Private Equity and

Venture Capital
Atul Kedia
VC: Financing company creation and
expansion
Sessions 7

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Lifecycle of a Company

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Seed Financing
 Riskiest and most complex
 High uncertainty – trust the idea of the entrepreneur
 Limited managerial role by investor at this stage
 Can the idea generate output?
 Does the output has marketability?
 Investment in an idea or R&D project
 R&D Project → Patent → Product
 100/10/1 rule
 VC needs to have high ‘threshold’ and invest in multiple projects
 Winning project may not be the first one!
 Bootstrapping: self-financing by entrepreneurs (control vs. value creation)
 Business Angels (BAs): High-net-worth individuals
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Start-up & Early Growth
Start-up Financing
 Funding initial operations; betting on a business plan
 Need for cash to buy initial equipment (inventory, P&M, building etc.)
 Risk remains high
 VC should protect her/his interest, e.g. by using put option
 Balance between investment and management

Early Growth Financing

 Financing of the day after; entrepreneur has started operations
 Money + hands on; e.g. re-write the business plan to analyse financing gap
 the first phase of growth of a new company that has started generating sales
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Venture Capital
 Typically minority investors, though bring-in experience, expertise, guidance, network
 Invest basis industries / technologies / geographies / sub-stage of investment
 Early-stage: Entrepreneur + idea + PowerPoint presentation
 Mid-stage: started operations and stable sales
 Late-stage: fast-growing business
 Capital requirements vary widely
 Challenge for start-up: reach next stage and raise capital before running out of cash
 Typically negative monthly cash flow and high burn rates
 VC must analyse idea, entrepreneur and provide mentorship
 1/3rd investments would fail, 2/3rd would lose money
 must be offset by at least one or two highly successful “home-runs”

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Funding in stages
 Funding basis milestones achieved
 Good way of unlocking value at a higher price
 Brings in discipline for the entrepreneur
 Helps investors safeguard their future
investments in case the venture doesn’t go well
 Stop ‘feeding losses’
 Tranches:
 maybe designed in the same Term Sheet to be
invested basis milestones
 drawback – all investments at initial valuation
resulting in higher equity dilution

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Deal pricing
 Common question: what percentage of equity stake to offer against an amount of investment?
 Negotiation depends on formal due diligence and valuation
 Pricing involves placing a value on the business, establishing share price and equity stake
 Pre-money value refers to the value prior to the addition of investor capital
 Post-money value = pre-money value + additional investment
 Pre-money value and amount invested determine the investor’s ownership percentage
 Example:
 Pre-money valuation = $4 million; outstanding shares = 1.5 million
 New investment = $1 million
 Post-money valuation = $4m + $1m = $5 million
 Investor’s shareholding = $1m / ($4m + $1m) = 20%
 Share price = $4m / 1.5m = $2.66

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Case study
 Nina has been working on a new energy technology on part-time basis for the past 3 years
 She now wishes to focus fully on it and, along with Rahul, invest next one year on development
 With their existing savings, they start a new venture – EnerTech
 At incorporation:
 1 mio common shares are issued (Nina 60%, Rahul 40%)
 9 months:
 Things speed up, they need to have 2 FTEs and purchase equipment
 With the above, prototype should be ready in 6 months
 Savings are drying up; they need an investor to save the venture
 Seed Round:
 VC1 (Seed funding) values the venture at $2.5 mio and is ready to invest $1.5 mio

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Case study contd…
 After 8 months, prototype EnerPro is ready
 Energy experts are impressed, though it’s yet to be transformed into a product
 Long way to go, new investments required to further develop into a promising product
 Additional engineers, development lab, offices, machines
 Series-A round – Early-stage phase:
 VC2 finds it promising; sits with EnerTech and determines funding requirement of $8 mio
 VC2 will invest $6 mio with VC1 co-investing $2 mio at the same terms
 Pre-money valuation is agreed at $15 mio
 Another condition by VC2: set up ESOP plan with 5% of o/s shares, post-money

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Case Study contd…
 After 1 year, EnerPro is in production
 Additional funds are required to further develop production & invest in sales channels
 Though the venture looks very promising, it is still ‘burning’ cash
 Series-B round – Growth phase:
 Basis initial due diligence, VC3 and VC4 (syndicate) submit TS to fund $15 mio out of $20 mio reqd
 After several rounds of negotiation, pre-money valuation is set at $45 mio
 VC1 and VC2 decide to provide $1 mio and $4 mio respectively
 ESOPs to remain at 5%, post-money

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Case study contd…
 After 2 years, the company has been doing well
 Entered into strategic partnership with large OEM
 The company has reached break-even
 Cash-flow deficit is at its peak, but will now reduce steadily
 Additional funds are required to further expand sales, set up overseas offices & maybe acquisition
 With existing investors, it is determined that at least $40 mio will be required
 Series-C round – further growth:
 VC5 submits a TS to fund $25 mio
 Pre-money valuation is set at $100 mio
 VC3 and VC4 decide to provide remaining $15 mio
 ESOPs to be increased to 15%, post-money, to attract / retain highly skilled people

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Dilution
 Reduction in a shareholder’s relative ownership %age as a result of the venture issuing more shares
 Original investors would not want valuations too high in an initial equity round. Why?
 What if dilution happens with a lower pricing? (down round)
 Include Anti-Dilution clause in Term Sheet

Anti-Dilution clause in Term Sheet (by Series-A investor):

In the event that the Company issues new shares or securities convertible into or exchangeable for shares at a
purchase price lower than the applicable conversion price of the Series A Shares, then the conversion price of
the Series A Shares will be subject to a full ratchet adjustment, reducing the applicable conversion price of
the Series A Shares to the price at which the new shares are (to be) issued.

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