Entrepreneurial Finance

1
INTRODUCTION
Manuel Adelino
Duke University’s Fuqua School of Business
2
VALUATION
=
Price Present Value
(Cash Flows)
Ingredients:
Current
(Cash) Profits Growth Risk + Timing
3
DETERMINING CASH FLOWS

Manuel Adelino
4
DETERMINING FREE CASH FLOWS

TO THE FIRM
Revenue
- Cost
Includes cost of goods sold, sales, general and administrative
costs and depreciation
= Earnings Before Interest and Taxes
- Taxes
- Investments
4a. Capital Expenditures
4b. Changes in Net Working Capital =
Changes in Op. Assets – Op. Liabilities
5

Free Cash Flow = EBIT * (1 – T)
+ Depreciation
- Capital Expenditures
- Changes in Net Working Capital
Find a set of comparable companies (risk, industry, etc.)
Valuation starts with cash profits!
Need to invest in order to generate profits

(CAPEX, ∆NWC)
6
Free Cash Flow = EBIT * (1 – T)
+ Depreciation
- Capital Expenditures
- Changes in Net Working Capital
What this does not include:
Interest Expenses
Dividends
7
TIME VALUE OF MONEY

Manuel Adelino
8
WHY “PRESENT”:
TIME VALUE OF MONEY
Cash in 1 year, 2 years, … , 10 years

is worth less than today
9
WHY “PRESENT”:
TIME VALUE OF MONEY

100 dollars in the bank, interest rate of 10%
grows to
100 * (1+10%) = 110 after 1 year

10
WHY “PRESENT”:
TIME VALUE OF MONEY
grows to
100 * (1+10%) = 110 after 1 year
is worth
110 / (1+10%) = 100 today

11
WHY “PRESENT”:
TIME VALUE OF MONEY
grows to
100 * (1+10%) = 110 after 1 year
After 2 years is worth
100 * (1+10%) * (1+10%) = 100 * (1+10%)2 = 121

12
WHY “PRESENT”:
TIME VALUE OF MONEY

Future Value
Present Value =
(1+rd)t
for some discount rate “rd”.
13
MORE THAN 1 CASH FLOW
0 1 … 6 7 8 9 …
CF1 CF6 CF7 CF8 CF9
CF0 CF5 CF6 CF7 CF8

Present Value, = + ⋯+ 5
+ 6
+ 7
+ 8
+⋯
1 + r3 1 + r3 1 + r3 1 + r3 1 + r3
14
MORE THAN 1 CASH FLOW
0 1 … 6 7 8 9 …
CF1 CF6 CF7 CF8 CF9
With constant growth rate g:
CF2 =(1+g)*CF1
CF3 =(1+g)*CF2 = (1+g)2*CF1; …)
CF0
Present Value, =
r3 − g
15
WHAT IS THE DISCOUNT RATE?

Manuel Adelino
16
DETERMINING THE DISCOUNT RATE

What goes into rd?
Pure time value Risk

17

What goes into rd?
Pure time value
Risk-free rate: Interest rate paid (annually) by the government

for an equivalent period.
One common choice for valuation of firms is the US

government’s 10-year constant maturity rate.
18

What goes into rd?
Risk
Does not include “idiosyncratic” or “diversifiable” risk
Includes only “systematic” risk, measured by how the returns

of the firm co-vary with the market
This is measured by 𝛽
19

What goes into rd?
Together:
𝑟𝑑 = 𝑟𝑓 + 𝛽 ∗ (𝑟𝑚 − 𝑟𝑓)
Risk-free Beta: Market risk

rate From CAPM premium
20
COMPARABLES VALUATION
Manuel Adelino
21
USING MULTIPLES
Find a set of comparable companies (risk, industry, etc.).
1
For each comparable, divide value (EV or Equity, depending

2 on the multiple) by an accounting measure
• Firm Value / EBITDA

• Firm Value / EBIT
• Firm Value / Sales
• Price / Earnings (or Market Capitalization / Net Income)
Multiply the average ratio across comparables by your

3 estimate of the same accounting statistic for the project (or
firm)
1
RECAP: DISCOUNT RATE

Manuel Adelino
2

What goes into rd?

3

What goes into rd?
Pure time value
Risk-free rate: Interest rate paid (annually) by the government

for an equivalent period.
One common choice for valuation of firms is the US

government’s 10-year constant maturity rate.
4

What goes into rd?
Risk
Does not include “idiosyncratic” or “diversifiable” risk
Includes only “systematic” risk, measured by how the returns

of the firm co-vary with the market
This is measured by 𝛽
5

What goes into rd?
Together:
𝑟𝑑 = 𝑟𝑓 + 𝛽 ∗ (𝑟𝑚 − 𝑟𝑓)
Risk-free Beta: Market risk

rate From CAPM premium
6
ADDING PROBABILITY OF FAILURE

Manuel Adelino
ADDING UNCERTAINTY
Suppose cash flows period-by-period are:
• High with 50% probability

• Zero with 50% probability
How does this change the problem?

ADDING UNCERTAINTY EXPLICITLY
Suppose cash flows are:
• High with 50% probability

• Zero with 50% probability
How does this change the problem?
• It doesn’t, as long as risk is idiosyncratic AND investor

holds diversified portfolio.
• NPV applies to expected cash flows.
IMPLICATIONS FOR STARTUP FUNDING
If investors hold (reasonably) diversified portfolios
AND
Startups are evaluated using expected cash flows
=> No changes to FCF + WACC approach

10
INTERPRETING BUSINESS PLANS

Manuel Adelino
THE PITCH
T=0 T=1 T=2…
Invest High CF High CF

EVALUATING A BUSINESS PLAN
(or what a business plan really is)
Statement of ambition
VS
Expected outcome
REAL WORLD
1 Few companies (really) succeed
2 Returns are made on the large successes
3 Experts often can’t tell the difference

ADJUSTING CASH FLOWS
Business Plan Cash Flows

x
Probability of Success
Expected outcome
15
ADJUSTING DISCOUNT RATES

Manuel Adelino
COMPUTING NPV
Cash Out
P(success)
Cash In
0
COMPUTING NPV
𝐶𝑎𝑠ℎ 𝑂𝑢𝑡 ∗ 𝑝(𝑆𝑢𝑐𝑐𝑒𝑠𝑠)

𝑁𝑃𝑉 = −𝐶𝑎𝑠ℎ 𝐼𝑛 +
1 + 𝑟: ;
COMPUTING NPV
𝐶𝑎𝑠ℎ 𝑂𝑢𝑡 ∗ 𝑝(𝑆𝑢𝑐𝑐𝑒𝑠𝑠)

1 + 𝑟: ;
Or, equivalently:
𝐶𝑎𝑠ℎ 𝑂𝑢𝑡
1 + 𝑟: ;
𝑝 𝑆𝑢𝑐𝑐𝑒𝑠𝑠
VC REQUIRED RATE OF RETURN
The required rate of return on each individual investment can be re-
defined as:
)
1 + 𝑟* )
1 + 𝑟'( =
𝑝(𝑆𝑢𝑐𝑐𝑒𝑠𝑠)
So that
1 + 𝑟*
𝑟'( = + −1
𝑝 𝑆𝑢𝑐𝑐𝑒𝑠𝑠 )
Suppose rD=10%, suppose 20% probability of success and exit in 5 years:
1 + 10%
𝑟'( = + − 1 = 51.7%
20%-
VC REQUIRED RATE OF RETURN
5-YEAR EXIT, WACC=10%
DISCOUNT RATE BY P(SUCCESS)

Financing Options for Entrepreneurial Ventures
David T. Robinson
Duke University
DTR 1 / 50
Sources of Capital for Startups
Two Critical Lessons
1 A $1 is not just a $1: from whom you raise money can be as important as how
much you get
I Investors can be important business leads who can help you build your business; they
are not just there to plug holes in a cash flow statement (although they might be)
I These “value-added" services end up costing more in terms of greater loss of control,
of ownership (but sometimes are worth it)
I Some businesses are not well suited to some types of investors
2 Timing is everything
I Investors specialize in certain points of the lifecycle of a business
I It takes time to build relationships that lead to funding outcomes
I Capital providers are often complements, not substitutes
I Raising too much money too early can be deadly
DTR 2 / 50
How important are the various arrows?
Corporate VC
Venture Capital
Venture Capital
n
io
at
Venture Capital
ic
nd
Sy
Entrepreneurs
Angel Investors Banks

Strategic
Alliances
DTR 3 / 50
The Who and What
What:
Who: Debt Equity
Insiders The 3 F’s Angels
Customers/Suppliers Trade credit Alliance partners
Outsiders Banks Venture Capital and

“growth equity"
DTR 4 / 50
UNDERSTANDING DEBT
DTR 5 / 50
Kauffman Firm Survey 2004
All Firms
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
All Firms High Credit Low Credit
Owner Equity Owner Debt Insider Equity

Insider Debt Outsider Equity Outsider Debt
DTR 6 / 50
Kauffman Firm Survey 2004
The Difference: Total Capital
300000
250000
200000
150000
100000
50000
0
All Firms High Low All Hi- High Low
Credit Credit tech Credit Credit
DTR 7 / 50
What about Garage businesses?
Garage businesses vary by size
140,000
120,000
100,000
54,536
80,000 50,087
44,839
Outside Debt
42,208
Outside Equity
Insider Debt
60,000
Insider Equity
21,530
Owner Debt
Owner Equity
16,268
26,960 18,753
40,000 8,841
19,353
4,731
2,774
20,000
17,269 31,201 35,433

20,035
31,784
31,609
0
Non
Home
Employer Pre
Based Pre
Revenue Survived
Proﬁts Closed
thru 2006
by 2006
DTR 8 / 50
What about Equity-backed Businesses?
Again, Size Varies
2,500,000
2,000,000
628,398
1,500,000
Outside Debt
Inside Debt
Owner Debt
1,000,000 Outside Equity
Inside Equity
1,499,644
Owner Equity
164,891
500,000 75,156
328,999
515,051
0 96,030
Angel 171,145
VC
Corporate
Govt-‐Other
DTR 9 / 50
A Closer Look at Debt
6%
7%
10%
39%
8%
30%
Personal loans for business Business bank loans

Business Credit Cards Business Credit Line
Non-bank loans Other loans
DTR 10 / 50
How Debt Works
Borrow money, receive cash, repay principal plus interest
This means that entrepreneur keeps the upside
Debt has covenants: guidelines that must be adhered to if the debt is considered
to be in good standing
If default, debtholders can seize the firm’s assets and liquidate them
Collateral is typically required, often this is the entrepreneur’s personal assets

(their home, etc.)
DTR 11 / 50
A CLOSER LOOK AT VENTURE CAPITAL
DTR 12 / 50
Some Important Valuation Concepts for VC
Suppose an entrepreneur takes $10 for 5% of her company. What does this imply
about its value?
Post-money valuation
I Definition: the value of an enterprise after the VC has invested
$ invested
I Post $ = Ownership Share
Pre-money valuation
I Definition: the value of the idea before the new money goes in
I Pre $ = Post $ − Money invested
DTR 13 / 50
What VC Investment looks like
Suppose an entrepreneur takes $10 for 5% of her company. What really happens?
VC and Entrepreneur agree to a “terms sheet" which specifies corporate

governance rights, control rights, and amount of equity received for the amount of
money being provided
VC injects capital into the firm, receives a special type of security called
Convertible preferred equity
I CP receives interest like a loan
I Converts to common equity at a “conversion price"
I Balances “downside protection" when things go wrong with share in upside of firm’s
value
DTR 14 / 50
VC Securities
VCs typically use convertible preferred equity or participating preferred equity when
they invest in a startup
Initially structured as debt with accrued interest
“Liquidation rights" mean that the holder is entitled to some multiple of their
investment back before others get anything
CP: this right is surrendered if the security is converted into equity
An example:
I Firm has 100 shares outstanding–80 common shares, 20 cp shares
I CP convert to 1.8 shares of common but have a face value of $10 each
I CP is thus worth
F $200 as debt
F 31% of the company as equity
If participating, then the liquidation right is first honored, then converted to equity
Incentives
I VCs: this is downside protection
I Management: only gets paid well for big exits
DTR 15 / 50
VC FUNDS
DTR 2/5
What is a VC Investor?
Uni.% The%FUND%
$$%
Carry%
Calls,%Fees% General%%
Pensions%
Distribu?ons% Partner%
$$%
Carry%
Fam.%
Limited%Partners% Por.olio%%
Companies%
DTR 3/5
Fund Lifecycle
Most funds have a 10 year life, include provisions to extend beyond 10.
New
Investments
Follow-on
Investments
Exit/
Wind down
0 5 10 15
DTR 4/5
Compensation Basics
How do VC Investors Earn Money?
Management fees
I Typically 1.5% to 2.5%
I Fee reductions common as fund gets older
Carried interest
I Typically between 20% and 30% of net return
I Often cannot be earned until fund’s whole invested capital is returned to Limited
Partners
DTR 5/5
HOW DO VC’S VALUE BUSINESSES?
DTR 16 / 50
The Cruel Math of Venture Investing
Why are VC hurdle rates so high?
A VC who invests LPs money for T years must earn a return based on the
expected payout
Cash
| {z In} (1 + r )T = p × Cash Out
| {z } | {z }
VC invest LP required return Expected Outcome
This equation can be used to find the cash-on-cash return required by the VC
This accounts for idiosyncratic risk as well as expected return
Cash Out (1 + r )T
=
Cash In p
We can also express the cash-on-cash return as a hurdle rate
r s
T Cash Out T (1 + r )T
Hurdle Rate = −1= −1
Cash In p
DTR 17 / 50
The VC METHOD
DTR 18 / 50
The Simplified VC Method
What determines how much equity they take?
1 What is the required investment today? ( = $100 )

2 What is the exit valuation for this company? (=$20,000)
I How do we estimate this number???
3 What is the cash multiple we have to earn?

I If r=15%, T=5 yrs, p=10%, then Hurdle Rate is 82%; C-on-C is 20
4 Discount the exit by the hurdle rate:
Exit valuation
NPV =
hurdle rate
5 This is today’s NPV of the entire company. In our example, NPV=$1,000
6 How much of this do you need to own in order to break-even on required
investment?
Note: this calculation overlooks the effect of later investment rounds coming in
DTR 19 / 50
Alternative Formulations
How large does an exit have to be to justify a $10M investment for a 28%
ownership if we expect to wait 5-7 years for an exit and our current ownership will
be diluted 50% before an exit occurs?
How much equity should we negotiate for a $10m investment if we expect to wait
3-5 years for an exit that will be priced at an 11X EBITDA multiple on 100M in
EBITDA? What does this depend on?
DTR 20 / 50
UNDERSTANDING TERMS SHEETS
DTR 21 / 50
Main Terms Sheet Provisions
Valuation:
I Pre-money value
I round size
Governance
I Board Seats
I Preferred Voting Rights (Veto Rights)
I Option pool: incentive current and future management
Exit
I Anti-dilution protection: protect against future value decrease in later funding
I Dividends: seldom cash, but can affect value at liquidation
I Liquidation preferences and participation
Others
I Drag-along versus tag-along rights
I Piggy back versus demand registration rights
I Pay-to-play
I lockup
DTR 22 / 50
UNDERSTANDING OPTION POOLS
DTR 23 / 50
Option Pool
Provides incentives for management
Size of the option pool depends on stage and size of investment
Typically range from 10% to 20% of the total shares outstanding
Standards differ across sectors and over time
When do new options go in:
I Before the raise or after?
I Referred to as options in the pre-money vs. post-money
DTR 24 / 50
Accounting for the Option Pool
Is it in the Pre or in the Post?
Founders own 2M shares, raise an additional $1M for 40% ownership. New money
requires 18% option pool.
With no option pool, VC would get 1,333,333 shares

Options are in the PRE:
I The trick: Options come completely out of the founders pocket. He doesn’t own 60%.
2M
He owns 42%. New total shares outstanding is 0.42 = 4, 761, 905
I Venture investor receives convertible shares worth 1,904,762 shares of common on a
fully diluted basis
I Options then equal 18% of that: 857,143. Requires 857,143 newly issued options.
In the POST:
I Previous example takes down pre money by 0.18 * 2.5M.
I Post money splits the 18% on a 60/40 basis between founder and new investor.
I Ownership fractions are 18%, 32.8%, 49.2%
I In this scenario there would be 4M shares total, 720,000 options.
DTR 25 / 50
Exercise
Consider a company founded with 1m shares of common equity, split amongst the
founders. A year later the company raises $3M of Series A funding at a $1M
pre-money valuation. At this time they also established an option pool of 10% of
post-money shares outstanding, taken out of the post-money valuation of the firm. Two
years later they raise a Series B round from the same investors. The company is
valued at $6m before the $9 M Series B capital raise.
1 How many shares outstanding are there, on a fully diluted basis (i.e., including the
effect of the option pool) after the Series A round?
2 How large is the option pool in terms of the number of shares on a fully diluted
basis?
3 How many shares are outstanding after the B round?
4 What is the price per share of the Series B round?
5 What fraction of the total post-money value of the company after series B does the
option pool represent?
DTR 26 / 50
UNDERSTANDING ANTI-DILUTION
DTR 27 / 50
Anti-Dilution Protection
Protects shares in the case of a future down-round
When new shares are issued at a lower price
Lowers the price at which an old share converts to common (rather than issue
more shares)
Flavors of anti-dilution
I Full ratchet: if a single share issues at a lower price, all covered shares change to that
price
I Weighted average: old price adjusts partially to new price depending on relative
amount of capital in each raise
Where is anti-dilution protection appropriate?
DTR 28 / 50
Alternative Anti-Dilution Calculations
Weighted Average versus Full Ratchet
Full Ratchet: Easy to calculate, hard to stomach
New Conversion Price = Old Conversion Price
Weighted Average: trickier to calculate, easier to stomach:
Old shares + Would Be New Shares

New Price = Old Price ×
Old shares + New Shares
New Money In
where WBNS = Old Price
DTR 29 / 50
A Weighty Example
Series A pays $100 for 20 shares ($5 conversion price)
Scenario 1: Series B puts in an additional $100 but gets 50 shares ($2 price)
20 + ( 100
5
=)20 4
New Price = $5 × = $5 × = 2.86
50 + 20 = 70 7
Scenario 2: Series B puts in an additional $300 at a $2 conversion price
20 + 300
5
= 60 80
New Price = $5 × = $5 × = 2.35
150 + 20 = 170 170
Scenario 3: Series B puts in an additional $100 at a $0.5 conversion price

20 + 20 40
New Price = $5 × = $5 × = $0.91
220 220
DTR 30 / 50
ANGEL INVESTORS
DTR 31 / 50
Who Are Angels?
Term comes from financiers of early Broadway shows
Typically refers to high net worth individuals
SEC Rule 501 defines “Accredited Investor" as
I Net Worth > $1 million
I Annual Income > $200K for last 2 yrs, or joint income > $300K
Federal Reserve Board’s Survey of Consumer Finances suggests there are about 10
million qualified households. Far, far fewer are investors, yet this market is large
compared to the VC market.
DTR 32 / 50
What do Angels do?
Invest in unregistered securities offerings
Primarily to support pre-seed, seed and very early stage companies
Round Size Def’n.

Seed $250K-$750K Prove a concept, build an MVP
Early Stage $2-3M Pre-revenue
DTR 33 / 50
Some Success Stories
Amazon.com
I 8/1995: Two angels invest $54K. At IPO in 5/97, this was worth $7.6M.
Some other famous examples:
I Bell Telephone (1874),
I Ford Motors (1903),
I Apple (1977),
I Pete’s Brewing (1986)
DTR 34 / 50
Angel returns
DTR 35 / 50
ANGEL Securities
DTR 36 / 50
Angel Contracts
How Angel Investments Work
Many Angel investments are supported by two legal documents:
Note Purchase Agreement
I Sets the rules for who is investing and who is receiving investment, what constitutes
change of control, bankruptcy, default, etc.
Promissory Note or Convertible Note
I Actually describes the security that the investor is receiving when they make an
investment
I Key parameters: investment amount, interest or dividend, conversion, cap
Increasingly, Convertible Notes are being replaced by SAFEs (Simple Agreements for
Future Equity)
DTR 37 / 50
Angel Contracts
Debt versus Equity
What’s the difference between a Convertible Note and a SAFE?
SAFE: an equity security. Technically a warrant that earns accrued dividends.
Convertible Note: a debt security that earns accrued interest.
As a practical matter the distinction isn’t so important because in the event that the
startup fails to raise follow on financing, the difference between being a debt holder or
an equity holder isn’t so important: both securities are probably worthless.
DTR 38 / 50
Angel Contracts
ANGEL Term Sheets
DTR 39 / 50
Angel Contracts
Key Investment Terms
This Convertible Promissory Note is one of the Notes referred to in, and is executed
and delivered in connection with, that certain Note Purchase Agreement, dated as of
[date] (as amended from time to time, the “Purchase Agreement"), by and among
Borrower, Lender and the other parties to such agreement. Additional rights of Lender
are set forth in the Purchase Agreement. Capitalized terms used in this Note without
definition will have the meanings given to such terms in the Purchase Agreement.
1 Principal Repayment. Unless this convertible promissory note (the “Note") has
been converted in accordance with the terms of Section 4 below, and subject to
acceleration as provided in this Note, the outstanding principal amount of the Loan
and all unpaid accrued interest will be fully due and payable in cash twelve (12)
months from the date of this Note (the “Maturity Date").
2 Interest Rate. Borrower promises to pay interest on the outstanding principal

amount hereof from the date hereof until payment in full, which interest will be
payable at the rate of eight percent (8%) per annum. Interest will be calculated on
the basis of a 360-day year for the actual number of days elapsed.
DTR 40 / 50
Angel Contracts
Automatic Conversion
Notwithstanding the provisions of Section 1, in the event that the Borrower is-
sues and sells shares of any series of its Preferred Stock on or before the Ma-
turity Date raising an aggregate of $400,000 or more (a “Qualified Financing”),
then, the outstanding principal balance of (and any unpaid accrued interest
under) this Note will automatically convert in whole without any further action
by the Lender into that number of shares the series of Preferred Stock issued
in the Qualified Financing (the “Shares") as is equal to the unpaid principal
balance (and unpaid accrued interest, if elected) of this Note as of the closing
of the Qualified Financing divided by the multiple of (i) the per share purchase
price of the Shares paid by the investors purchasing such stock and (ii) eighty
percent (80%) (a discount of twenty percent (20%), with any fraction of a Share
rounded down to the next whole Share, and otherwise on the same terms and
conditions as given to such investors. Borrower will pay in cash the fair market
value of any fraction of a Share.
DTR 41 / 50
Angel Contracts
Conversion Math
As a Note-holder, you will receive
$ invested
# shares =
0.8 × Next Series Share Price
number of shares in exchange for the money you invested in the company as an angel
investor. E.g., assume that you put in $400,000 into a convertible note and then one
year later the company raises Series A funding at $5 share. You receive 100,000
shares instead of the 80,000 that a Series A investor would have received for that
much money.
DTR 42 / 50
Angel Contracts
Capped Conversion Prices
DTR 43 / 50
Angel Contracts
Capped Conversion Prices
What if the value of the company is very high in the next financing round?
I This causes the number of shares received to be low
I Effectively the angel investor is diluted
To protect the angel investor against this possibility, the term sheet will impose a
cap
I A maximum pre-money valuation implies a capped conversion price
I A capped conversion price guarantees a minimum number of shares
DTR 44 / 50
Angel Contracts
The Cap
DTR 45 / 50
Angel Contracts
Simple Translation
As a Note-holder, you will receive the larger of
$ invested
# shares =
0.8 × Next Series Share Price
number of shares in exchange for the money you invested in the company as an angel
investor.
OR
$ invested
# shares =
Capped Price
Where capped price is the price per share of assuming the company had a $10 million
pre-money valuation.
DTR 46 / 50
Angel Contracts
An Example
One year ago, you invested $100,000 in a SAFE with a 8% annual dividend. The
company has 10 million shares outstanding. A qualified financing event arrives:
$6 million invested on a $20 million pre-money valuation.
They get 3 million shares.
You get
108, 000
67, 500 shares =
1.60
But wait! You have a share price capped by a $10 million pre-money valuation!
Instead of a $2 per share price, the capped price is $1/share.
You get
108, 000
108, 000 shares =
1.00
DTR 47 / 50
Angel Contracts
CONCLUSION
DTR 48 / 50
Angel Contracts

How important are the various arrows?
Corporate VC
Venture Capital
Venture Capital
n
io
at
Venture Capital
ic
nd
Sy
Entrepreneurs
Angel Investors Banks

Strategic
Alliances
DTR 49 / 50
Angel Contracts

Two Critical Lessons
1 A $1 is not just a $1: from whom you raise money can be as important as how
much you get
I Investors can be important business leads who can help you build your business; they
are not just there to plug holes in a cash flow statement (although they might be)
I These “value-added" services end up costing more in terms of greater loss of control,
of ownership (but sometimes are worth it)
I Some businesses are not well suited to some types of investors
2 Timing is everything
I Investors specialize in certain points of the lifecycle of a business
I It takes time to build relationships that lead to funding outcomes
I Capital providers are often complements, not substitutes
I Raising too much money too early can be deadly
DTR 50 / 50
PREFERRED EQUITY
David T. Robinson
Back to the Terms Sheet
The term sheet will specify:

a number of shares being purchased
for an amount of money being invested
The Securities purchased will often include:

dividends that accrue unpaid until a liquidation event or
redemption occurs
a liquidation preference
participation rights after liquidation preferences have
been satisfied
Key Features
Liquidation preference:
we get paid first
Referred to as “times money”, e.g. 1x is typical
Typically includes unpaid dividends
Senior to other series vs. pari passu
Participation rights:
After liquidation preferences are paid
Typically capped for total return (times money)
Liq. Preferences and Participation
In the event of any liquidation, dissolution or winding up of the

Company, the proceeds shall be paid as follows:
Liquidation Preference:
First pay [_____] times the Original Purchase Price plus
accrued dividends on each share of Series A Preferred.
Thereafter, Series A Preferred participates with Common Stock
pro rata on an as-converted basis until the holders of Series A
Preferred receive an aggregate of [_____] times the Original
Purchase Price (including the amount paid pursuant to the
preceding sentence).
A merger or consolidation (other than one in which stockholders

of the Company own a majority by voting power of the
outstanding shares of the surviving or acquiring corporation)
and a sale, lease, transfer, exclusive license or other disposition
of all or substantially all of the assets of the Company will be
treated as a liquidation event (a “Deemed Liquidation Event”),
thereby triggering payment of the liquidation preferences
described above [unless the holders of [___]% of the Series A
Preferred elect otherwise].
Conversion Rights
The Series A Preferred initially converts 1:1 to Common Stock at

any time at option of holder, subject to adjustments for stock
dividends, splits, combinations and similar events and as
described below under “Anti-dilution Provisions.”
The Series A Preferred initially converts 1:1 to Common Stock

Optional Conversion: at any time at option of holder, subject to adjustments for stock
dividends, splits, combinations and similar events and as
described below under “Anti-dilution Provisions.”
Mandatory Conversion
Each share of Series A Preferred will automatically be converted

into Common Stock at the then applicable conversion rate in the
event of the closing of a underwritten public offering with a price
of [___] times the Original Purchase Price (subject to adjustments
for stock dividends, splits, combinations and similar events) and
[net/gross] proceeds to the Company of not less than $[_______]
(a “QPO”), or (ii) upon the written consent of the holders of
[__]% of the Series A Preferred.
Mandatory Conversion: Each share of Series A Preferred will automatically be
converted into Common Stock at the then applicable conversion
rate in the event of the closing of a [firm commitment]
underwritten public offering with a price of [___] times the
Original Purchase Price (subject to adjustments for stock
dividends, splits, combinations and similar events) and
[net/gross] proceeds to the Company of not less than $[_______]
(a “QPO”), or (ii) upon the written consent of the holders of
[__]% of the Series A Preferred.
CAPITALIZATION TABLES
David T. Robinson
Blue Devil Enterprises
Founders have 3M shares prior to first round
Raise $5M Series A round at a $5M pre-money

$3M from VC 1, $2M from VC 2
1x liquidation preference to common, 3x cap
Before the round is raised, option pool created totaling 20% of the
post-money capitalization of the firm
Raise $15M Series B round at a $15M pre-money

No further options in round
Half comes from VC 1, remainder 60/40 between VC 2 & 3
1x liquidation preference to A and common, 3x cap
Common Series A Series B Fully

Shares % $ Shares % $ Shares % Diluted %
VC 1 $ - 0%
VC 2 $ - 0%
VC 3 $ - 0%
Total Preferred $ - 0%
Founders 3 100% 3 100%

Options 0% 0 0%
Total Shares 3 3 100%
Price/Share
Founders initially own 100% of the firm

David T. Robinson

VC 1 $ - 0%
VC 2 $ - 0%
VC 3 $ - 0%
Total Preferred $ - 0%
Founders 3 100% 3 100%

Options 0% 0 0%
Total Shares 3 3 100%
Price/Share
Founders initially own 100% of the firm

Option Pool
Founders Series A Founders Series A
Options Options
Pre-money Post-money
David T. Robinson

VC 1 $ 3.00 3 60% $ 3.00 30%
VC 2 $ 2.00 2 40% $ 2.00 20%
VC 3 $ - 0%
Total Preferred $ 5.00 5 100% $ 5.00 50%
Founders 3 60% 3 30%

Options 2 40% 2 20%
Total Shares 5 5 0 10 100%
Price/Share $ 1.00
Founders now own 30% of the firm

Series A: 1x preference to Common, 3x cap on participation
David T. Robinson

VC 1 $ 3.00 3 60% $ 7.50 5 50% $ 8.00 40%
VC 2 $ 2.00 2 40% $ 4.50 3 30% $ 5.00 25%
VC 3 $ 3.00 2 $ 2.00 10%
Total Preferred $ 5.00 5 100% $ 15.00 10 80% $ 15.00 75%
Founders 3 60% 3 15%

Options 2 40% 2 10%
Total Shares 5 5 10 20 100%
Price/Share $ 1.00 $ 1.50
Series B: 1x preference to A and Common, 3x cap on participation

Series A: 1x preference to Common, 3x cap on participation
Fully Diluted Cap Tables
What does “Fully Diluted” mean?

Assume all warrants and options are issued and exercised
Assumes all convertible equity has converted to common
Is this necessarily true?

There usually are unissued options in the pool
If the distribution is low, options and/or warrants may not
exercise

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What are the key steps in determining cash flows?

What are the key steps in determining cash flows?

What is the time value of money and why is it important?

What is the time value of money and why is it important?

1

DETERMINING CASH FLOWS

DETERMINING FREE CASH FLOWS

= Earnings Before Interest and Taxes

DETERMINING CASH FLOWS

Find a set of comparable companies (risk, industry, etc.)

Valuation starts with cash profits!

Need to invest in order to generate profits

DETERMINING CASH FLOWS

Free Cash Flow = EBIT * (1 – T)

TIME VALUE OF MONEY

Cash in 1 year, 2 years, … , 10 years

Cash in 1 year, 2 years, … , 10 years

100 dollars in the bank, interest rate of 10%

100 * (1+10%) = 110 after 1 year

100 dollars in the bank, interest rate of 10%

100 * (1+10%) = 110 after 1 year

110 dollars in the bank, interest rate of 10%

110 / (1+10%) = 100 today

100 dollars in the bank, interest rate of 10%

100 * (1+10%) = 110 after 1 year

100 dollars in the bank, interest rate of 10%

After 2 years is worth

100 * (1+10%) * (1+10%) = 100 * (1+10%)2 = 121

Cash in 1 year, 2 years, … , 10 years

MORE THAN 1 CASH FLOW

CF1 CF6 CF7 CF8 CF9

CF0 CF5 CF6 CF7 CF8

MORE THAN 1 CASH FLOW

CF1 CF6 CF7 CF8 CF9

With constant growth rate g:

WHAT IS THE DISCOUNT RATE?

DETERMINING THE DISCOUNT RATE

Pure time value Risk

DETERMINING THE DISCOUNT RATE

Pure time value

Risk-free rate: Interest rate paid (annually) by the government

One common choice for valuation of firms is the US

DETERMINING THE DISCOUNT RATE

Does not include “idiosyncratic” or “diversifiable” risk

Includes only “systematic” risk, measured by how the returns

DETERMINING THE DISCOUNT RATE

Pure time value Risk

Risk-free Beta: Market risk

For each comparable, divide value (EV or Equity, depending

• Firm Value / EBITDA

Multiply the average ratio across comparables by your

RECAP: DISCOUNT RATE

DETERMINING THE DISCOUNT RATE

Pure time value Risk

DETERMINING THE DISCOUNT RATE

Pure time value

Risk-free rate: Interest rate paid (annually) by the government

One common choice for valuation of firms is the US

DETERMINING THE DISCOUNT RATE

Does not include “idiosyncratic” or “diversifiable” risk