Valuation=5/0.3797=13.17 million

Implied PRE MONEY Valuation= 13.17-5=8.17 million

Let us assume Y is the number of new shares that must be issued to the VC, X are the existing number of shares

Y/(X+Y) = F =37.97%; algebraic manipulation yields Y = 612,091 shares.

Price per share = 5,000,000/612,091 = $8.17

Analysis based on value at EXIT DATE!

An Example• Hoya.com is asking for $5 million, Projected income in year

5 is $ 4 million and expected exit multiple is 25x. Comapny currently has 1 million shares all owned by the entrepreneur. What share of company would a VC require today if VC’s required return is 30%?

Exit Value = $4 x 25 = $100 million

Value of VC’s 5 million investment at 30% = 5*(1+.30)5 = $18.6 million

VC would ask for 18.6/100 = 18.6% of the firm!What fraction does VC need if $ 12 Million is needed and VC needs 50% IRR

How many shares if VC needs 30% return (would ask for 18.6% of the firm).

Value of VC at Exit =12x(1.5)^5

=91.125!!!

Y = X(F/1-F) = 1*(0.186/1-0.186)

Y = 0.2285 million shares

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

Only 85 million available after the option pool

VC would want 37.97/85 = 44.67% of the company today so that at exit its share is 37.97%.

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 sharesF1New Number of Shares Y X

(1-(F1 OP))0.3797

Y 1 0.807 million shares(1-(0.3797 0.15))

Another Approach (easier).• 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

VC Current Ownership = 0.3797/(1-0.15) = 44.67%

Final%) sOwner'Later 1(

Ownership% Final

Retention%

Ownership% FinalOwnership%Current

Final%) sOwner'Later 1(Retention%

Ownership%Current

Ownership% FinalRetention%

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

Amount available after option pool is 85 million implying 6.59/85 = 7.75%

Round 1 still needs $38 million to generate 50% but only has (100-6.59-15) million to get it out of implying initial stake = 38/(100-6.59-15)=0.485 or 48.5% stake.

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.

What is the Post and Pre Money Valuation at round 1?

How many shares need to be issued to Round 1, Round 2 and option pool?

5/0.485=10.32; 5.32

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…

Tomorrow

• How Do VCs Evaluate Investments• Term sheet for Trendsetter

VC Framework• Critical Issues

– Uncertainty– Asymmetric

Information– Nature of Firm’s

assets– Conditions of

relevant financial and product markets

• Responses by investors– 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

Capitalization TablesPage 10 (Bottom) of ONSET ventures case describes the financing history of TallyUp. Onset offered to invest $750,000 at a price $1 per share in return for 31.6% of the company. Later, ONSET invested another $250,000 at the same price ($ 1 per share) when Reed Tausig as the CEO. Please draw up the capitalization tables, pre-money and post money valuations for tally before and after each round of financing.

Before Financing After Intial 750,000 investment

Investor # of shares $ per share $ total%

ownership # of shares$ per share $ total

% ownership

Founders 1,625,000 $0.000 $0 100% 1,625,000 - $1,625,000 68.42%ONSET Ventures 750,000 $1.00 $750,000 31.58%Option Pool

Total For Round

Cumulative Total 1,625,000 $0.000 $0 100% 2,375,000 $1.00 $2,375,000 100%

Price Per Share$1

Pre-Money Valuation 1,625,000Cash Infusion 750,000Post-money Valuation 2,375,000

After Next Investment of $250,000

After Intial 750,000 investment After next 250,000 investment

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownership

Founders 1,625,000 - $1,625,000 68.42% 1,625,000 - $1,625,000 61.90%ONSET Ventures 750,000 $1.00 $750,000 31.58% 1,000,000 $1.00 $1,000,000 38.10%Option Pool

Total For Round 250,000 $1.00 $250,000 9.52%Cumulative Total 2,375,000 $1.00 $2,375,000 100% 2,625,000 $1.00 $2,625,000 100%

Price Per Share$1 $1

Pre-Money Valuation 1,625,000 $2,375,000Cash Infusion 750,000 250000Post-money Valuation 2,375,000 $2,625,000

After option pool creation of 750,000 Shares

After next 250,000 investment After Option Pool

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownershi

p

Founders 1,625,000 - $1,625,000 61.90% 1,625,000 - $1,625,000 48.15%ONSET Ventures 1,000,000 $1.00 $1,000,000 38.10% 1,000,000 $1.00 $1,000,000 29.63%Option Pool 750,000 $1.00 $750,000 22.22%

Total For Round 250,000 $1.00 $250,000 9.52% 750,000 $0.00 $0 22.22%Cumulative Total 2,625,000 $1.00 $2,625,000 100% 3,375,000 $1.00 $3,375,000 100%

Price Per Share$1 $1

Pre-Money Valuation $2,375,000 $2,625,000Cash Infusion 250000 0Post-money Valuation $2,625,000 $3,375,000

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 Raise 3.5 Million Total at 2.5 Step Up

Investor # of shares$ per share $ total

% ownership # of shares

$ per share $ total

% ownership

Founders 1,625,000 - $1,625,000 48.15% 1,625,000 - $4,062,500 34.03%ONSET Ventures 1,000,000 $1.00 $1,000,000 29.63% 1,400,000 $2.50 $3,500,000 29.32%Option Pool 750,000 $1.00 $750,000 22.22% 750,000 $2.50 $1,875,000 15.71%New VC 1,000,000 $2.50 2500000 20.94%

Total For Round 750,000 $0.00 $0 22.22% 1,400,000 $2.50 $3,500,000 29.32%Cumulative Total 3,375,000 $1.00 $3,375,000 100% 4,775,000 $2.50 $11,937,500 100%

Price Per Share$1 $2.50

Pre-Money Valuation $2,625,000 $3,375,000Cash Infusion 0 3,500,000Post-money Valuation $3,375,000 $11,937,500