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© 2016 Fox Rothschild
IVC 3rd Annual High-Tech Seminar: Expanding Your Business into the US MarketLoren D. Danzis, Esq. February 9, 2016
US Venture Capital Activity
US Venture Capital Activity
Angel Funding
Angel Funding
U.S. Venture Capital Activity
Venture Capital Investment
U.S. Venture Capital Fundraising
$0
$2
$4
$6
$8
$10
$12
Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015
Quarterly U.S. VC Fundraising
U.S Venture Capital Fundraising
$0
$20
$40
$60
$80
$100
$120
US VC Fundraising ($B)
20 Year Average
Annual U.S. VC Fundraising
$9 $12$18
$31
$53
$101
$39
$10 $9
$18
$30 $31 $30
$25
$16 $13$19 $20 $18
$31$28
Source: Thomson Reuters & National Venture Capital Association
U.S. Venture Capital Fundraising
Venture Backed M&A Market
0
100
200
300
400
500
600
700
800
900
2011Q1
2011Q2
2011Q3
2011Q4
2012Q1
2012Q2
2012Q3
2012Q4
2013Q1
2013Q2
2013Q3
2013Q4
2014Q1
2014Q2
2014Q3
2014Q4
2015Q1
2015Q2
2015Q3
2015Q4
Mergers & Acquisitions
Venture Backed IPO Market
0
100
200
300
400
500
600
700
800
900
2011Q1
2011Q2
2011Q3
2011Q4
2012Q1
2012Q2
2012Q3
2012Q4
2013Q1
2013Q2
2013Q3
2013Q4
2014Q1
2014Q2
2014Q3
2014Q4
2015Q1
2015Q2
2015Q3
2015Q4
Venture Capital Exits
2015 Billion Dollar Club
10
5 53 2 2 2 3
59 11
2023
28
61
88
$1B Private Companies
Selection Bias in VC
Source: Greenspring Associates Fall Investor Meeting
Investment Terms
The 10most frequently
negotiated provisions in a term sheet
1. Valuation2. Control
3. Size of the ESOP4. Liquidation preference5. Dividends6. Anti-Dilution protection
7. Drag along8. Repurchase and co-sale rights
9. Redemption10. Vesting and Employment Agreements
A great company is not necessarily a great investment. Terms drive ROI.
Provision 1: Valuation
MethodologiesThe venture capital method (5‐year terminal value to get 10X)
Discounted cash flow or net present value
More art than science
Share price is calculated on a pre-money basis. Ownership stakes are calculated on a post-money basis
Existing shareholders tend to
focus on the pre-money valuation
Existing shareholders tend to
focus on the pre-money valuation
New investors care about how
post-money valuation…
New investors care about how
post-money valuation…
Provision 1: Valuation, continued
Pre-money value = (a) share price * shares outstanding before investment, and (b) share price * shares outstanding after the investment - investment amount.
Pre-money
Post-moneyValue growth
Company’s estimated value after investment & growth
…plus growth in value…
…plus growth in value…
…becomes the exit value
…becomes the exit value
Provision 1: Valuation, continued
What can you do with the money?
Pre$ $25 million
New $ $15 million
Post$ $40 million 5 FV
$200 million
Suppose (a) the existing shareholders ask for $15 million in new money on a $25 million valuation and (b) the VCs require a 5X valuation pop
FV$125 million
New $ $15 million
Post$ $25 million5 Pre$
$10 million
What if $15 million will produce a $125 million company?
If the company raises a large Series C Round, then what are the ownership consequences?
Provision 1: Valuation, continued
To keep the share price flat in a follow-on round, the pre-money valuation of the new investment will be the same as the post-money valuation of the prior round.
• The current pre-money valuation is $20 million• $30 million of new money is needed• The price per share grows 5X between the Series C capital raise and the Series D capital raise
• The stock option pool will be increased to 15% at the closing of the Series C capital raise
Provision 1: Valuation, continued
Compare the two scenarios
Company’s estimated
value prior to investment
Expected growth in
value
Company’s estimated value after investment
and growth
Scenario 1
Series C$20 million
Series D$10 million
$20 million in the Series C and then $10 million in the
Series D
$20 million in the Series C and then $10 million in the
Series D
$20 million in the Series C and then $10 million in the
Series D
$20 million in the Series C and then $10 million in the
Series D
Company’s estimated
value prior to investment
Expected growth in
value
Company’s estimated value after investment
and growth
Scenario 2
Series C$10 million
Series D$20 million
$20 million in the Series C and then $10 million in the
Series D
$10 million in the Series C and then $20 million in the
Series D
$20 million in the Series C and then $10 million in the
Series D
$10 million in the Series C and then $20 million in the
Series D
Provision 1: Valuation, continued
Ownership after the Series D round
Investors
ScenariosSeries C = $20 million Series C = $10 million
Series D = $10 million Series D = $20 million
Provision 1: Valuation, continued
"No, thank you, I don't want your money now. I want it next year."
Lessons• Raise the money needed, grow value, then raise the rest• Capital efficiency preserves ownership
Other Considerations
• If the money is available, then take it• Essential employees may get "trued up"
through option grants. Early investors and nonessential employees get diluted
Provision 2: Control
… Board control important?
… Board control not enough?
Board control
Provision 2: Control, continued
Shareholder veto
Do all preferred vote as 1 class, or is there a separate vote of each series?
Provision 2: Control, continued
VC approval
The company must get the VC’s approval to …
• Raise more money, issue new shares• Make C-level appointments• Approve next year’s budget or
deviate from budget by > 10%• Select key corporate partners• Out-license or in-license technology• Acquire or sell any material asset• Etc.
Provision 3: Size of the PoolThe option pool lowers the pre-money valuation.
VC: “$10 million of new money on a $20 million pre-money valuation.”
VC: “$10 million of new money on a $20 million pre-money valuation.”
Company: “Great, we have a deal.”
Company: “Great, we have a deal.”
VC: “We’ll need to refresh the stock option pool for
employees, consultants, and key partners. 20% should be
sufficient.”
VC: “We’ll need to refresh the stock option pool for
employees, consultants, and key partners. 20% should be
sufficient.”
Provision 4: Liquidation PreferencesA liquidation preference is the amount investor will receive prior to pro rata distribution
A 1X liquidation preference means that, upon a sale of the company, the investor gets back its initial investment
Provision 4: Liquidation Preferences, continued
Nonparticipating vs. participating preference
1X nonparticipating preferred stock
Investor gets back 1X its initial investment, and all other funds go to the holders of Common Stock. However, the investor can waive the preference and convert to Common Stock, which is investor would do if its more lucrative
1X participating preferred stock
Investor gets back 1X its initial investment, and the remainder goes to the holders of Common Stock and Preferred Stock on a pro rata basis
Hybrid: 1X preference; 3X capped participation
Investor gets back 1X its initial investment, and the remainder goes to the holders of Common Stock and Preferred Stock on a pro rata basis, but if the investor would receive more than a 3X return, then the preference is forfeited
Investment Shares Stake (with C) Stake (without C)
Series C $ 20,000,000 7,482,031 50% 0%
Series B $ 2,500,000 2,081,600 14% 28%
Series A $ 864,500 914,500 6% 12%
Common 4,485,931 30% 60%
Provision 4: Liquidation Preferences, continued
Suppose we are considering $20 million of new money based on a pre-money valuation of $20 million
1X non-participating¹
1Xparticipating
1X preference;3X cap ROI
Series C $ 20,000,000 $ 23,317,750 $ 23,317,750 1.17
Series B $ 4,346,084 $ 3,423,042 $ 3,423,042 1.37
Series A $ 1,675,532 $ 1,270,016 $ 1,270,016 1.47
Common $ 3,978,384 $ 1,989,192 $ 1,989,192
Total $ 30,000,000 $ 30,000,000 $ 30,000,000
Distribution of $30 million in sale proceeds
In a modest exit, the preference is very impactful.
¹The Series C will take its preference rather than convert to common.
Distribution of $100 million in sale proceeds.In a healthy exit, the non-participating preferred would forfeit its preference. Participation impacts ROI substantially.
1X non-participating¹
1Xparticipating
1X preference;3X cap² ROI
Series C $ 48,317,750 $ 58,317,750 $ 58,317,750 2.92
Series B $ 15,942,637 $ 13,160,504 $ 13,160,504 5.26
Series A $ 6,770,193 $ 5,547,932 $ 5,547,932 6.42
Common $ 28,969,420 $ 22,973,814 $ 22,973,814
Total $100,000,000 $100,000,000 $100,000,000
¹ The Series C has converted to common.² The Series C has not converted to common.
Distribution of $120 million in sale proceeds
Capped participation flattens the ROI.
1X non-participating¹
1Xparticipating
1X preference;3X cap² ROI
Series C $ 58,317,750 $ 68,317,750 $ 60,000,000 3.00Series B $ 18,724,769 $ 15,942,637 $ 18,256,745 7.30Series A $ 7,992,455 $ 6,770,193 $ 7,786,840 9.01Common $ 34,965,026 $ 28,969,420 $ 33,956,416Total $120,000,000 $120,000,000 $120,000,000
¹ The Series C has converted to common.² The Series C has not converted to common, but has capped out.
Distribution of $ 160 million in sale proceeds.At the higher exit values, capped participation matters, but not so much.
1X non-participating¹
1Xparticipating
1X preference;3X cap¹ ROI
Series C $ 78,317,750 $ 88,317,750 $ 78,317,750 3.92
Series B $ 24,289,033 $ 21,506,901 $ 24,289,033 9.72
Series A $ 10,436,978 $ 9,214,717 $ 10,436,978 12.07
Common $ 46,956,239 $ 40,960,633 $ 46,956,239
Total $160,000,000 $160,000,000 $160,000,000
¹ The Series C has converted to common.
Provision 4: Liquidation Preferences, continued
Liquidation preferences are down-side protection for the investor.
Lessonslearned
Capped participation: nice to have, not need to have.
ROI is greatest for the investors that pay the lowest price, but the relative IRR is more compressed.
Question How do investors attempt to improve their ROI while accepting a high pre-money valuation?
● Juices the investor’s returns, but only modestly● Cumulative vs. if declared● Non-compounded (typical)● Accrue until exit (typical)● Cash vs. PIK
Provision 5: Dividends
The impact of dividends matters most if the company is eventually sold for a modest amount, or if the investment is held for many years.
The holders of the Series A Preferred shall be entitled to receive [non-] cumulative dividends in preference to any dividend on the Common Stock at the rate of [8%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of Series A Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis
Provision 6: Anti-Dilution Protection
Protects existing investors from the adverse impact experienced when a company issues new securities at a lower price than that paid by the existing investors
Question
Answer
How do anti-dilution provisions work?
Adjust the Conversion Price downward
1 stock/ml
0.1 stock/ml
0.01 stock/ml
0.001 stock/ml
0.0001 stock/ml
1 stock/ml +9 ml +9 ml +9 ml +9 ml
Full strength stock
1/10 0.1/10 (1/100)
0.01/10 (1/1,000)
0.001/10 (1/10,000)
1 ml 1 ml 1 ml 1 ml
Concentration
Actual stock dilution
Provision 6: Anti-Dilution Protection, continued
Weighted average anti-dilution protection is more friendly to entrepreneur than full ratchet anti-dilution protection.
What are the common types of anti-dilution protection?
• Ratchet• Weighted average
What are the common types of anti-dilution protection?
• Ratchet• Weighted average
What kind of “issuance” can trigger anti-dilution protection?
What kind of “issuance” can trigger anti-dilution protection?
Provision 6: Anti-Dilution Protection, continued
Pay-to-Play Anti-Dilution
If you don’t invest your pro
rata share, then …
1 you lose your weighted-average anti-dilution protection
or2 automatic conversion to common stock
Pay‐to‐play is rare due to tracking stock
Provision 7: Drag AlongDrag along has become standard.
• The new investor can require existing stockholders to vote in favor of a merger or sale of assets, or otherwise to sell their stock to a third party
• Rationale: (1) added security that a negotiated M&A event can be closed; (2) avoid/minimize dissenters rights, which interferes with tax‐free transactions
• Is it necessary?
Provision 7: Drag Along, continued
Drag along is only invoked if there are hold-outs.
ProblemProblem Some receive little or nothing
QuestionQuestion
How should existing shareholders push back?1.Approvals2.Minimum price3.Cash/freely tradable securities4.No reps or warranties; several (not joint) liability
Provision 8: Repurchase and Co-Sale RightsRepurchase and co-sale right limit the incentive and ability of the founders to dispose of a significant portion of their holdings.
RoFR A repurchase right, exercisable by the company or the investor
Co-Sale The right to tag along with a founder or junior preferred stockholder who is selling
Provision 9: RedemptionVenture capital funds have a 10-year life. Avoids lifestyle companies.
Push backPush back
• No cumulative dividends
• 6 months prior notice
• Paid over 2 or 3 years
IssuesIssues
• 5 years (typical)
• Could impact balance sheet
• Exercisable on M.A.C.?
Provision 10: Founder/Employee Issues
Negotiation Points
• 4-year vesting; 12-month cliff; thereafter, quarterly; is a portion fully vested up front?
• Upon employment termination, Company has right to repurchase unvested at cost and vested at FMV
• 12-month acceleration upon termination without cause or change of control (single trigger)
Vesting motivates the founder to continue working. Often allows the company to repurchase unvested at less than FMV.
VC: “If we didn’t believe in the management
team, then we would not invest.”
VC: “If we didn’t believe in the management
team, then we would not invest.”
Provision 10: Founder/Employee Issues
• At will• Severance if terminated without cause
• Severance is less than the non-compete (eg, 6 mo base salary paid over an 18 mo non-compete period)
• Company can waive the non-compete to avoid severance
Employment agreements are too often procrastinated until 11th hour when the pressure to close is most intense.
Recap
The 10most frequently
negotiated provisions in a term sheet
1. Valuation2. Control
3. Size of the ESOP4. Liquidation preference5. Dividends6. Anti-Dilution protection
7. Drag along8. Repurchase and co-sale rights
9. Redemption10. Vesting and Employment Agreements
Comparing Two Term Sheets
East Coast VC West Coast VCPre-money value $ 20,000,000 $ 15,000,000Series C investment $ 20,000,000 $ 10,000,000Post-money $ 40,000,000 $ 25,000,0005x step up $ 200,000,000 $ 125,000,000Series D investment $ 10,000,000 $ 20,000,000Dividend 8% cumulative 8% noncumulativeLiquidation preferences 2X participating 1x nonparticipating
East Coast West CoastSeries D 5% 14%Series C 48% 34%Series B 13% 15%Series A 6% 7%Common 29% 30%Total 100% 100%
Lesson: Despite raising the Series C at lower pre-money value, the existing shareholders (common and Series A and B) end up owning a greater stake in the long run by postponing the big capital raise to the Series D round.
Proceeds: $150,000,000 East Coast ROI West Coast ROILiquidation Preference• Series D $ 20,000,000• Series C $ 40,000,000• Series B $ 2,500,000 $ 2,500,000• Series A $ 864,500 $ 864,500Dividend• 3 yrs Series D $ 2,400,000• 6 yrs Series C $ 9,600,000Balance $ 74,635,500 $146,635,500 • Series D $ 3,554,071 $ 20,225,586 • Series C $ 35,540,714 $ 50,563,966 • Series B $ 9,887,896 $ 22,606,629 • Series A $ 4,344,005 $ 9,931,669 • Common $ 21,308,813 $ 43,307,650 Aggregate• Series D $ 25,954,071 2.60 $ 20,225,586 1.01• Series C $ 85,140,714 4.26 $ 50,563,966 5.06• Series B $ 12,387,896 4.96 $ 25,106,629 10.04• Series A $ 5,208,505 6.02 $ 10,796,169 12.49• Common $ 21,308,813 $ 43,307,650
$ 150,000,000 $150,000,000
ModestLessons: First, the early investors (Series A and B) realize a much higher ROI from the West Coast deal than the East Coast deal due to capital efficiency and the liquidation preference and cumulative dividends that go to the Series C and D investors. Second, even the Series C investor’s ROI is better in the West Coast deal because it is more capital efficient (ie, turning $10 into $50 is better than turning $20 into $85).
Relative to pre-money value company sold for $150 million in cash
Proceeds: $300,000,000 East Coast ROI West Coast ROILiquidation Preference• Series D $ 20,000,000• Series C $ 40,000,000• Series B $ 2,500,000 $ 2,500,000• Series A $ 864,500 $ 864,500Dividend• 3 yrs Series D $ 4,800,000• 6 yrs Series C $ 9,600,000Balance $ 222,235,500 $ 296,635,500• Series D $ 10,582,643 $ 40,915,241• Series C $ 105,826,429 $ 102,288,103• Series B $ 29,442,311 $ 45,731,960• Series A $ 12,934,759 $ 20,019217• Common $ 63,449,359 $ 87,608,978Aggregate• Series D $ 35,382,643 3.54 $ 40,915241 2.05• Series C $ 155,426,429 7.77 $ 102,288,103 10.23• Series B $ 31,942,311 12.78 $ 48,231,960 19.29• Series A $ 13,799,259 15.96 $ 20,955,717 24.24• Common $ 63,449,359 $ 87,608,978
$ 300,000,000 $ 300,000,000
Home RunEven in a home run scenario, the same lessons two apply. First, preferences for later investors dramatically lower the ROI enjoyed by early investors. Second, capital efficiency impacts ROI even more than liquidation preferences and cumulative dividends (as demonstrated by the Series C investor’s superior ROI in the West Coast deal compared to the East Coast deal).
Relative to pre-money value company sold for $300 million in cash
Conclusions
Capital Efficiency To preserve ownership, raise the money needed, grow value, then raise the rest.
Terms MatterCumulative dividends and liquidation preferences can impact ROI more than the pre-money valuation.
ControlVenture investors exercise disproportionate control through shareholder veto rights, drag along, rights of first refusal and redemption.
