TS play several different roles:
CF rights -> Term sheets Agency conflicts o govern the rights, obligations, rewards of the parties
Convertible preferred stock/claims (D = statet yield) (NPV): pHR – I > 0 > pLR + B – I ⇒ 0 > (pLRb + B – A) + (pLRl – (I – A)) o shape the incentives for all parties (incl. employees)
PT = I + DIV = I + I*D*T (Div compounded: I + I*(D)T) (icc): pHRb ≥ pLRb + B ⇔ Rb ≥ B/∆p | Rl ≤ R – B/∆p /// P = pH(R – Rb) o bring the parties to clarify their expectations
Convert if CF Common stock > Preferred Terms (pc): P ≥ I – A (no profit: P=I-A) | Rb = R – (I – A)/pH ≥ B/∆p | pH Rb – A = pHR – I o allocate risk across the two parties
Control rights (-> Term sheets): Interim action: (τR<у) (slecht voor E) o specify the rights and duties of the parties towards external parties
FINV*X > PT → CT = PT/FINV → X > CT (employees, future investors)
Implied valuation VCM: Cash-on-cash (1 period Inv) [Financing->InterimAction->Moral-Hazard->Outcome] Stock compensation: to attract&retain talent & defer cash payments
I = FINV*VPOST = P*SINV VPOST = Xe/(1+)T (icc ENT): [(pH + τ)Rb – у] – [(pL+ τ)Rb – у] ≥ B ⇔ Rb ≥ B/∆p to key employees/board members. Stock granted directly or through
VPOST = I/FINV = P*SPOST = VPRE + I VPRE = VPOST – I (pc INV): (pH + τ)(R – Rb) ≥ I – A ➝ INV not lose from action but can ↑payoff stock options. Stock options are issued in a ‘pool’, typically at first
VPRE = VPOST – I = P*SPRE FINV = I/VPOST Multiple liquidation preference (-> get cap back M times) (payoff/utility ENT): (pH + τ)R – I – у < pHR – I ➝ ENT loses from action round. Often 10% to 20% of total ownership.
SPOST = SPRE + SINV VCM (CF INV): Multiple rounds PT =M*I + DIV | CTM = PT/FINV = (M*I + DIV)/FINV > CT Economic Determinants of Valuation
(pH + τ)(R – Rb) ≥ I – A > pH(R – Rb)➝ ENT only gets (I-A) if INV control 1. The opportunity itself: the better the more courted
FPRE = SPRE/SPOST (recursively, 1 period to previous) Participating preferred Damage Control (vRb >у) (goed voor E als ze geen effort doet) 2. The market context: hot vs. cold market
FINV = SINV/SPOST CCMer = (1+)Tr(r+1) E control: (icc): pHRb ≥ (pL + v)Rb + B – у ⇔ Rb ≥ (B – у)/(∆p – v) (H:E notimpl, L:E impl) 3. Deal competition: more competition, higher valuation
Stock Option Pool VPOST(r) = VPRE(r+1)/CCMer
SPOST = SPRE + SINV + SSOP PP cap(preserve E incentives): Participation vanish X > XCAP INV control ➝ (icc): pHRb – у ≥ (pL+v)Rb + B – у ⇔ Rb ≥ B/(∆p – v) (H/L: I always impl) 4. Investor quality: good investor achieve higher valuations
VPRE(r) = VPOST(r) – I(r) Milestones have important economic roles:
VPRE = P*(SPRE + SSOP) Contingent Control Rights (τR<у) (slecht voor E) o define performance targets
FINV(r) = I(r)/VPOST(r)
FSOP = SSOP/SPOST [Financing->Moral-Hazard->IntermediateSignal->InterimAction->Outcome] o align expectations of entrepreneurs and investors
VCM :Failure rate premium
Ownrshp dilution – multiple rounds INV control: (always impl)(can’t observe effort) o provide a focal point (reference point) for renegotiation
Survival to exit pr = (1-z)T
I(r) = Fr(r)*VPOST(r) = P(r)*S(r) (icc): σHHRb – у ≥ σLHRb + B – у ⇔ Rb ≥ B/(σHH – σLH) | (pc): (pH + τ)R – σHHRb ≥ I – A o facilitate negotiation about valuation, bylinkingitto performnce targets
Xpctd exit val. = Xe*(1-z)T FAST = Founder Allocation of Shares Tool based on steps:
VPRE(r) = VPOST(r) – I(r) = P(r)*SPOST(r-1) ENT control: (not impl)
VPOST = Xe*(1-z)T/(1+d)T= Xe/(t+)T o define team members and their roles
VPOST(r) = P(r)*SPOST(r) = I(r)/Fr(r) (icc): σHHRb ≥ σLHRb + B ⇔ Rb ≥ B/(σHH – σLH) | (pc): pHR – σHHRb ≥ I – A
= (d+z)/(1-z) (z=0 => = d, else > d) o define time period and their weights
SPOST(r) = SPOST(r-1) + Sr(r) If INV only control when σxL o allocation points to founders for their contributions
VCM : Financial risk premium (icc): σHHRb – σHLу ≥ σLHRb + B – σLLу ⇔ Rb ≥ [B/(σHH – σLH)] – у
Fi(r) = Si(r)/SPOST(r) (drop in cap smoothed out to avoid providing perverse o Identify net transfers across founders
CAPM: = Rf + B(Rm-Rf) (pc): (pH + σHLτ)R – σHHRb ≥ I – A o recommend ownership stakes and contingencies
Fi(r) = Fi(r-1)*(1-Fr(r)) incentives at time of exit)
B = Systematic risk (market) Contingent(INV control if σxL) vs unconditional(INV always control): Common performance metric multiples are based on:
Investor returns Staged financing
XINV = FINV*X Discounted CF model (pH + σHLτ)R – σHH([B/(σHH – σLH)] – у) > (pH + τ)R – σHHB/(σHH – σLH) ⇔у >τR o earnings ... but may be negative or volatile
Retention rate(↓FINV) = FPOST/FPRE (=FINV(r)/FINV(r-1)) o cash flow ... clear economic interpretation
NPV = [XINV/(1+d)T]-I VPRE = [FCFt/(1+d)t + TVt/(1+d)T + Casht] Anti-dilution (TS): P WA = P * (S + I /P )/(S + I /P ) min E income to max P = max (I-A) ➝ facilitates access funding o revenues ... possible also with negative cash flow
1 1 Base 2 1 Base 2 2
CCM = XINV/I (cash-on-cash multiple) FCF net of fundraising (company CF) Full ratchet: P1WA = S1/(S1/P2) = P2 (=I2/S2) |Narrow(Broad)-based prtctn: SBase = S1 (+ SENT) o operating measures ... tenuous link to income
IRR: I*(1+IRR)T = XINV TVT = [FCFT*(1+g)]/(d-g) Investor syndicate the deal to: (common (50% to 80% of deals))
CCM = (1+IRR)T Discount rate = d < Entrepreneurial Ventures: o Uncertainty o Risk often ‘extreme’/much fail |return right skewed o Illiquid (liquidity risk) o FIT: matching process E & I [E&I search challenge (networking,
o obtain second opinions (justify Inv with LPs)
(Exit) Comparables o reduce commitment/diversify/keep ‘dry powder’ (share risk)
Returns with multiple rounds Reduce risk -> diversify + become actively involved in comp o Asymmetric info + lack of info -> value difficult info gathering) & Selection challenge (screening & signaling,
𝐶𝑜𝑚𝑝 o reciprocate invitations (give up cherry-picking) (access future deals)
t(r) = investment dates 𝑋𝑗 o Info opaque + diff to interpret o Inadequate accounting intangibles (human cap) o have few tangible assets (few things due-diligence(track record,credibility))] | INVEST: process of
𝐶𝑜𝑚𝑝 o involve investors with complementary skill & network
Fi(EXIT) = Fi(R) (=exit ownrshp) 𝑀𝑗 = that can be collateralized) o don’t have a settled business model, often no revenues/profits o Moral hazard: E actions too closing a deal - money for ownership [E needs, I needs (fuel),
𝐶𝑜𝑚𝑝 o capital constraints
𝑃𝑀𝑗 risky/harm I’s share of comp value/choice effort H/L o Adverse Selection: E conceals value-relevant info from I -> I wrong expectations(venture’s future), market conditions(brgaining
Xi = Fi(R)*X choice (vb accept risky projects)
Three main rationales for using preferred stock:
𝐶𝑜𝑚𝑝 pwr I&E)] | RIDE: path forward, with all surprises and pivots
NPV = [Xi/(1+d)Ti(EXIT)]-I(i) MComp = avg(𝑀𝑗 ) 1. Provide incentives to founders (need for balance)
VC: o alternative assets -> illiquid & specialized o market: high volatility/cyclical o VC compensation has option like endemic to entrepreneurial process. [E&I help grow the
CCM = Xi/I(i) Xe = PMe*MComp 2. Screen out weaker projects
structure -> encourage risk taking o Seasoned GPs: Past performance ifluences future performance -> fundraising o New company (learning, governance)] | EXIT: INV sells some/all
Uncertainty 3. Align investor and entrepreneurs’ expectations
IRR: I(i)*(1+IRRi)Ti(EXIT) = Xi VC: First funds: lack of track record -> cornerstone LP + LP friendly LPA terms o Deal flow Network: link VC to E shares to get return on I [IPO, acq, Fin Sale(buyout, secondary),
Entrepreneur: motivations for staged financing
CCM = X/VPOST Scenario analysis:Early-stage: require Time, require less cap, High risk | Late-stage: higer cap, less risk closing down (with(out) bankruptcy)]
o reduces the cost of fundraising and the associated dilution
XENT = (1-(I/VPOST))*X (mon. gains) (average val) V = pSVS
LPA: LPs can’t see (Asym info) & assess (lack expertise) what GPs do
I nature&approach to the deal (I defining traits), I impact on Investor: motivations for staged financing
MFee: cover operational costs + give incentive raise larger funds | Carry: align LP&GP incentives (max final fund value)
VPOST = Xe/CCMe Simulation
Angel: own money, act for themselves, no clear/open ended Exit strategy, proximity, Early-stage, shallow pockets
company -> I not fungible, money not green = I add value door o option value of waiting (reducing amount of money at risk)
Value Non-dilution clause PROFEX (prob exit): expertise & network o staging increases control through the ‘power of the purse’
Multiples (-): reflect market valuations -> prone to herding (follow crowd, not own analysis)
= (FINV*VPOST met – zonder clause) VPOST = value(r+1)e disc Fundamental structure: who is the investor? •(resources, o facilitates termination of investing (refusal vs getting back)
Milestones (-): Short-termism(achieve target),under-pivoting (bring product quick to market),definig performance may be
governance & decision making) | Underlying motivation: what o option to abandon anyitme without penalty
Elusive (when is prototype really working?)
does he want? •((non)fin return, risk tolerance, patience) | o allows VC to monitor firm before making refinance decision
Deal structuring: negotiation (VPRE = BVE if BSE = 1) CF rights: to max Expected Venture Value o downside protection: debt-like payoff when failure o profit-sharing in upside
Expertise and networks: what does he contribute? | Logic and Informal control
SV = JV – OOE – OOI | JV = BVE + BVI | BVE/I = OOE/I + BSE/I*SV (I&E incentives!): conversion to common equity
CN(+): simple,standardized, structure -> save on legal costs, not control/protective rights | delegates/postpones valuation style: how does he operate? (select/interact with firm) o power of the purse: staged financing gives substantial power
JV=X, OOI=I, (BVI/JV)=FINV | VPOST=(JV*OOI)/BVI o power of personality: comes from credibility and respect
and negotiation | Soft elements buffer in deal: o Trust (action wo control & decisions when contracts can’t help) o LT
o power of persuasion: experience and strength of arguments
Operating CF (= NI + D - NWC) (1-T)EBIT + D - NWC perspective (create future value-creating opportunties)
Milestones measure performance in different dimensions:
- Investing CF (Capex) (assets) Insider: knowledge, exploitation, limited contribution, want high V(avoid dilution -> less new S for same I -> E keeps more S)
o financial (e.g., sales, ebit, operating CF, financial ratio)
= FCF (X) = FCF Outsider: expertise, want low V(buy cheap -> more new S for same I)
o operational (e.g., regulatory approval, supply contract)
+ Cash balans (0) - interest Principal-agent problem: Informational asymm & diff incentives/objectives. IA alone not a problem if incentives of o managerial (e.g., hiring of CxO, independent director)
= Ending Cash before financing CF = (X) agent are perfectly aligned with principal’s. Different inc/obj also not problem if principal has full info and can write o technical (e.g., working prototype, license acquisition)
+ Financing CF (Liabilities & Equity) contracts conditional on this info. The latter assumes that the info is verifiable in court and that contracts can be Anti-dilution: protect FINV1 in Down round (P(r)<P(r-1))
= Cash balans (1) complete. Full info and diverging objectives can become a problem if it is impossible to cover all contingencies in a -> reprice P1 (compensate for payed too much)
NWC = (CA-CL) (CA: cash, Inv, receiv, CL: payables) complete contract, e.g. due to feasibility constraints.
problem less sever in entrepr ventures than mature: Incentives I-E more likely to be aligned ● Both intrinsically VEM Market risk Technology risk People risk
Revenues
Debt: D = I * (1+r)T driven to see company grow, not just financial objectives (Vb: founder ent venture less likely than manager mature Attractiveness Customer (demand) Company (supply) Entrepreneur(founder)(impl a solution)
- OE
*Salaries, stock options
Spread over each comp to limit working hours to contractual min & business angel more likely to work through difficulties with the ent Value proposition NEED (what, SOLUTION (solve need?, TEAM (talent: skills, experience,
*huur, R&D, SG&A period: D = 1T I * rt + I => reduces differences in incentives/objectives) | More proximity between I(angel) en E reduces info asymmetries (Micro) strength, WTP) alternatives?, protect innovation?, motivation, commitment,
● But Entrepreneurial ventures are more opaque, harder to predict growth en value dus this can increase info asym create value experimentation, design thinking) trustworthiness)
*marketing, distribution
*(in)tangible assets Company-level returns = X | Gross returns (Fund level) = X(comps) Convertible notes Industry (Macro) MARKET (size of opp: COMPETITION (current&future NETWORK (access resources, reputation,
*Capital expenses (Inv LT assets) Management fee = 2%*(commited or invested capital) scale up/ achieve scale market size, growth rivals, differentiation from rivals, form/maintain relationships, network
Conversion rate: PCN = (1-DIScount)*PINV speed, adaptation) entry barriers) centrality(diversity, position))
= EBITDA → 2% Com C (InvPeriod) & 1% Inv C (HarvPeriod) Ownership: SCN = ICN/PCN = ICN/[(1-DIS)*PINV]
- Development costs Strategy (Dynamic) SALES (reach PRODUCTION (development, scope ORGANIZATION (develop/maintain
Carried interest = 20%*Profits = 20%*(X – I*(1+hurdle)T – Fee) Valuation Cap: (avoids ‘paying for success‘) Growth (capture value) customers, of activities, partnering, efficiency company leadership, governance, cultural
*D/A, Interest
- Tax Net returns (LP level) = I*(1+hurdle)T + 80%*(X – I*(1+hurdle)T – Fee) PCN = [VCAP/SPRE] (1-DIS)*PINV (ability to be marketing, of operations, technical imprint, talent recruiting/retention,
= Net income (LP comp) = Gross r – GP Comp | GP compensation = Management Fee + Carry PINV = VPRE/(SPRE + SCN) dynamically sustainable) distribution, pricing, milestones/key inputs, choice on founders’ succession)
adoption costs) boundaries of firm)
Valuation: FCFE method: FCFE = 100% equity FCF – after tax interest expenses + net borrowing @ equity cost of capital Competitive advantage Access to customers erect and maintain Entry barriers developing key competencies
WACC method: VL = 100% equity FCF @post-tax wacc // APV: VU = 100% equity @pre-tax wacc + PV(tax shield) @pre-tax wacc = VL
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller heleen123. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $5.35. You're not tied to anything after your purchase.