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Exam 2 Review

Exam Rules and Format

Time – 1 hour and 45 minutes

Open notes – The path to answering every question on the exam can be found in the slides attached to this deck

No phones or computers

Bring a calculator

The practice is critical – make sure that you go over the examples and exercises that we covered in class

Format Similar to Exam I

Section I (50 points)

10 multiple-choice questions worth 5 points each

Section II (50 points)

3 to 5 questions requiring computations

What’s on the exam?

While the exam is cumulative, we will primarily focus on Lectures 8 through 13

Systematic risk question from Exam I will be on this exam, in a slightly different form

Lecture 8 – Crowdfunding and Angel Investors

Lecture 9 – Sources of Financing (Venture Capital)

Lecture 10 – The Investment Process (perhaps 1 question about Due Diligence)

Lecture 11 – Term Sheets I

Lecture 12 – Term Sheets II

Lecture 13 – Exits

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Lecture 8 – Sources of Financing

Crowdfunding, Incubators, and Angels

Equity-based crowdfunding

Backer receives shares of a company in exchange for the money pledged

Crowdfunding platforms cannot make commissions on equity raising, so they have to make money by alternative means:

Flat rate listing fees

Premium services

Selling data

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SEC limits on Equity Crowdfunding

Equity crowdfunding is tantamount to the sale of equity securities to the public and is therefore regulated under Securities Act of 1933

Crowdfunding was severely limited until the Jumpstart Our Business Startups (JOBS) Act of 2012

Made major amendments to Rule 506 of Reg D and Rule 144A

Key requirements of SEC regulations issued under the Jobs Act:

Transactions must be conducted through an intermediary that is either a registered broker or an SEC approved funding portal

The issuer may sell up to $1 million of its securities, per 12 months

Individual investments in a 12-month period are limited based on the annual income and net worth of the investor. Current range is $2,200 to $107,000, per investor per year.

Independent CPA reviewed financial statements for raises from $100,000 to $500,000 and Audited financial statements for raises from $500,000 to $1,000,000

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SEC limits on Crowdfunding Investors

Annual IncomeNet WorthCalculation12-month Limit
$30,000$105,000greater of $2,200 or 5% of $30,000 ($1,500)$2,200
$150,000$80,000greater of $2,200 or 5% of $80,000 ($4,000)$4,000
$150,000$107,00010% of $107,000 ($10,700)$10,700
$200,000$900,00010% of $200,000 ($20,000)$20,000
$1,200,000$2,000,00010% of $1.2 million ($120,000), subject to cap$107,000

If either annual income or net worth is less than $107,000, then during any 12-month period, you can invest up to the greater of either $2,200 or 5% of the lesser of your annual income or net worth.

If both annual income and net worth are equal to or more than $107,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $107,000.

Source: US Securities and Exchange Commission, Investor Bulletin, May 5, 2017

Examples from the SEC

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Angel Investor Definition

High net worth individuals who invest directly into entrepreneurial businesses in return for equity (or convertible debt)

Often successful, exited entrepreneurs or retired business persons

Typically invest in areas of professional expertise or interest

 

Accredited investors – SEC definition

E.g. net worth >$1M or annual income >$200K

Angels are the largest source of start-up capital

 

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Angels provide smart money

Many angels provide mentoring before and after investment

Often provide an advisory role for the management team

Some serve as board members or observers

Some join the venture as C-level executive for an interim period

 

Develop relationships with Venture Capital firms for expansion capital

 

Some angels are better than others…

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Super angels

Super angel: Set of very active, influential angel investors

E.g., have a portfolio of >20 companies and invest >$100 per company

 

Famous super angels: Aydin Senkut (former Google exec), Ron Conway (SV Angel), Chris Sacca (former Google exec), Mike Maples, Dave McClure (former Paypal exec)

 

Often co-invest alongside own fund or other VC firms

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Angel groups

Networks of angels who pool their resources and coordinate on leads, due diligence, contacts, and management advice and invest jointly

 

First Angel group “Band of Angels” founded in 1995 by Hans Severiens

 

In 2013, 400+ angel groups with an average of 42 members per group

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Lecture 9 – Sources of Financing

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Who invests in venture capital?

Accredited Investors Only

VC funds sell interests in “Private Transactions”

Not a public offering

Exempt from registration under the Securities Act of 1933.

Restrictions:

An investment manager cannot advertise the offering or broadly solicit investors

The offering is restricted to a small number of Accredited Investors

No more than 100 investors

Net worth > $1M or $200K annual income

Who invests in venture capital?

 

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Private placement memorandum (PPM)

The document which VC funds send to institutional investors to advertise fund investment opportunities

 

Includes

Fund’s investment strategy

Fund size, term, fees, minimum contribution, & GP commitment

GP’s background and expertise

Market opportunity

Other legal, tax, and regulatory matters

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Limited partnership agreement

A legal document that contains the terms that describe the control, management, financial investment, and distribution of returns for a fund

 

The PPM is the starting point for negotiation between LPs and GPs

 

Main goal: Alignment of LP and GP financial interests

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Limited partnership agreement

Structure of the funds

Minimum investment amount

Minimum and maximum size of the fund

“Takedown” schedule

Extreme conditions under which LPs can terminate their investment before the 10-year limit

Keyman provisions (key GP exits)

Bankrupt

The majority of LPs vote that GPs are damaging the fund

Penalty on LPs failing to meet their capital commitments

Charge interest for late payments

Seize LP’s stake; Sue LP

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Limited partnership agreement

Management of the Fund

Activities of the General Partners

Types of Investments

Compensation

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What is a VC fund?

Each fund is structured as a Limited Partnership

 

Typically the fund life is 10 years with possible extensions

Life science funds are often established as 12-year funds

Invest in the first 3-5 years

Exit in the second half

The real-life of funds can be much longer than 10 years.

 

A typical fund consists of 12-24 investments

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What is a VC fund?

Funds typically have a stage or industry focus:

Stage: Seed/Early, Growth/Expansion, Later

Industry: Internet, healthcare, cleantech, etc.

 

A VC firm can manage several funds, which are typically raised a few years apart.

In 2008, KPCB raised its 13th fund: KPCB XIII, $700 mn

In 2012, KPCB raised its 15th fund of $525mn

Flow of funds: Fees & Carry

 

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Fund terminology

Committed capital: the amount of money promised by LPs over the fund life

Only a portion (10-30%) of the committed capital is transferred to VC right after the fund closes

The rest will be called down as the need arises

Capital calls: Request from GP to LP for pledged capital

Typically, takes 2 weeks for capital to arrive from the time of the call

Lifetime fees: the total amount of fees paid over the lifetime of a fund

 

Fund terminology

Investment capital: committed capital – lifetime fees

 

Invested capital: cost basis for the investment capital of the fund that has already been deployed

 

Net invested capital: invested capital – cost basis of all exited and written-off investments

Investment period (commitment period): Period of time during which the fund can make new investments

Typically, the first 5 years

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Simple Example

ABC Ventures raised its first fund – ABC I

Committed capital: $100M

Management fees: 2% (level) of committed capital (basis) annually

Fund life: 10 years

What are the lifetime fees and investment capital of this fund?

Lifetime fees = 2% x 100M x 10 = $20M

Investment capital = $100M – $20M = $80M

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Slightly less Simple Example

ABC Ventures raised its first fund – ABC 1

Committed capital: $100M

Same management fee and carried interest

Invests $5M per company in 10 companies

Sells 2 companies for $200M a piece

What are the invested capital and net-invested capital of this fund?

Invested capital = $5M x 10 = $50M

Net-invested capital = $50M – $10M = $40M

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Practice problem

Greylock Partners raised its 15th fund in 2008

Committed capital of $400M

2% Management fee on committed capital

12 year fund life, 5-year commitment period

Greylock has made 10 investments of $30 million each by 2012, and

Greylock has exited 5 deals with a total cost basis of $150M

It is now 2015

 

Calculate:

Lifetime fees

Investment capital

Invested capital

Net-invested capital

Practice Problem Solution

FormulaCalculation ($M)
Step 1Lifetime fees:
Committed Capital x Fee % x years$400 x 2% x 12 = $96
Step 2Investment Capital
Committed Capital – Lifetime fees$400 – 96 = $304
Step 3Invested Capital
Sum of all investments made to date10 investments x 30 = $300
Step 4Net Invested Capital
Invested Capital – Cost basis of all exited or written off investments$300 – 150 = $150

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Computation of fees in practice

Requires two values:

Level (%)

Variation among funds

Variation over fund life

Basis

Committed capital

Invested capital

Implications on VCs’ behaviors?

 

In roughly 40% of firms, the management fee base changes from committed capital to net invested capital after 5 year investment period

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Practice problem #2

Fund XYZ has committed capital equal to $500M and is 7 years into its fund life of 10 years. Management fees for XYZ are 2% of committed capital during the first 5 years of the fund’s life, and 2% of net invested capital after its initial 5 year investment period. XYZ has invested $400M and has experienced 3 firm exits at the end of year 5 which totaled a cost basis of $125M.

 

Calculate fund XYZ’s lifetime fees assuming no more exits by year 10

Practice Problem #2 Solution

FormulaCalculation ($M)
Part 1Fees for the first 5 years:
Committed Capital x Fee % x years$500 x 2% x 5 = $50
Part 2Fees for last 5 years:
Net Invested Capital x Fee % x years
1Invested Capital
Sum of all investments made to date$400
2Net Invested Capital
Invested Capital – Cost basis of all exited or written off investments$400 – 125 = $275
3Calculate fees for the last 5 years
Net Invested Capital x Fee % x years$275 x 2% x 5 = $27.5
Part 3Lifetime Fee
Part 1 + Part 2$50 + $27.5 = $77.5

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Computation of carried interest

Carried interest (carry): the portion of the profit that goes to GPs

Carry = Carry percentage * Profit

Profit = Exit Proceeds – Carry Basis

Carry percentage: typically 20%

Carry Basis: Threshold that must be exceeded before GP can claim a profit

Committed capital (used by about 70% of funds)

Investment capital (i.e., committed capital – fee)

May include a hurdle rate

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Practice problem

Fund Z has a carry a percentage of 15% and a carry basis equal to committed capital.

 

If committed capital is equal to $100M how much will the GPs make after selling all the fund’s portfolio companies for

$250M?

 

GP carry = (250 – 100)*0.15 = 22.5

 

How much would the LPs make?

 

LP profit = 250 – 100 – 22.5 = 227.5

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Practice problem

Fund VII has committed capital equal to $350M. The carry percentage is 20% and the carrying basis is equal to committed capital plus a 10% hurdle rate. At the end of the funds, life exit proceeds equal

$560M.

 

Calculate the GPs carry.

Carry = (560 – (350 x 1.1)) x 0.2 = $35M

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Computation of carried interest

Timing of distributions:

Deal-by-deal (most popular)

Real-estate model — wait till LPs get their money back

 

Deal-by-deal: What could possibly go wrong?

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Lecture 10 – The Investment Process

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Due diligence

Due diligence: Investigation of a business or person prior to signing a contract

The rigorous process that determines whether or not the venture capital fund or another investor will invest in your company

The primary purpose is to confirm valuation and identify material risks.

The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity.

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Preliminary due diligence

For firms that successfully pass the pitch meeting, the next step is preliminary due diligence

 

Primarily focuses on an in-depth analysis of the company’s management and market potential.

 

If other VCs are also interested in the firm, preliminary due diligence is short

 

If the results of the preliminary due diligence is positive, the VC prepares a term sheet that includes a preliminary offer.

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Warren Buffet due diligence

4 simple criteria:

Can I understand it? (Buffet defines “understanding a business” as “having a reasonable probability of being able to assess where the company will be in ten years”)

Does it look like it has some kind of sustainable competitive advantage?

Is the management composed of able and honest people?

Is the price right?

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Final due diligence

Further analysis of management, market, customers, products, technology, competition, projections, partners, burn rate of cash, legal issues, etc.

 

Legal due diligence: “I’m interested in learning how well-formed the company is, if there are skeletons in the closet like fired co-founders or large debts or consultants who are owed shares or pending lawsuits.”

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Lecture 11 – Term Sheets I

Term sheet

A term sheet is a non-binding agreement setting forth the basic terms and conditions under which an investment will be made

 

A term sheet is NOT a legal promise to invest, rather it’s a reference point in future negotiation

 

“Think of it as a blueprint for your future relationship with your investor” – Brad Feld, Foundry Group

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Term sheet

The primary goal of the term sheet is to outline the economic and control terms of the entrepreneur – investor relationship

 

Economic terms: Terms which determine how the money will be split between the entrepreneurs and investors when the firm is sold or goes public

 

Control terms: Terms which explain how the control of the start-up is split between the entrepreneurs and investors

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Timeline of a VC investment

The company presents a business plan to VC

 

VC performs preliminary due diligence on the company

Business model, management team, competition, technology, capital intensity, etc.

VC proposes a term sheet to the company

 

VC and company negotiate the terms of the term sheet

 

Company signs term sheet, exclusivity period starts (No- Shop provision)

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Timeline of a VC investment

VC performs legal due diligence on the company

IP filing, customer and supplier contracts, organizational documents

 

VC prepares definitive investment documents (the “5 documents”) based on the signed term sheet

 

More negotiations

Things not addressed in the term sheet

New information found in due diligence

 

Closing of the transaction

Both company and VC sign definitive investment documents

Transfer funds

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No Shop Provision

A term sheet is NOT a legal promise to invest

 

Once signed the only legally binding portion of the term sheet is the “No Shop Provision”

 

The No Shop Provision it requires the company to:

Keep the negotiations confidential

Stop looking for other investors for a period (say 30-60 days)

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Overall

The term sheet is critical and is much more than a simple letter of intent

 

It will provide the basis for your future relationship with your investor and will influence your ability to get future financing

 

Outlines trade-off between economic and control rights

 

The best way to negotiate a higher valuation is to have multiple VCs interested in investing in your company

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Term sheet

Economic terms

Valuation—pre-money valuation

Liquidation preference

Anti-dilution provisions

Vesting

Option pool

Dividends

Control terms

Board of directors

Protective provisions

Drag-along agreement (M&A)

Conversion

 

 

 

 

 

Key negotiating points

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Key term sheet provisions for negotiation

Pre-money valuation

A key determinant of ownership structure

 

Size of the unallocated employee option pool

Also impacts ownership structure

 

Governance provisions

Board Structure & Voting rights determine who controls the company

The ideal outcome is a balanced Board

 

Participating preferred

VC’s best friend when the business generates a sub-optimal outcome

 

 

Outlines pre-money and post-money valuation

 

Ownership is recorded on a “fully diluted basis” – i.e., it assumes all preferred stock is converted and all options are exercised

 

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Pre-money and post-money valuation

Pre-money valuation is the company’s valuation before it accepts the new investment

Post-money valuation is the company’s valuation after the new investment.

Pre- and Post-money valuations are implied valuations

Post-money valuation =

$ investment / ownership percentage

Pre-money valuation =

Post-money valuation – $ investment

Example: $5M for 33.33% of firm

Post-money valuation = $5M/0.3333 = $15M

Pre-money valuation = $15M – $5M = $10M

Capitalization table

Term sheet states: $1M for 50%

Post-money = $1M/0.5 = $2M

Pre-money = $2M – $1M = $1M

 

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Pre-money vs. post-money

When a VC says, “I’ll invest $5 million at a valuation of

$20 million”

The smart entrepreneur says “Is that a pre- or post- money valuation?”

Why?

If $20 million is a pre-money valuation, then

 VC owns 20% after financing (post-money, 5/25)

If $20 million is a post-money valuation, then

 VC owns 25% of $20M post-money (5/20)

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Practice problem

Assume the following:

2,000,000 shares held by founders before investment

$10M pre-money valuation

$5M investment by VC

 

What % ownership does the VC have?

ClassSharesPrice per shareValuationPercentage
Founders2,000,000A
Employee poolB20.00%
VCCD$5M33.33%
TotalED$15M100.00%

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Practice problem – Solution

A = 100% – 33.33% – 20% = 46.67%

E = 2,000,000/0.4667 = 4,285,408

B = E*0.2 = 4,285,408*0.2 = 857,081

C = E*0.3333 = 4,285,408*0.3333 = 1,428,326

D = 5,000,000/1,428,326 = $3.50 per share

ClassSharesPrice per shareValuationPercentage
Founders2,000,000A
Employee poolB20.00%
VCCD$5M33.33%
TotalED$15M100.00%

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Option pool

Why?

 

Typically 10-20% of fully diluted shares following the new issuance to VC

 

The bigger the pool the better?

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Not necessarily…

Large pool  unlikely to run out of available options, but

Large pool  dilution, since the pool is typically carved out of owners equity pre-financing

 

Negotiation strategies:

Try to trade-off pool size for higher pre-money valuation,

Try to get pool added to the deal post-money

Entrepreneurs should come armed with an options budget (i.e., a list of all planned hires)

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Liquidation preference

Specifies which investors get paid first and how much they get paid when a liquidation event occurs

 

Liquidation event: when the firm is acquired, merges, or sells most of its assets, but NOT an IPO

An IPO is a funding event

 

Helps protect VCs from losing money by making sure they get their initial investments (plus profit) back before other parties

Especially important for VCs when the company is sold for less than what they’ve invested

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Liquidation preference

Each series of preferred stock will have its own liquidation preference

This can get complicated when there are multiple rounds

Typically, latest-round investors get money back first

 

Two components that makeup Liquidation preference:

The actual preference – who gets paid first

The participation – how much they get paid

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Participation

Three ways to structure liquidation preference for preferred stock:

Non-participating preference

 

Participating preference without a cap

 

Participating preference with a cap

1. Non-participating preference

The preference holder gets back its original investment (or multiple) plus, in some cases, unpaid accrued or declared dividends.

The non-participating preference is as an option.

At the time of liquidation, an investor must choose to either:

Receive the liquidation preference, or

Share in the proceeds in proportion to his or her equity ownership after converting his or her preferred shares into common stock

The investor would choose whichever option provides the better return

 

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Non-participating preference example

Ali Corp is raising a $250K seed round at a $1M “pre-money valuation” through the issuance of preferred stock with non-participating liquidation preferences. Assuming $250K is raised, the seed investors would own 20% of the company ($250K / $1.25M).

Holding all else equal, what happens in each of the following scenarios if the company either does well and is acquired for $3M, is mediocre and sells for $2M, or performs worse-than-expected and sells for only $1M:

1X liquidation preference (most common)

1.5X liquidation preference

2X liquidation preference

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Investor Exercises Liquidation Preference
Liquidation Preference
Exit Value1.0x1.5x2.0x
$3,000,000250,000375,000500,000
$2,000,000250,000375,000500,000
$1,000,000250,000375,000500,000
Investor Elects Return Based on Ownership
Exit Value1.0x1.5x2.0x
$3,000,000600,000600,000600,000
$2,000,000400,000400,000400,000
$1,000,000200,000200,000200,000

2. Participating preference without a cap

Participating Liquidation Preferences are sometimes referred to as “Double-Dip Preferred” and are the most favorable preference to investors.

After the VC fund gets its original investment (or multiple), the VC fund then shares in the balance of the sale proceeds with the common stockholders on an as-converted basis (e.g. as if their preferred shares were converted to common stock).

 

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3. Participating preference with a cap

After the VC fund gets its original investment (or multiple), the VC fund then shares in the balance of the sale proceeds with the common stockholders on an as-converted basis up until their aggregate return reaches a pre-negotiated cap (usually some multiple of the original purchase price per share).

Note: The cap includes the original investment. For example, if the cap is at 15M and the original investment is $5M then the investors will participate until they receive an additional $10M

 

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Quick note: Conversion Provision

Preferred stock can convert to common stock at any time!!!

 

This is non-negotiable

 

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Liquidation preference example 1

Suppose only 1 round of financing equal to $5M at $10M pre-money  VC owns 33.33%

 

Assume the company has an offer to be acquired for $30M

CASEVCEntrepreneur
1) Non-participating33% = $10M67% = $20M
2) ParticipatingFirst $5M, then 33%*$25M = $8.3M67% of $25M = $16.7M
3) Participating w/ 3X capWon’t reach the cap of $15M, so same as 2)Same as 2)

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Liquidation preference example 1

Suppose only 1 round of financing equal to $5M at $10M pre-money  VC owns 33.33%

 

Assume the company has an offer to be acquired for $100M

CASEVCEntrepreneur
1) non-participating33% = $33M67% = $67M
2) ParticipatingFirst $5M, then 33%*$95M = $36.35M67% of $95M = $63.65M
3) Participating w/ 3X capSeries A makes better than 3X  Convert shares, same as 1)Same as 1)

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Conclusions

Participation has a lot of impact at relatively low outcomes, but the little impact at high outcomes

 

Which liquidation preference will start-ups prefer?

Non-Participating Preferred Stock

 

Which liquidation preference will VCs prefer?

Participating in Preferred Stock without a cap

 

Middle ground: Participating in Preferred Stock with a cap

about 25% of deals

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Liquidation preference practice problem

Suppose Company X receives 1 round of financing equal to $2M at a $10M pre-money valuation

The VC receives participating preferred stock without a cap

If the company is acquired for $50M how much will the VC receive?

 

Value of PS = 2 + (2/12)*(50 – 2) = $10M

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Terminology: Down round

A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the company by earlier investors.

 

Down rounds cause dilution of ownership for existing investors  BAD!

 

Unfortunately, sometimes the only other option is going out of business. In this case down rounds are necessary and welcomed.

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Anti-dilution provision

Protects investor’s stake in down rounds

 

Two types:

Full ratchet anti-dilution: Earlier round preferred stock can only convert at a new price

E.g. Series A 1000 shares at $2 per share, new share price $1 per share  convert at $1 per share, get 2000 shares

 

Weighted-average anti-dilution: the number of shares issued at the reduced price is considered in the repricing of the Series A

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Participation rights

Investors have the right of first refusal to invest in future rounds, usually their pro-rata portion of the new financing

 

Note: This is a market term and is in most every VC deal you will see

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Board of directors

The key control mechanism is the process for electing board of directors

Board of directors (Early-stage, typically 5 members)

Founder

CEO

VC

A second VC

Outside board member (chosen by the board or by the common and preferred shareholders voting together as a single class)

 

Key: Balance of control

The later stage will have 7-9 board members

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What does the board of directors do?

Typical duties include:

Select, appoint, support, and review CEO

Set the salaries and compensation of company management

Establish broad policies and objectives

Ensure the availability of adequate financial resources

Approve annual budgets

Account to the stakeholders for the organization’s performance

Approve any transactions above an agreed-upon threshold.

Your board is your judge, jury, and executioner all in one – so be careful who you choose to be on it!

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Board of directors

VC as the board of director has a fiduciary duty to the company

 

But,…

 

VC is also an investor

 

Conflict???

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Protective provisions

Veto rights that investors have on certain actions by the company:

Issuing new shares

Change the terms of the stock owned by VCs

Issue stocks senior or equal to VCs

Buyback common shares

Sell the company

Change the certification of incorporation or bylaws

Change the size of the board of directors

Payor declare a dividend

Borrow money in excess of a threshold (e.g., 100K)

Why do protective provisions exist?

Mandatory conversion

Most underwriters require the outstanding preferred stock to convert before IPO

 

Rather than negotiate at the time of IPO with preferred holders, Qualified Public Offering (QPO) provisions force conversion prior to IPO

 

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Qualified public offering (QPO)

QPO is an IPO surpassing:

A minimum offering price (e.g., X times original purchase)

Minimum offer amount

Minimum market cap (sometimes)

 

All convertible preferred stocks are subject to mandatory conversion in case of QPO

 

If a proposed IPO is not a QPO, mandatory conversion can still happen as long as a majority of preferred holders agree

 

In that case, preferred holders may be able to receive more common shares as an incentive for them to agree to convert

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How to negotiate QPO

What will entrepreneurs want?

The entrepreneur will want lower conversion thresholds to ensure more flexibility

 

What will the VC want?

VCs will want higher thresholds to give them more control over the timing and the terms of the IPO

 

VCs want to set the QPO requirement high enough to prevent founders from pushing the firm public too early

Minimum price: ensure a decent return for VC; a thinly traded stock makes it harder for VCs and their LPs to trade out of the stock.

Minimum offering amount: An IPO with a small offering amount (i.e.,

$ raised in IPO) will not attract established underwriters, which can hurt the success of the IPO.

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Drag along with rights

Allows a subset of investors to force the other investors and the founders to agree to a sale or liquidation of a company

 

Prevent holdout problem (esp. when the sale value is below the liquidation preference)

 

Requires a majority of preferred holders

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Negotiating drag along with rights

Get the drag-along rights to pertain to the majority of the common stock, not the preferred;

The investors can convert some of their preferred to common stock to create a majority (which would lower the liquidation preference).

 

Negotiate a higher threshold (e.g. 2/3 instead of 51%) to trigger the drag-along rights

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Other terms of the Term Sheet

Redemption rights – Conditions under which investors may redeem their initial investment

E.g. prespecified length of time to reach milestones

Rarely exercised due to legal difficulties

 

Registration rights – Provide a contractual right for investors to demand that the company register their shares with the SEC. Following registration, the investor can sell their shares on the public market.

Important since US law permits the company, but not the shareholder, to register company securities.

Ensures that liquidity is an option for the investor

 

 

Co-sale and Right of first refusal – Investors right to sell stock to the same buyer, at the same price and same percentage that a founder or other major holder sells to.

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Lecture 12 – Term Sheets II

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IPO process summary

Obtain Board of Directors re-approval to begin the formal process

 

Select underwriters, legal team, and auditor team

 

Prepare and file the registration statement with SEC, apply for stock exchange listing

SEC examines the registration during a 20-30 day waiting for period and issues comments on the registration statement

A preliminary prospectus, called a red herring, is distributed during the waiting period

If there are problems, the company is allowed to amend the registration and the waiting period starts over

Cap table practice problem

Sequoia Capital proposes to invest $3M in YouFace.com for 6M shares of Series A preferred stock

 

 

Assume that the three founders, Chad, Steve, and Carl each own 3M shares of common stock

 

 

In addition, there are 3M shares of common stock for the employee stock pool, of which 600,000 shares have been issued

 

Construct the capitalization table of YouFace for this transaction.

What is the pre- and post-money valuation?

What is Sequoia’s fully-diluted ownership after the investment?

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Cap table – Solution Steps

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Step 1 – Fill in pre-money shares and ownership percentages Fill in post-money shares for founders and option holders

Step 2 – Calculate the post-money shares: Pre-money shares + New shares = post-money shares

Step 3 – Calculate individual post-money ownership percentages: Individual shares / total post-money shares

Step 4 – Calculate the post-money valuation: New Investment / Series A ownership percentage

Step 5 – Calculate post-money individual ownership values ($) Post-money valuation x ownership percentage

Step 6 – Calculate the pre-money valuation Post-money valuation – investment

Step 7 – Calculate pre-money individual ownership values ($) Pre-money valuation x ownership percentage

 

Cap table practice problem – Solution

3

Pre-moneyPost-money
Shares$%Shares$%
Common – FoundersStep 1Step 7Step 1Step 1Step 5Step 3
Common – Option poolStep 1Step 7Step 1Step 1Step 5Step 3
IssuedStep 1Step 7Step 1Step 1Step 5Step 3
UnissuedStep 1Step 7Step 1Step 1Step 5Step 3
Series A Preferred6.0Step 5Step 3
TotalStep 1Step 6100.0Step 2Step 4100.0

Cap table practice problem Answer Sheet

3

Pre-moneyPost-money
Shares$%Shares$%
Common – Founders
Common – Option pool
Issued
Unissued
Series A Preferred6.0
Total

Cap table practice problem – Solution

3

Pre-moneyPost-money
Shares$%Shares$%
Common – Founders9.04.575.09.04.550.0
Common – Option pool3.01.525.03.01.516.7
Issued0.60.35.00.60.33.3
Unissued2.41.220.02.41.213.3
Series A Preferred6.03.033.3
Total12.06.0100.018.09.0100.0

Sequoia Capital proposes to invest $3M in YouFace.com for 6M shares of Series A preferred stock

Assume that the three founders, Chad, Steve, and Carl each own 3M shares of common stock

In addition, there are 3M shares of common stock for the employee stock pool, of which 600,000 shares have been issued

91

A lesson for VC’s investing in common stock

VC is willing to invest $3M in the founder’s idea for a new software company

 

Founder and VC agree on a 50.05/49.95 split, with founder holding the majority stake

Suppose the VC invests in common stock

 

On the day after closing, the founder receives an offer of $4M to buy his company

Will the founder accept this offer?

92

Will the founder accept the $4 million offer?

It depends on the founder

Simple valuation analysis might lead the founder to reject the offer

Prior to the $4 million offer, the founder’s stake is worth $3 million (50.05% of a business valued at $6 million)

Is she accepts the new offer, she only gets $2 million.

Is a bird in the hand worth two in the bush?

The founder might accept the offer if any of the following are true:

The offer includes a lucrative compensation package for the founder to continue as CEO

The founder is uncertain about the future of her business or has other projects to pursue and wants the surety of $2 million in the bank.

93

All possible outcomes for the VC are bad

If the contract provides for drag-along rights, the VC could be forced to sell and will quickly lose $1 million on its investment

If no drag-along rights, VC could refuse to sell which might kill the deal

The alternative would be to threaten or pursue litigation to block the sale.

Immediately file for a temporary injunction to halt sale until a final ruling on the merits of the case

Final outcome of the litigation will depend on whether the final agreements include minority shareholder protections

Litigation will destroy both the business and the relationship

Lose focus on running the business

Potential customers may walk away

Cash drain

Animosity

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How could the VC have avoided this disaster?

Invest in preferred stock

“money-back” feature

Liquidation preference

Ensures that VC gets fully paid back before any proceeds go to the founder

Require supermajority approval by investors on important decisions (such as the sale of the company)

Reverse vesting provision

The founder must relinquish her shares and then re-earn them on a new vesting schedule

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Features of preferred stock

Liquidation preference

With or without the participation

Capped or uncapped participation

Optional conversion provision

Mandatory conversion provisions

Qualified public offering

Anti-dilution protection (in the event of down rounds)

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Liquidation preference

All types of preferred stocks have this feature (downside protection)

 

Determines who gets paid first and how much is paid in the event of liquidation

Who gets paid first?

Preferred vs. common stockholders

Later round investors vs. previous rounds

 

How much is paid (redemption value)?

1X original investment

Majority of deals

> 1X original investment

“Excess liquidation preference”

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Types of preferred stock

Redeemable preferred (RP)

Non-convertible

 

Convertible preferred

without participating rights (CP)

with participating rights

Unlimited participating rights (PCP)

Capped participating rights (PCPC)

 

Exit diagrams allow us to compare the payoff of different types of securities

98

Non-participating convertible preferred stock (CP)

Popular in the 1980’s – more money around, more competitive VC industry, so the security needs to be more founder-friendly

 

Liquidation preference offers downside protection

 

The convertible feature provides upside potential if the exit value is high enough

But in order to share the upside, need to convert to common stock

If converted to common stock, liquidation preference is lost

 

Cannot have both downside protection and upside potential

simultaneously

Non-participating convertible preferred (CP) stock exit diagram

Assume a $1M investment in CP stock with a 5X liquidation preference and a 1/3 ownership if converted to common stock

Voluntary conversion point: The exit value at which the investor is indifferent between converting or not converting.

 

 

 

$W (total exit)

The exit value of an investment

Slope = 0

 

 

 

 

5

 

Slope = 1

5

 

Slope = 1/3

 

 

 

voluntary conversion point

 

 

15

 

 

 

 

99

Common stock return,

Slope = 1/3

 

100

Participating in convertible preferred stock (PCP)

Popular in the 1990’s – attract later rounds of investors

 

Liquidation preference offers downside protection

 

Participating feature allows the holder to share upside potential without converting

 

“Double dipping”— can have downside protection and upside potential (on an as-if-converted basis) simultaneously.

Participating convertible preferred (PCP) stock exit diagram

 

 

 

 

 

5

$W

 

 

PCP

Slope = 1/3

Slope = 1

 

 

 

 

 

Assume a $1M investment in PCP stock with a 5X liquidation preference and participation as if 1M shares of common stock (i.e., 1/3 ownership)

Exit value of

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investment

Does the VC have an incentive to voluntarily convert if she invests in PCP?

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Participating convertible preferred with a cap (PCPC)

PCPC is the same as PCP, except that it caps how much investors can receive.

 

Will the PCPC investor have the incentive to convert voluntarily?

For example, if the cap is low and the exit value is high enough.

 

The cap determines how long you can “double-dip”.

Participating convertible preferred with a cap (PCPC) stock exit diagram

 

 

 

 

 

 

 

 

PCPC

(Redemption value)

Assume a $1M investment in PCP stock with a 5X liquidation preference and participation as if 1M shares of common stock (33%) with a 7X cap

Exit value of

investment

PCP

 

PCPC

(Conversion value)

voluntary conversion point

 

 

 

$W (total exit)

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PCPC practice problem

Suppose that Sequoia invests $3M in YouFace.com for 1/3 ownership with their investment structured as follows:

PCPC with the purchase price of $3M

1X liquidation preference,

and a liquidation cap of 6 times investment.

 

Questions:

Will Sequoia convert and how much will Sequoia get if the company is sold for

9 million

90 million

105

PCPC practice problem

Suppose that Sequoia invests $3M in YouFace.com for 1/3 ownership with their investment structured as follows:

PCPC with the purchase price of $3M

1X liquidation preference,

and a liquidation cap of 6 times investment.

 

Questions:

If there is no cap, will Sequoia convert and how much will Sequoia get if the company is sold for

9 million

90 million

 

If the firm went through IPO at an offer price of $3 per share, how much is Sequoia’s stake worth?

106

Pre-money valuation isn’t everything…

Term sheet 1

$5m invested

VCs ask for 1/3 of the company

Pre-money = 15-5= $10m

 

Term sheet 2

$5m invested

VCs ask for 1/2 of the company

Pre-money = 10-5 = $5m

 

Should you choose TS 1 because of the higher pre-money value?

107

Pre-money valuation isn’t everything…

Term sheet 1

$5m invested

VCs ask for 1/3 of the company

Pre-money = 15-5= $10m

 

Term sheet 2

$5m invested

VCs ask for 1/2 of the company

Pre-money = 10-5 = $5m

 

Should you choose TS 1 because of the higher pre-money value?

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(1) Liquidation preference

Assume both are convertibly preferred

Term sheet 1 has 2x liquidation preference

Term sheet 2 has 1x liquidation preference

 

If the company is sold for 10m, how much goes to VC and how much to founders?

Term sheet 1: VC gets 10m, founders 0

Term sheet 2: VC gets 5m, founders 5m

 

For other scenarios, exit diagrams will help clarify.

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(2) Participating rights

Assume both have 1x liquidation preference

Term sheet 1 is participating convertibly preferred

Term sheet 2 is non-participating

 

If the company is sold for 10m, how much goes to VC and how much to founders?

Term sheet 1: VC gets 5+1/3*(10-5)=6.67, founders 3.33

Term sheet 2: VC gets 5m, founders 5m

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(3) Participating with cap

Assume both are participating convertible preferred with 1x liquidation preference

Term sheet 1 participates with no limit

Term sheet 2 has a cap of 1.5x on participation

 

If the company is sold for 13m, how much goes to VC and how much to founders?

Term sheet 1: VC gets 5+1/3*(13-5)=7.7m, founders 5.3m

VC is capped at 1.5*5=7.5m, founders get 5.5m

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Anti-dilution provision

Anti-dilution provisions protect against a down round by adjusting the price at which the preferred stock converts into common stock

 

Conversion price and/or rate, of earlier round investors, gets adjusted according to a pre-specified formula

 

Different types of conversion formulas:

Full ratchet

Weighted average

Broad-based

Narrow-based (Rarely used)

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Conversion rates

Full ratchet:

New conversion price = price of the new stock sale

New conversion rate =

Old conversion price

New conversion price

 

Weighted Average – Broad-based method

New conversion price =

Old conversion price x shares outstanding before the new round + new investment)

Shares outstanding before the new round + shares issued in the new round)

 

New conversion rate =

Old conversion price

New conversion price

 

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End Game Comparison of the 3 Scenarios

Founders prefer no anti-dilution provision

Series A investors prefer the Full Ratchet provision

Series B investors prefer the Weighted Average provision or insist on a fixed ownership percentage

No Anti-dilution protectionFull Ratchet ProvisionWeighted Average Provision
InvestorShares$%Shares$%Shares$%
Founders3M1.5M253M1.5M203M1.523
Series A3M1.5M256M3.0M404M2.031
Series B6M3.0M506M3.0M406M3.046
Total12M6.0M10015M7.5M10013M6.5100

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How well do anti-dilution provisions work in practice?

Full-ratchet anti-dilution was popular during the last downturn

 

Misleading to take the mechanical security of full-ratchet (and other) anti-dilution protections at the face value

 

Why?

Everything is negotiable in the Series B round

New investors are not dumb

Who has bargaining power?

 

However, it is valuable to understand how anti-dilution works if only to understand each party’s negotiating leverage

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How well do anti-dilution provisions work in practice?

VCs are forced to waive anti-dilution protection in about 64% of applicable down rounds, and in the remaining 36% of cases protections don’t work as strongly as the language suggests

 

Why?

 

Anti-dilution protection is only useful when the protected party is willing to walk away from the deal

E.g., if the company is doing poorly and the VC is willing to liquidate, then the anti-dilution provisions are useful

But if VC wants new financing, then it has little leverage to maintain the protections

New investors will insist on old investors waiving anti-dilution rights

116

Lecture 13 – Exits

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IPO process summary

Obtain Board of Directors re-approval to begin the formal process

 

Select underwriters, legal team, and auditor team

 

Prepare and file the registration statement with SEC, apply for stock exchange listing

SEC examines the registration during a 20-30 day waiting for period and issues comments on the registration statement

A preliminary prospectus, called a red herring, is distributed during the waiting period

If there are problems, the company is allowed to amend the registration and the waiting period starts over

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IPO process summary

Find investors

Distribute preliminary prospectus (red herring) to investors during the waiting period

Begin roadshow

 

Finalize the deal

File final registration statement with SEC, SEC declare offering effective

Obtain final Board of Directors approval

Set the final offer price, sign the underwriting agreement

Print tombstone ad

Offer date, begin trading

The Methods of Issuing New Securities

MethodTypeDefinition
Public Traditional Negotiated Cash OfferFirm Commitment Cash offerThe company negotiates an agreement with an Investment Bank to underwrite and distribute new shares. A specified number of shares are bought by underwriters and sold at a higher price.
Best Efforts Cash OfferThe company has investment banks sell as many of the new shares as possible at an agreed-upon price. The underwriter does not guarantee how much cash will be raised.
Dutch Auction Cash OfferThe company has investment banks auction shares to the determine the highest offer price obtainable for a given number of shares to be sold.

Firm Commitment Underwriting

Issuer sells entire issue to the underwriting syndicate

 

The syndicate then resells the issue to the public

 

The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold

The underwriters buy stock from the issuer at a discount (typically 6-7% of the offering price) and then sell it to the public at the full price.

 

The syndicate bears the risk of not being able to sell the entire issue for more than the cost

 

Most common type of underwriting in the United States

15.120

This is a good place to review the difference between primary and secondary market transactions. Technically, the sale to the syndicate is the primary market transaction, and the sale to the public is the secondary market transaction.

 

Note that the cost of the issue includes the price paid to the issuing company plus the expenses of selling the issue.

Best Efforts Underwriting

An underwriter must make its “best-effort” to sell the securities at an agreed-upon offering price

 

The company bears the risk of the issue not being sold

 

The offer may be pulled if there is not enough interest at the offer price. In this case, the company does not get the capital, and they have still incurred substantial flotation costs

 

Not as common as it was back in the day

15-121

15.121

Real-World Tip: “Corporate America is turning more fickle in choosing finance partners on Wall Street …[m]ore companies are ditching the Wall Street underwriters they had selected for initial public offerings and picking different investment banks when it comes time to complete follow-on stock sales.” So read the opening lines of an article in the December 19, 1996 issue of The Wall Street Journal. But why is this occurring? According to the article, the phenomenon is attributable in part to the fact that many offerings quickly rise above the offering price, leading issuers to feel that their shares were underpriced (and that they left millions of dollars “on the table” as a result).

Potential Exam Topic

Know the difference between Firm Commitment and Best Efforts underwriting

 

Who bears the risk?

 

Sample Question:

Big Bank agrees to underwrite the IPO of NewCo Under a firm commitment agreement, Big Bank agrees to purchase 2,000,000 shares of NewCO at a price of $10 per share and sell them to the public at $11 per share. When the issue comes to market, Big Bank can only find buyers for 1,800,000 shares at $9.50 per share. Does the deal need to move forward? If so, how much will Big Bank need to pay Newco?

15.122

Real-World Tip: “Corporate America is turning more fickle in choosing finance partners on Wall Street …[m]ore companies are ditching the Wall Street underwriters they had selected for initial public offerings and picking different investment banks when it comes time to complete follow-on stock sales.” So read the opening lines of an article in the December 19, 1996 issue of The Wall Street Journal. But why is this occurring? According to the article, the phenomenon is attributable in part to the fact that many offerings quickly rise above the offering price, leading issuers to feel that their shares were underpriced (and that they left millions of dollars “on the table” as a result).

IPO Underpricing

It may be difficult to price an IPO because there isn’t a current market price available

 

Private companies tend to have more asymmetric information than companies that are already publicly traded

 

Underwriters want to ensure that, on average, their clients earn a good return on IPOs

 

Underpricing causes the issuer to “leave money on the table”

15.123

Lecture Tip: More recent evidence (see “Underpricing, Overhang, and the Cost of Going Public to Preexisting Shareholders” by Dolvin and Jordan in the 2007 issue of Journal of Business Finance and Accounting) suggests that underpricing has little impact on owners, as very few preexisting shares are sold in IPOs.

124

Money left on the table phenomenon

The share price is likely to increase for most IPOs:

TheGlobe.com jumped 900% on the first trading day (the dot- com boom)

Hyatt jumped 12% on the first trading day

Dollar General jumped 8%

 

These high returns on the first day of trading have been observed across many nations and time periods

/

 

IB with a better reputation and more experienced VC investors are associated with reduced underpricing

Average initial return

 

125

 

AVERAGE INITIAL RETURN VARIES BY COUNTRY. IN WELL ESTABLISHED MARKETS, IT IS THE 1-DAY RETURN.

 

125

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Why?

Compensation for information gaps

Investors may need a discount to buy a newly listed company with high risk and uncertainty

informed vs. uninformed investors

 

Momentum effect (retail investors rush in after price increases)

 

IB sets the price deliberately low to transfer wealth to the bank’s clients in return for future business (“spinning”)

127

Greenshoe option

Investment bankers reserve the option to sell 15% more shares than the stated offering size—stabilizing the stock price in the period following the IPO (often 30 days)

 

If the offering was 1M shares, the bank will sell 1.15M shares

If the price goes up after IPO, the bank will declare that the offering was 15% larger than the size originally projected

 

If the price drops below the offering price, the bank will buy back the additional 15% of the shares, hoping to drive up the price. In the meantime, the bank also makes money.

 

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