1

INTRODUCTION
Manuel Adelino
Duke University’s Fuqua School of Business
 2

VALUATION

=
Price Present Value
(Cash Flows)

Ingredients:

Current
(Cash) Profits Growth Risk + Timing
 3

DETERMINING CASH FLOWS

Manuel Adelino
Duke University’s Fuqua School of Business
 4

DETERMINING FREE CASH FLOWS

TO THE FIRM

Revenue
- Cost
Includes cost of goods sold, sales, general and administrative
costs and depreciation

= Earnings Before Interest and Taxes

- Taxes

- Investments
4a. Capital Expenditures
4b. Changes in Net Working Capital =
Changes in Op. Assets – Op. Liabilities
 5

DETERMINING CASH FLOWS

Free Cash Flow = EBIT * (1 – T)

+ Depreciation
- Capital Expenditures
- Changes in Net Working Capital

Find a set of comparable companies (risk, industry, etc.)

Valuation starts with cash profits!

Need to invest in order to generate profits

(CAPEX, ∆NWC)
 6

DETERMINING CASH FLOWS

Free Cash Flow = EBIT * (1 – T)

+ Depreciation
- Capital Expenditures
- Changes in Net Working Capital
What this does not include:

Interest Expenses

Dividends
 7

TIME VALUE OF MONEY

Manuel Adelino
Duke University’s Fuqua School of Business
 8

WHY “PRESENT”:
TIME VALUE OF MONEY

Cash in 1 year, 2 years, … , 10 years

is worth less than today
 9

WHY “PRESENT”:
TIME VALUE OF MONEY

Cash in 1 year, 2 years, … , 10 years

is worth less than today

100 dollars in the bank, interest rate of 10%

grows to

100 * (1+10%) = 110 after 1 year

 10

WHY “PRESENT”:
TIME VALUE OF MONEY

100 dollars in the bank, interest rate of 10%

grows to

100 * (1+10%) = 110 after 1 year

110 dollars in the bank, interest rate of 10%

is worth

110 / (1+10%) = 100 today

 11

WHY “PRESENT”:
TIME VALUE OF MONEY

100 dollars in the bank, interest rate of 10%

grows to

100 * (1+10%) = 110 after 1 year

100 dollars in the bank, interest rate of 10%

After 2 years is worth

100 * (1+10%) * (1+10%) = 100 * (1+10%)2 = 121

 12

WHY “PRESENT”:
TIME VALUE OF MONEY

Cash in 1 year, 2 years, … , 10 years

is worth less than today

Future Value
Present Value =
(1+rd)t
for some discount rate “rd”.
 13

MORE THAN 1 CASH FLOW

0 1 … 6 7 8 9 …

CF1 CF6 CF7 CF8 CF9

CF0 CF5 CF6 CF7 CF8

Present Value, = + ⋯+ 5
+ 6
+ 7
+ 8
+⋯
1 + r3 1 + r3 1 + r3 1 + r3 1 + r3
 14

MORE THAN 1 CASH FLOW

0 1 … 6 7 8 9 …

CF1 CF6 CF7 CF8 CF9

With constant growth rate g:

CF2 =(1+g)*CF1
CF3 =(1+g)*CF2 = (1+g)2*CF1; …)

CF0
Present Value, =
r3 − g
 15

WHAT IS THE DISCOUNT RATE?

Manuel Adelino
Duke University’s Fuqua School of Business
 16

DETERMINING THE DISCOUNT RATE

What goes into rd?

Pure time value Risk

 17

DETERMINING THE DISCOUNT RATE

What goes into rd?

Pure time value

Risk-free rate: Interest rate paid (annually) by the government

for an equivalent period.

One common choice for valuation of firms is the US

government’s 10-year constant maturity rate.
 18

DETERMINING THE DISCOUNT RATE

What goes into rd?

Risk

Does not include “idiosyncratic” or “diversifiable” risk

Includes only “systematic” risk, measured by how the returns

of the firm co-vary with the market

This is measured by 𝛽
 19

DETERMINING THE DISCOUNT RATE

What goes into rd?

Pure time value Risk

Together:
𝑟𝑑 = 𝑟𝑓 + 𝛽 ∗ (𝑟𝑚 − 𝑟𝑓)

Risk-free Beta: Market risk

rate From CAPM premium
 20

COMPARABLES VALUATION
Manuel Adelino
Duke University’s Fuqua School of Business
 21

USING MULTIPLES
Find a set of comparable companies (risk, industry, etc.).
1

For each comparable, divide value (EV or Equity, depending

2 on the multiple) by an accounting measure

• Firm Value / EBITDA

• Firm Value / EBIT
• Firm Value / Sales
• Price / Earnings (or Market Capitalization / Net Income)

Multiply the average ratio across comparables by your

3 estimate of the same accounting statistic for the project (or
firm)
 1

RECAP: DISCOUNT RATE

Manuel Adelino
Duke University’s Fuqua School of Business
 2

DETERMINING THE DISCOUNT RATE

What goes into rd?

Pure time value Risk

 3

DETERMINING THE DISCOUNT RATE

What goes into rd?

Pure time value

Risk-free rate: Interest rate paid (annually) by the government

for an equivalent period.

One common choice for valuation of firms is the US

government’s 10-year constant maturity rate.
 4

DETERMINING THE DISCOUNT RATE

What goes into rd?

Risk

Does not include “idiosyncratic” or “diversifiable” risk

Includes only “systematic” risk, measured by how the returns

of the firm co-vary with the market

This is measured by 𝛽
 5

DETERMINING THE DISCOUNT RATE

What goes into rd?

Pure time value Risk

Together:
𝑟𝑑 = 𝑟𝑓 + 𝛽 ∗ (𝑟𝑚 − 𝑟𝑓)

Risk-free Beta: Market risk

rate From CAPM premium
 6

ADDING PROBABILITY OF FAILURE

Manuel Adelino
Duke University’s Fuqua School of Business
ADDING UNCERTAINTY
Suppose cash flows period-by-period are:

• High with 50% probability

• Zero with 50% probability

How does this change the problem?

ADDING UNCERTAINTY EXPLICITLY
Suppose cash flows are:

• High with 50% probability

• Zero with 50% probability

How does this change the problem?

• It doesn’t, as long as risk is idiosyncratic AND investor

holds diversified portfolio.
• NPV applies to expected cash flows.
 IMPLICATIONS FOR STARTUP FUNDING
If investors hold (reasonably) diversified portfolios

AND

Startups are evaluated using expected cash flows

=> No changes to FCF + WACC approach

 10

INTERPRETING BUSINESS PLANS

Manuel Adelino
Duke University’s Fuqua School of Business
THE PITCH

T=0 T=1 T=2…

Invest High CF High CF

EVALUATING A BUSINESS PLAN
(or what a business plan really is)

Statement of ambition

VS

Expected outcome
REAL WORLD

1 Few companies (really) succeed

2 Returns are made on the large successes

3 Experts often can’t tell the difference

ADJUSTING CASH FLOWS

Business Plan Cash Flows

x
Probability of Success

Expected outcome
 15

ADJUSTING DISCOUNT RATES

Manuel Adelino
Duke University’s Fuqua School of Business
COMPUTING NPV

Cash Out
P(success)

Cash In

0
 COMPUTING NPV

𝐶𝑎𝑠ℎ 𝑂𝑢𝑡 ∗ 𝑝(𝑆𝑢𝑐𝑐𝑒𝑠𝑠)

𝑁𝑃𝑉 = −𝐶𝑎𝑠ℎ 𝐼𝑛 +
1 + 𝑟: ;
 COMPUTING NPV

𝐶𝑎𝑠ℎ 𝑂𝑢𝑡 ∗ 𝑝(𝑆𝑢𝑐𝑐𝑒𝑠𝑠)

𝑁𝑃𝑉 = −𝐶𝑎𝑠ℎ 𝐼𝑛 +
1 + 𝑟: ;

Or, equivalently:

𝐶𝑎𝑠ℎ 𝑂𝑢𝑡
𝑁𝑃𝑉 = −𝐶𝑎𝑠ℎ 𝐼𝑛 +
1 + 𝑟: ;
𝑝 𝑆𝑢𝑐𝑐𝑒𝑠𝑠
 VC REQUIRED RATE OF RETURN
The required rate of return on each individual investment can be re-
defined as:

)
1 + 𝑟* )
1 + 𝑟'( =
𝑝(𝑆𝑢𝑐𝑐𝑒𝑠𝑠)

So that
1 + 𝑟*
𝑟'( = + −1
𝑝 𝑆𝑢𝑐𝑐𝑒𝑠𝑠 )

Suppose rD=10%, suppose 20% probability of success and exit in 5 years:

1 + 10%
𝑟'( = + − 1 = 51.7%
20%-
VC REQUIRED RATE OF RETURN
5-YEAR EXIT, WACC=10%

DISCOUNT RATE BY P(SUCCESS)

 Financing Options for Entrepreneurial Ventures

David T. Robinson

Duke University

DTR 1 / 50
Sources of Capital for Startups
Two Critical Lessons

1 A $1 is not just a $1: from whom you raise money can be as important as how
much you get
I Investors can be important business leads who can help you build your business; they
are not just there to plug holes in a cash flow statement (although they might be)
I These “value-added" services end up costing more in terms of greater loss of control,
of ownership (but sometimes are worth it)
I Some businesses are not well suited to some types of investors

2 Timing is everything
I Investors specialize in certain points of the lifecycle of a business
I It takes time to build relationships that lead to funding outcomes
I Capital providers are often complements, not substitutes
I Raising too much money too early can be deadly

DTR 2 / 50
Sources of Capital for Startups
How important are the various arrows?

Corporate VC
Venture Capital
Venture Capital

n
io
at
Venture Capital
ic
nd
Sy

Entrepreneurs

Angel Investors Banks

Strategic
Alliances

DTR 3 / 50
The Who and What

What:
Who: Debt Equity

Insiders The 3 F’s Angels

Customers/Suppliers Trade credit Alliance partners

Outsiders Banks Venture Capital and

“growth equity"

DTR 4 / 50
 UNDERSTANDING DEBT

DTR 5 / 50
Kauffman Firm Survey 2004
All Firms

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
All Firms High Credit Low Credit

Owner Equity Owner Debt Insider Equity

Insider Debt Outsider Equity Outsider Debt

DTR 6 / 50
Kauffman Firm Survey 2004
The Difference: Total Capital

300000

250000

200000

150000

100000

50000

0
All Firms High Low All Hi- High Low
Credit Credit tech Credit Credit

DTR 7 / 50
What about Garage businesses?
Garage businesses vary by size

140,000  

120,000  

100,000  

54,536  

80,000   50,087  
44,839  

Outside  Debt  
42,208  
Outside  Equity  
Insider  Debt  
60,000  
Insider  Equity  
21,530  
Owner  Debt  
Owner  Equity  
16,268  
26,960   18,753  
40,000   8,841  
19,353  

4,731  
2,774  
20,000  

17,269   31,201   35,433  

20,035  
31,784  
31,609  
0  

Non  
Home  
Employer   Pre  
Based   Pre  
Revenue   Survived  
Profits   Closed  
thru  2006  
by  2006  

DTR 8 / 50
What about Equity-backed Businesses?
Again, Size Varies

2,500,000  

2,000,000  
628,398  

1,500,000  

Outside  Debt  
Inside  Debt  
Owner  Debt  
1,000,000   Outside  Equity  
Inside  Equity  
1,499,644  
Owner  Equity  

164,891  
500,000   75,156  

328,999  
515,051  

0   96,030  

 Angel     171,145  
 VC    
 Corporate    
 Govt-­‐Other  

DTR 9 / 50
A Closer Look at Debt

6%
7%

10%
39%

8%

30%

Personal loans for business Business bank loans

Business Credit Cards Business Credit Line
Non-bank loans Other loans

DTR 10 / 50
How Debt Works

Borrow money, receive cash, repay principal plus interest

This means that entrepreneur keeps the upside

Debt has covenants: guidelines that must be adhered to if the debt is considered
to be in good standing

If default, debtholders can seize the firm’s assets and liquidate them

Collateral is typically required, often this is the entrepreneur’s personal assets

(their home, etc.)

DTR 11 / 50
 A CLOSER LOOK AT VENTURE CAPITAL

DTR 12 / 50
Some Important Valuation Concepts for VC

Suppose an entrepreneur takes $10 for 5% of her company. What does this imply
about its value?

Post-money valuation

I Definition: the value of an enterprise after the VC has invested

$ invested
I Post $ = Ownership Share

Pre-money valuation

I Definition: the value of the idea before the new money goes in

I Pre $ = Post $ − Money invested

DTR 13 / 50
What VC Investment looks like

Suppose an entrepreneur takes $10 for 5% of her company. What really happens?

VC and Entrepreneur agree to a “terms sheet" which specifies corporate

governance rights, control rights, and amount of equity received for the amount of
money being provided

VC injects capital into the firm, receives a special type of security called
Convertible preferred equity

I CP receives interest like a loan

I Converts to common equity at a “conversion price"

I Balances “downside protection" when things go wrong with share in upside of firm’s
value

DTR 14 / 50
VC Securities
VCs typically use convertible preferred equity or participating preferred equity when
they invest in a startup
Initially structured as debt with accrued interest
“Liquidation rights" mean that the holder is entitled to some multiple of their
investment back before others get anything
CP: this right is surrendered if the security is converted into equity
An example:
I Firm has 100 shares outstanding–80 common shares, 20 cp shares
I CP convert to 1.8 shares of common but have a face value of $10 each
I CP is thus worth
F $200 as debt
F 31% of the company as equity

If participating, then the liquidation right is first honored, then converted to equity
Incentives
I VCs: this is downside protection
I Management: only gets paid well for big exits

DTR 15 / 50
 VC FUNDS

DTR 2/5
What is a VC Investor?

Uni.% The%FUND%

$$%

Carry%
Calls,%Fees% General%%
Pensions%
Distribu?ons% Partner%

$$%

Carry%
Fam.%

Limited%Partners% Por.olio%%
Companies%

DTR 3/5
Fund Lifecycle

Most funds have a 10 year life, include provisions to extend beyond 10.

New
Investments

Follow-on
Investments

Exit/
Wind down

0 5 10 15

DTR 4/5
Compensation Basics
How do VC Investors Earn Money?

Management fees

I Typically 1.5% to 2.5%

I Fee reductions common as fund gets older

Carried interest

I Typically between 20% and 30% of net return

I Often cannot be earned until fund’s whole invested capital is returned to Limited
Partners

DTR 5/5
 HOW DO VC’S VALUE BUSINESSES?

DTR 16 / 50
The Cruel Math of Venture Investing
Why are VC hurdle rates so high?

A VC who invests LPs money for T years must earn a return based on the
expected payout

Cash
| {z In} (1 + r )T = p × Cash Out
| {z } | {z }
VC invest LP required return Expected Outcome

This equation can be used to find the cash-on-cash return required by the VC

This accounts for idiosyncratic risk as well as expected return

Cash Out (1 + r )T
=
Cash In p
We can also express the cash-on-cash return as a hurdle rate

r s
T Cash Out T (1 + r )T
Hurdle Rate = −1= −1
Cash In p

DTR 17 / 50
 The VC METHOD

DTR 18 / 50
The Simplified VC Method
What determines how much equity they take?

1 What is the required investment today? ( = $100 )

2 What is the exit valuation for this company? (=$20,000)
I How do we estimate this number???

3 What is the cash multiple we have to earn?

I If r=15%, T=5 yrs, p=10%, then Hurdle Rate is 82%; C-on-C is 20

4 Discount the exit by the hurdle rate:

Exit valuation
NPV =
hurdle rate
5 This is today’s NPV of the entire company. In our example, NPV=$1,000
6 How much of this do you need to own in order to break-even on required
investment?

Note: this calculation overlooks the effect of later investment rounds coming in

DTR 19 / 50
Alternative Formulations

How large does an exit have to be to justify a $10M investment for a 28%
ownership if we expect to wait 5-7 years for an exit and our current ownership will
be diluted 50% before an exit occurs?

How much equity should we negotiate for a $10m investment if we expect to wait
3-5 years for an exit that will be priced at an 11X EBITDA multiple on 100M in
EBITDA? What does this depend on?

DTR 20 / 50
 UNDERSTANDING TERMS SHEETS

DTR 21 / 50
Main Terms Sheet Provisions
Valuation:
I Pre-money value
I round size

Governance
I Board Seats
I Preferred Voting Rights (Veto Rights)
I Option pool: incentive current and future management

Exit
I Anti-dilution protection: protect against future value decrease in later funding
I Dividends: seldom cash, but can affect value at liquidation
I Liquidation preferences and participation

Others
I Drag-along versus tag-along rights
I Piggy back versus demand registration rights
I Pay-to-play
I lockup

DTR 22 / 50
 UNDERSTANDING OPTION POOLS

DTR 23 / 50
Option Pool

Provides incentives for management

Size of the option pool depends on stage and size of investment

Typically range from 10% to 20% of the total shares outstanding

Standards differ across sectors and over time

When do new options go in:

I Before the raise or after?

I Referred to as options in the pre-money vs. post-money

DTR 24 / 50
Accounting for the Option Pool
Is it in the Pre or in the Post?

Founders own 2M shares, raise an additional $1M for 40% ownership. New money
requires 18% option pool.

With no option pool, VC would get 1,333,333 shares

Options are in the PRE:
I The trick: Options come completely out of the founders pocket. He doesn’t own 60%.
2M
He owns 42%. New total shares outstanding is 0.42 = 4, 761, 905
I Venture investor receives convertible shares worth 1,904,762 shares of common on a
fully diluted basis
I Options then equal 18% of that: 857,143. Requires 857,143 newly issued options.

In the POST:
I Previous example takes down pre money by 0.18 * 2.5M.
I Post money splits the 18% on a 60/40 basis between founder and new investor.
I Ownership fractions are 18%, 32.8%, 49.2%
I In this scenario there would be 4M shares total, 720,000 options.

DTR 25 / 50
Exercise
Consider a company founded with 1m shares of common equity, split amongst the
founders. A year later the company raises $3M of Series A funding at a $1M
pre-money valuation. At this time they also established an option pool of 10% of
post-money shares outstanding, taken out of the post-money valuation of the firm. Two
years later they raise a Series B round from the same investors. The company is
valued at $6m before the $9 M Series B capital raise.

1 How many shares outstanding are there, on a fully diluted basis (i.e., including the
effect of the option pool) after the Series A round?
2 How large is the option pool in terms of the number of shares on a fully diluted
basis?
3 How many shares are outstanding after the B round?
4 What is the price per share of the Series B round?
5 What fraction of the total post-money value of the company after series B does the
option pool represent?

DTR 26 / 50
 UNDERSTANDING ANTI-DILUTION

DTR 27 / 50
Anti-Dilution Protection

Protects shares in the case of a future down-round

When new shares are issued at a lower price

Lowers the price at which an old share converts to common (rather than issue
more shares)

Flavors of anti-dilution

I Full ratchet: if a single share issues at a lower price, all covered shares change to that
price

I Weighted average: old price adjusts partially to new price depending on relative
amount of capital in each raise

Where is anti-dilution protection appropriate?

DTR 28 / 50
Alternative Anti-Dilution Calculations
Weighted Average versus Full Ratchet

Full Ratchet: Easy to calculate, hard to stomach

New Conversion Price = Old Conversion Price

Weighted Average: trickier to calculate, easier to stomach:

Old shares + Would Be New Shares

New Price = Old Price ×
Old shares + New Shares

New Money In
where WBNS = Old Price

DTR 29 / 50
A Weighty Example

Series A pays $100 for 20 shares ($5 conversion price)

Scenario 1: Series B puts in an additional $100 but gets 50 shares ($2 price)

20 + ( 100
5
=)20 4
New Price = $5 × = $5 × = 2.86
50 + 20 = 70 7

Scenario 2: Series B puts in an additional $300 at a $2 conversion price

20 + 300
5
= 60 80
New Price = $5 × = $5 × = 2.35
150 + 20 = 170 170

Scenario 3: Series B puts in an additional $100 at a $0.5 conversion price

20 + 20 40
New Price = $5 × = $5 × = $0.91
220 220

DTR 30 / 50
 ANGEL INVESTORS

DTR 31 / 50
Who Are Angels?

Term comes from financiers of early Broadway shows

Typically refers to high net worth individuals

SEC Rule 501 defines “Accredited Investor" as

I Net Worth > $1 million

I Annual Income > $200K for last 2 yrs, or joint income > $300K

Federal Reserve Board’s Survey of Consumer Finances suggests there are about 10
million qualified households. Far, far fewer are investors, yet this market is large
compared to the VC market.

DTR 32 / 50
What do Angels do?

Invest in unregistered securities offerings

Primarily to support pre-seed, seed and very early stage companies

Round Size Def’n.

Seed $250K-$750K Prove a concept, build an MVP
Early Stage $2-3M Pre-revenue

DTR 33 / 50
Some Success Stories

Amazon.com

I 8/1995: Two angels invest $54K. At IPO in 5/97, this was worth $7.6M.

Some other famous examples:

I Bell Telephone (1874),

I Ford Motors (1903),

I Apple (1977),

I Pete’s Brewing (1986)

DTR 34 / 50
Angel returns

DTR 35 / 50
 ANGEL Securities

DTR 36 / 50
 Angel Contracts

How Angel Investments Work

Many Angel investments are supported by two legal documents:

Note Purchase Agreement

I Sets the rules for who is investing and who is receiving investment, what constitutes
change of control, bankruptcy, default, etc.

Promissory Note or Convertible Note

I Actually describes the security that the investor is receiving when they make an
investment

I Key parameters: investment amount, interest or dividend, conversion, cap

Increasingly, Convertible Notes are being replaced by SAFEs (Simple Agreements for
Future Equity)

DTR 37 / 50
 Angel Contracts

Debt versus Equity

What’s the difference between a Convertible Note and a SAFE?

SAFE: an equity security. Technically a warrant that earns accrued dividends.

Convertible Note: a debt security that earns accrued interest.

As a practical matter the distinction isn’t so important because in the event that the
startup fails to raise follow on financing, the difference between being a debt holder or
an equity holder isn’t so important: both securities are probably worthless.

DTR 38 / 50
 Angel Contracts

ANGEL Term Sheets

DTR 39 / 50
 Angel Contracts

Key Investment Terms

This Convertible Promissory Note is one of the Notes referred to in, and is executed
and delivered in connection with, that certain Note Purchase Agreement, dated as of
[date] (as amended from time to time, the “Purchase Agreement"), by and among
Borrower, Lender and the other parties to such agreement. Additional rights of Lender
are set forth in the Purchase Agreement. Capitalized terms used in this Note without
definition will have the meanings given to such terms in the Purchase Agreement.

1 Principal Repayment. Unless this convertible promissory note (the “Note") has
been converted in accordance with the terms of Section 4 below, and subject to
acceleration as provided in this Note, the outstanding principal amount of the Loan
and all unpaid accrued interest will be fully due and payable in cash twelve (12)
months from the date of this Note (the “Maturity Date").

2 Interest Rate. Borrower promises to pay interest on the outstanding principal

amount hereof from the date hereof until payment in full, which interest will be
payable at the rate of eight percent (8%) per annum. Interest will be calculated on
the basis of a 360-day year for the actual number of days elapsed.

DTR 40 / 50
 Angel Contracts

Automatic Conversion

Notwithstanding the provisions of Section 1, in the event that the Borrower is-
sues and sells shares of any series of its Preferred Stock on or before the Ma-
turity Date raising an aggregate of $400,000 or more (a “Qualified Financing”),
then, the outstanding principal balance of (and any unpaid accrued interest
under) this Note will automatically convert in whole without any further action
by the Lender into that number of shares the series of Preferred Stock issued
in the Qualified Financing (the “Shares") as is equal to the unpaid principal
balance (and unpaid accrued interest, if elected) of this Note as of the closing
of the Qualified Financing divided by the multiple of (i) the per share purchase
price of the Shares paid by the investors purchasing such stock and (ii) eighty
percent (80%) (a discount of twenty percent (20%), with any fraction of a Share
rounded down to the next whole Share, and otherwise on the same terms and
conditions as given to such investors. Borrower will pay in cash the fair market
value of any fraction of a Share.

DTR 41 / 50
 Angel Contracts

Conversion Math

As a Note-holder, you will receive

$ invested
# shares =
0.8 × Next Series Share Price

number of shares in exchange for the money you invested in the company as an angel
investor. E.g., assume that you put in $400,000 into a convertible note and then one
year later the company raises Series A funding at $5 share. You receive 100,000
shares instead of the 80,000 that a Series A investor would have received for that
much money.

DTR 42 / 50
 Angel Contracts

Capped Conversion Prices

DTR 43 / 50
 Angel Contracts

Capped Conversion Prices

What if the value of the company is very high in the next financing round?

I This causes the number of shares received to be low

I Effectively the angel investor is diluted

To protect the angel investor against this possibility, the term sheet will impose a
cap

I A maximum pre-money valuation implies a capped conversion price

I A capped conversion price guarantees a minimum number of shares

DTR 44 / 50
 Angel Contracts

The Cap

DTR 45 / 50
 Angel Contracts

Simple Translation

As a Note-holder, you will receive the larger of

$ invested
# shares =
0.8 × Next Series Share Price

number of shares in exchange for the money you invested in the company as an angel
investor.

OR

$ invested
# shares =
Capped Price

Where capped price is the price per share of assuming the company had a $10 million
pre-money valuation.

DTR 46 / 50
 Angel Contracts

An Example

One year ago, you invested $100,000 in a SAFE with a 8% annual dividend. The
company has 10 million shares outstanding. A qualified financing event arrives:

$6 million invested on a $20 million pre-money valuation.

They get 3 million shares.

You get
108, 000
67, 500 shares =
1.60

But wait! You have a share price capped by a $10 million pre-money valuation!

Instead of a $2 per share price, the capped price is $1/share.

You get
108, 000
108, 000 shares =
1.00

DTR 47 / 50
 Angel Contracts

CONCLUSION

DTR 48 / 50
 Angel Contracts

Sources of Capital for Startups

How important are the various arrows?

Corporate VC
Venture Capital
Venture Capital

n
io
at
Venture Capital
ic
nd
Sy

Entrepreneurs

Angel Investors Banks

Strategic
Alliances

DTR 49 / 50
 Angel Contracts

Sources of Capital for Startups

Two Critical Lessons

1 A $1 is not just a $1: from whom you raise money can be as important as how
much you get
I Investors can be important business leads who can help you build your business; they
are not just there to plug holes in a cash flow statement (although they might be)
I These “value-added" services end up costing more in terms of greater loss of control,
of ownership (but sometimes are worth it)
I Some businesses are not well suited to some types of investors

2 Timing is everything
I Investors specialize in certain points of the lifecycle of a business
I It takes time to build relationships that lead to funding outcomes
I Capital providers are often complements, not substitutes
I Raising too much money too early can be deadly

DTR 50 / 50
PREFERRED EQUITY
David T. Robinson
Duke University’s Fuqua School of Business
 Back to the Terms Sheet

The term sheet will specify:

a number of shares being purchased
for an amount of money being invested

The Securities purchased will often include:

dividends that accrue unpaid until a liquidation event or
redemption occurs
a liquidation preference
participation rights after liquidation preferences have
been satisfied
 Key Features
Liquidation preference:
we get paid first
Referred to as “times money”, e.g. 1x is typical
Typically includes unpaid dividends
Senior to other series vs. pari passu

Participation rights:
After liquidation preferences are paid
Typically capped for total return (times money)
 Liq. Preferences and Participation

In the event of any liquidation, dissolution or winding up of the

Company, the proceeds shall be paid as follows:
Liquidation Preference:
First pay [_____] times the Original Purchase Price plus
accrued dividends on each share of Series A Preferred.
Thereafter, Series A Preferred participates with Common Stock
pro rata on an as-converted basis until the holders of Series A
Preferred receive an aggregate of [_____] times the Original
Purchase Price (including the amount paid pursuant to the
preceding sentence).

A merger or consolidation (other than one in which stockholders

of the Company own a majority by voting power of the
outstanding shares of the surviving or acquiring corporation)
and a sale, lease, transfer, exclusive license or other disposition
of all or substantially all of the assets of the Company will be
treated as a liquidation event (a “Deemed Liquidation Event”),
thereby triggering payment of the liquidation preferences
described above [unless the holders of [___]% of the Series A
Preferred elect otherwise].
 Conversion Rights

The Series A Preferred initially converts 1:1 to Common Stock at

any time at option of holder, subject to adjustments for stock
dividends, splits, combinations and similar events and as
described below under “Anti-dilution Provisions.”

The Series A Preferred initially converts 1:1 to Common Stock

Optional Conversion: at any time at option of holder, subject to adjustments for stock
dividends, splits, combinations and similar events and as
described below under “Anti-dilution Provisions.”
 Mandatory Conversion

Each share of Series A Preferred will automatically be converted

into Common Stock at the then applicable conversion rate in the
event of the closing of a underwritten public offering with a price
of [___] times the Original Purchase Price (subject to adjustments
for stock dividends, splits, combinations and similar events) and
[net/gross] proceeds to the Company of not less than $[_______]
(a “QPO”), or (ii) upon the written consent of the holders of
[__]% of the Series A Preferred.
Mandatory Conversion: Each share of Series A Preferred will automatically be
converted into Common Stock at the then applicable conversion
rate in the event of the closing of a [firm commitment]
underwritten public offering with a price of [___] times the
Original Purchase Price (subject to adjustments for stock
dividends, splits, combinations and similar events) and
[net/gross] proceeds to the Company of not less than $[_______]
(a “QPO”), or (ii) upon the written consent of the holders of
[__]% of the Series A Preferred.
CAPITALIZATION TABLES
David T. Robinson
Duke University’s Fuqua School of Business
 Blue Devil Enterprises
Founders have 3M shares prior to first round

Raise $5M Series A round at a $5M pre-money

$3M from VC 1, $2M from VC 2
1x liquidation preference to common, 3x cap

Before the round is raised, option pool created totaling 20% of the
post-money capitalization of the firm

Raise $15M Series B round at a $15M pre-money

No further options in round
Half comes from VC 1, remainder 60/40 between VC 2 & 3
1x liquidation preference to A and common, 3x cap
 Blue Devil Enterprises

Common Series A Series B Fully

Shares % $ Shares % $ Shares % Diluted %
VC 1 $ - 0%
VC 2 $ - 0%
VC 3 $ - 0%
Total Preferred $ - 0%

Founders 3 100% 3 100%

Options 0% 0 0%

Total Shares 3 3 100%

Price/Share

Founders initially own 100% of the firm

CAPITALIZATION TABLES
David T. Robinson
Duke University’s Fuqua School of Business
 Blue Devil Enterprises

Common Series A Series B Fully

Shares % $ Shares % $ Shares % Diluted %
VC 1 $ - 0%
VC 2 $ - 0%
VC 3 $ - 0%
Total Preferred $ - 0%

Founders 3 100% 3 100%

Options 0% 0 0%

Total Shares 3 3 100%

Price/Share

Founders initially own 100% of the firm

 Option Pool

Founders Series A Founders Series A

Options Options

Pre-money Post-money
CAPITALIZATION TABLES
David T. Robinson
Duke University’s Fuqua School of Business
 Blue Devil Enterprises

Common Series A Series B Fully

Shares % $ Shares % $ Shares % Diluted %
VC 1 $ 3.00 3 60% $ 3.00 30%
VC 2 $ 2.00 2 40% $ 2.00 20%
VC 3 $ - 0%
Total Preferred $ 5.00 5 100% $ 5.00 50%

Founders 3 60% 3 30%

Options 2 40% 2 20%

Total Shares 5 5 0 10 100%

Price/Share $ 1.00

Founders now own 30% of the firm

Series A: 1x preference to Common, 3x cap on participation
CAPITALIZATION TABLES
David T. Robinson
Duke University’s Fuqua School of Business
 Blue Devil Enterprises

Common Series A Series B Fully

Shares % $ Shares % $ Shares % Diluted %
VC 1 $ 3.00 3 60% $ 7.50 5 50% $ 8.00 40%
VC 2 $ 2.00 2 40% $ 4.50 3 30% $ 5.00 25%
VC 3 $ 3.00 2 $ 2.00 10%
Total Preferred $ 5.00 5 100% $ 15.00 10 80% $ 15.00 75%

Founders 3 60% 3 15%

Options 2 40% 2 10%

Total Shares 5 5 10 20 100%

Price/Share $ 1.00 $ 1.50

Series B: 1x preference to A and Common, 3x cap on participation

Series A: 1x preference to Common, 3x cap on participation
 Fully Diluted Cap Tables

What does “Fully Diluted” mean?

Assume all warrants and options are issued and exercised

Assumes all convertible equity has converted to common

Is this necessarily true?

There usually are unissued options in the pool
If the distribution is low, options and/or warrants may not
exercise