Lecture 7: Econ & Why VCs Say "No" | Adv. Venture Capital-FINAN 6310 | Chad Jardine, University of Utah, 2008–

3. Advanced Venture Capital: FINAN 6310 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM Anatomy of a Meltdown Advanced Valuation Formula Term Sheets Agenda

4. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. What’s Congress been up to? 85 years of finance legislation

5. Photo Credit: history.com U.S. Presidents 1933 Securities Act 1933 Glass-Steagall Act 1934 Securities & Exchange Act Regulated the sale of securities and separated commercial and investment banking

6. 1977 Community Reinvestment Act Tied FDIC insurance to anti-redlining policies

7. Tax Reform Act 1986 Resolution Trust Corporation (RTC) 1989 Overhauled the tax system, including taxes on investing activities. Response to the Savings & Loan crisis, liquidates the asset of failed S&Ls

8. 1999 Gramm-Leach-Bliley Act Partial repeal of Glass-Steagal. Banks can be commercial and investment banks.

11. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown 1973, publish The Pricing of Options and Corporate Liabilities Introduce the Black-Scholes Formula

13. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown 1973, publish The Pricing of Options and Corporate Liabilities Introduce the Black-Scholes Formula Win a Nobel Prize and become famous!

14. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. John W. Meriwether Vice Chairman & Head of Bond Trading at Salomon Bros. Meltdown Leaves and creates a hedge fund, recruiting some of the all stars from Saloman Bros.

17. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM posts stellar performance and extends into foreign investments to grow. Meltdown

18. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. 1997 Asian and 1998 Russian Financial Crises Hit LTCM is sucker- punched It starts to lose money Meltdown

19. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Sep 1998: Goldman and Berkshire Hathaway offer to buy out LTCM For $3.75 B But LTCM was valued at $4.7 B in Jan Buffet gives Meriwether 1 hour to make up his mind Meltdown

20. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM passes. It knows everybody on Wall Street and asks for help Sep 1998: Fed NY Orchestrates a Bailout of creditors and Wall Street players (setting a precedent) Bear Stearns conspicuously doesn’t participate Meltdown

22. Advanced Venture Capital: FINAN 6310 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM Anatomy of a Meltdown Advanced Valuation Formula Term Sheets Agenda ✓

23. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown AnAtomy of A meltdown How the events of the sub-prime mortgage crisis created the perfect storm for the game-changing market meltdown of 2008 Originally published October 2008 Revised & Edited 2015

25. Internet stocks are growing like crazy. Stock market valuations are hitting all-time highs. S&P 500 P/E Ratio

26. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Veterans of the market are getting nervous.

27. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown “How do we know when irrational exuberance has unduly escalated asset values which then become subject to unexpected and prolonged contractions?” —Alan Greenspan Federal Reserve Chairman 1987–2006

28. S&P 500 P/E Ratio Market ignores Greenspan’s warning and keeps on growing!

29. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown The markets are “groping for the appropriate valuations of these companies.” —Alan Greenspan Federal Reserve Chairman 1987–2006 “Speculating” is not necessarily the same as “investing.”

30. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown Greenspan begins raising interest rates. —Alan Greenspan Federal Reserve Chairman 1987–2006

31. In early 2000 the bubble bursts and values begin to free fall. S&P 500 P/E Ratio

32. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown Greenspan tries to lower rates to stop the free-fall —Alan Greenspan Federal Reserve Chairman 1987–2006 But the market had already lost over $5 trillion in value.

33. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. 9/11 punches the ailing economy in the face Meltdown

34. S&P 500 P/E Ratio By Nov 2002, the Fed has lowered rates to below 1%

35. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Investors pull money to the sidelines in cash Meltdown Investors flee the markets and hold cash on the sidelines.

36. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Pressure mounting to put cash to work. Interest rates at 1%, Inflation at 2-3%. Cash is devaluing.

38. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Greenspan encourage the creation of financial products to help people buy homes.

39. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Political motives to make it easier to buy a home

40. Resolution Trust Corporation (RTC) 1989 Banks stop carrying loans themselves. Instead they sell them to the secondary mortgage market.

41. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Meltdown The largest secondary players are Fannie Mae and Freddie Mac

42. 1995 President Clinton revives the CRA and opened the door to Fannie and Freddie accepting subprime loans

43. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Since subprime mortgages could be sold on the secondary market, mortgage companies had greater incentive to issue them

44. Advanced Venture Capital: FINAN 6310 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Loans were made to previously un- lendable customers. Like NiNJAs, No Job, No Assets; or simply stated income liar loans

45. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Wall Street enters real estate with a product called the CMO

46. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. CMOs just needed insurance and a credit rating.

47. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. CMOs are extremely popular. Even among the banks themselves.

48. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Huge pull-through demand for mortgages. Many are written as ARMs in order to get more borrowers into bigger and bigger homes.

50. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Greenspan gets nervous again. And pulls out his playbook for raising interest rates.

51. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. ARMs push payments beyond what people can afford

52. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Values start to fall, so people can’t sell except at a loss

53. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. By 2006–07 the writing is on the wall and foreclosures start mounting

54. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. All of a sudden leveraged investment banks are in trouble. Failing CMOs can’t be sold, leading to a liquidity crisis. Meltdown

55. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. 2006: Investment Banking is Dominated by the “Big Five” (who all have a “net cap” exemption) Meltdown

56. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Bear is the first to fall… but not before it asks for help Meltdown

57. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Memories of LTCM burn bright and a cold shoulder is turned to Bear… who gets purchased by JPM Meltdown

58. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Lehman implodes. Merrill gets purchased by Bank of America (See video: Breaking the Bank) Meltdown

59. Troubled Asset Relief Program 2008 $475 billion stimulus

60. 2009 American Recovery and Reinvestment Act 2010 Dodd-Frank Act 2012 JOBS Act $831 billion stimulus followed by enormous regulatory changes

61. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. All of this went down about a decade ago now. But the memory of it burns bright for anyone still operating in finance. Meltdown

62. Advanced Venture Capital: FINAN 6310 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM Anatomy of a Meltdown Advanced Valuation Formula Term Sheets Agenda ✓ ✓

64. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. (1+IRR)X (Investment) The Valuation Formula Valuation Formula: Should be very familiar by now (Multiple) (Exit Value) Hurdle Rate =

65. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Convert % ownership to # of shares new shares old shares + new shares % Ownership = % ownership Determine new shares to be issued 1 - % ownership New shares = X old shares Advanced Valuation Formula

66. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Reverse Engineer total # of shares .35 e.g., If there are 1M shares premoney and VC must own 35% 1 - .35 538,462 shares = X 1M Total shares 1 1 - % ownership = X old shares Advanced Valuation Formula

67. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Derive price per share $3.5 M e.g., If $3.5M is invested in 538,462 shares 538,462 $6.59 per share = Share price investment new shares = Advanced Valuation Formula

68. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Infer total value (post-money) based on VC stake $3.5 M e.g., If VC invests $3.5M for 35% .35 $10 M = post-money valuation = investment % ownership acquired Advanced Valuation Formula

69. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Infer total value (post-money) based on VC stake $3.5 M e.g., If post-money is $10M and investment is $3.5M $6.5 M pre-money = $10 M - pre-money valuation = (post-money valuation) - (new investment) Advanced Valuation Formula

70. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Advanced Valuation Formula What if you have multiple rounds? (1+0.5)5 ($1.5 Million) (15) ($2.5 Million) 30.4% = Round 1 (1+0.4)3 ($1.5 Million) (15) ($2.5 Million) 7.3% = Round 2 (1+0.25)2 ($1.5 Million) (15) ($2.5 Million) 3.3% = Round 3 This is the equity required post-dilution

71. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Advanced Valuation Formula Retention is the equity percentage you keep. retention % = 1 - (total of future final % ownership) 89.3 % = 1 - (7.3% + 3.3%) How much equity do I want in the end?

72. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Advanced Valuation Formula Keep the end in mind from the beginning. How much equity do I want in the end? current % ownership final % ownership retention % =

73. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. FINANCING ROUND Price per Share (PPS) Bootstrap Angel Seed Series A Series B IPO EOPP $203,450,000 ITY VALUATION 15,650,000 How much is each investor worth now? • 35.1% Public $71,500,000 • 22.4% B-VC $45,500,000 (17,500,000) • 16.0% A-VC $32,500,000 (5,000,000) • 5.1% Seed $10,400,000 (1,000,000) • 2.2% Employees $4,550,000 • 0.6% Angel $1,300,000 (100,000) • 18.5% Entrepreneur $37,700,000 (10,000)

74. Venture Capital: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Advanced Valuation Formula Keep the end in mind from the beginning. 26.5 % = 1 - (35.1% + 22.4% + 16.0%) Seed Round 19.3 % 5.1% 26.5 % =

75. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. “In founding a startup, you throw yourself off a cliff, and build an airplane on the way down.” —Reid Hoffman Cofounder of LinkedIn

76. Advanced Venture Capital: FINAN 6310 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM Anatomy of a Meltdown Advanced Valuation Formula Term Sheets Agenda ✓ ✓ ✓

79. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Why Use Term Sheets? • Get the essence of the deal down before you pay attorneys • Not binding—expression of good faith, testing the waters. • Leverage negotiating with other investors. (First guy in creates social proof AND anchors the terms.)

81. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Term Sheet Sections •Preamble/Opening Info (Mini PPM) •New Securities Offered •Total Raised, Number of Shares, Price per Share •Post-financing Capitalization •Dividend Provisions: Rights, Preferences & Privileges of Series [X] Preferred •Liquidation Preference •Redemption •Conversion/Automatic Conversion •Dilution Clauses •Voting Rights •Protective Provisions •Board Composition •Special Board Approval Items •Information Rights •Registration Rights •Right of First Refusal/Pro Rata Rights (Pay to Play) •Conditions Precedent •Purchase Agreement •Employee Matters •Closing Date, Legal Counsel, Expenses/Fees and Finders

82. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. •Preamble/Opening Info (Mini PPM) •New Securities Offered •Total Raised, Number of Shares, Price per Share •Post-financing Capitalization •Dividend Provisions: Rights, Preferences & Privileges of Series [X] Preferred •Liquidation Preference •Redemption •Conversion/Automatic Conversion •Dilution Clauses •Voting Rights •Protective Provisions •Board Composition •Special Board Approval Items •Information Rights •Registration Rights •Right of First Refusal/Pro Rata Rights (Pay to Play) •Conditions Precedent •Purchase Agreement •Employee Matters •Closing Date, Legal Counsel, Expenses/Fees and Finders Term Sheet Sections

83. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Preamble/Opening Optional Basic length of time to put a deal together Exclusivity “No-Shop” clause

85. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. New Securities What class and series of equity? How will this impact the cap stack?

87. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Keys of valuation. How much is your company worth?

89. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. “There are only two things that VCs really care about when making investments: economics and control.” —Brad Feld Managing Director, Foundry Group Co-founder, Techstars

91. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Yes or no? Cumulative or Regular? Preferred or non?

93. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Liquidation Preference = Front of the line at liquidity events.

95. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Redemption Protects VCs against cash cow exits. Forces a return of capital if the deal hasn’t progressed sufficiently.

97. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Conversion Preferred 1 : 1 Common Automatic Conversion: Terms under which preferred automatically converts to common (i.e., Qualified IPO, value of common in relation to original investment, and company valuation). Should be the same for all preferred. At option of preferred. Is value of common worth more than the liquidation pref of preferred? Standard Conversion:

99. Common Shares   (post conversion) A-Round 35% Founder 65%

100. Common Shares   (post conversion) B-Round 35% A-Round 23% Founder 42%

101. Common Shares   (post conversion) B-Round 35% A-Round 35% Founder 30%

104. Forget your Financial Accounting text. Preferred is typically given the right to vote “as-if converted”

106. Protective Provisions Veto rights on major decisions (like issuing shares)

108. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Board of Directors Senior Management Shareholders

113. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Right of First Refusal, Pro-rata Rights, Pay to Play ROFR = Previous investors HAVE THE RIGHT to buy stock in subsequent rounds ahead of new investors. Pro-rata = Previous investors MAY purchase enough stock to retain their percentage ownership in subsequent rounds. Pay to Play = Previous investors MUST buy their pro-rata shares in subsequent financings or have their shares converted to common stock.

115. Venture Capital: Financing New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Conditions Precedent What if due diligence uncovers a material problem?

118. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. Employee Matters Consider preparing an Options Budget 10–20% of the company is a ballpark. Look at your starting point, who you need to hire, and consider growth of 4–5% per year in the number of options you will need to offer. How many of those will need to be granted before the next financing? Typical equity (after vesting): 5–10% CEO 1.5–3% VPs 0.3–0.7% Senior Engineers (Software Co.) 0.2–0.4% Mid-level Engineers (Software Co.)

119. Venture Capital: Financing for New Ventures: FINAN 6300 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. •Preamble/Opening Info (Mini PPM) •New Securities Offered •Total Raised, Number of Shares, Price per Share •Post-financing Capitalization •Dividend Provisions: Rights, Preferences & Privileges of Series [X] Preferred •Liquidation Preference •Redemption •Conversion/Automatic Conversion •Dilution Clauses •Voting Rights •Protective Provisions •Board Composition •Special Board Approval Items •Information Rights •Registration Rights •Right of First Refusal/Pro Rata Rights (Pay to Play) •Conditions Precedent •Purchase Agreement •Employee Matters •Closing Date, Legal Counsel, Expenses/ Fees and Finders Term Sheet Sections

120. Advanced Venture Capital: FINAN 6310 Course copyright © Chad Jardine. Images, works cited, etc. are copyright © their respective owners. LTCM Anatomy of a Meltdown Advanced Valuation Formula Term Sheets Agenda ✓ ✓ ✓ ✓

Lecture 7: Econ & Why VCs Say "No" | Adv. Venture Capital-FINAN 6310 | Chad Jardine, University of Utah, 2008–

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Lecture 7: Econ & Why VCs Say "No" | Adv. Venture Capital-FINAN 6310 | Chad Jardine, University of Utah, 2008–