Distribution = Call option => Strike = Contributed Cap + Pref.
Return | If Return < Hurdle  Option is OTM (all $$ to LP) | If Return > Hurdle  Option is ITM (GP gets HIGHER return) *assume GP contribute little/no capital
PE: LBO History and Wave PE activities is cyclical
Taxonomy of Private Capital 1) VC invested at 1)
early stage: SEED (R&D in biochem, IT, pharma)  very
high uncertainty (idea to output, marketability of output)
STARTUP enterprise starts its own initial operation (put
option, stocks options, balance of control) 2) Early
Growth – usually the first phase of growth as founders
need capital to grow 2) Growth Capital (expansion fin)
usually at the fastest phase of growth, use to reduce gap
btw CF and $ needed, moderate risk level INTERNAL
GROWHT: Innovation, R&D EXTERNAL: more customers,
markets 3) Buyout (replacement fin): at the mature
stage, buyout firm will replace existing shareholders,
usually occur when firm face strategic decisions.
Objective of PE is to UNLOCK the potential value of the
firm. Risk is moderate. LBO/MBO diff? MBO is subset of
LBO where mgmt of the target firm offers to buy the firm
(Potential conflict of int. as mgmt. has insider info)
4) Turnaround (Vulture) fin occur at final stage
(decline, crisis). Very risky. Restructure Fin 
restructure debt with banks/suppliers Distressed Fin 
reorganized company through COURT (only diff)
Structure: Limited Partner(LP): Investors in the fund
General Partner (GP):
Mgmt of the fund | LP needs
to pledge committed capital,
then it’s going to be call
when a target is found:
‘Capital Call’
Principal-Agent Issues
(from Asymmetric info)
Moral Hazard: When a party take risk without having to
suffer consequenceslead to inefficiency in benefits from
risk allocation: happen after the deal is closed
Adverse Selection: When seller has more info than buyers
about some aspects of product qualityinefficiency in
price discovery: happen before the deal is closed
What Investor Care abt? 1) Team’s stability at partner’s
level 2) Investment strategy (Theme) 3) GP’s reported
IRR 4) Reputation 5) Multiples on previous funds [hinge
on performances] Target investment for PE’s firm
Strong stable CF, Good mgmt. team, Large asset based
Target for Publicprivate: Declining in liquidity (you can
pick them up cheap | Financial Constraint: Cannot raise
capital from market since no one cares | Low EBITDA
multiples | Low cost of capital Exit Channels: 1)
Reversed LBO (Private to Public) 2) SBO (Secondary
buyout)not the real exit 3) DIV recapitalization
DIV recap=raised debt to pay DIV to investors
LBO: Jensen (1986) – disciplining role of debt in Profit= Total Exit Proceed – Carried Interest Basis (CIB)
motivating managersadvantage in controlling agency CIB can be 1) EU style: based on whole fund basis – cal at
costs of free cash flow once when exited all the investment 2) US style: Cost Basis
EV and Equity Value (EqV) of Exited Investment+Mgmt.Fees paid (based deal by deal)
EqV = EV – Net Debt – minority interest Normally PE structure as 2/20 (2%mgmt fee and 20% carry)
Net debt = Debt – Cash&S/T investment Carry hurdle: Priority Return=Preferred return=hurdle return
Why LBO is based on EV not EqV? LBO GP gets no carry unless fund earns x%, no catch up=’true
uses lots of debt so debt is dynamic as it preferred return’ hurdle is there to reduce agency conflict
gets refinanced all the time Catch-up provision profit calculated absent ‘hurdle’ – if fund
Levered FCF (LFCF) = NI+D&A-CAPEX-ChangeNWC earns X%, GP gets Y% of additional returns up to 20% of
How to increase Equity Value 1) De-leveraging (pay down profit | Catch-up can be FAST,SLOW (100% VS 50%,80%)
the debt fore exit) 2) EBITDA expansion (operation but in the end you will get the same 20% carry
improvement, M&A, consolidation) 3) Multiple Expansion Why catch up? to incentivize GP’s performance to be a
Most important =EBITDA expansion because you can use function of total return not solely on the return in excess of the
it to pay down debt pref. return (tho LP get lower return compared to no catch-up)
Money Multiple (MM) for PE Waterfall distribution Align GP incentives and Pay Structure to
(495+525)/(250+40)=3.5 protect LP’s interests and maximize return | Set rules and
IRR=3.5^(1/6)-1 =23.22% procedures for DISTRIBUTION OF PROFITS
MM for management = Primary components: 1) Capital Return to LP 2) Preferred
130/10 = 13x IRR = 54%
Return 3) GP catch-up on Carry 4) Remaining split
Clawback: GP MUST return funds to investors from
Market Value of Debt (MVD)
• Diff from BV of debt overpayment of carry (only with US basis/ no issue for EU)
• Market price of debt (a) more than its carry% of cum. Net profit (over fund’s life) or
investor willing to buy for (b) any carried INT that ultimately doesn’t satisfy pref.ret hurdle
• Aka off-B/L obligations Distribution of profit Preferred Accrued Value f(p) =
To estimate MVD: f(p)=∑ 𝑪𝑪𝑪𝑪𝑪𝑪 ∗ (𝟏𝟏 + 𝒑𝒑)𝒏𝒏
• Think of debt as single CP p=preferred return (hurdle%), CF=Contribution m,n =period
bond, with CP = Debt. Int Exp
Alt1: Carry Caught-up Return (Rcc) = (p * u) / (u – c)
• Maturity=weighted AVG
maturity of debt u=Catch-up%, c=carried interest (of GP,%)
Alt2: u*x = c*(pd+x) x=Next dollar to be caught-up
pd=pref.return in $
EX: LP contributes $200M, Hurdle 10%, Fund worth $300 end of
Ex: Int.Exp=100k, Total debt=1M WeightAVG mat=6 yrs year, Carry 80/20 (LP/GP), Catch-up rate: 1) 100%, 2) 50%?
Current cost of debt =5% MVD =1.254M 1) 100% (FAST): f(p)=200*(1.01)1 =220M (220 VS 300ITM)
Influencing factors: INT, Company performance (CF), Rcc= (0.01*1)/(1-0.2)=12.5%  12.5%*200 = 25M | LP receive
Collateral value, Covenants first 20M (Pref. return) | Next dist. 25-20=5M  GP got 100% of
PE-Econ&Fin(Clss7): Fees structure, profit distribution 5M (GP caught-up) |Remaining 80/20 split, (100-25=75) LP gets
Committed Cap What LP pledge which will be ‘draw’ once 75*0.8=60 GP gets 75*0.2=15 | in total LP gets 20+60=80 GP
GP found target company (Capital Call) gets 5+15=20 2) 50%: f(p) same| Rcc=(.1*.5)/(.5-.2)=16.67%
Mgmt. Fee Have to be paid before even seeing performance 200*16.67%=33.33 | First 20 to LP, 33.33-20=13.33GP got
Why? Because it’s private, not public fund. LP has to 50% 6.67 LP got the rest 6.67| rest 100-33.33=66.67 80/20
entertain mgmt. fee as a cost of searching and finding split: LP gets 66.67*0.8=53.33 GP: 13.33 total LP=80 GP 20
info. as the private is much less transparent Clawback EX: Asset X (bought for 170) sold for 200 in Yr1
2 Basis 1)Invested Capital Basis: % original investment Asset Y(bought for 30) sold for 10 in year 2 | 80/20 carry, 10%
amt. 2)Net Invested Capital: excluding investment that
hurdle What is 1)Carry at yr1 , 2) yr2 1) f(p)=170*(1.1)=187 ITM
Profit=30 GP got 20%*30=6M(assume100%catch-up) LP 24M
already exitedFairer to LP
2) 10-30=-20 loss accrues to LP| At fund termination: Hurdle
Total mgmt. fees=lifetime fees, Investment
rate: 170*(1.1)+30(1.1)^2=223.3MPref.Return Accrual |
Capital=Committed Cap-lifetime fees
Carry: Fraction of profit that goes to GP (only if fund is ITM) LP gets (170+24+10)=204 GP Clawback =6M (return all)

High fee doesn’t matter as long as return is superiornet-of-fees return
Fees: High Avg. fee for PE| Fund terms depend on supply
and demand investor wants to be on TOP fund
Fees GP charged to PC: 1)Transaction Fees: c.2% of
Transaction value<$100M. 1% for the next 900M. 50% of
this used to offset mgmt. fees. 2)Monitoring Fees: c.0.4% p.a.
on firm value for 5yrs irrespective of actual length of inv, 80%
is used to offset mgmt. feeSCC just regulated, before this
GP use to charge this to PC with no offset with mgmt. fees
Coinvestment when GP allows their preferred LP to invest
alongside them in a PC to reduce fees. Findings: Fang,
Ivashinaproprietary data from 7LPs: Coinvestment
underperform. Direct investment outperform Jenkinson, Braun
Schemmerl33% of coinvestment outperform with limitation
1)Same hold true for deals does not offer coinvesment 2)
Return are highly positively skewed, most deals have worse
return that fund returns. Data only 1 LP Conclusion in yellow
Clss1: Entrepreneurial Fin. Entrepreneur: the pursuit of
opportunity beyond resources control | Opportunity implies
offering that is novel in the following ways 1) pioneer a truly
innovative product 2)Devising new biz model 3)create a better
/cheaper version of existing products 4)targeting an existing
products to new set of customers. Implies resource constraints
Venture creation’s impact on society: Job creation,
opportunity, Value created with exits [in tech, healthcare]
Customer Lifetime Value (CLV): use for 1) Acquire new
customer (worth the effort/at price?) 2)Retain existing ones
3)Fire one 4)Acquire entire customer base (what to pay?)
Cal CLV: Retention (r)=1-attrition (1 year always no effect)
st
1 2 3 4 5 4)Multiples of Earnings EBITDA multiple (growth, mkt size,
Initial Acquisition Cost 500 Margin 350 350 350 350 350
Net Margin (rev-cost) 350 w/attrition 350 315 284 255 230
Attrition Rate 10% PV 324 270 225 188 156
Cost of Capital 8% CLV 1,163
Period 5 yrs CLV net 663
PV of net customer lifetime value?
CLV Perpetual Estimate: CLV = Return/Churn (Churn=1-r)
CLV= Return/(Churn+Discount Rate)
CLV Implications: Be selective, acquire so long as CLV is +
Higher r, higher to pay to acquire | Investor like to see as
much recovery from fewer transactions | Customers are diff Cap
on 1) Retention profit potential 2) Acquisition recovery time
Financing Dilutive funding: Angels,VC,Acceralators Non-
dilutive: Self-funded, Friend&Fam,DEBT Mix: Crowdfunding Transaction PPS
Non dilutive funding: usually all pre-seed
Proforma FSFeasibility of your financial plan, 3yrs. Provide w/scenarios Redeemable PF always specifies when it must be redeemed
If Can’t reduction in conversion price/more Board Seats
Traction = initial progress and momentum a startup builds as it grows
Funding consideration: Funding: Who provide funds? BurnRate:Net Negative CF/Unit/time Runway:How much
Stage of Interest: Pre-seed; build MVP | Seed; Show traction time you have left until out of $$ 210K Burn rate 30K7m
build prototype | A Round; start to scale/build final product runwayFumeDate: no remaining runway |Clss4: VC Deals
INV amt: Pre-seed<500k Seed<$1.5M A-round <$5M Entrepreneur cares abt: 1)Build Successful Biz 2)Raise
Value added: Can investor add values to the biz? Fund size enough$ to fund venture 3)Maintain value and control 4)Get
How they make $$: What’s the motive? expertise/Contacts to grow company 5)Share risk w/investor
Round: sequence of investment in the same start-up Stage: 6)Financial returns from venture| VC cares: 1)Max $ return
Degree of biz maturity a start-up reaches when raising fund 2)Ensure PC make sound inv/mgmt. decisions 3)Participate
DEBT: Trade debt (AP), Credit card, Equipment Fin(lease), in later financing rounds if venture is a success 4)Achieve
Bank line of Credit, Gov loan, Convertible note (angels) liquidity(exit): sell/IPO/M&A 5)Build reputation2folds:
Issue: Int.has to be paid from CF, hard for start-ups | Require Attract good startup and good LP |Both care: 1)Success
collateral/Personal guaranteesunattractive to those with 2)Split of $return 3)Allocation of control rights 4) Liquidation
large personal assets| if secured by valuable assets Key terms: Preferred Stock 1)Redeemable(straight) PF
(A/R,INV,equipment) alternative to EQ fin for growth phase 2)Redeemable+commSt. 3)ConvertiblePF 4) 3+Participating
WC Financing: Line of credit loan 70% of A/R, Inv. Which Redeemable: Issuer(firm) redeemcall |Retractable:
specified in loan agreement, still need personal guarantee) investor driven(put): Redemption rights: prevent lifestyle Co.
Factor Financing factor receivable super high int.(~24%) 1) no convert, Div accrue 2) Downside protection+upside
Convertible Note(CN): use at early stage| used to delay potential 3) convert@pre-specified Conversion price/auto
the valuation of the firm| more like equity than debt convert@IPO 4) Best for VC: when IPO/Sale VC gets FV+EQ
Usually have 1) Discount 2) Cap pick one converted to the participation| Why payoff structure matters? AsymmetricInfo
lowest PPS highest#of shares | let x=conversion price Anti-dilution: down round1) Full Ratchet 2) Weighted AVG
then compared 1)use the lowest price/share for conversion, result in #of
with DISCOUNT shares that retain the investor’s original investment value
Equity Fin: Valueprice of transaction between willing 2) everyone gets diluted, fairer to founders
buyer and willing seller| in any specific case, determined by New Conv.Price=[(A+C)/(A+D)]*Initial Conv.Price
negotiation| ideally the negotiated value should reflect A=#of Common shares BF transaction C=#of shares to be
fundamental financial value (intrinsic value of the company) issued using initial Conv.Price D=#of shares w/ actual price
If valuation is too high: won’t be able to attract investors, New shares to initial investors (#)=(Initial Conv.Price/
your investor won’t be able to make good return as well New Conv.Price)*initial shares owned (#)
Too low: entrepreneur won’t retain enough equity to be Pay to Play provision: PF holder lose anti-dilution provision if
motivated to max. value  founders get less ownership they do not participate in next round financing at lower price
How 1)Value of Inputs (early stage start-up) 2)Comparable Liquidation Pref: only when winding up, common=1x
companies/transactions (But no 2 companies are the same) First Refusal: Give VC rights to buy shares offered by firm
3)Discounting for time and risk for some estimated FV (~DCF) before 3rd partyallow VC to prevent ownership dilution
Pre-emptive: Similar to first refusal, ends at time of IPO
risk, leverage affect multiple, macro: econ. cycle, dry powder) Currently: to invest 2x prorata ownership in later round
When we need to value the firm?Cash out(exit)/Raise $$ Control right: Voting rights/Board Seat(c.41.5% on AVG)
Pre-post money: Post = Pre-money + New investment Protective Provision: Approval for Sales/M&A,liquidation,
Pre-money Fully Diluted Capitalization (all PF,CN/ESOP/ Change in Corp Charter, Budget Changes, Appt./Fire CEO
options have been converted/exercised/issued) Commonly Exit Provision Tag(Minority)/Drag along(Majority forced
PPS = Pre-money Valuation/Pre-money fully diluted cap 3-4 Yrs Sale) Co-sale(VC exit @same rate & time as founding SH)
Option pool: mostly created pre$ (founders get diluted) Vesting Vesting: ’GoldenHandcuff’ prevent stock sale bf. some date
Dilutive Funding Before MHS Investment
Staged Capital Commitment (SCC) Role: 1)Control
FD Cap $M #Shares %own
Converitble Note(CN)
Founder 18.8 18.8 96.5% mechanism: investors can monitor the firm and shut
Principal 0.2 Amt(+int) 0.216
CN 0.2 0.678 3.5% down if poor success probabilities/option to abandon
6 Price(Disct) 0.80
Discount 20% Price(Cap) 0.32
Total 19.48 1 2)Signaling&Screening: allows founders to issue equity@
Post-money
Interest 4% CN received 0.678 more favorable price, VC to screen among entrepreneur
Founder 15.8 16.37 77.1%
Initial Price/Share 1 (#shares) Entrepreneur who confident abt their prospect will want
0.97 Pre$/FD (#shares)
ESOP 2.4 2.43 11.5%
CN 0.65 0.68 3.2% to defer raising capital until firm has passed some milestones
Option pool 12.5% of FD
MHS 1.7 1.76 8.3%
0.125*19.48 2.435 Shares
Total 20.5 21.2 100.0%