For Tuesday, Mar 21st

The following Venture Capital Problem Set is due today. There is no other assignment for today;
however, in class we will be covering the material assigned for last Tuesday, March 14th, when classes
were cancelled because of snow. In preparation for todays class, review the March 14th assignment and
be prepared to discuss it.

The Problem Set takes a considerable amount of time to complete so you are advised not to put it off
until the last minute. For each question, write up your answers showing all work on 8.5x11 inch paper
and submit it in hard copy (not online) at the beginning of class. If you attach Excel or other
spreadsheets, be sure to annotate these sheets as needed to clearly show how answers were derived.
Credit will not be given for answers where all work is not shown. You should feel free to discuss the
Venture Capital Method as it applies to this Problem Set with other students; however, when you work
out the answers to the Problem Set, all work must be your own, subject to the Universitys Code of
Academic Integrity, and not the product of a collaborative effort.

VENTURE CAPITAL PROBLEM SET

Kenneth Cook and Sue Strickler launched XL Microdevices, Inc. in December 2016. They each
invested $50,000 of seed money from personal funds at that time to finance their new venture. Ken, a
recognized expert in microdevice technology, conceived the initial idea for XL and had invested the
greater amount of sweat equity. He received 600,000 shares of XL common stock and Sue, an MBA
with significant high-tech marketing experience, received 400,000 shares. No other shares have been
issued since. As of today, March 2017, they have completed a preliminary design and concept testing
for a revolutionary new solid state flash drive product and are confident that a large number of tablet
and laptop computer manufacturers will want their product.

Jerry Mancini, a local angel investor with substantial experience in computer data storage devices, has
been introduced to Ken and Sue by a trusted acquaintance and is considering an investment in XL. Jerry
has reviewed XLs business plan and has conducted enough due diligence to be comfortable with an
investment in the company. XLs business plan calls for three rounds of financing. Jerry is planning to
be the initial seed round investor, which is scheduled for December 2017. His investment will be in the
form of a $350,000 convertible note. The terms of Jerrys $350,000 convertible note include: (a) a
compound interest rate of 8% p.a.; (b) a conversion price discount of 20% from the Series A pricing; (c)
a duration of 18 months; (d) a minimum Series A investment of $1,000,000 to trigger conversion; and
(e) a pre-money valuation cap of $8,000,000. These funds are primarily intended for prototype
development, alpha and beta testing, and advance marketing.

Following the seed round, XLs business plan anticipates two additional rounds of financing. The Series
A round of financing is planned for December 2018. This will be a priced round in the amount of
$2,500,000 and will fund a third-party manufacturing contract and staffing for engineering, marketing
and sales. The Series B round is planned for December 2019. It will also be a priced round in the
amount of $4,500,000 and will fund product launching, inventory buildup, distribution and staffing for
customer support. Pro forma financial projections in XLs business plan estimate annual sales revenues
of $5,000,000 by the end of 2021 under a success scenario. The plan also anticipates that a strategic
investor will acquire XL at the end of 2021, this being the exit strategy for XLs investors. Jerrys due
diligence has determined that a comparable price/revenues ratio for similar early-stage microdevice
companies is about 6.5:1.

(Continued)
Jerry has also introduced Ken and Sue to his acquaintances at Technology Ventures Corp. (TVC), a
regional venture capital firm. Like Jerry, TVC has significant experience with computer storage devices
and feels that XL would be an ideal complement to their portfolio of high-tech startups. TVC has
expressed interest in funding both the Series A and Series B investments in XLs financing plan
assuming, of course, that the venture continues to look promising and achieves its interim milestone
targets. TVC intends to invest in XL through its new TVC High Technology III Fund that includes
funds from high net worth individuals, pension plans and institutional investors. For XLs Series A
investment TVC is targeting a 40% per annum return on investment (compounded annually). For XLs
Series B investment, which is perceived to be somewhat less risky than the earlier round, TVC is
targeting a 30% per annum return on investment (compounded annually).

Question #1. What % of the company must TVC acquire in December 2018 if it funds the full
$2,500,000 Series A round? How many new shares of XL stock should TVC acquire at that time? What
should be the price per share? What are XLs pre-money and post-money valuations for the Series A
round?

Question #2. What % of the company must TVC acquire in December 2019 if it funds the full
$4,500,000 Series B round? How many new shares of XL stock should TVC acquire at that time? What
should be the price per share? What are XLs pre-money and post-money valuations for the Series B
round?

Question #3. At the planned liquidity event in December 2021, what will Kens founders shares be
worth? What annual rate of return (compounded) on his original $50,000 investment does this
represent? What will Sues founders shares be worth? What annual rate of return (compounded) on
her original $50,000 investments does this represent? Explain any difference between the rate of return
earned by Ken and that earned by Sue. What will Jerrys shares be worth? What annual rate of return
(compounded) on his original $350,000 investment does this represent?

Question #4. Ken and Sue are also considering the alternative of eliminating the convertible note,
Series A and Series B rounds of investment and, instead, raising the total amount of $7,350,000 in a
single priced round in December 2017. They assume investors in this priced round would require a 50%
per annum (compounded) rate of return. After analyzing this alternative, Ken and Sue do not pursue it.
Why did they decide this?

Question #5. Based on his prior experience, Jerry believes that stock options will be needed as
employee incentives for XL. He convinces Ken and Sue to plan for the future creation of a pool of new
XL shares for such option incentives equal, in total, to 10% of the company at the time of the liquidity
event in 2021. Given the plan to create a future pool of incentive stock options immediately prior to the
liquidity event, recalculate your answers to questions #1, #2 and #3.

Question #6. Immediately before the Series B round, it becomes apparent that the liquidity event will
be delayed one year until December 2022 and that an additional $1,000,000 (i.e., a total of $5,500,000)
will be needed in the scheduled Series B round. At the time this delay becomes apparent, TVCs Series
A investment is already a done-deal and cannot be renegotiated. The stock option pool, as described
above, is included in XLs plans. XLs terminal value is not affected by the delay. How does this
change your answers to question #5? Given this delay scenario, what compound annual rates of return
are actually realized on the Series A and Series B investments?

(Continued)
Question #7. During TVCs term sheet negotiations, it is agreed that TVC will receive convertible
preferred XL stock in return for its Series B investment (the founders shares, Jerrys shares, the Series
A shares and the option pool shares remain common stock). The difference between common and
preferred shares is that the latter shareholders receive an annual dividend payment equal to a prescribed
percentage of their investment. In this case, TVC negotiates for a cumulative non-cash non-
compounding dividend of 13% per annum for Series B. At the time of the liquidity event in 2021, each
preferred share is convertible into one new XL common share and the accumulated dividends are
convertible into new XL common shares at the original price per share paid by TVC.

TVC priced the XL deal assuming that it received non-dividend bearing common stock and that an
option pool would be created (i.e., the same assumptions used for Question #5, above). What cash
distributions and compound annual rates of return will TVC realize on their Series A and Series B
investments, respectively, as a result of using convertible preferred stock for Series B? What is the
effect on the cash distribution realized on Jerrys convertible note? What is the effect on the amount of
cash distributed to the founders? (In answering this question, ignore the delay scenario of Question #6).

Question #8. During TVCs term sheet negotiations, TVC also proposed using a hybrid security called
participating preferred stock for its Series B investment. This security is like the convertible preferred
stock described above, but it has an additional provision in that, at conversion (i.e., at the liquidity event),
the entire original purchase price would also be repaid to TVC on a priority basis before any other
distributions are calculated.

What cash distributions and compound annual rates of return would TVC realize on their Series A and
Series B investments, respectively, as a result of using participating preferred stock for Series B? What
is the effect on the cash distribution realized on Jerrys convertible note? What is the effect on the
amount of cash distributed to the founders? (In answering this question, ignore the delay scenario of
Question #6).

Rev. March 2017