Entrepreneurial

Finance Professor
FM 476 Juanita
Gonzalez-
Uribe
Weekly Planner
Quiz 4
 Today:
• Fast Ion, Part 1
• Deal structure
 Fast Ion
Part 1 (Staged Financing)
 Cap Table so far (Exhibit 2)
Series --> Series A1 ($ 4 M) Series A2 ($ 6 M)
Timing --> June 2008 September 2009
Share price --> $1.00 $1.50
• Why tranches?
Pre-Money --> $5,000,000 $13,500,000
Post-Money --> $9,000,000 $19,500,000
Number of
shares Ownership Value Number of shares Ownership Value
Common (Founders, Mgmt & 5,000,000 55.6% $5,000,000 5,000,000 38.5% $7,500,000
option pool)
Series A1 Investors
Ware Street Capital 1,500,000 16.7% $1,500,000 1,500,000 11.5% $2,250,000
Franconia Ventures 1,500,000 16.7% $1,500,000 1,500,000 11.5% $2,250,000
Bluelock Ventures 1,000,000 11.1% $1,000,000 1,000,000 7.7% $1,500,000
Series A2 Investors
Ware Street Capital 1,500,000 11.5% $2,250,000
Franconia Ventures 1,500,000 11.5% $2,250,000
Bluelock Ventures 1,000,000 7.7% $1,500,000
Series B Investors
Ware Street Capital
Franconia Ventures
Bluelock Ventures
Series B Investor
 Tranched Series A Decision Tree

Series B pre-
money
Meet A1 Pr(S2)
Value = 50
Milestone (S1)
Pr(S1)
Invest A2= $6
EV2 = $13.5
Note that valuations
Tranche A1= $4
1-Pr(S2) Failure (F2)
Value = 0
at each financing
EV1 = $5
(pre-money) 1-Pr(S1) Miss milestone round contain
Abandon
implied success
A1
probabilities
A2
 Tranched Series A Decision Tree

Series B pre-
money
Meet A1 Pr(S2)
Value = 50
Milestone (S1)
Invest A2= $6

Tranche A1= $4
Pr(S1)
EV2 = $13.5 Back out the
1-Pr(S2) Failure (F2)

EV1 = $5
Value = 0 success
(pre-money) 1-Pr(S1) Miss milestone probabilities
Abandon

A1 A2

EV2 if S1: EV2 = -6 + 50 Pr(S2) = 13.5 Implies Pr(S2)= 39%

EV1 = -4 + 13.5 Pr(S1) = 5 Implies Pr(S1)= 66.6%
 One-shot Series A investment

Compare to a
Series B pre-
single shot
Pr(S) = 0.39 x 0.667 = 0.26 money
Value = 50
investment
Series A • Use unconditional
Investment: 10
EV = ? success probability to
1-Pr(S) Failure obtain pre-money
Value = 0
valuation

One-shot investment
Abandonment option?

EV = -10 + 50 x 0.26 = 3
Abandonment option value = 5 - 3 = $2 million
 Cap Table so far (Exhibit 2)
Series --> Series A1 ($ 4 M) Series A2 ($ 6 M)
Timing --> June 2008 September 2009
Share price --> $1.00 $1.50
Pre-Money --> $5,000,000 $13,500,000
Post-Money --> $9,000,000 $19,500,000 • Why tranches?
Number of
shares Ownership Value Number of shares Ownership Value
Common (Founders, Mgmt &
• Why continue when
5,000,000 55.6% $5,000,000 5,000,000 38.5% $7,500,000
option pool) milestones are not met?
Series A1 Investors
Ware Street Capital 1,500,000 16.7% $1,500,000 1,500,000 11.5% $2,250,000
Franconia Ventures 1,500,000 16.7% $1,500,000 1,500,000 11.5% $2,250,000 → “Investor friendliness” affects
Bluelock Ventures 1,000,000 11.1% $1,000,000 1,000,000 7.7% $1,500,000
Series A2 Investors
early stage valuation
Ware Street Capital 1,500,000 11.5% $2,250,000
Franconia Ventures 1,500,000 11.5% $2,250,000
Bluelock Ventures 1,000,000 7.7% $1,500,000
Series B Investors
Ware Street Capital
Franconia Ventures
Bluelock Ventures
Series B Investor
Proposed Bridge
• Exhs. 4 and 5
• $5 million
• Pro-rata
•WSC: $1.875M
•Franconia: $1.875M
•Bluelock: $1.25M
• Price: same as A2, identical terms
• Oversusbcription and pay-to-play
• Milestones: hire new CEO and achieve A2 milestones missed
• If met, back on track for Series B (although a year later)
 $5M Bridge Financing
Pros
• Is technology fundamentally
sound?
• Why lack of progress? Solvable?
• Opportunity for the founder to
avoid failure?
• Opportunity for VC to grab a large
share of the firm?
• Value of the abandonment option
implied by the bridge?
Cons
• Throwing good money after bad?
• Cleantech falling out of favor among
investors?
• Sound milestones or too aggressive
given the long development cycles
in cleantech?
• Bad governance on the part of John
Davidson?
• Opportunity cost of $2.5 million?
 Bridge Financing Decision Tree

Series C pre-
Assumptions (and
Meet Bridge Pr(S2)
money
Value = 175
exhibits 2 and 4):
Milestone (S1) • Valuation and price:
Invest: 25
Pr(S1)
EV2 = 50
same as series A2
Bridge (Series B) 1-Pr(S2) Failure (F2) • Investment/valuation in
Investment: 5 Value = 0
EV1 = 19.5 case of S1: same as
(A2 post-money) 1-Pr(S1) Miss milestone Series B
Abandon

Use to calculate implied

Bridge Round Series B round success probabilities

EV2 if S1: EV2 = -25 + 175 Pr(S2) = 50 Implies Pr(S2)= 43%

EV1 = -5 + 50 Pr(S1) = 19.5 Implies Pr(S1)= 49%
 One-shot $30M Investment
Compare to a
single shot
Series C pre- investment
money
Pr(S) = 0.43 x 0.49 = 0.21
Value = 175
• $5M bridge + $25M
Bridge + Series B Series B
Investment: 30
EV = 6.75 • Use unconditional
1-Pr(S) Failure success probability to
Value = 0
obtain pre-money
valuation
One-shot investment

Abandonment option?
EV = -30 + 175 x 0.21 = 6.75

Abandonment option value = 19.5 - 6.75 = 12.75

 Original Cap Table (Exhibit 2)
Series --> Series A1 ($ 4 M) Series A2 ($ 6 M) Series B ($ 25 M)
Timing --> June 2008 September 2009 September 2011
Share price --> $1.00 $1.50 $3.85
Pre-Money --> $5,000,000 $13,500,000 $50,000,000
Post-Money --> $9,000,000 $19,500,000 $75,000,000
Number of
shares Ownership Value Number of shares Ownership Value Number of shares Ownership Value
Common (Founders, Mgmt & 5,000,000 55.6% $5,000,000 5,000,000 38.5% $7,500,000 5,000,000 25.6% $19,230,769
option pool)
Series A1 Investors
Ware Street Capital 1,500,000 16.7% $1,500,000 1,500,000 11.5% $2,250,000 1,500,000 7.7% $5,769,231
Franconia Ventures 1,500,000 16.7% $1,500,000 1,500,000 11.5% $2,250,000 1,500,000 7.7% $5,769,231
Bluelock Ventures 1,000,000 11.1% $1,000,000 1,000,000 7.7% $1,500,000 1,000,000 5.1% $3,846,154
Series A2 Investors
Ware Street Capital 1,500,000 11.5% $2,250,000 1,500,000 7.7% $5,769,231
Franconia Ventures 1,500,000 11.5% $2,250,000 1,500,000 7.7% $5,769,231
Bluelock Ventures 1,000,000 7.7% $1,500,000 1,000,000 5.1% $3,846,154
Series B Investors
Ware Street Capital 975,000 5.0% $3,750,000
Franconia Ventures 975,000 5.0% $3,750,000
Bluelock Ventures 650,000 3.3% $2,500,000
Series B Investor 3,900,000 20.0% $15,000,000

Series B investor carried interest, 33.3%, remains the same with the bridge
 Cap Table with Bridge Round
No Warrants or Pay-to-play
Series --> Bridge ($ 5 M) Series B ($ 25 M)
Timing --> December 2011 September 2012
Share price --> $1.50 $3.06
Pre-Money --> $19,500,000 $50,000,000
Post-Money --> $24,500,000 $75,000,000
Number of shares Ownership Round Investment Number of shares Ownership Round Investment
Common (Founders, Mgmt & option
5,000,000 30.6% $7,500,000 5,000,000 20.4% $15,306,122
pool)
Series A1 Investors
Ware Street Capital 1,500,000 9.2% $2,250,000 1,500,000 6.1% $4,591,837
Franconia Ventures 1,500,000 9.2% $2,250,000 1,500,000 6.1% $4,591,837
Bluelock Ventures 1,000,000 6.1% $1,500,000 1,000,000 4.1% $3,061,224
Series A2 Investors
Ware Street Capital 1,500,000 9.2% $2,250,000 1,500,000 6.1% $4,591,837
Franconia Ventures 1,500,000 9.2% $2,250,000 1,500,000 6.1% $4,591,837
Bluelock Ventures 1,000,000 6.1% $1,500,000 1,000,000 4.1% $3,061,224
Bridge Round
Ware Street Capital 1,666,667 10.2% $2,500,000 1,666,667 6.8% $5,102,041
Franconia Ventures 1,666,667 10.2% $2,500,000 1,666,667 6.8% $5,102,041
Series B Investors (assumption: WSC
and Franconia pro-rate Bluelock B and
C investments) 33.3%
Ware Street Capital 1,633,333 6.7% $5,000,000
Franconia Ventures 1,633,333 6.7% $5,000,000
Series B Investor 4,900,000 20.0% $15,000,000
Effect of bridge
No Warrants or Pay-to-play
Multiple on
BASE CASE Ownership at Exit Total Investment Total Return Investment
WSC 18.8% $11,250,000 $65,705,128 5.8
Franconia 18.8% $11,250,000 $65,705,128 5.8
Bluelock 12.5% $7,500,000 $43,803,419 5.8
Series B 19.0% $20,000,000 $66,666,667 3.3
Series C 9.5% $20,000,000 $33,333,333 1.7
Common 21.4% $74,786,325
Total 100.0% $70,000,000 $350,000,000

Multiple on
NO PTP or warrants Ownership at Exit Total Investment Total Return Investment
WSC 23.8% $16,250,000 $83,333,333 5.1
Franconia 23.8% $16,250,000 $83,333,333 5.1
Bluelock 6.8% $2,500,000 $23,809,524 9.5
Series B 19.0% $20,000,000 $66,666,667 3.3
Series C 9.5% $20,000,000 $33,333,333 1.7
Common 17.0% $59,523,810
Total 100.0% $75,000,000 $350,000,000
 Effect of bridge
No Warrants or Pay-to-play
BASE CASE IRR 2008 2009 2010 2011 2012 2013 2014 2015
WSC 45.0% ($1,500,000) ($2,250,000) $0 ($3,750,000) $0 ($3,750,000) $0 $65,705,128
Franconia 45.0% ($1,500,000) ($2,250,000) $0 ($3,750,000) $0 ($3,750,000) $0 $65,705,128
Bluelock 45.0% ($1,000,000) ($1,500,000) $0 ($2,500,000) $0 ($2,500,000) $0 $43,803,419
Series B 39.6% ($15,000,000) $0 ($5,000,000) $0 $66,666,667
Series C 29.1% ($20,000,000) $0 $33,333,333
Common

NO PTP or
warrants IRR 2008 2009 2010 2011 2012 2013 2014 2015 2016
WSC 38.6% ($1,500,000) ($2,250,000) $0 ($2,500,000) ($5,000,000) $0 ($5,000,000) $0 $83,333,333
Franconia 38.6% ($1,500,000) ($2,250,000) $0 ($2,500,000) ($5,000,000) $0 ($5,000,000) $0 $83,333,333
Bluelock 35.4% ($1,000,000) ($1,500,000) $0 $0 $0 $0 $0 $0 $23,809,524
Series B 39.6% ($15,000,000) $0 ($5,000,000) $66,666,667
Series C 29.1% ($20,000,000) $33,333,333
Common
Fast Ion: Closing Comments
• Multi-stage financing is best seen as a sequence of experiments, where each
stage of financing is tied to achieving a set of milestones
• Industries where experiments are expensive and not as discriminating will be
ones in which startups have lower initial valuations and lower step-ups across
rounds of funding
• Investment cycles in VC industry imply that there may be sector-specific
shocks to the availability of capital, making it hard for even promising startups
associated with certain sectors to access capital
• Information that comes back from early experiments is mixed: ventures have
met some milestones but not others, yet investors need to make binary
decisions based on incomplete information about whether to continue
funding a startup or whether to shut it down
 Terms
(Deal Structure)
Goals Plan
• Introduce the common • Why not straight
securities used in funding equity?
venture firms • Cash flow and control
• Gain an intuition of the rights
cash flow, control, and • Payoff diagram to
incentive consequences analyze terms
of different deal
structures
Negative cash flows
Why not use
standard
equity and
Entrepreneurs and Venture debt?
capitalists care about different
things
Entrepreneur:
• Build a successful business
• Raise enough money to fund the
venture
• Maintain as much value and
control of the company as
possible
• Get expertise and contracts to
grow the company
• Share some of the risks with
investors
• Financial returns from the
venture
VC:
• Maximize financial returns
• Ensure that portfolio firms
make sound
investment/management
decisions
• Participation in later financing
rounds if venture is a success
• Exit, i.e. sell the firm in IPO,
merger, strategic sale
• Build own reputation
• You come up with a promising but
risky idea for a social networking app
• You need $1.5 million to go to market Example
• A VC offers $1.5 million for 49.95% of
the company (you keep control rights)
Consider a
• The day after closing, Facebook offers new venture
to buy the company for $2 million backed with
straight equity
• If you accept
• You earn immediately $1 million risk-free
Do you sell and take the
risk-free $1 million?
Payoff Diagram
(represents how pie is shared)

Slope=1
(100% of the pie)

Liquidation
value
Payoff Diagram
(represents how pie is shared)

Slope=1 Common
(100% of the pie)
Your
Stock
payoff
You get 50.05% and VC
gets 49.95% of every
additional $1 of liquidation
value
Slope= 0.4995
VC payoff

Liquidation
value
 Payoff Diagram
(represents how pie is shared)
Common
Stock
Slope=1
(100% of the pie)
Your VC valued venture at its
payoff potential value
With equity finance,
entrepreneur earns $0.5
$2M per $1 of value: has
incentives to exit early
Slope= 0.4995 without achieving the full
$1M VC payoff potential of the venture

Liquidation
Facebook offer for $2M value
• Vesting period for shares owned
by the founder The VC solves
this problem
• Super majority provisions by adding
terms to the
• Preferred Stock contract
Preferred stock
• VCs typically purchase some variant of preferred stock rather than
common stock
• Preferred stock has liquidation preference over common equity (it
gets paid first)
• Preferred stock has a face value, generally equal to the cost basis
• In the example:
• Suppose VC had purchased preferred stock with face value of $1.5 million
• Then $1.5M would have been returned to the VC through redemption in case
of a sale to Facebook
 V: Liquidation Value
FV: Face Value of Preferred
Redeemable
(or Straight)
Your Preferred
payoff
Slope=1 Stock
Entrepreneur gets nothing
$1.5M
if the liquidation value is
below the face value of
VC payoff preferred (and gets every
$1 of value above it!)
FV = $1.5M V
Redeemable Preferred stock
• Redeemable preferred or “straight preferred” is preferred stock that
cannot be converted to common equity
• Its intrinsic value: face value plus any dividend rights it carries
• Behaves like deeply subordinated debt except
• Carries a negotiated term specifying when it must be redeemed by the
company (e.g. earlier of IPO or 5-8 years)
• Provides assurance liquidity event will occur before end of VC fund’s life
• Often combined with common stock
• Example: VC buys 49.95% for $1 and redeemable preferred for $1.5M

Why?
 Preferred
V: Liquidation Value
FV: Face Value of Preferred
Your
payoff
packaged with
Common
Slope=1 Entrepreneur gets nothing
if the liquidation value is
below the face value of
VC preferred (and gets every
$1.5M
payoff $0.5 of value above it)
Slope=0.4995
Incentivizes the VC to
FV V create value, compensate
for high fail rate
Catching up
• In the example, after VC is repaid $1.5M investment, you and VC
share equally in gains above $1.5M
• But you may find it unfair that you are not allowed to “catch-up” first
before VC starts sharing equally
• For example, you may view it as fair that VC gets the first $1.5M, but you get
the second $1.5M
• Subsequently each dollar split 50-50
• One possibility: convertible preferred
Convertible Preferred Stock
• Can be converted at the shareholder’s option into common stock
• In liquidity event (IPO/sale) will choose whichever is worth more (common at
IPO value or liquidation preference with accrued dividends)
• Most term sheets include automatic/mandatory conversion at IPO provided
the IPO price and proceeds are high enough

• Forces the shareholder to choose between taking returns through

liquidation feature or underlying common equity position
• Like debt OR equity, as opposed to debt AND equity
 V: Liquidation Value
FV: Face Value of Preferred Convertible
CV: Min firm value at
conversion
Entrepreneur
payoff
Preferred
VC will take liquidation
Slope=1
preference if V<$3M (as
with Facebook’s $2M
offer)

$1.5M VC converts if V>$3M

Slope=% common=0.4995 VC payoff Entrepreneur “catches
FV
up”
CV=$3M V
More Terms (Incentives)
• Convertible preferred reassures the VC that you will reject Facebook’s
offer at $2M
• However, VC is still concerned that you may be tempted to accept a
sale at a low valuation (say $3 million) instead of developing fully the
venture and aiming for an IPO
• Can add an extra feature to the terms of the convertible preferred:
• In the event of liquidation or sale (not IPO) the holder gets face value + equity
participation
• Called Participating Convertible Preferred Stock
 Participating
V: Liquidation Value
Convertible
FV: Face Value of Preferred Entrepreneur
payoff
Preferred
Same as Convertible
Preferred in case of IPO
Slope=1 Sale
Same as Preferred +
Common in case of private
IPO sale
$1.5M
Entrepreneur should ask:
Slope=% common VC payoff why discourage private
sales at high valuations?
FV V
 Participating
V: Liquidation Value Convertible
Entrepreneur
FV: Face Value of Preferred
payoff Preferred +
redemption
cap
Sale
$2.25M
$1.5M Maximum redemption
value (cap) of $2.25M in
Slope=% common VC payoff case of a sale
FV $3M V
 Participating
Convertible
V: Liquidation Value
FV: Face Value of Preferred Entrepreneur Preferred + 2x
payoff conversion
Before conversion:
1.5M+50%*(3M-1.5M)=$2.25M Same as Preferred +
After conversion: Common for any exit with
50%*$3M=$1.5M V<2x liquidation preference
Drop=$0.75M
Forced conversion for any
exit> 2x the liquidation
$1.5M preference
VC gets 150% of the face
Slope=% common VC payoff value of the preferred
(225/150) before starting to
FV V share with entrepreneur
$3M
Even More Terms – After the break!
• Vesting: entrepreneur’s stock is not “owned” until she has been with company for
a period of time (3-5y) or value accretion event occurs
• Prevents founder from opposing sale, but buyer concerned founder leaves
• Redemption rights: allows VC to put Preferred back to the company
• Force liquidity event, prevent “lifestyle” company, penalties if cannot redeem
• Anti-dilution provisions
• If additional funding raised at a price below the prior round VC’s price, VC’s conversion price
is lowered to protect against dilution
• Comes out of founders shares or (unprotected) earlier round investors
• Incentivizes founders to create value, prevents strategic expropriation
• Pay-to-play: Preferred holders lose anti-dilution provision if they do not participate in the
next round financing at lower price
Coming up Town Hall

Henry Philipson –
Beringea/ESG_VC