VC Introduction and Players (Class Notes)

Introduction & Players

(8/22) Introduction & Players

I. PLAYERS INVOLVED IN VC WORLD

Entrepreneur ; (co) Founders: Its all about Entrepreneurs (not same as Small businesses) o Management Team (CEO, CTO, COO, CFO, etc) = what side of the door are you on when big decisions made; (CTO = chief technical officer; ex. back to the future); (COO = chief operating officer; ex. janitor, everythign else tech peeps dont want to do); Order fill both spots first: tech & business o Board of Directors= fiduciary duty (Main job hiring/firing CEO) o Equity Owners o Mentors= 2 types: helpful and advisors for money (scavengers) o Lawyers Limited Partners (LPs): Investors into VC fund Structure of a VC Firm o Managing Director = General Partner (GP) o Principles/ Directors o Associates (very little power) o Analyst (glorified internship) o Entrepreneur in-residence (EIR)= Temp position o Venture Partners Additional Terminology o Term Sheet = sketch of the deal they have in mind; not legally binding (2-6pgs) o Definitive Docs = (~80 pgs) Round = series designated by letters o Lead Investor= leads negotiations w/ syndicate (all investors); usually will take a board seet o Syndicate= more than one VC funding a co.; o Exit= everything from going bankrupt to being sold to another co to going public; (IPO; Merger/ Acquisition; Bankruptcy or dissolution; Secondary Markets= allowing for liquity that did not exist before)

II. BUSINESS BASICS

Economics & Control: Relationship between VC firm and Portfolio CO / Relationship between LPs and VC 1st famous VC investment: American Research & Development Corp ( AR&D) put $70k into Digitial Equip Corp (DEC) in 1957; returned $355m in 1968 ; o Valuation (investing $70k bought 78% of co; resulting in a $90k postmoney control of co) Pre-money: what you agree the value of the co is before you put money in ($20k) Post-Money: value of co= Pre + money invested (if invest $70k, then = $90k) o Multiple= my money in; what I got back; o Internal Rate of Return (IRR) = time matters in addition to amt of money got back

III. WHY VC? (drivers affecting why VC is selected as a source of entrepreneurial financing): What makes the services
of a VC more valuable than the cost of services? Why VC financing instead of other sources of capital like a... o Bank Loan often only have intangible assets and few tangible assets to use as collateral o Public Markets not IPO because uneducated public: (nobody knows you; tough to value); public markets are fickle; disclosure requirements of public companies o Direct from Institutional LP (pension funds, univ endowment) limited time, expertise (see below) o Bootstrapping self-funding: living on pennies; but may need funding quickly (if have competition) o Direct from individual (3Fs; angel) not always available, not always enough (provide less help) o Grants and govt funding: not always available

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VC Introduction and Players (Class Notes) 5 Drivers for intermediary (VC) to come between investors & startup 1. Uncertainty: (will this market even realize? what are surrounding market conditions?) 2. Asymmetrical info: (entrepreneur knows most about company) 3. Nature of Assets: (intangible and difficult to monetize) cant get bank loans 4. Market Conditions 5. Reputation*

How do VCs add value? Why dont LPs invest directly in startups? o LPs lack expertise in management and markets o VCs pool portfolio companies and mitigate risk o VCs dont just try to pick winners they also provide services to portfolio companies once funding is obtained that add value to the investment (VCs value is nonfungible) Team Key factors that must be balanced when choosing portfolio companies: o Team vs. Idea pick run o Picking vs. Running Key challenges of entrepreneurial finance and a VCs value-adding response: idea o Challenge: Time constrained investors/LPs with diverse investment portfolios (Yale: LPs perspective) VCs Response: act as LPs agent by vetting, monitoring, and assisting companies in a specific investment class o Challenge: information asymmetries between entrepreneur and source of capital (i.e. LPs) VCs Response: employ various mechanisms to get more information (e.g. diligence, monitoring, board seats); use private contracts to align incentives o Challenge: Uncertainty and difficult assessing chances of success (mkt conditions; things nobody knows) VCs Response: expertise and pattern recognition; many portfolio co in each fund distributes risk; able to assess AND affect outcome by helping portfolio co. (not just about picking) o Challenge: Startups have limited access to traditional sources of capital and expertise (intangible assets) VCs Response: provide capital and advice; kingmaker and networking functions
VC Industry Overview (8/24)

Course Goals

VC OVERVIEW:

(1) Useful VC framework (common problems & solutions); (2) Understand Incentives of Players involved + diagram strategies to address potential problems; (3) Role of policy architecture Course Topics (1) Raising the Fund; (2) Doing a Deal; (3) Considerations after the deal (term sheet; letter of intent; board representation); (4) Ingredients of an Innovations Ecosystem (threaded throughout) - what goes into creating a regional environ that makes entrepren flourish Themes: Main Course Questions o How do you exploit the information gaps associated with innovation without getting exploited? Information gaps present Great opportunities but also great risks o How do you navigate uncertainty to direct capital to the right types of innovative opportunities? o How do you manage and mitigate information asymmetries? (ex. Oblong is writing a different type of operating system than has ever been done before) o How do you align interest with the parties involved? 5 Distinguishing Characteristics of a VC (respond to these problems or at least emerged because of them) 1. VC is a financial intermediary between capital and startups 2. Investment into private companies for non-public securities p.2

VC Introduction and Players (Class Notes) Public vs. private = Private companies do not have the same disclosure requirements as public companies; this means (1) information that is made publicly available is very limited; and (2) non-public securities = means illiquid markets: there is often not a ready market to sell your stake in this company by definition, inefficient markets 3. Active involvement of the VCs (VCs don't just pick companies, they run them) extra financial contributions of a VC; after capital comes in, whole bunch of fucntions a VC performs 4. VC needs to find an exit (limited time frame for investment) ~10 yrs (w/ option for two 1 yr. extensions) Self liquidating process (geometric not just percentage point returns) looking for big swings of 10x and up returns because most portfolio companies will range from bad to total failure 5. Funding internal growth not just about financial engineering, you are trying to build companies (what distinguishes VC from other asset classes, like hedge funds and private equity) hedge funds = investors, LPs, are not locked up for long period of time, can take money out on quarterly basis; in and out of investments in short period often in publicly traded companies private equity (2 meanings): 1) umbrella term (VC can be a form of PE); and 2) as an asset class PE asset class: usually get in later stage companies, short or long term VC: getting in early, for longer time frames to buid companies o key dif is that PE often uses leverage: can take on debt, very rare for VC o also, PE usually takes a majority position (control companies); VCs usually take a minority position Inefficient markets (non-public) where there are information gaps (uncertainty) which can be exploited by experts (experts are the entrepreneurs)

Review: legal structure = A limited partnership with a general partner running it (=VC) Why might an angel be able to do a deal that VC should not?: Lifestyle business model: dont want to exit, or comp might not be attractive for sale to others (as financial intermediary, VCs must exit; angels don't have to) Why VC financing instead of other sources like a... o Bank loan?: Risk/reward, a new business doesnt have collateral to put up; doesnt bring much expertise o Direct investment from University Endowment Uncertainties = about mkt, if company will get along, if technology will work (things nobody knows); Cf. Info Assymetries: tech expertise in the area will know more about the company University: not as able to monitor; make network connections, time constraints

SIZE OF FIRM AND INNOVATION

Why arent all firms a goliath? How do start-ups have a chance? Flexibility/Nimble; cheap; theory of the firm o Innovators dilemma = incentive to invest in research and development, but not incentive to deploy it into the market (ex. cell phones in 1950s: large company, innovative technology, no competition; Nimbleness: or Xerox park: developed GUI and mouse but wasnt focus of what company did, didnt have nimbleness to see the future, Apple did o Corporate Culture (start up can start fresh, not developed path dependencies like lg companies) o Theory of the Firm: Coases paper: Transaction costs vs admin cost of vertical integration transaction costs of make vs buy (ex. printer company making paper) as transaction cost of buy instead of make go down then its better to buy (horizontal) rather than vertical integration (ex. tech/internet world: transaction costs have gone down) Counter-ex: apple vertical integration despite all the drivers for a horizontal company

TECHNOLOGY DRIVING INNOVATION

What we do with information? (enablers of information revolution) = lower costs, take less time to exit o Process: Moores law: processing power doubles every 18 24 months; analog to digital o Move: TCP/IP + broadband o Store: cloud computing Case Study: Internet Development TCP/IP (agreed upon rules/standards) o We are going to go with standards that actually work (not theories) : We reject: kings, presidents and voting. We believe in rough consensus and running code. o Protocols: p.3

VC Introduction and Players (Class Notes) The Rise of the Stupid Network: how internet has made it possible for the startup business models to exist o Protocols facilitate modularity: Layers & modularity: agreed upon logical layer (protocols) rise of start-ups because can innovate at one particular place rather than trying to do everything o The stupid network (telephone): standard protocols turns the telephone network inside out; internet: just deliver the bits and let the intelligent people (at edges) say what to do with it o Tools for innovation by edge users capable of great generatively (can experiment and find new uses) and the potential (stove: many dif possible uses vs. toasters: one use) Isenberg: fears that security concerns and more toasters (iphone) will lead to less ability of people to tinker less inovation by edge users o

LOGISTICS

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VC Raising the Fund (class notes)

Raising the Fund

Class 3 8/29: Complete Business concept basics (JM); LPs in VC Fund (BB): #6: Lerner, Yale Study Follow-ups Private equity & Efficient vs Inefficient Markets difference is a matter of degree, not binary categories o Efficient Markets: price reflects value of the market because information has been accounted for o Secondary market: (preview of later in course) becoming more efficient because sending mole throughout company getting information (why FB and others have banned secondary mkts) Liquidity Today (1) LPs Persepective: what views do various LPs bring to the fund? what objectives? What obligations? What investment choices? (2) Allocation Choices & Strategy: attraction of inefficient asset classes (3) Sushi v. Burritos (4) Agency costs (principle/ agent problems) (5) VC sector overall: Boom And Bust Cycle

I. The LPs perspective: Yale University Investment Office

Who gets in? types of LPs in VC fund: 1. Pensions plans/ employment funds 2. Financial institutional funds 3. University endowments & foundations 4. Individuals & families 5. Fund of funds= gatekeepers: LP invests in other LPs (only ones that dont invest directly in VCs) 6. Sovereign wealth funds 7. Corporations (note: do not confuse with corporate VCs) Raising a Fund = Mendelsons Ex of Fund 1 (2006): hard to get at first then got lots of people came in after one of the big guys wanted in; then Fund 2 was really easy to get and only took one meeting; o also, side note: Foundry is syndication agnostic, never conditions their money on a company first being able to raise a certain amount) Objective and Obligations: if you are Yale in 2003 what do you do with the endowment o Obligations Part will go for operating budget of school (43%) - *really impt because pays salary o Objectives Grow endowment (5% return) o Constraints Small office, not a lot of resources o Accountability goes to investment committee at end of year and have target allocations of where money will go, Incentives of LP: better hit it may force them to liquidate just so they can hit these target allocations (Denominator effect: important to know when talking to a potential investor where they stand on their allocation and if they will actually be able to invest)

Ii. Yales Strategy: Go Heavy On Inefficient Asset Classes Yale Investment Principles: (Swensen and Tachachy)
1) Heavy on Equity, light on bonds = over time, favors an equity stake in a company rather than just a contractual right (like debt and bond)Equities are a claim on a real stream of income, vs a bond, which is a contractual right on nominal cash flows (debts) 2) Diversify Portfolio (avoid market timing, dont want to be over exposed to a single asset class) 3) Heavy on Inefficient Asset Classes: Experts that can exploit information gaps 4) Align the incentives with managers Asset Types: Different types of ways to invest (2003 Target allocation): o Bonds: (7.5%) o US Stocks/ equity: (15%) o Foreign stocks/ equities: (15%) o Absolute Return Strategies (incl hedge funds): (25%) o Private Equities (Incl VCs): (17.5%) o Real Assets (oil, timber, real estate): (20%) Ineffcient Markets: inefficient because less info available, thinly traded: not as many players; but these information gaps which can be exploited by experts
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VC Raising the Fund (class notes) Less information opportunities for high returns: if you get in on a good company at a time before others are able to, can get high return (i.e., less information means you can get an equity stake at a lower price than co actually worth) o But gaps also high risks: others may know more than you and can exploit you (Yale & Harvard: have star managers; the best experts) Why endowments better able to invest in inefficient markets? dont need a liquidity event in a year; able to stay in an illiquid market for longer o CU Endowment: why might they be cautious about going as heavy in inefficient markets as Yale? Take Aways o If LPs are having trouble getting in funds, its because VC funds are not clearing the market, closing door and not raising as large a fun as they can; Why would VCs not be clearing the market? (why did Jason stop at $250M rather rather than raise $1 billion? Individual lifestyle/VC cant scale o Why do best managers matter more in VC world of private equity than it does cf. to managers in public equity? Its about the individual human decision making that you are paying for an expert manager o Variance for manager performance by asset class b/t 25 and 75 percentiles (how much of a difference can the best experts make depending on asset class): o Fixed income (bonds) manager U.S. = minimal diff/yr. (whos managing doesn't really matter) o Common Stock portfolio = 3% diff per yr o Private Equity manager US = 20% diff per yr. btwn performance of the best experts and worst Sushi & Burritos Analogy to Managers o Variance in Sushi = Private Equity (large variance: Good sushi is great; bad sushi is horrible) o Variance in Burritos = Bonds (smaller variance: Good burrito is satisfying; bad burrito is still fine) What makes VC managers different from private Equity as a sub-class o VC = Unique skill set, value added approach is Not fungible (David Swensen) o PE = In general PE model is to go in and make company more efficient (doesnt add value) o Govt recognizing VCs different other PE asset classes: FCC making all others register and be regulated by fed govt, not VCs Can VCs Scale cf to other types: Its not easy, very difficult to grow up (Fund scaling, VC industry overall) (similar to scaling a class; ex. clinics where students have to be supervised) o In 1990s: difficulties of scaling refered to technologies and server size, now its all about the individuals (technology has surpassed humans ability to scale) Agency Costs: Why could incentives get misaligned? o If manager (VC/agent) compensation is based on size assets are that are being managed (becomes about raising money: more money raised = more money make) (e.g., mgt fee is based on how big fund is, has nothing to do with VCs performance); VC cares about raising money/ LP cares about making money o Number of transactions performed: a fee for each transaction: endowment cares about making money, VC would care about making lots of transactions VC would want to trade a lot/ LP cares about making money o Managers spliting time, Yale wants their best efforts How did Yale solve these problems? 3 ways Yale aligned incentives to constrain Agency Costs o Skin in the game: They wanted managers to put some they feel same pain: When Yale makes moneyVC makes money / When Yale loses money VC loses money Right amount of skin in the game for it to hurt: LPs will try to audit to figure out how wealthy you are and make sure asking enough to align incentives Jason: $225M fund + required 3% above that = is $8M among partners ($2M ea) o Best Efforts = Invest in funds that will give most attention to Yale investments o 2% & 20%: having compensation tied to 20% carry

III. Sushi & Burritos

IV. Align Incentives: Constrain Agency Costs Principle (LP) & Agent (Foundry Group)

(INGREDIENTS OF VC ECOSYSTEM) Bottom-up elements of entrepreneurship:Horizontal networking; mentor-driven models; agglomeration economies; spiky world Class 4 8/31: #64: Saxenian, Inside-Out: Regional Networks Silicon Valley & Route 128 #77: Florida, The Rise of the Creative Class
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VC Raising the Fund (class notes) Today: last time = (1) agency costs (principal/agent problems); and (2) VC sector overall: boom & bust cycle Explanations of Innovation Geography= (1) External economies (agglomeration economies) Critical Mass; (2) Network explanation; (3) Creative class magnets

I. Align Incentives; Constrain Agency Costs

Principal (LP) / Agent (VC) Agency Costs difficult to resolve with o Monitoring o Market controls o Corporate controls Yale: how they constrained agency costs o Heavy on bonds o Diversity portfolio o Hire experts that can exploit info gaps in inefficient markets o Align incentives with managers make sure they don't misbehave at your expense Difficulties: Corporate controls: Normally if unhappy with manager you can sell, not ideal here because loose money (Harvard did it for .50 on the dollar) Monitoring: Board of directors why difficult for yale investment office to perform this role?Expensive and costly to manage the VCs; Resource constraints Solutions: align incentives with managers Skin in the game Making sure get best efforts; Yale is their best client Performance based on compensation (most powerful) 20% carry manager gets paid well if returns are really good Denominator Effect: How to Diversity the Portfolio: $100 > denominator drops form 100 to 85 (if us and foreign public markets drop by half, then value of private equity has not changed, but allocation has) Bonds: $7.50 US pub : $15 $7.5 Foreign: $15 $ 7.5 Absolute return: $25 Private Equity: $17.5 20 % Real assets: $20

II. External/ Agglomeration Economies

The world is Flat vs. The World is Spiky: = it's a boom and bust world BUST CYCLE = Prudent Man amend: allowed to start putting more money in to riskier asset class + tech boom in early 80s o Led to more VCs more start ups o Problems of more and more deals o In the aggregate returns BUST (Dip in mid to late 80s) Item 1: 3 fundamental drivers on whether the VC model is going to work or not o Drivers last week o Are there liquid markets that allow for o Are there entrepreneurs that are highly skilled that are The World is Flat by Thomas Friedman: o World is Flat = we are in an era where you can move info anywhere/anytime Geography Matters: In 1950: choice between B student in NY, or A student in china would choose B in NY; now flipped: technology has changed things, its flattened the world, Technological enablers o World is Spiky = regions and cities matter (florida guy); concentrations in cities that are taking advantage of that

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VC Raising the Fund (class notes) Explanations concerning relationship of place and innovation (Marshall, Porter) Agglomeration Economies: share costs of o Infrastructure = Researched Knowledge Base; Shipping Cost; Labor; and Space o Services = VC (if only one portfolio company cant support the cost of a VC investing) & Legal Economies of Scale = More users add per system the lower the per unit cost o Arithmetic Example: one vs. 100 deals: Legal Fees = $500/hr First deal will cost $75k because will take more time to do nd 2 Deal: $38k you know what you are doing so doesnt take as long rd 3 Deal: $23k Avg prices per deal = $46k o Diseconomies of Agglomeration = offsetting costs that become problematic Critical Mass = (Boulder Entrepreneurial Ecosystem) something like techstars doesnt make sense if there is only one startup to help, but once you reach critical mass able to stream line services and share costs o Regional advantage doesnt make sense until you reach critical mass

III. Network Explanation

Route 128 vs. Silicon Valley Why dont agglomeration economies explain Valley > Route 128?doesnt account for horizontal information flow What relevant market and tech drivers changed the environments in 80s? o Technology changing faster (horizontal specialization means can react faster) o Less stable market Saxenians explaination for why SV > Route 128? o Horizontal (porous boundaries) vs Autarkic Non-competes: legally enforced in Boston but not in California o Open Systems; Network Effects Proprietary systems can restrict innovation bc shrinks the amount of people that can work on and help fix (but can also help innovation (apple): optimized to work together, smaller learning curve) Open system (UNIX) works in disruptive technology market b/c can innovate faster, more people working on system, allows you to update to a new technology in a different area 4 gen in 5 yrs: although product could be reversed engineered. By the time a competitor could have done that, they had already come out with a new gen Proprietary system of Apollo: have to update all parts of system to adapt to new tech o Network effects = more users on a network, more valuable the network is ATT ex: more people you can talk to the more valuable it is to you (also facebook ex) SV? Network effect & horizontal info: able to take advantage of innovation going on in area Summary: both got to enjoy agglomeration economies, but SV got to take advantage of regional network which is what explains their success

IV. Creative Class Magnets:

Creative Class = The places that thrive today are those with the highest velocity of ideas, the highest density of talented and creative people, the highest rate of metabolism. What: Members whose function is to create meaningful new forms; forms are transferable & broadly useful Who: the super creative class: poets, professors, broader class that support core Where and why are they migrating/clustering? they feel like outsiders, so going to open communities (gay): where ideas challenge them, among others, outdoors (see quote on slides)

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VC Raising the Fund (class notes) GP Perspective VC fund structure Class 5 9/7: VD Ch.8: How VC Funds Work; opt: # 1, p.23-25, 65-91 (TWEN) Overview: (1) Corporations; (2) Raising Money; (3) How VCs get compensated (Reread book) CORPORATIONS OVERVIEW: 3 Different Structures: Corporations: (C-Corp, Boxes) o Legal entity w/ Limited Liability for indiv: separates person from company interest Owners not liable if things go wrong (as long as play by rules); ex. If corp gets sued, indiv doesn't pay o Double Taxation: Taxes get corp rates (50%), then after money distributed owners taxed again o Different classes of stock issued can have stock options to incentivize EEs) o Dont have partners; technically just employees thus you can fire them. (But cf. to LLC & LP is not at will, so difficult to fire (unless clauses in mgmt K that you agree to eject role as GP of funds) Limited Liability Corporation (LLC): o Issue Units (cf to stock); hard to have stock option plans o Flow through tax entity: not really taxed bc: I got $225 this yr and spent $225 so no profit to tax) Limited Partnership (Triangles): o Limited liability for limited partners (investors) In order for a LP to have limited liability, it needs to have a GP that has unlimited liability (i.e. personal liability if something goes wrong) You can make an LLC the GP of a limited partnership, so you have some protection o Flow through taxes HOW TO RAISE MONEY: Raising first fund difficult process: o Gotta pay initial costs out of own pocket (flying around meeting with potential LPs, etc.) (Jasons cap was $750k and actual cost was $718) o Dif types of LPs: Pension funds, gatekeepers, fund of funds, consultants (gotta get em all together) o Even though may have raised $100M fund, you dont have any money until you do something with it: (3 Things to do w/ $$: Invest in startups; Pay management fees; Pay lawyer and accountant fees) Management Fees: o Range 1.5% to 2.5% inversely related to size of fund (Smaller Fund, higher percentage) o Money Flow: 2% management fee actually goes from LP GP (LLC) to be paid no matter what; then contract between GP Management Co o Commitment period = management fee is full load during this time, afterwards it becomes something less called a cost basis (each firm has different way of calculating this); Cost of Investment: Raised $100M invested $50M in those 5 yrs, thus cost of investment = $50M and take 2% management fee off that ?? Incentivized to over invest: if sold company and made lots of money off of it, management fee goes down so actually make less money Provision that once raise fund 2, commitment period of fund 1 ends no matter where it is; Incentivizes to fully invest in fund 1 before invest in fund 2 Dont get rich off mgt fees; Can only get one fully loaded management fee at a time**

HOW DO VCs GET RICH: Carry = VCs share of the profits (20%) Money trapped in GP/LLC level: Taxed at capital gains (15%) rather than if it went to management co where there would be double taxation Ex: $100M Fund; o invested $50M in 5 companies 1 company goes public and returns $60M so now have 4 companies Technically made $10M profit, thus carry =$2M o Invest the other $50M and make $0 Profit on total fund is $-40 $2M carry already taken is Clawed Back and each partner, as an individual, is joint and severally liable (cant be contracted away) Solution: just not pay carry; return $100M before start taking carry

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VC Raising the Fund (class notes) Terms of K with LPs Class 6 9/12: Item 2, p.21-44 (Metrick - CP); Skim: Item 8, Foundry PPM (TWEN) Overview Terms: Management Fees = 1-3% and inversely related to size of fund Commitment Period = 5yrs then management fees will go down; Calculated based on cost of investment minus already exited companies * 2% (??) Claw back = joint and several liability o Is claw back pre or net taxes? Most debated negotiation term As soon as VC returns the fund, he could lose money on all the rest but hes still taking 20% on an ything that comes back consider how this would affect incentive of VC Recycling = if raise $100 fund only have $85 to actually invest so when money comes back in can reinvest up to amount of fund to cover management fees GP commit = money GP puts in on top of fund ~2-3% (ex. Jasons fund $250M so partners have to put up $8M) Most VCs are not able to put in this money Two ways of paying: 1) every time capital call comes pay from bank account, but at tax rates would have to make 4M in order to be able to pay the $2M 2) Management Fee Carve out: pre-tax dollars, salary may go down but ok Terms Net of Taxes = after you take taxes Gross of Taxes = pre-tax Pro-Rata = if call, gets pro-rata taken based on percentage of LPs ownership in fund ( o Only thing not pro-rata is the joint liability for paying back call back If LP cant make a capital call, options: FU, pay me or youre in default o After 30 days half of his interest becomes the GPs, then in another 30 days, another half Why is it better for GPs to get it and not LPs: GPs are the ones on the hook to come up with the money; LPs would just get a windfall because they wouldnt owe any more o If small amount, GPs will probably cover it, if big player, will need to find someone else Maybe give him a few days to see if he can come up with the money, would do this to avoid the hassle of trying to find someone else to cover their interest Advisory board of the Fund: (review this on audio) Sort of like board of directors (but unlike an official BOD, they dont have fiduciary duty) They cant replace the management so easily, but they have a similar role Advisory board (of LPs) can help cleans some of the conflicts of interest and tough questions that occur within the Venture Capital Fund. Help make the VCs more clear and transparent Types of LPs: big investors; those who think they are big name Problem with VC personally investing in a company If start-up conflicts with a company in the fund If fund is struggling and is so behind that no chance of collecting carry, then a great investment comes along; if invests funds money, no chance he will get carry on it so invests his own money (bad) Restrictions on Raising a new fund: Thou shall not raise another fund until you are 70% invested and reserved Reserve: when investing in a company you are also saying that you have reserve money to invest in them at a later round (early stage: reserving $1 for every $1 he puts in; seeds: 10x) Opportunistic Behavior: Incentive to play games with reserve to meet 70%. Over reserve, then those companies go out of business and all reserve has to be taken off the book, fall below 70% and LPs get mad Idea behind 70%: never want to be out of market and it takes time to raise a new fund (reputation HUGE) Key Man Clause If VC dies or goes away, LPs have the ability to shut down the fund and have the option to replace the entire general partnership with new management (ex. Brad used to be it for foundry group, now LPs wanted everyone to be Key Man. Thus if any one of them dies, foundry group is over) nd Public valuation (Valuation of Public Securities) - 2 Hottest Negotiat Term (more than carry or mgmt fees): Investment bankers demand insiders hold on to their shares 180 days, then all insiders sell, stock drops This is so important because this is what sets reputation which then determines carry PPM: Private Placement Memorandum Executive summary or business plan for firm p.6

VC Raising the Fund (class notes) SELECTION, SCREENING AND VALUATION: Understanding Entrepreneurs / VC Approaches To Vetting; Brief Valuation Of Early Stage Companies / Concrete Case Study From Jasons Experience Class 8 9/14: #44: Gartner, Hypomanic Edge, p.1-18; #69: Gladwell; #56: Js blog; #72: Valuing Early Stage TODAY (Lots of review) Mechanisms to constrain agency costs Determinants of covenant provisions doing the Deal previews o Hypo Edge o Invest strategies o Valuation Review Questions MECHANISMS TO CONSTRAIN AGENCY COSTS Opportunistic Behavior: o Hypo: Utility next to coal mine, What could go wrong? Long-term relatshp, jacking up price later o Point: when looking at long-term relationships there will be opportunistic behavior Like a VC and LP relationship, its not liquid Agency Costs: Principle (LP) / Agent (GP); As LP how constrain opportunistic behavior of GPs? o Tools (Issues) to Constrain Agency Costs (interest) o Issues: the different tools used to get at the same interests (constrain opportunistic behavior) Reputation Compensation Structures Restrictive Covenants Generally applicable laws (securities; fiduciary duties) Other Intermediaries (gatekeepers) Essential Diemensions of Carry: o What is the basis? the threshold that needs to be exceeded before the GP can claim a profit Investment Capital Basis Committed Capital Basis o Timing: when does GP get to see the carry? Don't see carry until all capital is returned Get carry on capital that is returned o Clawback: how does it work? o Is there a priority return (viz., a hurdle) involved? DETERMINANTS OF COVENANT PROVISIONS: 3 ways of thinking about restrictive covenants o What does it do? o What is it guarding against? What is the opportunistic behavior they are worried about here? o What are the consequences of having this proviion in there? Why does Jason think the management fee structure is bad? o Way it is now: first five years 2 % of committeed capital; after 5 yrs off invested capital o This is bad because in the later years of the firm when you have money invested in companies your management fees go down if they have an exit Downside of including restrictive covenants: o Dont tie M.Jordans Hands: let expert VC do what he does best o Costs: Initial Transaction Costs (Negotiation Ks); Montoring ; Enforcement nd o Relationships matter: a multiperiod game, doesn't matter just at time 1 it will also matter 2 o Perverse Incentives: by trying to solve one problem you create another Supply/ Demand: Why use indirect tool of restrictive covenant rather than direct compensation? o People dont want to attract direct attention to compensation structure so they indirectly provid e economic share through indirect coventnats

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VC Raising the Fund (class notes) th Quiz/ Hypo: VC Newbie is a $100M fund focused upon early stage companies. VC Veteran is on its 6 fund, a $500M fund focused on mid to latge stage companies. Where expect to use more covenants Information assymtries of higher risk early stage, thus might use covenatns more then, but at the same time, with less known about early stage might not want to tie Michael Jordans hands Higher cost of monitoring early stage DOING THE DEAL PREVIEW: Hypomania: the right amount of something wrong with you Valuation: Alchemey and Vectors Traditional approaches (doesnt work too well with start ups) o Market (comparable) o Income/ Cash Flows o Costs/ Assets Vectored Analysis = Team, value prop, IP, time to market, path to profitability, cap needs, volatitliy, etc. #1 Hypo: You are CEO. 2 terms sheets. Indentical provisions. Same geography. Similar GP and fund reputationsWhat about the funds might you want to know before you decide btwn terms sheets#1 and #2? Where in their investment cycle they are. o If you are a long term project an early fund may look better than if they are at end, especially if there are control mechanisms in place, because you may be forced to exit before you are ready. o Money left to invest/ how much is already reserved for prior portfolio cos How many boards is the VC sitting on? Will you actually have time for me? #2: Hypo: Jason would prefer that management fees after committee period automatically step down #3: Explain the structure on p.100 of VD in terms of the following three functional interest (structure as a tool, what about the fund structure would get you to the following interest?:) will return to next class Individual VC would like to limit personal liability Individual VC would prefer tax advantage compensation Investor in fund does not want day-to-day management LP decision-making among VC fund alternatives
Class 7 9/19: #13 (Orchid CP); #46-48 (Wilson posts -CP); #68: Gompers, Specialization and Success

Millionaire tax: Will hurt angel investors; will crash stock market; biggest fear is uncertainty 3 Questions of Fund structure to explain following interests: (p.100 of VD) VC would like to limit personal liability o Other VC partners could sue you o Portfolio co could sue for giving bad advice; going to go after Fund and Management company which is a C-Corp Individual GP would prefer tax advantage compensation o Carry is not considered income its considered capital gains so taxed at a different rate o GP is a float through entity Investor in fund does not want day-to-day management o Limited partners cant have daily control by def or would lose their limited liability status Separate Issues from underlying interests: What are the functions you are trying to get to by using these ORCHID PARTNERS 5 Team members, 4 of which had prior relationship: Todd Krasnow: Staples and Zoot dry cleaning; retail; No early stage tech experience; Susan Pravada: Lawyer, Managing Partner; Friend: young entrepreneur; Nelson; Flowers: CTO Would you Invest in this VC? o Pros of this fund: prior close relationship; lots of background in business o Cons: Still working in their other jobs part time; not necessarily a lot of early tech experience; personal motivation to change from busy lives to spend more time with family Initial $50M fund: Cant pay salaries with that Other VC funds giving advice? Wolf in sheeps clothing? Probably not here, the well established funds dont really believe these new guys doing probably one fund will be able to touch them reputationally The process? What is the incentive of doing a deal? Deal flow? o Need deal flow give a bucket of money or 1 deal per person connects to ego p.8

VC Raising the Fund (class notes) Most VCs are unlike Jasons, no ego connected, and they sit down and budget how many dea ls per year. When one comes in everybody tackles it and may even it assign it to someone else that has more skill or experience

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VC Raising the Fund (class notes) Steps of process = (p.12?) Once a deal had been screened and met minimum entry requirements, would do due diligence (1 month) - offends Jason: he would never close a deal if he had this process o Length of time this would take depends on company; Early stage company with not much to research, why should it take longer than a day Market research doesnt have to be done from zero each time Supposed to be investing in industry you know, so why are you planning on starting from scratch each time Voting Provisions: (p.14) o All investments: unanimous; Votes for new partner: 80%; routine matters: 60% o There is no right way but Jason thinks this is flow Jasons: 3-4 must vote for everything; they have yet to do a deal that hasnt been unanimous; if there is one person that doesnt like it it just signals that they better figure out whats bugging him but wouldnt actually squash it o Unanimous voting is dangerous: allows one person to have a bad day and destroy your company Priority Return 8%: LPs will get all their money back + 8% before VC starts taking carry o 8% is not standard so signals they are having trouble getting money because rest of the industry has seen this deal and not liked it so they are having to give up negotiation points Investing other Peoples money vs. your own money o Nobody on this team has invested somebody elses money, which is so much more difficult; changes you emotionally and the way you see risk They were going to close in 2004, so why are they not still around? They failed never closed

DOING A DEAL
9/21: 9. Joogle Due Diligence exercise (legal basics): VD ch.13; (Item 59 (Bagley & Dauchy excerpt) HOT Ownership Issues (Capitalization tabels) (case ex. See crocs) o Phil Weiser in dorm room creating (wayward founder) o Surden: 5% of what and when? o Bernthal: no Dilution (could just be a medium issue because negotiate later) o Who owns the company?? Intellectual Property: (PIAA) o Ohm as independent contractor, work for hire if dont have written agreement that says this, IP belongs to independent contractor. How to fix: Proprietary Rights agreement: says I didnt steal this from anyone else and its yours (doesnt have to sign, now he has leverage but reputation matters here, if he screws you may hurt his reputation w/ Jason) Side note: Dislosure/Sharing of Ideas vs. Ownership of IP o Surden working at IBM; if IBM owns IP Asia Deals (?): Depends on how much IP youve hande d over MEDIUM S-Corp Issues: o Can only have one type of stock o Cant have flow through taxes for VC to invest o But pretty easy to switch to corp Employment: o Bernthal Vesting Fix: incentive issues: if he sucks and gets fired he gets to walk away with 100% of his stock, not much incentive to do a good job Easy to fix: if you want funding, must sign a new agreement (ex. 4 yrs schedule); usually, only 100% vesting for double trigger: 1) company gets bought; 2) then you get fired because buying company already has CEO manager types o Pool: Stock option program: want to to have lots of incentives (10 20%) Note: if VC wants a large option pool available, sending message that might be wanting a new CEO and will want stock options available to incentivize o Only 12 agreements and 13 employees p. 10

VC Raising the Fund (class notes) JUST TO NOTE Corp hygiene (minutes) Loan > Payoff?

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VC Doing a Deal (Class Notes)

TERM SHEETS
Term Sheets #1: Overview & Economic Terms; (10: VD 3&4; opt bkgrd: Wilmerding Term Sheet) ECONOMICS & CONTROL (Price; Liquidation Preference; Pay-to-Play; Vesting; Employee Pool; Antidilution) Price Valuation o Pre Money what the investor is valuing the company at today, before investment o Post-Money the premoney valuation plus the contemplated aggregate How much value does the VC want to fund in a company? Ownership: VC/Entrepreneur shift in past 20 years away from VC owning 80% and employees owning 20% Option Pool: increasing or decreasing If you do financing at too high a valuation that no way next round can be as high (up/flat/down round) o Wash out/cram down round: if it way low that you are owning the co. for too cheap o If too high, are setting expectations down the round, but if next round is lower then you are

Liquidation Preference (ex. In book ar wrong; http://www.askthevc.com/wp/errata) When the company liquidates, who is getting the money back Series A $5M with a 1x liquidation preference, means first $5M will be coming back to investors o 2x means first $10M coming back to investors o 1x is most common today Participation = done liquidation preference, now what happens. Three Types: o Capped Participation = 3x is inclusive, is not 3x after the $5 its 3x including At flat line, dont always convert, wait until price goes up enough Implications at flat spot, no incentive for VC/preferred stock to get more after flat spot; where common stock get more return for every increase in price Incentives often get unaligned under capped particpation; everybody is different o No Paticipation = you get yoru original investment back (1x or otherwise) and thats it Convert: normally you can convert your special preferred stock to common stock. You would only do this if there was a huge return and you would make more money with common, but note: all the stock preferences, and term sheet things go away when convert o Full Participation = get original investment back and then a percentage of the profits. Would never convert if you have full participation Precedent in Venture Deals: What has come before will happen again; if aggressive in early rounds, will be likely be more aggressive later o Each successive round wants at least the same treatment as the round before it Priority matters: So if you want full participation and 2x liquidation preference and youre Series A youre setting precedient for future rounds o Stacked Participation & Seniority = Series A usually before common stock, and Series B often gets before Series A, (sometimes at same time as Series A parripassu); admits this is confusing why Series B gets seniority when Series A came in earlier and took all the risk (just way it was done in 1990s; entrepreneur has no reason to negotiate for Venture Firm A against Venture Firm B) o Why would Series B do parripassu (at same time as SA)? REPUTATION MATTERS: Can negotiate hard The earlier you invest, the more that come behind you, you start looking more like common stock, better off keeping liquidation preferences low earlier on; o Early stage investors should never get caped participation Three Points: (made by Brad) o Could be a Lemons Problems: information assymetry, if Series A says I have to get paid first, may signal outsider that don't have as much info that something is wrong with this co. o Investors love precedent (!!) ? o Liquidation preferences above 1x? p.1

VC Doing a Deal (Class Notes) Two Hats: Board & Shareholder o As a board member have a fiduciary duty to make money o As a shareholder/ VC with a fiduciary duty to investors o May have a conflict of interets and need to recuse himself. Pay to Play = if you are an investor in the company, you have to participate in every round or else will lose priority status and be converted to common As an entrepreneur, do you like it? Yes, means they will stay with you As a VC why would you like it? For other investors Why would it ever be triggered: 1) company sucks Jason: he does a 9-1 reverse stock split if someone doesnt continue investing: he converts 10 shares of preferred to 1 share of common: AWESOME for entrepreneur (free money) Vesting = Keeps employees incentives, if they leave they loose their shares; Also good in GP agreemetns because vest over time Cliff: may vest over 4 yrs, but get nothing if guy quits within a year, as if he was never there (do not fire someone 1 month before a vesting; CONTRACT TODAY SETS NEGOTIATION FOR TOMORROW Anti-dilution: mechanism by which if company sells stock down the road for cheaper than I bought it, have this in place to prevent dilution; two types Full Rachet: if I have $2/share and E sells later for $1/share, then get at least same as if you had paid $1/share (doubles) Dont actually get new shares, just changes conversion rate so get 2x as much on convers o Rare: usually only see them if: (1) Company has little negotiating power (i.e.. lots of problems) or (2)Cant come to a valuation agreement but still want to work together tool to bridge valuation Weighted Average Anti-dilution Valuation: Kinder anti-dilution; see it in 95% of the deals; Takes into account how many shares the company sells without the radical pre-price of the full ratchet formula (9/28): 11. Term Sheets #2: CONTROL VD ch.5: Control Terms; Item 2: Term Sheets (p.145162) DEVILS AND ANGELS: Connecting How To And Why in Vc/Portfolio Term Sheet Provisions Two Perspectives of the course: Understand both sides HOW TO: (Term sheet is a good example of how these things work) WHY: (Why do we use dilution.)

I. LENSES OF ENTREPRENURAL FINANCE

Conceptual tool re WHY Provisions are Used = Return (economic) / Control / Interest alignment 4 COMMON PROBLEMS: Another WHY Conceptual Tool Uncertainty Info Assymetry Misaligned incentives (Agency Costs) Transaction Cost = Where transaction cost high, the cost of getting the deal done start to exceed the expected benefits, even if otherwise efficent TYPES OF RESPONSES TO PROBLEMS OF ENTREPRENEURIAL FINANCE Private Contracts = Align Incentives; Control Mechanisms for effictive monitoring (eg, board), incentives aligned with board Standardization to get to efficiency = Tension between standardization and ability to tailor contract to particular (ex. Debate on whether angel investors can have standardizied term sheets) Specialization = Jasons stratgey: focuses on early stage investing with high technologies (techbkgrd) Time: Staging the investment over time (holding reserves) o Tranche: 8M in this round and then 4M when you accomplish x (jason has changed his opinion about this to non-traunche; hard to control incentives with this. Ex. If x = getting product out, they may do it but it will suck or other areas will be neglected Tension: lower negotiating cost by doing negotiations only once but may end up misaligning incentives Legal Background Reputation / Diligence

II. CONTROL TERMS

Conversion (2 ways) Elective Conversion = Converted preferred to common if you would get a better outcome Automatic Conversion = IPO: if going public, want all these (like voting) opt in preferred stock to go away; p.2

VC Doing a Deal (Class Notes) Board Of Directors = Want a manageable number at start with the idea that it will expand with each round as you take on outsiders; Jasons prefers Balanced Board: equal amount of VCs, Founders, & Outsiders (if VC controls the board, could get sued as the real controller of company if things go wrong) Outsider = gives neutral perspectives somebody who has industry expertise, but not a financial investor or full time employee Frequency of meeting: early stage every 4 /6/8 wks, but maintain constant contact in btwn official meetings Types Of Stock Tax: 409A says what you have to price your stock at Options (go to employees) / Warrant (goes to anybody else), but same thing Banks: (Silicon Flatiorns Bank & Square one) often gets warrants as part of their deal Protective Provisions = Basically, a Veto right: protective provisions require approval of shareholders before things can be done Common provisions include changing terms of preferred stock o Issuing senior o Buying back common stock o Changing certificate of corporation or by laws of company Two Fiduciary duties of VC (the Two hats of VC while on board) o As the GP, To the fund o As board member to best interest of the company Protect VC (only veto, no affirmative rights) Drag Along = Way to force sale if a certain % of shareh want to go ahead and others are dragging it along; Allows the majority to trump dragger Litigation & Disssentors rights: want to lock up 100% of consent Affirmative rights: Drag-Along to drag other people

III. ECONOMIC TERMS-TESTS AND EXPANSION

HOW TO Liquidation Prefs Exercise: Start up Co. $5M pre-money valuation Series A $5M VC investment ($10M post-money valuation) Preferred my convert at any time Omit Dividends Consider three exists for three different liquidation preferences/ participation scenarios: o Will there be conversion o What will Series A VC Take? o What will common s/h take? Price company sold three yrs following investment $5M $20M $50M 1x Liquid Pref No Participation Cap n/a No / $5M / 0 Yes / $10M/ $10M Yes / $25M / $25M 3x Liquid Pref Participating No partic. Cap NO / $5M / 0 NO / $17.5/ $2.5 NO / 37.5 / 12.5 1x Liquid Pref Participating 3x partic. cap NO / 5 / 0 NO / $12.5 / $7.5 YES/ $25 / $25

WHY EXPLAIN LIQUIDATION PREF AS RESPONSE TO DEVILS OF ENTREPRENUAL FINACNE

Uncertainty= liq pref as response to problem of uncertainty o As imprecise as valuation is in early stage, VC will still come up with some valuation point o What if valuation too high, how do liquidatio pref Info Assymetry = o What does it signal for entrepreneur (who knows more about the company) to give a liquidation prefrence? CONFIDENCE (cf to something else.lemons problem) Agency Costs/ Align Interest = o A hurdle for the company to get over to get some compensation, so it helps alling interests. o Although it can create opportunistic behavior of VC at the expense of the company (Flatline zone of indifferson) VC incentivized to force an exit, but not so great for common stock Transaction Costs o When Jasons blog series gave away VC secrets how did it make deals more efficient? - Now speaking same language, not what terms are actually important p.3

VC Doing a Deal (Class Notes) o By aligning incentives this way, then dont have to try to foresee all other hypothetical that could happen to company and contract for. Reputation: (Silver lake example of screwing employees: Silverlake bought and then sold Skype to Microsoft; Upon sale, relied upon unusual provision: ex-employees vested options can be repurchased by company at cost of issuance. This did not make Silicon Valley insiders happy. If a SV VC firm had been involved instead of Silver Lake, even assuming same option Ks, why likely different outcome

(10/2): 12. Term Sheets #3: OTHER (VD Ch. 6)

Protective Provisions: (from last time) Last wk jason resigned as board member to exercise his protective provisions rights as shareholder Material Adverse Conditions (MAC clause) don't know what material means Standard terms: Probably dont want to change (usually based on settled case law) o Which is better?: Opt 1: Series A and Series B vote separately; Opt 2: Series A & B vote together o Founder wants all preferred vote together (lower transaction costs) o For investors: depends on what they own: if Series A only owns 40% might lose vote if vote together (B would have 60% say); thus would want own vote Reputation becomes important here because if you have done prior deals with Series B then you know how he will vote and will want all together in case you take on Series C and dont know how they will vote Dividends= if co making bunch of $, dividends allow some of that profit to be returned to shareholders East Cost: automatic & cumulative (will affect share of profits) West Cost: not cumulative; and must be declared by the board (usually wont happen because company wont be making much money) Redemption Rights = Allows VC to effectively force the company to buy shares back Typically 5 to 7 yrs: If company has not returned the investment in 5 to 7 yrs company has to buy VCs shares back; but if going badly, then co doesnt have any money and shares are worthless Life style Business = company doing well enough to run on its own but not going anywhere so not good for IPO exit; Creates a negotiation point because VC has the ability to shut company down o Not quite same as walking dead because lifestyle co is sustainable on own Conditions Precedent To Financing = Illusory Contracts: promise where somebody says I promise to do something if I feel like it (a K with no teeth) Binding = Legal Fees & No-Shop Clause (you cant talk to any other VCs) Pending Partnership Approval: o Could just be a fishing expedition: meaning that you are negotiating a term sheet and none of the other investors have any idea whats going on (more junior the VC, more wary to be) Why Need? o Sets up relationship expectations: (Heres what I need before we can proceed); o Shows not in bad faith (ex. where VC assumes presenter has financials summary but VC doesnt get a chance to go through them before terms sheet negotiations; thus just saying hey we can start this but im still going to have to go through your records) Information Rights = Back up: if for some reason VC is no longer on board, then will still have legal rights to access information Different sources in which you have a right to get information (ex. statutory rights o Right under corporate law o Right as board member o Contract right as shareholder o State Statutory Laws: California: Long-Arm Statute: regardless of where you are incorporated, if company is in CA or pays taxes there, they are liable under California law note on Fiduciary Duty Issues: Indemnification Clause: if an LP sues jason, he can use LPs money to fight law suit (but if only 1 LP sues, hes still using all the other LPs money that arent involved in suit) Registration Rights = Keep in Mind: When a company goes public, doesnt mean all their shares go public (create 20% new shares and make those public) between 10-30% virgin shares, which means dilutes dif ways of forcing the company to register VCs shares so he can then sell them on the open market Do not mark up, how its written does not matter Why S1: if a whole bunch of things happen only way to register shares, but its already gone public p.4

VC Doing a Deal (Class Notes) Right Of First Refusal = Allows VC to buy if there are new shares sold on a pro rata basis. Allows you to maintain control of the company at least as to percentage. Mirror img of pay-to-play (investors have to step up), here they will want to step-up to keep oship Also, Allows investors to buy if an owner/ investor wants to sell their stock, allows other investors to buy up that stock VOTING RIGHTS RESTRICTIONS ON SALE: Put entrepreneurs feet to the fire FOUNDERS ACTIVITIES = Says this can be your only job (Used to not be a big deal, but E like to dabble) IPO SHARE PURCHASE = right of VC to purchase sales blew past NO-SHOP AGREEMENTS = Infinite Return: 0 in millions out because Microsoft bought day supposed to close deal IDEMNIFICATION: standard requires insurance ASSIGNMENT= can assign shares to other entites

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VC Doing a Deal (Class Notes)

Brads Dilution Talk (very quickly went through)

Two types of anti-dilution protection Basic Structural (pro rata right, rihgt of first refusal, registration right) Price Based Protection = protection against later issuance of stock that is at a lower price then you are going to reprice older shares (mentioned last week: not issuing new shares just changing conversion price) Price Protection: The Acorn Problem (source Bagley & Dauchy, pp.462-66) see cap tables on slides Series A: $3M preferred issued @ $9M for 1.5M Series A shares Series B: New investors lined up; valuation is $10M pre Why does this suggest a problem? Because it's a down round; valuation is lower Series B investors pay $2M ($12M post) for 1.2M shares UPSHOT: Series B paid less ($1.67/sh) than Series A ($2/sh) Which type of anti-dilution price protection Provides most benefit to the Series A? full ratchet (makes full adjustment based on just the price being lower, doesnt account for how many shares issued) Results in least harm to common s/h? weighted average Dif between Full Ratchet & Weighted Average weighted average asks how many shares were issued based on new price (more mild) o Narrow vs. Broad Based Weighted Average Broad based: considers bigger denominator (considers everything, including consider warrants) Walk through three scenarios No anti-dilution price protection Full Ratchet Weighted Average

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VC Doing a Deal (Class Notes)

(10/5): 13. When Reputation Is (And Isnt) A Constraint On Behavior; Reputation As It Affects Economic Terms Item 2: The Best VCs (pp. 83-97); Item 10: The VC Investment Bust (Bankman and Cole)

COMMON RESPONSES TO CHALLENGES OF ENTREPRENEURIAL FINANCE [see slide]

LP/VC K Align Incentives via compensation Use Time Control Mechanisms 2&20 (emphasis on carry); skin in game Return 10 yr. fund; GP vesting Restrictive Covenants; Reputation VC/ Portfolio K Equity over cash comp (restricted stock and opt) Stage Investments; Vesting Protective Provisions; Drag Along; Reputation

I. CONDITIONS FOR REPUTATIONAL MARKET Basic: I think you wont screw me over because you have a reputation to uphold (football ex) What conditions you need for Reputation to work: o #1: Party anticipates repeat future transactions (Multi Period Game) o Behavior Observable by Others o Consequences/ Shared Expectations II. VC REPUTATION: PORTFOLIO CO PERSPECTIVE (VC as Kingmaker) What does VC do: o Pick Co o Monitor: VC adds value to portfolio co through Network (Human Resources) Corporate Governance (Hygenie; Controls) Match Making (Customers & Suppliers) o Exit Does reputation track with reality? Tension between reputation and information that informs that reputation (Ex. Deep throats) Other VC groups in CO: o Cat I = Foundry; GroTech (out of DC area, but one of their GPs is in this area managing about 9 firms); High Country (includes state of CO)/ Tango; Access; Sherpa; Altira; Greenmont o Category II: Winding up = Boulder Ventures (last investment already made); Sequal (unable to raise another fund); Centennial (original fund in 1981: when Prudent Man amendment chaged; guy retiring); Vista (went to access); Meritage o Software: angels stepping into place of VC firms that are going away because its easier for them to get in (but wont work in biotech) Why dont they scale well? o VCs are not fungible, not everyone can do this; also o Deal flow might not be there o Free Rider concerns: Bigger the fund -> less individual VC matters

In 2000, what did insiders think about the market? Bubble, at some point valuation will go down So why did they keep investing? o Investor made decision to invest in VC (ex. Yale Study: choosing to allocate in dif areas) o Greater Fool Theory: somebody else will end up buying (ie general public) o Reputation: harm VC if stopped getting $ into play (ex. lose seat at poker table problem) o Agency Cost problems Hooked on Fees High Reputation VCs vs. No Reputation VCs who were newcomers No rep VCs: view as one period game (The Bankman Emphasis) High Rep: if they have a bad one, still able to raise next fund. (not adjusting compensation structure when things go well, and also not doing it when things go bad also decreasing VCs sensitivity to LPs interests) In Pure Option Position: if stinker not getting carry anyways so might as well get as much money in play so you can get management fees If in an already carry position, where have already returned money, anything left is yours III. VC REPUTATION: LP PERSPECTIVE (Reputation as a constraint on Agency Costs (or not) p.7

VC Doing a Deal (Class Notes)

(10/10): 14. Negotiations & Term Sheet Exercise [MISSED CLASS] VD ch9; Skim Beyond Winning 11-43

RYANS NOTES: Today is the negotiation lecture: lots of what he thinks about this is in the book Three things that matter in a successful negotiation o Not killing your reputation and relationship while negotiating Reputation matters more in multi-play games Least friendly negotiation: litigation More friendly negotiation: early-stage venture capital o More possible for everyone to win o Anchoring: The points of the deal that you wont budge on These might be good, but they also tie you down and make it hard to move forward: see Congress o BATNA: Knowing what your walk-away point is critical, otherwise you can make a deal that doesnt benefit you Most lawyers are crappy negotiators: Take Peppets Negotiation class o Dont assume that your ethics are the same as the person you are negotiating with o Pay attention during your daily negotiations Threats o Only make a threat if you absolutely follow through with it o Jason wanted a rep that was fair but just crazy enough to walk away if you piss him off o People are conditioned to not take threats seriously o Lots of time, negotiators dont have the authority to make the threats that they are making Game Theory = The game or situation that people find themselves in that will affect the way that they make decisions o Prisoners Dilemma o A Beautiful Mind: pretty girl analogy o No war during lunchtime: the tit for tat concept Negotiation Skills o The Art of Listening and Asking Questions o The Power of Silence (think of it in the context of a deposition too) o Market isnt applicable: each company is unique and individual, market shouldnt matter What Jason did a few weeks ago: This is my range, one partner says this, o ne partner says that, this is what would make me happier, what price do you want? (This worked out fairly well for him) o Consult your lawyer before you talk about anything with a VC o Meeting in person: Not as common as it used be: Jason sees it as a waste of his time to meet in person, reflects badly on the person requesting it o Negotiating order In order: maybe not great, because you negotiate on a ton of little issues, changing your perspective, and then taking your wallet on the important terms Death by a thousand cuts: Never let an M&A attorney negotiate in order because you have no idea what is going on and they will crush you o Time inequalities: A CEO only has one company, more time to negotiate than the VC, hourly billing restricts how much a companys lawyer can work on the negotiation though, because the client will be pissed if it costs too much o Changing Leadership: Let one side get all of its grievances out on the table, dont agree to anything Then, air your grievances and make some concessions to theirs Then get them to concede to your issues Wednesday: o Sallet: read closely; Gilson: on non-competes, read closely but will not be accountable for specifics o Policy Architecture Exercise

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VC Doing a Deal (Class Notes) (10/12): 15. INTENTIONAL TOP DOWN ACTIONS TARGETING ENTREPRENEURSHIP: Ingredients Of VC Ecosystem Agglomeration Economies And Clusters; Non-Competes; Prudent Man Amendment, Startup Visa
Sallet Item 65 (URL below) + Percustionland Exercise; Item 75 Gilson Non-competes(TWEN)

FOUR DEVILS OF THE COURSE: (Make sure you know this) Information Assymetries Uncertainty Agecny Cost (misalignted incentives) Transaction Cost COMMON RESPONSES Monitoring (Specialized intermediary) Control Provisiosn Align incentives (2 & 20; pay portfolio company in equity) Timing: o Staging (managing uncertainity and information assymetries) o Vesting Reputation POLICY Economic geography: location of factros of production in space Cluster industry specific geographic concentration of companies Spiky World weirdness creative class: want to be around others Economic Concepts o External economies of scale: shared fixed cost (lowering cost of starting up) o Network Effects: more people added, then more valuable it becomes even for existing users (raising the value of network) o SV vs. Boston: Information Spillovers Saxenian thesis: adapt to changing technology Gilson: Non-Compete Article: Covenants not to compete in california are not enforceable, but they are in mass o CA doesnt care if you are a masscht company, if it's a california resident, we wont enforce o Adoption: California adopted proposed NY statute (written by Fields); No real common law (spanish, mexican) needed structure and certainity Collective Action Problem: its in the individual firms best interest to lcok down employees and protect IP even when its in regions best interest to open up Incentives to Invest? FIRST, figure out what your problem is: Information sharing? Or R&D investment? o Deterrent? Nukes incentive to invest in R&D If individual company cant do whats in their best interest might not come o Resolves the collective action problem in terms of information sharing Test Analysis APPROACH Answer the Question 3 levels of analysis: o Macro Course Concept: Ex. see today 4 devils o Specific Concept like: Economic, Tech, Private K, Insights, Cities/ Precedent Ex. Horizontal networks, define, cite saxenian o Apply to Facts

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VC Doing a Deal (Class Notes) VC Class Exercise: Percussionland October 12, 2011 Objectives: (1) Construct and apply a mental model concerning the determinants of an entrepreneurial ecosystem; (2) Connect elements of entrepreneurship policy to VC courses concepts related to private contracting and incentives of actors involved; (3) Conduct simulation involving analysis expected on a law school exam. Directions: You are assigned a constituency based upon your location in the classroom (see page 2). Read the fact pattern from your constituencys perspective. Prepare a bullet point analysis of the following three questions. You will not submit this analysis, however, Wednesdays class discussion will be oriented around this fact pattern. 1. Structural Problems = Identify three flaws in the PCVF proposal. Is there a better approach that you would advise to remedy these shortcomings? o Monopoly Hard to figure out who is good and who is low quality VC players (sushi/ burritos) Reputation market: one round game Insure 90% losses Removing motivation for due diligence; and VCs arent going to worry about losing deals Bad Incentive program: 2x + 10%: (capping the upside) Changes model of how bets are made (diversification strategy) Who are VCs? How many are there? Weird mix chosen by govt VC doesnt scale (100B fund managed by 60 VCs = $1.6B per VC) Staging: There is no staging Takes away time as a response to uncertainty Control: No board seat; Minority ownership postion so no voting No protective provisions Effiicent Allocation of Capital By altering the private capital incentives Is there really $100B worth of good ideas out there?

o o o

2.

What can your constituancy do? Identify three action steps that you would recommend that your constituency take to support Percussionlands efforts. o Incentivize Clusters Research grants to Universities Tech Transfer Office (TTO) Policy architecture: used to be that if you did research under federal grants, then fed govt owned IP; in early 80s legislation changed this and gave IP to universities to incentivize o Challenges to Top Down approach: Needs to be a bottom up style effort in how information sharing occurs (those that are there know better about whats going on) o Immigration Policy o Prudent Man Amend: allowed capital in alt investment class Factors outside your control: Identify three notable aspects that are outside of your constituencys control and, perhaps, any entitys control that will help determine whether this initiative succeeds or fails. a. Culture b. Picked Right Business Model c. Takes ~20 years to grow good structure Govt can radically affect the plans: This is a long term goal, if you have to rely on govt for support the ones that start it wont be there anymore d. Know How and Tacit Knowledge requires close connection that cant be passed by broadband p.10

3.

VC Doing a Deal (Class Notes) Your analysis should utilize the following: !!!!!!!! 1) Precedents and lessons learned from past instances of efforts successful and failed -- to nurture entrepreneurship as discussed in-class as well as in readings; 2) Course concepts, economic principles and technological trends (if appropriate); 3) Your own analysis. Players and entities: City = Drumstick; State = Snare; Nation = Percussionland; University = Top Hat Your constituency is determined by your location in the classroom: Advise federal policy-makers of Percussionland Advise state policy-makers in Snare Advise mayors team in Drumstick Advise business community members who control significant amounts of private capital in Drumstick Advise the geeks and engineering community in Drumstick Advise Top Hat university Chancellor and key faculty members

The $100B Percussionland Venture Capital Fund

The mythical city of Drumstick, located in the State of Snare, is the engineering center of the nation of Percussionland. Drumstick, Snare and Percussionland believe that in order to compete in the 21st Century, they need to kick-start a venture capital market. They are committed to promoting innovation. Relevant facts and circumstances are below. Percussionland is a developed country with an excellent education system, access to functioning public capital markets, a reliable legal system which enforces private agreements, and strong telecommunications infrastructure with ubiquitous gigabit/second broadband service. There is a tri-partite governmental system similar to the U.S. (federal/state/local) and similar separation of powers (executive/legislative/judicial). Intellectual property rights are respected. To assist IP protection, Snares law and courts predictably enforce company agreements which prohibit employees from moving directly to rival or related companies. Percussionland suffered terrorist attacks a few years ago. No one claimed responsibility. Most suspect the String Alliance was behind the attack. As a result, military spending is high. In the wake of attacks, Percussionland also adopted highly restrictive policies about entering the country and who can become a citizen. Percussionland is not a risk-taking culture. As a cultural reality, individual failure is difficult to recover from. It is relatively affluent, however, thanks to companies oriented around natural resources activities in the 20th Century. Saving and conservative investment is regarded as responsible behavior. Reflecting this social norm, current policies make it hard for Percussionland's leading banks, savings and loans, pension funds, and public university endowments (collectively, "Institutional Investors") to invest in risky asset classes. Drumstick is located in a beautiful valley, enjoys terrific outdoor opportunities, and is also the artistic heartbeat of the country. Drumstick is arguably the worlds funkiest music scene. It attracts large numbers of visiting young adults from around the world. Although Trombone City is not happy about it, everyone agrees that Drumstick is Percussionlands most fertile area for innovation. Drumstick is home to Top Hat University, an excellent state-funded engineering school which produces basic research renowned throughout the world. Top Hat professors proudly call it MIT without the commercial distractions. Snare provides a significant share of Top Hats budget each year to ensure this leading university is well funded. Top Hat also pulls in a large amount of federal grants from Percussion.
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VC Doing a Deal (Class Notes)

The country's policy-makers recognize that innovation is critical to its future economic well being. One challenge is to create a market which provides capital to new and private businesses and start-ups. You have been identified as an expert based, in part, upon your cogent comments in a well-regarded American Venture Capital course, which were then tweeted by your professors. Provide to your constituency an analysis critique concerning the proposal to create a VC market. There are three key components, sketched below: Induce funding and raise the $100 billion Percussionland Venture Capital Fund: Percussionland will create a single super-VC $100 billion fund with a 10 year life span known as the Percussionland Venture Capital Fund (the "PVCF"). Percussionland intends to alter existing policies so that its Institutional Investors can invest as limited partners in the PVCF. In order to induce institutions to provide necessary capital for the PVCF, as well as to ensure the financial stability of the Institutional Investors, Percussionland's government will insure up to 90% of Institutional Investors' losses in connection with the PVCF. Protect the Entrepreneur: PVCF believes that entrepreneurs "on the ground" can best exploit information gaps and generate innovative breakthroughs. In view of this, the PVCF seeks to limit interference by investors in portfolio companies. Accordingly, PVCF will only take a minority position in companies, will not take significant control rights (such as board control) in connection with its investments, and will generally provide investments in a single lump sum (which should also increase efficiency by reducing transaction costs associated with extra financings). All PVCF investment decisions must be approved by one of Percussionland's 10 government-sanctioned "super VC teams." Each of the super VC teams will be composed of six-members: one banker, one government representative (from the Ministry of Finance), one former entrepreneur, one early stage venture capitalist, one later stage private equity specialist, and one professor (from business, economics or law).

Incentivize the Entrepreneur: Finally, in order to provide additional incentive to catalyze entrepreneurship and individual risk taking, the PVCF will allow portfolio companies to purchase successful investments back from the PVCF for 2x the fund's original investment plus a 10% annual interest rate (i.e., this would function somewhat like a 2x liquidation preference plus a 10% dividend, but without participation or conversion rights). This would allow PVCF to realize some upside in its successful investments; however, it will strongly motivate risk taking by enabling entrepreneurs to reap the majority of the benefits associated with their "home run" exits.

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VC Doing a Deal (Class Notes) 10/19: Bottom-up elements of entrepreneurship: international cross-regional advantage Item 74: Saxenian New Argonauts 4 challenges of our time 1) Debt crisis 2) Environmental 3) IT revolution (Phenomena outruns experience 4) Globalization

Saxenian, New Argonauts

Core Periphary Model: Large companies in the core doing lead development and after processes become standardized goes to other countries who get leftovers (core is where innovation occurs), but how do you explain innovation 10 yrs ago, people said China was not a problem because all it would ever be was a manufacture The new Argonauts are undermining the old pattern of one-way flows of technology and capital from the core to the periphery, creating far more complex and decentralized two-way flows of skill, capital, and technology. But then, How do you explain indigenous entrepreneurship in these areas? Brain Drain of these countries : Used to be best and brightest stayed in developing countries Saxeninan traces change from brain drain brain circulation Note: article should remind you of Florida and Hypomanic Clustered groups of those who felt like outsiders in Silicon Valley Shared context: open, common linguistic abilities, trust and reputation within these groups, when start companies in other countries ability to navigate the entrepreneurial their In 20 Century something switched went from core periphary view to a decentralized flow of information Hyper specialization is altering globalization enabling The social structure of a technical community appears essential to the organization of production at the global as well as the local level o Big deal is Social Structure Cf to Floridas Article: How do you square this with Floridas Thesis of Creative Class that world is spiky? Saxenians Arg: Allows for a tight knit but geographically disperse network Has the rise of entrepreneurial hot beds come at the expense of Silicon Valley Silicon valley is now integrated into a specialized cross-regional network thus not hurt because then new market for suppliers. But how do we explain the fall of Route 128 and the upcoming areas that have replaced it? Saxenians take away for policy makers Don't try to build the next Silicon valley from Top Down; Instead try to Plug IN o Bottom up o Entrepreneurial cycles (mentors) Boulder thesis (must be driven by entrepreneurs) tech stars Create great educational systems (brain circulation idea: encourage them to leave (go to MIT) and bring that education back) Create good infrastructure to support (hwys, internet connections): enables/supports innovation but doesnt cause If New Argonauts is true, (to the extent that this is a new type of regional advantage) whats that mean for nd the front range (First, we don't have much international immigration into Boulder; 2 , we don't have
th

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VC Doing a Deal (Class Notes) JASONS LECTURE: 12 Things that will Quickly Blow up your Start-up 1. You have a bad team (make sure first people are A+) Biggest mistake: hiring first few people out of desperation Initial hires are most important: Those first few people may be the only people actually doing start up, They also define the culture of your company You need to find someone that is okay accepting equity as compensation (Benefit of people in Boulder is they understand value of alternate compensation) 2. Have a bad idea (You need a good idea that you love) Dont commit crimes of passion (if you do it for the $ will burn out, make sure you <3 what you do) Adapt is one thing, but changing is another (dont change) 3. Pick bad advisors Bad advisors are ones that will take you out for coffee and then charge youNot only will you get bad advice, your reputation might also be hurt by your association with them 1/4 % of company that vest monthly over 4 yrs (not on final) 4. Be arrogant Fine line between confidence (self aware) and truly just arrogance Arrogant people dont adapt quicly (one exception: steve jobs) 5. Not knowing your business model Two components to knowing your business model o Knowing how you are going to make money o If you are making money then by definition you are taking money from others (at some point you will start hurting someone elses income stream how are they going to react? (whats their business model?) o Ex. Zynga business model based on selling virtual farmville, distinct from advertising. At first okay because only ones doing that but then starts to hurt others like EA and had to adjust) 6. Not knowing your competition Everyone has competition (No competition not an answer) Entrepreneurs tend to mistakenly define competition too narrowly (eg. I haz cheezburger business model based on people wasting time on your site competition is the entire internet: everyother thing you could be doing on internet) 7. Delusions of grandeur: Hiring too quickly You will never have enough people so don't get there Mistake of hiring sales people too early (#1 sales person should be the CEO, if they cant something wrong with product) 8. Not constantly testing hypothesis Always be paying attention to how the market is changing 9. Stay on top of PR. People are paying attention to startups. Whether you like it or not, you are going to get press before you are ready. Be prepared On the other hand, dont jump the gun. If you get too excited and start telling everyone they will go to your site and the mass stream of visitors will crash your site then they wont come back 10. Over-promising and Under-delivering Huge deal. Where CEOs get in trouble trusting CFO with numbers 11. Not paying attention to how people are incentivized Ex. Co-founder has a kid that is sick or spouse needs medical care Need to be a touchy feeling arm chair psychologist 12. Buying Too Expensive Furniture and Fancy Jets

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VC Doing a Deal (Class Notes) 10/24: ANGELS (DAY 1): The Role Of Super Angels; Convertible Debt (Angel Variants); Jasons Approach To Vetting Companies (Preview Pitch Day) Convertible Debt Series on AsktheVC.com; (Optional: Item 71 Gawande, Airline pilot protocols in finance (URL)) How VC makes decisions Vetting Questions (Jason):

Amount

Emotion Intellectual

Time over Jasons Career as a VC Graph: At beginning of career, Jason tried to suppress the emotional aspect and keep it analytical, as time has gone on switched and he has started to trust this more; Now, Intellectual less of a factor because he knows market more and what hes doing (so in background); good thing How Jason Vetts Companies (dating analogy) Team: Do you have the person on your team for the important stuff; whatever the core things are that the team must do, Jason wants those experts in place before he invests o Excitement? If they dont love what they are doing, raises a red flag o He wants the person to be interesting, he wants to be able to learn from them too o How is the vibe between members (cute couple vs. bickering spouses) o Beer Test: Would Jason want to go grab a beer with him after this? Polish (sloppy vs. used car sales man: want to find something in the middle); (Brad: Dynamism: know your stuff so you can jump around, dont say Ill get to that later Idea: Does Jason find it personally interesting? Doesnt make investments just based on whether he can get money back, he doesnt want to be bored (not all VCs have this luxory) o VCs Deal flow Too much deal flow (4.8 to 1: meaning for approx every 5 companies they wan to invest in, can only actually do 1) <-- Foundry group 1.5 deals to 2 deals < deal flow (.8 deals to 1 deal) Exit: M&A: Jason always assume company will NOT go public, so is there a natural market for someone else to buy (lots of exits are lucky) o Want to make sure that exit makes sense , dont want to rely on luck o Why is this statement false: I invested in company X, it got bought by company Y, and I got money back in my fund, so good investment Greater Fool theory: Doesnt mean that Company Y was smart to buy it, you just got lucky Competitors & Potential Competitors (now & in the future) Bill Cycle = how long does it take to evolve your product (releasing software 1/wk vs. 1/yr.) o Jason likes quickly because then if something goes wrong get feed back and fix quickly How much of VCs time is this going to take? How much money need to raise and how much other VC partners will like it (if need to raise a lot and know another partner will no like idea then probably not good) Legal accounting and operations stuff: Due diligence & IP stuff o What are all the bad things that could go wrong (risk assessment)

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VC Doing a Deal (Class Notes)

ANGEL INVESTMENT (DAY 1): CONCEPTS AND CONSIDERATIONS

TO EQUITY OR NOT TO EQUITY. THAT IS THE QUESTION Topics: (1): Distinguishing traits of angels (vs. VCs); (II): Mechanics of Convertible Debt (III): To equity or not to to equity (should you use angel as convertible debt or as equity round?) PART I: DISTINQUISHING TRAITS OF VCS 3 Types of Angels: o Savy Han Solos (experienced entrepreneurs); Have a good sense of the market and the risk; May even still be a CEO doing angel investing on the side Rich intellectuals: (non savy) people who have made money in another area, dont know much about tech o Rebel Alliance (Angel Groups): some groups collectively share due diligence Open angel forum: requires angel to have at least done 3 investments >$25k in the past 12 months; lose knit group just gives entrepreneurs all in one place (J likes) Jason has bad experience with angel groups; thinks group think causes process to drag on for months longer than it would take a VC and wastes entrepreneurs time (C -Tech Angels) o Obi-Wans: (VC investing his own money as an angel) Reputational consequences of hosing this is worse than han solos Note: Jason cant (by K) angel invest in tech companies b/c those have to go to foundry but can do other things on the side (just doesnt want them taking bandwith once raises fund) Operating a fund vs. using your own money: fiduciary duty o Other peoples money VC o Own money Angel o Super Angel: blurs two categories (more like a mini VC) Traditionally investing as a full time job but still doing it out of their own money Now, people started asking them to also invest their money and they started taking carry, etc. --> start to look like micro VCs All of these can be in the same round (including angel round or seed round) Angels vs. VC o Risk & Ability to make investment with your own $ (easier) vs. other peoples $ (hard) o Market Sensitivity Angels: if market crashes you feel that now VC: already have fund $ committed, thus wont feel it until later o Incentives to participate after the investment Angel is not getting paid to get involved (also, hans solos are very busy individuals VC: 2 & 20 o Horizon of an Exit Angels can play in areas VCs cant (ex. science projects) VCs have time limit pressure to exit o Angel round earlier (uncertainty?) o Hans Solo Angels (not working together) in Negotiation dynamics of doing a deal Less Leverage in an Angel deal : Entrepreneur driving the deal and no one angel in lead; Cf. to one VC bringing all the money to the table where they will be driving the deal terms PART II. MECHANICS OF CONVERTIBLE DEBT Convertible debt = Loan with o Equity like risk, and o Ability to convert loan to equity ownership (by right or automatic) Discount = Warrants & Price Discount Ex: $100k note; 10% annual simple interest; 20% discount; auto convert upon qualified financing (QF) of $1M or more coming in 365 days lter, VC A Round; $1M for 1M shares; $2M post o Q1: How much ownership will note convert to post A round? $110k/ .80 = 6.875% o Q2: Company does great; Post A round value is $8M (instead of $2M) = 1.7% o Problem better company does, less value (situation where interests are not aligned) p.16

VC After the Deal (Class Notes)

AFTER A DEAL:

10/26: ANGELS (DAY 2 of 2): Hypomanic LLC Exercise

MISSED

11/7: Negotiations de-brief; Secondary Markets: Altering Incentives?

Item 76 Ibrahim: New Exit in VC (TWEN); Optional: Beyond Winning CH 5 (TWEN) Pitch Day Recap Guy (VP of Engineering) left because he needed paycheck shows they have been fundraising for longer than planned Beer Test? If Jason knows more than CEO about his company, not good Strategies: Asking questions to see how CEO responds; jokes to test personality Biggest Challenges: Team: getting VP of engineering; while living in monument Secondary Markets Discussion Topics: o Challenges of Ent Finance o Definitions o Benefits o Risks Challenges of Entrepreneurial finance o Info Asymmetries o Trans Cost 2nd market is a broker dealer; Share-post is more like a bulletin board just posting Search costs, negotiation costs. o Agency Cost o Uncertainty Terms o Lock In (two types) Capital Lock-in = once money is in you cant pull it out, it stays in company; same as public companies Investor Lock-in = dif than an IPO, extreme version, person cant sell their shares, they are illiquid unless exit events Benefits o Increased liquidity (Illiquidity Premium) Reduce cost of capital from perspective of the company Allow certain class to get to funding that otherwise could not o Align incentives in exist by untangling those that want to exit and those that dont o Improve governance

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VC After the Deal (Class Notes)

11/9: Term Sheets #4 (Trish Rogers) Definitive docs (to be provided)

Founder should be concerned about o loss of control (what is the reputation of the investor) o Dilution is it worth it o Termination of your employment o Security interest in key aspects of company (normally doesnt happen up front) Is this enough money to get me to the next round? Investors intend you to accomplish certain goals with money, if you dont do it then they arent going to just give you more money, your going to have give something up. Options Give Bridge loan (often secured by founders stock ) How much money is it going to take to get to an exit? o If problems Dont have surprises at board meetings Regular updates to angel investors, if a surprise warrants a special meeting ok, then ask for advice As VC counsel, concerns o Who owns stock? Interest in company o Who has rights to IP in the company (important issue) (story of doctor coming forward with notes: clear evidence) If guy comes out of woodwork? Buy his interests in the IP (compensate w/ equity?) Important, before company makes money, get those with interest in IP to assign their interest. Get signatures before profit o Brad calls this Wayward Founder problem They forget, then your job to ask more questions to due diligence Oh its just a buddy, still get paperwork Oh hope they wont notice, they will better to do it early Documents Aspect: Taking Term Sheets Documents o Make sure terms in documents match what term sheet says o Dilution: If Round A paid $1 / share and then at next round company is not worth as much as planned then can still get financing but Series B only wants to pay $0.50/share; but that would dilute those who paid $1 o Don't issue them more stock that day, it just changes conversion price, comes into play on exit event o Example 1.5M Common 2.5M Series A (issue = $1.00) 2.0M Series B (issue = $2.00) 1.0M Options =7 M total

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VC After the Deal (Class Notes)

11/14: AFTER THE DEAL: Board Activity; Conflicts of Interest #36 (Jaffe & Levensohn CP); Review #44 (Hypomanic Edge)
IBRAHAM ARTICLE: SECONDARY MARKET 3 reasons why secondary markets good o Reduce Illiquidity Premium o Improve startup governance mechanisms ability of investors to walk away, that threat exit should improve governance of a company in responding to concerns of shareholders If you cant run this company right, Im walking away How to get around this: clause no transfer of stock without company permission o Relieve pressure to exit due to misaligned incentives: Responds to an agency cost problem How to align: company employees dont get paid until exit Under SEC regulations at 500 shareholders you essentially have a back door going public, 1 constraint fro companies that dont want to have reporting obligations o Proposals to raise to 1000 o 220 action: any shareholder of a private company can get access to a list of shareholder, records, as long as it's a reasonable request that a shareholder would want this information bad for competitive intelligence issues reduction of information asymmetry best way to combat this : don't let competitors in Conclusion: o Private contract in the form of right of first refusal o In terms of information disclosure, companies are defining their trader policies- any non-public information is defined as insider trading o Total restrictions POINT: class has taught to deconstruct incenties to individual level of decision makers o But Ibraham is making this arg based on overall benefit, in reality individual dont care about the system, they are going to do what makes sense for them HOW VENTURE BOARD ADDS VALUE 3 Types of capital (ranked from most important to less) o Intellectual/Pattern recognition o relationship capital (network) (most VCs network are over rated: if good know people, they are probably employed, cant poach ee from your own companies) o Social/Mentor sounding board Debate: what makes a good VC: a good picker (hypo) or a good runner (levhenson) (Jason is turning more towards a picker) Why are these responsibilities difficult for the VC? Should NVCA adopt this article as a Best Practices No then you could sue VCs much more easily (did for 36 hours until Jason bitched them out) 11/16: M&A Other Term Sheet VD Ch 12; Items 39-40 (LoI and blog - CP); Items 42-43 (carve outs - CP) 3 TYPES OF EXITS IPO Merger & Acquisitions (can be great or shitty, for 1$ Bankruptcy MOU, LOI, or TERM SHEETS TWO TYPES OF STRUCTURES: Stock or Asset Deal? o Stock Deal: acquirer is buying all of the stock; owns everything: the good, bad, and ugly o Asset Deal Reverse triangular merger (done for tax reasons) Benefits: Acquirer takes assets and leaves liabilities behind Exception: If company is not doing well, can get caught in Fraudulent Conveyance DON'T WANT TO GET SUED FOR FRAUD, its losing, if even allege fraud, insurance will sit back and not pay Cons: As a VC, have to wind company down p.3

VC After the Deal (Class Notes) Price: o Working capital (what you have in your bank account and receivables you can get cash for) o #1 thing that will affect escrow changes (you said you would have x amount, instead you have y amount pay me the difference of x-y) Technology Companies: all you care about is the technology, so we will promise $0 working capital, and give any o Takeaway; Big deal Always important Hard to figure out Tells you motive of buying company (if they need a lot, signals strength of buying company is weak) Term Sheets : Vague (2pgs) or Detailed (20pg) LOIs? want detailed, no surprises lower transaction cost Stock Option Plans o Stock option plans generally accelerate if not acquired by the seller o Why? Hard to hire someone and say oh btwubbs, if we get acquired, you get nothing On other hand, If fully invested, employees have no incentive to stay on, already got stock compensation paid out o Allocation of price affected by stock option plans Earn-Outs: don't like them as entrepreneur because totally dependent on the buyer after the deal is done. Its kind of illusory (MTV deal, company worth more than originally planned, so now buyer owes them money) Escrow = basically an insurance plan, if something is deemed incorrect, escrow is way get buyer paid for any damages incurred o Typically held for 12-24 months o Sometimes the deal will have indefinite liabilities on taxes for 7 years and stuff like that (patent trolls, etc.). How do you handle it? Theres no good answer. Can either hold back some from L Ps clawback if needed but often that doesnt work well o Option 1: SRS (Shareholder Rep Services): created a fund that they believe they can factor for how much this is worth (thus, can give them and get escrow in cash, but at a steep discount (horror story about missing indemnification notice (not opening mail), which equals gross negligence and then VC has a duty to shareholders and has to sue) o Joint & Several Liability: can just go after all other shareholders to get money back Deal breaker if don't get this clause: want several, not joint, and limited to pro-rata share (if he could be liable for someone elses debts it could blow up his indemnification clause between VC/LPs) Management Carve Outs o Important management is happy Don't want them to quit because they are not happy Reputation concerns (dont wan to come off cheap) Right thing to do o Carve out can be for cash or for stock (creative) But, If stock management is getting illiquid asset they have to pay taxes on immediately

11/28: Overview: VC Guest Lecture

Management fee is a loan against carry Top 3 things VCs do: o Hiring firing CEOs o Find good investments o Help in exit Being a vc is like being an underware gnome

11/30: Early stage securities: electronic markets and venture capital

Guest: Rick Levin, Baker Hosteler; Reading TBA

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