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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle

Introduction to Venture Capital


The Venture Capital Cycle & Industry Statistics
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Institutional
Investor
(LP)
Venture
Fund/Firm
Portfolio
Company
Public
Markets
The Venture Capital Cycle
Professor David Wessels
The Wharton School of the University of Pennsylvania
Capital
Call
Institutional investors are accredited if they
have more than $5 million of assets. These
generally include government or company
pensions, charitable organizations or financial
institutions. Accreditedindividualsmust have
individual income over $200,000 or net worth
over $1 million.
(Rule 501, Regulation D, 1933 Securities Act)
Secondary transactions are limited to
Qualified Institutional Buyers (QIBs), whose
assets under management (AUM) must
exceed $100 million. No individuals.
(Rule 144A, 1933 Securities Act)
Public capital markets. While the IPO
may be the most glamorous type of exit for
the venture capitalist, most successful exits
of venture investments occur through a
merger or acquisition of the company by
either the original founders or another
company.
Portfolio companies are typically
young, privatelyheld companies in
high growth industries, such as
technology or health care. Revenues
are expected to reach $25 million
within five years.
Venture Capital firms typically
comprise of 3-20 partners (and an
equal number of associates) who
screen potential investment
opportunities in high-growth
industries. Venture capitalists are
typically active investors.
Direct
Investment
Exit
Distribution
Other: PIPEs and Buyouts
Exceptions:
Evergreen Funds
Recycle Provisions
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
The Investors Choice
The typical limited partner (LP) is looking to diversify across investment
opportunities. Diversification mitigates portfolio volatility. Many argue that access
to alternatives provides exposure to alpha.
Professor David Wessels
The Wharton School of the University of Pennsylvania
PensionFunds
Endowements
Source:Wessels,2010
PrivateEquity
Seed
EarlyStage
VetureCapital
LateStage
SuperAngels
PrivateEquity
Alternatives
LeveragedBuyouts
RealEstate
Distress
Commodities
Treasuries
InstitutionalInvestors
CorporateBonds
GrowthEquity
HedgeFunds
PublicEquities
Mezzanine
QualifiedInvestors
VentureCapital
Investors AssetClasses "Alternatives"
1. How are venture capital
partnerships structured?
2. Does venture capital (in aggregate)
outperform other asset classes on a
risk reward basis?
3. Do particular VCs outperform their
peers and is this performance
persistent?
4. How does a portfolio perspective
alter a VCs perspective on risk and
investment?
Core Issues
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Capital versus Growth Equity
Super Angels.
Super angels, who typically are successful technology entrepreneurs or former tech
executives, have begun adding to their own investments by raising funds from
outside investors. Unlike traditional angels, they also take a hands-on role in
helping their start-ups. Like most angels, however, they still deal in relatively small
sums of money, often investing $25,000 to $250,000 in a start-up. WSJ , 2010.
Besides First Round, these "super angels," as they're called in the industry, include
Baseline Ventures, Maples Investments, and FelicisVentures. They're pushing
ahead and financing startups even as big-name venture firms cut back and conserve
capital until the economy improves. First Round Capital has quietly become the
country's most active seed-stage investor, outpacing such marquee names as
Sequoia Capital and Kleiner Perkins Caufield& Byers. BusinessWeek 2009.
Growth Equity.
Growth equity investors focus on rapidly growing companies with proven business
models. Unlike venture capital firms, they generally avoid investing in early-stage
companies with unproven ideas. Growth equity investors also differ from buyout
specialists in that they seek to earn returns from growing the business, rather than
through financial engineering, restructuring or cutting costs. Summit Partners,
2010.
Unlike late-stage VC, growth equity investments are traditionally done in
companies that havent taken prior institutional investment and dont require future
institutional investment. Volition Capital, 2010.
Professor David Wessels
The Wharton School of the University of Pennsylvania
PrivateEquity VetureCapital
SuperAngels
Seed
VentureCapital
EarlyStage
GrowthEquity
LateStage
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Capital under Management
Venture Capital steadily grew during the 1980s and 1990s, exploding in the late 1990s.
Opinion differs among long term observers as to whether the industry has reached an
optimal size or is still too large for the amount of investment and exit opportunities.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: National Venture Capital Association, U.S. Federal Flow of Funds
0
75
150
225
300
375
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
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2
1
9
9
4
1
9
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6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
$

b
i
l
l
i
o
n
s
TotalCapitalUnderManagement
0%
1%
2%
3%
4%
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
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2
1
9
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4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
VentureCapitalasa%ofNonFinancialU.S.Equities
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Capital: Capital Commitments
Venture capital fundraisingpeaked during the internet boom (of 2000) at $105 billion.
The number dramatically fell, only to rise steadily again between 2002 and 2006. In
2011, roughly $18 billion was committed to new venture funds.
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
10,000
20,000
30,000
40,000
50,000
60,000
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
VentureCapitalCommitments
1980 2011
0%
25%
50%
75%
100%
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
VentureCapitalas%ofPrivateEquity
DollarsCommitted
Buyouts
Venture
Capital
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Capital: Typical Fund Size
Venture capital funds are smaller than buyout funds, averaging $80 million in 2010
(versus $280 million for buyouts). Still, some VC funds are quite large. Insight
Venture Partners (IV) raised $1.25 billion in 2007.
Professor David Wessels
The Wharton School of the University of Pennsylvania
How much capital managed by partner?
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Funds Under Management per Partner
During the 1990s, the
average funds under
management per partner
grew from $5 to $10 million.
Today, the average funds
under management is
approximately $25 million.
At a 2% fee level, how much
does each partner generate in
management fees?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
5
10
15
20
25
30
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
$

m
i
l
l
i
o
n
s
AverageFundsUnderManagement
perPartner($million),1980 2011
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Sources of LP Capital by Type
Public, private, and union-
based pension funds
comprise nearly half the
funding for venture capital.
What are the positive trends
leading to greater availability
of venture capital?
What are the negative trends
leading to less potential
capital?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Venture Economics, Tuck Private Equity Center
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Characteristics of LP Capital
The percentage allocated to private equity is correlated to assets under
management (AUM). The same holds true for VC, but the results are not
statistically significant.
Professor David Wessels
The Wharton School of the University of Pennsylvania
0%
1%
2%
3%
4%
5%
0 500 1,000 1,500 2,000 2,500 3,000
AssetsunderManagement (AUM)in $millions
PercentAllocatedtoPrivateEquity
byLPSize
Publicemployeeplans
Unionplans
VentureCapitalOnly
RegressonofPercentAllocatedto Pri vate Equi ty by LP Si ze
PrivateEquity VentureCapitalOnly
Constant 8.21 Constant 1.55
Logsize 1.24 * Logsize 0.26
Corporate 2.36 * Corporate 0.46
Public 1.25 Public 0.24
*Basetypeisunion
Source:"TheDeterminantsofInvestmentinPrivateEquityand
VentureCapital:EvidencefromAmericanandCanadian
PensionFunds"byGillesChemla,UBC
USpensionfundassetallocationdatafromPensionsandInvestments
magazine.The1,000pensionfundsinthedatahavetotalassetsof
US$3,611billionindefinedbenefitplans.
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Professor David Wessels
The Wharton School of the University of Pennsylvania
Capital Calls from LPs to Fund
Capital calls (also know as
drawdowns or takedowns) occur
frequently during the funds
early years.
Traditionally, capital
contributions were made in
three equal installments.
Today, capital contributions are
timed with investment needs.
During significant downturns,
many funds either return or
release capital.
Source: Anonymous VC Annual Report
(100)
(80)
(60)
(40)
(20)
0
20
40
60
80
100
1 0 1 2 3 4 5 6
$

m
i
l
l
i
o
n
s
Yearssince "Official Closing"
CapitalDrawdowns
$400millionFund
Significantmarketdownturn
causingfundtotemporarily
returncapital
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Failing to Meet the Capital Call
Capital calls generally must be fulfilled within 10 days.
If necessary, LPs can borrow short-term:
According to Larry Allen, the managing member of NYPPEX (a specialist in
secondaries), one investment bank made advances of $1.5 billion for
delinquent capital calls through its funds-of-funds programs between 2000
and 2002. The total extent of capital-call delinquencies was around $7 billion
to $10 billion, Allen estimated.
The penalty for refusing so-called capital calls can include forfeiting half
(to all) of the money already invested, according to Bon French, CEO of
Chicago-based Adams Street Partners LLC.
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
WaMuDefaults on Capital Call
Bankrupt holding company Washington Mutual Inc. (WMI) is looking to sell its interests in 10 venture capital funds after being
penalized for not meeting a $700,000 capital call from one of the funds. Washington Mutual Inc.s subsidiary, WMI Investment, has
committed $36.5 million to 10 funds, and has to date contributed $27.8 million, according to court documents.
The funds are ARCH Venture Fund V; ArrowpatheCommerceFund II; Digital Partners III; Financial Technology Ventures; Financial
Technology Ventures II; Financial Technology Ventures III; MadronaVenture Fund I-A; MadronaVenture Fund III; MaveronEquity
Partners 2000 and Northwest Venture Partners III.
WMI is in default on its fund commitment to Financial Technology Ventures III, which issued a $700,000 capital call on 1
October 2008. The fund is run by San Francisco-based FTVentures, a growth capital firm that invests in business services and software
companies. The firm recently committed $30 million to Mu Sigma, a provider of analytical decision support services. WMI committed
$10 million to the fund in March 2007, and has so far contributed $3.3 million. WMI has not fulfilled the capital request from
FTVentures and is being penalized with an 18 percent default interest accrual on the amount of the capital call, according to
court documents. In the event of continuing failure to meet the capital request, WMI will forfeit 25 percent and 50 percent of
contributed capital on 6 December 2008, and 6 February 2009, respectively.
WMI has notified Financial Technology Ventures that the accrual of default interest on the capital request is a violation of bankruptcy
law and should not be applied. ARCH Venture Fund also issued a $30,000 capital call on 29 September, but has yet to inform WMI
that it is in default, the company said. WMI committed $3 million to the fund in 2000 and has contributed about $2.9 million.
While [WMI] believes that the imposition of default interest. . . is a violation of [bankruptcy law], out of an abundance of caution and
to avoid any disputes, [WMI] is requesting approval of the sales procedure, the company said. J udge Mary Walrath, of the bankruptcy
court in Wilmington, Delaware, must approve the auction process of the fund interests. A hearing is set for 16 December. Private
Equity OnLine, Christopher Witkowsky, 2008.
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Direct Investment
Venture capital investments typically are:
Young. The company has a proven concept
but lacks the infrastructure and professional
management to grow successfully.
High Growth. Venture capital is used to
fund internal growth, primarily intangible
investments such as development (not
research) and marketing. Rarely is venture
capital used to provide liquidity.
Big Potential. Given the high failure rate of
start-ups, venture capital funds generate a
good portion of their returns from the
home-run
Privately Held. Highly illiquid and
difficult to value, venture capital is not for
the faint of heart!
Professor David Wessels
The Wharton School of the University of Pennsylvania
Institutional
Investor
Venture
Fund
Portfolio
Company
Public
Markets
Capital
Call
Direct
Investment
Exit
Distribution
Monitor & Advise
How many investments per year?
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Number of Investments & Investment Size
In 2010, approximately 3,300 companies received an average of $6.7
million in venture financing.
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
1,000
2,000
3,000
4,000
5,000
6,000
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
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8
1
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9
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1
9
9
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1
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4
1
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6
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2
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0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
CompaniesReceivingFinancing
1990 2011
0
3
6
9
12
15
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
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1
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4
1
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2
0
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0
2
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2
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4
2
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8
2
0
1
0
$

m
i
l
l
i
o
n
s
AverageInvestmentSize
1990 2011
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
High-Profile Investments (KPCB)
Professor David Wessels
The Wharton School of the University of Pennsylvania
Led by high-profile investors J ohn
Doerr and Brook Byers, Kleiner
Perkins Caufield & Byers funds
promising companies, helps them
grow, and then actively grooms them
for purchase or public offering. Since
its inception in 1972, KPCB has
invested more than $3 billion in more
than 475 companies.
The firm focuses its investments in
four main areas: information
technology, life sciences, pandemic
and bio-defense, and green
technology. The company current
holds approximately 100 portfolio
companies.
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Typical Investments (KPCB)
Professor David Wessels
The Wharton School of the University of Pennsylvania
Information Technology
Zettacore: develops new memory
capabilities by using unique
molecules in electronics
Life Sciences
Invuity: develops technologies to
improve visualization in surgeries
Pandemic and Bio-defense
Hx Diagnostics: diagnostics
company, focusing on seasonal
and emerging infectious diseases
Greentech
Altra: develops renewable energy,
focusing on ethanol
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Stages of Venture Capital
Professor David Wessels
The Wharton School of the University of Pennsylvania
Stage
%of
Capital
(2011)
%of
Deals
(2011)
Definition
Seed/Startup Stage 3% 11%
The company has a concept or product under development, but is
probably not fully operational. Usually, the company has been in
existence for less than 18 months.
Early Stage 29% 39%
The companys product or service is in testing or pilot production. In
some cases, the product may be commercially available. The company
may or may not be generating revenues. Usually, the company has been in
business for less than three years.
Expansion Stage 34% 27%
The companys product or service is in production and commercially
available. The company demonstrates significant revenue growth, but
may or may not be showing a profit. Usually, the company has been in
business for more than three years.
Later Stage 33% 23%
The companys product or service is widely available. The company is
generating ongoing revenue and is probably cash-flow positive. It is
more likely to be profitable, but not necessarily.
Source: NVCA (2011) and MacMillan, Roberts, Livada, Wang (2008)
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Investments by Stage
Prior to 1995, nearly 40% of
all VC investment dollars
went into seed or early stage
companies.
By 2002, the percent of
investment dollars going into
seed or early stage companies
fell below 25%.
VCs have been moving into
later stage deals, where more
capital per deal can be
invested.
Professor David Wessels
The Wharton School of the University of Pennsylvania
What percent do you get for Series A?
0%
25%
50%
75%
100%
1
9
8
0
1
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8
2
1
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4
1
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6
1
9
8
8
1
9
9
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1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
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0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
DollarInvestmentsbyStage
1980to2011
Later
Expansion
Early
Seed
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Industry Data on Ownership and Capital, Q4 2011
We do not invest strictly based on discounted cash flow or a terminal value.
Our primary goal is to invest in companies that will become a lasting and
strong presence in very large markets. High Profile VC.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Wilson Sonsini Entrepreneurs Report, 2012. WSGR Database.
Implied
Valuation
20.0%
18.9%
10.2%
SeriesA
SeriesB
SeriesCandlater
PercentOwnership
PostMoneyOwnership
2.3
3.5
8.5
SeriesA
SeriesB
SeriesCandlater
$millions
MedianAmountofCapitalRaised
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Investments by Industry
Venture capital is highly
concentrated in hot
industries.
Today, approximately
60% of venture capital is
invested in four industries:
Biotechnology
Software
Medical devices
Industrial / Energy
Professor David Wessels
The Wharton School of the University of Pennsylvania
What percent of startups are from CA?
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Investments by (US) State in 2011
Professor David Wessels
The Wharton School of the University of Pennsylvania
Google Maps
Source: NVCA (2012)
More on ecosystems:
http://techcrunch.com/2012/04/10/startup-genome-compares-top-startup-hubs/
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Exits
Depending on the investment focus
and strategy of the venture firm, it
will seek to exit the investment in the
portfolio company within three to
seven years of the initial investment.
While the IPO may be the most
glamorous type of exit for the
venture capitalist, most successful
exits of venture investments occur
through a merger or acquisition of
the company by either the original
founders or another company.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Institutional
Investor
Venture
Fund
Portfolio
Company
Public
Markets
Capital
Call
Direct
Investment
Exit
Distribution
Monitor & Advise
23
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Exits
The number of liquidity events rebounded from 280 in 2009 to 500 in 2011.
The average age has risen from a low of 4 years to nearly 9 years, as buyers (in
the public and strategic buyer markets) become wary of uncertainty.
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
200
400
600
800
1
9
8
0
1
9
8
2
1
9
8
4
1
9
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6
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8
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0
1
0
LiquidityEvents(M&A&IPO)
0
3
6
9
12
1
9
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0
1
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1
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Y
e
a
r
s
MedianAgeofCompanypriortoIPO
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Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Valuation Multiples
Two-thirds of first-round
investments fail to return
original capital, and nearly half
are total write-offs.
Slightly under 30% of
companies return between 1x
and 10x the initial investment.
Only 5% percent of companies
return more than ten times
(commonly known as the home
run)
Professor David Wessels
The Wharton School of the University of Pennsylvania
0%
20%
40%
60%
80%
100%
0
0

t
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o

1
0
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>
1
0
0
GrossValueMultiples
AllFirstRoundInvestments
LessThan100%ofOriginalCapitalReturned
25
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Valuation Multiples: IPO versus M&A
The gross value multiple for
IPOs is higher than for M&A.
For IPOs, few companies go
public at a gross value
multiple (GVM) less than 1x.
For M&A, the distribution of
gross value multiples is quite
wide, with nearly 40% of
gross value multiples at less
than 1x.
Professor David Wessels
The Wharton School of the University of Pennsylvania
What percentage of exits are IPOs?
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
<0.25 0.25
to0.5
0.5to
1
1to
1.5
1.5to
2
2to3 3to5 5to
10
10to
20
20to
50
50to
100
>100
GrossValueMultiplesfor
IPOsandAcquisitions
IPOs
Acquisitions
26
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Venture Exits: M&A and IPO
There has been a gradual shift from IPO exits to M&A exits for venture
investments. According to the NVCA, this is a capital markets crisis for the
start-up community.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Thomson Reuters & NVCA
0%
25%
50%
75%
100%
1980 1985 1990 1995 2000 2005 2010
VCBackedExitbyType
1980 2010
M&AExits
IPOs
27
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Why the Crisis?
According to Dixon Doll,
NVCA Chair,
While we clearly recognize
that the IPO drought is being
driven largely by a weak
economy, there are other
systemic factors that are
making the IPO exit less
attractive for high quality
venture-backed companies.
Professor David Wessels
The Wharton School of the University of Pennsylvania
NVCA Survey, J uly 2008
12%
14%
15%
18%
57%
64%
77%
Lackofcompany interest
Reductionininvestment banks
PoorIPOcandidates
Lackofanalyst coverage
SarbanesOxley
CreditCrunch
Skittishinvestors
FactorsCausingIPODrought
NVCASurvey,660Responses
28
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
An Alternative Exit: Secondary Directs?
Industry Ventures Closes $265 Million Fund V
Oversubscribed Secondary Fund Focused on Venture Capital Increases Fund Size
SAN FRANCISCO, CA -- (MARKET WIRE) -- Mar 23, 2009 -- Industry Ventures, L.L.C., a leading secondary firm focused on acquiring venture portfolios,
limited partnership interests and other private equity investments, today announced the close of its oversubscribed fifth fund, Industry Ventures Fund V, L.P. with
$265 million in committed capital from over twenty institutional investors. Originally targeting $200 million, the firm was granted approval by its limited partners to
increase its fund size due to investor demand and overall market growth. Industry Ventures will actively deploy the new capital in the secondary market consistent
with its previous strategy focused on acquiring positions in high quality venture backed companies through positions in venture capital funds and secondary direct
transactions.
"The strength of the secondary market is one of the few bright spots in these challenging economic times," said Hans Swildens, principal and founder of Industry
Ventures. "As markets dried up in 2008 and the global financial crisis spread, we began to see a proliferation of diverse sellers in the market as the need for early
liquidity increased. This increased deal flow coupled with the secondary market's unique ability to steadily deploy capital resulted in significant investor demand and
an oversubscribed fund that was larger than originally intended."
In 2008, Industry Ventures completed over 40 acquisitions -- which included secondary direct investments in private companies and limited partner interests --
compared to 27 acquisitions the previous year. Some of the transactions involved the nation's high-profile venture-capital funds, as well as successful growth stage
private companies, said Swildens. "Since last quarter, we have seen the volume of secondary deals grow more than 25% and we estimate there is more than $5
billion for sale in the secondary venture capital market. This vibrant market is providing an important liquidity option for entrepreneurs, sellers of venture funds and
financial institutions and is contributing to the stabilization of the venture capital and financial markets," concluded Swildens.
Industry Ventures is planning to invest its Fund V over a period of two to three years through new acquisitions of direct investments and limited partnership interests
typically ranging in size from $1 million to $25 million each. The firm also has a co-investment capability in Fund V that enables the firm to acquire larger special
situation transactions with its limited partners larger than $25 million in size.
Professor David Wessels
The Wharton School of the University of Pennsylvania
29
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Cash is King: Distributions
The final segment of the venture capital
cycle is returning capital to the limited
partners.
Most venture capital firms have 20%
carry, which means they first return
committed capital, but then keep 20% of
all distributions above committed
capital.
Distributions primarily come in two
forms:
Cash
Distribution In Kind: To avoid capital
gains taxes, venture capital firms will
return IPO shares to limited partners.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Institutional
Investor
Venture
Fund
Portfolio
Company
Public
Markets
Capital
Call
Direct
Investment
Exit
Distribution
Monitor & Advise
30
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Distributions versus Investments
Although distributions occur years after capital is raised, the aggregate amount
moves in tandem, as investors tend to chase returns.
Why compare total investments versus distribution (on a gross basis) and not
committed capital?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
20
40
60
80
100
120
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
$

b
i
l
l
i
o
n
s
InvestmentsandDistributionsbyYear
19952011
Invested
Distributions
0
100
200
300
400
500
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
$

b
i
l
l
i
o
n
s
CumulativeInvestmentsandDIstributions
19802011
Invested
Distributions
5YearLagged
Distributions
31
Venture Capital & the Finance of Innovation Lecture 1 - The Venture Capital Cycle
Typical Carry Distribution Waterfall
1. Limited partner receives capital commitment (or alternatively
invested capital), known as the return of capital.
2. Limited partner receives compounded hurdle rate (typically 8%),
known as the preferred return.
3. General partner receives catch-up. Catch-up goes x% to general
partner and (1-x%) to limited partner until general partner has
received 20% of the profits. Note: Catch-up eliminates the hurdle
return.
4. Both partners receive traditional 80/20 split, once GP is caught up
Professor David Wessels
The Wharton School of the University of Pennsylvania
32
32
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Private Equity Funds: Organizational Structure
General Partners, Limited Partners, and the Fund
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
2
33
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Organizational Structure & Compensation
1. Outline the organizational structure of a venture capital fund who
runs the fund (general partners) and who are the investors (limited
partners)?
Various stakeholders desire different ownership structures
2. What are the critical components in a contract written between limited
and general partners?
An in-depth discussion of compensation (fees, carry, and partial
ownership). What actions do they incentivize?
How is compensation split among key principals and what happens if key
principals leave the fund before its conclusion?
Professor David Wessels
The Wharton School of the University of Pennsylvania
34
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Organizational Structure
Most venture capital funds are actually limited liability partnerships,
consisting of both general and limited partners. Limited partners contribute
capital, general partners contribute capital, effort, and knowhow.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Portfolio
Company
Limited
Partners
Fund LP
Management
Company
General
Partners
Tom
Robertson
Patrick
Harker
Thomas
Gerrity
capital
effort and
knowhow
fees
Accel Internet
Fund IV, L.P.
Accel Partners LLC
35
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
General Partnership Agreements
Partnership
Granted
Screening,
Investment,
and
Monitoring
The
Disagreement
The Initial
Public
Offering
The Lawsuit
Professor David Wessels
The Wharton School of the University of Pennsylvania
An example of a smooth transition: VinodKhoslaleft Kleiner Perkins gradually, taking on a smaller role
in early 2004, but not officially launching his new firm until March 2006. He declined to be a GP on new
funds KPCG was launching, but remained a GP on older funds to avoid triggering key man provisions.
36
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Organizational Structure
Most venture capital funds are actually limited liability partnerships,
consisting of both general and limited partners. Limited partners contribute
capital, general partners contribute capital, effort, and knowhow.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Portfolio
Company
Limited
Partners
Fund LP
Management
Company
General
Partners
Tom
Robertson
Patrick
Harker
Thomas
Gerrity
capital
effort and
knowhow
fees
Accel Internet
Fund IV, L.P.
Accel Partners LLC
37
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
An Example: Accel Partners (Palo Alto)
Professor David Wessels
The Wharton School of the University of Pennsylvania
Accel has raised ten separate primary funds and another eight specialized
funds. The specialized funds have been focused on international investments,
telecommunications, and the internet.
The Firm The Fund
Year Fund Name Amount Year Fund Name Amount
1983 Accel Capital L.P. 64 1984 Accel Capital L.P. (Intl) 28
1989 Accel III, L.P. 100 1985 Accel Telecom L.P. 40
1993 Accel IV L.P. 136
1996 Accel V L.P. 150 1996 Accel Internet Fund 20
1998 Accel VI L.P. 275 1998 Accel Internet Fund II L.P. 35
1999 Accel VII L.P. 480 1999 Accel Internet Fund III L.P. 120
2000 Accel VIII L.P. 815 2000 Accel Internet Fund IV 275
2004 Accel IXL.P. 400
2007 Accel X, L.P. 520 2001 Accel Europe, L.P. 509
2011 Accel XI, L.P. 475 2005 Accel London II, L.P. 450
2008 Accel London III, L.P. 525
2008 Accel Growth Fund 480
2011 Accel Growth Fund II 875
2011 Accel India III 155
2011 Accel Big Data Fund (Set Aside)
Total ($ mi l l i ons) 3,415 Total ($ mi l l i ons) 3,513
Speci al i zed Tradi ti onal
Note: Does not include IDG-Accel joint venture funds.
38
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
The Bulge Bracket
Professor David Wessels
The Wharton School of the University of Pennsylvania
With hundreds of VC firms, there is no traditional bulge bracket. The top
firms however account for the majority of capital raised (for instance, 80% of
capital in 2Q 2012 was raised by just five funds).
VentureCapitalFundRaising VentureCapitalFundRaising
UnitedStates,2011Q22012 RestofWorld(i.e.China!)
Rank Fund Firm $mil Rank Fund Firm $mil
1 New Enterprise Associates 14, L.P. New Enterprise Associates 14 2,075.9 1 RRJ Capital Asia Fund II RRJ Capital Fund 3,000.0
2 Bessemer Venture Partners VIII Bessemer Venture Partners 1,600.0 2 Tencent Collaboration Fund Tencent Collaboration Fund 1,531.2
3 Andreessen Horowitz Fund III, L.P. Andreessen Horowitz 1,500.0 3 Zhongxinjian China Merchants Equity
Investment Fund
China Merchants Kunlun Equity Invest
Management Co., Ltd.
1,156.0
4 Sequoia Capital 2010, L.P. Sequoia Capital 1,343.0 4 Shanghai Ruili Emerging Industry
Investment Fund
Shanghai Ruili Investment Fund
Management Co., Ltd.
1,095.6
5 J .P. Morgan Digital Growth Fund, L.P. J .P. Morgan Chase & Co. 1,217.5 5 China Culture Industry Capital Fund China Culture Industry Capital Fund
Management Co., Ltd.
927.8
6 Khosla Ventures IV, L.P. Khosla Ventures 1,050.0 6 Northstar Equity Partners III PT Northstar Pacific Capital 825.0
7 Institutional Venture Partners XIV, L.P. Institutional Venture Partners 1,000.0 7 Guangdong Guangdian Fund Guangdong Zhongguang Investment
Management Co., Ltd.
786.5
8 KPCB Digital Growth Fund LLC Kleiner Perkins Caufield & Byers 932.3 8 YR Delta Fund Y.R. Delta Fund Management Co.,
Ltd.
776.2
9 Accel Growth Fund II, L.P. Accel Partners 875.0 9 Guangdong Small & Medium
Enterprise Equity Investment Fund
Bank of China Finance Equity
Investment Fund Management
762.1
10 Lightspeed Venture Partners IX, L.P. Lightspeed Venture Partners 675.0 10 Shanghai Shipping Industry Fund Shanghai Shipping Industry Funds
Management Co., Ltd.
759.7
39
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Professor David Wessels
The Wharton School of the University of Pennsylvania
Organizational Structure: The Limited Partner
Most venture capital funds are actually limited liability partnerships, consisting
of both general and limited partners. Limited partners contribute only capital.
How do Limited Partners Differ
from General Partners?
Limited partners can not have a
management role. Their liability is
limited to initial investment.
Why 1% of capital? Before
the IRS began allowing a
check-the-box declaration
of partnership in 1996, a 1%
capital interest was required to
avoid corporate taxation.
Portfolio
Company
Limited
Partners
Fund LP
Management
Company
General
Partners
capital
effort and
knowhow
fees
Accel Internet
Fund IV, L.P.
Accel Partners LLC
40
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Examples of LP Capital: Public Pensions
Public pension funds are a major contributor to venture capital, and as the data
shows below, can be quite aggressive in the allocations.
Professor David Wessels
The Wharton School of the University of Pennsylvania
LimitedPartners
Assetsunder
management($
millions)
Target
allocationto
PE(in%)
LastYear's
Commitments
($millions)
OregonStateTreasury 64,000 16 3,200
PennsylvaniaStateEmployeesRetirementSystem 36,400 14 1,480
CityofPhiladelphiaBoardofPensions&Retirement 5,250 12 173
SanFranciscoEmployeesRetirementSystem 16,700 12 575
PennsylvaniaPublicSchoolEmployeesRetirementSystem 67,500 11 5,000
MassachusettsPensionReservesInvestmentManagementBoard 54,000 10 1,541
NewMexicoEducationalRetirementBoard 9,400 10 260
IndianaPublicEmployeesRetirementFund 17,600 8 670
NationalPensionReservesFund(Ireland) 31,000 8 500
TeachersRetirementSystemoftheStateofIllinois 42,000 8 1,400
LosAngelesCountyEmployeesRetirementAssociation 42,000 7 635
LosAngelesCityEmployeesRetirementSystem 11,480 5 1,000
YMCARetirementFund 5,400 5 90
StateRetirement&PensionSystemofMaryland 40,000 2 428
Sample of funds recently announcing calls for investment proposals
41
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
New Limited Partners in Private Equity
New Mexico Educational Retirement Board
$9.4 billion AUM
New Mexico Education Retirement Board is ramping up its appetite for private equity rapidly. The
system originally approved a 5% target allocation in 2006, and has already doubled that to 10%,
freeing up some $400 million to commit during the calendar year.
The pension, with adviser Aldus Equity Partners, devised a plan that calls for it to allocate 62% of
its PE bucket to buyouts, 18% to special situations, and 10% each to venture capital and
mezzanine.
So far, New Mexico Educational Retirement Board has shown a willingness to champion newer
firms, particularly spin offs, including Lion Capital, HM Capital, Newstone Capital Partners,
Goode Partners, GF Capital and Industrial Opportunity Partners.
Professor David Wessels
The Wharton School of the University of Pennsylvania
More information about : New Mexico Education Retirement Board
More information about: Aldus Equity Partners
Does due diligence matter? Yes.
42
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Raising LP Capital: The Fundraising Process
1. Preparing offering materials (the investment memorandum)
Strategy & scope of fund; if necessary, the economics of the space
Partner experience in VC and more broadly, investment (not advisory)
Historical performance of previous funds
High profile exits (grandstanding)
High profile LPs (herding)
2. Identifying and meeting with appropriate and compatible investors and their
professional advisors
3. Responding to LP due diligence requests (background of partners)
4. Negotiating the partnership agreement (terms of the LP commitment).
Professor David Wessels
The Wharton School of the University of Pennsylvania
43
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Limited Partner Concerns
Limited partners are highly focused
on incentives and somewhat price
sensitive.
Do the general partners have sufficient
capital at stake?
Do they split carried interest in an
equitable way, or does one partner
dominate?
The level of management fees is more
important to LPs than the level of
carry.
Be prepared to discuss these issues
beforemeeting with limited partners!
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Private Equity Investors Survey, : Probitas Partners
52%
42%
42%
39%
35%
24%
23%
18%
9%
LevelOfGeneralPartnerFinancial
Commitment totheFund
DistributionOfCarriedInterestBetween
theSeniorInvestment Professionals
StructureorInclusion ofaKeyMan
Provision
TheOverallLevelOfManagement Fees
Maximum FundSize
LevelofCarriedInterest
TransactionFeeSplits
CarryDistribution Waterfalls
StructureorInclusion ofaNo Fault
DivorceClause
PercentofLimitedPartnersConcernedAbout:
44
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Hot Topic: The Key Professionals
Staff Exits Roil Liquid Realty
Three senior executives have resigned from Liquid Realty, throwing a wrench into plans for the shops next fund. Chief
investment officer Jeffrey Giller, the No. 2 executive to Liquid founder Scott Landress, will leave by year end. Two other
top managers left Sept. 30: J oshua Cleveland, who led efforts to find investments, and due-diligence head Brendan MacDonald.
The departures left some limited partners upset with Liquid, whose funds buy interests in real estate vehicles on the
secondary market. In a contentious conference call in August, investors in the San Francisco firms most recent fund
said they felt betrayed that the departures were coming so early in the life of that 2007-vintage entity, Liquid Realty
Partners 4.
The official line is that Giller, Cleveland and MacDonald have no specific plans. However, some market players believe the
departing executives intend to start their own investment shop. In either case, the trio would almost certainly be subject tonon-
compete provisions for a time. As for Liquids next fund, the firm started informal talks with investors late last year with the
idea of setting out to raise $750 million to $1 billion once Fund 4 had deployed most of its $570 million of equity. But with
Fund 4s portfolio building up slower than expected, Liquid has yet to distribute marketing materials for the follow-up.
The departure of three senior executives will clearly complicate Liquids fund-raising plans, market players said, adding that a
generally tough environment for soliciting capital could force the shop to reduce its equity goal. Fund 4, meanwhile, is about
two-thirds deployed and is considering a large deal that would exhaust the uncommitted equity. But if Giller departs
before the position is added, it could trigger a key-man provision that would allow limited partners to block the
investment. One source said Giller offered to stay on until the fund is fully invested. But limited partners suggested it might be
better for him to leave soon.
Professor David Wessels
The Wharton School of the University of Pennsylvania
45
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Private Equity Funds: Organizational Structure
Why Structure Matters and Experienced Attorneys are Critical
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
46
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Organizational Structure: Fund LP
Why is the fund structured at a limited partnership and not a traditional
corporation? Answer: To avoid taxation at the fund level.
If the portfolio company earns profits, it will be taxed at the corporate income
tax rate. Why not structure the portfolio company as a LLC also?
Answer: To avoid unrelated business taxable income, commonly known as
UBTI. UBTI includes income which is not substantially related to the
organizations exempt purpose.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Portfolio
Company
Institutional
Investors
Fund LP
Limited Partnership C-Corp
47
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Why Structure Matters: Stakeholder Conflicts
To prevent UBTI, limited partners demand that the portfolio company be
structured as a C-Corp, with the fund purchasing shares.
A few years pass and the founder decides to sell to a strategic buyer. Assume
the original investment is $10 million and the company is worth $50 million.
Corporate income is taxed at 35%, dividends at 15% (39.6% post-2012), and
long-term capital gains at 15% (20% post-2012).
Two primary alternatives exist:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Stock Sale
Seller friendly, elimination of ALL
liabilities
Sale taxed at long-term capital gains
rate.
Asset Sale
Buyer friendly, only agreed
liabilities are transferred.
Gains and losses are recognized as
corporate income, and then
liquidating dividend paid.
48
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Tax Implications (post 2012)
Assume the capital is $10 million and the company is worth $50
million. Corporate income is taxed at 35%, dividends at 15% (39.6%
post-2012), and long-term capital gains at 15% (20% post-2012).
Professor David Wessels
The Wharton School of the University of Pennsylvania
Asset Sale of C-Corp Asset Sale of LLC
Company
Founder
Limited Partner
49
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
Why Entrepreneurs Need Experienced Attorneys!
Consider the ownership structure proposed by Professor Borghese:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Blocker
Corp
Institutional
Investors
Fund LP
Limited Partnership C-Corp
Entrepreneur
Portfolio
Company
Limited
Liability
Company
If portfolio company earns
profit, then distribution will
need to be paid to Blocker
Corp to cover tax burden.
50
Venture Capital & the Finance of Innovation Lecture 2 - Organizational Structure and the Limited Partner
The Knock on LLCs
In most transactions, the entrepreneur does not think through the impact of
organizational structure, but if they do
Professional investors will rarely accept a blocker C structure for the following
reasons:
Administrative costs: Pass through organizations are more difficult to administer.
The Blocker-C must be administered (and funded) by the professional investor, not
the entrepreneur. Any income generated in the LLC creates an unfunded tax burden
for the LLC.
Employee Options. Employees (or others) who receive options are treated similar to
members, and are given information rights that employees typically dont have.
Cultural inertia: Nonstandard terms are always met with skepticism. One lawyer
writes, Every LLC I have worked on for high growth company has had some kind of
problem.
Professor David Wessels
The Wharton School of the University of Pennsylvania
51
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Partnership Agreements & GP Compensation
The Economics of Contracting
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
3
52
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Typical Partnership Agreement
1. Fund Size: $100 million
2. Term of Agreement: Following the tenth anniversary of the initial closing, the term of the partnership will expire on
December 31 unless extended for up to two consecutive one year periods at the discretion of the general partner. This
is to permit orderly dissolution, and no management fees will be charged during any such extension.
3. Commitment Period: Following the fifth anniversary of the initial closing, all partners will be released from any
further obligationwith respect to their unfunded commitments on December 31, except to the extent necessary to
cover expenses and obligations of the partnership (including management fees) in an aggregate amount not to exceed
unfunded commitments.
4. Management Fees: The annual contributions will equal 2.0 percent of committed capital for the first ten years of the
fund. These contributions will be paid quarterly.
5. Distributions: distributions in respect of any partnership investment will be made in the following order of priority:
100% to the Limited partners until they have received an amount equal to their invested capital.
80% to the Limited partners and 20% to the general partners.
6. Diversification and Investment Limits: The Fund may not invest more than 25% of aggregate commitments in any
single portfolio company.
7. No Fault Divorce Clause: By vote, limited partners are permitted to remove the general partner of a fund and either
terminate the Partnership or appoint a new general partner.
Professor David Wessels
The Wharton School of the University of Pennsylvania
53
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
General Partner Compensation
The fund compensates the
general partners through fees
and carry. The typical
compensation rule for venture
capital is 2/20, meaning 2% fees
and 20% carry.
But 2% and 20% of what?
The LP contract will state the
basis, such as committed
capital, contributed capital, etc.
Lets discuss each in detail.
Professor David Wessels
The Wharton School of the University of Pennsylvania
54
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Cost Basis & Portfolio Value
When fees and carry are
computed on net
invested capital, they are
computed on the cost
basis, not the net cash
flow invested.
For instance, what is the
funds cost basis each
year, for fund that makes
four investments?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Portfol i o Compani es Year 1 Year 2 Year 3 Year 4
Company A -10 20
Company B -15 15
Company C -25 35
Company D -20 40
Fund Fi nanci al s: Year 1 Year 2 Year 3 Year 4
Capital call -10 -40 -20 0
Distribution 0 20 15 75 IRR
Net cash flow -10 -20 -5 75 41%
Cost Basis:
55
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Management Fee Negotiation
Split up into pairs. One person should act as the LP. Another should
act as the general partner. Both have equal power and would like to
work together.
You must design a fee contract that uses either committed capital, net
invested capital, or a combination of both.
How would you argue your position? Do NOT argue the other
persons position! Imagine you are working on behalf of your
organization.
Professor David Wessels
The Wharton School of the University of Pennsylvania
56
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Potential Fee Schedules
1. Level fee structure - e.g. 2% of committed capital. Assuming a 10 year
fund, only 80% of capital is investable. The remaining capital is pledged
towards fees.
2. Declining percentage e.g. 2% of committed capital for the first five years
(the investment period), declining by 25 basis points per year.
3. Declining capital - The third type of fee schedule uses a constant rate, but
changes the basis for this rate from committed capital (first five years) to net
invested capital (last five years). Net invested capital equals gross
investment less cost basis of exited investments.
4. Declining fee and committed capital.
Professor David Wessels
The Wharton School of the University of Pennsylvania
57
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
43%
55%
16%
84%
45%
39%
%offundschanging fee
basisafterinvestment
period
%offundschanging fee
levelafterinvestment
period
%offundschanging both
basisandlevel
HowFeesChange
afterInvestmentPeriod
Venture
Capital
Buyouts
Typical Fee Structures
Professor David Wessels
The Wharton School of the University of Pennsylvania
The typical VC firm charges 2% of committed capital and 70% lower the fee
basis from committed capital to net invested capital after the investment period.
Does lowering the fee basis make sense?
Key insight:
Why the
difference?
10%
51%
47%
41%
43%
8%
Venturecapital Buyouts
InitialFeeLevelbyFundType
>2%
=2%
<2%
58
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Hot Topic: Fees on UninvestedCapital
TPG Plans to Return $20 Million in Fund Fees
The war on private-equity fees is heating up. TPG, one of the world's largest private-equity firms, told investors at its
annual conference this week that it would refund $20 million in fees paid this year on its $18.8 billion flagship
investment fund. The gesture is TPG's second concession this year, as it tries to shore up its relationships with investors who
have committed billions of dollars with the private-equity firm but have seen little in the way of new deals or positive
investment returns.
The move could ratchet up pressure on other buyout shops to reduce their fees or the size of their funds. Last week Sun
Capital Partners reduced its $6 billion fund by $1 billion, an acknowledgement that there is too much money chasing too few
deals. It also comes at a time moment when investors in private-equity funds have begun agitating for lower fees on their own.
At the market peak, large private-equity firms raised billions of dollars in anticipation of striking dozens of new deals. But as
the credit markets closed, they found themselves with immense cash hordes and no way of spending them. At the same time,
the buyout funds have also been collecting annual management fees, typically 1% to 2% of the assets raised. Originally
designed to cover firm overhead, the fees now represent significant sources of revenue on their own some $150
million for 1% of a $15 billion fund.
Last December TPG became the first U.S. buyout fund to cut the size of its fund, ultimately reducing it by $1 billion to
$18.8 billion. Still, as the firm's deal activity remained limited throughout this year -- roughly 85% of the fund remains
uninvested -- some of the firm's large clients, including the Government of Singapore Investment Corp. and California State
Teachers Retirement System, urged the firm to consider other moves, according to people familiar with the discussions.
Professor David Wessels
The Wharton School of the University of Pennsylvania
59
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Carried Interest
Carried interest or carry is a share of the profits of a successful
partnership that is paid to the manager of a private equity fund or
hedge fund as a form of compensation that is designed as an incentive
to the manager to maximize performance of the investment fund.
In order to receive (keep) carried interest, the manager must first
(eventually) return all capital contributedby the investors and in
certain cases the fund must also return a previously agreed upon rate of
return (the hurdle rate) to investors
Professor David Wessels
The Wharton School of the University of Pennsylvania
60
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Distribution Structure: Carried Interest
Carry level - The carry level refers to the percentage of profits distributed to the general
partner (e.g. 20% of profits)
Carry basis - The carry basis refers to how initial investment (and subsequently profits)
is measured (e.g. commitment capital or investment capital).
Carry timing - Finally, carry timing, not surprisingly, refers to the set of rules that govern
the timing of carried interest distributions (e.g. does all committed capital need to be
returned before profits are declared or is it done on a per-deal basis).
Clawback provision dictates that excess distributions will be returned (i.e. if future deals go bad)
Carry hurdle - The carry hurdle refers to whether a GP must provide a preferred return
to LPs before collecting carried interest and, if so, the rules about this preset return.
Contracts that include hurdles typically come with catch-up provisions, described in two slides.
Professor David Wessels
The Wharton School of the University of Pennsylvania
61
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Distribution Structure: Carry Timing
Traditional contracts require that
committedcapital (and potentially
preferred return) must be distributed to
LPs before GPs are paid carry.
European carry allows for carried
interest to be paid once all contributed
capital (to date) is returned.
American carry allows for carried
interest to be paid once the contributed
capital for realized deals is returned.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Venture
Carry
European Carry
American
Carry
Conservative
(LP Friendly)
Aggressive
(GP Friendly)
62
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Carried Interest Timing
Imagine a GP collects carry on the first few
transactions, but then writes off the remaining
investments a few years later. In an extreme case,
the GP can generate carry even without generate
aggregate profits!
To prevent carry without profits, two additional
contracts terms are common:
Clawback. LPs have the right to demand a
return of carry if the fund does not earn a
profit. Clawbackscan lead to ugly
discussions between GP/LP.
Fair-value test. LPs can restrict carry to paid
only when cumulative unrealizedinvestments
exceed 120% of their cost basis.
Professor David Wessels
The Wharton School of the University of Pennsylvania
63
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Carry Hurdle: Payout Diagram
Suppose LPs invest $100 in a 10-
year fund. Assume payouts are
made in year 10 (unrealistic, but
assumed for simplicity).
If the fund pays 20% carried
interest to the GP, draw the payout
diagram for:
1. Straight carry (venture)
2. True preferred return of 8%, with no
catch-up
3. Compounded hurdle rate of 8% with
100% catch-up (buyouts)
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
10
20
30
40
50
60
70
0 100 200 300 400 500
C
a
r
r
y

(
$

m
i
l
l
i
o
n
s
)
Distributions($millions)
GeneralPartnerCarriedInterest
) 216 )( 1 ( ) 100 (
5
1
x x
64
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Typical Carry Distribution Waterfall
1. Limited partner receives capital commitment (or
alternatively invested capital), known as the return of capital.
2. Limited partner receives compounded hurdle rate (typically
8%), known as the preferred return.
3. General partner receives catch-up. Catch-up goes x% to
general partner and (1-x%) to limited partner until general
partner has received 20% of the profits. Note: Catch-up
eliminates the hurdle return.
4. Both partners receive traditional 80/20 split, once GP is
caught up
Professor David Wessels
The Wharton School of the University of Pennsylvania
[ ]
[ ]
[ ]
[ ]
65
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Do Hurdles Matter for VC?
VCs argue hurdles are irrelevant when 10x is the goal. Should LPs
fight for preferred returns?
Take the University of California Retirement System (UCRS), a
prominent institutional investor. More than one in ten venture funds
failed to return 8%, and nearly one in five would have received less
carry if a hurdle rate mechanism were used.
David Toll, Private Equity Partnership Terms And Conditions, Dow
J ones, (2008);
Professor David Wessels
The Wharton School of the University of Pennsylvania
66
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Carry Hurdle: An Example
Consider an $80 million fund with an 8% hurdle.
Contract states hurdle rate is paid on committed capital until cumulative distributions
exceed hurdle. Once the hurdle is exceeded, General Partner will receive 100% of all
distributions until 20% of profits are held by General Partner. Once General Partner
holds 20% of profits, all future distributions are split at 80% to limited partner and 20%
to the general partner.
Professor David Wessels
The Wharton School of the University of Pennsylvania
VentureFundCashFlows
$millions Year1 Year2 Year3 Year4 Year5
Capitalcall(Jan1st) 20.0 40.0 20.0 0.0 0.0
Grossinvestedcapital 20.0 60.0 80.0 80.0 80.0
Distribution(Dec31st) 0.0 25.0 60.0 45.0 50.0
Requiredhurdle
67
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Catch-Up Calculation
Professor David Wessels
The Wharton School of the University of Pennsylvania
The most difficult
calculation occurs the year
in which the hurdle rate is
exceeded.
The catch-up can be
determined using the
formula first presented with
the payout diagram.
Step Component Value
Step1 Distribution 45.0
Step2: Hurdlerequirement 108.8
Cumulativedistribution
t1
85.0
ReturnofHurdle 23.8
Step3: Remainingdistribution(afterhurdle) 21.2
Step4: Breakeventhreshold(formula) 116.0
Hurdlerequirement 108.8
Catchup 7.2
Step5: Remainingdistribution(aftercatchup) 14.0
Step6: PortiontoLP 11.2
PortiontoGP 2.8
68
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Carry using Contributed Capital
Professor David Wessels
The Wharton School of the University of Pennsylvania
European Waterfal l
Payout Structure
$millions Year1 Year2 Year3 Year4 Year5
Capitalcall(Jan1st)
20.0 40.0 20.0 0.0 0.0
Distribution(Dec31st)
0.0 25.0 60.0 45.0 50.0
Drawdown 1
Distribution 0.0 21.6
Cumulative distribution 0.0 21.6
Hurdle 20.0 21.6
Drawdown 2
Distribution 3.4 39.8
Cumulative distribution 3.4 43.2
Hurdle 40.0 43.2
Drawdown 3
Distribution 20.2 45.0 50.0
Cumulative distribution 20.2 65.2 115.2
Hurdle 20.0 n/a n/a
Compensati on Total
LP Return of Capital 0.0 25.0 59.80 0.0 0.0 84.8
LP Profits 0.16 36.0 40.0 76.2
GP Profits 0.04 9.0 10.0 19.0
Total distributions 0.00 25.00 60.00 45.0 50.0 180.0
In a European Carry
structure, the fund needs to
return the hurdle on a
drawdown-by-drawdown
basis.
Does the European carry
lead to higher or lower
distributions than the
traditional method?
69
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Typical Carry Structure
The typical fee structure is 2% of committed capital plus 20% of profits once
original capital is returned. Nearly all funds use committed capital as the
basis. Hurdle rates are common in buyouts, but mixed in VC.
Professor David Wessels
The Wharton School of the University of Pennsylvania
* Real estate fund typically charge 1.5% with a 20% carry. Real estate funds have a preferred return of 9% with a 60/40 catch-up.
92%
48%
84%
93%
%offundsusing
committed capital as
base(i.e. feesincluded)
%offundsthat includea
hurdlerate
CharacteristicsofTypicalCarryContracts
Venture
Capital
Buyouts
4%
0%
95%
100%
1% 0%
Venturecapital Buyouts
CarryPercentagebyFundType
>20%
=20%
<20%
70
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Incentives Related to Carry
Carry: the GP wins only when the LP wins, but Consider three investment
opportunities.
Professor David Wessels
The Wharton School of the University of Pennsylvania
If the probability of up is 50% and the cost of capital is 10%:what is the
NPV of investment A? What is the present value of carry?
Carry
130 8
90
90 0
Time 0 Time 1
Portfol i o Company A
71
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Incentives Related to Carry
Now consider two alternative investments, A versus B and A versus C.
If only one of the two can be made, is A the optimal investment?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Carry Carry Carry
130 8 140 10 150 12
90 90 90
90 0 100 0 40 0
Time 0 Time 1 Time 0 Time 1 Time 0 Time 1
Portfol i o Company A Portfol i o Company B Portfol i o Company C
72
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Drivers of Option Value
Does carry (which is a call option) encourage the VC to invest in portfolio
companies with better returns? Yes, as the underlying asset value (S) rises, so
does call option value. But there are four other drivers of option value!
Professor David Wessels
The Wharton School of the University of Pennsylvania
Driver Conflict? Implication
Stockprice S OK
Strike price K OK
Volatility Potential conflict
Timeto maturity T Potential conflict
Riskfree rate R Not applicable

73
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Are you Willing to Pay a Higher Carry?
Nearly 2/3 of limited partners would be willing to raise the percent
carry in exchange for return hurdles and lower management fees.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Private Equity Investors Survey: ProbitasPartners
65.8%
27.1%
7.1%
WillingtoChangetheCarryStructure?
Noway, 20%is
toohigh!
Noway, 20%is
adequate
Potentially
42.2%
33.3%
29.0%
11.0%
Onlyoverspecific
returnhurdles
Onlyforthosewith a
longtrack record
Inexchangefor
limits on
management fees
Inexchangefor
limits onfundsize
%ofLimitedPartnersWillingtoRaiseCarry
74
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Appendix
Articles on Performance Contracts
Professor David Wessels
The Wharton School of the University of Pennsylvania
75
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Venture Funds Sweetening the Terms: Firms Cut Fees to Lure Investors
After Decade of Mediocre Returns; 30% 'Deal Stopper'
Venture-capital funds are cutting fees as they scrounge for cash amid a bruising fund-raising environment. Battery
Ventures, Draper Fisher J urvetsonand Opus Capital are among venture-capital firms that have dangled lower costs in front
of investors in the past few months. Some are cutting fees outright, while others are building performance-based hurdles
into fee structures. The moves mark the first retreat by the venture-capital industry since the dot-com bust, which forced
many firms to cut fees in hopes of luring back investors. Before the latest downturn, fees were steady for several years at
venture-capital funds.
Lower fees will hit venture capitalists in their wallets. Most funds charge a 2% annual management fee based on total
assets in the fund. Such fees can add up to $1 million a year for some venture-capital partners, says J on Holman, a recruiter
for the venture-capital industry. Venture-capital firms get their biggest money from "carried interest," or profits reaped
when the companies in which funds invest go public or are sold. Fees on carried interest usually are about 20%, with some
funds charging higher carried-interest fees, dubbed "premium fees," of as much as 30%. The inflow from such fees has
been scarce since the financial crisis shrank the pipeline of initial public offerings and sales of venture-capital-backed
companies. Now, the fees themselves are heading south.
Opus, based in Menlo Park, Calif., and trying to attract investors to a new $250 million fund, recently cut its carried-interest
fee for the fund to 20%. The firm's previous fund charged 25%. "Better fee terms can certainly make a difference to
investors," says Kirk Dizon, a managing director at Hall Capital Partners LLC, which invests in venture-capital funds.
These days, carried-interest fees of 30% would be a "deal stopper.
The softening stance follows the venture-capital industry's decade of poor returns. The average return for venture-capital
funds fell to 14% for the 10 years ended J une 30, down from 34% for the 10 years ended J une 30, 2008, largely because the
venture returns generated in the first half of 1999 dropped out of the calculation, according to research firm Cambridge
Associates LLC.
Professor David Wessels
The Wharton School of the University of Pennsylvania
76
Venture Capital & the Finance of Innovation Lecture 3 - Partnership Agreements & GP Compensation
Venture Funds Sweetening the Terms: Firms Cut Fees to Lure Investors
Continued
As a result, many investors are reluctant to put more money into venture capital, especially amid the liquidity crunch from
last year's market turmoil. Some venture-capital funds have scaled back their size ambitions or abandoned efforts to drum
up cash, particularly with so many rivals competing for capital.
This year, 435 venture-capital funds have hit the road to raise money, compared with 452 for all of 2008 and 445 in 2007,
according to research firm Preqin. Out of that field, just 134 new venture-capital funds had completed their fund raising
and closed to investors as of early November, down from the full-year totals of 309 funds in 2008 and 363 in 2007.
The newcomers raised just $20.4 billion in total capital, down 65% from $58.2 billion in all of 2008, according to Preqin.
David Sze, a general partner at Greylock Partners, says the San Mateo, Calif., firm allotted more time than usual to fund
raising because of the uncertain market, but ended up raising money for a new $575 million fund in four to six weeks.
One reason investors boosted the fund above its $500 million target: Greylock'smanagement fee is based on a yearly
budget that investors must approve, instead of the 2% industry norm. Investors "appreciate" that kind of fee transparency,
Mr. Szesays. According to a person familiar with the matter, Greylock, an investor in social-networking site Facebook
Inc., is charging a premium carried-interest fee on the new venture-capital fund.
Battery Ventures is incorporating a performance hurdle into the new $750 million venture-capital fund being raised by the
firm. The fund will charge a carried-interest fee of 20%, down from the previous 25%, until it returns three times its capital.
After that, the fee will climb to 30%. Highland Capital Partners LLC, which recently closed on a $400 million fund, also is
incorporating a performance-based hurdle into its carried-interest fee, says a person familiar with the matter. Draper Fisher
J urvetson, which backed hits such as Skype and Hotmail and is raising a fund targeted at $400 million, sent a letter to
prospective investors this year that said the firm would charge a premium carried-interest fee only if the fund meets certain
performance targets. Investors would pay a 20% carried-interest fee until the fund returns 2.5 times its committed capital,
according to the letter, a copy of which was reviewed by The Wall Street J ournal. The fee would increase after that.
Professor David Wessels
The Wharton School of the University of Pennsylvania
77
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
The Cost of Equity for VC-backed Start-Ups
How the CAPM applies to VC & Founders
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
4
78
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Session Overview
In this session, we estimate the opportunity cost of capital for limited partners,
venture capitalists, and entrepreneurs.
Many believe the limited partners cost of capital is quite high for start-ups (i.e.
greater than 30%), as technological uncertainty is extreme and poor results
often lead to business failure. This view, however, is inconsistent with:
The theory of the CAPM, in that only systematic risk is rewarded.
The empirical evidence, which shows that historical VC returns average less than
15% and when properly measured, abnormal returns are indistinguishable from zero.
In this session, we derive the algebraic expressions for risk and return. We use
these derivations to test how an opportunitys risk can differ across investors.
79
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Thinking about Risk & Return
Today, we examine risk and return from the investors perspective and test how
it differs from the manager/founders perspective. To get started, lets analyze
the following risky project:
Professor David Wessels
The Wharton School of the University of Pennsylvania
You are the program manager at the Baikonur
cosmodrome in Kazakhstan. You have been
approached by DirecTV to launch their new series 10
satellite.
Because the rocket must be modified to fit the satellite,
you are uncertain about success. Your engineers place
probability of a successful launch at 75%.
If the launch is successful, DirecTV will compensate
the cosmodrome $200 million. If the launch fails,
your organization must reimburse DirecTV $100
million for the lost satellite.
80
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Thinking about Risk & Return
With a 25% probability of failure and a
potential downside of $100 million cash
outflow, you are nervous about accepting the
project without good financial analysis.
Professor David Wessels
The Wharton School of the University of Pennsylvania
1 s 2
(p )CF (1 p )CF
PV
1 R
s
+
=
+
Where p
s
equals the probability of launch
success, CF
1
equal the cash inflow from success
and CF
2
equals the cash outflow from failure.
How much is the contract worth? What
discount rate would you use? Use judgment,
NOT formulas!
13.1%
9.2%
8.0%
7.2%
6.2%
6.0%
SmallCapgrowthstocks
Hedgefunds
International stocks
Largestocks(S&P500)
Corporatebonds
Realestate
AssetReturnsbyClass
1990 2010
81
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Risk & Return of Various Asset Classes
The limited partner (portfolio manager) has a number of asset classes to choose
from, including equities, debt, and alternatives. Below are summary statistics
for 14 asset classes using monthly returns.
Professor David Wessels
The Wharton School of the University of Pennsylvania
RiskandReturnbyAssetClass
20012010
AssetClass
Expected
return
Historical
average
Standard
deviation
Expected
return
Historical
average
Standard
deviation
1 LargeCapValue 10.0% 2.1% 16.3% 0.8% 0.2% 4.7%
2 LargeCapGrowth 7.2% 0.5% 18.3% 0.6% 0.0% 5.3%
3 SmallCapValue 14.4% 21.0% 55.0% 1.2% 1.7% 15.9%
4 SmallCapGrowth 11.1% 5.9% 23.3% 0.9% 0.5% 6.7%
5 NASDAQ 8.4% 3.6% 24.0% 0.7% 0.3% 6.9%
6 MSCIEurope 8.2% 1.6% 16.9% 0.7% 0.1% 4.9%
7 MSCIAsia 9.8% 15.1% 25.3% 0.8% 1.3% 7.3%
8 MSCILatinAmerica 9.9% 20.5% 28.7% 0.8% 1.7% 8.3%
9 CoreBond 4.1% 6.2% 4.5% 0.3% 0.5% 1.3%
10 HighYield 3.8% 5.7% 7.3% 0.3% 0.5% 2.1%
11 RealEstate 14.0% 6.8% 24.5% 1.2% 0.6% 7.1%
12 Commodities 7.3% 12.5% 24.7% 0.6% 1.0% 7.1%
13 CrudeOil 8.3% 17.6% 32.3% 0.7% 1.5% 9.3%
14 HedgeFunds 4.6% 7.1% 5.6% 0.4% 0.6% 1.6%
Source:Bloomberg
AnnualStatistics MonthlyStatistics
82
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Plotting Risk and Return
A helpful tool for visually
evaluating individual assets,
asset classes, and portfolios
of asset classes is the mean
volatility plot.
The goal of the limited
partner is to target the highest
return for the lowest amount
of risk.
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
0%
3%
6%
9%
12%
15%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
83
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Limited Partner: Portfolio Optimization
The goal of the portfolio manager is to get the highest return for the
lowest risk. Rather than focus on both goals simultaneously, lets give
the portfolio manager a target return, and minimize risk.
The mathematical expression for this concept is,
p
N
1 i
i i
N
1 i
i i
x
R R
~
x E such that R
~
x Var min =
(


= =
Rather than focus on the mathematical expression, lets examine the
portfolio managers task graphically
84
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Find an Efficient Portfolio
The goal of the limited
partner is to target the
highest return for the lowest
amount of risk.
If higher rates of return
mean higher risk of loss,
what rate of return would
you target for retirement?
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
0%
3%
6%
9%
12%
15%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
85
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Efficient Frontier
A Markowitz Efficient
Portfolio is one where no
incremental diversification
can lower the portfolio's risk
for a given return expectation
The Markowitz Efficient
Frontier is the set of all
portfolios that will give the
highest expected return for
each given level of risk.
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
0%
5%
10%
15%
20%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
Note: This efficient frontier was built using Fama-French expected returns,
historical covariances, and no short-selling of individual portfolios.
86
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
0%
3%
6%
9%
12%
15%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Risk Free Rate and Portfolio Theory
A risk free asset (for instance,
treasury bills) has a standard
deviation of zero.
When we combine a risk free
asset with a risky portfolio
using various weights, we get a
straight line.
Should we create a portfolio of
a riskless bond and a single
stock?
Portfolios comprised of
commodities and the 10-
Year treasury
87
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
Tangency
Portfol i o
0%
5%
10%
15%
20%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Capital Market Line (CML)
We can adjust the portfolio
line such that it is tangent to
the efficient frontier. The
place where the line touches
the efficient frontier is
known as the tangency
portfolio.
The tangent line is known
as the capital market line.
Portfolios comprised of
the tangency portfolio
and the 10-year
treasury
88
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Tangency Portfolio & The Market Portfolio
Key Assumptions:
1. What if returns are normally
distributed?
2. What if every investor preferred
high return and low volatility?
(reasonable assumption)
3. What if every investor agreed on
the risk and return of individual
securities? (strong assumption).
Which portfolio would they choose?
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
Tangency
Portfol i o
0%
5%
10%
15%
20%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
89
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Which Portfolio Would You Prefer?
Based on Sharpes work, assume the limited partner holds a well diversified
market portfolio. If the following opportunities were available, would you
recommend adjusting the portfolio?
90
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Risk and Return: An Experiment to Guide Us
You are a sophisticated limited partner, attempting to maximize risk
and return. You have been given the opportunity to increase your
allocation percentage towards venture capital.
You ask your data analysis team to answer two questions:
1. How will this new allocation affect our potential return?
2. How will this new allocation affect our potential risk?
Professor David Wessels
The Wharton School of the University of Pennsylvania
91
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Step 1: Increasing Your Portfolios Expectation
What if you held the market portfolio and decided to buy a small
amount of venture capital, financed by borrowing at the risk free rate?
Let the small amount equal $y dollars.
f vc m lp
yR R
~
y R
~
R
~
+ =
) yR R
~
y R
~
E( ) R
~
E(
f vc m lp
+ =
f vc m lp
yR ) R
~
yE( ) R
~
E( ) R
~
E( + =
The new portfolios expectation would be calculated as follows
92
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Step 1: Increasing Your Portfolios Expectation
How does the expectation of our portfolio change when we increase y?
f vc
lp
R - ) R
~
E(
y
) R
~
E(
=
c
c
From the last slide:
f vc m lp
yR ) R
~
yE( ) R
~
E( ) R
~
E( + =
As we purchase a small amount ($y) of venture capital, our portfolios
expectation increases by E(R
vc
) R
f
.
93
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Step 2: Increasing Your Portfolios Variance
What if you held the market portfolio and decided to buy a small
amount of venture capital, financed by borrowing at the risk free rate?
Let the small amount equal $y dollars.
f vc m lp
yR R
~
y R
~
R
~
+ =
) yR R
~
y R
~
Var( ) R
~
Var(
f vc m lp
+ =
( )
vc m lp
R
~
y) ( R
~
(1) Var ) R
~
Var( + =
The new portfolios variance would be calculated as follows
94
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Step 2: Increasing Your Portfolios Variance
To determine the variance of our portfolio, we use the portfolio
variance formula, substituting x = 1.
) R
~
, R
~
2yCov( ) R
~
Var( y ) R
~
Var( ) R
~
Var(
vc m vc
2
m lp
+ + =
How does the variance of our portfolio change when we increase y?
) R
~
, R
~
2Cov( ) R
~
2yVar(
y
) R
~
Var(
vc m vc
lp
+ =
c
c
) R
~
, R
~
Cov( 2 ) R
~
Var( ) R
~
Var( ) R
~
Var(
2 1 2
2
1
2
p
xy y x + + =
becomes
95
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Step 2: Increasing Your Portfolios Variance
From the last slide we have the following relation.
For extremely small investments in venture capital (i.e. as the
incremental investment approaches zero), the marginal variance equals
venture capitals covariance with the market.
) R
~
, R
~
2Cov( ) R
~
2yVar(
y
) R
~
Var(
m vc vc
lp
+ =
c
c
) R
~
, R
~
2Cov(
y
) R
~
Var(
lim
m vc
lp
0 y
=
c
c

96
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Case Study: When Volatility Lowers Risk
You have been approached by the board of directors at General Mills.
The company manufactures and distributes ready-to-eat cereals,
refrigerated yogurt, microwave popcorn, and frozen pizza.
Given the low risk associated with the company, a prominent director
believes employees defined contribution (DC) plans should hold only
General Mills stock.
You have countered that holding General Mills stock in isolation is
actual high risk, and that adding a stock such as Google to the portfolio
would actually lower the portfolios risk. But how is this possible?
Google is a highly volatile security!
Professor David Wessels
The Wharton School of the University of Pennsylvania
97
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
The Risk of General Mills versus Google
The board is concerned about Google volatility and plans to vote against
diversification using Google. As can be in Googles stock return chart, the
stock has fluctuated wildly.
Based on portfolio theory, what do you think?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
10
20
30
40
50
60
Dec06 Dec07 Dec08 Dec09 Dec10 Dec11
AdjustedStockPrice(AdjustedforSplitsandDividends)
GeneralMills
0
100
200
300
400
500
600
700
800
Dec06 Dec07 Dec08 Dec09 Dec10 Dec11
AdjustedStockPrice(AdjustedforSplitsandDividends)
Google
98
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
The Efficient Frontier for Two Stocks
As long as two securities have a
reasonably low correlation,
adding a second security will
lower volatility of the portfolio
through diversification, even if
it has high volatility!
If too much of the second
security is added however,
volatility trumps diversification
and portfolio volatility rises.
Professor David Wessels
The Wharton School of the University of Pennsylvania
10%
11%
12%
13%
14%
0% 10% 20% 30% 40%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
StandardDeviation
EfficientFrontier
NewProject
Investor'sPortfolio
99
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Thinking about Risk & Return
Today, we examine risk and return from the investors perspective and
test how it differs from the manager/founders perspective. To get
started, lets analyze the following risky project:
Professor David Wessels
The Wharton School of the University of Pennsylvania
You are the program manager at the Baikonur
cosmodrome in Kazakhstan. You have been
approached by DirecTV to launch their new series 10
satellite.
Because the rocket must be modified to fit the satellite,
you are uncertain about success. Your engineers place
probability of a successful launch at 75%.
If the launch is successful, DirecTV will compensate
the cosmodrome $200 million. If the launch fails,
your organization must reimburse DirecTV $100
million for the lost satellite.
100
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Student Perceptions
The general perception of
cost of capital, both in the
classroom and in the field,
is that risky ventures should
earn 20-30%.
But what does earn really
mean, and should this rate
be used as the discount rate
/ hurdle rate to value
ventures?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
5
10
15
20
25
30
35
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% More
KazakhstanLaunchVenture
FrequencyofSelectedDiscount Rates
101
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Step 3: Marginal Risk Reward Ratios
We can now combine our two elements, marginal expectation and
marginal risk into a single risk-reward ratio:
f vc
lp
R - ) R
~
E(
y
) R
~
E(
=
c
c
) R
~
, R
~
2Cov(
y
) R
~
Var(
m vc
lp
=
c
c
) R , 2Cov(R
R - ) R
~
E(
Risk
Reward
m vc
f vc
=
c
c
Marginal Reward Marginal Risk
The risk-reward ratio for a
small incremental investment
in venture capital, while
primarily holding the well-
diversified market portfolio.
102
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Sharpes Insight: No Deviation at Equilibrium
In an efficient market, where investors can buy and sell asset classes, each asset
class should have the same risk return ratio. Therefore, if we can assess risk by
asset class, we should be able to predict the asset classs return.
All portfolios have risk-reward of 3.5x
103
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
Marginal Benefit = Marginal Cost
In the 1960s, Bill Sharpe hypothesized that the risk-reward ratio for all assets
or any combination of assets(including the market portfolio) must be equal,
otherwise investors would flow into the higher risk/reward asset class.
) R , 2Cov(R
R - ) R
~
E(
) R , 2Cov(R
R - ) R
~
E(
m m
f m
m vc
f vc
=
Venture Capital Market Portfolio
) Var(R
R - ) R
~
E(
) R , Cov(R
R - ) R
~
E(
m
f m
m vc
f vc
=
which can be rearranged,
and simplified,
) Var(R
R - ) R
~
E(
) R , Cov(R R ) R
~
E(
m
f m
m vc f vc
+ =
104
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Risk-Reward Model
As long as a particular investment is a small part of an investors portfolio, then
covariance drives portfolio volatility, NOT the investment's variance.
If the investor holds the market, what drives return is covariance with the market!
Expected return
of venture
capital
The risk reward
ratio of the market
portfolio
Risk free rate
The risk of a
particular asset
class
) R
~
Var(
R ] R
~
E[
) R
~
, R
~
Cov( R ] R
~
E[
m
f m
m vc f vc

+ =
105
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Marginal Risk of a Portfolio
The big picture: If investors care about lowering the variance of their
portfolio (i.e. the market portfolio), then whats important is not an
individual assets variance, but its covariance with the market.
A small covariance will raise the variance of the market portfolio less
than a large covariance will. Subsequently, investments with a higher
covariance must offer a higher return.
This logic has been formalized by Sharpe and Traynor as the CAPM:
| |
f m
m
m vc
f vc
R ] R
~
E[
) R
~
Var(
) R
~
, R
~
Cov(
R ] R
~
E[ + =
106
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Appendix
Incremental Portfolio Variance: Two Assets
Professor David Wessels
The Wharton School of the University of Pennsylvania
107
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Incremental Variance: Two Assets
In this lecture note, we increased our holdings in venture capital by borrowing
money. This allows us to examine the components of risk and derive the
CAPM.
In the assignment, we transferred holdings from a safe stock to a risky stock.
Therefore, the mathematics is slightly different. The variance of the portfolio
is as follows:
Professor David Wessels
The Wharton School of the University of Pennsylvania
) R
~
, R
~
Cov( ) 1 ( 2 ) R
~
Var( ) R
~
Var( ) 1 ( ) R
~
Var(
2 1 2
2
1
2
p
y y y y + + =
) R
~
, R
~
Cov( ) 4 2 ( ) R
~
Var( 2 ) R
~
Var( ) 1 ( 2
y
) R
~
Var(
2 1 2 1
p
y y y + + =
c
c
Similar to before, we examine how the portfolios variance changes as we
increase our holdings in the second asset:
108
Venture Capital & the Finance of Innovation Lecture 4 - The Cost of Equity for VC-backed Start-Ups
Incremental Variance: Two Assets
From the previous page:
Professor David Wessels
The Wharton School of the University of Pennsylvania
) R
~
, R
~
Cov( 2 ) R
~
Var( 2
y
) R
~
Var(
lim
2 1 1
p
0 y
+ =
c
c

0
y
) R
~
Var(
lim
p
0 y
<
c
c

) R
~
Var( ) R
~
, R
~
Cov(
1 2 1
< when
) R
~
, R
~
Cov( ) 4 2 ( ) R
~
Var( 2 ) R
~
Var( ) 1 ( 2
y
) R
~
Var(
2 1 2 1
p
y y y + + =
c
c
Next, determine the incremental variance at y equal to zero:
The derivative will be negative (i.e. portfolio variance will drop) when the
covariance of the two assets is less than the variance of the primary asset.
when
) R
~
(
) R
~
(
) R
~
, R
~
(
2
1
2 1
<
Using the
definition of
correlation (p):
) R
~
( ) R
~
(
) R
~
R
~
Cov(
) R
~
, R
~
(
2 1
2 1
2 1
<
) R
~
( ) R
~
Var(
1
2
1
=
109
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
The Cost of Equity for VC-backed Start-Ups
The Founders Perspective
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
5
110
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
The Founders Investment Choice
An entrepreneur you know has developed a set
of revolutionary processes to manufacture
silicon wafers, solar cells, and other critical
ingredients for solar power generation.
The first production technology, polysilicon,
has limited competition and strong expected
IRRs.
The second production technology, silane, has
similar expected IRRs, but much greater
uncertainty.
If both technologies are available to the
entrepreneur/founder, should the entrepreneur
put their life into either of them?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Financial Assessment
Polysilicon Silane
production production
Projected IRR 21% 18%
Risk Metrics
Comparable beta 1.8 0.8
Comparable volatility 45% 60%
Market Metrics
Risk free rate 4% 4%
Market risk premium 5% 5%
Market volatility 17% 17%
111
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
0%
5%
10%
15%
20%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
Entrepreneurial Opportunities & the Efficient Frontier
Although professionals are quick to
use the CAPM to evaluate
opportunities, this is not appropriate
for an undiversified founder.
From a financial perspective, the
founder should compare the
opportunity versus a levered efficient
portfolio on the capital markets line
(CML).
Unlike a professional investor, the
founder must also consider non-
financial benefits of starting an
enterprise.
Professor David Wessels
The Wharton School of the University of Pennsylvania
New silane
production
process
New polysilicon
production
technology
112
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
LargeCapVal ue
Smal l Cap
Growth
Hi ghYi el d
Commodi ti es
Tangency
Portfol i o
0%
5%
10%
15%
20%
0% 5% 10% 15% 20% 25% 30% 35%
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Volatility of Returns
MeanVolatility Plot
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Financial Threshold for Entrepreneurs
The equation for any line equals:
Y = a + bX
The intercept for the capital market
line (CML) equals the risk free
rate.
The slope for the capital market
line can be computed as rise over
run. Therefore the entrepreneurs
cost of capital equals:

f m
m
i
f
R ] R
~
E[
) R
~
(
) R
~
(
R Hurdle Financial
New silane
production
process
New polysilicon
production
technology
113
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
Additional Insight into Beta
We can use the definition of covariance to rearrange beta.
) R
~
Var(
) R
~
, R
~
Cov(
b
m
m vc
vc

can be
rewritten as:
) R
~
(
) R
~
(
b
m
vc
vc

Individual securities tend to have much higher volatilities than the diversified
market portfolio. Thus, for highly correlated stocks, the beta is greater than
one. For assets uncorrelated with the market, their beta is zero.
As can be seen by the second equation, the market has a beta of one.
vc m
vc m
Cov(R ,R )

(R )(R )



114
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
CAPM Betas versus Entrepreneur Betas
GT Solar International is a beacon along the path of the solar power supply chain. Its key
products include photovoltaic wafer fabrication machinery, silicon furnaces, and optical
scanning systems. The company also provides solar module assembly services.
If the risk free is 4% and the
market risk premium is 5%,
What is the limited partners
cost of capital
What is the founders cost of
capital?
MarketPricing
ManualCalculation
Statistics GTATUS S&P500
Historicalaverage 3.6% 1.5%
Standarddeviation 18.2% 5.3%
Correlation 33.4%
Covariance 0.31%
Date GTATUS S&P500 GTATUS S&P500
Dec11 7.60 1,277.81 6.2% 1.0%
Nov11 8.10 1,264.87 5.9% 0.2%
Oct11 8.61 1,267.67 16.8% 10.9%
Sep11 7.37 1,142.77 42.5% 7.0%
Aug11 12.82 1,229.18 10.5% 5.4%
Jul11 14.32 1,299.79 15.8% 2.0%
Jun11 17.01 1,326.77 27.0% 1.7%
May11 13.39 1,349.26 14.2% 1.1%
AdjustedStockPrice($) MonthlyReturns
115
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Cost of Capital versus Expected Return
Based on the CAPM & its modifications, the cost of capital for the
startups limited partners is 9.7%. The cost of the capital for the
founders is 21.2% (assuming they are fully invested).
Critical question:
If the founder invests $1 million to start the company, does this mean
the founder will earn 21.2% on average? i.e. if they started 100
companies with identical characteristics, would the average investment
earn 21.2%?
116
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
Correlation & Volatility by Industry
Cross-sectional variation in beta is driven by relative volatility and correlation
with the market portfolio. If Internet companies have high volatility, but low
correlation with the market, what does this mean for the founder/LP relationship?
1.0
1.6
2.4
2.6
2.9
3.9
4.3
4.3
4.8
5.8
6.3
WaterUtility
FoodWholesalers
Average
SpecialtyChemical
Aerospace&Defense
Drug
SoftwareandServices
Biotechnology
ComputerPeripherals
Semiconductors
Internet
RelativeVolatilitybyIndustry
26.2%
29.0%
29.1%
29.4%
30.9%
33.4%
36.7%
38.1%
41.0%
43.0%
55.1%
Internet
Drug
ComputerPeripherals
Biotechnology
SoftwareandServices
FoodWholesalers
Semiconductors
SpecialtyChemical
Aerospace&Defense
Average
WaterUtility
MarketCorrelationbyIndustry
Industry data via Compustat and Aswath Damodaran.
What is the cost of
capital by type for
Internet companies and
water utilities?
117
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
The Cost of Equity for VC-backed Start-Ups
Concluding Perspectives
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
118
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
The CAPM and Uncertainty: An Example
You work for a biotechnology company,
entirely financed with venture capital. The
company is on the edge of a major
breakthrough, although the probability of
success is gauged at just 20%.
If clinical tests are successful, Merck will
contract/license the drug for $10 million per
year forever. Conversely, failure kills the
project completely.
If the risk free rate is 5% and Mercks cost of
capital is 15%, should the company spend $15
million to proceed with the clinical trials?
119
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
Why such a High Cost of Capital in VC?
In the previous example, we assumed
the clinical tests were uncorrelated with
the market. Therefore, a cost of capital
of 5% was appropriate (assuming Merck
is unlikely to default on its obligations).
A venture capitalist is likely to
incorporate risk into the denominator,
not into the numerator.
What is the net present value of the
win scenario discounted at 20%, 25%,
30%. Which is theoretically correct?
NPV
15%
=
NPV
25%
=
NPV
35%
=
120
Venture Capital & the Finance of Innovation Lecture 5 The Founders Perspective on Required Return
Professor David Wessels
The Wharton School of the University of Pennsylvania
S. Korean satellite misses orbit
GOHEUNG, South Korea: South
Korea launched its first space rocket
yesterday but failed to put a satellite
into its planned orbit, in a setback
for the country's nascent space
program.
The payload separated from the
second-stage booster about eight
minutes after liftoff but did not enter
its targeted orbit, project officials
said at the space center on Oenaro
Island, about 465 km south of Seoul.
"The first-stage engine and the
second-stage kick motor operated
normally and the satellite separated,
but it did not put it precisely in the
target orbit," said Science Minister
Ahn Byong-man. "We cannot spot
the satellite in its orbit, where it is
supposed to be."
The satellite reportedly separated 36
km higher than its target position.
Officials could not immediately
explain what went wrong or what
would happen to the satellite, but
they said it did not have a booster to
correct its trajectory.
121
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Venture Capital Performance
Are High Hurdle Rates Justified? Empirical Evidence
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
6
122
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Venture Capital Performance
Over the past 30 years, venture capital has (slightly) outpaced returns of both the S&P
500 and the NASDAQ composite index. Performance continued after the dot-com
meltdown of 2001-2003.
Between 1980 and 2010, VC has earned 11.9% versus 11.6% for the S&P 500.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Cambridge Associates, Bloomberg
1
10
100
1981 1984 1988 1992 1996 1999 2003 2007 2011
VentureCapitalPerformance
(19812011)
Cambridge
Associates
Nasdaq
S&P500
0.0
0.5
1.0
1.5
2.0
2003 2004 2005 2006 2007 2008 2009 2010 2011
VentureCapitalPerformance
(20032011)
Cambridge
Associates
Nasdaq
S&P500
123
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
Venture Capital Indices
Sand Hill Econometrics (SH) began by combining the databases of the two
main industry-trackers, VentureOne and VentureEconomics, supplemented
with other industry sources. The database includes over 20,000 companies and
more than 70,000 financing rounds and is produced monthly.
The gross returns from 1988-2008 are 12.8% (versus 7.9% for NASDAQ).
Cambridge Associates (CA) U.S. Venture Capital Index includes more than
75 percent of the dollars raised by VC funds since 1981. CA is an investment
consultant to endowments (etc) that serves as a gatekeeper for potential LPs.
The net returns from 1988-2008 are 16.2% (versus 7.9% for NASDAQ).
124
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Gross versus Net Returns
Sand Hill Economics uses gross returns. Gross returns are raw returns, computed
without management fees or carry.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Limited Partner Venture Fund Limited Partner
Venture Fund Portfolio Company Venture Fund
Cambridge Associates uses net returns. Net returns are computed after subtracting
management fees and carry.
Capital Call Distribution
Investment Exit Proceeds
Why is the CA index higher than SHE? By its construction, CA is subject to severe survivorship bias (funds must be successful to
raise additional capital). SHE is too conservative because it only computes proportional ownership and ignores embedded optionality.
125
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
Is a High Hurdle Rate Justified?
So, what is the cost of capital for Venture Capital? We know the probability
of failure for start-ups is high, but does this translate to priced risk? ? i.e.
does the CAPM explain returns?
To test this question, we regress excess venture returns against excess market
returns. If the CAPM holds, what do you expect the values of alpha and beta
to be?
) R ] (E[R B R - ] E[R
f m i f i
+ =
Sand Hill Index
(monthly) and the
CA Index (quarterly)
CRSP Value Weighted
Stock Index less short-
term bills
126
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
Unexplained VC-Performance
Early results are impressive. Abnormal performance (i.e. performance
unexplained by beta) is equal to 6% per year. Note, how beta is remarkably
low. Are VC investments really this uncorrelated with the market?
Coefficient
Monthly Data from
Sand Hill Econometrics
Quarterly Data from
Cambridge Associates
Alpha (in % per year) 4.92
****
6.10
Market Beta 0.76
***
0.56***
Adjusted R
2
72% 19%
Gross or Net Returns? Gross Net
Sample Period Jan 1989 to Dec 2008
(240 monthly observations)
Q2 1981 to Q4 2008
(111 quarterly observations)
Is this really superior performance? Or perhaps the CAPM fails to measure
risk appropriately. Lets examine two alternative pricing models, Fama-French
and Pastor-Stambaugh.
127
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Effect of Stale Prices
Many GPs report valuations based on the most recent round of financing, even if a
companys outlook had changed significantly since that time.
During the post-boom period, LPs complained old valuations significantly overstated
the value of the portfolios, which made it difficult for LPs to properly assess their
holdings.
The Solution?
Lagged Beta
15%
10%
5%
0%
5%
10%
15%
20%
10% 5% 0% 5% 10% 15%
F
u
n
d

R
e
t
u
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n
s
MarketReturns
MonthlyFundReturns
versusMarketReturns
Market FundReturns
Month Returns Actual Reported
1 4.5% 5.8% 0.0%
2 3.9% 5.1% 0.0%
3 1.3% 1.7% 0.0%
4 3.8% 5.0% 0.0%
5 2.1% 2.7% 3.3%
6 6.7% 8.7% 0.0%
7 6.6% 8.6% 0.0%
8 3.5% 4.6% 12.7%
9 5.8% 7.5% 0.0%
10 1.5% 1.9% 0.0%
11 2.5% 3.2% 0.0%
12 1.4% 1.8% 0.0%
128
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
Fama-French 3-Factor Models
Many academics believe beta is a poor measure of risk. Instead, many use the
Fama and French (1993) three factor model to determine the risk of an asset
class:
) R (R ) R (R ) r (R r R
L H 3 B S 2 f M 1 f p
+ + + =
According to Fama & French (data), three factors drive investment returns:
The performance of economy as a whole, as measure by a traditional market beta
A premium for companies that have returns correlated with small companies. Small
companies have outperformed large companies by 24 basis points per month, or 3.0%
per year.
A premium for companies that have returns correlated with companies with high book-
to-market values. High B/M companies have outperformed their counterparts by 38
basis points per month, or 4.6% per year.
129
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Fama-French Portfolio Returns
Many have proposed theories to explain the higher returns associated with small
companies and low book-to-market values, but none have gained wide acceptance.
Regardless, the data are robust and any excess performance must be tested.
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
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19262011
130
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Fama-French Factor Loadings by Asset Class
Although equity indices each have similar exposure to the market, they have
different exposures to the other two Fama-French Factors.
Professor David Wessels
The Wharton School of the University of Pennsylvania
RiskandReturnbyAssetClass
20022011
AssetClass
Expected
return
Historical
average
Standard
deviation
Expected
return
Historical
average
Standard
deviation HMLbeta SMBbeta
Market
beta
1 MSCIIndex 9.0% 6.2% 17.5% 0.8% 0.5% 5.0% 0.02 0.11 1.05
0 S&P500 8.7% 2.2% 15.9% 0.7% 0.2% 4.6% 0.04 0.15 1.00
1 LargeCapValue 9.3% 2.7% 16.7% 0.8% 0.2% 4.8% 0.23 0.14 0.95
2 LargeCapGrowth 8.4% 2.6% 16.3% 0.7% 0.2% 4.7% 0.18 0.06 1.06
3 SmallCapValue 11.7% 6.4% 20.8% 1.0% 0.5% 6.0% 0.21 0.78 0.91
4 SmallCapGrowth 11.5% 6.3% 22.1% 1.0% 0.5% 6.4% 0.24 0.91 1.14
5 NASDAQ 9.9% 4.9% 20.2% 0.8% 0.4% 5.8% 0.27 0.33 1.19
6 MSCIEurope 8.5% 0.9% 16.6% 0.7% 0.1% 4.8% 0.07 0.06 0.88
7 MSCIAsia 9.9% 12.3% 24.3% 0.8% 1.0% 7.0% 0.14 0.18 1.19
8 MSCILatinAmerica 10.1% 18.4% 28.6% 0.8% 1.5% 8.3% 0.23 0.19 1.52
9 CoreBond 4.1% 5.9% 4.5% 0.3% 0.5% 1.3% 0.02 0.01 0.00
10 HighYield 3.8% 5.5% 7.3% 0.3% 0.5% 2.1% 0.03 0.11 0.06
11 RealEstate 11.9% 6.7% 25.1% 1.0% 0.6% 7.3% 0.61 0.46 0.82
12 Commodities 6.3% 16.6% 24.8% 0.5% 1.4% 7.2% 0.20 0.09 0.57
13 CrudeOil 6.9% 21.5% 32.6% 0.6% 1.8% 9.4% 0.25 0.30 0.59
14 HedgeFunds 5.2% 6.4% 5.8% 0.4% 0.5% 1.7% 0.09 0.05 0.27
Source:Bloomberg Averagemonthlyreturns:
0.3% 0.2% 0.4%
AnnualStatistics MonthlyStatistics RegressionCoefficients
131
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
Handling Illiquidity: the Pastor-Stambaugh Model
For venture capital applications, the most important innovation is the
measurement of liquidity risk developed by Pastor and Stambaugh (2003).
Many practitioners feel that venture capital should earn a higher return because
the investments are illiquid.
The Pastor-Stambaugh model (PSM) allows us to estimate this premium using
data on VC returns by adding a liquidity factor to Fama & French (1993)
) R (R ) R (R ) R (R ) r (R r R
Liq Illiq 4 L H 3 B S 2 f M 1 f p
+ + + + =
In the 1966 to 2004 period, the average return to the liquidity factor was 3
percent per year. Since 1980, however, the returns have been almost 6 percent
per year. Liquidity data can be found in WRDS.
132
Venture Capital & the Finance of Innovation Lecture 6 - Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Cost of Venture Capital
Using a lagged beta model to compute regression coefficients for the Pastor
Stambaugh model leads to:
Total Coefficient Monthly Data (SHE Index) Quarterly Data (CA Index) Risk Premium
Alpha (in % per year) 2.11 0.13
Market Beta 1.63
***
2.04
***
5.0%
Size Beta 0.09 1.04
***
2.5%
Value Beta 0.68
***
1.46
***
3.5%
Liquidity Beta 0.26
**
0.15 5.0%
Adjusted R
2
83% 55%
Sample Period Jan 1989 to Dec 2008
(240 monthly observations)
Q2 1981 to Q4 2008
(111 quarterly observations)
Source:
Metrick (2010)
Based on these statistics, what is the cost of capital for the typical venture
fund? Does the typical venture capital fund beat the market?
133
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Choosing Amongst Venture Capital Firms
Measuring Fund Performance & Manager Persistence
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
7
134
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Session Overview
Over the last 30 years, venture capital has failed to statistically outperform
either a Fama-French adjusted set of indices. But can you beat the VC index
by investing in particular VCs, and if so, can you reliably find which ones?
During this session, we examine how to measure historical performance on a
fund-by-fund basis. We will examine three metrics in particular: times-
money-earned (investment multiple), internal rate of return (IRR), and
discounted times-money earned.
Venture capital managers exhibit persistence. Therefore, historical
performance is a helpful selector. But how strong is persistence? More
specifically, should you be willing to pay higher fees and carry for a manager
with strong historical performance?
Professor David Wessels
The Wharton School of the University of Pennsylvania
135
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Venture Capital as an Asset Class
Over the last 30 years,
venture capital has failed to
statistically outperform
either a stock index, or a
Fama-French adjusted set of
indices.
But can you beat the VC
index by investing in
particular VCs, and if so, can
you reliably find which
ones?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Cambridge Associates, Bloomberg
1
10
100
1981 1984 1988 1992 1996 1999 2003 2007 2011
VentureCapitalPerformance
(19812011)
Cambridge
Associates
Nasdaq
S&P500
136
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Variation Across VC Funds
Professor David Wessels
The Wharton School of the University of Pennsylvania
Between 1978 and 2010, the University of
California invested $2.4 billion in 124
venture funds, the most recent being
Insight Venture Partners VII.
With an average return of 15.3%, UC
performed better than the VC index of
12.7%, but given the enormous variation
of fund performance (standard deviation
equals 43%), picking the right fund
really matters.
How should we measure individual fund
performance?
Source: University of California, Office of the President,
0
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30%20%10% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
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InternalRateofReturn
DistributionofVCAnnualReturns
UniversityofCaliforniaHoldings
Five venturefunds
hadIRRsgreater
than100%peryear
137
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
University of California VC Returns
The University of California has made investments in more than 100 venture capital
funds. To report fund performance, UC records an unrealized value multiple and the net
internal rate of return:
Professor David Wessels
The Wharton School of the University of Pennsylvania
VentureCapitalFund VintageYear
UC
Commitment CashIn CurrentNAV CashOut
CashOut+
CurrentNAV
Investment
Multiple NetIRR
1 BrentwoodAssociatesII,L.P. 1978 3,000.0 (3,000.0) 0.0 4,254.0 4,254.0 1.42x 5.5%
2 InterWestPartnersI,L.P. 1979 3,000.0 (3,000.0) 0.0 6,681.0 6,681.0 2.23x 18.5%
3 AltaCompany 1980 3,000.0 (3,000.0) 0.0 6,655.0 6,655.0 2.22x 13.8%
4 Golder,ThomaFundI 1980 5,000.0 (5,000.0) 0.0 59,349.0 59,349.0 11.87x 32.1%
5 KleinerPerkinsCaufield&ByersII 1980 7,500.0 (7,500.0) 721.0 31,521.0 32,242.0 4.30x 50.6%
6 Welsh,Carson,Anderson&StoweII 1980 4,000.0 (4,000.0) 0.0 8,670.0 8,670.0 2.17x 14.2%
7 AltaII,L.P. 1981 3,000.0 (3,000.0) 0.0 5,300.0 5,300.0 1.77x 7.0%
8 MayfieldIV,L.P. 1981 5,000.0 (5,000.0) 0.0 13,158.0 13,158.0 2.63x 26.1%
9 SequoiaCapitalIII 1981 4,000.0 (4,000.0) 30.0 7,232.0 7,261.0 1.82x 11.3%
10 InterWestPartnersII,L.P. 1982 4,000.0 (4,009.0) 0.0 6,972.0 6,972.0 1.74x 8.4%
11 KleinerPerkinsCaufield&ByersIII 1982 7,832.0 (7,832.0) 0.0 13,596.0 13,596.0 1.74x 10.2%
117 DCMVI,L.P. 2009 25,000.0 (3,125.0) 2,712.0 0.0 2,712.0 0.87x NM
118 KhoslaVenturesFundIII,L.P. 2009 60,000.0 (31,800.0) 35,961.0 0.0 35,961.0 1.13x NM
119 KhoslaVenturesSeed,L.P. 2009 17,143.0 (6,171.0) 6,477.0 0.0 6,477.0 1.05x NM
120 CaduceusPrivateInvestmentsIV,L.P. 2010 25,000.0 (2,550.0) 2,365.0 0.0 2,365.0 0.93x NM
121 InsightCoinvestII,L.P. 2010 13,000.0 0.0 0.0 0.0 0.0 NA NA
122 InsightVenturePartnersVII,L.P. 2010 50,000.0 0.0 0.0 0.0 0.0 NA NA
123 PolarisVenturePartnersVI,L.P. 2010 20,000.0 0.0 0.0 0.0 0.0 NA NA
124 TheColumnGroupII,L.P. 2010 20,000.0 0.0 0.0 0.0 0.0 NA NA
Source: University of California, Office of the President,
138
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
UC Regent Definitions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Term Definition
Vintage Year Represents the year each partnership commenced investment activities. This may be different than the year in which The Regents
committed to invest in the partnership.
UC
Commitment
Represents the total commitment made by The Regents to each partnership, adjusted for any subsequent reductions to partnership
commitments by the General Partners.
Cash In Represents the total portion of The Regents commitment that has been contributed to the partnership from inception through the
most recent year-end.
Current NAV Represents the net asset value of The Regents interest in each partnership as determined by the General Partners in financial
statements.
Cash Out Represents the total distributions received by The Regents from inception through the most recent year-end.
Cash Out +
Current NAV
Represents the sum of distributions received by The Regents from inception through the most recent year-end and the net asset
value of The Regents interest in each partnership as determined by the General Partners in financial statements.
Investment
Multiple
Represents each partnerships total value as a multiple of invested capital; the multiple is calculated by dividing Cash Out +
Current NAV by Cash In.
Net IRR Represents the cash-on-cash return net of fees, expenses, and carried interest from inception through the most recent year-end as
well as the net asset value of The Regents interest in each partnership as determined by the General Partners in financial
statement.
Source: UC Regents
How is the data reported? The UC Regents use the following definitions:
139
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Measuring Performance
Investment Multiple / Times money earned (TME)
An Investment Multiple is computed by dividing cumulative
distributions by contributed (and eventually committed) capital. Can be
computed with or without the value of unrealized investments.
Internal rate of return (IRR)
The internal rate of return is solved by setting the NPV of cash flows
equal to zero. IRR is computed using = IRR(range)
Discounted Investment Multiple.
Rather than compute a raw multiple, discount cash flows at an appropriate
cost of capital.
Professor David Wessels
The Wharton School of the University of Pennsylvania
140
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Measuring Performance: Cash Flows
Your boss, the Alternative Investments
manager at the New Mexico Education
Retirement Fund is considering an
investment in either the Alpha Partners
or Beta Capital:
Alpha Partners raised a $500 million dollar
fund in 2002.
Beta Capital raised an identically sized fund in
the same year.
At the end of each funds life, what is the
net value multiple? How do we
determine IRR?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Drawdown
Distributions
AlphaPartners BetaCapital Year
2002 500 500
2003 50 0
2004 40 0
2005 0 0
2006 140 50
2007 80 0
2008 600 0
2009 0 300
2010 400 0
2011 0 800
2012 650 1600
141
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Which is Fund is Better?
Your boss, the Alternative
Investments manager at the
New Mexico Education
Retirement Fund is
considering an investment in
either the Alpha Partners or
Beta Capital.
Which fund manager has
better historical performance?
Professor David Wessels
The Wharton School of the University of Pennsylvania
PerformanceMetrics
Times Internal
Money Rateof
Fund Earned Return
AlphaPartners 3.9 22.5%
BetaCapital 5.5 20.6%
142
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Measuring Performance: Investment Multiples
The fund multiple grows
over time as distributions
are made.
Alpha partners made early
distributions, whereas beta
capital made late
distributions.
What is the problem with
investment multiples?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
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FundYear
Alpha&BetaReturnMultiples
Alpha
Partners
Beta
Capital
143
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Measuring Performance: Internal Rate of Return
A common alternative to showing
an investment multiple is to
compute an internal rate of return.
Internal rate of return is solved by
setting the NPV of cash flows
equal to zero.
Professor David Wessels
The Wharton School of the University of Pennsylvania
10 4 2
IRR) (1
600
...
IRR) (1
140
IRR) (1
20
-500 0
+
+ +
+
+
+
+ =
Based on each funds IRR,
which fund is superior?
20.6%
22.5%
10% 15% 20% 25%
BetaCapital
AlphaPartners
InternalRateofReturn
144
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
The Theory: Internal Rate of Return
The internal rate of return is
an extremely popular
method to evaluate capital
budgeting projects.
IRR separates positive NPV
projects from negative NPV
projects.
The theory dictates that you
select projects whose IRR
is greater than the cost of
capital
Professor David Wessels
The Wharton School of the University of Pennsylvania
(200)
(100)
0
100
200
300
400
500
10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%
$

m
i
l
l
i
o
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s
PresentValueofLPCashFlows
AlphaPartners
145
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Pitfalls of Internal Rate of Returns
But the internal rate of
return separates positive
from negative projects, it
can not be used to compare
projects.
The same holds true for
funds. Even if two funds
have the same initial
investment and the same
risk, IRR fails to measure
performance consistently.
Professor David Wessels
The Wharton School of the University of Pennsylvania
(300)
(200)
(100)
0
100
200
300
400
500
600
700
10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%
$

m
i
l
l
i
o
n
s
PresentValueofLPCashFlows
BetaCapital
AlphaPartners
146
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
The Extreme: Multiple Rates of Return!
Professor David Wessels
The Wharton School of the University of Pennsylvania
Each time the cash flow
pattern changes sign, a real
root is possible.
Since distributions can
occur before capital
commitments, negative can
be followed by positive, by
negative again!
Consequently, multiple
rates of return are possible!
150
100
50
0
50
100
150
0% 20% 40% 60% 80% 100%
$

m
i
l
l
i
o
n
s
DiscountRate
PresentValueofLPCashFlows
Guess IRR
0% 1%
10% 15%
80% 86%
147
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Other Practical Drawbacks of IRR
A typical fund will make a set of capital calls immediately preceding
investments. This process is imperfect and subsequently, the fund
will sometimes hold cash.
What will holding cash do to a funds IRR? Is this penalty
appropriate?
Professor David Wessels
The Wharton School of the University of Pennsylvania
148
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Distribution of Investment Multiples
The University of California reports investment multiples for each of its
investments. The average investment multiple was 2.6x (after fees and
carry), but the median fund was only 1.1x. What does this imply?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
5
10
15
20
25
0.0 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6 4.0 4.4 4.8
F
r
e
q
u
e
n
c
y
UnrealizedInvestmentMultiple
DistributionofVCInvestmentMultiples
UniversityofCaliforniaHoldings
Nineventurefundshad
investmentmultiples
greaterthan5x
VentureCapitalFund
Vintage
Year
Investment
Multiple NetIRR
KleinerPerkinsCaufield&ByersVII 1994 32.51x 121.7%
KleinerPerkinsCaufield&ByersVIII 1996 17.00x 286.6%
SequoiaCapitalVII 1995 16.39x 174.5%
SequoiaCapitalVI 1992 15.67x 110.4%
Golder,ThomaFundI 1980 11.87x 32.1%
InstitutionalVenturePartnersVII,L.P. 1996 6.71x 96.2%
InstitutionalVenturePartnersVI,L.P. 1994 5.82x 64.6%
Merrill,Pickard,Anderson&EyreV,L.P. 1989 5.49x 46.1%
SequoiaCapitalV 1989 5.30x 39.6%
KleinerPerkinsCaufield&ByersXA,L.P. 2000 0.59x 17.5%
SequoiaCapitalX 2000 0.55x 31.0%
Google
149
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Gross Versus Net Multiples/IRRs
Professor David Wessels
The Wharton School of the University of Pennsylvania
Gross returns are raw returns, computed without management fees or
carry. Net returns are computed after subtracting management fees
and carry. Consider the following two venture funds:
You are considering investing in one of the two venture funds. Which
metric would you use to make a decision? Why? Can anything be
learned from Gross IRRs?
Gross Net Gross Net
Fund Multiple Multiple IRR IRR
CapitalPartners 4.7 3.9 25.0% 19.0%
DeltaVentures 4.5 4.2 23.0% 22.0%
150
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Realized &Unrealized Multiples/IRRs
Professor David Wessels
The Wharton School of the University of Pennsylvania
What are the realized, unrealized, and total value multiples for the fund
below? If you were an LP evaluating the fund for the next capital
raise, which multiple would you use?
PortfolioValuation
$millions
Liquidation Unrealized Total
Company Investment value value value Source/Methodology
Company1 3.0 7.5 0.0 7.5 M&A
Company2 5.0 0.0 20.0 20.0 SeriesCat$4.00pershare
Company3 3.0 36.0 0.0 36.0 IPOat$15.00pershare
Company4 3.5 0.0 0.0 0.0 Writeoff
Company5 4.0 0.0 0.0 0.0 Writeoff
Company6 4.5 13.5 0.0 13.5 M&A
Company7 5.0 0.0 30.0 30.0 SeriesDat$5.50pershare
Company8 4.0 0.0 12.0 12.0 SeriesBat$1.75pershare
Company9 3.0 0.0 3.0 3.0 Cost
Company10 5.0 0.0 5.0 5.0 Cost
Total 40.0 57.0 70.0 127.0
151
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Realized versus Unrealized Multiples/IRRs
Professor David Wessels
The Wharton School of the University of Pennsylvania
Your boss is considering an investment in either Evergreen Partners or
Foundation Ventures. Both funds have only one prior fund, both in
their fifth year.
Which metric would you use to make a decision? Why? How would
this influence your due diligence interview?
Realized Total Realized Total
Fund Multiple Multiple IRR IRR
EvergreenPartners 1.2 3.1 14.0% 29.0%
FoundationVentures 1.6 2.8 18.0% 26.0%
152
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
The Impact of FAS 157 on Unrealized Multiples
Fair value reporting for illiquid investments: Ready or not here it comes
For many years, private equity funds (both venture and buy-out) carried illiquid portfolio companies at cost for at least a
year or more unless a subsequent financial transaction supported a different valuation, says Roger Mulvihill, a partner at
law firm Dechert.
In some cases, cost basis valuations continued until liquidity. This approach, often justified as conservative, tended to
understate the actual performance of privately held portfolio companies in strong markets and overstate performance in
weak markets. In the most extreme example, it took some years for the full impact of the internet bubble collapse to flow
through to the financial statements of some limited partners.
Although generally accepted accounting principles require that investments be valued at fair value, and most general
partners are required to furnish GAAP financials to their limited partners, private equity funds and their auditors could
plausibly argue for many years that cost approximated fair value for many private companies, partly because there was
little guidance from the Financial Accounting Standards Board. In September 2006, the FASB issued FAS #157, which
outlined specific methodologies for valuing illiquid investments and the accompanying required disclosures. Compliance
with FAS #157, which is generally effective for financial statements issued for fiscal years beginning after November 2007
and interim periods within those years, could lead to much greater volatility in reported results of private equity funds and,
at a minimum, will require significantly more attention to valuations by general partners.
In general, FAS #157 and the Updated PEIGG Guidelines seek to have all portfolio investments reported at fair value on a
consistent, transparent, and prudent basis. Fair value is defined as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the measurement date. The objective is to
estimate the price at which a hypothetical willing marketplace participant would agree to transact in the principal market or,
lacking a principal market, the most advantageous market.
Professor David Wessels
The Wharton School of the University of Pennsylvania
153
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Sample Presentation
Professor David Wessels
The Wharton School of the University of Pennsylvania
154
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Sample Presentation
Professor David Wessels
The Wharton School of the University of Pennsylvania
155
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Persistency of Venture Capital Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
156
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Persistence by Asset Class
Mutual Funds
Persistence in mutual fund performance does not reflect superior stock-picking skill. Rather,
common factors in stock returns and persistent differences in mutual fund expenses and transactions
costs explain almost all predictability in mutual fund returns. Only the strong, persistent
underperformance by the worst-return mutual funds (bottom decile) remains anomalous. On
Persistence in Mutual Fund Performance, Mark Carhart, Journal of Finance.
Hedge Funds
Using parametric (regression) and non-parametric (binary) methods, we examine persistence in the
performance of hedge fund managers. We find a reasonable degree of persistence which seems to be
attributable more to the losers continuing to be losers instead of winners continuing to be winners.
In particular, we find that there are more LLs than WWs in every quarter. On Taking the
'Alternative' Route: Risks, Rewards, Style and Performance Persistence of Hedge Funds, Vikas
Agarwal and Narayan Naik, Journal of Alternative Investments
Professor David Wessels
The Wharton School of the University of Pennsylvania
157
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Persistence of Venture Capital
When investment managers consistently perform above (or below) other
managers over multiple periods, this is known as persistence.
Kaplan and Schoar (2005) find:
Returns persist strongly across funds raised by individual private equity partnerships.
Returns improve with partnership experience.
Both coefficients are significant at the 95% level. The standard deviation of the
noise term (e) is quite large: 22.5%
Professor David Wessels
The Wharton School of the University of Pennsylvania
F 1 F 2
IRR(F) Year Fixed Effect (.36) IRR (.42) IRR

= + + +
Steven N. Kaplan & Antoinette Schoar, 2005. "Private Equity Performance: Returns, Persistence, and Capital Flows," Journal of Finance, American
Finance Association, vol. 60(4), pages 1791-1823, 08
Note: Because KS
includes year fixed
effects, past IRRs are
demeaned by their
vintage year returns.
158
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
How Reliable is Persistence?
Your boss, the Alternative Investments manager at the
New Mexico Education Retirement Fund is considering
an investment in either the Wharton Ventures VI fund or
the HBS Financial Institutions Fund IV.
The historical returns on the two funds have been:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Vintage
Year
Number
ofFunds IRR
1980 22 23%
1981 24 13%
1982 29 5%
1983 65 14%
1984 74 15%
1985 59 23%
1986 61 13%
1987 97 14%
1988 71 12%
1989 79 18%
1990 45 21%
1991 24 20%
1992 50 23%
1993 67 23%
1994 68 23%
1995 70 18%
1996 67 19%
1997 109 13%
Source:Kaplan&Schoar(2005)
PerformanceCharacterstics
ByFund
Fund
Vintage
Year IRR
WhartonVenturesIV 1993 27%
WhartonVenturesV 1997 20%
HBSSkillingFundVI 1991 17%
HBSSkillingFundVII 1996 13%
159
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
How Reliable is Persistence?
Using the estimates of Kaplan and Schoar and excess fund returns from the
previous slide, what is the probability that the IRR of Wharton VI will
exceed the IRR of HBS VIII? Assume the error term e is normally distributed,
has a standard deviation of 22.5%, and the two funds returns are uncorrelated.
What is the expected return of Wharton VI?
What is the expected return of Harvard VI?
True/False: Since VC performance is persistent, Wharton Ventures VI will
have a higher IRR than HBS Financials Fund VIII.
Professor David Wessels
The Wharton School of the University of Pennsylvania
160
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Converting Expectation to Probability
The fund with the higher expectation has a greater probability of
outperforming the alternative fund. But what is the probability of
outperformance? To determine this, we need to compute a t-stat:
To determine the standard deviation of the difference: use the tools
from portfolio theory, such that x = 1 and y = -1, covariance between
the two funds equals zero.
Professor David Wessels
The Wharton School of the University of Pennsylvania
) B Cov(A, 2 ) Var(B y ) Var(A x ) R
~
Var(
2 2
p
xy + + =
B) (A
B) E(A
stat t

=
161
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Determining Probability of Outperformance
Required Steps:
1. Using the KS equation, compute
each funds predicted performance.
2. Determine a t-statistic by dividing
the difference by the standard
deviation of the difference. To
determine the standard deviation
of the difference, use the portfolio
rule introduced in a past lecture!
3. Use the PDF table found in every
statistics book to determine the
probability that the difference will
be positive.
Professor David Wessels
The Wharton School of the University of Pennsylvania
StandardNormal(Z)Table
Probability(RandomVariable>Cutoff)
Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.500 0.504 0.508 0.512 0.516 0.520 0.524 0.528 0.532 0.536
0.1 0.540 0.544 0.548 0.552 0.556 0.560 0.564 0.568 0.571 0.575
0.2 0.579 0.583 0.587 0.591 0.595 0.599 0.603 0.606 0.610 0.614
0.3 0.618 0.622 0.626 0.629 0.633 0.637 0.641 0.644 0.648 0.652
0.4 0.655 0.659 0.663 0.666 0.670 0.674 0.677 0.681 0.684 0.688
0.5 0.692 0.695 0.699 0.702 0.705 0.709 0.712 0.716 0.719 0.722
0.6 0.726 0.729 0.732 0.736 0.739 0.742 0.745 0.749 0.752 0.755
0.7 0.758 0.761 0.764 0.767 0.770 0.773 0.776 0.779 0.782 0.785
0.8 0.788 0.791 0.794 0.797 0.800 0.802 0.805 0.808 0.811 0.813
0.9 0.816 0.819 0.821 0.824 0.826 0.829 0.832 0.834 0.837 0.839
1.0 0.841 0.844 0.846 0.849 0.851 0.853 0.855 0.858 0.860 0.862
1.1 0.864 0.867 0.869 0.871 0.873 0.875 0.877 0.879 0.881 0.883
1.2 0.885 0.887 0.889 0.891 0.893 0.894 0.896 0.898 0.900 0.902
1.3 0.903 0.905 0.907 0.908 0.910 0.912 0.913 0.915 0.916 0.918
1.4 0.919 0.921 0.922 0.924 0.925 0.927 0.928 0.929 0.931 0.932
1.5 0.933 0.935 0.936 0.937 0.938 0.939 0.941 0.942 0.943 0.944
1.6 0.945 0.946 0.947 0.948 0.950 0.951 0.952 0.953 0.954 0.955
1.7 0.955 0.956 0.957 0.958 0.959 0.960 0.961 0.962 0.963 0.963
1.8 0.964 0.965 0.966 0.966 0.967 0.968 0.969 0.969 0.970 0.971
1.9 0.971 0.972 0.973 0.973 0.974 0.974 0.975 0.976 0.976 0.977
2.0 0.977 0.978 0.978 0.979 0.979 0.980 0.980 0.981 0.981 0.982
162
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Persistence does not Guarantee Performance
Professor David Wessels
The Wharton School of the University of Pennsylvania

5
4
%

4
8
%

4
2
%

3
6
%

3
0
%

2
4
%

1
8
%

1
2
%

6
%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
7
2
%
7
8
%
8
4
%
9
0
%
Wharton
Forecasted
IRR = 16.2%
Harvard
Forecasted
IRR = 8.6%
Standard
Deviation of
Fund Returns =
22.5%
163
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
But Why Does Persistence Occur in VC?
If mutual fund performance is not persistent, why is venture capital persistent?
Compare the mutual fund investment process to the venture capitalist.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Make
investment
How does the
search process
work?
At what price
is the security
purchased?
Hold the
investment
What occurs
during the
holding
period?
Liquidate the
investment
How does the
liquidation
process work?
At what price
is the security
liquidated?
Whartons David Hsu (JF 2004) studies a sample of companies that receive multiple VC
offers, and finds that offers made by VCs with a high reputation are three times more likely to
be accepted, and high-reputation VCs acquire start-up equity at a 1014% discount!
David Hsu, 2004. What Do Entrepreneurs Pay for Venture Capital Affiliation? Journal of Finance, American Financial Association 59: 1805-1844.
164
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
Can Skilled VCs Captures Greater Wealth?
Imagine a company with a great
product, such as an exciting new
game for the Nintendo Wii. How
would a smart entrepreneur increase
shareholder/personal wealth?
How is a venture capitalist different?
Should they capture greater wealth
in the same way as a traditional
business?
Why not grow? Why not charge
more?
Professor David Wessels
The Wharton School of the University of Pennsylvania
165
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
The Haves and the Have-Nots
CRV raises $375 million for new fund
by Dan Primack, March 2012.
Charles River Ventures today will announce that it has closed its fifteenth fund with $375 million in
capital commitments. The bi-coastal firm originally went out with a $300 million target just over two
months ago, and was oversubscribed well beyond what it ultimately accepted.
CRV still has some dry powder remaining in the $320 million fund it raised in early 2009, so don't expect
CRV XV to be tapped until the end of Q2 or early Q3. Recent IPOs for CRV portfolio companies include
RPX Corp. (RPXC), Broadsoft (BSFT) and The Active Network (ACTV). TechCrunch has more info.
This close both its size and speed fits into the VC market's larger narrative of haves and have-nots. A
group of around two dozen firms seems able to raise what they want, when they want. The rest spend
months, if not years, begging and pleading for a few LP crumbs. As the stratification continues to harden,
it will be interesting to see how many new firms are able to break through and if any of the current
"haves" will fall out of LP favor
Professor David Wessels
The Wharton School of the University of Pennsylvania
166
Venture Capital & the Finance of Innovation Lecture 7 - Measuring Fund-by-Fund Performance
End of Section 1
Valuing High Growth Companies
Professor David Wessels
The Wharton School of the University of Pennsylvania
167
Venture Capital & the Finance of Innovation
Screening New Venture Opportunities
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
8
Lecture 8 Screening Opportunities
168
Venture Capital & the Finance of Innovation
Best Practice versus Actual Practice
Professor David Wessels
The Wharton School of the University of Pennsylvania
EHarmony
Hot Or Not
Guy Kawasaki: The Art of Raising Venture Capital
Raising venture capital is like dating. There are two kinds of dating sites in the world. One is hot or not. There is
a picture of a person and you decide whether the person is hot or not, thats it. At the other extreme is e-harmony.
You create a psychographic. I am interested in long walks on the beach, I drive a Prius
Venture capital is hot or not. In the first five, ten or fifteen seconds, people decide and that has important
consequence. Many entrepreneurs spend the first fifteen minutes describing the background of the founders. Until I
know what they do, I could care less about their background.
Lecture 8 Screening Opportunities
169
Venture Capital & the Finance of Innovation
Screen the Opportunity
An entrepreneur enters your office. What makes the opportunity
interesting? Use five minutes to structure your criteria for instance,
use three main categories.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 8 Screening Opportunities
170
Venture Capital & the Finance of Innovation
A Fourth Dimension: Later Stage Deals
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 8 Screening Opportunities
171
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Key Value Drivers
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
9
172
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
Session Overview
Traditional rules of thumb about valuation can be misleading, and in some
cases harmful. We start our discussion by demonstrating why EBITDA &
Earnings Per Share (EPS) often fail to measure value
In the second part of our discussion, we demonstrate how the value of a
company can be traced to four key value drivers, core operating profit, return
on capital, cost of capital, and organic revenue growth
Value creation & the practice of finance is about tradeoffs. Although an action can
lead to an improvement in one metric (such as worker productivity), it may have an
adverse impact on other metrics, such as growth or capital required.
Every business, product category, customer group, channel, must be thoroughly
evaluated for the potential of growth and return on capital.
173
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
Two Simple Companies
Company A earns $100 million a year in after-tax profit. Part of the profit
will be reinvested in the business, the remainder distributed to investors.
EBIT (1-T)
=$100
Reinvested
in business
Returned
to investors
$50
$50
Reinvestment Rate (IR) =50%
Payout Rate =50%
Financial Term
EBITDA
=$180
$80
174
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Model of Two Simple Companies
Assume the company
plans to reinvest $50
million at a 10% rate of
return.
This investment leads to
an extra $5 million in
profits.
For simplicity, we assume
all ratios, investment rate
etc, never change.
CompanyA
Reinvestmentrate(IR) 50%
Returnonnewinvestment 10%
Growthinprofits 5%
Year1 Year2 Year3
Aftertaxoperatingprofit 100.0 105.0 110.3
NetInvestment (50.0) (52.5) (55.1)
Freecashflow 50.0 52.5 55.1
175
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
Which Company is Worth More?
Both Company A and Company B have a starting profit of $100 million
and expected growth in profits of 5%.
If both companies have 100 million shares outstanding, what would each
companys E.P.S. and E.P.S. growth rate be?
CompanyA CompanyB
Reinvestmentrate(IR) 50% Reinvestmentrate(IR) 25%
Returnonnewinvestment 10% Returnonnewinvestment 20%
Growthinprofits 5% Growthinprofits 5%
Year1 Year2 Year3 Year1 Year2 Year3
Aftertaxoperatingprofit 100.0 105.0 110.3 Aftertaxoperatingprofit 100.0 105.0 110.3
NetInvestment (50.0) (52.5) (55.1) NetInvestment (25.0) (26.3) (27.6)
Freecashflow 50.0 52.5 55.1 Freecashflow 75.0 78.8 82.7
176
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
EPS Growth: Only Part of the Story!
Boston Scientific 3rd-quarter loss narrows
Bill Berkrot, Reuters
NEW YORK, Oct 21 (Reuters) - Boston Scientific
reported a smaller third-quarter net loss on Tuesday as
increased sales of implantable defibrillators helped to
offset charges and a decline in sales of its drug-coated
stents.
The company's adjusted profit of 18 cents per share
topped Wall Street expectations by 2 cents, according
to Reuters Estimates. Total net sales for the quarter
fell to $1.98 billion from $2.05 billion, but that was in
line with Wall Street expectations.
"It was kind of an on-target quarter and right now with
Boston Scientific, not falling below the range of
expectations is a good thing," said Phillip Nalbone, an
analyst with RBC Capital Markets.
Source: Wall Street J ournal
Boston Scientific
Source: Yahoo! Finance
177
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Drivers of Profit Growth
Before we value the two companies, lets examine a general relation between
IR (reinvestment rate), ROIC (return on invested capital), and g (growth).
Growth =Reinvestment * Rate of Return
G = IR * ROIC
Company A
Reinvestment Rate (IR) 50%
Return on New Investment 10%
Growth in Profits 5%
Company B
Reinvestment Rate (IR) 25%
Return on New Investment 20%
Growth in Profits 5%
Company A: 5% =50% * 10%
Company B: 5% =25% * 20%
178
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
Session Overview
Traditional rules of thumb about valuation can be misleading, and in some
cases harmful. We start our discussion by disavowing two rules of thumb.
Lesson 1: Value is driven by growth, but not all growth is created equal
Lesson 2: EBITDA & Earnings Per Share (EPS) often fail to measure value
The value of a company can be traced to four key value drivers, core operating
profit, return on capital, cost of capital, and organic revenue growth
Value creation & the practice of finance is about tradeoffs. Although an action can lead to an
improvement in one metric (such as worker productivity), it may have an adverse impact on
other metrics, such as growth or capital required.
Everybusiness, product category, customer group, distribution channel, must be thoroughly
evaluated for the potential of growth and profitability.
179
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Growing Perpetuity Formula
A company is worth the present value of its future free cash flow. For example,
Company A can be valued as:
.........
WACC) (1
Flow Cash
WACC) (1
Flow Cash
WACC) (1
Flow Cash
Value
3
3
2
2 1
+
+
+
+
+
+
=
g WACC
Cashflow
Value
1

=
.........
10) . (1
55.1
(1.10)
52.5
10) . (1
50
Value
3 2
+ + + =
In our simple example, cash flows grow forever at a constant rate. Therefore, we
can use the growth perpetuity formula to value each company.
via the
Growing
Perpetuity
Formula
180
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
What Drives Value?
As Cash Flow rises, what happens to value?
As WACC rises, what happens to value?
As growth rises, what happens to value?
g WACC
Flow Cash
Value
1

=
But what
determines
cash flow?
181
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
Deriving the Key Value Driver Formula
In order to develop the key value driver formula, we will rely on two
simple substitutions.
g WACC
ROIC
g
1 Profit
g WACC
IR) Profit(1
g WACC
Flow Cash
Value
1

|
.
|

\
|

=

=
Substitution #1
Cash Flow =Profit (1 IR)
Substitution #2
Growth =IR x ROIC
182
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Key Value Driver Formula
g WACC
ROIC
g
1 Profit
Value

|
.
|

\
|

=
Company A
Company B
Terminology used by Consulting Firms
Profit After-tax Operating Profit (NOPAT/NOPLAT )
ROIC - Return on Invested Capital (ROI/RONIC/ROCE/RONA)
WACC - Weighted Average Cost of Capital (Hurdle Rate)
g Long term growth in profit and cashflows
183
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Driving Value through Organic Growth
You sit in corporate headquarters evaluating international expansion proposals.
Algeria (whose characteristics mirror company A) and Belgium (whose
characteristics mirror company B) are presenting their proposals.
Algeria can increase projected growth from 5% to 8% while Belgium can increase
it from 5% to 6%. If both countries require the same resources to accelerate growth
and headquarters can only fund one plan, which should it choose?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Algeria
Value =1000, Value =
Belgium
Value =1500, Value =
20
184
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
What Drives Value?
As starting Profit rises, what happens to value?
As ROIC rises, what happens to value?
As WACC rises, what happens to value?
As growth rises, what happens to value?
g WACC
ROIC
g
1 Profit
Value

|
.
|

\
|

=
185
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
As we will show later, if the spreadbetween ROIC and WACC is
positive, new growth creates value.
The market value of a company, with a starting Profit of $100 million,
and a 10% cost of capital, is as follows:
The Growth/Value Matrix
7.5% 10.0% 12.5% 15.0%
2% $917 1,000 1,050 1,083
Growth 4% 778 1,000 1,133 1,222
6% 500 1,000 1,300 1,500
ROIC
186
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
How Growth Drives Value
In 1995, two Fortune 500 companies had $20 billion in revenue. Since then
one company has grown dramatically. Which company is the high-growth
company? A or B?
0
20
40
60
80
1995 1998 2001 2004 2007 2010
$

b
i
l
l
i
o
n
s
AggregateRevenues
19952010
10.0%
4.4%
CompanyA
MarketCapitalization($billions) 146.6
EnterpriseValue($billions) 158.4
ForwardP/E(FYE'11) 18.1
PEGRatio(3yearexpected): 1.5
ROIC(viaThomsonFirstCall): 21.0%
CompanyB
MarketCapitalization($billions) 31.7
EnterpriseValue($billions) 34.0
ForwardP/E(FYE'11) 21.8
PEGRatio(5yrexpected): 1.2
ROIC(viaThomsonFirstCall): 9.6%
Source:ThomsonFirstCall,Jan11
187
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Value of Alternative Strategies
Assume your company earns a 15% return on invested capital, while growing
at 2%. The new CEO has argued the company should grow faster, even if it
means some sacrificing financial performance. What do you think?
Assume your company earns a 10% return on invested capital, while growing
at 6%. The new CEO has argued the company should focus on higher profit
customers, even if it means reducing growth. What do you think?
7.5% 10.0% 12.5% 15.0%
2% $917 1,000 1,050 1,083
Growth 4% 778 1,000 1,133 1,222
6% 500 1,000 1,300 1,500
ROIC
188
Venture Capital & the Finance of Innovation Lecture 9 Key Value Drivers
Professor David Wessels
The Wharton School of the University of Pennsylvania
As long as the spreadbetween ROIC and WACC is positive, new
growth creates value. In fact, the faster the firm grows, the more
value it creates.
If the spread is equal to zero, the firm creates no value through
growth. The firm is growing by taking on projects which have a net
present value of zero!
When the spread is negative, the firm destroys value by taking on new
projects. If a company can not earn the necessary return on a new
project or acquisition, its market value will drop (and often does).
Creating Value: To Review
189
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Evaluating High-Growth Opportunities
An Analysis of AtriCure
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
10
190
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Value Creation: A Focus on Key Value Drivers. A company / projects value
is driven by organic revenue growth and return on capital. For new
opportunities with great uncertainty, a top-down focus on critical value drivers
is more insightful than a detailed line-by-line valuation.
What are the long-run economics (margins, etc) of this business in this industry?
How quickly will the company move from its current performance to long-run
economics
Cash Burn: Value Drivers Also Drive Cash Burn. Unlike established
companies with easy access to capital, high growth companies must focus on
value creation and cash burn. When revenue growth outstrips return on capital,
the company will typically consume cash.
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Professor David Wessels
The Wharton School of the University of Pennsylvania
What Drives Value?
g WACC
ROIC
g
1 Profit
Value

A companys value is driven by:


Its ability to earn healthy margins, as
represented by its core operating profit
An ability to generate strong returns on
capital, through good margins and high
capital efficiency
A well-engineered cost of capital, through
the efficient use of debt and equity.
The ability to grow. Growth can come
through selecting high growth markets,
stealing share from others, and
acquisitions but each comes with its own
return characteristics!
The Zen of Corporate Finance
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Professor David Wessels
The Wharton School of the University of Pennsylvania
Dynamic Value Driver Framework: ROIC
A company / projects value is
driven by organic revenue growth
and return on capital.
For new opportunities with great
uncertainty, a top-down focus on
critical value drivers is more
insightful than a detailed line-by-
line valuation.
Start by assessing how, why, and
when ROIC will exceed the cost
of capital.
-10%
0%
10%
20%
30%
0 5 10 15 20
Time
ROIC and WACC Projections
Capital
Units
x
Units
Cost) (Revenue
ROIC

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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
An Example: Amgen
When companies are not earning
the cost of capital, you must
assess two questions:
How long will it take before
the company starts creating
value?
How large will the initial
investments (or losses) be?
Amgen failed to earn its cost of
capital until Epogen, its
blockbuster drug, was approved
by the FDA.
Professor David Wessels The Wharton School of the University of
Pennsylvania
Percent
ROIC at Amgen (1984- 2003)
ROIC measured as 3-year rolling average
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
An Example: Intel
Two distinct periods of value creation
have occurred at Intel Corporation:
Memory chips in the 1970s and
Microprocessors in the 1990s.
Although an early leader in memory
chips, new foreign competition
lowered prices, driving down ROIC.
In the 1990s, Intel reestablishes a
competitive advantage through its
reinvention as the brains of the
personal computer.
Professor David Wessels The Wharton School of the University of
Pennsylvania
ROIC at Intel Corporation (1973- 2003)
ROIC measured as 3-year rolling average
Percent
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
ROIC Decay Rates
ROIC demonstrates a pattern of mean reversion. Companies earning high
returns tend to gradually fall over the next fifteen years and companies earning
low returns tend to rise over time.
Professor David Wessels The Wharton School of the University of
Pennsylvania
ROIC
Percent
>20
15-20
10-15
5-10
<5
Number of years following portfolio formation
Median ROIC of portfolio*
At time zero,
companies are grouped
into one of five
portfolios, ranked by
their current ROIC
Source:Compustat; McKinsey & Companys corporate performance database
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Professor David Wessels The Wharton School of the University of
Pennsylvania
Dynamic Model of Value Creation
Core Operations
Return on Capital
Time
Making the Investment
How large is the
necessary investment?
Are investments tangible
or intangible?
How long will it take to
get to market?
Capturing the Return
What is the maximum return on
investment the business can provide?
Is the product differentiable?
Is the ROI driven by price premiums
or financial discipline?
Protecting the Return
Are there barriers to entry? How
quickly can competition duplicate our
efforts?
197
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Professor David Wessels
The Wharton School of the University of Pennsylvania
Dynamic Value Driver Framework: Growth
To value a new opportunity, you must size the
addressable market and project adoption rates.
Market sizing can be done top-down (through
filters) or bottom-up (through channel aggregation).
A helpful tool is Everett Rogers Innovation
ACCORD model, which examines the product or
service from the customers perspective:
Relative (A)dvantageto what it replaces
Compatibility with current behaviors / systems
Complexity of communicating the benefits
Observabilityof the products benefits
Risk of product failure
Divisibility or trialability.
0
20
40
60
80
100
0 5 10 15 20
$

m
i
l
l
i
o
n
s
Time
Revenue Projections
Initial
investment
Liquidity
event
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Market Sizing: A Momentum Perspective
Knowing the size of an end market is a great start. But how quickly can companies
grow? We examined the growth rates of 100 publically traded technology start-ups
between 1995 and 2008.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Years 1-4 Years 5-8 Al l Years
Upper Quartile 89.0% 17.8% 49.3%
Median 52.4% 16.3% 33.1%
Lower Quartile 32.0% 13.8% 22.6%
Average Growth Rates by Peri od
0
50
100
150
200
250
300
1 2 3 4 5 6 7 8 9
$

m
i
l
l
i
o
n
s
RevenueforPublicTechnologyStartUps
afterReachingthe$10millionThreshold
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Market Sizing: A Momentum Perspective
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: New York Times
With advances in distributional channels and the improved availability of
external funding, time to full penetration has dwindled. Whereas, the
computer took 50 years to capture 60% share, the Internet accomplished
60% share in fifteen years.
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Professor David Wessels The Wharton School of the University of
Pennsylvania
ROIC vs. DCF Valuations
Core Operations
Cash Flow Projections
Time
0
requires consistency
Core Operations
Return on Capital
Time
Measuring how cash flows through the firm is simple and cash flow is difficult
to game. Consequently, DCF is a favorite among academics.
ROIC-based valuation, however, tie much more closely to corporate strategy,
competitive positioning, barriers to entry, etc. Both provide benefits!
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
An Analysis of AtriCure
Professor David Wessels
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
202
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
AtriCure: The Product
Professor David Wessels
The Wharton School of the University of Pennsylvania
Ablation
In medicine, ablation is the
removal of a part of biological
tissue, usually by surgery.
Surface ablation in the skin (also
called resurfacing, because it
induces regeneration) can be
carried out by chemicals
(peeling) or by lasers.
AF (Atrial Fibrillation)
AF is the fibrillating (i.e.,
quivering) of the heart
muscles of the atria, instead of
a coordinated contraction.
The atria are the chambers in
which blood enters the heart,
as opposed to the ventricle,
where blood is pushed out to
the organs.
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
AtriCure: The Founder
AtriCurewas founded by
Mike Hoovenin West
Chester, Ohio (outside of
Cincinnati).
Not well known as a capital
of innovation, why would a
founder choose West
Chester, Ohio to
headquarter a company?
Professor David Wessels
The Wharton School of the University of Pennsylvania
West Chester, Ohio
AtriCure
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
AtriCure: The Founder
AtriCurewas founded by Mike Hoovenin 2001. Prior to launching
AtriCure, Hoovenwas director of new product development for
Ethicon Endo-Surgery, a J ohnson & J ohnson operating company
located in the Cincinnati suburbs. "I told my superiors right from the
start that I wanted to work here for about five years, get the experience,
and make the contacts so I could start my own business and sell
products back to the J &J 's of the world
Based on Hoovenswork experience, what are the positives associated
with his background? What are the negatives?
Professor David Wessels
The Wharton School of the University of Pennsylvania
RIM
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
AtriCure: The Investors
In its first outside investment, the company issued
2,182,521 shares of Series A Preferred Stock at
$2.39 per share to U.S. Ventures. In exchange for
the Series A Preferred Stock, the Company
received $4,025,000 in cash and converted a
$1,150,000 promissory noteand the related
accrued interest of $49,958.
In the second round, AtriCure issued 3,829,499
shares of Series B Preferred Stock at $5.43 per
share. In exchange for the Series B Preferred
Stock, the Company received $17,274,500 in cash
and converted a $3,500,000 note and the related
accrued interest of $35,000. Second round
financed by Camden Partners, Charter Ventures,
Foundation Medical Partners.
Professor David Wessels
The Wharton School of the University of Pennsylvania
20
1,766
9,792
19,157
30,957
Founding Year2 Year3 Year4 Current
AtriCure
Revenuesin$thousands
Series A Series B
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
U.S. Ventures (USVP)
Professor David Wessels
The Wharton School of the University of Pennsylvania
Since 1981, USVP has invested more than $1.8
billion in over 350 companies. More than 70
companies achieved IPO. Many others have
realized positive merger outcomes
Bill Bowes, who has 50 years of venture
investment experience, was also the founder of
Amgen, a $70 billion pharmaceutical company.
The firms investment interests include
components, software, systems, services, and
life sciences. Areas of current focus include
semiconductors, software as a service,
networking solutions for storage, wireless data,
the Internet version 2.0, biomedical devices and
new drugs with profound social benefits.
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Due Diligence: Value Creation
Imagine you are taking a meeting with the founder of AtriCure. Using the value
creation framework we developed earlier in class, take notes on pertinent information.
At the end of the video, be prepared to present your thoughts.
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
A Note on Technical Expertise
The benefits of this procedure are the immediate confirmation of a
transmural ablation line as exhibited by the presence of an entrance
and exit block. The disappearance of the excitation from the
ganglionicplexi and the removal of the left atrial appendage. 5:39.
Professor David Wessels
The Wharton School of the University of Pennsylvania
209
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Innovation and the Status Quo
Drug Therapies. Currently available drugs are often ineffective, not well-tolerated and may be associated with severe
side effects. For these reasons, drug therapy for AF fails for as many as 50% of patients within one year. Of those who
initially respond to drug therapy, only approximately 25% of patients can continue to be managed with drugs after five
years.
Implantable Devices. Implantable devices, such as defibrillatorsand pacemakers, can be effective in reducing the
symptoms and frequency of AF episodes, but neither device is intended to treat AF. Patients may continue to experience
the adverse effects of AF as well as some of the symptoms and complications, including dizziness, fatigue, palpitations
and stroke, because the AF continues.
Catheter-Based Treatment. A catheter ablation is an ablation procedure that is typically performed by an
electrophysiologist. The ablations are made from the inside of the heart using a flexible catheter. The heart is reached via
a blood vessel, most commonly through the femoral vein. Catheter-based AF treatments are often technically challenging,
can be associated with serious complications and have been known to yield inconsistent results. In proportion to the
prevalence of AF, only a small number of catheter-based AF treatments are performed each year in the United States.
Cut and Sew Maze. The cut and sew Maze procedure is a highly invasive open-heart surgical procedure that involves the
use of a heart-lung bypass machine and cutting and sewing back together sections of the heart in order to block the
abnormal electrical impulses causing AF. Although this procedure is highly effective at treating AF, it is rarely performed
because it requires extensive open-heart surgery, is technically challenging and is typically associated with long recovery
times. For these reasons, only a limited number of these procedures have been performed by a small number of
cardiothoracic surgeons.
Professor David Wessels
The Wharton School of the University of Pennsylvania
According to AtriCure:
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Value Creation: Analyzing Magnitude
Assessing the level of innovation is subjective and requires synthesis of
multiple points of information. For instance, consider the analysis presented
by our expert (Wharton graduate and physician) AmanKumar:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Option How
Invasive
Local or General
Anesthetic
Op Time Time in
Hospital
Success Rate
Drug Therapy 1 - - - 50-80%
DC Cardioversion 2 LA +sedation hr <1day <50%
Catheter Ablation 4 LA +sedation 2hrs <1day 70%
Pacemaker 5 LA 1-2hr 1day 99%
Thorascopic
Ablation
8 GA 2-3hrs 3-4 days 80-85%
Cox-Maze(III)
Procedure
10 GA 2-4hrs 5-7 days >95%
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Customer Need: Who is the Customer?
The end customer is clearly the patient. But many others will influence
the purchase decision, and subsequently the ability for AtriCure to
generate revenue. Who are the influencers?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Patient
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Status Quo: The Doctors Perspective
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Manual of Intensive Care, Irwin and Rippe
While the consumer has some clout in the treatment process, the key decision maker is
the doctor. The current decision process for the treatment of Atrial Fibrilationis outlined
below:
Synchronized
DC
cardioversion
AtrialFibrilation
Considerpossibleunderlyingcauses
Hemodynamically stable/lesssevere
symptoms
Hemodynamically
unstableorsevere
symptomsattributable
toatrialfibrilation;
angina,heartfailure
Ratecontrol
blocker
CalciumChannel
Blocker
Digoxin
Amoidarone
Durationof
AF<48h
Duration
ofAF>48
hor
uncertain
Pharmacologiccardioversion (classIa,
Ic,orclassIIIagent)
or
ElectiveDCcardioversion
or
LongTermStrategyofratecontrol
andanticoagulation
Coumadin (warfarin) withINR
23for3weeksbeforeand4
weeksafterelectiveDC
cardioversion
or
TEEtoexcludeleftatrial
thrombus,IVheparin,early
DCcardioversion followedby
>4weekswarfarin
or
Longtermstrategyofrate
controlandanticoagulation
LongtermcoagulationifrecurrentAF
andmoderateorhighrisk.Consider
longtermantiarrhythmicorrate
controltherapyifrecurrent
What Does it Mean in English?
Hemodynamically stable normal
circulation of blood, normal blood pressure.
Coumadin (warfarin) - a controversial drug
initially used as a pesticide against rats and
mice, now used to prevent blood clots from
forming (anticoagulant). A common side
effect is hemorrhage (internal bleeding),
which is the method used to kill rodents and
by which it adversely affects many patients.
Cardioversion - medical procedure by which
an abnormally fast heart rate is converted to a
normal rhythm by using electricity or drugs.
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Due Diligence: Market Sizing
Professor David Wessels
The Wharton School of the University of Pennsylvania
What opportunities generate excitement among venture capitals and senior executive
teams alike? Those that open the doors to large market opportunities. For AtriCure,
how large is the market for RF ablation?
Infiniti Medical LLC
Addressable
Market
Largest
Possible
Market
1.
2.
3.
4.
5.
6.
7.
Subset
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Market Sizing as a Roadmap to Growth
A good market sizing analysis can lead not just to an appropriate market size, but also a
road map for growth plateaus. Once a plateau is reached, the company can release the
next filter point to generate new growth.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Affordability
Proper Diagnosis
0
50
100
150
200
250
300
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
$

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s
ForecastYear
PortfolioCo
RevenueProjections
Affordability
ProperDiagnosis
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Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Market Sizing: Academic Research
From four large recent population-based surveys, we estimated the overall age- and gender-specific
prevalence of AF. These estimates were applied to the recent US census data to calculate the number
of men and women with AF in each age group. There are an estimated 2.2 million people in the
United States with AF, with a median age of about 75 years. The prevalence of AF is 2.3% in people
older than 40 years and 5.9% in those older than 65 years. Approximately 70% of individuals with
AF are between 65 and 85 years of age
1
.
The number of patients with AF is increasing throughout the industrialized world as the population
ages. In the United States, the prevalence of AF is expected to grow 2.5-fold to 5.6 million by 2050,
and over half of those afflicted will be age 80 or older. As the burden of this disorder grows,
increased emphasis will be placed on developing more effective ways to treat AF to reduce its
associated morbidity and mortality
2
.
1. Feinberg WM, Blackshear J L, LaupacisA, Kronmal R, Hart RG. Prevalence, age distribution, and gender of patients with atrial
fibrillation. Arch Intern Med. 1995;155:469-473.
2. Go AS, HylekEM, Phillips KA, Chang Y, HenaultLE, Selby J V, Singer DE. Prevalence of diagnosed atrial fibrillation in
adults: National implications for rhythm management and stroke prevention: the AnTicoagulationand Risk Factors in Atrial
Fibrillation (ATRIA) study. J AMA. 2001;285:2370-2375.
Professor David Wessels
The Wharton School of the University of Pennsylvania
216
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
Appendix
Professor David Wessels
The Wharton School of the University of Pennsylvania
217
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
The Story behind AtriCure
The traditional notion is that entrepreneurs are born and not bred-either you've got that risk-taking spirit in your core and you can deal with the
uncertainties that go along with start-up culture, or you don't. For Mike Hooven, founder, president and CEO of West Chester, Ohio-based
AtriCure Inc., there was never any doubt about which group he fell into. Prior to launching AtriCure, Hoovenwas director of new product
development for Ethicon Endo-Surgery, a J ohnson & J ohnson operating company located in the Cincinnati suburbs. "I told my superiors right
from the start that I wanted to work here for about five years, get the experience, and make the contacts so I could start myown business and sell
products back to the J &J 's of the world," Hoovenexplains.
For Hooven, the entrepreneurial itch was so strong that when, true to his plan, he left Ethicon in April 1994 to found his own company, Enable
Medical Inc., it was without the slightest notion of what kind of technology or what clinical area Enable would focus on. One of the first things
Hoovenset out to do was meet with physicians in an effort to come up with an unmet clinical need for which he could develop a new product.
Dan Smith, MD, a surgeon who had recently joined the faculty of the University of Cincinnati Medical Center from the Mayo Clinic, was among
the first clinicians Hoovenmet with, and when Hooventold Smith he had just started a medical device company, Smith said, "OK, show me
what you've got." Hoovenhanded Smith his business card and said, "That's it.
Hoovenused his contacts with physicians like Smith and his own device background to look at a range of technologies and clinical applications,
and initially drew upon his background at Ethicon in radio-frequency (RF) energy devices to set the product development path in motion at
Enable. The company developed a variety of instruments for endoscopic and minimally invasive surgery (MIS) that were sold both as OEM and
branded devices. After employing this strategy for five years at Enable, Hoovengot some unsolicited advice from his mentor and Enable
investor, Norm Weldon. "I told him, 'None of us is ever going to make any real money unless we can concentrate on a single, high value, large
market opportunity,'" Weldon recalls. At that point, Hoovencame under the tutelage of Enable board member, Donald Harrison, MD, former
chief of cardiology at the Stanford University Medical Center, then at the University of Cincinnati, who helped Hoovenexplore potential market
opportunities. Based on those discussions, Hoovencame up with an idea for an atrial fibrillation (AF) device. While that initial device proved
unsuccessful, Hoovenrealized that he had found the major opportunity he'd been after, and in November 2000, spun AtriCure out of Enable to
focus exclusively on AF. Atrial fibrillation, once thought of as a benign condition affecting a relatively small patient population, has recently
been found to be a major contributor to stroke and congestive heart failure (CHF), and to afflict a much larger patient pool, particularly as the
population ages, making AF one of the largest unmet cardiovascular clinical opportunities.
Professor David Wessels
The Wharton School of the University of Pennsylvania
218
Venture Capital & the Finance of Innovation Lecture 10 - Evaluating High Growth Opportunities
The Story behind AtriCure
AtriCure'sproprietary RF ablation technology will be used either as an adjunct to a cardiothoracic procedure or as a stand-alone minimally
invasive procedure. The significance of this technology is that it provides surgeons with an elegant device that ensures the creation of
transmural lesions (completely penetrating tissue), which have been shown, through a complex surgical procedure, to be the only way to cure
AF. All other current available means of treating AF are palliative, not curative. The curative surgical procedure is a traumatic surgery called
the Maze procedure, which because it is so hard on the patient and complex for the surgeon, is rarely performed. Palliative treatments are
limited to drug regimens that are often ineffective and can produce serious side effects, or electrophysiology (EP) and cardiac rhythm
management procedures that are only used for a relatively small number of patients since they only offer temporary relief.
Clearly the size of the AF market offers a tremendous opportunity for a start-up like AtriCure, even in its initial ability to address only a
segment of the total AF patient pool. But this opportunity does not come without challenges. Cardiovascular surgeons are notoriously slow
adopters of new technology. AtriCure claims that initial surgeon reaction to its device has been extremely positive because it is very easy to
use and requires no significant learning curve. And the company also knows that, with surgeons losing increasing numbers of potential bypass
surgery candidates to interventional cardiologists, a trend that only looks to continue with the advent of drug-coated stents, a device that may
open up a new patient population for surgeons may be welcomed.
But every major cardiovascular device company is looking to enter the AF space, as are many start-ups, utilizing a variety of energy sources
and both surgical and interventional approaches. The question for AtriCure is whether its first-mover advantage in generating transmural
lesions, which is likely to result in the company's device being used initially by surgeons for the adjunctive treatment of AF, can provide the
company with the momentum that will enable it to drive more broad-based adoption aimed at the ultimate goal of treating AF as a stand-alone
procedure. Phrased differently: can AtriCure establish itself as a technology leader in this market in time to withstand the inevitable stampede
of competition that is likely not far behind, or will it ultimately remain a niche player?
Professor David Wessels
The Wharton School of the University of Pennsylvania
219
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Value Creation:
Value Drivers and Cash Burn
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
11
220
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
The Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Value Creation: A Focus on Key Value Drivers. A company / projects value
is driven by organic revenue growth and return on capital. For new
opportunities with great uncertainty, a top-down focus on critical value drivers
is more insightful than a detailed line-by-line valuation.
What are the long-run economics (margins, etc) of this business in this industry?
How quickly will the company move from its current performance to long-run
economics
The Link between Value Drivers and Cash Burn. Unlike established
companies with easy access to capital, high growth companies must focus on
value creation and cash burn. When revenue growth outstrips return on capital,
the company will typically consume cash.
221
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Growing Company
How quickly a company can grow depends on four key variables: operating
margin, capital efficiency, cash buffer (leverage), and investor payout.
Key Drivers
Operating
margin =
Capital
turnover =
Cash reserves =30%
Investor
payout rate =15%
Revenue growth =
CashBurnCo
Fi nanci al Statements
Item Amount NetAssets DebtandEquity
Revenues 2,000 Operati ngcapi tal 1,200 Debt 0
Operati ngexpenses (1,800) Cashreserves 360 Equi ty 1,560
Aftertaxprofi t 200 Total fundsi nvested 1,560 Total fundsi nvested 1,560
Item Amount Assets Liabilities
Revenues 2,245 Operati ngcapi tal Debt
Expenses Cashreserves Equi ty
Aftertaxprofi t Total fundsi nvested Total fundsi nvested
Operati ngcapi tal equal soperati ngassets(i nventory,PP&E,etc)l essoperati ngl i abi l i ti es(payabl es,etc)
BalanceSheet2011
BalanceSheet2012E
IncomeStatement2011
IncomeStatement2012E
222
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
An Example of a Cash Shortfall
Key Drivers
Operating
margin =10%
Capital
turnover =1.67
Cash reserves =30%
Investor
payout rate =15%
Revenue growth =30%
If revenue growth is too high, the project/company will run out of cash. To
prevent this, profitability needs to improve, capital efficiency must rise, or the
company must raise capital.
CashBurnCo
Fi nanci al Statements
Item Amount NetAssets DebtandEquity
Revenues 2,000 Operati ngcapi tal 1,200 Debt 0
Operati ngexpenses (1,800) Cashreserves 360 Equi ty 1,560
Aftertaxprofi t 200 Total fundsi nvested 1,560 Total fundsi nvested 1,560
Item Amount Assets Liabilities
Revenues 2,600 Operati ngcapi tal Debt
Expenses Cashreserves Equi ty
Aftertaxprofi t Total fundsi nvested Total fundsi nvested
Operati ngcapi tal equal soperati ngassets(i nventory,PP&E,etc)l essoperati ngl i abi l i ti es(payabl es,etc)
IncomeStatement2011 BalanceSheet2011
IncomeStatement2012E BalanceSheet2012E
223
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Sustainable Growth Rate: Derivation
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OC
S
2
1
1
1
1
1
2
2
2
2
2
+
|
|
.
|

\
|
|
|
.
|

\
|
=
|
|
.
|

\
|
|
|
.
|

\
|
( ) d) (1 P
OC
E
S
OC
S S
2 1 2
=
|
.
|

\
|
|
.
|

\
|

As a general rule, a companys current equity equals its previous equity plus reinvested
profit. Reinvested profit equals after-tax operating profit less after-tax interest and
dividends. We proxy for interest and dividends, by using a investor payout rate (d).
Next we multiply both sides by Sales / Sales and Operating Capital / Operating
Capital to create ratios which contain the inverse of capital turnover and financial
leverage:
Next, we assume that capital turnover and the cash buffer wont change. Thus, we
eliminate the subscripts and rearrange:
d) (1 P E E
2 1 2
+ =
224
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
The Sustainable Growth Rate: Derivation
Professor David Wessels
The Wharton School of the University of Pennsylvania
( ) d) (1 P
OC
Cash OC
S
OC
S S
2 1 2
=
|
.
|

\
|
+
|
.
|

\
|

( ) d) (1 P
OC
Cash
1
S
OC
S S
2 1 2
=
|
.
|

\
|
+
|
.
|

\
|

( )
d) (1
S
P
S
OC
Cash
1
S
OC
S
S S
S
2
2
2
1
1 2
1
=
|
.
|

\
|
+
|
.
|

\
|

Next, multiply the left side by S


1
/S
1
and the right side by S
2
/S
2
.
Simplify the term the third term:
From the previous slide, convert equity (E) into OC +Cash. Note, this assumes the
start-up has no debt. For companies that can raise debt, substitute D +E for Operating
Capital (on the last slide).
225
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Sustainable Growth Rate: Derivation
Move S
1
, asset turns, and financial leverage to the right.
Given that g =(S
2
S
1
)/ S
1
, and 1+g =S
2
/ S
1
,
OC
Cash
1
d) (1
OC
S
S
P
S
S
g
1
2
+

|
.
|

\
|
|
.
|

\
|
|
|
.
|

\
|
=
We are close, but have the following ugly equation:
x
g 1
g
=
+
OC
Cash
1
d) (1
OC
S
S
P
g 1
g
+

|
.
|

\
|
|
.
|

\
|
=
+
x - 1
x
g=
226
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Sustainable Growth Rate
Given a fixed (1) return on invested capital, (2) financial leverage ratio, and (2) re-
investment rate, the sustainable sales growth is pre-determined.
Revisit CashburnCo from earlier in this note. Based on the characteristics of this company,
what is the companys sustainable growth rate?
( )( )
( )
(1 payout)
step1 margin capital productivity
1 cashcushion

=
+
step 1
sustainable growth
1- step 1
=
ROIC Financial Flexibility
227
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Sustainable Growth Rate: No New Equity
How quickly a company can grow depends on four key variables: operating
margin, capital efficiency, cash reserves, and investor payout.
CashBurnCo
Fi nanci al Statements
Item Amount NetAssets DebtandEquity
Revenues 2,000 Operati ngcapi tal 1,200 Debt 0
Operati ngexpenses (1,800) Cashreserves 360 Equi ty 1,560
Aftertaxprofi t 200 Total fundsi nvested 1,560 Total fundsi nvested 1,560
Item Amount Assets Liabilities
Revenues 2,245 Operati ngcapi tal 1,347 Debt 0
Expenses (2,020) Cashreserves 404 Equi ty 1,751
Aftertaxprofi t 224 Total fundsi nvested 1,751 Total fundsi nvested 1,751
Operati ngcapi tal equal soperati ngassets(i nventory,PP&E,etc)l essoperati ngl i abi l i ti es(payabl es,etc)
IncomeStatement2011 BalanceSheet2011
IncomeStatement2012E BalanceSheet2012E
Key Drivers
Operating
margin =10%
Capital
turnover =1.67
Cash reserves =30%
Investor
payout rate =15%
Revenue growth =12.2%
228
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Need to Raise Additional Capital
When growth occurs too quickly, i.e. actual growth exceeds return on
capital x leverage x payout, there will be a cash shortfall.
To avoid raising additional capital, ROIC needs to improve, payout
must drop, the firm must borrow beyond expected levels. Otherwise,
additional capital will need to be raised.
* Traditional research, as reported in Smith and Smith (2003) and Higgins (2006), uses net income and total assets to determine the sustainable
growth in equity. Our definition focuses on operating profit, operating capital, and growth in sales.
ROIC x Financial Flexibility
g
1- ROIC x Financial Flexibility
>
actual growth
sustainable growth
For startups, financial
flexibility equals
(1-d) / (1+cusion).
For companies with debt,
financial flexibility equals
(1-d) x (1 +D/E).
229
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
Professor David Wessels
The Wharton School of the University of Pennsylvania
Start-Ups: No Payout or Cash Cushion
Given a fixed (1) return on invested capital, (2) financial leverage ratio, and (2) re-
investment rate, the sustainable sales growth is pre-determined.
For the typical startup, payout =0 and the cash cushion can be drained to zero. In this case:
( )( )
( ) cushion cash 1
payout) (1
ty productivi capital margin x
+

=
( )( ) ROIC ty productivi capital margin x = =
ROIC
ROIC - 1
ROIC
g ~ =
230
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
ROIC & Growth Drive Cash Burn
Overlaying the two key value drivers, we can determine when a company will
need to raise additional capital. This is consistent with startups requiring capital
and mature companies generating significant cash.
Professor David Wessels
The Wharton School of the University of Pennsylvania
30%
20%
10%
0%
10%
20%
30%
40%
50%
0 5 10 15 20
Year
KeyValueDrivers
ValueCreation
30%
20%
10%
0%
10%
20%
30%
40%
50%
0 5 10 15 20
Year
KeyValueDrivers
CashBurnRates
The value of a company
should not depend on the
methodology used. So why do
the areas look so different?
231
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
The Discipline of Capital Markets
In this class, we are
focused on the early
years of value creation.
Interesting dynamics
happen in the later years
as well.
If you were on the board
of directors of the
company on the right,
what would you
recommend to the board
in year 15?
Professor David Wessels
The Wharton School of the University of Pennsylvania
15%
5%
5%
15%
25%
0 5 10 15 20
Year
KeyValueDrivers
ValueCreation
232
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
An Example: CashBurn Co
You project the revenue growth and return on capital for CashBurn Co, a high-growth
start-up. The company has $4 million in cash reserves generated from a Series A
financing.
Based on the projections below, when will it need another round of financing?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
5
10
15
20
25
1 2 3 4 5 6 7 8 9
$

m
i
l
l
i
o
n
s
Yearssince SeriesA Round
CashBurnCo
RevenueProjections
30%
20%
10%
0%
10%
20%
30%
40%
1 2 3 4 5 6 7 8 9
Yearssince SeriesA Round
CashBurnCo
Return oncapital
233
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
CashBurn Co: Cumulative Cash Needs
When ROIC is below revenue growth, cash is consumed. Therefore, the
company will need funding through year 5. According to the cash burn
calculations, the original financing will finance only 3 years under the current
projections.
Professor David Wessels
The Wharton School of the University of Pennsylvania
40%
20%
0%
20%
40%
4
3
2
1
0
1
2
3
4
1 2 3 4 5 6 7 8 9
$

m
i
l
l
i
o
n
s

Yearssince SeriesA round


CashBurnCo
CashFlowProjections
Revenue
growth
Annual
cashburn
0.1
1.7
4.3
7.0
8.5
7.9
5.7
2.6
1.0
2
0
2
4
6
8
10
1 2 3 4 5 6 7 8 9
$

m
i
l
l
i
o
n
s
Yearssince SeriesA round
CashBurnCo
CumulativeCashBurn
234
Venture Capital & the Finance of Innovation Lecture 11 - Value Drivers and Cash Burn
CashBurn Co: Financial Data
Professor David Wessels
The Wharton School of the University of Pennsylvania
CashBurnCo
CashBurnusingKeyValueDrivers
$millions Year1 Year2 Year3 Year4 Year5 Year6 Year7 Year8 Year9
Revenue 1.00 3.50 7.88 12.80 16.80 19.42 20.94 21.76 22.18
Costofsales (1.10) (3.82) (8.35) (13.05) (16.29) (17.48) (18.01) (18.17) (18.41)
Aftertaxprofits(EBITA) (0.10) (0.32) (0.47) (0.26) 0.50 1.94 2.93 3.59 3.77
Incrementalcapital n/a (1.25) (2.19) (2.46) (2.00) (1.31) (0.76) (0.41) (0.21)
Freecashflow (0.10) (1.57) (2.66) (2.72) (1.50) 0.63 2.17 3.18 3.56
SupplementalCalculations:
Operatingcapital 0.50 1.75 3.94 6.40 8.40 9.71 10.47 10.88 11.09
Cumulativecashneeds 0.10 1.67 4.33 7.04 8.54 7.91 5.74 2.55 1.00
KeyValueDrivers
percent Year1 Year2 Year3 Year4 Year5 Year6 Year7 Year8 Year9
Revenuegrowth 500% 250% 125% 63% 31% 16% 8% 4% 2%
Aftertaxoperatingprofit 10% 9% 6% 2% 3% 10% 14% 17% 17%
Capitalturnover 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0
Returnoncapital 20% 18% 12% 4% 6% 20% 28% 33% 34%
235
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Venture Capital Valuation:
Mapping Value Drivers to DCF
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
12
236
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
A Practical Perspective on VC Valuation
Many venture capitalists have their own sweet spot for ownership percentages and
funding amounts for Series A investments. What implication does this have for
valuation? How should the founder respond?
Professor David Wessels
The Wharton School of the University of Pennsylvania
25% 27% 29% 31% 33% 35% 37% 39% 41% 43% 45%
RedCapVentures
OwnershipPercent(SeriesA)
2.00 2.25 2.50 2.75 3.00 3.25 3.50
RedCapVentures
AmountInvested(SeriesA)
$millions
Reluctance Reluctance Reluctance Reluctance
237
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Industry Data on Ownership and Capital, Q3 2011
We do not invest strictly based on discounted cash flow or a terminal value.
Our primary goal is to invest in companies that will become a lasting and
strong presence in very large markets. High Profile VC.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Wilson Sonsini Entrepreneurs Report, 2011. WSGR Database.
Implied
Valuation
238
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Financial Analysis of AtriCure
Professor David Wessels
The Wharton School of the University of Pennsylvania
The key value driver formula relied on a perpetuity which assumes
the company has reached a steady state. For Atricure, neither growth
rates or margins are stable. Therefore, we rely on a five-year forecast
model, combined with a reasoned exit multiple.
In this VC valuation model:
The first five years of cash flows are projected and discounted
The terminal value is determined using a intermediate or steady-state
competitor multiple (i.e. a competitor who is at steady-state today).
239
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
Basic Valuation Framework
AtriCureInc
HybridDCFValuation
$thousands Today Year1 Year2 Year3 Year4 Year5
1 Revenues 30,957 39,006 48,367 59,492 72,580 83,467
2 EBITDA (10,643) (11,312) 2,805 5,949 10,887 20,867
Depreciation (160) (202) (250) (308) (375)
Operatingprofit(EBITA) (10,803) (11,513) 2,555 5,641 10,512
3 Operatingtaxes 4,030 (894) (1,975) (3,679)
Aftertaxoperatingprofit (7,484) 1,661 3,667 6,833
4 Incremental investment (1,730) (2,012) (2,391) (2,814) C.V.
Freecashflow (9,214) (352) 1,276 4,019 166,934 5
6 Discountfactor 1.09 1.19 1.30 1.41 1.41
Discountedcashflow (8,453) (296) 985 2,847 118,260
KeyValueDrivers
Revenuegrowth 26.0% 24.0% 23.0% 22.0% 15.0%
Cashoperatingmargin 29.0% 5.8% 10.0% 15.0% 25.0%
Capitalturnover 4.7 4.7 4.7 4.7 4.7
Forecast
240
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
Quantifying Value Drivers
A good historical analysis
might give some insights
concerning revenue growth
and capital productivity, but
is unlikely to tell you much
about margins.
To create a meaningful
valuation, you must bound
reasonable estimates of:
Key Inputs
1. Revenue growth. How fast is the aggregate market
growing? How fast is the company capturing relevant
share?
2. Operating margin. What do established companies in the
field generate in margins?
3. Operating tax rate. Does the company have tax loss
forward to shield future taxes?
4. Required investment. How much investor capital is
required to grow the business?
5. Terminal value. What is the appropriate terminal
multiple? Examine industry multiples company by
company to understand differences.
6. Discount rate. For venture funded companies, the
discount rate should be determined by the CAPM, not
arbitrary rates!
241
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Revenue Projections
The most critical aspect of valuing a venture opportunity is sizing the
relevant market. A top down forecast, starts with the global population
and narrows the market size by relevant discriminators.
Professor David Wessels
The Wharton School of the University of Pennsylvania
37
42
54
68
87
103
122
148
178
AtriCure
Founding
Year3 Year5 Year7 Year9
AggregateSurgicalAFMarket
RevenueForecast
$millions
Global Population
Heart Conditions
Atrial Fibrillation
Geographic Screen
Proper Diagnosis
Severity
Source: Rodman & RenshawProjections
242
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Competitive Landscape
The most critical aspect of valuing a venture opportunity is sizing the
relevant market. How fast is the market growing, who are the major
players? Why are they gaining or losing share?
Professor David Wessels
The Wharton School of the University of Pennsylvania
AggregateSurgicalAFMarket
Revenuesharebycompetitor
Marketshare Year2 Year3 Year4 Current Year6 Year7 Year8 Year9
Medtronic 58.3% 55.5% 47.1% 41.3% 37.5% 37.0% 36.7% 36.0% 35.2%
AtriCure 0.1% 4.2% 18.1% 28.1% 35.7% 37.2% 39.5% 40.3% 41.0%
Getinge 16.2% 15.3% 12.9% 11.2% 9.7% 9.5% 9.4% 9.1% 8.9%
CryoCath 14.1% 14.4% 13.1% 12.0% 11.0% 10.9% 4.3% 0.0% 0.0%
ATS 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 5.3% 10.3% 11.2%
Other 11.3% 10.5% 8.7% 7.3% 6.1% 5.5% 4.9% 4.3% 3.8%
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
AtriCure 0.0 1.8 9.8 19.1 31.1 38.3 48.2 59.6 73.0
Source:Rodman&RenshawProjections
AtriCure
Founding
243
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Side Note on Revenue: Quality
Some Due Diligence:
Aehr (pronounced "air) with $30 million in revenue, makes gear that tests
logic and memory semiconductors to weed out defective devices. Its burn-in
systems test chips' reliability under stress by exposing them to high
temperatures and voltages.
Sales to the Company's five largest customers accounted for approximately 85%, 85%,
and 95% of its net sales in fiscal 2011, 2010 and 2009, respectively.
During fiscal 2011, SpansionInc., or Spansion, and Texas Instruments Incorporated
accounted for approximately 61% and 11%, respectively, of the Company's net
sales.
During fiscal 2010, Spansion, MicronasSemiconductor Holding AG and Texas
Instruments Incorporated accounted for approximately 55%, 12% and 11%,
respectively, of the Company's net sales.
244
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Moving from Accounting to Economic Profits
Professor David Wessels
The Wharton School of the University of Pennsylvania
The second most critical
element of high-growth
valuation is to develop a
perspective on margins.
From an accounting basis, the
company is losing money.
Why might the losses be
overstated?
How could we adjust after-tax
profits to account for
investments in intangible
assets?
AtriCureInc
IncomeStatement
$thousands Year2 Year3 Year4 Current
Revenues 20 1,766 9,792 19,157 30,957
Costofrevenues (8) (681) (2,612) (5,202) (8,057)
Grossprofit 12 1,085 7,180 13,955 22,900
Researchanddevelopment (1,838) (2,721) (2,501) (4,422) (9,109)
Sellingandgeneralexpenses (1,314) (4,026) (8,036) (15,169) (24,594)
Lossfromoperations (3,140) (5,662) (3,357) (5,636) (10,803)
Preferredstockinterest (469) (2,563) (3,905) (3,905) (2,332)
Otherincome(expense) 13 (806) 154 106 499
Lossbeforeincometaxes (3,596) (9,031) (7,108) (9,435) (12,636)
Incometaxexpense 0 0 0 (17) (47)
Netincome(loss) (3,596) (9,031) (7,108) (9,452) (12,683)
AtriCure
Founding
245
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Calibrating Sustainable Profits
Efficient markets (with
limited barriers to entry)
dictate that long run returns
will approach the cost of
capital.
Consequently, profits
should equal the cost of
capital x capital? But can
we measure capital
effectively?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Core Operations
Return on Capital
Time
246
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Typical SG&A to Gross Margin Levels
To remain competitive, companies must right-size, selling (advertising and
promotion) and support (R&D, administrative) expenses. This proves
challenging when a product mix changes cause a decline in gross margin.
REGRESSIONOUTPUT
RegressionStatistics
MultipleR 0.83
RSquare 0.69
AdjustedRSquare 0.69
StandardError 0.09
Observations 416
ANOVA
df SS MS
Regression 1 7.6 7.6
Residual 414 3.4 0.0
Total 415 11.0
Coefficients StandardError tStat
Intercept 1.7% 1.0% 1.8
XVariable1 65.0% 2.1% 30.3
0%
20%
40%
60%
80%
0% 20% 40% 60% 80% 100%
S
G
&
A

R
e
v
e
n
u
e
s
Grossmargin
SG&AExpensevs.GrossMargin
Standard&Poors500
Professor David Wessels
The Wharton School of the University of Pennsylvania
247
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Estimating Intangibles Investment
There is no reliable method to estimate investment in intangibles, either inside
or outside the company. As a calibrating point, we can assume any selling
and research expense above comparable averages are investments.
Professor David Wessels
The Wharton School of the University of Pennsylvania
AtriCureInc
Intangibles
$thousands Year2 Year3 Year4 Current
Intangibleexpenses 3,152 6,747 10,537 19,591 33,703 Normalized
Normalizedintangibles (8) (723) (4,787) (9,304) (15,267) intantibles 66.7%
Excessintangibleexpenses 3,144 6,024 5,751 10,288 18,436
BalanceSheet:
Startingintangibleassets 0 3,144 8,853 13,719 22,634
Add:Excessintangibleexpenses 3,144 6,024 5,751 10,288 18,436 Amortization
Deduct:Amortizationofintangib 0 (314) (885) (1,372) (2,263) schedule 10
Endingintantibles 3,144 8,853 13,719 22,634 38,807
AtriCure
Founding
248
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Amortization Schedules
When capitalizing
expenses, it is easy to
become consumed by
estimates of the
amortization period.
As long as the period is
longer than five years,
the choice does not lead
to dramatic differences.
Professor David Wessels
The Wharton School of the University of Pennsylvania
42%
23%
17%
14%
13%
12%
12%
0% 10% 20% 30% 40% 50%
None
2
4
6
8
10
12
ReturnonCapital
A
m
o
r
t
i
z
a
t
i
o
n

P
e
r
i
o
d
EfffectofAmortizationPeriod
onReturnonCapital
5%of
Revenue
15%of
Revenue
249
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Operating Margin
The second most critical element of high-growth valuation is to
develop a perspective on margins. Established players provide some
guidance. But what about J NJ ? Should they be included?
Professor David Wessels
The Wharton School of the University of Pennsylvania
79.0%
78.7%
75.5%
84.9%
50.0% 60.0% 70.0% 80.0% 90.0%
Medtronic,
Incorporated
Johnson&
Johnson
St.JudeMedical,
Inc.
BostonScientific
Corporation
Atricure,Inc.
GrossMargin
30.5%
22.3%
24.3%
14.0%
38.6%
60.0% 40.0% 20.0% 0.0% 20.0% 40.0%
Medtronic,Incorporated
Johnson&Johnson
St.JudeMedical,Inc.
BostonScientificCorporation
Atricure,Inc.
OperatingMargin
Boston Scientifics
acquisition of Guidant
has lowered margins by
7.7% in amortization
250
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
Capital Requirements: Defining Invested Capital
Operating
Assets
Operating
liabilities
Non-
Operating
Assets
Debt &
Debt
Equivalents
Equity &
Equity
Equivalents
Payables
Customer advances
Warranty reserves
Traditional debt
Pension liabilities
Environmental reserves
Excess cash
Short-term investments
Strategic investments
Deferred taxes
Common stock
Retained earnings
Receivables
Inventories
Fixed assets
Goodwill
Assets Liabilities & Equity
251
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Atricure: Capital Requirements
Using the principles of invested capital, what is the companys current
operating capital? How does this differ from total assets? Is operating capital
growing as quickly as total assets?
Professor David Wessels
The Wharton School of the University of Pennsylvania
AtriCureInc
BalanceSheet
$thousands Year4 Current $thousands Year4 Current Notes: Year4 Current
Cashandcashequivalents 5,175.2 27,432.9 Accountspayable 733.4 1,243.4 Accruedcommissions 791.6 987.6
Shortterminvestments 0.0 6,369.2 Accruedliabilities 2,572.3 4,131.6 Accruedbonus 236.3 600.8
Accountsreceivable 3,520.6 4,865.1 Currentmaturitiesoflongtermdebt 0.0 398.0 Accruedvacation 175.7 469.0
Inventories,net 1,087.4 2,135.1 Totalcurrentliabilities 3,305.8 5,773.0 Otheraccruedliabilities 1,368.7 2,074.2
Othercurrentassets 112.7 845.3 Totalaccruedliabilities 2,572.3 4,131.6
Totalcurrentassets 9,895.9 41,647.7 Longtermdebt 0.0 1,084.0
Propertyandequipment,net 2,410.1 3,359.5 SeriesA,2,182,521shares 7,979.4 0.0
Deferredofferingcosts(legal) 412.0 0.0 SeriesB,3,829,499shares 28,776.7 0.0
Intangibleassets 0.0 986.8 Totalredeemablepreferredstock 36,756.1 0.0
Goodwill 0.0 3,840.8
Otherassets 12.6 205.5 Commonstock,12,086,482shares 1.9 12.1
Totalassets 12,730.6 50,040.4 Additionalpaidincapital 3,281.4 86,107.5
Unearnedcompensation (981.6) (599.6)
Accumulateddeficit (29,633.0) (42,336.6)
Liabilitiesandshareholdersequity 12,730.6 50,040.4
252
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
Investments & FCF
In our simple valuation
model, we defined free cash
flow as after-tax operating
profit less the increase in
invested capital.
To best understand why this
measure works, lets first
examine the definition of
investment, such as capital
expenditures.
253
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
Alternative Definitions of Free Cash Flow
The traditional definition of free cash flow is:
FCF =
After-tax
operating
profit
+
Non-cash
expenses
Investments
in invested
capital
-
Capex =Increase in Net PP&E +Depreciation
FCF =
After-tax
operating
profit
Increase in
invested
capital
-
As shown earlier, investment is defined as:
Therefore, free cash flow can also be defined as:
254
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Terminal Value: Transaction Multiples
Precedent Transactions
Dublin-based Medexhas reached an agreement
with Ethicon Endo-Surgery, a Cincinnati-based
subsidiary of J ohnson & J ohnson, to buy its
catheter business. Ethicon Endo-Surgery is a
worldwide health-care company with 5,000
employees. The portion of the business involved in
the sale makes catheters for injecting into veins.
The company has 1,000 employees worldwide;
150 permanent and 350 temporary employees
work at 6250 Shier-Rings Rd., the site of the
corporate headquarters and a manufacturing plant.
Medexmakes plastic parts -- including pumps,
tubes, valves, and syringes -- used to supply fluids
and medicine intravenously to patients.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Worldscope, Thomson Financial, Wharton Analysis
0.0%
25.0%
50.0%
75.0%
100.0%
0
10
20
30
40
50
60
70
80
90
100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
DistributionofEVtoEBITDA
S&PSmallCapIndex
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Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Review: Fundamental Valuation Framework
AtriCureInc
HybridDCFValuation
$thousands Today Year1 Year2 Year3 Year4 Year5
1 Revenues 30,957 39,006 48,367 59,492 72,580 83,467
2 EBITDA (10,643) (11,312) 2,805 5,949 10,887 20,867
Depreciation (160) (202) (250) (308) (375)
Operatingprofit(EBITA) (10,803) (11,513) 2,555 5,641 10,512
3 Operatingtaxes 4,030 (894) (1,975) (3,679)
Aftertaxoperatingprofit (7,484) 1,661 3,667 6,833
4 Incremental investment (1,730) (2,012) (2,391) (2,814) C.V.
Freecashflow (9,214) (352) 1,276 4,019 166,934 5
6 Discountfactor 1.09 1.19 1.30 1.41 1.41
Discountedcashflow (8,453) (296) 985 2,847 118,260
KeyValueDrivers
Revenuegrowth 26.0% 24.0% 23.0% 22.0% 15.0%
Cashoperatingmargin 29.0% 5.8% 10.0% 15.0% 25.0%
Capitalturnover 4.7 4.7 4.7 4.7 4.7
Forecast
Analyst
Projections
Estimated
using capital
turns at 4.7x
256
Venture Capital & the Finance of Innovation Lecture 12 Mapping Value Drivers to DCF
Professor David Wessels
The Wharton School of the University of Pennsylvania
So Why Such Complex Valuations?
Complex valuation tools
are especially useful when
analyzing mature
companies.
Consider Lockheed Martin.
Is the company creating
value?
Computing raw EBITA
leads to extremely
misleading results. A
complex model is required
to uncover true economic
performance.
(in $ millions) 2001 2002 2003
Service cost (1)
523 565 640
Amortization of prior service cost (2)
64 72 79
Interest cost (3)
1,357 1,401 1,453
Expected return on plan assets (4)
(2,177) (2,162) (1,748)
Recognized net actuarial losses (gains)
(117) (33) 62
Amortization of transition asset (6)
(4) (3) (2)
Total net pension expense (income)
(354) (160) 484
Source: Lockheed Martin 10-K, 2003
(in $ millions) 2001 2002 2003
Revenue 23,990 26,578 31,824
EBITA 1,787 1,949 1,976
Add: Interest cost (3) 1,357 1,401 1,453
Subtract: Return on plan assets (4+5+6) (2,298) (2,198) (1,688)
Adjusted EBITA 846 1,152 1,741
EBITA / Revenues (raw) 7.4% 7.3% 6.2%
EBITA / Revenues (adjusted for pension) 3.5% 4.3% 5.5%
Lockheed Martin - EBITA Pension Adjustment
Non-
Operating
Lockheed Martin 10-K, Note on Retirement Plans
Operating
257
Venture Capital & the Finance of Innovation
Using Multiples Effectively
Triangulating Todays Value and Determining Exit Valuation
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
13
Lecture 13 - UsingMultiples Effectively
258
Venture Capital & the Finance of Innovation
Todays Discussion
1. What are multiple (comparables) and how are they computed? To
determine a multiple, each companys market valuation is normalized by
earnings, invested capital, or some other measurement. This allows us to
easily compare valuations across companies of different size.
2. What drives the difference in multiples across companies? Enterprise-
value multiples are driven by incremental ROIC and growth. Thus, not all
multiples within an industry will be identical!
3. Which multiple is appropriate and why? Most investment bankers use the
enterprise-value-to-EBITDA multiple, but certain circumstances dictate using
EV-to-Sales or EV-to-EBITA multiples.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
259
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
What are Comparables/Multiples?
Multiples such as the Enterprise-Value-to-Revenue and Enterprise-Value-to-
EBITDA are used to compare companies.
A multiple size-adjusts a companys market value using revenues, profits, book
values, or nonfinancial statistics. Consider the standard banking comps table:
Lecture 13 - UsingMultiples Effectively
MedicalDevices
EnterpriseValueComparablesAnalysis
Nov10
Debt Net
Market netof enterprise
Ticker Company Price cap cash value Revenue EBITDA EBITA
BDXN Becton,DickinsonAndCompany 77.54 18,000.6 621.4 18,622.0 2.40 8.0 9.8
BSXN BostonScientificCorporation 6.92 10,518.9 5,128.0 15,646.9 2.00 8.6 10.4
COVN CovidienPlc 41.73 20,929.8 1,910.0 22,839.8 2.03 7.8 8.8
MDTN Medtronic,Incorporated 35.35 38,174.0 3,385.0 41,559.0 2.43 6.6 7.1
STJN St.JudeMedical,Inc. 38.69 12,667.2 1,497.8 14,165.0 2.75 8.7 9.7
SYKN StrykerCorporation 52.43 20,821.0 (2,860.0) 17,961.0 2.47 8.0 8.7
ZMHN ZimmerHoldings,Inc. 51.81 10,229.5 349.9 10,579.4 2.52 6.8 8.1
Note:Debtincludesunfundedpensionliabilities IndustryMean 2.37 7.8 8.9
IndustryMedian 2.43 8.0 8.8
StdDev/Mean 11.3% 10.5% 12.7%
OneYearForwardMultiples
260
Venture Capital & the Finance of Innovation
Step 1: Computing the Multiple
If next years Medtronic's
EBITDA is forecasted at
$6.0 billion, how do we
compute the enterprise-
value-to EBITDA multiple?
How is enterprise-value
defined on Wall Street?
What constitutes a
consistent multiple?
Professor David Wessels
The Wharton School of the University of Pennsylvania
How does our language differ from Wall Streets language?
Lecture 13 - UsingMultiples Effectively
38.8
4.0
2.8
45.5
7.3
0.1
38.2
0
10
20
30
40
50
Core
operating
value
Excess
cash
Other
nonoperating
assets
Gross
enterprise
value
Shortand long
termdebt
Unfunded
retirement
Equity
value
$

b
i
l
l
i
o
n
s
Medtronic,Incorporated
EquityValuation
261
Venture Capital & the Finance of Innovation
Requirements of a Robust Multiple
Although multiples appear simple to calculate, they fall prey to accounting and
economic pitfalls.
1. Is the multiple consistent given the organizational structure of the company?
How did you compute the multiple on the previous page?
2. For multiples that are calculated in a consistent manner, does the multiple
commingle assets with different economics? For instance, could we compute the
multiple as gross enterprise value divided by EBITDA plus interest income?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
262
Venture Capital & the Finance of Innovation
Step 2: Using Multiple to Determine Continuing Value
To determine continuing
value, multiply the forecast
of EBITDA by the
enterprise value multiple.
Use comparables that best
approximate where the
company will be financial
by year five.
If you use a forward
multiple, make sure to
discount by only four years.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
AtriCureInc
HybridDCFValuation
$thousands Today Year1 Year2 Year3 Year4 Year5
Revenues 30,957 39,006 48,367 59,492 72,580 83,467
EBITDA (10,643) (11,312) 2,805 5,949 10,887 20,867
Depreciation (160) (202) (250) (308) (375)
Operatingprofit(EBITA) (10,803) (11,513) 2,555 5,641 10,512
Operatingtaxes 4,030 (894) (1,975) (3,679)
Aftertaxoperatingprofit (7,484) 1,661 3,667 6,833
Incremental investment (1,730) (2,012) (2,391) (2,814) C.V.
Freecashflow (16,698) 1,309 4,943 10,852 166,934
Discountfactor 1.09 1.19 1.30 1.41 1.41
Discountedcashflow (15,319) 1,102 3,817 7,688 118,260
Forecast
263
Venture Capital & the Finance of Innovation
Todays Discussion
1. What are multiple (comparables) and how are they computed? To
determine a multiple, each companys market valuation is normalized by
earnings, invested capital, or some other measurement. This allows us to
easily compare valuations across companies of different size.
2. What drives the difference in multiples across companies? Enterprise-
value multiples are driven by incremental ROIC and growth. Thus, not all
multiples within an industry will be identical!
3. Which multiple is appropriate and why? Most investment bankers use the
enterprise-value-to-EBITDA multiple, but certain circumstances dictate using
EV-to-Sales or EV-to-EBITA multiples.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
264
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Part II: What Drives Multiples?
g WACC
ROIC
g
1 T) (1
EBITA
Value

|
.
|

\
|

=
g WACC
ROIC
g
1 Profit
Value

|
.
|

\
|

=
g WACC
ROIC
g
1 T) - EBITA(1
Value

|
.
|

\
|

=
We know after-tax profits equal
EBITA x (1-T), where T is the
operating tax rate. Therefore,
we can make the substitution.
Start with the key value
driver formula.
Divide both sides by EBITA,
and we are left with a very
popular multiple that bankers
use to value companies.
This multiple is
known as an
enterprise value
multiple.
Lecture 13 - UsingMultiples Effectively
265
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
ROIC & Growth Drive Multiples
When ROIC >WACC, higher growth
leads to higher EV/EBITA Ratio
Note how
different
combinations of
growth and ROIC
can lead to the
same multiple!
Enterprise value to EBITA*
Return on invested capital
6% 9% 15% 20% 25%
Long-term
growth rate
7.8
7.8
7.8
7.8
7.8
10.3
10.9
11.7
12.7
14.0
11.2
12.1
13.1
14.5
16.3
4.7
3.9
2.9
1.7
n/a
11.8
12.8
14.0
15.6
17.7
4.0%
4.5%
5.0%
5.5%
6.0%
Increasing
Growth
Rate
Increasing
ROIC
Enterprise value to EBITA*
Return on invested capital
6% 9% 15% 20% 25%
Long-term
growth rate
7.8
7.8
7.8
7.8
7.8
10.3
10.9
11.7
12.7
14.0
11.2
12.1
13.1
14.5
16.3
4.7
3.9
2.9
1.7
n/a
11.8
12.8
14.0
15.6
17.7
4.0%
4.5%
5.0%
5.5%
6.0%
Increasing
Growth
Rate
Increasing
ROIC
Lecture 13 - UsingMultiples Effectively
266
Venture Capital & the Finance of Innovation
Careful: So Do Short-Term Downturns
Integral Systems designs satellite command and control, data processing, flight
simulation, integration and test, and signals analysis systems.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
IntegralSystemsInc
45810H107
$millions 2005 2006 2007 2008 2009 2010E 2011E 2012E
Revenues 97.7 116.5 128.7 160.2 159.9 171.3 195.0 222.0
EBITDA 15.5 22.2 20.3 27.7 4.4 8.9 19.8 35.0
EBITDAmargin 15.9% 19.1% 15.7% 17.3% 2.8% 5.2% 10.2% 15.7%
Netenterprisevalue
Marketcapitalization 197.0 255.7 218.2 207.8 150.1
Shortandlongtermdebt 0.0 0.0 0.0 0.0 10.5
Grossenterprisevalue 197.1 255.7 218.2 207.8 160.6
Excesscash (57.5) (62.8) (24.5) (15.0) (5.7)
Netenterprisevalue 139.6 192.9 193.7 192.8 154.9
EnterprisevaluetoRevenues 1.43 1.66 1.51 1.20 0.97
EnterprisevaluetoEBITDA 9.01 8.68 9.56 6.97 34.95
<Historical> <Forecast>
267
Venture Capital & the Finance of Innovation
The Limitations of Multiples
You are trying to value a well-established medical devices company. You
have built a well-structured DCF model, that implicitly leads to a 15x forward-
looking EBITDA multiple. What do the following comparables tell you about
your work?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
MedicalDevices
EnterpriseValueComparablesAnalysis
Nov10
Debt Net
Market netof enterprise
Ticker Company Price cap cash value Revenue EBITDA EBITA
BDXN Becton,DickinsonAndCompany 77.54 18,000.6 621.4 18,622.0 2.40 8.0 9.8
BSXN BostonScientificCorporation 6.92 10,518.9 5,128.0 15,646.9 2.00 8.6 10.4
COVN CovidienPlc 41.73 20,929.8 1,910.0 22,839.8 2.03 7.8 8.8
MDTN Medtronic,Incorporated 35.35 38,174.0 3,385.0 41,559.0 2.43 6.6 7.1
STJN St.JudeMedical,Inc. 38.69 12,667.2 1,497.8 14,165.0 2.75 8.7 9.7
SYKN StrykerCorporation 52.43 20,821.0 (2,860.0) 17,961.0 2.47 8.0 8.7
ZMHN ZimmerHoldings,Inc. 51.81 10,229.5 349.9 10,579.4 2.52 6.8 8.1
Note:Debtincludesunfundedpensionliabilities IndustryMean 2.37 7.8 8.9
IndustryMedian 2.43 8.0 8.8
StdDev/Mean 11.3% 10.5% 12.7%
OneYearForwardMultiples
268
Venture Capital & the Finance of Innovation
Todays Discussion
1. What are multiple (comparables) and how are they computed? To
determine a multiple, each companys market valuation is normalized by
earnings, invested capital, or some other measurement. This allows us to
easily compare valuations across companies of different size.
2. What drives the difference in multiples across companies? Enterprise-
value multiples are driven by incremental ROIC and growth. Thus, not all
multiples within an industry will be identical!
3. Which multiple is appropriate and why? Most investment bankers use the
enterprise-value-to-EBITDA multiple, but certain circumstances dictate using
EV-to-Sales or EV-to-EBITA multiples.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
269
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Which Multiple?
Although we have so far focused on enterprise-value multiples based on EBIT , other multiples
can prove helpful in certain situations.
EV/EBITDA Multiple. The most common multiple bankers use to value companies (and
probably the best financial multiple) is EV/EBITDA. Using EBITDA is popular because
the statistic more closely resembles forward-looking free cash flowthan EBIT, which
includes D&A costs that are sunk.
EV/EBITA Multiple. Although D&A is sunk, future investments in working capital and
capital expenditures are not. EBITA ratios are superior when reinvestment rates are
expected to be difference.
EV/Revenue Multiple. As we will show, an enterprise-value-to-sales multiple imposes an
additional important restriction beyond the EV/EBITA multiple: similar operating margins
on the companys existing business. For most industries, this restriction is overly
burdensome. But for start-ups, companies may not be profitable, and only the EV-Sales
ratio is available.
Lecture 13 - UsingMultiples Effectively
270
Venture Capital & the Finance of Innovation
Distribution of Enterprise Value Multiples
As of year-end 2010:
The median enterprise value to one-
year forward EBITDA ratio for the
S&P SmallCapindex was 7.6x.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Worldscope, Thomson Financial, Wharton Analysis
Lecture 13 - UsingMultiples Effectively
0.0%
25.0%
50.0%
75.0%
100.0%
0
10
20
30
40
50
60
70
80
90
100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
DistributionofEVtoEBITDA
S&PSmallCapIndex
S&PSmallCap600,2009
SummaryStatsticics
Statistic Revenue EBITDA EBITA
Median 0.98 7.61 10.40
Average 1.34 8.33 11.00
StdDev 1.27 3.65 4.37
271
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
When EBITA is Better than EBITDA
Many financial analysts use multiples of EBITDA, rather than EBIT, because
depreciation is a noncash expense, reflecting sunk costs, not future investment.
EBITDA multiples have their own drawbacks. To see this, consider two
companies, who differ only in outsourcing policies. Because they produce
identical products at the same costs, their valuations are identical ($150).
Depreciation
EBITA
Revenues
Raw materials
Operating costs
EBITDA
Comp B
Company B outsources
manufacturing to
another company
Incurs depreciation cost
indirectly through an
increase in the cost of
raw material)
(5)
20
100
(35)
(40)
25
Comp A
(30)
20
100
(10)
(40)
50
Company A
manufactures
product with their
own equipment
Incurs depreciation
cost directly
Lecture 13 - UsingMultiples Effectively
272
Venture Capital & the Finance of Innovation
When EBITA is Better than EBIT
Professor David Wessels
The Wharton School of the University of Pennsylvania
Consider three identical companies that only differ in size. Consequently, prior to
M&A activity, all three companies trade at the same multiple. If B purchases C
and must amortize intangibles over five years, what happens to the EBIT
multiple?
Lecture 13 - UsingMultiples Effectively
$millions CompA CompB CompC CompA CompB+C
Revenues 500 375 125 500 500
CashCosts (200) (150) (50) (200) (200)
Depreciation (100) (75) (25) (100) (100)
Amortization 0 0 0 0 (25)
OperatingProfit 200 150 50 200 175
BookCapital 1,000 750 250 1,000 1,125
MarketValue 1,500 1,125 375 1,500 1,500
EV/EBITDA 5.0 5.0 5.0 5.0 5.0
EV/EBIT 7.5 7.5 7.5 7.5 8.6
BAcquiresC
ProblemswithEV/EBIT
PreAcquisition
273
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Revenue Multiple
g
(1-T) 1-
Value ROIC
=Margin x
Revenues WACC-g
| |
|
\ .
The key value
driver formula.
Enterprise value divided by
revenue can be disaggregated
into two driving ratios, note
how revenues cancels.
Value EBITA Value
x
Revenues Revenues EBITA
=
EBITA / revenues equals pre-tax
margin and thus, the value to
revenue multiple is a function of
the enterprise-value-to-EBITA
multiple times margin!
Lecture 13 - UsingMultiples Effectively
274
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Revenue Multiples: Software Companies
Revenue multiplesare most commonly used to value high-growth start-ups. Still used
today to evaluate software companies, the multiple fails to normalize for operating
margins. Note how EBIT industries multiples are tightest.
Why does Oracle trade at nearly twice Intuit?
SoftwareCompanies
EnterpriseValueComparablesAnalysis
Market Net Enterprise
Ticker Company Price Cap Debt Value Revenue EBITDA EBITA EBIT
ADBE AdobeSystemsIncorporated 21.10 11,057.2 (1,669.2) 9,387.9 2.8 6.4 7.6 7.7
BMC BmcSoftware,Inc. 29.66 5,561.4 (1,338.4) 4,223.0 2.2 5.6 6.6 7.0
CA Ca,Inc. 18.65 9,676.9 (214.0) 9,462.9 2.2 6.4 8.9 7.2
INTU IntuitInc. 22.97 7,351.8 171.7 7,523.5 2.3 7.4 7.7 8.1
MSFT MicrosoftCorporation 19.09 169,720.8 (23,662.0) 146,058.8 2.4 6.1 6.1 6.7
ORCL OracleCorporation 17.72 89,418.3 193.0 89,611.3 3.8 7.8 8.4 8.4
SAP SapAg 37.12 44,071.2 (4,192.7) 39,878.5 2.5 9.0 9.2 9.8
Mean 2.6 6.9 7.8 7.8
Median 2.4 6.4 7.7 7.7
StdDev/Mean 21.1% 16.7% 14.5% 13.5%
OneYearForwardMultiples
Lecture 13 - UsingMultiples Effectively
275
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Revenue Multiples: Software Companies
The revenue multiple fails to normalize for operating margin. Note how operating
margins are 45% at Oracle, but only 28% at Intuit! Thus you can not use a revenue
multiple to value a company, when its comparable has different margins.
Using EBITDA to control for margins, both companies trade at the same multiple.
SoftwareCompanies
FinancialDriversofEnterpriseMultiples
Projected
3Year
Ticker Company Revenue EBITDA EBITA Margin Growth
ADBE AdobeSystemsIncorporated 2.8 6.4 7.6 37.2% 3.9%
BMC BmcSoftware,Inc. 2.2 5.6 6.6 32.1% 3.5%
CA Ca,Inc. 2.2 6.4 8.9 30.7% 1.7%
INTU IntuitInc. 2.3 7.4 7.7 28.4% 5.5%
MSFT MicrosoftCorporation 2.4 6.1 6.1 35.5% 2.9%
ORCL OracleCorporation 3.8 7.8 8.4 44.9% 4.4%
SAP SapAg 2.5 9.0 9.2 25.9% 5.7%
OneYearForwardMultiples
Lecture 13 - UsingMultiples Effectively
276
Venture Capital & the Finance of Innovation
Distribution of S&P SmallCapRevenue Multiples
Unlike the EBITDA multiple, revenue multiples for the S&P SmallCapindex have a wide
distribution. This distribution is mirrored by an similar distribution for S&P 500 pre-tax
operating margins. The median forward looking revenue multiple is 1.7x.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Lecture 13 - UsingMultiples Effectively
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0
10
20
30
40
50
60
70
80
90
100
0
.
2
5
0
.
5
0
0
.
7
5
1
.
0
0
1
.
2
5
1
.
5
0
1
.
7
5
2
.
0
0
2
.
2
5
2
.
5
0
2
.
7
5
3
.
0
0
3
.
2
5
3
.
5
0
3
.
7
5
4
.
0
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4
.
2
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4
.
5
0
4
.
7
5
5
.
0
0
DistributionofEVtoRevenues
S&PSmallCapIndex
0
10
20
30
40
50
60
2
.
5
%
5
.
0
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7
.
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2
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7
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.
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.
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7
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DistributionofEBITDAMargin
S&PSmallCapIndex
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0
1
2
3
4
5
6
5% 15% 25% 35% 45%
E
V

R
e
v
e
n
u
e
s
EBITDA Margin
RevenueMultiplesvs.OperatingMargins
S&PSmallCap600,2009
Revenue Multiples & Operating Margins
By regressing revenue multiples against pre-tax operating margins, we find a
1% increase in pre-tax operating margin leads to a .064 increase in the
enterprise value to revenue multiple.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Are companies
above the line
overvalued?
Lecture 13 - UsingMultiples Effectively
RegressionOutput
RegressionStatistics
MultipleR 0.613
RSquare 0.376
AdjustedRSquare 0.375
StandardError 1.000
Observations 462
ANOVA
df SS MS F
Regression 1 277.7 277.7 277.6
Residual 460 460.1 1.0
Total 461 737.8
CoefficientsandardErr tStat Pvalue
Intercept 0.42 0.07 5.92 0.00
EBITDAMargin 6.36 0.38 16.66 0.00
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Venture Capital & the Finance of Innovation
NonFinancial Multiples
Using Operating Data to Value Companies
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
Lecture 13 - UsingMultiples Effectively
Time Permitting
279
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Non-Financial Multiples
Does financial informationand/or non-financial informationimpact
the valuations of high-growth, money-losing investments?
During the euphoria of the late 1990s, many argued, the more you
lose the higher your stock price will be!
Whether or not you agree with the previous statement, it is clear that
valuing an industry with little history is extremely difficult. How do
you justify these extraordinary prices? For instance, at their peak:
Yahoo! had a P/E of 580
eBay had a P/E of 1,945
Amazon.com traded at a multiple to revenue of 13.5.
Lecture 13 - UsingMultiples Effectively
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Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Drivers of Value
To test the impact of financial information, academics often start with Ohlsons(1995)
model of residual income, which practitioners know as the Stern Stewart MVA
model, to value each internet firm,

=
+
+
+ =
1 i
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) E(RI
BV MV
In their research, Trueman, Wong, and Zhang (2000) decompose earnings into gross
profit, operating expenses, and net non-operating expenses,

=
+ + + +
|
|
.
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+
+ =
1 i
t
i t
t
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NonOp
BV
D & R
BV
A & SG
BV
GP
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MV
But how do we measure future profitability? For high-growth start-ups, are current
earnings good predictors of future earnings, like they are for established firms?
Lecture 13 - UsingMultiples Effectively
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Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Testing What Drives Value
The most interesting test would be to compare how future earnings affect valuation. Since
future earnings are difficult to measure/predict for start-ups, we instead ask whether current
earnings are related to a start-ups valuation:
Next, if we decompose net income into gross profits, support expenses, and/or current
operating statistics, such as website usage, do we see a clearer relation with valuation?
Do current support expenses consist or business-building activities?
Does current website usage predict demand for future revenues?
To test these questions, we run the following regression:
c + + + + + =
t
t
4
t
t
3
t
t
2
t
t
1
t
t
BV
Financial - Non
b
BV
D & R
b
BV
A & SG
b
BV
GP
b a
BV
MV
c + + =
t
t
1
t
t
BV
NI
b a
BV
MV
Lecture 13 - UsingMultiples Effectively
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Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Using Non-Financial Data
To test the impact of non-
financial information, we need
data from an external data source.
For this study, Trueman et al use
data from Media Metrix.
Unique Visitors are the
estimated number of different
individuals who visit the firms
web site during a particular
month.
Pageviews are the estimated
number of pages viewed by those
individuals visiting the firms
websites during the month.
Lecture 13 - UsingMultiples Effectively
283
Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Non-Financial Valuation Multiples
Unlike stable mature companies,
there was no relation between
Internet startups and net income. A
simple price to earnings ratio fails to
capture value.
Valuation, was however, correlated
with web traffic to the companies
site. Both unique visitors and page
views were predictors of value.
Why would firm size (as measured
by book equity) be a predictor of
market-to-book?
Regressions based on 95 portal companies and e-
tailers. A portal company would be CareerBuilder.com
versus Amazon.com, who is an e-tailer.
Variable Reg1 Reg2 Reg3
Intercept 20.1 11.2 8.9
6.0 3.1 3.1
Net Income (12.0) (13.8) (24.3)
(1.2) (1.4) (2.9)
Unique Visitors 252.5
5.2
Page Views 3.9
10.7
Firm Size (1/BV) (99.1) (246.5) (68.9)
(0.8) (2.0) (0.7)
Source: Trueman, Wong, & Zhang (2000)
Regression of Market to Book on:
Lecture 13 - UsingMultiples Effectively
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Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Financial Versus Non-Financial Multiples
When net income is broken into
components, we see that different
components have different effects.
Gross profits have a positive affect
on value, whereas marketing
expenses are negative. Perhaps this
implies marketing expenses are not
treated by investors as investments.
When disaggregating net income in
the regression, unique visitors are no
longer robust predictors of value.
Variable Reg4 Reg5 Reg6
Intercept (0.9) (1.3) (4.6)
(0.3) (0.5) (1.9)
Gross Profit 302.2 296.0 185.1
11.1 10.2 6.9
Marketing (46.5) (44.8) (37.9)
(2.4) (2.3) (2.3)
R&D 103.3 102.8 292.2
1.2 1.2 3.8
Other Expenses 3.7 3.4 7.2
0.4 0.3 0.8
Unique Visitors 23.8
0.6
Page Views 2.7
8.9
Firm Size (1/BV) (73.2) (88.1) (89.4)
(0.8) (1.0) (1.2)
Regression of Market to Book on:
Lecture 13 - UsingMultiples Effectively
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Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Segmenting By Business Type
In the previous slides, we examined
regressions based on all internet
companies.
What if we segmented the sample by
business type? i.e. separated the
sample into e-tailers versus portal &
content providers.
Notice how gross profit is extremely
important for e-tailers. And how
unique visitors matter for only
portal/content providers, not for e-
tailers.
Variable E P/C E P/C
Intercept 3.2 6.3 (2.2) 5.3
0.6 2.4 (0.6) 2.1
Gross Profit 475.1 124.7 313.9 88.7
9.7 5.0 7.3 3.4
Marketing (44.7) (41.8) (2.2) (38.9)
(1.4) (1.7) (2.0) (1.7)
R&D (174.5) 56.7 181.0 121.0
(1.3) 0.7 1.5 1.6
Other Expenses (1.1) 2.1 3.2 25.5
(0.1) 0.1 0.3 1.1
Unique Visitors 40.5 91.6
0.4 3.3
Page Views 2.9 1.8
7.2 4.7
Firm Size (1/BV) (560.3) (38.3) (457.7) (7.7)
(2.1) (0.6) (2.3) (0.1)
Source: Trueman, Wong, & Zhang (2000)
Regression of Market to Book on:
Lecture 13 - UsingMultiples Effectively
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Venture Capital & the Finance of Innovation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Closing Thoughts on Multiples
A multiples analysis that is careful and well reasoned will not only provide a
useful check of your DCF forecasts but will also provides critical insights into
what drives value in a given industry. A few closing thoughts about multiples:
Similar to DCF, enterprise value multiples are driven by the key value
drivers, return on invested capital and growth. A company with good
prospects for profitability and growth should trade at a higher multiple than
its peers.
A well designed multiples analysis will focus on operations, will use
forecasted profits (versus historical profits), and will concentrate on a peer
group with similar prospects.
Lecture 13 - UsingMultiples Effectively
287
Venture Capital & the Finance of Innovation
Appendix
Screening New Venture Opportunities
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
Appendix Screening Opportunities
288
Venture Capital & the Finance of Innovation
Screen the Opportunity
There is no one complete, well structure list, but consider the following attempt
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Market The Product The Management Team
Is the customer need clearly defined
and understood by the management
team?
How does the product solve the
customer problem? How innovate is
the solution versus the status quo?
Doesthe management team
understand the product market, its
customers, and competitors?
Experience?
How large is the opportunity? Will
the product open a door to new,
larger markets?
How can the solution beprotected? Is
there clear IP ownership?
Doesthe management team have
technical expertise to create an
effective product? Experience?
How strong is the competitors? Are
they also focused on the customer
need? Is therean alternative
solution to the problem?
Is the product complete? What
additional investments are requiredto
get the product suitable for launch?
Can the product scale without
additional investment?
Does the management team believe in
the companyand demonstrate an
enthusiasm that will attract new
talent?
The framework above focuses on the market and product. In the next discussion, we will
examine the key success factors for a robust business model.
Appendix Screening Opportunities
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Venture Capital & the Finance of Innovation
The Bucket List at Bessemer
In short, my theory is that you must make generalizations. This is a tough pill to swallow. Learn to quickly place companies in assigned buckets as
theyre evaluated. The case-by-case model is simply unworkable. Yes, youll be wrong sometimes. Hindsight and adjustment are part of the game.
There are many different types of buckets, Im including the ones I find myself most frequently using in making evaluations. At risk of stating the
obvious, many other VCs have significantly more experience and a more fine-tuned way of thinking about businesses than I do. Thepoint is to
provide context for thinking through your own beliefs about what makes a good investment opportunity. Form evaluations, try to justify them across
the spectrum of companies youre considering, and adjust your opinions and expectations as youre proven wrong and right
Teams: Evaluating team members is often cited as the most challenging and important part of venture investing. As J ohn Doerr says, Ideas
are easy. Teams win. Especially with early stage companies, where the barriers to entry are non-existent, a team that brings a competitive
advantage is essential. Prior experience, technical talent and proprietary industry relationships are some examples of great qualities a team
can bring to the table.
Market: Size matters. Im only interested in businesses that attack multi-billion dollar revenue opportunities. How many potential customers
are there? How much can you charge them? Multiply. Exogenous variables: Are there external risks which threaten the viability of a business
model? For instance, consider the regulatory and industry risks faced by music companies. Composition: Is the market competitiveor
commoditized? What are the barriers to entry?
Technology: Complexity. Is the product hard to build? I like to consider early stage companies that have a spectacular team and/or are
solving a very challenging technical problem. Otherwise, theres no reason to think theyll win over the next person who thinks of the idea or
copies them. Website: If this is a consumer facing company, or one which makes sales online, a poorly constructed website implies
inattentiveness to user needs or laziness.
Business Model: It must be transaction-oriented. Does the product involve a transaction which can eventually be monetized? Advertising:
Very few technology businesses have scaled efficiently with an ad-based model. I usually ignore them unless they collect very high quality
user-interest data which makes them uniquely capable of ad-targeting. Recurring revenue. Is the product priced on a subscription basis or as a
perpetual license? Recurring revenue businesses have smoother growth curves, as they simply need to add more customers than theylose to
experience temporal growth.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Rahul Jaswa, Bessemer Venture Partners
Appendix Screening Opportunities
290
Venture Capital & the Finance of Innovation
End of Section 2
Analyzing and Valuing High Growth Companies
Professor David Wessels
The Wharton School of the University of Pennsylvania
Section 2: Valuing High Growth Companies
291
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Capital Structure in VC-Backed Firms
The Term Sheet
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
14
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Term Sheets: Pick Your Battles
According to Matt Blumberg, CEO of Return Path, focus on terms that matter. A
typical VC term sheet will have at least 20 terms spelled out in it. There are only a
few that really matter in the end, although you should at least make sure your
lawyer is comfortable that the others are reasonable and somewhat standard.
Spend time on valuation, the option pool, the type of security (preference and
conversion), board composition(voting), and your /their rights(registration rights,
drag-along rights, etc).
Professor David Wessels
The Wharton School of the University of Pennsylvania
Closing Date: As soon as practicable following the Companys acceptance of this
Term Sheet and satisfaction of the Conditions to Closing (the
Closing).
Term Sheet
293
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Issue 1: Valuation
The financial issues related to venture capital are no different than
those of a traditional finance class. Theories and predictions related to
discounted cash flow, multiples, contingent claims, options, capital
structure, and Modigliani & Miller, still hold.
But the differences in language used can be daunting. Consider how
valuation is described:
Ill put in $4 million based on six pre-money
Im looking for two-fifths of the company post, and for that Ill put up
the four
Its worth six pre-money, and I want to own 40% after we close.
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Translating VC Language to Capital Structure
Your company current has three
million shares outstanding(no price
is available). Prior to the
transaction, there has never been a
discussion of valuation.
How does: Its worth ten post, and
I want to own 40% after we close,
Lets translate to the pre-money
valuation, the number of shares to
be issued, and the share price?
Pre-Money Valuation
+New Money
=Post-Money Valuation
Valuation Money - Post
Money New
Ownership %

Shares New Shares Old
Shares New
Ownership %

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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Corporate Valuation meets Venture Capital
You have just completed a discounted cash flow (DCF) valuation for a
potential investment. Excited about the opportunity, you are ready to negotiate
a term sheet with the company. You believe the company is worth $40 million
(using DCF) but desperately needs $20 million to launch the product.
In venture capital speak is the $40 million DCF a pre-money or post-
money valuation?
What ownership percentage does a $40 million pre-money valuation imply?
What ownership percentage does a $40 million post-money valuation imply?
To be fairly compensated, what ownership percentage should the VC demand?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Take 10 minutes
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Value of Core Operations
To value a company, estimate the value of core operations. To determine core
operating value, determine free cash flow using forecasts of revenues, margins,
capital intensity, and a terminal value.
At a 15% cost of capital, the company is valued at $40 million.
Professor David Wessels
The Wharton School of the University of Pennsylvania
DiscountedCashFlowAssessment
$million Today Year1 Year2 Year3
Freecashflow (10.0) (10.0) 85.6
Discountfactor 1.15 1.32 1.52
Discountedcashflow (8.7) (7.6) 56.3
Enterprisevalue
Valueofoperatons 40.0
Excesscash 20.0
Enterprisevalue 60.0
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Pre or Post-Money?
Discounted cash flow clearly points to a $40 million valuation. But is the $40
million valuation pre-money or post money?
To determine the ownership each implies, use the pre/post money formulas:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Pre&PostMoneyValuation
$million Method1 Method2
PreMoney 40.0 20.0
NewMoney 20.0 20.0
Postmoney 60.0 40.0
Impliedownership: 33.3% 50.0%
(newmoney/postmoney)
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Venture Capitalist Performance
To determine, the venture
capitalists expected
performance, we use internal
rate of return (IRR).
Regardless of the ownership
structure, $20 million is
invested today.
The venture capitalist than
receives nonoperating income
from unused cash and
eventually liquidation.
Professor David Wessels
The Wharton School of the University of Pennsylvania
VentureCapitalPerformanceat33%Ownership
Internalrateofreturn:
$million Today Year1 Year2 Year3
Companydividends 3.0 1.5 85.6
Venturecapitalflow (20.0) 1.0 0.5 28.5
Internalrateofreturn 15.0%
VentureCapitalPerformanceat50%Ownership
Internalrateofreturn:
$million Today Year1 Year2 Year3
Companydividends 3.0 1.5 85.6
Venturecapitalflow (20.0) 1.5 0.7 42.8
Internalrateofreturn 32.4%
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Issue 2: Employee Option Pools
Option Pool Shuffle
You have successfully negotiated a $4M investment on a $6M pre-
money valuation by pitting the famous RedCapVentures versus
Blue Shirt Capital. Triumphant, you return to your companys
tastefully decorated loft to tell the team that their hard work has
created $6M of value.
Your teammates ask what their shares are worth. You explain that
the company currently has 3M shares outstanding so the investors
must be valuing the companys stock at $2/share:
$6M pre-money 3M existing shares =$2/share.
Later that evening you review the term sheet from RedCap. It states
that the share price is $1.50. This must be a mistake! Reading on,
the term sheet states, The $6 million pre-money valuation includes
an option pool equal to 15% of the post-financing fully diluted
capitalization.
You call your lawyer and your lawyer explains that the so-called
pre-money valuation always includes a large unallocated option pool
for new employees, your stomach sinks. You feel duped and are left
wondering, How am I going to explain this to the team?
- Adapted from VentureHack
Professor David Wessels
The Wharton School of the University of Pennsylvania
Title Range(%)
ChiefExecutiveOfficer 510%
SeniorExecutives 25%
VicePresidents 12%
IndependentBoardMember 1%
Director 0.41.25%
LeadEngineer 0.51%
5+yearsexperienceEngineer 0.330.66%
ManagerorJuniorEngineer 0.20.33%
TypicalSiliconValleyGrants(SeriesA)
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Adding Employee Options to the Mix
Most venture capital deals include a
reservation for future shares to be
purchased by or granted to employees.
Investors typically demand between
15% and 30% of the share count.
What is the post-money valuation and
share price if an extra one million
sharesare allocated beforefinancing?
What would be the typical option
strike price? Would the options have
value?
Pre-Money Valuation
+New Money
=Post-Money Valuation
Valuation Money - Post
Money New
Ownership %

Shares New Shares Old
Shares New
Ownership %

301
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Employee Options: Issues
How are total shares determined if the share grants (or options) are:
Unissued and Unvested? When the term sheet is written to include future share grants
and options, the shares are yet to be issued. Since ownership is based on currently
issued shares, the venture capitalist would own 2.67 million of 5.67 million issued
shares or 47.1% (even thought they originally negotiated for 40% ownership) in the case
of immediate liquidation! Should the shares revert to the founder? Why or why not?
Issued, butUnvested? Depends on the original option plan. (1) Most plans require
options to be converted into options on the buyers stock but still unvested.
Alternatively, they may have a provision that states if the acquirer does not assume the
option plan or proposes to modify the plan, options vest immediately prior to the close
of the merger. This is known as accelerated vesting. Or there may be nothing stated!
Issued and Vested? In the case of a liquidation event, employees will receive
consideration for their shares.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Entrepreneurs:
Dont let your investors determine
the size of the option pool for you.
Use a hiring plan to justify a small
option pool, increase your share
price, and increase your effective
valuation.
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Employee Options: Issued but Unvested
Many companies write their employee option plans with the assumption that they will
not be acquired. In fact, company are acquired, even if they are publically traded. One of
the most common, and costly, areas of options lawsuits is what happens when there is an
acquisition. Will options immediately vest and become fully exercisable or be
cancelled? -- National Center for Employee Ownership
From a specialist in the M&A group at Intel:
When conducting a trade sale of an Angel-backed company at Intel, we request
that all unvested but issued shares are immediately vested for employees. Our
intention is to reward employees rather than the investors. For lockup, we use earn
outs and grant Intel stock options (with vesting) for all employees (as they are
typically tagged as key employees).
Professor David Wessels
The Wharton School of the University of Pennsylvania
303
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Option Pools: Bridge Financing
Any bridge financing that contains convertible promissory notes or warrants,
known as equity sweeteners must also be set aside.
For instance, to avoid a formal investment round, some venture capital
companies will loan the portfolio company money to be paid back at the time
of next official financing, plus escalating warrants (note, the loan will be
rolled into the next financing).
RedCaplends the portfolio company $1 million at a rate of 8% per year, plus 1% warrant
coverage per month. The warrants give the holder $10,000 of stock for each month the bond
is outstanding (1% of face per month).
VC warrants typically specify a dollar amount (via percentage), not a share amount, and this
has important valuation implications, which we discuss in the Angel Financing note.
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Capitalization Table
The term sheet will also contain a pre- and post-financing capitalization table.
In the first round, the capitalization is relatively straight-forward. As we add
multiple rounds of financing, the table can become quite complex.
Security #of Shares % #of Shares %
Common Founders 3,000,000 75.0% 3,000,000 45.0%
Common Employee Options
Issued 500,000 12.5% 500,000 7.5%
Unissued 500,000 12.5% 500,000 7.5%
Series A Preferred: Redcap Ventures 2,666,667 40.0%
Total 4,000,000 100.0% 6,666,667 100.0%
Pre-Financing
Capitalization Table
Post-Financing
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Closing Date: As soon as practicable following the Companys acceptance of this
Term Sheet and satisfaction of the Conditions to Closing (the
Closing).
Investors: RedCap Ventures: [ ] shares ( %)
Amount Raised: $[ ], [including $[ ] from the conversion
of principal [and interest] on bridge notes].[1]
Price Per Share: $[ ] per share (based on the capitalization of the Company set
forth below) (the Original Purchase Price).
Pre-Money Valuation: TheOriginal PurchasePriceis baseduponafully-dilutedpre-money
valuationof $[ ] andafully-dilutedpost-money valuationof
$[ ] (includinganemployeepool representing[ ]%of the
fully-dilutedpost-moneycapitalization).
Offering Terms
Source: NVCA, http://www.nvca.org/model_documents/Term_Sheet.doc
Representation in the Term Sheet
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Issue 3: The Type of Security
Shortly after a recent exit sale, a CEO called his lead venture
capital backer to complain that while he had thought his
management team owned 34% of the company, they had
received only 5% of the sale proceeds.
"How did we get such a bum deal?" he asked. The VC
patiently explained: liquidation preferences.
The capitalization table can be misleading
Liquidation Preferences: What You May Not Know
By Colin Blaydon and Michael Horvath
307
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
VC Ownership: Preferred Stock
How Preferred Stock differs from Common Stock:
For liquidation events: Preferred Stocks have a liquidation preferencewhich
provides that upon liquidation or dissolution of the company, the preferred
shareholders must be paid x times face before the common shareholders are
paid anything.
With no liquidation event: Some venture capitalists will ask for redemption
rights, i.e. the right to force the company to repurchase the preferred stock at x
times face plus cumulative dividends. Option becomes available in [5] years.
Dividends on preferred stock: Typically, the preferred stock earns dividendsat
some modest rate if/when declared by the companys board of directors.
308
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Liquidation Preferences
Venture capitalists are often maligned for the liquidation preference
and other partialities. VCs do this to avoid the Stanley Whiplash
and Dudley Do-Right problems.
Stanley Whiplash, a founder who put a year into a biotech
company, could raise $10 million for 50% ownership and then
immediately sell the company for cash to a similar company
pocketing $5 million. 1x liquidation prevents this.
Dudley Do-Right, a founder who believes in his company,
wants to raise $2 million, for 50% ownership. Dudley, has
some confidence in the company, but knows the companys not
worth much more than $5 million. 2.5x liquidation prevents
this deal from occurring.
Source: Kevin Laws, VentureBlog
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Advanced Equities & Pixelon
Professor David Wessels
The Wharton School of the University of Pennsylvania
LAUNCH PARTY: Betting on One Big Night
By Dan Goodin
The masses of gamblers hunched in front of slot machines
provided Pixelon.com, which hopes to hit the jackpot by bringing
television-quality video to the Net, with a potent reminder: Las
Vegas is where suckers go to strike it big.
That didn't stop the 3-year-old startup from coming to town to
throw itself a grand-opening party Oct. 29 that featured
performances by such glittering acts as the Who, Kiss, Brian
Setzer, Tony Bennett and the Dixie Chicks. The San J uan
Capistrano, Calif., firm, which has raised $23 million, insisted the
$10 million launch party made perfect sense.
"This space is a horse race," Michael Fenne, the company's
founder and chairman, says. "You're either fast and big or you're
dead." Fenne, a 31-year-old former concert roadie turned
computer programmer, won't get any arguments there.
Pixelon plans to become an online content factory, serving up
50,000 channels. "Since we're not a Time Warner (TWTC) with a
content library a mile long, we had to be skilled ... in our
execution," Fenne says.
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Dark Side of Entrepreneurs
Pixelon, whichonceraised$40million
on the strength of its Internet video
player, is now down to a handful of
managers working without pay, the
companyconfirmedFriday.
A top executive also said the
company's founder, who later was
revealed to be a fugitive fromjustice
with a false identity, didn't actually
create the software for the player and
fakedakeydemonstrationlast August.
Paul Ward, Pixelon's chairman and
chief executive, said the layoffs were
designed to save money while the
company fights a bankruptcy petition
brought bycreditorsseekingmorethan
$1million.
"If you have a bankruptcy pending
against us, we're going to have
difficulty
raising money from investors, so we
are going to have limited funds in the
future," Ward said. "I'm trying to
conserve our capital, like any
businessmanwoulddo."
Russell Reeder, vice president of
product development, painted adarker
picture: "(Themoney's) gone. Wedon't
have money to pay salaries. We don't
have money to pay creditors. I think
that'sthedefinitionof bankrupt."
Reeder added that employees had not
been paid for a month before the
layoffs. Those who are staying, he
said, are trying to recoup their
investments, or are remaining out of
loyalty. Reeder said he himself had
invested$100,000.
-- Orange Country Register
But consider Advanced
Equities Inc, a Chicago
venture-capital firm
that sank about $40
million into Pixelon.
Pixelon became
famous when they
threw a Las Vegas
bash costing $15
million (The Who was
the featured band!)
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Issue 4: Board Composition
At the initial closing, the Board shall consist of [ ] members comprised of
(i) [Name] as [the representative designated by [ ], as the lead investor,
(ii) [Name] as the representative designated by the remaining investors,
(iii) [Name] as the representative designated by the founders,
(iv) the person then serving as the Chief Executive Officer, and
(v) [ ] person(s) who are not employed by the Company and who are mutually acceptable [to
the Founders and Investors][to the other directors].
Naval Ravikant CEO of Epinions.com writes,
Valuation is temporary, control is forever.
Ravikantsrules of thumb: Make the board composition proportional to
ownership, be wary of independents (typically pro-investor), control is a one-
way street: from common to preferred.
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Issue 5: Your (Entrepreneur) Rights
Registration rightsallow the venture capitalist to force the company to register
the companys securities with the SEC so that it can be sold in the public
markets. Major issue: Will the founder be ready to cede control?
Drag Along rights allow the venture capitalist to demand that holders of
greater than 1% be required to vote their shares in favor of a deemed
liquidation event. Similar to registration right, but forcing sale.
Typically there is a provision that reads Matters Requiring Investor/Director
Approval. Investors, even holding minority positions, can restrict day-to-day
operations including the ability to hire & fire key positions.
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
The Dark-Side of Venture Capitalists
Although privately held, the story of FilmLoop leaked from multiple sources close to the company.
Heres a rough timeline of what appears to have happened
May 2006: FilmLoop raises $7 million from venture firm ComVentures. Roland Van de Meer joins
the board of directors.
November 2006: ComVentures, under pressure from its own limited partners to clean up its
portfolio, meets with FilmLoopmanagement to tell them that they must find a buyer by the end of the
year. The FilmLoop founders argue that they thought they had a good chance at success and did not
want to sell. However, ComVentures ownership percentage, plus certain rights they have (called
drag along rights), can force the company founders to sell.
December 2006: ComVentures proposes Fabrik, another one of their portfolio companies, as the
acquirer. Fabrikacquires FilmLoop for little more than the cash ($3 million) that FilmLoop has
remaining in its bank account. Due to liquidation preference rights, the founders and all employees
walk away with nothing.
One day, the founders and employees of FilmLoop had a viable company with $3 million in the bank. The
next day they had no stock, no job, and no company. - Michael Arrington, TechCrunch
Professor David Wessels
The Wharton School of the University of Pennsylvania
315
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
AOL, MySpace bosses bloody VC merger
Venture capitalists sell themselves as friends to entrepreneurs, and talk about how they're going into business together. Isn't it useful to
know how they treat the people they're actually in business with? The tale of the formation of Velocity Interactive Group is instructive
in that regard. Former AOL CEO J onathan Miller and ex-News Corp. executive Ross Levinsohn, who oversaw MySpace, raised
eyebrows when they switched VC teams last December. The full story is even more cutthroat than we imagined.
When Microsoft set Facebook's value at $15 billion last fall, Miller and Levinsohn'splans to acquire four startups and roll them into
one blog publishing company suddenly got a lot more expensive. Too expensive. So much so that funding partner General Atlantic
dropped out. That turn of events left Miller and Levinsohnready to listen to ComVenturescofounder Roland Van der Meer. Van der
Meer offered them spots on a five-man team leading a new venture capital firm focused on digital media. Miller and Levinsohnagreed
to join. Problem was: There were already five ComVenturespartners. Two would have to go. Van der Meer decided to ax Michael
Rolnickand J eb Miller.
On the morning of December 17, the ComVenturespartners gathered for their usual Monday morning meeting. Rolnickand Miller took
their seats, coffees in hand, according to PEHub. Then Van der Meer told them they were out. "They were blindsided," one VC told
PEHub. "There was no reason to treat people that way... Rolnickhad been there nine years. This isn't a giant company doing layoffs, it's
a small partnership. It was simply wrong. That's just business, right? Well, according to PEHub, investors aren't happy about how the
shakeup went down either. They feel it makes the firm seem unstable.
One investor said:
Levinsohn and Miller are impressive guys, but it's tough for me even if I want to invest with them. To do so, I have to believe that this
entire team is going to still be together in five years, and I just can't trust that. Either Levinsohn and Miller will decide to leave because
they aren't VCs at heart, or Roland will fire them for some reason or another. Either way, it's too risky.
Professor David Wessels
The Wharton School of the University of Pennsylvania
http://fusecapital.com/investment-team
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Appendix
Article on the Founder Experience
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
What I learned in selling my
company for $100 million
Charlie Crystle
My software company ChiliSoft
sold for $100 million in 2000. Or
$70million. Or $28million.
It depends on the date you choose,
the built-in triggers, and ego.
Notably, from December 1999 to
May 2000, my stake dropped from
40% to 15% when the deal closed.
Most employee stakes dropped as
well -- but not all employees.
Mypoint at theendof thisstorywill
be something like this: sweat the
details.
Somecontext: I started ChiliSoft in
1996 in Lancaster, Pa. I had no
money, and Dad had passed away
just daysbefore. It wasatoughtime,
but I saw this huge opportunity for
addingfunctionality to Webservers,
soI tookthedeepplunge.
I tried raising money nearby, but in
those days there wasn't a firm in
Pennsylvaniathat reallygot the
Professor David Wessels
The Wharton School of the University of Pennsylvania
space, soI headedtotheWest Coast
with a credit card, deeply believing
in our mission to take over the
world. Tip: Try to take over the
world.
To save money, I slept on my
attorney Ben's floor as I bounced
around Silicon Valley trying to get
meetings and raise money. Ben
finally got me a meeting with
Draper Fisher J urvetson, one of the
leading venture-capital firms in the
field, and a few months later they
produced a termsheet. Tip: Floors
are cheaper than hotel rooms.
I signed the term sheet for $1.4
millionat 11p.m. onaSundaynight
at abar in a casino in Las Vegas --
completely emblematic, it seemed.
But I wasout of debt. DFJ savedmy
life, in a way. Tip: Try not to run
up debt -- it's unlikely you'll be
saved by Series A.
The second financing round, Series
B, was nuts -- $3.7 million on $19
million pre-money valuation, and a
capontheliquidationpreference.
That meant if wesoldfor morethan
$42 million, those who invested in
the Series B round simply got their
shareback -- andeveryonewouldbe
thrilled. Tip: Don't create the
wrong incentives.
Over the next year and a half, we
fired the CEO, and I ended up
taking theCEO job back. I wasn't a
popular guy with investors for that,
but my gut (informedintuition) said
that we needed to cut the bullshit
and sell software. I figured they'll
like us when we win. Tip: They'll
like you when you win.
The chill set in, so I focused the
company on sales, andkept sending
reports to the board. We increased
revenueinthat next quarter by three
times the prior one, and things
thawed. Tip: Communication
matters with investor relationships.
I started a CEO search; I really
didn't want to run thecompany, but
also didn't want to seesomeonerun
it into the ground. A few months
later, wehadour guy. Tip: Run the
318
Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
had anumber of largeISP partners,
like PSI and ATT, and that kind of
distribution at the time was a big
win.
Somewhereintheconversations the
talkturnedtoamerger -- Cobalt saw
our application server as a strategic
edge, and admired our traction with
major customerslikeExcite.
And that's where it gets murky for
me; I hadbeenfocusedonlaunching
asuiteof small businessappsontop
of ChiliSoft, and the talks went on
without me.
A month later I got a voicemail
fromBen: "J ust makeit easy, accept
the severance, you'll make a lot of
moneyinthesale...
I sat downintheCEO'soffice, acted
like I didn't know anything, and
talked about how excited I was
about thecompany, andhowhewas
doing so well, and... he could have
at least had the balls to tell me
himself. Tip: You won't always be
indispensable.
company, get help with ops.
At thesametime, wewerelower on
cash than was comfortable, and I
had the choice of cutting from55
peopleto 9, or bringingontheCEO
and making sure he had cash in the
bank. DFJ and another firmoffered
an onerous bridge: monthly
escalating warrants, and a
controllingboardseat. I didn't really
grok the meaning of the warrants.
Tip: Sweat the details.
I didn't want to send people home
and our pipeline was strong, so I
chosetokeeptheriderollingandgo
with it. Everyone was surprised
when I wasn't fired right away, but
thereI was, still employed.
The Prospect
That fall a great sales/biz dev guy,
Brian Pavicic, asked me to attend a
conference with him. He was
incredibly excited about a
potentially big licensing deal with
Cobalt Networks, which made
Linuxserversfor ISPs. ChiliSoft
I imagine they wanted me out
because I was dogmatic about the
direction of the company. I wanted
to make the engine free and sell
apps into it, like the CRM systemI
was building. They wanted to get
the company sold and get liquid.
Besides, CRM wasn't going to be
bigor anything.
But I wasdifficult, admittedly.
The Deal
Thedeal was struck at $100million
inJ anuary2000.
But the VCs insisted on fixing the
number of shares, not the value of
thedeal. A monthlater, they looked
like geniuses: the deal was worth
$135million. Thenext month, it fell
to $70 million. It closed in May at
$28 million, 72% down from the
deal price. Tip: Fixtheprice, not the
stock.
Themanagement teamthreatenedto
quit if they didn't get an additional
10%of thedeal.
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Venture Capital & the Finance of Innovation Lecture 14 - The Term Sheet
Professor David Wessels
The Wharton School of the University of Pennsylvania
Frommy perspective, they already
hadbetter thanaveragestock option
allocations, andI didn't believethey
would walk. But at that point I
basically decided to stop paying
attentiontothedetailsandjust get it
done, after a threatening call from
theCobalt CFO. Funstuff.
The Drop
So how did my stock drop by 62%
in 6 months? Three things:
escalating warrants, management
shakedown, andthetimingof oneof
the dips in Cobalt's wild ride in
2000.
The deal closed at $28 million --
below the $42 million threshold,
which triggered more magic. The
management shakedown took
another 10%. Tip, again: sweat the
details.
And the escalating warrants? Let's
just say it made DFJ very happy.
They made (I think) more than 15
times their original investment, with
a big boost coming fromthe bridge
deal. Overall I owealot tothose
guys-- learnedalot, madealot, and
don't regret much of it. Tip: You
don't haveto accept abad deal at
least trytonegotiate.
Somefinal tips: Runyour company-
-you'll figure it out. Get good
advisors, but follow your gut. Don't
touch anything with escalating
warrants. Be generous with
employee options and make them
meaningful.
Andonceyoucloseyour acquisition
andget your stake? Don't let it ride,
especiallyinabubble.
I did. Then Sun bought Cobalt and
the stock dropped 97% in value. I
soldenoughstock to invest inafew
startups and support some great
nonprofits, but it was a huge, huge
hit. Founders love to take risks, but
we're notorious for taking stupid
riskswithour ownmoney.
My Next Big Thing? Something
new around search. I'm raising
capital and building a team, and
wouldloveto hear your thoughts on
it.
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Term Sheets
Intermediate Rounds: Anti-Dilution Protection
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
15
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Beware: The Danger of Dilution
Through this point we have focused on liquidation values at the time of exit. But what if
intermediate financing is done at a lower value? Consider the evil entrepreneur where a majority
owner (i.e. 53% ownership) issues 100 million additional shares to another company he/she owns at
one cent per share (versus 2.67 million shares at $1.50 in the Series A round). After the transaction,
who owns the company?

Right of First Refusal: Investors who purchase at least [ 5% ] shares of Series A Preferred (a Major Investor)
shall have the right in the event the Company proposes to offer equity securities to any person (other than the
shares (i) reserved as employee shares described under Employee Pool below, (ii) etc to purchase [ x times ]
their pro rata portion of such shares
Restrictions on Sales:
The Companys Bylaws shall contain a right of first refusal on all transfers (sales) of Common Stock by common
shareholders, subject to normal exceptions (such as employees transferring shares in their estate). If the Company
elects not to exercise its right, the Company shall assign its right to the Investors.
Co-Sale Agreement (Take-me-Along Provision)
The shares of the Companys securities held by the Founders shall be made subject to a co-sale agreement (with
certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange their
stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis.
Term Sheet
Note: Not every
investor
receives each
right
VC can buythe
shares being sold
by the founder
VC can sell
shares to third
party along with
the founder
VC can buythe
shares being
issuedto a third
party
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Anti-Dilution Provisions
The right to purchase shares in the new round will protect the VC from a complete
transfer of ownership at an artificially low price. This right will not however protect the
VCs original investment. To protect the original investment, the VC needs additional
anti-dilution provisions:
Professor David Wessels
The Wharton School of the University of Pennsylvania

Anti-dilution Provisions:
In the event that the Company issues additional securities at a purchase price less than the current
Series A Preferred conversion price, such conversion price shall be reduced to the price at which the
new shares are issued.

Term Sheet
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Anti-Dilution: No Protection (1)
In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money
valuation for 50% fully-diluted ownership. If no anti-dilution provisions were in the original
contract, what would happen to Redcap Ventures ownership position?
What is the pre-money valuation? How does this compare to last rounds post money valuation?

Shares New Shares Money - Pre
Shares New
p
+
=
Shares Money Pre
p) (1
p
Shares New

=
With No Dilution Provision,
Use Original Formulas
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 3.8%
Unissued 500,000 12.5% 500,000 7.5% 500,000 3.8%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 20.0%
SeriesBPreferred:SandHillVC 6,666,667 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 13,333,333 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.90
NoProtection
SeriesA SeriesB
CapitalizationTable
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Anti-Dilution: Full Ratchet (2)
In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money
valuation for 50% fully-diluted ownership.
A full ratchet enables early round investors to preserve a portion of their initial ownership
percentage in a down round. Full Ratchet protection multiplies the number of shares held by
RedCap by [prior-round price / current-round price].
Step 1
At a price of $0.90, the full
ratchet anti-dilution provision
would add how many shares?
Step 2
If RedCap is awarded this many
shares, will Sand Hill still own
50%?
Step 3
With RedCapsnew shares and
Sand Hills new shares will the
share price remain at $0.90?
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 3.7%
Unissued 500,000 12.5% 500,000 7.5% 500,000 3.7%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 20.0%
SeriesBPreferred:SandHillVC 6,666,667 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 13,333,334 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.90
CapitalizationTable
FullRatchet
SeriesA SeriesB
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Full Ratchet (post iteration)
Technically, there is only one unknown: how many shares will be issued to RedCap. Once
RedCap shares are known, all other figures quickly become apparent.
Since the algebraic solution is complex, the easiest way to determine the effect of anti-dilution
provisions is to use iteration via Excels Goal Seek function.
From the VCs
perspective, why could a
full ratchet be harmful?
RedCap Shares
RedCap shares will be
determined via iteration.
Sand Hill Shares
Sand Hill shares are
determined by the traditional
new money equation.
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 12.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 2.1%
Unissued 500,000 12.5% 500,000 7.5% 500,000 2.1%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 8,000,000 33.3%
SeriesBPreferred:SandHillVC 12,000,000 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 24,000,000 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.50
CapitalizationTable
FullRatchet
SeriesA SeriesB
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
The Language of VC: Adjusted Conversion Price
In the full-ratchet example, our capitalization table implied Redcap Ventures shares
owned would rise from 2.67 million to 7.98 million.
In actuality, Redcap would receive no new shares, but instead their conversion rate
would change from a 1:1 conversion (comnmon:preferred) to a 3:1 to conversion rate.
The Legal Language
Assume the original purchase price was set at $1.50, i.e. $1.50 of preferred is
convertible into $1.50 of common.
Under full ratchet, the adjusted conversion price for Series A would be $1.50 / 3 or
$0.50. Thus, the adjusted conversion price of $0.50 of preferred is convertible into
$1.50 of common i.e. 1 share to 3 shares.
The conversion price for Series B would be $.50 of preferred to $.50 of common.
Professor David Wessels
The Wharton School of the University of Pennsylvania
327
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Anti-Dilution: Weighted Average Ratchets
The NVCA defines narrow-based and broad-based weighted average anti-
dilution as follows:
Professor David Wessels
The Wharton School of the University of Pennsylvania

Shares VC Shares al Hypothetic
Shares VC Shares New
Factor Adjustment Based - Narrow
A
A
+
+
=

Shares PreMoney Shares al Hypothetic
Shares PreMoney Shares New
Factor Adjustment Based - Broad
+
+
=
Weighted-averageanti-dilution provides less protection to venture capitalists
than the full ratchet provision. Iteration is still required
Hypothetical shares equals the number of shares that would have been issued to Sand Hill
Ventures at the last rounds price (or if applicable, last rounds adjusted conversion price).
(pre-money
excluding
unissued options)
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Anti-Dilution: Narrow-Based (3)
In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money
valuation for 50% fully-diluted ownership.
A narrow-based weighted-average ratchet:
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 3.8%
Unissued 500,000 12.5% 500,000 7.5% 500,000 3.8%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 20.0%
SeriesBPreferred:SandHillVC 6,666,667 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 13,333,333 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.90
NoProtection
SeriesA SeriesB
CapitalizationTable
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Narrow-Based (post iteration)
In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money
valuation for 50% fully-diluted ownership.
A narrow-based weighted-average ratchet, following full iteration:
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 17.8%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 3.0%
Unissued 500,000 12.5% 500,000 7.5% 500,000 3.0%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 4,444,444 26.3%
SeriesBPreferred:SandHillVC 8,444,444 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 16,888,889 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.71
CapitalizationTable
NarrowBase
SeriesA SeriesB
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Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Comparison of Various Method
Professor David Wessels
The Wharton School of the University of Pennsylvania
PriorRoundPrice
left-side
CurrentPrice
=
Post Money
CurrentPrice
left-side
Post-Money
PriorRoundPrice

=
A
A
NewShares +VC
multiplier=
Hypothetical Shares+VC
Start with the anti-
dilution multiplier.
Replace new shares and
hypothetical shares
with their respective
definitions.
Divide both the
numerator and
denominator by post-
money.
which equals
the full ratchet
multiplier!
331
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Comparative Statics
The weighted average anti-dilution provision is a weighted average between
full ratchet and 1. As the new round increasesrelative to VC
A
, does the Series
A protective multiplier become larger or smaller?
Professor David Wessels
The Wharton School of the University of Pennsylvania
A
A
NewShares +VC
multiplier=
Hypothetical Shares+VC
PriorRoundPrice
M
CurrentPrice
=
M 1 =
332
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Anti-Dilution: Broad-Based (4)
In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money
valuation for 50% fully-diluted ownership.
A broad-based weighted-average ratchet:
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 22.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 3.8%
Unissued 500,000 12.5% 500,000 7.5% 500,000 3.8%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 20.0%
SeriesBPreferred:SandHillVC 6,666,667 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 13,333,333 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.90
NoProtection
SeriesA SeriesB
CapitalizationTable
333
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
Broad-Based (post-iteration)
In a Series B offering, Sand Hill Ventures offers $6 million in new money at a $12 post-money
valuation for 50% fully-diluted ownership.
A broad-based weighted-average ratchet, following full iteration:
PreFinancing
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 19.7%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 3.3%
Unissued 500,000 12.5% 500,000 7.5% 500,000 3.3%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 3,614,815 23.7%
SeriesBPreferred:SandHillVC 7,614,815 50.0%
Total 4,000,000 100.0% 6,666,667 100.0% 15,229,630 100.0%
Valuation(in$) 6,000,000 10,000,000 12,000,000
PricePerShare(in$)
1.50 1.50 0.79
CapitalizationTable
BroadBased
SeriesA SeriesB
334
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Comparison of Anti-Dilution Methods
Full ratchet provisions provide
the most protection, but as
discussed earlier are typically
unenforceable (64% of down
rounds waive protection).
For those contracts with anti-
dilution protections, only 27%
have full ratchet. The
remaining contracts used
weighted average anti-dilution
protection.
Professor David Wessels
The Wharton School of the University of Pennsylvania
33.3%
26.3%
23.6%
20.0%
Fullratchet
Narrow
based
Broad
based
No
protection
EffectofVariousAntiDilutionProvisions
Value
$4.00
$3.15
$2.83
$2.40
335
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Empirical Evidence
Professor David Wessels
The Wharton School of the University of Pennsylvania
Venture capitalists
understand the ex-post
incompatibility of full
ratchet protection.
Consequently, it is
rarely used, even
though it provides the
VC with the most
downside protection.
AntiDilutionProtection
WilsonSonsini
Protecti on Type 2010 Q1 Q2 Q3 Q4
Weighted average - Broad 91% 82% 91% 93% 82%
Weighted average - Narrow 3% 7% 4% 3% 1%
Full ratchet 3% 4% 1% 0% 6%
Other (including blend) 3% 7% 5% 4% 11%
Source:WilsonSonsini
2011
336
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Closed-Form Solution
Define x as the VC
A
multiplier.
Define the following variables as:
1. Define p as the percentage of
ownership Series B is requesting
2. F equals the #of founder shares
3. VC
A
equals the #of Series A shares
4. VC
B
equals the #of Series B shares
5. H equals the number of shares that
would have been issued to Series B at
the last rounds price.
Define AD as either zero (full ratchet),
the number of VC
A
shares (narrow
base) or the first round shares (broad
base) excluding unissued options.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Full Ratchet Narrow Base Broad Base
( )
( )( )
A
pVC AD H p - 1
AD p - 1 pF
x
+
+
=
( )
A B
xVC F
p - 1
p
VC + =
(pre) xVC (post) VC
A A
=
337
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Pay-to-Play Provision
Anti-dilution provisions do not provide a free ride to old investors. If an old
investor does not participate in the new round, they will be immediately
converted to common. Conversion to common means the investor will lose
their liquidation preference and their anti-dilution multiplier on prior round
shares?
Professor David Wessels
The Wharton School of the University of Pennsylvania

Pay-to-Play:
In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any
Investor which is offered the right to participate but does not participate fully in such financing by
purchasing at least its pro rata portion as calculated above under "Right of First Refusal" below will be
converted into Common Stock.
Term Sheet
338
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Appendix
Professor David Wessels
The Wharton School of the University of Pennsylvania
339
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
A
A B
VC H
VC VC
x
+
+
=
( )
A B A
VC VC VC H x + = +
( ) ( )
A A A
VC xVC F
p - 1
p
VC H x + + = +
(definition of narrow-based)
Appendix: Proof of Narrow-Based
Pre-money Shares
(including anti-dilution)
p =Series B Ownership %
Define x as the VC
A
multiplier.
Define the following variables as:
1. Define p as the percentage of
ownership Series B is requesting
2. F equals the #of founder shares
3. VC
A
equals the #of Series A shares
4. VC
B
equals the #of Series B shares
5. H equals the number of shares that
would have been issued to Series B at
the last rounds price.
340
Venture Capital & the Finance of Innovation Lecture 15 Anti-Dilution Provisions
Professor David Wessels
The Wharton School of the University of Pennsylvania
( )( ) ( )
A A A
VC p - 1 ) xVC p(F VC H p - 1 x + + = +
( )( ) ( )
A A A
VC p - 1 pF pxVC VC H p - 1 x + = +
( )
( )( )
A A
A
pVC VC H p - 1
VC p - 1 pF
x
+
+
=
( ) ( )
A A A
VC xVC F
p - 1
p
VC H x + + = +
Appendix: Proof of Narrow-Based
Define x as the VC
A
multiplier.
Define the following variables as:
1. Define p as the percentage of
ownership Series B is requesting
2. F equals the #of founder shares
3. VC
A
equals the #of Series A shares
4. VC
B
equals the #of Series B shares
5. H equals the number of shares that
would have been issued to Series B at
the last rounds price.
341
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Term Sheets: Security Design and
Capital Structure in VC-Backed Firms
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
16
342
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
A Review of the RedCap Ventures Transaction
During this session, we discuss
the payoff structure for various
capital structures related to
venture capital financing.
In our original example, Redcap
Ventures purchased 2.67 million
Series A shares at $1.50 per share.
(for an aggregate purchase price
of $4 million).
How these shares eventually
payout, depends on contractual
terms. Lets examine a few
Security #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5%
Unissued 500,000 12.5% 500,000 7.5%
SeriesAPreferred:RedcapVentures 2,666,667 40.0%
Total 4,000,000 100.0% 6,666,667 100.0%
Valuation(in$) 10,000,000
PricePerShare(in$)
1.50
PreFinancing
CapitalizationTable
PostFinancing
343
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Redeemable Preferred - Exit Diagram (RP)
Redcap Ventures purchased 2.67 million
shares at $1.50 per share for an aggregate
purchase price (APP) of $4 million.
If the stock is deemed preferred with a 2x
liquidation preference, what is the payoff
diagram upon liquidation.
For now, assume no conversion is allowed
and no common stock is issued stock can
only be redeemed at 2x initial stock price.
How does redeemable prefer compare to
traditional debt? How is it the same?
How is it different?
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemablePreferred(noconversion)
344
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Aggregate Purchase Price (APP)
Early transactions in venture capital were done
with a mixture of redeemable preferred and
common stock.
If two securities comprise a single investment
round, it is necessary to split the new money into
each security. For instance, assume RedCap
purchases:
Redeemable preferred (RP) with an
aggregate purchase price of $2 million
Common shares for $2 million, such that
common shares comprised 40% of
aggregate common shares.
If the RP has a 2x liquidation preference, what
does the payoff diagram for common look like?
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RP+CommonStock
345
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Features of Preferred Stock: Conversion
Redeemable Convertible Preferred (RCP):
VCs are not banks instead, they focus on upside. Therefore, preferred stock
is convertibleinto common shares at the original purchase price. Once
preferred stock is converted it loses any preference provisions.
Term Sheet

Liquidation Preference:
In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as
follows: First pay [ X ] times the Original Purchase Price plus accrued dividends on each share of
Series A Preferred. The balance of any proceeds shall be distributed to holders of Common Stock.
Optional Conversion:
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.
Either
Or
346
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Redeemable Convertible Preferred Stock
Redcap Ventures purchased 2.67
million shares at $1.50 per share for
an aggregate purchase price (APP)
of $4 million.
With this purchase, Redcap acquired
the rights to 40%of the common
stock upon conversion. What would
the payoff for straight conversion
look like?
When would RedCap redeem its
preferred? When would it chose to
convert preferred into common?
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
347
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Participating Convertible Preferred Stock(PCPS)
In half of all transactionsexamined by
Kaplan & Stomberg(2003), convertible
preferred was participating.
"Participating" preferred refer to
securities that participate in excess
earnings with the common stock over
and above their preferred dividend.
One of the most important features of
these securities is that they allocate
different cash flow rights depending on
whether exit occurs through a Trade Sale
(TS) or an Initial Public Offering(IPO).
Liquidation Preference:
In the event of any liquidation, dissolution or
winding up of the Company, the proceeds shall
be paid as follows:
First pay one times the Original Purchase Price
on each share of Series A Preferred. Thereafter,
Series A Preferred participates with Common
Stock on an as-converted basis.
A merger or consolidation and a sale, lease,
transfer 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.
Corporate Charter
348
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Participating Convertible Preferred Stock
If Redcap Ventures shares are convertible at 40% of total common stock, but are
designated as participating preferred (at 2x) in a liquidation event, what would
the exit diagram look like?
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
ParticipatingConvertiblePreferred
349
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Voluntary versus Mandatory Conversion
In a deemed liquidation event, such an acquisition, the preferred shareholders
can convert into common if they so choose (a voluntary conversion).
To complete an IPO, all preferred shares will be converted into common stock.
This is known as automatic conversion. In this case, PCSP no longer has value
Professor David Wessels
The Wharton School of the University of Pennsylvania
Term Sheet

Mandatory Conversion:
Each share of Series A Preferred will automatically be converted into Common Stock at the then
applicable conversion ratein 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.

350
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
Acquisition versus an IPO
Most venture capital agreements
provide for mergers or trade sale as
a liquidation event, in which case
the venture capitalist is entitled to
participation preferred rights.
Why is there a difference? Think
of the VC now as the informed
investor (versus the entrepreneur).
From a purely financial standpoint,
what will the VC prefer? What
non-financial considerations does a
VC have?
0
4
8
12
16
20
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
ParticipatingConvertiblePreferred
Trade Sale or
Liquidation
Qualified Public
Offering
Exercise: Which is worth
more to the VC? A $20
million acquisition or a $25
million IPO?
351
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
What does a QPO prevent?
Professor David Wessels
The Wharton School of the University of Pennsylvania
352
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Mandatory Conversion for RCP?
An investment banker will
be no more likely to
support a redeemable
convertible than a
participating convertible
in an IPO.
So why is there no
mandatory conversion
clause for RCP securities?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
Trade Sale or
Liquidation
Qualified Public
Offering
353
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
PCPS With Cap
When combined with a multiple times
liquidation preference, the double-
dipping of participating stock appears
over-reaching, especially for large
payouts.
Therefore, many VCs will cap their
preferred rights at some level, even in
the cast of an acquisition or liquidation.
A cap can be found either described
explicitly in the liquidation preference,
or implicitly in a provision on
mandatory conversion.
Liquidation Preference:
In the event of any liquidation, dissolution
or winding up of the Company, the
proceeds shall be paid as follows:
First pay one times the Original Purchase
Price on each share of Series A Preferred.
Thereafter, Series A Preferred participates
with Common Stock on an as-converted
basis until the holders of Series A
Preferred receive an aggregate of [ ]
times the Original Purchase Price.
354
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
PCPS With Cap: Exit Diagrams
Redcap Ventures purchased 2.67
million shares at $1.50 per share for an
aggregate purchase price (APP) of $4
million.
Redcap Ventures shares are
convertible at 40% of total common
stock, but are designated as
participating preferred (at 2x) in a
liquidation event.
If the participating preferred is capped
at 3x(which is typical) what do the
payout diagrams look like?
Note: Pro-entrepreneur attorneys will fight for 1x liquidation preference and
2x cap on participating, arguing that VC always can convert to common.
0
4
8
12
16
20
0 10 20 30 40
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
ParticipatingConvertiblePreferredwithCap
355
Venture Capital & the Finance of Innovation Lecture 16 - Capital Structure in VC-Backed Firms
Professor David Wessels
The Wharton School of the University of Pennsylvania
VC Hybrid Securities: A Summary
Long gone are the days of simple common stock.
Today, venture capitalists use a variety of preferred
stock contracts to limit the problems caused by
information asymmetries, both between the
entrepreneur & VC as well as between the VC and
the stock market. Preferred stock includes:
Redeemable Preferred (RP)
Redeemable Convertible Preferred (RCP)
Redeemable Convertible Participating Preferred
(PCP)
Redeemable Convertible Participating Preferred with
cap (PCP with CAP)
Payoff Diagrams
356
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Fundamentals of Options Pricing
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
17
357
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Venture Capital & Contingent Claims
To value a company, we use
traditional valuation techniques
such as discounted free cash flow
(using probabilities) or transaction
multiples.
Because the payoff structures in
venture capital are not linear
functions of enterprise value,
traditional methods are unreliable.
Instead, use option pricing models
to convert enterprise value into
preferred stock value.
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
358
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Derivatives / Contingent Claims
In this lecture, we review the
fundamentals of option pricing.
These valuation techniques were
pioneered by Black, Merton, and
Scholes during the early 1970s.
The valuation of contingent claims
(such as options and other
derivatives) is unique because if the
underlying security is traded, it
does not require probability
assessments, nor an estimate of the
cost of capital.
0
30
60
90
120
150
0 50 100 150 200
C
a
l
l

O
p
t
i
o
n

P
a
y
o
f
f
Stock Price
ExitDiagramforaCallOption
359
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Contingent Claims Valuation: Binomial Trees
Lets value a contingent claim in a
one period, two state world. For
exposition, we start with a two state
model and then we generalize to
multiple periods.
What is the value of a stock that
can either rise to $130 or fall to $90
with equal probability? The cost of
equity equals 10%
What are the payoffs and DCF
value for a call option with a strike
price (K) of $100?
S
0
= ?
The Underlying Asset
S
u
= 130
S
d
= 90
C
0
= ?
The Contingent Claim
C
u
= max(S
1
- K, 0) =
C
d
= max(S
1
- K, 0) =
360
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Replicating Portfolio: An Example
To value the call option, we can not use discounted cash flow, since we can not
properly measure the options cost of capital. Instead, we use replicating portfolios.
Since there are two states of the world, we need two assets to replicate the payoff
structure of the option. The first is the underlying asset (in this case a stock). The
second is a risk free bond, that pays B regardless of the future state.
Assume the risk free bond pays 5%, regardless of end state.
N(130)+ B = 30
N(90)+ B = 0
Payoff in
up state
Payoff in
down state
361
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Pricing the Option
To replicate the call payoffs perfectly, we need to purchase 0.75 shares (N) and
borrow $64.29 dollars (present value of B). Lets verify the portfolio payoff,
and then value this portfolio in order to value the call option.
(.75)(130) (67.50) =
(.75)(90) (67.50) =
Payoff in
up state
Payoff in
down state
Verify the Portfolio Payoff Value the Portfolio
f
0
r 1
B
NS C
+
+ =
Law of One Price:
362
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Arbitrage Portfolios
You are discussing option theory with a group of Harvard MBAs, who
are still using traditional DCF to value options. They offer to buy/sell
options on the stock at $13.64. If you can trade the underlying asset
seamlessly, how can you profit from the offer?
Professor David Wessels
The Wharton School of the University of Pennsylvania
In 2008, who played the role of the Harvard MBA? Why did the
arbitrage trades fail? Who backed up the trades?
363
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Contingent Claims Valuation: Key Insights
Discounted cash flow can be used to value the call option, but ONLY
if you know the appropriate cost of capital. Since we know the option
value, we can back out the cost of capital. Is the cost of capital higher
or lower than the underlying asset (which was 10%)?
C
0
= ?
The Contingent Claim
C
1
= max(S
1
- K, 0) =
C
2
= max(S
1
- K, 0) =
Key Insight
A call option is
identical to a levered
stock position
364
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Binomial Pricing Generalized Formula
Building a replicating portfolio to
value each option can be insightful,
but quite time consuming!
Therefore, we use general terms and
a touch of algebra to determine an
options price with a single formula.
The key determinants of option are
S, u & d, r
f
, and C
u
& C
d
. The
number of shares (N) and required
borrowing (B) are intermediate
steps.
Professor David Wessels
The Wharton School of the University of Pennsylvania
S
0
= ?
The Underlying Asset
S
1
= 130 = uS
0
S
1
= 90 = dS
0
C
0
= ?
The Contingent Claim
C
1
= max(S
1
- K, 0) = C
u
C
2
= max(S
1
- K, 0) = C
d
365
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Binomial Pricing: Derivation
We have just shown a specific example of how to price a call option
(or any contingent claim) using binomial option pricing. Lets
generalize our results.
u
C B N(uS) = +
d
C B N(dS) = +
) C - (C d)S - N(u
d u 0
=
0
d u
d)S - (u
) C - (C
N =
u 0
C B ) N(uS = +
) N(uS C B
0 u
=
f
0
r 1
B
NS C
+
+ =
366
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Binomial Pricing: Derivation
To derive a robust DCF based
model for option pricing, we
start with the price of the
replicating portfolio.
Using our solution for the
number of shares (N) and risk
free borrowing (B), we can use
algebra to rearrange the
equation.
The algebra is available in the
appendix of this presentation.
Professor David Wessels
The Wharton School of the University of Pennsylvania
f
0
r 1
B
NS C
+
+ =
| | N(uS) C ) r NS(1
) r (1
1
C
u f
f
0
+ +
+
=
|
.
|

\
|
|
.
|

\
|
+
+
+
+
=
d u 0
C
d - u
d - r) (1
1 C
d - u
d - r) (1
r) (1
1
C
( ) | |
d u
f
0
C * p 1 C * p
) r (1
1
C +
+
=
And now simplify
with a tremendous
amount of nasty
algebra!
367
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Binomial Pricing Generalized Formula
Economists call this formula risk-neutral
pricing. Call options are not risk-free,
rather the risk has been incorporated
within in the probabilities (p*) and not the
traditional cost of capital.
( ) | |
d u
f
0
C * p 1 C * p
) r (1
1
C +
+
=
d - u
d - ) r (1
p*
f
+
=
such that
| |
) r (1
* p p | C E
C
f
1
0
+
=
=
Economists call these probabilities risk-
neutral probabilities.
Note how the underlying assets cost of
capital and original probabilities (p) are not
required to solve for the call price!
Using the formula,
what is the value of
our call option?
368
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Valuation of Any Security
Risk neutral valuation works for any
payoff:
What is the value of a call option on a
stock trading at $100 with a strike
price of $110? Assume u = 1.3, d =
0.9, and the risk free rates equals 5%.
What is the value of stock, trading at
$100. Assume u = 1.3, d = 0.9, and
the risk free rate equals 5%.
( ) | |
d u
f
0
C * p 1 C * p
) r (1
1
C +
+
=
d - u
d - ) r (1
p*
f
+
=
such that
369
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
The Risk Neutral World: Minority Report
Professor David Wessels
The Wharton School of the University of Pennsylvania
Do you remember the movie
minority report? I was writing
a paper about option pricing
when it came out.
In the movie, Tom Cruise was
able to spin and move pictures
at will. If only we had this
technology for option
pricing
370
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
The Risk Neutral World: Algebraic Transformation
Professor David Wessels
The Wharton School of the University of Pennsylvania
Different call options have different hedge & leverage ratios, so why can we use just one
set of probabilities? Because the stock and bond now have the same expected rate of
return. So leveraging the portfolio does not change the expected rate of return!
0%
10%
20%
30%
40%
50%
0% 20% 40% 60% 80% 100% 120% 140% 160%
E
x
p
e
c
t
g
e
d

R
e
t
u
r
n
Annual Volatility
MeanVariancePlot:Actual
0%
10%
20%
30%
40%
50%
0% 20% 40% 60% 80% 100% 120% 140% 160%
E
x
p
e
c
t
g
e
d

R
e
t
u
r
n
Annual Volatility
MeanVariancePlot:RiskNeutralWorld
371
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Discrete Models Becoming Continuous
Clearly a one period, two state
world is very realistic.
What if we, however, took the
length of each intermediate
period to be very small? And
used many one period models
stacked upon another to create
a price diffusion process.
We could then use recursive
valuation (from back to front)
to value a derivative security.
Time 1 Time 2 Time 3 Time 4 Time 5
S
0
= 100
S
5
= 130
S
5
= 90
What happens if we take the length of each
time period towards zero?
372
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Black-Scholes Option Pricing Model
To value a call option, we can use
multiple binomial trees, starting
at the end and working
backwards.
Fischer Black and Myron Scholes
used the concept of arbitrage free
portfolios of two assets, but
instead worked in continuous
time.
They argued a call could be
replicated through a continuously
updated leveraged position in the
stock.
T -r
2 0 1 0
f
e )K N(d - S ) N(d C =
becomes
T
T
2

r
K
S
ln
d
2
f
0
1
|
|
.
|

\
|
+ +
|
.
|

\
|
=
T d d
1 2
=
such that
f
0
r 1
B
NS C
+
+ =
373
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Black Scholes: An Example
What is the value of a call option on a stock trading at $100 with a
strike price of $100. Assume the time to expiration is one year, the
risk free rate is 5%, and the annualized volatility is 20%.
EUROPEAN CALL
European Call Calculation
stock price S= $100.00
strike price X= $100.00
standard deviation (annualized) o= 20.00%
riskfree interest rate r= 5.00%
time until expiration T= 1
Call Option Value $10.45
Source: VCV
All inputs in
consistent
time periods
374
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Limitations in Practice
Black-Scholes is an extremely powerful
model, and can help to bound option
valuations. A few drawbacks exist, however,
for the Black Scholes model:
Black Scholes requires a constant
interest rate and a constant volatility .
Cochrane (2005), however, argues the
perceived drop in volatility following
investment rounds is not reliably found
in VC-based data.
Black Scholes requires that the
underlying asset be liquid. Otherwise,
the replicating portfolio is merely a
theoretical construct.
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
140.0%
Jun99 Jun00 Jun01 Jun02 Jun03 Jun04 Jun05 Jun06 Jun07
AnnualizedVolatility
Amazon.ComvsS&P500
Measuredusing2yearsofhistoricalreturns
375
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Determinants of Option Value
There are five primary determinants of an options value: the stock
price, the exercise price, the stocks volatility, the time to maturity, and
the interest rate.
Symbol Value Driver Current Value Effect on Call Value
Stock Price $90
Exercise Price $100
The Stock's Volatility 18%
Time to Maturity 3 months
Interest Rate 5%
376
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Sensitivity Analysis: Stock & Strike Prices
What happens to the value of a call option, as the stock price increases?
What happens to the value of a call option, as the strike price drops?
Probabi l i ty of Posi ti ve Payoff
Wi th Low Stock
0
10
20
30
40
50
60
0 50 100 150
Stock Pri ce
P
a
y
o
f
f
Probabi l i ty of Posi ti ve Payoff
Wi th Val uabl e Stock
0
10
20
30
40
50
60
0 50 100 150
Stock Pri ce
P
a
y
o
f
f
377
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Value of Uncertainty
The greater the volatility, the more opportunities for high payoff.
Therefore, options are the most valuable when the underlying asset is
highly volatile.
Probabi l i ty of Posi ti ve Payoff
Wi th Low Vari ance
0
10
20
30
40
50
60
0 50 100 150
Stock Pri ce
P
a
y
o
f
f
Probabi l i ty of Posi ti ve Payoff
Wi th Hi gh Vari ance
0
10
20
30
40
50
60
0 50 100 150
Stock Pri ce
P
a
y
o
f
f
378
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
The Determinants of Option Value
There are five primary determinants of an options value: the stock
price, the exercise price, the stocks volatility, the time to maturity, and
the interest rate.
Symbol Value Driver Current Value Effect on Call Value
Stock Price $90
Exercise Price $100
The Stock's Volatility 18%
Time to Maturity 3 months
Interest Rate 5%
379
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Appendix
Binomial Pricing Derivations
Professor David Wessels
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
380
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Binomial Pricing: Derivation
We have just shown a specific example of how to price a call option
(or any contingent claim) using binomial option pricing. Lets
generalize our results.
u
C B N(uS) = +
d
C B N(dS) = +
) C - (C d)S - N(u
d u 0
=
0
d u
d)S - (u
) C - (C
N =
u 0
C B ) N(uS = +
) N(uS C B
0 u
=
f
0
r 1
B
NS C
+
+ =
381
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Binomial Pricing: Derivation
Substitute the equation for B from the previous
page into the last formula. Rather than keep
(1+r) attached to B, move it outside the brackets.
f
0
r 1
B
NS C
+
+ =
| | N(uS) C ) r NS(1
) r (1
1
C
u f
f
0
+ +
+
=
| |
u
f
0
C u) - r NS(1
) r (1
1
C + +
+
=
(

+ +
+
=
d - u
d) - (u C
u) - r (1
d - u
C - C
r) (1
1
C
u d u
0
The value of a call option equals the value of the
tracking portfolio, where N equals the number of
shares, and B equals the debt borrowed.
Combine the two terms which are a function of N
and S into a single term.
Substitute the equation for N from the previous
page into the last formula. Multiply C
u
by one.
382
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Binomial Pricing: Derivation
|
.
|

\
|
+

+ +
+
=
d u 0
C
d - u
u - r 1
C
d - u
d - u u - r 1
r) (1
1
C
|
.
|

\
|
+
+
+
+
=
d u 0
C
d - u
r) 1 ( u
C
d - u
d - r) (1
r) (1
1
C
|
.
|

\
|
+ +
+
+
+
=
d u 0
C
d - u
d r) 1 ( d - u
C
d - u
d - r) (1
r) (1
1
C
|
.
|

\
|
|
.
|

\
|
+
+
+
+
=
d u 0
C
d - u
d - r) (1
1 C
d - u
d - r) (1
r) (1
1
C
Start with the last equation from the previous page.
(

+ +
+
=
d - u
d) - (u C
u) - r (1
d - u
C - C
r) (1
1
C
u d u
0
Separate C
u
from C
d
and then combine like terms.
Cancel u with itself, and rearrange -(1 + r u) into
u - (1+r).
Add and subtract d in the second term.
Cancel u-d in numerator and denominator of the
second expression and we are done!
383
Venture Capital & the Finance of Innovation Lecture 17 Fundamentals of Option Pricing
Professor David Wessels
The Wharton School of the University of Pennsylvania
Binomial Pricing Generalized Formula
Economists call this formula risk-
neutral pricing. Call options are not
risk-free, rather the risk has been
computed within in the probabilities (p*)
and not the traditional cost of capital.
( ) | |
d u
f
0
C * p 1 C * p
) r (1
1
C +
+
=
d - u
d - ) r (1
p*
f
+
=
such that
| |
) r (1
* p p | C E
C
f
0
+
=
=
Economists call these probabilities risk-
neutral probabilities.
Note how the cost of capital and
original probabilities are not necessary!
384
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
18
Valuation of Venture Capital Claims
Using VCV
385
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Session Overview
A preferred share can be replicated by a series of call options. To determine
the appropriate portfolio of call options, first build a payoff diagram.
Rather than compute the value of each option one-by-one, use the VCV Excel
model, built by Wharton alumni.
The VCV model uses a modified version of Black-Scholes to value each call
option, summing the resulting values.
The primary modification to the Black-Scholes valuation is the time to expiration.
Rather than use a fixed time, the model uses a series of probability-weighted times.
Dividends will affect the payoff diagrams and consequently the valuation.
VCV has the capability to handle dividends.
Professor David Wessels
The Wharton School of the University of Pennsylvania
386
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Venture Capital & Contingent Claims
To value the portfolio company,
use traditional valuation
techniques such as discounted
free cash flow (using scenarios
and probabilities) or multiples.
Because the payoff structures in
VC-backed companies are not a
simple linear functions of
enterprise value, use options
models to convert enterprise
value into preferred stock value.
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
387
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Constructing Tracking Portfolios: Redeemable
Earlier, Redcap Ventures purchased 2.67 million shares at $1.50 per share in
Series A financing (for an aggregate purchase price of $4 million).
If preferred stock is redeemable at 2x but not convertible, how can we
construct a portfolio of stocks and options?
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemablePreferred(noconversion)
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemablePreferred(noconversion)
388
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Constructing Tracking Portfolios: Convertible
If preferred stock is redeemable at 2x and convertible into 40% of
common, how can we construct a portfolio of stocks and options?
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
0
2
4
6
8
10
12
0 5 10 15 20 25 30
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
389
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Valuation of Preferred Stock
If the stock is redeemable at
2x and also convertible into
40% of common, we can
value the claim as follows:
20) (0.4)C(at 8) C(at EntVal PS
0 0
+ =
Supposedly, we purchasing
40% of a $10 million
company for $4 million. But
how much is the VC claim
really worth?
390
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Sensitivity: Increased Volatility
A few questions:
What happens to the value of
the company if the volatility
of cash flows rises, but
expected cash flow and
covariation with the economy
remains at historical levels?
What happens to the value of
preferred stockwhen volatility
rise?
391
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Negotiations: The Counter Proposal
Your VC firm is considering an investment in iPet.com. You estimate iPets
enterprise value at $20 million. The volatility of enterprise value is estimated
at 90% per year.
You propose making an investment of $5 million in participating redeemable
convertible preferred. The liquidation preference will equal 2x, and the
security in convertible into 25% of the common stock. What is the payoff
diagram? What is the security worth? Should you make the investment?
What if the founder balks at double-dipping? What percentage of common
would you counter with, for straight redeemable convertible preferred?
Continue to assume the 2x liquidation preference?
392
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Exit Diagrams
Build the payoff diagram for each preferred share type:
0
4
8
12
16
20
0 10 20 30 40
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
0
4
8
12
16
20
0 10 20 30 40
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
ParticipatingConvertiblePreferred
393
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Original Valuation: Participating
0
4
8
12
16
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0 10 20 30 40
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
ParticipatingConvertiblePreferred
394
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Valuation & the Counter Proposal
0
4
8
12
16
20
0 10 20 30 40
P
r
e
f
e
r
r
e
d

s
t
o
c
k

p
a
y
o
f
f
Enterprisevalue ($millions)
ExitDiagramfor
RedeemableConvertiblePreferred
395
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Negotiation: Interesting Issues
How will the Post-Money valuation change?
In the original offer, you propose a $5 million investment for 25% of a $20 million
post-money valuation. The participation feature made the security quite valuable.
In the response, you propose RCP with a greater percentage ownership. How does
this change the post-money valuation? Should we change the VCV model to
reflect the new post-money valuation?
Does security choice matter?
As the venture capitalist, you have designed two securities with identical economic
values ($8.78 million).
You offer both contracts to the entrepreneur. Even with identical economic values,
why should you care which security the entrepreneur chooses? How can you use
this information ex-ante?
Professor David Wessels
The Wharton School of the University of Pennsylvania
396
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Valuation of Venture Capital Claims
VCV: How the Model Works
Professor David Wessels
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
397
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Why the Need to Press Calculate?
European Call Options have a fixed expiration date. For VC-based
preferred stock, when do the imbedded options expire? They do not!
So how do we handle random expiration (RE)?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Value (T =1) =4.5 million
Value (T =2) =4.9 million
Value (T =3) =5.5 million
Value (T =4) =6.3 million
Value (T =5) =7.5 million
A Black-Scholes
valuation based on a (1)
particular underlying
asset price, (2) strike
price, (3) volatility, (4)
interest rate, and (5)
time to expiration of
three years.
398
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
RE Calls versus European Calls
Random expiration calls
require numerical
approximation because the
normal function N(d
1
) within
the valuation equation is
impossible to integrate.
The same inputs as a
traditional call are still
required, except now we
model time as the 50%
threshold of expiration.
EUROPEAN CALL
European Call Calculation
stock price S= $100.00
strike price X= $100.00
standard deviation(annualized) o= 35.00%
riskfree interest rate r= 5.00%
time until expiration T= 1
Call Option Value $16.13
399
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Why the Need to Press Calculate?
A traditional call option give its holder the right to purchase the underlying
asset (such as a stock) for a set period of time. The option holder can choose
when to exercise (American options).
Venture capital options are unlike to traditional call options, as the holder can
be forced to close out their positionat any time (Random Expiration).
We value random expiration by taking the expected value of multiple call
options:
| |

=
=
T
1 t
rt -
2 0 1 RE
)Ke N(d - )S N(d p(t) C
Probability that
option will be exercised
on date t
Value of
the option
400
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
The Exponential Distribution
The exponential distribution is the most common distribution for (theoretically) measuring
wait times, such as the time it takes before the next phone call arrives to a call center or the
time until default (on payment to company debt holders) in credit risk modeling.
The exponential distribution is described by a single parameter (denoted by lambda or q).
Professor David Wessels
The Wharton School of the University of Pennsylvania
0%
25%
50%
75%
100%
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0
ExponentialDistribution
CumulativeDistributionFunction
q=0.5
q=1.5
q=1.0
0.00
0.25
0.50
0.75
1.00
1.25
1.50
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0
ExponentialDistribution
ProbabilityDensityFunction
q=0.5
q=1.5
q=1.0
q
1
Exp[t] =
qt
qe PDF[t]

=
401
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Probability of Conversion: The Distribution
Various probability density functions are available to model random expiration, but to
be consistent with other theoretical models (such as component failure probabilities), we
choose the exponential distribution.
The exponential function is continuous, allows for any possible timeto conversion, but
decays at a reasonable rate.
| | 1 x )Ke N(d - )S N(d qe C
months 120
0 t
rt -
2 0 1
qt
RE
=

=
probability value
In VCV (module 2):
Do While counter <numPeriods

revar =revar +(qvar * Exp(-qvar * (counter / 15) / 24) * BS(svar, xvar, (counter / 15) / 24, vvar, rvar))
....
Loop
VCV is the work-product of
many alumni, which has led to
less than desirable coding.
For instance, the model started
with bi-monthly time periods,
and has now moved to daily
time periods
The program uses Simpson's rule integration.
402
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Exponential Distribution: Measuring Q
How should we think about the distribution? Currently the model uses expected holding
period to determine q, which is the best unbiased statistic if you are estimating
using historical exits. If you are conceptualizing exits with no data, than perhaps
median would be a better statistic
Professor David Wessels
The Wharton School of the University of Pennsylvania
0%
25%
50%
75%
100%
0 1 2 3 4 5 6 7 8
Timein Years
CumulativeProbabilityofMandatoryConversion
UsingExponentialDistribution
q=0.1
q=0.2
q=0.15
q
1
Exp[t] =
q
ln(2)
Median[t]=
Summary
Statistics
Note: The ln(2) equals 0.7, so Median =(0.7) Expectation
403
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Modeling Dividends
Preferred stock can include a cumulative dividend. Typically, this dividend does not pay
in cash; instead, it adds to the redeemable value of the preferred and is paid upon exit.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Alternative 1: Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and
if paid on the Common Stock
Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a
liquidation or redemption]. For any other dividends or distributions, participation with Common Stock
on an as-converted basis.
Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to
$[_____] per share of Series A Preferred when and if declared by the Board.
In some cases, accrued and unpaid dividends are payable on conversion as well as upon a
liquidation event. Most typically, however, dividends are not paid if the preferred is
converted. Another alternative is to give the Company the option to pay accrued and
unpaid dividends in cash or in common shares valued at fair market value. The latter are
referred to as PIK (payment-in-kind) dividends.
404
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Valuation with Dividends: Payoff Diagrams
Professor David Wessels
The Wharton School of the University of Pennsylvania
The payoff diagram will depend on dividends. This occurs because dividends will
change the redemption value.
Draw the payoff diagram for a company that pays 2x the liquidation preference, plus a
cumulative (but non-compounding) dividend of 8%. What is the payoff diagram in the
fifth year?
0
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ExitDiagramfor
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Payoff at
Time Zero
405
Venture Capital & the Finance of Innovation Lecture 18 - Valuation of Venture Capital Claims
Professor David Wessels
The Wharton School of the University of Pennsylvania
Dividends & RE Calls
Preferred stock can include a cumulative dividend. This dividend does
not pay in cash; instead, it adds to the redeemable value of the
preferred and is paid upon exit.
Including dividends in our analysis is more complex than the inclusion
of a liquidation preference, because the strike price is changingover
time. But this is easily handled in a random expiration call.
| | dt qe )K(t)e N(d - )S N(d C
qt
0 t
rT -
2 0 1 RE

=
}
=
probability
The strike (K )is a function of time as well
(DivRate)t
Ke K(t) =
such
that
Since the RE option already requires us to
compute a separate Black-Scholes formula at
every point in time, the model can easily
handle changing strike prices caused by
dividends.
406
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Valuation of Series B Preferred
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
19
407
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Round 2: Series B Financing
In the Series B financing, our portfolio company raises $6 million for 30% of
the fully-diluted share count. The shares are redeemable at a 2x liquidation
preference.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Questions:
How many shares will be
issued, and what happens
to Redcap's fully-diluted
ownership percentage?
Is Round 2 an up
round or a down
round?
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 31.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 5.3%
Unissued 500,000 12.5% 500,000 7.5% 500,000 5.3%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 28.0%
SeriesBPreferred:SandHillVC 2,857,143 30.0%
Total 4,000,000 100.0% 6,666,667 100.0% 9,523,810 100.0%
Valuation(in$) 6,000,000 10,000,000 20,000,000
PricePerShare(in$)
1.50 1.50 2.10
PreFinancing SeriesA SeriesB
CapitalizationTable
408
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series B Liquidation Preferences: New Money First
The Series B has preference over earlier rounds and the founder. Assuming
no conversion(i.e. only redeemable preferred) and Series B has preference to
Series A, draw the payoff diagram for each investor:
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Exit Diagram for
Redeemable Preferred
(Series B)
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Exit Diagram for
Redeemable Preferred
(Series A)
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Exit Diagram for
Common Stock
(Founder)
409
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Liquidation Preference Overhang
One downside of an aggressive liquidation preference (or multiple
rounds with preferences) is known as liquidation preference
overhang.
In an overhang situation, common stock holders (and others subordinated
in the capital structure) have no incentive to provide effort or capital.
If overhang becomes a motivation issue, the company can create a
bonus pool for key employees that will share in the liquidation, pari
passu.
Professor David Wessels
The Wharton School of the University of Pennsylvania
In one nasty negotiation, management demanded the elimination of the liquidation
preference, i.e. a cram down. They threatened to de facto transfer assets to a new
company. VC countered with threat to sue on grounds of illegal conveyance.
410
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series B Liquidation Preferences: Pari Passu
If liquidation preferences are pari passu then A & B share pro-rate on either
a share count basis, or a proportional liquidation preference.
For instance, what if liquidation preferences are paid on a proportional basis?
What would be the payoff diagrams look like?
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Exit Diagram for
Redeemable Preferred
(Series B)
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Exit Diagram for
Redeemable Preferred
(Series A)
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Exit Diagram for
Common Stock
(Founder)
411
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Optimal Conversion with Multiple Rounds
1. Compute the optimal conversion point for each investor (i.e. at what
valuation will investor convert versus redeem) , assuming the other
investors do NOT convert.
Compute Series A optimal conversion, assuming Series A does not convert.
Compute Series B optimal conversion, assuming Series B does not convert.
2. Using the optimal conversion points, rank them from lowest to highest.
3. Assuming lowest converts first, rerun conversion points for
investments with higher conversion points.
Professor David Wessels
The Wharton School of the University of Pennsylvania
412
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series A Optimal Conversion
In addition to demanding 30% at $20 post-money, Sand Hill also
demands a 2x liquidation preference to all prior financings.
Assuming Series B does not convert, at what point would Series A
convert? How is the fully diluted ownership of Series B determined?
Professor David Wessels
The Wharton School of the University of Pennsylvania
8 ) 12 tVal (40.0%)(En
Assume Series
B does not
convert
Fully diluted
ownership of
Series A
Redemption
value of
Series B
Redemption
value of
Series A
413
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series B Optimal Conversion
In addition to demanding 30% at $20 post-money, Sand Hill also
demands a 2x liquidation preference to all prior financings.
Assuming Series A does not convert, at what point would Series B
convert? How is the fully diluted ownership of Series B determined?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Assume Series
A does not
convert
Fully diluted
ownership of
Series B
Redemption
value of
Series A
Redemption
value of
Series B
414
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series B: Adjusted Conversion
The optimal conversion point for Series A is $32.0 million and Series
B is $36.8 million. Therefore, Series A would convert before Series B.
Assumes Series A converts at $32.0, what would the adjustedSeries B
conversion rate be?
Professor David Wessels
The Wharton School of the University of Pennsylvania
12 tVal) (30.0%)(En
Assume Series
A converts!
Fully diluted
ownership of
Series B
Series A no
longer redeems
Redemption
value of
Series B
415
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series B Payoff Diagram
With each investments
conversion point calculated,
draw the payoff diagram for
Series B.
Since Series B has the
highest conversion point, it
look similar to a traditional
Series A convertible
preferred investment.
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Exit Diagram for
Redeemable Convertible Preferred
(Series B)
416
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Series A & Founder
The Series A and founder payoffs are tricky. Each conversion point with drive
a change in slope. Assuming each investor converts optimally, draw the
following payoff diagrams:
Professor David Wessels
The Wharton School of the University of Pennsylvania
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Exit Diagram for
Redeemable Convertible Preferred
(Series A)
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Exit Diagram for
Common Stock
(Founder)
417
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Valuation of Founders Position
Professor David Wessels
The Wharton School of the University of Pennsylvania
418
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Valuation of Series A
Professor David Wessels
The Wharton School of the University of Pennsylvania
419
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Valuation of Series B
Professor David Wessels
The Wharton School of the University of Pennsylvania
420
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Which Valuation is Appropriate?
Using the fully-diluted share count, the Series A valuation rises from
$4.0 million (2.67 x $1.50) to $5.6 million (2.67 x $2.10). But what
happens to economic value?
Professor David Wessels
The Wharton School of the University of Pennsylvania
How is this possible?
Fully Economic Fully Economic
Diluted Value Diluted Value
Founder 6.00 4.62 Founder 8.40 6.27
SeriesA 4.00 5.38 SeriesA 5.60 5.11
SeriesB n/a n/a SeriesB 6.00 8.62
10.00 10.00 20.00 20.00
Round2 Round1
421
Venture Capital & the Finance of Innovation Lecture 19 - Valuation of Later-Round Investments
Negotiation: Force 1x Liquidation Preference
The aggressive 2x liquidation
preference for Series B
caused the Series A to drop in
economic value.
If the liquidation preference
is dropped to 1x, Series B
will convert first, and the
Series A threshold is
calculated as:
Professor David Wessels
The Wharton School of the University of Pennsylvania
8 al) (28%)(EntV
How does this new valuation compare to the
Series A valuation in Round 1?
422
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Valuing Later-Round Investments
Series C & Beyond
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
20
423
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
A Review: Series B Financing
In the Series B financing, our portfolio company raised $6million at a post-
money valuation of $20 million, with a 2x liquidation preference.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Security #ofShares % #ofShares % #ofShares %
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 31.5%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 5.3%
Unissued 500,000 12.5% 500,000 7.5% 500,000 5.3%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 28.0%
SeriesBPreferred:SandHillVC 2,857,143 30.0%
Total 4,000,000 100.0% 6,666,667 100.0% 9,523,810 100.0%
Valuation(in$) 6,000,000 10,000,000 20,000,000
PricePerShare(in$)
1.50 1.50 2.10
PreFinancing SeriesA SeriesB
CapitalizationTable
424
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
A Review: Conversion Order
1. Compute the optimal conversion point for each investor (i.e. at what
valuation will investor convert versus redeem) , assuming the other
investors do NOT convert.
Compute Series A optimal conversion, assuming Series B does not convert.
Compute Series B optimal conversion, assuming Series A does not convert.
2. Using the optimal conversion points, rank them from lowest to highest.
3. Assuming lowest converts first, rerun conversion points for
investments with higher conversion points.
Professor David Wessels
The Wharton School of the University of Pennsylvania
425
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Conversion Order: A General Formula
For investor i, let VC
i
equal their number of shares, LP
i
equal their liquidation
preference (in $), and Trigger Point
i
equal their exit value conversion
threshold, assuming noother investors convert. Let F equal the number of
shares of common stock (held by the founder and employees).
Professor David Wessels
The Wharton School of the University of Pennsylvania
i
i x
x i
i
i
LP LP Point Trigger
F VC
VC
= |
.
|

\
|

+

=
Assume all
other rounds
do not convert
Fully diluted
ownership of
Series i, assuming
NO other rounds
convert.
The cumulative
liquidation
preference of
all other rounds,
except Series i
Liquidation
preference of
Series i
426
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Conversion Order Rearranged
We start with the equation on
the previous page, which
determine the trigger point for
venture capitalist i.
Next, using a set of algebraic
changes (shown in the
appendix), we rearrange to solve
for the venture capitalist is
conversion point.
Professor David Wessels
The Wharton School of the University of Pennsylvania
i
i x
x i
i
i
LP LP Point Trigger
F VC
VC
= |
.
|

\
|

+

=
i i i
i
i i
LP LP LP
VC
F
LP Trigger + + =

+ =
i
i
i
i
LP
VC
LP
F Trigger
i
x
i x i
i
i
LP LP LP Point Trigger
F VC
VC
= |
.
|

\
|
+
+

And now simplify
with a some nasty
algebra!
427
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Conversion Order: Rearranged
In the appendix, the formula on the last slide is rearranged to solve for Trigger
Point
i
, the enterprise value at which Series i converts.
Professor David Wessels
The Wharton School of the University of Pennsylvania

+ =
i
i
i
i
LP
VC
LP
F Point Trigger
Since the number of founder shares andthe sum of liquidation preferences are
identical across classes, they do not affect the rank ordering of the Trigger
Points. Only the ratio of LP to VC (liquidation preference in $ divided by the
number of VC shares) affects the rank ordering.
The ratio of liquidation preference to VC shares is known as Redemption
Value Per Share (RVPS)
Note: This equation
assumes only venture
capitalist i is considering
conversion. All others
redeem.
428
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
A Conversion Short Cut
A critical component to drawing an accurate payoff diagram is the
order of conversion (i.e. $32 million for A, $40 million for B, etc)
The method outlined earlier is somewhat cumbersome. A simpler
method is to compute the redemption value per share (RVPS):
Professor David Wessels
The Wharton School of the University of Pennsylvania
Series A: $8 million / 2.67 million shares =
Series B: $12 million / 2.86 million shares =
Conversion will occur from lowest RVPS to highest RVPS
429
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Series C & Beyond
To value a portfolio companys shares that has had multiple financing
rounds, use the following steps:
1. Build the fully-diluted capitalization table
2. Using redemption values per share (RVPS), determine the
conversion order for each series.
3. Starting with the lowest RVPS, determine the conversion point
for each series, using the method from the last lecture note.
4. Build the payoff diagrams to determine the appropriate portfolio
of replicating options.
5. Use the VCV valuation model to price the shares.
Professor David Wessels
The Wharton School of the University of Pennsylvania
430
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Round 3: Series C Financing
In round three, our portfolio company is able to raise a Series C financing with
Back Bay Partners. Back Bay demands 25% fully-diluted ownership at a post-
money valuation of $50 million, with a 1x liquidation preference.
How many shares will be issued, and what is the new share price, and what are
the fully-diluted valuations of each investor?
Professor David Wessels
The Wharton School of the University of Pennsylvania
PreFinancing SeriesA SeriesB SeriesC
Fullydiluted
Security #ofShares % #ofShares % #ofShares % #ofShares %
Valuation
CommonFounders 3,000,000 75.0% 3,000,000 45.0% 3,000,000 31.5% 3,000,000 23.6%
CommonEmployeeOptions
Issued(strikeat1.50) 500,000 12.5% 500,000 7.5% 500,000 5.3% 500,000 3.9%
Unissued 500,000 12.5% 500,000 7.5% 500,000 5.3% 500,000 3.9%
SeriesAPreferred:RedcapVentures 2,666,667 40.0% 2,666,667 28.0% 2,666,667 21.0%
SeriesBPreferred:SandHillVC 2,857,143 30.0% 2,857,143 22.5%
SeriesCPreferred:BackBayPartners 3,174,603 25.0%
Total 4,000,000 100.0% 6,666,667 100.0% 9,523,810 100.0% 12,698,413 100.0%
Valuation(in$) 6,000,000 10,000,000 20,000,000 50,000,000
PricePerShare(in$)
1.50 1.50 2.10 3.94
CapitalizationTable
431
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Step 2: What is the Conversion Order?
The conversion order can be determined by ranking RVPS from lowest
to highest. Using the data from the Series C capitalization table,
determine the conversion order for Series A, B, and C.
Professor David Wessels
The Wharton School of the University of Pennsylvania
ConversionTable:
Liquidation Redemption Share Conversion Conversion
Newmoney preference(x) value count RVPS
1
order threshold
4,000,000
SeresA 4,000,000 2 8,000,000 2,666,667 3.00 1 50,000,000
SeresB 7,500,000 2 15,000,000 2,857,143 5.25 3 66,666,667
SeresC 15,000,000 1 15,000,000 3,174,603 4.73 2 61,500,000
1
RVPS=Redemptionvaluepershare.
432
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Step 3: What are the Conversion Points?
Series A will convert first. At what valuation point does Series A
convert? Remember, Series B and Series C do not convert!
Professor David Wessels
The Wharton School of the University of Pennsylvania
8.0 ) 5 . 24 tVal (40.0%)(En >
Fully diluted
ownership of
Series A
Cumulative liquidation
preference of Series B
and Series C
Liquidation
preference of
Series A
Series C will convert second. At what valuation point does Series C
convert? Remember, Series A converts, but Series B does not! Series
B will convert third.
What are the conversion points?
433
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Step 4: What are the Payoff Diagrams?
After you estimate the
conversion points for
each series, build the
corresponding payoff
diagrams.
Use the payoff
diagrams to determine
the portfolio of options
that will replicate the
security.
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
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0 15 30 45 60 75 90
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Exit Diagram for
Redeemable Convertible Preferred
(Series A)
434
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Step 5: What is the Series A Valuation?
Professor David Wessels
The Wharton School of the University of Pennsylvania
435
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Economic versus Capitalization Table
In Round 2, the Series A investor was punished by losing the power of
their liquidation preference.
In Round 3, the liquidation preference for Series C was small (1x) and
the higher post-money valuation drove an increase in investment value.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Fully Economic Fully Economic Fully Economic
Investor Diluted Value Investor Diluted Value Investor Diluted Value
Founder 6.00 4.62 Founder 8.40 6.27 Founder 15.75 13.66
SeriesA 4.00 5.38 SeriesA 5.60 5.11 SeriesA 10.50 9.65
SeriesB n/a n/a SeriesB 6.00 8.62 SeriesB 11.25 11.79
SeriesC n/a n/a SeriesC n/a n/a SeriesC 12.50 14.90
10.00 10.00 20.00 20.00 50.00 50.00
Round1 Round2 Round3
436
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
RVPS With Dividends
Assume the company negotiated Series A and B without dividend, but
Series C requires an 8% dividend rate paid on money in, accumulated
in the event of redemption. Assume dividends are not compounded.
How does this affect conversion at liquidation?
Professor David Wessels
The Wharton School of the University of Pennsylvania
ConversionTable:
Liquidation Redemption Share Conversion Conversion
Newmoney preference(x) value count RVPS
1
order threshold
4,000,000
SeresA 4,000,000 2 8,000,000 2,666,667 3.00 1 44,500,000
SeresB 6,000,000 2 12,000,000 2,857,143 4.20 3 53,333,333
SeresC 12,500,000 1 12,500,000 3,174,603 3.94 2 50,750,000
1
RVPS=Redemptionvaluepershare.
437
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Appendix
RVPS Proof
Professor David Wessels
The Wharton School of the University of Pennsylvania
438
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Appendix: RVPS Proof
Rank ordering the redemption value per share (RVPS) leads to the same order as
computing the conversion points manually.
For Investor I, let VC
i
equal their number of shares, LP
i
equal their liquidation
preference (in $), and w
i
equal their conversion point. Let F equal the number of shares
of the Founder.
Professor David Wessels
The Wharton School of the University of Pennsylvania
i
i x
x i
i
i
LP LP w
F VC
VC
= |
.
|

\
|

+

=
Assume all
other rounds
do not convert
Fully diluted
ownership of
Series i, assuming
NO other rounds
convert.
The cumulative
liquidation
preference of
all other rounds,
except Series i
Liquidation
preference of
Series i
439
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Appendix: RVPS Proof
Professor David Wessels
The Wharton School of the University of Pennsylvania
i x i
i
i
LP LP w
F VC
VC
= |
.
|

\
|

+

=i x

+
+
=
i i i
i
i
i
LP LP LP
VC
F VC
w
i i i
i
i i
LP LP LP
VC
F
LP w + + =

+ =
i
i
i
i
LP
VC
LP
F w
i
x
i x i
i
i
LP LP LP w
F VC
VC
= |
.
|

\
|
+
+

1. Start with the conversion point equation
from the pervious slide.
2. Include LP
i
in the negative summation and
add LP
i
separately. Adding and subtracting
identical amounts equals zero.
3. Multiply both sides by (VC
i
+F) / VC
i
.
Move the summation of LP
x
and LP
i
to the
right side.
4. Separate VC
i
from F. VC
i
/ VC
i
equals one.
5. Cancel LP
i
with negative LP
i
.
440
Venture Capital & the Finance of Innovation Lecture 20 - Valuing Later-Round Investments
Appendix: RVPS Proof
The conversion point for each Series can be rearranged as:
Professor David Wessels
The Wharton School of the University of Pennsylvania

+ =
i
i
i
i
LP
VC
LP
F w
Since the number of founder shares and the sum of liquidation
preferences are identical across classes, they do not affect the rank
ordering of w.
Only the ratio of LP to VC (liquidation preference in $ divided by the
number of VC shares) affects the rank ordering.
441
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Angel Financing
The Mechanics of Convertible Debt Financing
Professor David Wessels 2012
The Wharton School of the University of Pennsylvania
3620 Locust Walk, Philadelphia PA 19104
21
442
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Angel versus Professional Capital
Angels tend to invest in companies at a very early stage, where uncertainty is greatest,
and information asymmetries are highest.
Consequently, one would expect that Angels would demand higher equity stakes and
better investor protections than venture capital, but instead we find the exact opposite!
Angel contracts are notoriously simple!
For instance,
Angel investors tend not to stage investments. Most Angels invest all proceeds in the first
round, with no expectation of participating in future rounds.
Angel investors tend not to take board seats. One study of software companies found that less
than 20% of angel financing including the granting of a board seat.
Angel investors tend not to have veto rights over management decisions, such as hiring,
mergers, asset sales, etc. One study found less than 5% of investments have veto rights.
Angel investors tend not to have exit rights, forcing a sale or liquidation.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Legend has it that Andy
Bechtolsheimsimply handed
Googles founders a $100,000
check after they made a short
presentation!
443
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
J ustifying Limited Protection: Follow On Financing
Angels are the first, but not the last, source of outside funding for start-ups. According
to J effrey Leavitt, Angels generally invest with the expectation that, should the
company progress as planned, one or more venture capital (VC) firms will
subsequently invest. Venture capital is needed for a start-up to have any realistic
chance at an IPO or even a high-dollar sale to a larger company.
A venture capitalist might reject a funding proposal because of an overreaching Angel.
A start-up marred by a complicated angel round is unattractive to venture capitalists
because it requires them to unwind the non-standard angel preferences in order to
strike the venture capitalists standard deal. Will the Angel unwind preferential terms?
A survey by Stanco& Akahfound that although more than 90% of venture capitalists
consider Angels beneficial to the start-up industry roughly half of VCs found angel-
backed start-ups to be unattractive candidates for funding since Angels took
unnecessarily complex terms.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Darian Ibrahim, Vanderbilt Law Review
444
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
J ustifying Limited Protection: Reputation and Knowledge
Angel investing is highly localized, relationship-driven, and industry-specific. Angels
like to invest in start-ups where they know either the entrepreneur or the substantive area
(e.g., biotechnology or e-commerce), and preferably both limiting information
asymmetries.
Investment opportunities come to Angels from a network of trusted business associates.
This network of trust serves an important screening and sorting function by funneling
high-quality deals to Angels while excluding low-quality deals.
Conversely, venture capitalists must make more investments to generate timely returns
for fund investors, and this pressure inevitably forces venture capitalists to sacrifice
some of the intimacy and familiarity with start-ups that Angels without downstream
pressure enjoy.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Darian Ibrahim, Vanderbilt Law Review
445
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
J ustifying Limited Protection: Transaction Costs
Given the small amounts associated with Angel financing, the Angel must be extremely
careful about transaction costs. According to well-known Wilson Sonsini attorney
YokumTaku:
The legal fees for a simple note (loan) are typically much lower than the legal fees for a
preferred round, which are typically $50,000. For instance, on a $500,000 investment,
what percent is $50,000?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Convertible debt documents are generally much more
simpler todraft andreadthanequityfinancingdocuments, so
I typically recommend convertible debt for companies
raisingbelowaround$750K.
446
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
The Modern Angel Contract
SUMMARY OF PROPOSED TERMS FOR
CONVERTIBLE PROMISSORY NOTE FINANCING
Amount: $1,000,000inaggregateprincipal amount of convertiblepromissorynotes(theNotes).
Maturity Date: Principal andunpaidaccruedinterest ontheNoteswill bedueandpayable18monthsfromthedateof theissuanceof
thefirstNote(theMaturity Date).
Interest: Simpleinterestwill accrueonanannual basisat therateof 7%per annumbasedona365-dayyear.
Conversion to
Equity:
Automatic ConversioninaQualifiedFinancing: If theCompany issues equity securities (Equity Securities) in a
transaction or series of related transactions resulting in aggregate gross cash proceeds to the Company of at least
$1,000,000(i.e., not includingtheconversionof theNotes or any other debt obligations) (aQualified Financing),
thentheNotes, andanyaccruedbut unpaidinterest thereon, will automaticallyconvert intotheequitysecuritiesissued
pursuant to theQualifiedFinancingat aconversionpriceequal tothelesser of (i) 80%of theper sharepricepaidby
thepurchasersof suchequity securitiesintheQualifiedFinancingor (ii) thepriceobtainedbydividing$6,000,000by
theaggregatenumber of outstanding shares of theCompanys Common Stock as of immediately prior to theinitial
closingof theQualifiedFinancing(assumingfull conversionor exerciseof all convertibleandexercisablesecurities
thenoutstandingother thantheNotes).
Professor David Wessels
The Wharton School of the University of Pennsylvania
Much of todays angel financing is done with convertible debt, which means the Angel
can force the company into repayment without an exit. But how realistic is this?
447
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Conversion at Market Price
The Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity
securities issued pursuant to the Qualified Financing at a conversion price equal to the lesser of (i)
80% of the per share price paid by the purchasers of such equity securities.
As an Angel, you plan to invest $1,000,000 in convertible notes. You are considering two startups:
Start-up A: You expect the Series A investor to purchase 30% of the company at a post-money
value of $10 million. Based on the current shares outstanding, this would equate to issuing 3
million new shares at $1 per share.
Start-up B: You expect the Series A investor to purchase 30% of the company at a post-money
value of $20 million. Based on the current shares outstanding, this would equate to issuing 3
million new shares at $2 per share.
Professor David Wessels
The Wharton School of the University of Pennsylvania
A
P x d
Principal
Shares Angel =
A
P x Shares Angel Valuation=
Start-up A Start-up B
Which company is
the most financially
attractive to Angel?
Now try
start-up
B
448
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Security Types
To avoid transaction costs, many Angels use convertible debt.
The Angels convertible debt appears to have characteristics similar to
traditional convertible debt, but since the conversion price is to be
determined later, convertibility is quite misleading
Professor David Wessels
The Wharton School of the University of Pennsylvania
Angel: Convertible Debt
Note convertible into common
stock at futureSeries A price
(discounted).
Traditional Convertible Debt
Note convertible into common
stock at a pre-specifiedprice (e.g.
$20 per share).
VC: Redeemable Convertible
A stock which can either be
redeemed or converted into a pre-
specified percentage of company
(e.g. 40%)
vs.
vs.
449
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Purchase at the Market Price
The company receives a convertible note at time zero, which is convertible into shares at
the Series A price.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Company is
acquired at
P(2)
T =2
Company receives
Series A financing at
P(1)
Company receives
convertible note
with no price
T =1 T =0
But what is the expected return between time 1 and 2? If the expected return is a
CAPM fair return then what is the convertibles option really worth?
Implication: Are you really betting on the quality of company? Or are you betting on
the quality of the VC?
450
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
The Convertible Note: Potential Outcomes
With no cap, there are three
potential outcomes. Either the
company (1) fails, (2) the
convertible is (partially) repaid,
or (3) the note is converted at the
Series A price.
Since the option is only the right
to participate at a discount, what
is the value of the option?
How can Angel actively work for
better returns?
Professor David Wessels
The Wharton School of the University of Pennsylvania
Investment
($1 million)
Failure
Funding: $1.25
million of Series A
stock at Series A price,
i.e. right to participate!
Low-growth
company:
Company repays note
with interest
451
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Convertible Share Count: An Example
Prior to the Series A round, your company has 4 million fully-diluted shares outstanding
(non-inclusive of the convertible). Houston Capital offers to purchases 40% fully-
diluted at a $15.0 million post-money valuation.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Security #of Shares % #of Shares %
Common Founders 3,000,000 75.0% 3,000,000
Common Employee Options
Issued (strike at 1.50) 500,000 12.5% 500,000
Unissued 500,000 12.5% 500,000
Convertible bond: $1,000,000
Series A Preferred: Houston Capital 40.0%
Total 4,000,000 100.0%
Valuation (in $) 15,000,000
Price Per Share (in $)
Capitalization Table
Pre-Fi nanci ng Round 1
Step 1
Compute a price based on prior rounds
share count
Step 2
Determine the number of convertible
shares, based on the temporary price.
Step 3
Determine the number of shares for the
Series A holder
Step 4
Compute new price and start over!
452
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Tricky Share Count
Although the valuation is straight-forward, determining
the resulting share count is tricky. This is because the
conversion shares depend on the share price and share
price depends on the converted shares!
Define the following variables:
1. Define C as the #of convertible shares
2. Define Face Value as the principal of the note
3. Define EntValue as the post-money valuation offered by Series A
4. Define d as the Angels discount to Series A price
5. Define F as the #of founder shares (including options)
6. Define VC
A
as the #of Series A shares issued in offering
7. Define p as the percentage of ownership Series A is requesting
Professor David Wessels
The Wharton School of the University of Pennsylvania
Price x d
Value Face
C=
Shares Total
EntValue x d
Value Face
C=
) VC C (F
EntValue x d
Value Face
C
A
+ + =
(

+ + = C) (F
p 1
p
C F
EntValue x d
Value Face
C
(

= C) (F
p 1
1
EntValue x d
Value Face
C
C) (F
p 1
1
EntValue x d
Value Face
C +

=
453
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Tricky Share Count
In step 1, define the following variables:
1. Define Face Value as the principal of the
note
2. Define d as the Angels discount to Series A
price
3. EntValueas the post-money valuation
offered by Series A
4. Define p as the percentage of ownership
Series A is requesting
In step 2, define the following variables:
1. Define C as the #of convertible shares
2. Define F as the #of founder shares
(including options)
Professor David Wessels
The Wharton School of the University of Pennsylvania
F
#1 Step 1
#1 Step
C

=
p 1
1
EntValue x d
Value Face
#1 Step

=
C) (F
p 1
1
EntValue x d
Value Face
C +

=
C) (F x #1 Step C + =
with some additional algebra
454
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Convertible Share Count: An Example
Prior to the Series A round, your company has 4 million fully-diluted shares outstanding
(non-inclusive of the convertible). Houston Capital offers to purchases 40% fully-
diluted at a $15.0 million post-money valuation.
Professor David Wessels
The Wharton School of the University of Pennsylvania
Security #of Shares % #of Shares %
Common Founders 3,000,000 75.0% 3,000,000
Common Employee Options
Issued (strike at 1.50) 500,000 12.5% 500,000
Unissued 500,000 12.5% 500,000
Convertible bond: $1,000,000
Series A Preferred: Houston Capital 40.0%
Total 4,000,000 100.0%
Valuation (in $) 15,000,000
Price Per Share (in $)
Capitalization Table
Pre-Fi nanci ng Round 1
455
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Resulting Convertible Valuation
Without a cap, the convertible valuation is unaffected by the eventual post-
money valuation. The only upside is the discount (typically 20%) and the
post-financing performance of the shares.
Professor David Wessels
The Wharton School of the University of Pennsylvania
SeriesA Convertible
PostMoney($) Founder Convertible SeriesA Total Price($) Value($) Step#1
3,000,000 4,000,000 9,090,909 8,727,273 21,818,182 0.14 1,250,000 0.694
4,000,000 4,000,000 4,347,826 5,565,217 13,913,043 0.29 1,250,000 0.521
5,000,000 4,000,000 2,857,143 4,571,429 11,428,571 0.44 1,250,000 0.417
6,000,000 4,000,000 2,127,660 4,085,106 10,212,766 0.59 1,250,000 0.347
KeyVariables 7,000,000 4,000,000 1,694,915 3,796,610 9,491,525 0.74 1,250,000 0.298
Facevalue 1,000,000 8,000,000 4,000,000 1,408,451 3,605,634 9,014,085 0.89 1,250,000 0.260
9,000,000 4,000,000 1,204,819 3,469,880 8,674,699 1.04 1,250,000 0.231
Discount 80% 10,000,000 4,000,000 1,052,632 3,368,421 8,421,053 1.19 1,250,000 0.208
SeriesA 40% 11,000,000 4,000,000 934,579 3,289,720 8,224,299 1.34 1,250,000 0.189
12,000,000 4,000,000 840,336 3,226,891 8,067,227 1.49 1,250,000 0.174
Founder 13,000,000 4,000,000 763,359 3,175,573 7,938,931 1.64 1,250,000 0.160
Shares 4,000,000 14,583,333 4,000,000 666,667 3,111,111 7,777,778 1.87 1,250,000 0.143
15,000,000 4,000,000 645,161 3,096,774 7,741,935 1.94 1,250,000 0.139
16,000,000 4,000,000 598,802 3,065,868 7,664,671 2.09 1,250,000 0.130
17,000,000 4,000,000 558,659 3,039,106 7,597,765 2.24 1,250,000 0.123
18,000,000 4,000,000 523,560 3,015,707 7,539,267 2.39 1,250,000 0.116
19,000,000 4,000,000 492,611 2,995,074 7,487,685 2.54 1,250,000 0.110
20,000,000 4,000,000 465,116 2,976,744 7,441,860 2.69 1,250,000 0.104
ShareCount
456
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
The Cap: An Equity Sweetener
The Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity
securities issued pursuant to the Qualified Financing at a conversion price equal to the lesser of (ii):
the price obtained by dividing $6,000,000 by the aggregate number of outstanding shares of the
Companys Common Stock as of immediately prior to the initial closing of the Qualified Financing.
The legal language above can be converted into a minimum share count for the convertible:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Shares Money - Pre
Cap" "
P
min
=
min
P
Face
(C) Shares of # Min =
The Angel nolonger converts at
the Series A price, but potential
a better (lower) price.
Thisguarantees a minimum
number of shares in the new
financing.
457
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Convertible with a Cap: Resulting Payoffs
To determine the convertible share count, use the maximum between the share
count with no cap and the computed share count on the previous page. Upside
is created by the cap, creating a synthetic RCP contract.
Professor David Wessels
The Wharton School of the University of Pennsylvania
SeriesA Convertible
PostMoney($) Founder Convertible SeriesA Total Price($) Value($)
3,000,000 4,000,000 9,090,909 8,727,273 21,818,182 0.14 1,250,000
4,000,000 4,000,000 4,347,826 5,565,217 13,913,043 0.29 1,250,000
5,000,000 4,000,000 2,857,143 4,571,429 11,428,571 0.44 1,250,000
6,000,000 4,000,000 2,127,660 4,085,106 10,212,766 0.59 1,250,000
7,000,000 4,000,000 1,694,915 3,796,610 9,491,525 0.74 1,250,000
8,000,000 4,000,000 1,408,451 3,605,634 9,014,085 0.89 1,250,000
9,000,000 4,000,000 1,204,819 3,469,880 8,674,699 1.04 1,250,000
10,000,000 4,000,000 1,052,632 3,368,421 8,421,053 1.19 1,250,000
11,000,000 4,000,000 934,579 3,289,720 8,224,299 1.34 1,250,000
12,000,000 4,000,000 840,336 3,226,891 8,067,227 1.49 1,250,000
13,000,000 4,000,000 763,359 3,175,573 7,938,931 1.64 1,250,000
14,583,333 4,000,000 666,667 3,111,111 7,777,778 1.87 1,250,000
15,000,000 4,000,000 666,667 3,111,111 7,777,778 1.93 1,285,714
16,000,000 4,000,000 666,667 3,111,111 7,777,778 2.06 1,371,429
17,000,000 4,000,000 666,667 3,111,111 7,777,778 2.19 1,457,143
18,000,000 4,000,000 666,667 3,111,111 7,777,778 2.31 1,542,857
19,000,000 4,000,000 666,667 3,111,111 7,777,778 2.44 1,628,571
20,000,000 4,000,000 666,667 3,111,111 7,777,778 2.57 1,714,286
ShareCount
458
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
0
400,000
800,000
1,200,000
1,600,000
2,000,000
0 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000
ConvertiblePayoff
Convertible with a Cap: Resulting Payoffs
Upside is created by the cap,
which creates a synthetic RCP
contract.
The slopeequals the ownership
that results from the cap, which
is a function of the face value,
the cap, and the Series A
ownership percent (p).
For the current offer, what is
the trigger point and ownership
slope?
Professor David Wessels
The Wharton School of the University of Pennsylvania
( )
Cap
Face
1
Cap
Face
p 1 Slope
+
=
Note: the proof of
the slope and trigger
points are in the
appendix.
d
Face Cap
p 1
1
Point Trigger
+

=
459
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Avoiding a Valuation?
Many claim the purpose of convertible notes is to avoid having to determine a post-
money valuation. One professional investors writes:
Professor David Wessels
The Wharton School of the University of Pennsylvania
Here's one option to consider when trying to value your company for a seed-round
investment. Avoid it altogether; after all, it doesn't make sense and can only present a
potential liabilitydowntheroad. Instead of offering equity, offer debt that canbeconverted
into equity at some point in the future. This strategy avoids the problemof applying an
improper valuationtooearlyinthelifeof thecompany.
But is this accurate? J ust because there is no term sheet, cap table or share price, can the
Angel really avoid having a perspective on the companys enterprise valuation?
Contract A
Invest $1 million with at a
20% discount and a cap of
$6 million. Assume Series
A will take 1/3
Contract B
Invest $1 million with at a
25% discount and a cap
of $8 million. Assume
Series A will take 1/3.
We can even come
up with a fully
diluted valuation!
If we are investing
$1 million to get
into 8.3%, what is
the fully-diluted
valuation?
460
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Assignment: Which is Worth More?
As an angel, you are considering two contracts. The first contract is at
a 20% discount and $6 million cap. The second contract is at a 25%
discount and $8 million cap. If you believe the value of the company
is $4 million, what is the value of each contract?
Professor David Wessels
The Wharton School of the University of Pennsylvania
0
400,000
800,000
1,200,000
1,600,000
2,000,000
0 5,000,000 10,000,000 15,000,000 20,000,000
ConvertiblePayoff
0
400,000
800,000
1,200,000
1,600,000
2,000,000
0 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000
ConvertiblePayoff
461
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Comparative Statics
As the discount gets bigger (for instance from 80% to 70%), what happens to
the value of the convertible note?
Professor David Wessels
The Wharton School of the University of Pennsylvania
As the cap rises (for instance from $6 million to $20 million), what happens to
the value of the convertible note?
A
P x d
Principal
Shares Angel =
A
P x Shares Angel Valuation=
d
Principal
Valuation=
min
P
Face
C=
Shares Money - Pre
Cap
P
min
=
Shares Money Pre x
Cap
Face
C =
462
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Convertible Notes: Survey Data
Median amount raised $662,500
Median size of future financing in which note converts: $1,000,000
Percentage of deals in which valuation on conversion is capped: 83%
Percentage of deals that convert at a discount to the next equity round valuation: 67%.
Median initial discount: 20%
Percentage of deals with discount in which discount increases over time: 25%
Treatment of note if company is acquired prior to an equity financing:
Receive return of investment plus a premium: 50%
Median premium: 0.75x original principal amount
Median interest rate: 6.0%
Median term: 18 months
Percentage in which investors received a board seat: 8.3%
Professor David Wessels
The Wharton School of the University of Pennsylvania
Source: Fenwick and West
463
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Appendix
Professor David Wessels
The Wharton School of the University of Pennsylvania
464
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Proof: Conversion into Ownership (Slope)
For every dollar increase in exit value, the convertibles
value increases by the number of conversion shares divided
by the total shares.
Replace the number of VC
A
shares with the rearranged
percentage formula (p)
Combine terms and take the reciprocal of 1-p (to place in the
numerator). Next, use the definition of the number of
convertible shares (see the comparative statics slide for
derivation).
Insert the number of conversion shares into the slope
formula and
Simply by removing F (the founder shares) and we are done!
Professor David Wessels
The Wharton School of the University of Pennsylvania
A
VC C F
C
Slope
+ +
=
(

+ +
=
C) (F
p 1
p
C F
C
Slope
p 1
C F
C
Slope
+
= F x
Cap
Face
C=
p 1
F
Cap
Face
F
F
Cap
Face
Slope
+
=
( )
Cap
Face
1
Cap
Face
p 1 Slope
+
=
465
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Proof: Trigger Point
Professor David Wessels
The Wharton School of the University of Pennsylvania
( )
Cap
Face
1
Cap
Face
p 1 Slope
+
=
Slope
1
d
Face
Point Trigger =
Face/Cap
Cap
Face
1
p 1
1
d
Face
Point Trigger
+

=
|
.
|

\
|
+

=
Cap
Face
1
d
Cap
p 1
1
Point Trigger
d
Face Cap
p 1
1
Point Trigger
+

=
Start with the slope slide from the previous page.
The trigger point equals the bond value divided by the slope
from the previous page (as it is with RCP).
Inert the slope formula from the previous page.
Simplify by cancelling the Face value in the numerator and
the denominator . Move CAP from the denominator of a
denominator into the numerator.
Distribute CAP into the parenthesis and we are done!
466
Venture Capital & the Finance of Innovation Lecture 21- Angel Financing & Convertible Debt
Thank You!
I hope you found this
lecture note (and our class)
helpful.
J ust remember, innovation
never sleeps. Best of luck
in finding (or funding) that
next great idea!
Professor David Wessels
The Wharton School of the University of Pennsylvania
Final Slide
467

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