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EAS 545 - Timothy Li Study Sheet VC Problem Set

VC Method: Single round


With a VC investment, unlike NPV calculation based on discounted cash ows, an investment is made in a lump sum at a dened time (Io) in exchange for shares of stock in the company. The ROI is realized at some time in the future, at the time of a liquidity event (acquisition / IPO / buyout).

Pre-Money and Post-Money Valuation Example


Post-money Valuation = $1,500,000 / 0.304 = $4,934,210 Pre-money Valuation = $4,934,210 - $1,500,00 = $3,434,210 options are the right to buy a certain number of shares of existing stock at a certain price in the future. warrants are similar to options except new stock is issued when warrants are exercised. Valuations that include options and warrants as if they had been exercised in the total number shares are fully diluted.

Company Value
Terminal Value or VN = P/E x EN or VN = P/R x RN where P/E and P/R are multiples. They can be derived by examining comparable companies, such as companies with explicit market values.

Valuation Example
Find the value of a company in year 5, given income statement data

VC Method: Multiple rounds!


VI5 0 1 2 3 4 5

Sales projected in 5 years $30 MM COGS ($18 MM) Gross Margin $12 MM Sales, G&A expenses, R&D expenses ($7.5 MM) Taxes ($2.0 MM) Net Income (earnings) $2.5 MM

top line revenue


I0 = $1.5 MM Rnd 2 = $1 MM Rnd 3 = $1 MM

Percent Ownership
bottom line earnings Round #1 #2 #3 Invested $ 1. 5 MM $ 1.0 MM $ 1.0 MM Required ROI 50 % 40 % 25 % Final % Acquired 30.4 % 7.3 % 3.3 %

Referring to nancial references for comparable companies, we nd a P/E = 15. V5= 15 x $2.5 MM = $37.5 MM

Value of Investment
time-value of money and risk/return tradeoff The VC must determine the value of an investment in N years (VIN) based off their ROI: VIN = I0 x (1 + ROI)N

Note: This would leave 59% for the founders, options, or the other shares used for negotiations.

Retention Percentage
For the Rnd 1 investor to end up with 30.4%, they must acquire more at the time of their investment. This is a result of the dilution that occurs in Rnd 2 and 3, decreasing the percentage of the company owned by the previous shareholders as new shares are issued for each round. Retention % = 100% - (nal % of later rounds) %acquired = Final% / (Retention % 100%)

Value of Investment Example


Find the value of a $1.5MM investment in year 5, given required ROI of 50%. VI5 = $1.5MM x (1 + .50)5 = $11.4 MM

Ownership
How to calculate % of a company VC must own to realize ROI / # shares. %N = (1+ROI)N x I0 / (P/E x EN) How to calculate the # of shares the VC should own (new shares) %ownership = # of shares owned / total # of shares issued total # shares = old # shares (pre-invest) + news # shares (purchased) %ownership = new # shares / (old # shares + new # shares)

Retention Percentage Example


Round #1 #2 #3 Retention % 100% - 7.3% - 3.3% = 89.4% 100% - 3.3% = 96.7% 100% % Acquired 0.304 0.894 = 34.0% 0.073 0.976 = 7.6% 0.033 1.0 = 3.3 %

Number and Price of Shares


Using the new % acquired we can calculate the number of new shares that must be issued with each round and the price per share. # New shares = %ownership/(1-%ownernship) x # Old shares price/share = investment / # new shares

Ownership Example - Percent Ownership Required


In 5 years, at the liquidity event, the VC must own: %5 = (1+.50)5 x $1.5MM / (15 x $2.5MM) = 30.4%

Ownership Example - # Shares and Price/Share


Assume our company has issued 1,000,000 shares prior to the rst round of investment # New Shares = .304 / (1 - 0.304) x 1,000,000 = 436,782 shares investment Price/Share = = $1.5MM / 436,782 shares = $3.43/share # new shares

Number and Price of Shares Example - New shares ea round


Round #1 #2 #3 # New Shares 0.34/(1-0.34) x 1,000,000 = 515,055 shares 0.076/(1-0.076) x 1,515,055 = 124,077 shares 0.033/(1-0.033) x 1,639,132 = 56,522 shares

Pre-money and Post-money valuation


Post-money Valuation = Investment / %ownership = new price/share x (total # shares post-money) Pre-money Valuation = Post-money valuation - investment = New Price/Share x (# old shares)

New shares issued at each round must be added to the old shares when calculating new shares of a subsequent round. You cannot issue fractional shares of stock.

EAS 545 - Timothy Li Study Sheet VC Problem Set


Number and Price of Shares Example - price/share each round
Round #1 #2 #3 # New Shares = $1,500,000 515,055 = $2.91 = $1,000,000 124,077 = $8.06 = $1,000,000 56,522 = $17.69

Participating Preferred Stock


This security is like the Convertible Preferred Stock described above, but it has an additional benet in that, at conversion (i.e. at the liquidity event), the entire original purchase is also repaid to the investor on a priority basis before any distribution to the shareholders are calculated. In the above example, if only the round 2 investor has Participating Preferred Stock, then the investors distribution at the time of the liquidity event would be: Distrb = I + ([val of cmpny-I] x (tot shares owned)/(tot shares issued) 143,633 = $1,000,000 + ($37,500,000 - $1,000,000) x 1,695,654 + 19,556 = $4,056,538

Post-Money Valuation (review)

Example

Post-money Valuation = Investment / %ownership = new price/share x (total # shares post-money)


Round Investment % Acquired #1 $1,500,000 34.0% #2 $1,000,000 7.6% #3 $1,000,000 3.3% Price/Share Total #Shares Post-Money Val $2.91 1,515,055 $4.41 MM $8.06 1,639,132 $13.21 MM $17.69 1,695,654 $30.00 MM

Final Price Per Share

Example

Cap Table Template


Investment Pre-money valuation Shares outstanding Founder Investor 1 Total shares Price/share Post-money valuation % 2.91 MM 1,000,000 30.4 34% 1,518,055 $2.91 $14.41MM shares

We calculate the nal price/share at the time of liquidity using the same formula above (price/share = investment / # new shares). However we can also use an alternative version. Price/Share = Value of Company / Total # Shares
(2.4MM x 15) $37.5MM = = $22.12/share (1,000,000 + 515,055 + 124,077 + 56,522) shares 1,695,654 shares

1.5MM

515,000

Back-Check
We can conrm the ROI equals our original desired terms: ROI = (Price per share sold / Price per share purchased)1/N - 1
Round #1 #2 #3 ROI ($22.12 $2.91)1/5 - 1 = 50% p.a. ($22.12 $8.06)1/3 - 1 = 50% p.a. ($22.12 $17.69)1/1 - 1 = 50% p.a.

Example

R1 =100-7.3-3.3 = 89.4 Rough Calculations RD1 -> VI5= 1.5MM(1.5)5 = 11.8MM / 37.5 MM= 30.4% / 89.4 = 34% invest rtn yr my val mkt val dilution own

The results do match the desired returns sought by our investors in each round.

Lessons
1. Seizing the Opportunity
product + strategy leadership
Seize the Opportunity growth vision culture motivation

Convertible Preferred Stock


Preferred shares have preference over common shares and any cash distributions owed to preferred shareholders are paid out before common stockholders. Preferred shareholders may also receive an annual dividend payment equal to a percentage of their investment. This dividend is usually cumulative (i.e. if the company cannot afford to pay the dividend in one year, any unpaid amount rolls over to the next year and is added to the dividend due in the next year). The dividend may either be compounding or non-compounding (i.e. treated as a compound interest or simple. non-compounding interest). At the time of a liquidity event, each share of preferred stock may be converted (Convertible Preferred Stock or Shares) into a new share of common stock and the accumulated dividends re converted to additional shares of common stock often at the original price-pershare paid by the investor. Dividend = I [(1+i)N - 1] = $1,000,000 [1.053 - 1] = $157,625 At the original share price of %8.06, this would convert to: Additional Shares = $157,635 / ($8.06/share) = 19,556 shares The Round 2 investors total holdings at the liquidity event would be: Total shares owned = 124,077 + 19,556 = 143,633 shares Their (Rnd 2 Invst) distribution from the liquidity event would then be: Dist = (value of cmpny) x (total shares owned)/(total # shares issued) = $37,500,000 x 143,633 / (1,695,654 + 19,556) = $3,140,625 Note: If the dividend had been cumulative, non-compounding: Dividend = I x i x N = $1,000,000 x 0.05 x 3 = $150,000

harvest + give back

team
IP Strategy Product Strategy Pricing Strategy Operating Strategy Marketing Strategy

cash team

product + strategy

Vision Hire execution Cultural t Mentor(s) Strategic partners Customers

cash

Bootstrap Angel investors Venture capital Strategic investors Public offerings Recapitalizations

2. Lou Aggasiz / Druckers New Venture / HP Case


Aggasiz - Look at the sh! Look beyond the obvious. Determination is needed in observation. You may not always get a positive response, you may not always get direction, and you do not need expensive or complicated tools in order to succeed. Druckers New Venture - entrepreneurial management Need for market focus - open to adjacent markets Financial foresight - cash, capital, control Building a management team - allows focus on all fronts Understanding their role - outside advice+mentor / strengths HP - early mistakes (next-bench syndrome) but had great mentors, nancial foresight due to early mistakes, knew their role, open to new opportunities Venture Finance - equity is more expensive than debt. seed/early vc funding is usually highest reward, highest risk.

EAS 545 - Timothy Li Study Sheet Lessons


3. High-Tech / Winning Strat / Vermeer A, A-1, B, C
Winning Strategy, Davidow - (1) Create whole products, not devices. Devices are what we invest...complete products are what customers buy. [service, packaging, nd a need](2) Establish a commanding position. Segment market into small ponds, dont attack a fortied hill [threat of new entrants + substitutes, bargaining power of suppliers + buyers and rivalry of incumbents], focus on the segment [cost to switch, loyalty, IP, distribution, cost to enter], create a defensible position [position = segmentation + differentiation], reposition as customer base evolves.(3) Adapt strategy and plan for high tech marketing. Vermeer - started with 3 products; Culture - high performance, trust, sense of urgency, teamwork, paranoia, at org chart. Strategy - winning protoype+demo, 1st to market, industry std. team: mandile: execution, germano: task master, forgaard: empathetic,ferguson:operations. clashed sometimes. sold to microsoft (frontpage)

7. Crossing the Chasm / Palm Case


Rogers Crossing the Chasm - Diffusion of innovation, revenue in opportunity of the majority. different focus on each segment. WOM innovators - focus on tech: enthusiasts, give objective feedback, recognize competitive advantage, endorsement reassures others that it works. early adopters - focus on comp advantage: visionaries view tech as strategic opportunity, willing to take risk, least price sensitive, easy to sell, hard to please, inclusive, they nd you, understand and mkt the dream. early majority - large revenue opp/less risk tolerance, loyal once won, standardization benets. late majority - signicant prot opp: conservatives will wait for it, follow the early majority. window of opportunity, segment! segment! segment!, secure beachead Palm - rst to market with right product, right customer, right time, right price. talking to customers and learning from other peoples mistakes. keeping costs low, and pivoting to a market segment. negotiated on their vision with partners instead of giving in.

4. IP / Palm Case
IP - types: trade+service marks, copyrights, trade secrets, patents considerations: purpose, terms and protection, notice, process patents - new+novel, useful, non-obvious Forming of Palm - decision to be independent or part of Tandy. problems faced- tandy owned improvements on palmprint, hawkins owned original patent. had many partners from existing reputation, tandy had a huge bureaucracy, existing brand to uphold, couldnt attract talent without equity / stock options.

8. Busieness Model Canvas / Dell / Open Innovation (ches)


BMC
Key Partners Key Activities Value Prop Customer Customer Relations Segments

Key Resources Cost Structure

Channels

Revenue Streams

Dell - vert intgrtn = low cost direct partnerships with sony and intel, zero stock on hand, pull system, customer partnerships, Dell Platinum Councils, direct sales, problems with laptop market, battery choice. future value F = P (1+i)n

5. Financial Statements / X-IT


Financial - Income statement (P&L): net sales, cost of sales, selling expenses (salaries, ads), G&A expenses (ofce staff salaries, expenses). How well is the business running. Balance sheet [Assets(own) Liabilities(owe) = Shareholders Equity (net worth)]. Sources & Uses Statement. Statement of Cash Flows. Do you have cash? X-IT - IP litigation with Kidde. violation of NDA and copyright on packaging. patents not issued yet. Kidde violated NDA in order to nd loop hole in the patent (not published at the time). Packaging was a direct copy. IP litigation is long and expensive. X-IT just recently won.

Operational Strategies -Integrator - incremental innovtn, position strong, Orchestrator - innovtn breakthru, intense comp, substitutes strong, tech early stges, time-to-mkt critical, Licensor - mkt is new to innovator, brand importances low, IP protected, signif infrastruct

9. FDA / USDA / Nucleon


FDA regulatory approval and insurance reimbursement add time, cost, and risk to a venture. Each aspect of business has added complexity. Product development and regulatory approval time frames leave little time left to capitalize on IP protection. Operational strategy choices have dramatic nancial impacts (Nucleon). Product strategy can leverage the benets of mankind but carry higher risk (Sirtris). Multiple stakeholders, payors, and regulatory requirements impact marketing strategy. Nucleon - multiple options for manufacturing. calculate cash ows and then add the discount rate across all numbers to determine nal value.

6. Innovation & Sales Learning Curve / Palm


right product, right customer, right time, right price understand all stakeholders (aside from customers) 4 criteria for segmentation: psychographic homogeneity, identiable, accessible, signicant potential concept testing, conjoint analysis, perceptual mapping Innovation: A Customer Driven Approach - Stage-gate approach. customer research, latent need (delighters), concept generation, prototyping+feedback loop. Sales Learning Curve - Need to give company time to travel up the curve. Craft sales team towards early adopters to allow you to modify your product, then change sales as you grow your user base. Understand new-product sales challenges -> Adjust your sales strategy as you learn. communicate well with teams from other functions / tolerate ambiguity. (1) initiation, (2) transition (3) execution Palm Computing - focused on the product as a whole. searched for critical features (mvp/mdp). understood stakeholders involved and removed barriers. learned from bad examples in past (momenta) Innovators Dilemma - disruptive tech bring a new value prop to mkt. product attributes initially only valued only in emerging mkg, unimportant in mainstream

10. VC Method / Bootstrap Finance / Angel Investing


bootstrappers axioms for success: operational quickly...look for quick cash ow... offer high value products/services...forget about the crack team...keep growth in check... focus on cash...cultivate banks optimizing other peoples money: dont over or under capitalize. use proceeds to create a step up in value.

11. Onset Ventures


All high-tech investors look for a visionary leader & capable team, market leadership, fundamental, compelling tech advantage, capitalefcient business plan, de-risking. Its all about managing risk. Tech/ mkt/operating/distribution/team.

EAS 545 - Timothy Li Study Sheet Lessons


12. Communications / Walnut A
Walnut A was about investing in Bob OConnor and RBS Group. issues with some of the details in the business plan: forcasting scaling sales costs, early commitment to international before domestic expansion, customer segment mismatch (size / cost), is answer to protability scale? evidence to understand all costs. also beyond typical Walnut investment

22. Mark Palatucci


Follow your dream... but its hard and you may have to swallow your pride; The allure and pitfalls of consulting to bootstrap; Watch your IP when youre a grad student; They call it hardware for a reason... its hard; The stealth startup; Story yet to be written

23. MIPS / Spoiled Startup / Disruption


Level 5 Leaders: humility, come from within, have the will, vision Disruptive Technologies bring a new value proposition to a dened market segment, typically falls short and unimportant but eclipse sustaining technologies eventually, they are not simply substitutes for existing products, establish companies bound by risk, competencies, vision, assets, infrastructures, business models and expertise. Spoiled Startup - pretend you dont have it, stay strategic, nd customers rst, then look for funding, dont sell yourself too soon. MIPS - had a compelling, unique and protected tech, but MIPS had a lack of a focused vision, leadership, product (risc microprocessors, risc wrkstations, sw), customer.

13. Negotiation / Walnut C+D


3 provisions: valuation, governance, capital structure. > just valuation know both positions (objectives / must haves). Identify BATNA and evaluate the ZOPA. Build trust, and prepare for an impasse

14. Exits / Teleswitch


IPO, recap, acquistion. depends on capital needs, management, resources,external-ipo market, product demand, alternatives. Underwriter takes charge of IPO process Teleswitch - wanted to IPO to raise capital for their GSM tech push. Teleswitch did not do due diligence to understand their underwriter, intead went with a strong rm. Lack of alignment led to missteps, lost time opportunity and ultimately a lower valuation

24. Hiring / Sun Microsystems


First who then what: start with the right people, intrinsically motivated, inspirational leaders, As attract As. More than just intelligence. Sun Microsystems - Started with failed computervision deal. Hired a great team of motivated individuals to steer the company in the right direction. Level 5 leaders. complimentary skills, It was all based on trust. - Vinod Khosla

15. Andy Seidel


Power of techical breadth, presentation skills are critical, ask for high value, surround yourself with A players, engineering skills to problem solve, quant skills so numbers tell a story, try to learn on someone elses dime, build a great company...exits will come naturally

16. Brian Roddy


People are everything. Results != No results+Excuses, keep learning, keep changing, best time to start is when no one else is, take action

25. Michael Zisman


Capital...nancial vs human; Control is about cash; Comfort comes from trust; Condence vs arrogance; Competition...this is war; Certainty...there isnt any; Complete product; Communication... brevity+empathy; Mgmt team..complementary skills; Momentum = product x mktg; Message...succinct + branded; MVP

17. Nanogene / Innovators DNA / Paige Miller


skills: questioning, observing, experimenting, networking, associating hire ahead of curve, isnt all about the money, business plans dont survive customer contact, careful what you say..

18. Conjoint / Palm Financing


Palm faced with ncing thru Alpha, ABC, international or USR

26. Momenta - Kamran Elahian


Great ingredients without clear and strong strategy, execution, and culture can lead to failure. Didnt nd people that shared his vision (they were very talented tho). Did a technology push. Unrealistic goals. no room for failure. lack of exibility and overpriced.

19. Pricing / Sirtris


8 steps: how do customers value our product, does value vary across segments,assess customer price sensitivity, optimize pricing structure, anticipate competitor reaction, know the real price, assess customers emotional response; price high = skim; price low = penetrate; me too. Sirtris - odds of early-stage pharma companies succeeding small. Requires alot of capital to nd out, focus is progress an value at each milestone.. balance intrinsic vs extrinsic but investors only care of ext.

27. Ted Schlein


4 key risks - market, technical, people, nancial key to term sheets - pre/post valuation, liquidation pref, voting rights, board constitution / rights career advice - always look to learn; foundation- sell, launch a product, manage employees; develop personal / lifelong network; swing for the fences; culture matters: missionary vs mercenary. Ideas are easy, execution is everything. it takes a team to win.

20. Leadership + Motivation / VDS


VDS - motivations changed as VDS grew, PDM varied from VDS sales people incentive structure. Leadership dangled investment only if concrete goals were met, but under-invested in their success. Leadership did not change vision with new team, held on to external motivators, did not give freedom / autonomy. hands off leadership = no

28. Leaders & Managers


consensus building vs vision driven. Leaders, like artists, tolerate chaos and lack of structure. Managers seek order, control, and rapid resolution of problems. stewards are bottom-line oriented, while creators are creative technical employees. must be managed well to encourage innovation

21. Philip Yanni


Top startup mistakes: Titles...too senior, Perks... too many, Inclusiveness...overdone, Buddies on the Board, Crazy cap table, late to focus, late to listen, ignoring the voice of the customer. Value your nancial model!