[TRENDSETTER S TWO ROADS]

Transcription

1 [Type 2010 text] Emerging Company Finance FNCE Final Frank Kurupacheril [TRENDSETTER S TWO ROADS] Trendsetter, Inc a warehouse and distribution solution software company for clothing retailers is faced with the usual dilemma. They are running out of seed money that the founders contributed. Now they have received two term sheets from prospective VC s. The ball is in the founders court who have to choose one after weighing pros and the cons.

2 Contents Introduction... 3 Basic valuation... 3 Liquidation... 5 Dividends... 9 Anti-dilution... 9 Vesting Governance Questions and Answers Emerging Company Finance FNCE 480 TrendSetter, Inc 2

3 Introduction Trendsetter Inc was started by Wendy Borg and Jason Kushdog to deliver innovative warehouse and distribution management software program for clothing retailers. The firm was created with the knowledge and experience that Borg and Kushdog had in the supply chain management and specialty fashion industries respectively. The crux of the solution was a demand forecasting module which would draw a large number of retailers. This type of software could be developed with active participation from prospective customers. Fortunately Borg and Jason were able to convince one such customer into the development pipeline. It is this confidence that retail customers may find this solution incredibly useful that has led the founders to seek more funding. Six weeks. In such time Trendsetter, Inc will run out of their seed money. The founders Borg and Kushdog have no experience in raising capital from venture investors. Both the founders are inexperienced in the funding processes and consider a counsel to address their concerns. Their due diligence in pitching the firm to VC s has brought the two term sheets which look identical but have many clauses both similar and dissimilar. Unfortunately they don t have the expertise to evaluate the term sheets they have received from two VCS: Alpha Ventures and Mega Fund. These two term sheets came after the founders presented to seven VC s over a two month period. Both Alpha Ventures and Mega Fund provided almost similar top-line valuations even though Alpha has concerns about the company s revenue stream. There were also concerns about booking a five-star client early to confirm credibility in the product. In this analysis we look at the business valuation of the company before and after each VC s offers. We will also try to understand the difference in the offers given several scenarios. Vesting schedules and anti-dilution concerns of the founders and the investors is also discussed. Finally we shall delve upon the governance section to close the initial analysis. Later we try to answer the specific questions posed to complete the understanding of the term sheets and what they really mean to the founders and the VC s. Basic valuation Alpha has given a pre-money evaluation of $7.35M at a share price of $1.05. Their investment will be $5M. This makes a total of 7M shares of which 4M are common and 3M are option pool shares. Note that there is a provision of escrow shares of 501,253 which are to be released if the Company has not achieved the fiscal year 2000 revenues of $ The total post money valuation comes to $12.35M but the total shares in the market will be less by the escrow shares for a total of 11,761,905. In the scenario that the escrow shares are released to the investors, one can see that the total share ownership for the investors goes up. At the same time the financing for the escrow shares will come to $476, Emerging Company Finance FNCE 480 TrendSetter, Inc 3

4 Alpha Ventures Valuation pre-money $ 7,350, Share price $1.05 investment $ 5,000, Escrow share price $0.95 post-money $ 12,350, Capitalization : Shares Reserved Ownership common 4,000,000 34% option pool-reserved: 3,000,000 26% of which granted: 0% Series A 4,761, ,253 40% Total 11,761, % Revenue Shares Escrow financing if < $500 K (escrow) 501,253 $ 476, With the Escrow shares : Capitalization Shares Reserved Ownership common 4,000,000 33% option pool-reserved: 3,000,000 24% of which granted: Series A 5,263,158-43% Total 12,263, % For the Mega term sheet, we can see that there is no escrow clause involved whereas there is a sum of 929,889 previously granted options. The pre-money valuation of $7M and the investment of $5M make it a total of $12M with a given share price of $1. There is a reserved section of 2.5M shares in addition to the 4.5M common shares. Dividing the total shares of 12M gives the investors and the founder s 42% and 38% respective ownership in the firm. Mega Fund Valuation pre-money $ 7,000, Share price $1.00 investment $ 5,000, post-money $ 12,000, Capitalization Shares Granted before Ownership common 4,500,000 38% option pool-reserved: 2,500,000 21% of which granted: 929,889 Series A 5,000,000 42% Total 12,000, % From a basic valuation perspective, Alpha is a better deal for the founders. The reverse holds good for the investors. Note that Alpha initially valued the firm at a much lower value and then came back with a better approximation. But from the ownership perspective, the founders have larger control with 38% Emerging Company Finance FNCE 480 TrendSetter, Inc Basic valuation 4

5 in the Mega term sheet. Note that the 350K difference in the pre-money valuation comes precisely from the $0.05 share price difference between the two offers. As a founder, one wouldn t want the escrow clause because their ownership falls 1% while the ownership of the investors rises by 3%. Liquidation Alpha possesses a liquidation preference which allows the investors to make a choice between the equity returns during liquidation. Trigger events maybe a merger, an acquisition or any event where is transfer of control. This could be an IPO situation as well. In the event that they choose to collect on the liquidation preference, they would receive three times their investment. This could result in a payoff of $15M. On the other hand, if they decide to pick up on the pro-rata equity return, then the investors would have to account for the terminal value to estimate such a return. Two similar upside scenarios are depicted below. The third scenario is the conversion ratio clause where the trigger requires a qualified IPO offering of at least $15M. The final scenario is the downside valuation of $10M when everyone wants an immediate exit. Alpha Ventures Scenario 1 : Terminal Value $50,000, Upside (Exercise Liquidation Preference) $50,000, Series A Liquidation Preference $15,000, Series A Div $ 380, remaining $34,619, Series A $15,380, OR CHOOSE pro-rata basis no liquidation preference common $17,004, % option $12,753, % Series A $20,242, % Total $50,000, Scenario 2 : Terminal Value $100,000, Upside (Exercise Liquidation Preference) $100,000, Series A Liquidation Preference $15,000, Series A Div $ 380, remaining $84,619, Series A $15,380, OR CHOOSE pro-rata basis no liquidation preference common $34,008, % option $25,506, % Series A $40,485, % Total $100,000, Emerging Company Finance FNCE 480 TrendSetter, Inc Liquidation 5

6 Scenario 3 : Terminal Value $15,000, IPO (Exercise Liquidation Preference) $15,000, Series A Liquidation Preference $15,000, Series A Div $ - remaining $0.00 Series A $15,000, OR CHOOSE pro-rata basis no liquidation preference common $5,101, % option $3,825, % Series A $6,072, % Total $15,000, Scenario 4 : Terminal Value $10,000, Upside (Exercise Liquidation Preference) $10,000, Series A Liquidation Preference $10,000, Series A Div $ - remaining $0.00 Series A $10,000, OR CHOOSE pro-rata basis no liquidation preference common $3,400, % option $2,550, % Series A $4,048, % Total $10,000, In the case of Mega Funds, the participating feature allows the investor to pick up 1.25 times the investment and then also participate in the remainder of the funds available on a pro-rata basis. Note that this feature allows the investor to double dip into the equity pool for a nearly 8% jump in the total ownership. As can be seen from the below graphs, the investor ownership jumps radically as the terminal value of the firm reduces. The reverse is true from the founder s perspective (though not as radical). The ownership of the founder s falls as the value of the firm also follows a similar trend. Emerging Company Finance FNCE 480 TrendSetter, Inc Liquidation 6

7 Mega Funds Scenario 1 : Terminal Value $50,000, Upside Terminal Value $50,000, Series A Liquidation Preference $6,250, Series A Div $732, Remaining $43,017, And now exercise the PCPT clause pro-rata basis common $16,131, % option $8,962, % Series A $17,924, % Pro-rata Total $43,017, So total cash returns : Final Equity Final Ownership common $16,131, % option $8,962, % Series A $24,906, % Total $50,000, Scenario 2 : Terminal Value $100,000, Upside Terminal Value $100,000, Series A Liquidation Preference $6,250, Series A Div $732, Remaining $93,017, And now exercise the PCPT clause pro-rata basis Ownership common $34,881, % option $19,378, % Series A $38,757, % Pro-rata Total $93,017, So total cash returns : Final Equity Final Ownership common $34,881, % option $19,378, % Series A $45,739, % Total $100,000, % Emerging Company Finance FNCE 480 TrendSetter, Inc Liquidation 7

8 Scenario 3 : Terminal Value $25,000, IPO Terminal Value $25,000, Series A Liquidation Preference $6,250, Series A Div $732, Remaining $18,017, And now exercise the PCPT clause pro-rata basis Ownership common $6,756, % option $3,753, % Series A $7,507, % Pro-rata Total $18,017, So total cash returns : Final Equity Final Ownership common $6,756, % option $3,753, % Series A $14,489, % Total $25,000, % Scenario 4 : Terminal Value $10,000, Downside Terminal Value $10,000, Series A Liquidation Preference $6,250, Series A Div $732, Remaining $3,017, And now exercise the PCPT clause pro-rata basis Ownership common $1,131, % option $628, % Series A $1,257, % Pro-rata Total $3,017, So total cash returns : Final Equity Final Ownership common $1,131, % option $628, % Series A $8,239, % Total $10,000, % Putting the scenarios together, we can see the returns that the founders and the investors receive at each terminal value junction. The ownership of the investors is much more safeguarded from risks in the Alpha term sheet as opposed to the Mega term sheet. Interestingly the investors also seem to be in a better position on their returns in the Mega term sheet. Approximately $9M equity returns more than Alpha with a larger % ownership as well on the upside. Of course the downside is not comparable because Alpha wants all the valuation when the result is an offering less than $15M. Emerging Company Finance FNCE 480 TrendSetter, Inc Liquidation 8

9 % returns of the total terminal value Terminal Value Alpha Founders Cash/ (%) Alpha Investors Cash/ (%) Mega Founders Cash/ (%) Mega Investors Cash/ (%) Low Upside 50M 17M/34 20M/40 16M/38 24M/50 High Upside 100M 34M/34 40M/40 34M/35 45M/46 IPO 15M or 25M 0/0 15/ M/ M/58 Downside 10M 0/0 10/ M/11 8.2M/ Liquidation Equity returns Alpha Founders (%) Alpha Investors(%) Mega Founders(%) Mega Investors(%) 0 50M 100M 15M-25M 10M Dividends Both Alpha and Mega offer dividends. Alpha s dividends are non-cumulative and 8% of the shares are expected to return non-cumulative dividends. Assuming that we look at the company s performance at the end of year 5 and no dividends were declared before, the total dividends of the investor would be $380, On the flip side the Mega Funds dividends plan maybe cumulative, but only 10% (500,000) is available after 1 year for dividends growing year over year. So in year 5, assuming no dividends was declared before, a future value of $ is dispersed as dividends. For the investors, from a dividends point of view, Mega offers much better terms giving a larger % return cumulatively. Anti-dilution In the case of Alpha, if we assume a share price of $0.65 ( between the required % ) and series B accounts for a total of $6.5M, we can see that a weighted average anti-dilution protects the investor by offering 735,608 more Series A shares whereas an offering of the same amount at $0.50 raises the free shares of Series A to 1,210,897. Emerging Company Finance FNCE 480 TrendSetter, Inc Dividends 9

10 Alpha Ventures Weighted Average share price $0.65 Raising 6.5M in Series B Series A shares 4,761,905 Company 7,000,000 Total 11,761,905 Share price $1.05 Series A Fund-raise $ 12,350, Series B shares 10,000,000 Share price $0.65 Series B Fund-raise $6,500, Total Fund Raise $ 18,850, Total Shares 21,761,905 Adj Series A price/share $ 0.87 Adj Series A shares 5,497,513 Free shares for A 735,608 Weighted Average share price $0.50 Raising 5M in Series B Series A shares 4,761,905 Company 7,000,000 Total 11,761,905 Share price $1.05 Series A Fund-raise $ 12,350, Series B shares 10,000,000 Share price $0.50 Series B Fund-raise $5,000, Total Fund Raise $ 17,350, Total Shares 21,761,905 Adj Series A price/share $ 0.80 Adj Series A shares 5,972,802 Free shares for A 1,210,897 Emerging Company Finance FNCE 480 TrendSetter, Inc Anti-dilution 10

11 With Mega, we are faced with the full-ratchet possibility which would give the investors a much larger number of series A shares. Also note that the weighted average anti-dilution doesn t give the Series A investors as much as they obtain through the full ratchet. This is a huge issue for the founders who are now under pressure not seek new investment in the firm. On the other hand, they have more leeway to seek further funding in the Alpha term sheet. But note that in the case the revenue stream is lower than 500K, and then Alpha would get both the weighted average Series A shares and the escrow Series A shares a double whammy for Borg and Kushdog. Mega Funds Weighted Average Share price $0.65 Raising 6.5M in Series B Series A shares 5,000,000 Company 7,000,000 Total 12,000,000 Share price $ 1.00 Series A Fund-raise $ 12,000, Series B shares 10,000,000 Series B share price $0.65 Series B Fund-raise $6,500, Series A + B $ $ 18,500, Series A+B shares 22,000,000 Adj Series A price/share $ 0.84 Adj Series A shares 5,945,946 Free shares for Series A 945,946 Full Ratchet Share Price $0.50 Raising 5M in Series B Series A shares 5,000,000 Series B shares 10,000,000 Series B share price $0.50 Series B Fund raise $5,000,000 Adj Series A shares 10,000,000 Free Shares for Series A 5,000,000 Vesting Vesting schedules for either term sheet are similar. The founders can vest 25% when they purchase and spread the remaining over a 36 month period. Employees get a 12 month 25% cliff and then spread the Emerging Company Finance FNCE 480 TrendSetter, Inc 11

12 Month remaining over a 48 month period. These are standard terms with the expectation that the 180 day lockup period will be in place in the case of an IPO. Employees are expected to have a longer shelf life and hence retention is the key to the longer vesting period. Entrepreneurs being the champions of the firm get early returns and a shorter cycle (starting acceleration for their innovation). Vesting Schedules for either term sheet % % 80.00% 60.00% Founders Employees 40.00% 20.00% 0.00% Governance The board of directors structures established by both the term sheets is quite identical. The requirement is for a 5 person board. One member is the CEO while two are Series A representatives. The other two are outsiders nominated by the founders and by the board respectively. In the case of releasing the escrow shares, Alpha has placed a restriction on the 5 th member of the board which allows them to replace the outside member with their nomination - clearly this is designed to tilt the board in their favor in case the firm is floundering in its attempts to reach a run rate of 500K+ revenue stream. Another governance piece is the formation of the compensation committee. Alpha requires that this would be a 3 person committee with 2 representatives from the investor with one outside director. In such case as well, the founders do not have say over the compensation committee actions. Mega does not need define any such clauses and hence it is assumed that the founders are free to choose the committee. Alpha seems to clearly indicate that they want more control over the governance of the company which directly ties into the risk mitigation policy that they have followed throughout the term sheet. Emerging Company Finance FNCE 480 TrendSetter, Inc Governance 12

13 Questions and Answers 1. What are the main differences and similarities between the two term sheets? Major Differences/Similarities: Conditions Alpha Ventures Mega Fund Delta What term sheet is more attractive? Amount Invested $5,000, $5,000, None Both are similar - investment amount does not change Valuation (pre-money) $7,350, $7,000, $350, Very closely valued - the 350K comes from the $0.05 share price difference. Valuation (post-money) $12,350, $12,000, $350, alpha has higher pre-valuation but this doesn t make it a clear choice rightaway Normal Share price $1.05 $1.00 $0.05 Leads to the same difference in the pre and post money valuation Escrow Share price $0.95 No Escrow clause Escrow Founders would not want escrow clause Type of new shares issued Convertible Preferred Convertible Participating Preferred Mega PCPT Founders would not want PCPT clause Outstanding None Not an issue - pre money valuation provided for Alpha. # of New Shares Around 250K difference in the shares issued Escrow shares ( only if revenue less than 500K) Alpha's lack of confidence in the firm is confirmed by this risk mitigating feature. Option Pool The pool is larger for Alpha, thereby giving more leeway for the founders to hire quality staff After 1 year, 10% cumulative and only upto 25% of purchase price. Only payable if declared by the board or at liquidation. Common shareholders get dividend if 60% of the then outstanding Mega totals to a higher % Clearly Alpha is a better dividend plan for the founders - the reverse can be argued for the Dividends Non-cumulative, 8% if declared Preferred consent and accumulative. investors. Vesting Liquidation Preference Employees have 48 month vesting with 12 month cliff and linear monthly vesting thereafter. Founders vest 25% upon purchase and 75% linear vesting over 36 months and subject to buyback. Upon employment termination, Company will repurchase unvested shares. Founders also receive accelerated vesting on IPO. First dibs of 3x on preferred and then also an option to collect pro-rata isuance price and declared but unpaid dividends. Could be triggereed by a merger, reorg, transfer of control(ipo). Reserved shares have 48 month vesting with 12 month cliff and linear monthly vesting thereafter. Founders vest 25% upon purchase and 75% linear vesting over 36 months and subject to buyback. Upon employment termination, Company will repurchase unvested shares. Clearly Alpha is a better vesting plan for the founders - the reverse can be argued for the Founders have more attractive investors. options with Alpha Alpha liquidation preference which would clearly provide higher equity Alpha for the investors and Mega for the founders Conversion 1:1 ratio Triggers: majority rule or qualified IPO at $5+/share 1:1 ratio, qualified IPO at $20+/share with total offering of at least $15M with total offering of at least 25M Higher offering for Mega Valuation expectation for Alpha is lower than Mega - conversion would be limited in the case of Mega unless and until 25M offering with $20/share can be reached. Anti-Dilution 1.WA on Series A preferred shares. 2. No adjustments for issuance of option pool up to shares 1. WA on new shares with price between 50% to 100% of Series A price 2. Full ratchet if new shares price is less than 50% of Series A with Full ratchet capability for designated financing terms Mega Mega is obviously a better choice for the investor Emerging Company Finance FNCE 480 TrendSetter, Inc Questions and Answers 13

14 Minor Differences/Similarities: Counsel and Expense Company pay up to $20K for counsel fees etc 20K paid to Mega counsel None Similar terms Registration Rights Exactly identical Exactly identical None Similar terms Key Person Insurance $2M for each founder None Alpha requires insurance for founders Alpha's risk mitigation in case of founder loss etc Information distributed to any requesting Need to hold 250,000+ shares to qualify. investor who has Series A Preferred No qualifying clauses for Information Right Info distributed with 45 days outstanding Mega Investors have more clout to get information with Mega's terms. 5 person board 1: Wendy Borg, CEO, Founder 2&3: Representatives of Series A 4: Outsider nominated by founder 5: Outsider nominated by board who can be replaced if the escrow shares are Corporate Governance (Board Structure) released. 3 person committee 2 reps from series A Compensation Committee 1 outside director None Indemnification Severance full coverage by law On termination, Founders get 6 months additional vesting and 6 months severance pay. Restriction on Common stock transfers 180 day lock-up in IPO scenario None specified 5 person board 1: Wendy Borg, CEO, Founder 2&3: Representatives of Series A 4: Outsider nominated by founder 5: Outsider nominated by board None No such committee identified by Mega Applicable Blue Sky laws, covenants drafted by Mega counsel. Standard law Not much difference coverage's. identified Mutually agreeable agreement - details not stated The escrow clause allows Alpha to replace the outsider chosen by the board by one chosen by the investors. This tilts the board in their favor. Makes Alpha investors powerful to decide compensation Similar terms. Voting Rights 1. Only on a as -converted basis 1. As-if converted basis to vote along with common holders2. Protective provisions consent for super majority holders of Series A super majority Series A Representations and warrantiesstandard standard None Similar terms Non-disclosure everyone covered Everyone is covered None Similar terms Right of First Refusal Co-sale Pro-rata right to subsequent equity financing based on % ownership of Preferred - when selling common stock shareholders should first offer them to Series A. Pre-emptive rights to purchase securities (non-reserved shares) based on % equity ownership on preferred stock. Vesting and severance package Alpha deals better from option Alpha for Founders Lock up period in Alpha doesn t allow the founders The lock up period makes Alpha less attractive to the founders. But we don t expect the to vest after IPO founders to ditch the firm within 6 months of IPO. Mega voting rights offered to common and Series A though some decisions have to be consented by Alpha is a simpler voting system for the firm whereas the Mega terms make management control limited. No common stock selling clause Similar terms except for common stock selling first dibs to Series A. Series A Preferred can participate on transfer of shares from common based on pro-rata percentage ownership of Series A ( non-ipo or later ) None No co-sale rights for Mega These are standard clauses which don t make either term attractive. Emerging Company Finance FNCE 480 TrendSetter, Inc Questions and Answers 14

15 2. If you were the entrepreneur and could not negotiate any of the terms in either term sheet which one would you prefer and why? Mega seems to be the better choice between the terms. The valuation is a tad lower and the anti-dilution ratchet may cause an excessive Series A shares granted to the investors together with the participating preferred clause. But the equity returns to the founders does never go to 0% in the case the firm doesn t prove successful. With Mega, the founders make at least 10% even in the 10M downside scenario. One would not want to be left with nothing if the valuation of the firm during the IPO phase is less than $15M, which is the case with the Alpha term sheet. Due to the participating nature of the Mega term sheet, the founders always have some pro-rata ownership left to divide among them. Alpha requires a 180 lock up period together with an unattractive escrow release clause. Further the governance structure that Alpha requires is unattractive. Alpha s term sheet is based on a high risk factor which reflects on the (poor) confidence level in the company. A long term relationship with the VC s would be a good starting point and hence Mega Funds would be the choice. 3. How would you seek to alter the terms in each term sheet during the negotiations with each venture capitalist? Which terms would you seek to alter first? Alternate scenarios can be drawn to give the founders some returns in the downside valuation. This is especially true for the Alpha term sheet which is lopsided to suit the investors. In the case of Alpha, the liquidation preference choice is a limiting factor and should be negotiated. Removal of the escrow clause with the same valuation is needed. The governing structure of the Alpha term weakens the founders and should be tilted in their favor. There could be poor, weak or incorrect long term management decisions made by the board which could derail the progress of the firm. In the case of Mega, the anti-dilution full ratchet clause causes much damage and needs to be removed or negotiated down. The participating should be removed completely. The severance packages are undefined and should also be placed in the terms. Vesting plans are better with Alpha and hence unemployment vesting and accelerated vesting on IPO can also be included in the Mega term sheet. 4. Does it make a difference to you whether you expect Trendsetter.com to grow fast or grow slowly? Alpha term sheet places a time limit on the amount of revenue expected (fiscal year 2000). While Alpha does have the escrow shares as a backup together with the governance issue, Mega doesn t have either. In either case growing too soon can only help to get a quicker exit. Growing too slow can result in more Series A shares granted in the case of Alpha. So from a founder standpoint, Mega Funds is a safer term sheet. For the founders, choosing Alpha would be disastrous in case the company does not grow! Emerging Company Finance FNCE 480 TrendSetter, Inc Questions and Answers 15

16 5. Does it make a difference to your wealth whether you expect to realize on Trendsetter.com through an IPO or merger? Either IPO or merger is defined as a change of control event. The difference is in the valuation that Mega requires during an IPO which would kick in the liquidation preference and the PCPT clauses in to action. From the founders point of view this is critical, since the same clause in the Alpha term sheet leaves them with nothing when the offering is at the minimum. Usually a merger would leave a firm s valuation lower thereby directly affecting the pro-rata ownership that the founders can expect. The ideal choice would be an IPO under the Mega Fund VC s which would at least give the founders 27% prorata of the terminal value assuming the worst case scenario. 6. If you were an aspiring venture capitalist looking for a blueprint term sheet to use at your firm which one of the two term sheets would you use? Why? It would be the Mega Fund term sheet again. With the full ratchet anti-dilution and the PCPT clauses the VC is assured of returns greater than those the Alpha sheet can offer. Also the entrepreneurs are not left with nothing in the downside. This leaves both parties happy in such case. The number of governing clauses is lesser leaving the entrepreneurs the freedom to drive the firm with their leadership. Giving trust would help them make better decisions. 7. If you were looking for advice on these term sheets whom would you call? How would you know the people you call knew what they are talking about? I would call Prof. Randall Bambrough first. Subject matter expertise and the vast experience in this field are critical to understanding the nuances of these term sheets. I would also call other investment banking folks in my network who have taken firms IPO to get a larger market perspective. Finally I would consult my classmates from the Emerging Company Finance program - today s students are tomorrows VC s and entrepreneurs and so their perspectives are also vital. I would know that they are well versed in the funding processes if they are able to break it down to simpler terms and explain the pros and cons of each term sheet as they see it. Of course certain percentage of error can be attributed to subjective decision making but for the most part, their evaluations of the term sheet should be similar. Emerging Company Finance FNCE 480 TrendSetter, Inc Questions and Answers 16