Class 6 IEOR 191 VC model Dilution Equity Gate 1(1).pptx

dilution of equity

1. Sources of Capital Dilution of Equity IEOR191 Class 6 Understand how VCs view entrepreneurs & how the process of seeking investment works Naeem Zafar 1 All rights reserved © Naeem Zafar

2. Agenda Last class review Virgin Mobile & positioning VC & Investors profile Dilution & equity distribution Gate 1 presentations Etcheverry 3106, 3109, 3111 All rights reserved © Naeem Zafar 2

3. HR Budget for 2 Years How do you build budget? It is a spreadsheet Talk to mentors Look at proxies Start with whom you need to hire, when What they will cost? What else do you need? All rights reserved © Naeem Zafar 3

4. All rights reserved © Naeem Zafar 4 Etcheverry 3106 Mentor: Gopi Teams : Broccoli Wi-fi Free Pepper SpendWallet Gate 1 Etcheverry 3109 Mentor: Faraz Teams: Smart Sense College Shift Searching Infinity Medherence Lab EasyLife Etcheverry 3111 Mentor: Rajiv Teams: TeleSense Rent Mochi Shopping GPS WYD

5. Capital Needs You need capital (money) to grow a business All rights reserved © Naeem Zafar 5 $0 time cash

6. Each Source of Capital Has Own Motivations Sources: Friends, family and fools Angels Venture capitalists Strategic investors Banks Government loans Crowd-funding [email protected] 6 You! Domain, You Traction, Exit! Channels, products, technology Collateral

7. De-Risk The Deal = Increase Valuation [email protected] 7 time A B C Risk months

8. Timing of Capital SV Innovation & Culture All rights reserved © Naeem Zafar 2015 8 Idea discovery & mkt Research Prototype Prod Dev Prod Delivery & customers Scaling & Channel Pre-Seed Seed Startup funding Expansion funding Friends & family Angel investors Early stage VC Late stage VC PE or IPO $10K -$100K $200K to $2m $2m to $10m $10m to $50m $50m to $1b

9. 9 Funding Needs homework Bootstrap Or Angel Prod Dev Deployment proliferation Prototype Series A Series B Series C F&F All rights reserved © Naeem Zafar ~6 mo. ~6 to 12 mo. ~15 to 24 mo. ~18 to 24 mo.

10. Angel Investors & Groups VCs invest $30B a year in ~3,000 deals per year Angels are investing between $20B and $30B in ~30K deals per year http://www.angelcapitalassociation.org/ Angel groups The Angel’s Forum http://www.angelsforum.com/ The Band www.bandangels.com Sand Hill Angels http://www.sandhillangels.com Keiretsu Forum http://www.keiretsuforum.com [email protected] 10

11. VCs vs. Angels [email protected] 11

12. Demystifying Venture Capitalism Firms with partners who have financial & operating experience Invest other people’s money in high risk, high reward ideas Nurture & guide them to an exit [email protected] 12

13. Profile of an Angel Investor Successful entrepreneurs & business people Seeking: Superior returns than bank/stock markets Emotional engagement with business Mentoring younger generation Stay connected & feel useful Naeem Zafar (c) all rights reserved 13 Peter Thiel German-born US entrepreneur,   age 45, Stanford Law School – Made money at PayPal & then first angel investor in Facebook Worth: $1.5B

14. Profile of a Venture Capitalist VC Successful entrepreneurs & financial/operational experts Have a “thesis” on: what will be hot in a few years who can seize that opportunity Naeem Zafar (c) all rights reserved 14 Reid Hoffman venture capitalist at Greylock partners, Best known as the co-founder of LinkedIn, age 46,  Education:  Rensselaer Polytechnic Institute, Stanford, Oxford

15. [email protected] 15 What Investors Looks For Traction is most important Sales, customers, revenues Hierarchy of traction Sales Field testing or pilot sites Agreements for beta testing, pilots, field trials Potential customer testimonials Names of prospects

16. How Angels Invest What is the fair price? Term sheets Dilution & Cap Tables All rights reserved © Naeem Zafar 16

17. Convertible Note Convertible note is loan to company that will convert to stock once value is determined by VC Until then it is a loan, accruing interest, secured by the IP of the company Avoids valuation discussion Simple 1-2 page note, minimal legal fees Term sheets Dilution & Cap Tables All rights reserved © Naeem Zafar 17

18. Issue #1 with Convertible Note Why should I invest before VCs? Do I get any incentive? Yes you will get a better price once we compute the share price Typically 20% discount but … negotiable Term sheets Dilution & Cap Tables All rights reserved © Naeem Zafar 18 Discount on Series A

19. Issue #2 with Convertible Note What is you become too successful? Will I get anything significant for all my initial risk? If the value of the company rises a lot [& share price becomes too high] you will still get a not-to-exceed price Typical cap can be $3m to $5m Term sheets Dilution & Cap Tables All rights reserved © Naeem Zafar 19 Cap on valuation

20. Demystifying Equity Dilution All rights reserved © Naeem Zafar 20 Term sheets Dilution & Cap Tables

21. Example 3 people start a company 10M shares issued Each founder has 25%, reserve 25% for employees & advisors Price $0.01 (resulting in company valuation of $100K) All rights reserved © Naeem Zafar 21 Term sheets Dilution & Cap Tables

22. 22 All rights reserved © Naeem Zafar Equity Ownership Term sheets Dilution & Cap Tables

23. Example: Initial Money 1 st round investment (product development) Pre-money valuation ~ $2M Per share price = $2M/10M shares = $0.20 Investors put in $3M (buy shares at $0.20)  15 M new shares will be issued All rights reserved © Naeem Zafar 23 Term sheets Dilution & Cap Tables

24. Example: Initial Money 1 st round investment (product development) Pre-money valuation ~ $2M Per share price = $2M/10M shares = $0.20 Investors put in $3M (buy shares at $0.20)  15 M new shares will be issued Post money is $5M ($2M pre plus $3M new money) Investors own 60% of the company now Total number of shares = 10M + 15M new = 25M All rights reserved © Naeem Zafar 24 Term sheets Dilution & Cap Tables

25. Equity Ownership Post Round A All rights reserved © Naeem Zafar 25 Term sheets Dilution & Cap Tables

26. Example: Prod Dev Money Raised 2 nd round investment (Series B) Series B =Product deployment Pre-money valuation ~ $10M New share price = $10M/25M shares = $0.40 Investors put in $8M (buy shares at $0.40) New 20M shares issued ($8M / $0.40 per share) Total 45M shares (existing 25M + new 20M) All rights reserved © Naeem Zafar 26 Term sheets Dilution & Cap Tables

27. Example: Prod Dev Money Raised Post money is $18M– everyone get diluted But gets smaller share of a bigger pie Added 5M to ESOP (Employee pool) Total shares = 50M All rights reserved © Naeem Zafar 27 Term sheets Dilution & Cap Tables

28. 28 All rights reserved © Naeem Zafar Equity Ownership Post B Round Term sheets Dilution & Cap Tables

29. Example: Expansion Money Raised 3 rd round investment (Series C) Series C = channel expansion Pre-money valuation ~ $50M New share price $50M/50 shares = $1.00/share Investors put in $15M Post money is $65M– everyone get diluted But gets smaller share of a bigger pie 15M new shares issued (total 65M) All rights reserved © Naeem Zafar Term sheets Dilution & Cap Tables 29

30. 30 Equity Ownership: Post C Term sheets Dilution & Cap Tables All rights reserved © Naeem Zafar

31. Example: Going Public Initial Public Offering (IPO) Valuation by investment bankers ~ $100M Reverse split shares 5:1 to get decent price at IPO Market needs to see stock price in $6 to $18 range Now 65M outstanding shares become 13M but they are 5x more valuable 13M shares pre IPO All rights reserved © Naeem Zafar 31

32. Example: Going Public Sell 2M new shares at IPO at $100/13=7.70 per share Raise $15.4M for operations (less fees) Employee lock up Founder lockup All rights reserved © Naeem Zafar 32

33. Ownership After Going Public All rights reserved © Naeem Zafar 33 Term sheets Dilution & Cap Tables

34. Founders’ Wealth All rights reserved © Naeem Zafar Term sheets Dilution & Cap Tables 34

35. Your Equity Distribution Options Set aside portion of stocks for advisors & consultants & key advisors Founders should end up with bulk of shares Dilution will happen when money is raised Do simple one page agreements & convert to legal agreement when time to incorporate All rights reserved © Naeem Zafar 35

36. Why Raise Money in Chunks Preserve equity by de-risking the deal All rights reserved © Naeem Zafar 36 time Valuation Risk: tech, team, market Risk: team, market Risk: team, execution Risk: mkt size seed Series A Series B Series C

37. Summary Read chapter 3 of the Get Funded! Book The 12-step funding process should be a must read Understanding how VCs operate will help you pick the Right Source of the Funding at the Right Time 37 All rights reserved © Naeem Zafar

38. Next Week: Business Models Deliverable: 2-year budget – hiring plan and expenses Speaker: Russ Tillet CEO & founder Embee Mobile Golf Logix [Harvard case 9-503-004] Questions to prep: what should Golf Logix do? Should Golf Logix even offer the Complete System? Why? How does the channel choice affect long term differentiation? Assigned reading: Get Funded, Chapter 7 (12-Step process of getting funded) Deliverable in 2 weeks: Research comparable public companies in your space and outline what percent of revenue do they spend on (a) R&D (b) sales and marketing (c) G&A their gross profit and net income as a % of their revenue. All rights reserved © Naeem Zafar 38

39. Gate 1 Present your business summary & market research findings: What unmet need, market size, target customer, your solution, positioning, value proposition 7 minutes pitch 7 minutes of peer feedback & mentor comments Enforce timing strictly – don’t short change teams Resist temptation to answer questions & defend All members should take notes (or record feedback) All rights reserved © Naeem Zafar 39