Venture capital and the finance of innovation 2nd edition metrick solutions manual by catherine.ayala881

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Teaching Notes to accompany Venture Capital and the Finance of Innovation

Chapter 8 Term Sheets CHAPTER OUTLINE 8.1

The Basics 8.1.1 Investors 8.1.2 Price Per Share 8.1.3 Pre-Money and Post-Money Valuation 8.1.4 Capitalization 8.2 The Charter 8.2.1 Dividends 8.2.2 Liquidation Preference 8.2.3 Voting Rights and Other Protective Provisions 8.2.4 Mandatory Conversion 8.2.5 Redemption Rights 8.3 Investor Rights Agreement 8.3.1 Registration Rights 8.3.2 Matters Requiring Investor-Director Approval 8.3.3 Employee Stock Options 8.4 Other Items 8.4.1 Rights and Restrictions 8.4.2 Founders’ Stock Summary Key Terms Exercises

KEY TERMS Term Sheet, Charter, Investor Rights Agreement Expropriation Rounds Series A investment $investment Original purchase price (OPP), Aggregate purchase price (APP) Copyright © 2011 John Wiley & Sons, Inc.

Fully diluted basis, fully diluted share count Capitalization table Proposed ownership percentage Tranch Pre-money valuation, post-money valuation Deemed liquidation event Dividend preference

Chapter 8 - 1

Teaching Notes to accompany Venture Capital and the Finance of Innovation

Stock dividends = payment-in-kind (PIK) dividends Accrued cash dividend Cumulative dividends, noncumulative dividends Simple interest, compound interest Liquidation preference, 2X (3X, 4X, etc.) excess liquidation preference Down round Qualified public offering (QPO) Redemption rights Restricted stock

Registration rights, demand registration rights, S-3 registration rights, piggyback registration rights Rule 144, Rule 144A In-kind distributions Qualified Institutional Buyers (QIBs) Lockup Step vesting, cliff vesting Transfer restrictions, take-me-along = tag-along, right of first offer, right of first refusal, drag-along

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Teaching Notes to accompany Venture Capital and the Finance of Innovation

TEACHING NOTES 8.1

The Basics

Students are exposed to the basic information presented in a term sheet. To better understand this content, they should know the following terms: rounds, Series A investment, $investment, fully diluted basis, fully diluted share count, proposed ownership percentage, tranches, original purchase price (OPP), aggregate purchase price (APP), pre-money valuation, post-money valuation, common stock, and preferred stock. As discussed in Chapter 1, VCs tend to invest in rounds. A first-round investment is designated as Series A, a second-round investment as Series B, and so on. The chapter begins by presenting a sample term sheet for a Series A investment. Term sheets are broken down into sections, with each section providing a summary for a longer legal document that will be executed at closing. Section 8.1 provides the basic opening information of a sample term sheet. Investors – This section lists the round’s investors, the dollar amounts of their investment ($investment), and the number of shares they will receive. The implied ownership percentage, given in parentheses, is calculated on a fully diluted basis. This means the reported figure represents the ownership percentage assuming all stocks have been converted and all options exercised. We refer to this number as the proposed ownership percentage, as the number is negotiable. Price Per Share – The price per share is also called the original purchase price (OPP). With one security type, OPP is simply the purchase price divided by the number of shares. The book uses the term aggregate purchase price (APP) to refer to the price paid for all shares of one security type, where APP = OPP * shares purchased. APP = $investment when there is only one security type. Chapter 9 will analyze the complications that arise with multiple security types. Chapter 9 also discusses the importance of knowing the exact division of each $investment into the APP for each security in the case of multiple securities. Pre-Money and Post-Money Valuation – The post-money valuation, akin to market capitalization, represents the value of the company after the investment round. The pre-money valuation can be thought of as market capitalization of the company before the VC investment. • Post-money valuation = $investment / proposed ownership percentage = Price-per-share * fully-diluted share count

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Teaching Notes to accompany Venture Capital and the Finance of Innovation

• Pre-money valuation = Post-money valuation - $investment = Price per share * pre-transaction fully diluted share count Notably, these calculations do not differentiate between preferred and common stock. Thus, comparing the valuations to market capitalization is not entirely appropriate, as they do not reflect the true market value of the company. Capitalization - The details of fully diluted share count are given in the capitalization table, which outlines the capital structure of the company. The founders and employees hold common stock, while VCs typically purchase some form of preferred stock. Chapter 9 discusses the possible security types in detail.

8.2

The Charter

Students should be able to define the following terms: charter, dividend preference, accrued cash dividends, stock dividends or payment-in-kind (PIK) dividends, cumulative dividends, noncumulative dividends, simple interest, compound interest, deemed liquidation event, liquidation preference, excess liquidation preference, antidilution protection, down round, qualified public offering (QPO), redemption rights. Section 8-2 exposes students to the Charter section of a sample term sheet. The Charter establishes the rights, preferences, privileges, and restrictions of each class and series of the company’s stock. Dividends – Preferred stock in VC transactions rarely pays cash dividends, because the companies generally lack excess cash. However, VCs have adopted alternative dividend structures. Preferred stockholders might receive accrued cash dividends payable upon a deemed liquidation event. Alternatively, preferred stockholders may receive dividends in the form of additional stock. Some term sheets impose a dividend preference, which stipulates that the company cannot pay dividends to common shareholders without first paying preferred shareholders. Liquidation Preference – The liquidation preference section of the charter describes different investors’ places within the capital structure hierarchy. When the company is sold, merged, or shut down (a deemed liquidation event), the proceeds are first distributed to bondholders, then to preferred shareholders, and, finally, common shareholders. With multiple rounds, later rounds typically get their money back first. In some cases, investors negotiate excess liquidation preferences. These investors have liquidation preferences of more than their APP of the preferred shares.

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Teaching Notes to accompany Venture Capital and the Finance of Innovation

Voting Rights and Other Protective Provisions – Many provisions in term sheets can be understood as VCs (the minority shareholders) protecting themselves from expropriation by the majority shareholders. Another concern of VCs is the threat of a down round. A down round is a round that gives the company a lower valuation than the one given in the previous round. To address this concern, VCs typically add some sort of antidilution protection. Chapter 9 addresses antidilution provisions in detail. Mandatory Conversion – Mandatory conversion events trigger the conversion of convertible preferred stock. For example, if a public offering meets certain thresholds (qualified public offering), the convertible shareholders must convert. Redemption Rights – A VC may attempt to make their initial investment redeemable under certain conditions. Such rights are rarely exercised due to the legal challenges of doing so.

8.3

Investor Rights Agreement

Students should be able to define the following terms: restricted stock, registration rights, demand registration rights, S-3 registration rights, piggyback registration rights, Rule 144, Rule 144A, in-kind distributions, Qualified Institutional Buyers (QIBs), lockup, step vesting, cliff vesting. Registration rights – These rights give investors the power to sell some of their shares in a registered transaction: an SEC approved transaction on a public exchange. These rights come in the following strengths (listed from strongest to weakest): demand registration rights, S-3 registration rights, and piggyback registration rights. Matters Requiring Investor-Director Approval – These rights protect minority investors from possible expropriation by managers and other investors. Employee Stock Options – Typically key employees receive shares or options to buy shares as part of their compensation. Such shares are usually earned over time, referred to as a vesting period.

8.4

Other Items

Students should understand the ways the term sheet incentivizes founders to stay at the company and work hard.

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Teaching Notes to accompany Venture Capital and the Finance of Innovation

Transfer restrictions prevent founders from selling their shares prematurely. VCs also include a buyback right on founders’ stock. This right allows the VC to repurchase the founders’ shares at cost in the event the founder has been dismissed from the firm “for cause”.

SUGGESTED ANSWERS TO EXERCISES 8.1 True, False, or Uncertain: After a portfolio company has an IPO, the VCs are free to sell their stock in this company in the public market. False Please see Excel Solutions for the reasoning behind this answer.

8.2 EBV is considering a $6M Series A investment for 6M shares of CP at $1 per share. The proposed capitalization table for Newco is as follows: (a) What are the OPP and APP for the Series A? (b) What is the fully diluted share count? (c) What is the proposed ownership percentage? (d) What is the post-money valuation? (e) What is the pre-money valuation? (a) OPP is $1 and APP is $6M (b) 24M shares post-financing (c) 25% ownership by Series A (d) $24M post-money valuation (e) $18M pre-money valuation Please see Excel Solutions for the full, worked solution to this exercise.

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