Term Sheet Calculator 1 Beta Version, March 2011 Thomas Hellmann UBC Sauder School of Business 2 This note introduces the Term Sheet Calculator, a model for valuing preferred securities which are commonly used in financial contracts between entrepreneurs and venture investors, such as venture capitalists, angels, corporate investors and others. The model values a variety of terms associated with preferred shares, such as dividends, liquidation multiples, forced conversions, and seniority rules across different classes of preferred shares. Venture investors typically negotiate term sheets without a quantitative understanding of the underlying value of these terms. The Term Sheet Calculator is a spreadsheet model that quantifies the value of these contract terms. Users must be familiar with basic finance concepts as well as have a basic understanding of term sheets in order to make effective use of the Term Sheet Calculator. This note contains three main sections. The first section explains the fundamental structure of the model. The second section explains how the term sheet calculator accounts for specific terms. The third section contains practical information on how to use the Term Sheet Calculator spreadsheet. 1 Copyright 2011 Thomas Hellmann 2 2053 Main Mall, Vancouver, BC, Canada, V6T 1Z2, Tel: 1 604 822 8476 ; hellmann@sauder.ubc.ca http://strategy.sauder.ubc.ca/hellmann/. I would like to thank Max Miller for his invaluable help in developing the materials of this note, as well as the accompanying spreadsheet. 1
Section 1: Fundamental Structure of the Term Sheet Calculator The Term Sheet Calculator focuses on investor payoffs. In order to derive these it is necessary to start with some fundamental assumptions about the underlying company values. Many terms are only relevant if company values fall into certain ranges (e.g., below investment value). Moreover, earlier round terms may also depend on the terms of later rounds. As a consequence it is essential that the valuation model comprises fundamental uncertainties about company exit values and refinancing terms. The Term Sheet Calculator makes some basic assumptions that keep the complexity to a reasonable level. While sophisticated user can still make use of a fairly broad set of features, users that prefer simplicity can use a number of shortcuts that significantly reduce the complexity of the model. The basic approach taken by the Term Sheet Calculator is to model two rounds of financing, followed by an exit event. The model focuses on valuing the terms of an initial round (called Round 1). It allows for up to five scenarios for the later round of financing (called Scenarios). Moreover, the model can handle up to ten distinct exit values. To model the fundamental uncertainty the user needs to specify probabilities for each of the five scenarios and ten exit values. Users wanting to simplify this framework can easily reduce the number of scenarios or exit values by giving them a probability of zero. Moreover, the input sheet only asks for one set of exit value probabilities, which is used as a default specification across all scenarios. However, sophisticated users can override these defaults and specific different exit value probabilities for each scenario. The Term Sheet Model is based on a set of fundamental assumptions that the user can make about the likely performance of the company. We distinguish four main types of assumptions. First, the user must specify the terms of the deal (the model also allows for a comparison of alternative term sheets). Second, the user must specify the different value outcomes that the company may obtain, as well as their timing. Third, the user must specify the probabilities of 2
the different value outcomes. Fourth, the user must specify a discount rate, to be used throughout the analysis. 3 The user may want to compare a term sheets with a plain vanilla equity deal, where all shares are common shares. Alternatively, the user may want to compare two term sheets both containing different terms. The Term Sheet Calculator allows for all such comparisons. The key outputs of the Term Sheet Calculator are presented in a spreadsheet with four columns. The first column reports the results of a simple valuation model for plain vanilla equity. In particular, it uses the well known venture capital method, which values companies on the basis of their exit values. 4 This model generates some default prices per share for the first round, as well as for the different later round scenarios. The second column uses those default prices and calculates the net present value of a term sheet that includes the preferred terms specified by the user. It also shows the results for the premium value and the premium per share, which measures the difference between the investor s values obtained under the term sheet versus a plain vanilla equity deal. The third and fourth columns then allow the user to input different terms, including different prices per share. Together these four columns allow for a wide variety of comparisons. The use of default prices requires some additional explanation. These prices may or may not be appropriate, depending on what assumptions the user wants to use. If a user already has a clear sense of the price per share for the first round investment, then is seems sensible to use to override the default price. If no such price has been determined, then the default price is a reasonable starting point. The main advantage is that it is based on fundamental assumptions that are formulated within the model. However, one important limitation is that, by construction, the default price is based on a straight equity valuation model. This assumes a 3 While the venture capital model combines survival risk and time value of money into one large discount rate, this model allows for a more traditional discount rate that only captures the time value of money, whereas the outcome probabilities directly account for survival risk. 4 To be specific, the Term Sheet Calculator uses a straightforward extension of the venture capital where instead of a single exit value there are different exit values each associated with their own probabilities. See A Note on Valuation of Venture Capital Deals by Thomas Hellmann, Stanford Case E 95, 2001, and The PROFEX Valuation Model by Thomas Hellmann, UBC 2010, available at http://strategy.sauder.ubc.ca/hellmann/ 3
somewhat naive pricing mechanism where the entrepreneur does not take into account the fact that the investor receives additional returns from the preferred shares. If the entrepreneur is less naive, s/he may ask for a higher price per share. Among other things, the user can search for the price per share at which the premium value becomes exactly zero. This generates a valuation that fully incorporates all the investor s returns from the preferred shares. Put differently, under the default prices the investor gets all the additional returns from the preferred security, but by setting the premium value to zero, the investor pays a higher price per share that fully accounts for all the privileges of holding a preferred security. 5 This is the very first version of the Term Sheet Calculator, it should be considered preliminary, work in progress. The current version has several important limitations. It cannot account for more than two rounds of financing, five later round scenarios or ten exit values. It is formulated for a first financing round, and while it can be used for pricing later rounds, this requires an assumption that all prior round investors hold common shares. The model treats all first round investors as the same. It cannot account for the possibility that in a later round some investors behave differently than others (e.g., some investors pay to play, other don t). It models some but not all of the most common terms used. For example, the current version of the model cannot account for anti dilution clauses. Finally it should be noted that the choice of terms is assumed not affect the company s fundamentals, i.e., that value of the company is invariant across all the different possible term sheets. 5 Note also that this point applies not only to the price per share in the first round, but also to the follow up rounds (scenarios). One limitation of the current version of the Term Sheet Calculator is that obtaining prices that fully incorporate the value of the preferred shares is not automated, i.e., the user has to find those prices manually. 4
Section 2: Calculating the value of preferred terms The value per share is calculated by determining each investor payoff based on an analysis of the different possible company exit scenarios. The model generates the payoff of each investor using a scenario analysis to determine which terms will be exercised. The model then multiplies each scenario with the appropriate probabilities, and discounts all values to round 1. The discounted expected value is then divided by the number of shares to determine the value per share. The premium per share is then defined as the difference between the value per share and the price per share. In order to determine the investor payoff at exit, the user must specify the type of equity issued. The user must input whether the investor is receiving common equity or preferred equity. If both investors are issued common equity, then the value per share and the price per share will be the same since both will utilize the Venture Capital Method. If an investor has preferred equity, the model must determine if the investor will be forced to convert to common equity and if not, will the investor voluntarily convert to common equity. There are three situations in which the investor will be forced to convert: 1. Exit through Initial Public Offering (IPO): In the model, the user must specify the type of exit, IPO or acquisition. If the user specifies IPO for the exit event, then any preferred shares will automatically convert into common equity, which is standard in private equity contracts. 2. Exit Cap Exceeded: In many private equity contracts, an exit value cap is specified which states the minimum exit value amount in which investors are forced to convert their shares to common equity. In the Term Sheet Calculator, investor will be forced to convert at each exit event if the value at that event is greater than the exit value cap set. 3. User Specified Forced Conversion (only applicable to Series A investors): In each scenario, the user can specify whether the Series A investor is forced to convert. There are a variety of reasons that the Series A investor may be forced to convert, 5
the most common reason being pay to play provisions, which require the Series A investor to invest a specific amount in Series B in order to avoid share conversion to common equity. If an investor holds preferred equity and is not forced to convert, that investor has the option of either converting to common equity or holding preferred equity. For each exit events, the model determines the best decision for each type of investor. There are three different constellations in which investors need to make decisions regarding voluntary conversions. 1. Series A investor has preferred equity, Series B investor has common equity: In this scenario, the decision is made by the Series A investor regarding whether to take preferred or common equity. The condition for conversion is then given by: # 2. Series A investor has common equity, Series B investor has preferred equity: The series B investor decision is determined the exact same way as above, using the same conditions but applied to series B inputs. # 3. Both Series A and Series B investors have preferred equity: The optimal conversion decisions are interdependent. Using simple game theoretic reasoning, we can find the optimal decisions by answering the following three questions: 6 a.) Which investor has a greater incentive to convert? To answer this question we first calculate the value per preferred share for each series of investor, given by: We then compare this value for Series A and Series B holders, and note that Series A holders are the first to convert whenever: 6 The game theoretic proof is available upon request from the author. 6
b.) What is the minimum exit value at which an investor will convert? The minimum value is the exit value at which investors are indifferent between requesting preferred equity and converting. In order to determine this minimum, we make use of the above question Which investor has a greater incentive to convert? If an investor has a stronger incentive to convert (in other words, will convert first), then the following formula is used to determine the minimum conversion exit value: If an investor has a weaker incentive to convert (in other words, will convert second), then the following formula is used to determine the minimum conversion exit value: = With the minimum conversion exit value, we can answer the third question. c.) What is the investor s decision? If the exit value is above the minimum exit value, the investor converts, but if the exit value is below the minimum exit value, the investor prefer not convert. 7
Section 3: Practical Instructions for using the Term Sheet Calculator We now discuss which variables need to be specified by the user. Note that the user should input data only into the first tab named Instructions and Names and the second tab named Deal assumptions. All outputs are collected in the third tab called Term sheet calculator. All other tabs should not be touched by the user. The following table shows the round 1 variable that need to be specified by the user. Variable Units Notes/Explanations Founder name Alphabet On Instructions and Names sheet Series A Investor name Series B Investor name Founder Existing Shares Number Include all shares issues at the time of the first round. All such shares are presumed to be common shares Existing Options Number All options outstanding at the time of the first round. Options Replenishment Factor Percentage The user can specify the number of new (employee) stock options issued at the time of the first round. This number must be expressed as a percentage of the number of new shares issued in the first round. Series A Investment Dollar Total amount invested. Amount Discount rate Percentage The user should specify a discount rate that account for time value of money and undiversifiable risk (beta), but not any failure risk. Type of Equity Choose from Common Equity or Preferred Equity list Annual Dividend Rate Percentage Accrued dividend, not actually paid in cash except at time of exit if investor asks for preferred equity. Type of Dividend Choose from list Simple interest (calculated only on investment amount) or compound interest (calculated on principle plus accrued interest). Liquidation Multiple Number Used to calculate the total value of the preferred security Exit Value Conversion Cap Dollar Conversion to common applies once the exit value exceeds this cap. Probability of Failure Percentage This is the probability that the exit value will be $0 at some point after the round is complete. 8
Note that the Term Sheet Calculator uses a particular structure for specifying probabilities. In particular, the user gets to specify one probability of failure (any number between 0% and 100%). where failure is defined as an outcome where the investor receives nothing back. In addition, the user can specify the probabilities of differences scenarios for round 2. These scenario probabilities are conditional on there being no failure. This means that the scenario probabilities add up to 100% by themselves. 7 At each of the round 2 scenarios, the user needs to specify the same variables as for round 1, expect that the user no longer has to specify the founder existing shares, existing options and the replenishment factor for the different scenarios. However, the user must also specify the following additional variables for each scenario: Variable Units Notes/Explanations Probability of Scenario Percentage Chance that the scenario will occur. Years to Scenario Number Time from round 1 to scenario. Series B Investment Dollar Total amount invested. Amount Probability of Failure After Round Percentage This is the probability that the exit value will be $0 at some point after the round is complete. Value of Exit Dollar The total exit value. The user can specify up to ten exit values. Probability Percentage Probability that a particular exit value will occur given that round occurs and company does not fail. Exit Type Choose from list Initial Public Offering (IPO) (investors will be automatically required to convert if preferred equity has been issued) or Acquisition Years to Exit Number Years from scenario (not round 1) until exit. At each of the scenarios, the user has the options to specify the deal terms. If the user decides not to specify the deal terms, the terms will automatically default to those assumed in round 1. 7 The user can thus specify the probability of failure independently of the scenario probabilities. Note that the unconditional probability of reaching a scenario is thus given by (1 probability of failure)*scenario probability. 9
The sheet titled Term Sheet Calculator provides the model s relevant outputs. Below is a list of the variables that the model derives: Variable Units Notes/Explanations Price per Share Dollar Based on VC Method see discussion of default prices in Section 1. Value per Share Dollar Discussed in detail above. If no preferred shares have been issued, this value will equal the price per share. Premium per Share Dollar Equals $0 if no preferred equity is issued. Total Value Dollar Equals investment amount if no preferred equity issued. Premium Value Dollar Equals $0 if no preferred equity is issued. Pre Money Valuation Dollar Post Money Valuation Dollar There are four main columns on the sheet titled Term Sheet Calculator. Valuation Based on VC Method: This provides outputs assuming the venture capital method is used for calculating the value per share. No terms are accounted for, so the premium per share is always zero by constructions. Term Valuations Based on VC Method: This method shows the value per share taking into account the investor s payoffs from the terms. The price per share is derived using the venture capital method, just as in column 1. Term Valuations Based on User Inputs (Case 1 and 2): The final two columns give the user the ability to change terms in the contract, including the price per share. These columns are called cases. Each case gives the user the ability to change many of the inputs in order to see how they affect the outputs discussed above. It is recommended that users change terms to determine how much they affect the value of each share. 10
Finally, here are some tips for simplifying the use of the Term Sheet Calculator. What if I only want to analyse a single round. If there is no second round to consider, change Scenario 1 probability to 100%. Change all other scenarios to 0%. Change Years to Scenario 1 to 0. Change Series B Investment amount to $0. Change Scenario 1 probability of failure to 0%. Fill in exit scenarios accordingly. What if I want to consider less than five scenarios: Change the scenario probability to 0%. There is no need to change any other cells relating to that scenario. Any inputs will automatically not affect the model. Also, ignore any sheets relating to those scenarios as they will not affect outputs. What if there are investors from previous round that already own shares? You will need to assume that all investor from prior rounds have been issued common equity. You can then include their shares with founder shares and include their options under the existing options. What if there are no preferred shares? Change type of equity shares to common equity. There is no need to fill in any other cells in the terms sections of the Deal Assumptions sheet. If you encounter any problems, or have suggestions for improvement, please contact Thomas Hellmann at Hellmann@sauder.ubc.ca 11