Venture Capital Contracts :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Venture Capital Contracts


What Do Entrepreneurs Care About? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION What Do Entrepreneurs Care About? Build a successful business Raise enough money to found a venture Maintain as much value and control of the company as possible Get expertise and contacts to grow the company Share some of the risks with investors Financial rewards if the venture turns out to be a good one


What Do VCs Care About? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION What Do VCs Care About? Maximize financial returns to justify the risk and effort involved in funding a company Ensure that the firm is using capital in the best possible way Participation in later financing rounds if the venture is a success Eventually achieving “liquidity”, i.e. being able to sell the company in an IPO or merger Building their own reputation


Both Care About: :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Both Care About: The success of the new venture The split of financial returns The allocation of control rights Eventually liquidating some or all of their stake in the company Potential conflicts of interest?


Logic Behind the Contracts :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Logic Behind the Contracts Financial returns divided to: Reward investors for their investment in the firm Provide high-powered incentives to entrepreneurs to maximize value and stay with the firm Provide VCs with incentives to add value Contrast with incentives in firms Dynamic allocation of control Gives more control to entrepreneur if thing turn out well Gives more control to VC if things do not turn out well Provides incentives to achieve a liquidity event


Do Simple Financial Instruments Meet the Needs of VCs and Entrepreneurs? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Do Simple Financial Instruments Meet the Needs of VCs and Entrepreneurs? Common stock Returns? Control? Liquidity? Debt Returns? Control? Liquidity?


Key Terms of VC Contracts :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Key Terms of VC Contracts Preferred stock Redeemable (of straight) preferred Redeemable preferred packaged with common stock Convertible preferred Participating convertible preferred Anti-Dilution Provisions Full Ratchet Weighted Average Anti-Dilution Covenants/Control Terms Employee Terms


Two Key Feature of all Preferred Stock Used in Venture Capital :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Two Key Feature of all Preferred Stock Used in Venture Capital Liquidation Preference over Common Stock Redemption


Liquidation Preference over Common :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Liquidation Preference over Common Prevents the “Take-the-Money-and-Run” Problem Prevents founders from being able to pull out money before they create any real value Tax Deferral Redemption of preferred is just return of capital, thus no capital gains tax Favorable Pricing of Common Stock IRS (Internal revenue service) will accept low common-stock valuations and thus will not put heavy tax burden on employees/founder with common stock.


Redemption :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Redemption Mandatory redemption rights allows VC to “put” the preferred stock back to the company Force liquidity event Prevent “life-style company” (stable no growth) Specified in 84% of VC deals Redeemable preferred stock always specifies when it must be redeemed by company Typically the sooner of IPO or 5 to 8 years: company has to pay cash to redeem preferred at original price or “fair market value” If company does not redeem, then penalties can kick in: Reduction in conversion price Increased board seats for VC


Redeemable Preferred/Straight Preferred :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Redeemable Preferred/Straight Preferred No convertibility into common stock Dividend accrue (i.e. are added to the face value) but aren’t typically paid prior to redemption Example: preferred of $2M


Preferred Packaged with Common Stock :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Preferred Packaged with Common Stock Downside protection and upside potential Example: Preferred of $2M + common stock for 40% of the company


Convertible Preferred :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Convertible Preferred Can be converted at the shareholders’ option into common stock at a pre-specified conversion price Convert if total value at IPO/sale/liquidation is greater than the liquidation preference (with accrued dividends) Most contracts include automatic/mandatory conversion at IPO provided the IPO price and proceeds are high enough


Convetible terms :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Convetible terms Conversion option: If initial investment is $2,000,000 and conversion price is $5/sh, then can convert into 400,000 shares. If there are initially 600,000 common shares outstanding, then own 40% of the common stock on conversion In this case, will convert if .4*V>$2M or V>$5M (ignoring accrued dividends) Automatic conversion VC must convert at an IPO provided the IPO prices is greater than some multiple of the initial conversion price The median multiple is 3.0; it is higher for early stage deals (4.0);lower for later stage deals (2.7)


Payoffs from Convertible Preferred :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Payoffs from Convertible Preferred


Participating Convertible Preferred :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Participating Convertible Preferred Convertible preferred with extra feature that “in the event of liquidation or sale” the holder get face value plus equity participation Redeemable preferred + common stock if the company is liquidated (including private sale but not IPO). In our example, would get $2M and 40% of the company Convertible preferred if company goes public. In our example, would get $2M or 40% of the company In this case, convert if .4*VIPO>$2M + .4*(VSALE-$2M) (ignoring accrued dividends)


Payoffs from Participating Preferred :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Payoffs from Participating Preferred


Payoffs from Participating Preferred :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Payoffs from Participating Preferred


Evolution of Preferred Stock Over Time :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Evolution of Preferred Stock Over Time 1970s: security of choice – Redeemable preferred Often in combination with common stock Not many IPOs 1980s: security of choice – Convertible preferred Active IPO market Large increase of funds flowing into VC industries 1990s: security of choice – Participating convertible preferred Many later stage investors paid very high prices


Do these Pay-off Structures Matter? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Do these Pay-off Structures Matter? No, in the world of Modigliani-Miller! Just alternative ways of slicing up to pay Yes, in the real world High-powered incentives for VCs to add value High-powered incentives for entrepreneurs to create long-term value


The Role of Preferred Stock :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION The Role of Preferred Stock Preferred feature aligns incentives of entrepreneur with VC to strive for lager payoffs Limits returns to the founder for modest outcomes-incentives to reach high payoffs The extent to which the VC wants to encourage the entrepreneur to go for the big payoffs can be controlled by specific choice of security. Redeemable preferred + Common Stock > Participating convertible preferred > convertible preferred > Common Stock > Minimum wage


Convertible Preferred and its Relation to the Implied Firm Value :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Convertible Preferred and its Relation to the Implied Firm Value VCS typically derive the “post-money” (“pre-Money”) value of a firm based on the terms of the convertible preferred contract If, for example, the VC invests $2M in the above convertible preferred contract (which converts into 40% of the firms’ common stock), then VC will say that the pre-money value is $2M/.4=$5M and the post-money value is $3M ($ 5M-$2M) Alternatively, it the VC method comes up with a values of $5M post-money, and the investment is $2M, then the VC method chooses a % ownership, s, such that s*$5M=$2M. Here s is 40%


Two examples to make the point :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Two examples to make the point Example 1: if the firm value is V with probability 0.5 and zero with probability 0.5, can we figure out V --- the pre-money value used by the VC --- based on the deal terms? If investing $2M for 40% of the company, then in order to earn a market return on her investment, it must be that implied value, V*, used by the VC is: $2M = 0.5*40%* V* + 0.5* 100%* 0 Thus V* = $10M


The Other Example :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION The Other Example Example 2: the firm value is V*>$2M with probability 0.5 V=$1M with probability 0.5. What is the implied value V* the VC is offering based on the deal terms of the contract? In order for the VC to earn a market return on her investment: $2M=0.5*40%*V + 0.5*$1M Thus it follows that the implied value V* is $7.5M, 25% less than the $10M value we derived in example 1.


A more Systematic approach to backing out the Implied Value, V* :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION A more Systematic approach to backing out the Implied Value, V*


Anti Dilution Provision :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Anti Dilution Provision If the firm raises additional funding at a price below the prior round VC’s price, the VC’s conversion price is lowered to protect against dilution Anti-Dilution protection comes out of founders share Prevents company from strategically raising later rounds to expropriate initial investors (avoid “wash out” financing Helps to maintain constant fraction of equity – control rights Company and founders bear most of the risk: Why is downside risk not shared among founders and investors? Incentive for founders to create value Golden rule: “Those that have the gold make the rules”


Anti Dilution Provision :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Anti Dilution Provision Pay to Play Only those investors who are willing to participate in the dilutive financing are entitled to the benefits of the anti-dilution formula in place Best approach is to require each investor to purchase a percentage equal to its pro rata ownership among the investor group of that portion of the financing allocated to the old investors (by the board of directors). The balance of the financing (if any) will be allocated to new investors.


Anti Dilution Provision :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Anti Dilution Provision Full Ratchet anti-dilution: the conversion price is lowered to the price of the new financing Weighted Average anti dilution: the new conversion price takes into account the number of new shares issued New conversion price= [(A+C)/(A+D)]*old conversion price A: # of common shares outstanding before transaction C: # of shares to be issued if old conversion price had held D: # of shares that are actually issued under the new conversion price New shares to initial investors = (old price/new price)*initial shares owned The more shares are issued (D) at a dilutive price the more the weighted ratchet bites.


Anti Dilution Provision: Example :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Anti Dilution Provision: Example Example: Company has 2 M shares outstanding 1 M common stock to founders 1 M convertible preferred to investors, conversion price $1 New issue of 50,000 shares at $0.50 Full Ratchet: New conversion price: $0.50 Convertible preferred holders get 2 M shares or 65.6% or equity Weighted average ratchet: New conversion price = (2M+25000)/(2M+50000)*$1=0.988 Preferred stock holders get 1,012,145 shares or 49.08% of equity


Key Terms of VC Contracts :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Key Terms of VC Contracts Anti-Dilution Provision Covenants/Control Terms Voting rights/Board representation Protective provision Registration rights Employee Terms Vesting periods/Stock Restrioctions Non-competes


Participation Rights :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Participation Rights First refusal rights Rights to purchase shares proposed to be sold by any shareholders Preemptive rights Gives investors the right to buy new shares offered by the firm in later financing rounds Rights end at time of IPO In current environment: right to invest 2X pro-rata ownership in later round


Control Rights :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Control Rights Entrepreneurs want to have control over the development of the business Control is most important when the company is growing VC wants to insure high returns to investments Control is most important when things are not going well The goal is to structure contracts as to allocate control to the party that has more benefits and expertise in using it Voting rights/Board representation Protective Provision


Control Terms :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Control Terms Voting rights Preferred votes number of share as if converted into common VCs control votes in 57% of deals, whereas entrepreneurs control votes in 23% of deals. Neither has control in 20% of the deals If performance and vesting targets are not met, VC increases control in 72% of the cases Board Representation Average size of board is 5 VCs get 41,5% of seats on average; entrepreneurs get 34,7% on average; outsiders the remainder


Mile Stone :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Mile Stone Performance contingencies: Historically in about 44% of deals, some aspect of the contracts is contingent on financial or non-financial performance measures Voting control to VC if EBIT below some thresholds Share vesting contingent on FDA approval “Earn-ins”: Earn equity by meeting value goals Additional funding conditional on completing a new benchmark In current environment: majority of closings includes milestone based tranches


Exit provisions :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Exit provisions Tag-Along If an offer is made for a shareholder’s shares, that offer must be extended to other shareholders (VC) Drag-Along Right to force all shareholders to sell company upon board and majority shareholders approval Co-Sale Right Allows VC to exit at the same rate and time as a funding shareholder


Registration rights :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Registration rights Stipulate to extent to which preferred versus common stock will share equal/preferential treatment when the stocks have been converted and participated in an IPO Demand rights: allow investors to demand that company goes public even if managment does not want to “Piggy-back” Rights: allow investors to include his shares along side with company in an IPO Lock-up provision: specifics the period until shares vest Often determined by the underwriter


Goal of employee terms :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Goal of employee terms Compensate employees for taking risk and hard work Provide incentives to encourage superior performance Retain talent in a company


Employee Terms :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Employee Terms Reserved shares Pool of shares that can be given to employees for incentives/compensation reasons Typically represents 10%-15% of total fully diluted capitalization Usually require board approval Shares issued in excess of the allotted pool trigger anti-dilution provisions Non-competes Investors want ensure that key employees do not leave to form competitive firms Time period of non-compete: 1-2 years


Stock restriction agreements :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Stock restriction agreements Vesting of founders’ shares “golden hand-cuffs”: prevents sale of stock before a certain date Four years on the East-Coast, three years on the West Coast In current environment: moving to five year vesting Right to buy back unvested shares of entrepreneur at original purchase price, if he leaves the company Accelerated vesting for certain (top) managers in acquisition Avoid hold-up problems


Important aspects of VC Deals :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Important aspects of VC Deals Staging of Capital Commitment Type of Venture-Capital Firm


Staged Capital Commitment (SCC) :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Staged Capital Commitment (SCC) VCs fund companies in multiple “rounds”: Seed stage Start-up Early stage Expansion…… In the 1982-1990 period, the time between rounds was typically a year, with more dollars being committed in the later rounds The rounds tend to be shorter in high-tech industries and for smaller sums


The dual role of SCC :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION The dual role of SCC Control Mechanism Entrepreneurs has to come back to VC for funding at several points. Allows investor to monitor the firm and to shut it down (i.e. not fund it) if the success probabilities are poor Option to abandon! Signaling and screening Entrepreneurs who are confident about their prospects will want to defer raising capital until the firm has passed some milestones SCC allows the entrepreneur to issue equity at a more favorable price and enables VCs to screen among entrepreneurs


Example: SCC as a contol mechanism :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Example: SCC as a contol mechanism Mit.com needs $10M to get things off the ground $20M a year from now for further development of the business Next year, news about firm’s prospects will have come out: Good news (2/3 prob.): Certain success  $150M payoffs Bad news (1/3 prob.): 1/10 chance of success ($150M payoffs) and 9/10 chance of failure ($0 payoffs) If bad news comes out, efficient not to invest $20M to get expected payoffs of $15M


Example: Financing without SCC :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Example: Financing without SCC Suppose company raises $30M all at once, upfront The entrepreneur will always choose to invest at both stages if his next best job is not very good (even when it is economically inefficient) and he’d have to return the $20M if he didn’t invest In exchange for $30M, VC will demand 28.5% of the equity, as 28.5%*(2/3+150+1/3*.1*150)=30 Entrepreneur is left with 71.5% of the company


Example: Financing with SCC :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Example: Financing with SCC Assume: Entrepreneur raises $10M now, extra $20M if good news realizes. If bad news comes out, he does not raise money Solve backwards: If good news comes out, sell 13.3% of firm to raise $20M (=13.3%*150) In start-up stage, company is worth 2/3*150=100, sell 10% of the company to raise $10M The entrepreneurs sells only 23.3% of company Note: The initial round investor has to own more than 10% of the company initially in anticipation of getting “diluted” in the subsequent round. For example, if initially there are 1000 shares owned by E, first round investor buys 130 shares (owning 13.4% of company) and second round investor buys 173.9 shares


Type of Venture-Capital Firm :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Type of Venture-Capital Firm VCs differ in many ways – capital under management, age, portion of fund invested, and industry expertise These differences affect the way VCs manage their investments For example, VCs with considerable industry expertise can more effectively guide portfolio firms, bring in industry experts, or use their industry contacts to help portfolio firms (thus, the Kleiner-Perkins keirestu)


An important Caveat about VC firms :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION An important Caveat about VC firms VC firms are intermediaries, i.e. they are agents of the venture fund’s limited partners To finance the next fund, VCs have to prove they’ve made money on the current fund by selling portfolio firms or taking them public, i.e. reach a liquidity event This creates incentives to sell or take a company public too early Funds have an incentive to “grandstand” Particularly for young and small VC firms


Evidence of Grandstanding :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Evidence of Grandstanding On average, first-fund VCs take firms public after 2.7 years versus 4.5 years for later-fund VC firms First-fund VCs set up next fund 1 year after first IPO in first fund; later-fund VC firms set up next fund in 2.4 years IPOs of first-fund VC firms are greater than IPOs of later-fund VC firms (18.5% versus 7.8%) Age of VC firm matters!!


VCs bring Assets and Liabilities :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION VCs bring Assets and Liabilities Assets Cash Industry Contacts Managerial Expertise Liabilities Need to reach liquidity event Conflicts among the syndicate Different objectives