VC’s role Valuation Warrants and convertibles Term sheet contracting

Venture capital
ISB – PGPGPGP – Co22

Ramana Sonti

Indian School of Business

March 2022
VC’s role Valuation Warrants and convertibles Term sheet contracting

1 VC’s role
Value-added role

2 Valuation
VC Method

3 Warrants and convertibles

4 Term sheet contracting

Cash flow rights and Security choice
Control terms
Stockholders and management terms
VC’s role Valuation Warrants and convertibles Term sheet contracting

VC microcosm
VC’s role Valuation Warrants and convertibles Term sheet contracting

VC involvement: Screening

• Importance of referrals to get to VCs

• Preference for serial entrepreneurs
• Cycles of what is hot or not
VC’s role Valuation Warrants and convertibles Term sheet contracting

Post-investment involvement

• Board of directors and governance

• Monitoring and regular contact
• Advice, mentoring and crisis management
• Networking with customers, suppliers, etc
• Hiring and firing of senior management
• Additional fundraising with other VCs, banks
• Exit planning: IPOs, Acquisitions
VC’s role Valuation Warrants and convertibles Term sheet contracting

VC investment styles

• Specialization by stage
• Early-stage, late-stage, all-stages
• LBOs, PIPEs (SPACs is a leading example)
• Specialization by industry
• Consumer tech, retail,. . .
• Specialization by geography
• Local, national, global
• Choice of syndication partners and network position
• Range of hands-on and hands-off involvement
VC’s role Valuation Warrants and convertibles Term sheet contracting

Are all VCs/VC firms Identical? Research evidence

• Bottazzi, Rin and Hellmann (JFE, 2008)

• Survey of European VCs from 17 countries who invested in 1998-2001
• Try to identify the value of active investors

• Active investors
• More business experience counts, NOT VC experience or scientific education
• more active in recruiting managers and directors
• help with fundraising
• more frequently interact with portfolio companies
• Active investors positively benefit performance (success of portfolio companies)
• The importance of human capital
VC’s role Valuation Warrants and convertibles Term sheet contracting

Summary

• VCs play a critical role in the entrepreneurial process:

• Financing
• Screening/Due diligence
• Value-adding functions
• Choice of VC is perhaps as important as idea
VC’s role Valuation Warrants and convertibles Term sheet contracting

Why do VCs need to do valuations?

• To determine objective company value?

• To determine investment size?
• To determine ownership stake?
VC’s role Valuation Warrants and convertibles Term sheet contracting

Alternative valuation models

• Asset-based
• Inappropriate for start-ups
• Comparables
• Hard to get data on private firms
• NPV method
• “Company” cash flow projections messy, etc.
• Venture capital method
• Focus on “investor’s” cash flows
• Option valuation based methods?
VC’s role Valuation Warrants and convertibles Term sheet contracting

Valuation: Ingredients

• V is terminal (or exit) value

• Own sales and earnings from projections
• Use comparable exit events (IPOs/acquisitions)
• Find comparable ratios - e.g. price-earnings, price-sales
• t is time to exit
• Hard to estimate realistically
• Rely on VC fund criteria, for example
• r is discount rate
VC’s role Valuation Warrants and convertibles Term sheet contracting

Discount rate

• Commonly seen discount rate, r > 50%!

• Why so high?
• Justifications offered
• High systematic (market) risks affecting small/new firms
• However, even a β = 3 (rf = Erm − rf = 6%) gives r = 24%, not 50%!!
• Illiquidity
• Legal restrictions, few potential buyers
• Compensation for VC’s value-added services
• Entrepreneur’s over-optimism
• Survival risk
• Forecasted cash flows not adjusted for failure
VC’s role Valuation Warrants and convertibles Term sheet contracting

Discounting and survival risk

• Suppose we take entrepreneur’s cash flows as given (big leap of

faith!)
• Let exit value be V
• If probability of failure every period is π, then the exit value
conditional on survival = (1 − π)T V
• Let the discount rate be the relevant cost of equity (CAPM expected
return)=r
(1−π)T V V
• Now, the discounted value is (1+r )T
= ,
(1+radj )T
• where (1 + radj ) = (1+r )
1−π)
• r = 20% and π = 20% ⇒ radj = 50%!
• Feel better now?
VC’s role Valuation Warrants and convertibles Term sheet contracting

Valuing the company - As an outsider

• Objective: At the time of investment of $I , what is the value of the firm

(Pre-money valuation)?
• VC Method allows us to infer the value based on observed information.
• Key relationships are:
• Post-money valuation: Post = Pre + I , where
• I is investment
• Investor’s ownership stake: F = (I /Post)
• Given number of existing shares, x, the number of new shares, y , is given by:
y F
= F =⇒ y = x
x +y 1−F

• Price per share: p = I /y

• Of the 5 variables, I , F , x, y , p, knowing any 4 can help determine the remaining
variable
• This allows us to reverse engineer the pre-money valuation
VC’s role Valuation Warrants and convertibles Term sheet contracting

Valuing the company - As an Investor

• Objectives:
• Analysis 1: Given initial number of shares (x), the investment (I ), equity stake taken
(F ), determine whether it is worth investing (relative to the VC’s target IRR)?
• Analysis 2: Given a VC’s target IRR and the investment amount (I ), what is the
equity stake the VC would need? What is the implied pre-money valuation?
• For either case, one needs an exit value or terminal value
as of the expected date of VC’s exit
• As of exit year, use FCF to generate the terminal value
• Use comparables’ equity beta and apply CAPM to get cost of equity
• Add Ending (excess) Cash Balance to Terminal Value
VC’s role Valuation Warrants and convertibles Term sheet contracting

Analysis 1: What is the implied IRR?

• Assumes: cash flow to equity is zero until exit

• Given:
• VCs’ investments I
• VCs’ equity stake, F
• Firm’s terminal value, V

0 1 2 Resulting IRR
VC1 I1 , F10 0, F11 F11 × V IRR1

VC2 0, 0 I2 , F21 F21 × V IRR2

• Note: VC1 ’s equity stake is diluted when VC2 invests in period 1, i.e., F11 < F10
• Apply the final equity share of each VC to the terminal value V
• Compare each VC’s IRR with its target IRR
VC’s role Valuation Warrants and convertibles Term sheet contracting

Analysis 2: What is the VC’s appropriate stake to meet the target IRR?

• Assumes: cash flow to equity is zero until exit

• Given:
• Initial shares, x
• VCs’ investments, I
• VCs’ target IRR, r
• Firm’s Terminal Value, V
• Work backwards

• Note: Given the intial number of shares x, and having determined F1 above, we
can estimate number of shares for VC1 and then for VC2
VC’s role Valuation Warrants and convertibles Term sheet contracting

Call options v. Warrants

• Call option: Right to buy 1 share from a seller at a specified price

(exercise or strike price) on a specified date (expiration date)
• Call options are obligations of the seller and rights of the holder
• No impact on firm

• Warrant: Right to buy 1 share from the firm at a specified price

(exercise or strike price) on a specified date (expiration date)
• Warrants are obligations of the firm and rights of the holder
• Value and dilution impact on firm
VC’s role Valuation Warrants and convertibles Term sheet contracting

Warrants: An example
• Firm has 6 ounces of platinum, worth 500 an ounce
• 2 stockholders A and B, each hold 1 share; each share worth 1500

• Call option
• A writes a call with strike price 1800 to C
• If platinum prices are 700/oz
• C exercises option, pays 1800, and becomes stockholder
• Shareholders: B and C; Share valued at 2100
• C makes 300
• Warrant
• Firm gives warrant with strike price 1800 to C
• If platinum prices are 700/oz
• C exercises warrant, pays 1800, and becomes stockholder
• New value of firm= 4200+1800=6000
• Shareholders: A, B, and C; Share valued at 2000
• C makes 200
VC’s role Valuation Warrants and convertibles Term sheet contracting

Warrants: In symbols

• N: number of shares outstanding before exercise

• q: number of warrants outstanding / N
• X : Strike price
• Gain from call option: (Firm equity value/N) − X

• Gain from warrant: Firm equity value+qNX

h i
N+qN −X
1
= 1+q [(Firm equity value/N) − X ]
VC’s role Valuation Warrants and convertibles Term sheet contracting

Warrants: Valuation

• If we know how to value a call, we know how to value a warrant

• Simply multiply by the dilution factor 1
1+q
• Methods exist to value a call option
• Black-Scholes formula (of limited use)
• Binomial tree method (very useful)...details in Async 2
• Factors affecting call (and warrant) price:
• Current stock price (S)
• Exercise price (X )
• Expiration period (T )
• Risk-free rate (r )
• Volatility of stock return (σ)
VC’s role Valuation Warrants and convertibles Term sheet contracting

Convertible bonds
• A fixed income obligation that gives the bondholder the right to
convert the bond into a fixed number of shares (conversion ratio)
• Conversion price = Face value
Conversion ratio
• Convertible is often priced as a package
• Convertible bond=Straight bond+Warrant
• This is a simplification
• In the package, warrant exercise requires payment of exercise price
and the straight bond is undisturbed (not extinguished)
• In a convertible, there is no cash payment at conversion, and the
straight bond is given up
• As a first approximation the convertible may be valued as a package
of
• A straight bond
• A warrant with an exercise price equal to the value of the bond at
the time of conversion
VC’s role Valuation Warrants and convertibles Term sheet contracting

Convertible preferred

• Dividend paying preferred stock that can be converted to common

stock at a fixed conversion ratio
• Convertible preferred normally has no maturity date

• Used extensively in VC contracts

• Also be used in special situations, e.g., Warren Buffett’s investment
in Goldman Sachs in Sep 2008
• See WSJ article
VC’s role Valuation Warrants and convertibles Term sheet contracting

Contracting

• VCs face significant risks post-investment

• These risks can affect the size of the pie
• Contract terms have implications for
• Share of the pie
• Returns
• Investment decision
VC’s role Valuation Warrants and convertibles Term sheet contracting

Key terms

• Cash flow rights

• Investment and ownership stake, Security type, Dividends, Liquidation
claims
• Control rights
• Stockholders and management terms
VC’s role Valuation Warrants and convertibles Term sheet contracting

Cash Flow Rights

• Common equity
• “Straight” (or redeemable) preferred stock
• Preferred: preference on dividends payments over common equity (fixed
dividend yield)
• Recover principal plus any promised dividends first
• Convertible preferred stock - most common in VC
• Sits between debt and common stock
• Bond-like: Fixed dividend yield
• Equity-like: Subordinate to debt
• Convertible at holder’s option into common equity at a conversion price
• Participating or non-participating
• Participating: At liquidity event, have liquidation preference plus accrued
dividends and equity share as common
• Non-participating: At liquidity event, have liquidation preference plus
accrued dividends or equity share as common
VC’s role Valuation Warrants and convertibles Term sheet contracting

Rationale for convertible preferred

• Cash flow reasons

• Convertible debt allows firm to conserve cash by lowering the interest rate
compared to straight bonds
• Reduces adverse selection by discouraging weak entrepreneurs
• Higher perceived risk translates into a higher value of the conversion
option. Easier for managers and outside investors to agree on the issue of a
convertible
• Convertibles have a smaller equity component than an equivalent equity
offering, convertible issuance is less likely to be perceived as a signal of
firm overvaluation
VC’s role Valuation Warrants and convertibles Term sheet contracting

Terms for conversion rights

• Automatic or mandatory conversion into common equity (e.g., in

case of an IPO)
• Requires minimum performance - a minimum common stock price
and proceeds amount
• Conversion price - price to convert to common stock
• All of the Series A Preferred shall be automatically converted into Common
Stock, at the then applicable conversion price, upon the closing of a firmly
underwritten public offering of shares of Common Stock of the Company at a
per share price not less than [three] times the Original Purchase Price (as
adjusted for stock splits, dividends and the like) per share and for a total offering
of not less than [$15] million (before deduction of underwriters commissions and
expenses) (a “Qualified IPO”). All, or a portion of, each share of the Series A
Preferred shall be automatically converted into Common Stock, at the then
applicable conversion price in the event that the holders of at least a majority of
the outstanding Series A Preferred consent to such conversion.”
• Avoids holdup by a VC
VC’s role Valuation Warrants and convertibles Term sheet contracting

Anti-dilution provisions: Types

• Anti-dilution provisions: Specify adjustments to conversion price in
event of subsequent financings
• If a further financing round is raised at a price less than the conversion price
of the original preferred, the number of preferred goes up to adjust for this
• “Full ratchet”
• Conversion price automatically ratchets to the lower price of newly issued
shares providing full protection to incumbent VCs
• New financiers would be unwilling to dilute – so dilution cost is borne by
founders and others (e.g., employees)
• Example:
• Initially, Founder has 1m shares and Incumbent VCs have 1m convertible
preferreds, at conversion price of $1 per share. A new VC gets 50K shares at
$0.50 per share
• Incumbent’s conversion price ratchets down to $0.50 per share, so that she can
convert to 2M shares
• Founder’s share diluted from 50% to 32.8%

• “Weighted average” (after substantial cash infusion/good

performance)
• Adjustment to price is not for the full amount
• Gives incentive for incumbent investors to come in at the new diluting price
VC’s role Valuation Warrants and convertibles Term sheet contracting

Liquidation rights

• Offer protection in bad states

• Optional redemption rights (“put” right)
• Allows investors to require the company to purchase their shares after a
specified period of time
• Gives investors the opportunity to exit from ”living dead” companies since
they have a fixed life fund
• Liquidation preference - multiple of investor’s investment (e.g., 3×)
• Not eligible with non-participating convertible preferred stocks if the
investor converts
• In the event of any liquidation or winding up of the Company, the holders
of the Series A Preferred shall be entitled to receive in preference to the
holders of the Common Stock a per share amount equal to [x] the Original
Purchase Price plus any declared but unpaid dividends (the Liquidation
Preference).
VC’s role Valuation Warrants and convertibles Term sheet contracting

Key terms

• Co-sale or Tag-along rights: Ensure that investors will be able to participate on a

pro rata basis in any sales made by founders or other stockholders who pass a
specified ownership percentage threshold (VC)
• Right of first refusal: Company and common stock holders can buyout preferred
holders before outside parties (E)
• Drag-along rights: If company is sold by majority consent (investors), all have to
follow (VC)
• Board composition and control (E ↔ VC)
• Voting rights - super voting rights giving disproportionate rights to preferred
holders (VC)
• Registration rights (VC)
• Tranching/Staging (and anti-dilution provisions) - with milestone for subsequent
funding (VC)
VC’s role Valuation Warrants and convertibles Term sheet contracting

Registration rights

• What is registration?
• Sale or exchange of securities (shares) can be done only if the shares
are registered with the SEC
• Registration is done e.g., usually before an IPO
• Usual registration is through Form S-1 (long form) or Form S-3
(short form)
• Registration rights
• Demand rights: Investors demand the company to register their
securities so they can be liquid
• Piggyback rights: Essentially limit (a future) IPO underwriter to
limit the investors to participate in the IPO
VC’s role Valuation Warrants and convertibles Term sheet contracting

Multi-round financing

• Ex ante (tranching) and ex post (staging)

• Tranching
• Price of future rounds specified
• Need observable milestones
• Time between installments is short
• Gives right to liquidate in bad states
• Staging
• Price of future rounds unspecified
• VC protects herself through pre-emptive and anti-dilution rights
VC’s role Valuation Warrants and convertibles Term sheet contracting

Staging - Pros and Cons

• Benefits
• Entrepreneur: less dilution, manage uncertainty about company’s
requirement for funds
• Investor: option for future investment, prevents wastage by
entrepreneur (lowers need for monitoring)
• Challenges
• Protect entrepreneur and early investors from power of future
investors
• Protect entrepreneur from future power of early investors
VC’s role Valuation Warrants and convertibles Term sheet contracting

Benefits of outsider round

• Validation
• Signaling to other outsiders
• Expertise
• Limits incumbent VCs’ exposure to one company
• Benefits of quid pro quo among VCs
VC’s role Valuation Warrants and convertibles Term sheet contracting

Key terms

• Vesting: Restrictions on amount of shares that can be sold by

management/employees
• Investors’ right to replace CEO
• Non-compete agreements: Critical especially in a tech start-up
situation
• Life, and D&O insurance borne by the company
VC’s role Valuation Warrants and convertibles Term sheet contracting

Summary

• Deal structure protects VC if management team does not execute

• Provides strong incentives / payoff to VC and management team if
team executes
• Control rights (contrast with cash flow rights) of VCs are very
strong
• Control rights are rights to make decisions
• Control rights of VCs decline on a number of dimensions as company
performs..Decline is complete with automatic conversion
• Other important aspects
• Use of contingencies / milestones
• Common to condition funding / shares / etc. with milestones