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
