Exam 2 Review

Exam Rules and Format

Time – 1 hour and 45 minutes

Open notes – The path to answering every question on the exam can be found in the slides attached to this deck

No phones or computers

Bring a calculator

Practice is critical – make sure that you go over the examples and exercises that we covered in class

Format Similar to Exam I

Section I (50 points)

10 multiple choice questions worth 5 points each

Section II (50 points)

3 to 5 questions requiring computations

What’s on the exam?

While the exam is cumulative, we will primarily focus on Lectures 8 through 13

Systematic risk question from Exam I will be on this exam, in a slightly different form

Lecture 8 – Crowdfunding and Angel Investors

Lecture 9 – Sources of Financing (Venture Capital)

Lecture 10 – The Investment Process (perhaps 1 question about Due Diligence)

Lecture 11 – Term Sheets I

Lecture 12 – Term Sheets II

Lecture 13 - Exits


Lecture 8 – Sources of Financing

Crowdfunding, Incubators, and Angels

Equity-based crowdfunding

Backer receives shares of a company in exchange of the money pledged

Crowdfunding platforms cannot make commissions on equity raising, so they have to make money by alternative means:

Flat rate listing fees

Premium services

Selling data


SEC limits on Equity Crowdfunding

Equity crowdfunding is tantamount to the sale of equity securities to the public and is therefore regulated under Securities Act of 1933

Crowdfunding was severely limited until the Jumpstart Our Business Startups (JOBS) Act of 2012

Made major amendments to Rule 506 of Reg D and Rule 144A

Key requirements of SEC regulations issued under the Jobs Act:

Transactions must be conducted through an intermediary that is either a registered broker or an SEC approved funding portal

Issuer may sell up to $1 million of its securities, per 12 months

Individual investments in a 12-month period are limited based on annual income and net worth of the investor. Current range is $2,200 to $107,000, per investor per year. 

Independent CPA reviewed financial statements for raises from $100,000 to $500,000 and Audited financial statements for raises from $500,000 to $1,000,000


SEC limits on Crowdfunding Investors

Annual Income Net Worth Calculation 12-month Limit
$30,000 $105,000 greater of $2,200 or 5% of $30,000 ($1,500) $2,200
$150,000 $80,000 greater of $2,200 or 5% of $80,000 ($4,000) $4,000
$150,000 $107,000 10% of $107,000 ($10,700) $10,700
$200,000 $900,000 10% of $200,000 ($20,000) $20,000
$1,200,000 $2,000,000 10% of $1.2 million ($120,000), subject to cap $107,000

If either annual income or net worth is less than $107,000, then during any 12-month period, you can invest up to the greater of either $2,200 or 5% of the lesser of your annual income or net worth. 

If both annual income and net worth are equal to or more than $107,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $107,000. 

Source: US Securities and Exchange Commission, Investor Bulletin, May 5 2017

Examples from the SEC


Angel Investor Definition

High net worth individuals who invest directly into entrepreneurial businesses in return for equity (or convertible debt)

Often successful, exited entrepreneurs or retired business persons

Typically invest in areas of professional expertise or interest

Accredited investors – SEC definition

E.g. net worth >$1M or annual income >$200K

Angels are the largest source of start-up capital



Angels provide smart money

Many angels provide mentoring before and after investment

Often provide an advisory role for management team

Some serve as board members or observers

Some join venture as C-level executive for an interim period

Develop relationships with Venture Capital firms for expansion capital

Some angels are better than others…


Super angels

Super angel: Set of very active, influential angel investors

E.g., have a portfolio of >20 companies and invest >$100 per company

Famous super angels: Aydin Senkut (former Google exec), Ron Conway (SV Angel), Chris Sacca (former Google exec), Mike Maples, Dave McClure (former Paypal exec)

Often co-invest alongside own fund or other VC firms


Angel groups

Networks of angels who pool their resources and coordinate on leads, due diligence, contacts, and management advice and invest jointly

First Angel group “Band of Angels” founded in 1995 by Hans Severiens

In 2013, 400+ angel groups with an average of 42 members per group


Lecture 9 – Sources of Financing


Who invests in venture capital?

Accredited Investors Only

VC funds sell interests in “Private Transactions”

Not a public offering

Exempt from registration under the Securities Act of 1933.


Investment manager cannot advertise the offering or broadly solicit investors

Offering is restricted to a small number of Accredited Investors

No more than 100 investors

Net worth > $1M or $200K annual income

Who invests in venture capital?



Private placement memorandum (PPM)

Document which VC funds send to institutional investors to advertise fund investment opportunities


Fund’s investment strategy

Fund size, term, fees, minimum contribution, & GP commitment

GP’s background and expertise

Market opportunity

Other legal, tax, and regulatory matters


Limited partnership agreement

Legal document that contains the terms that describe the control, management, financial investment, and distribution of returns for a fund

The PPM is the starting point for negotiation between LPs and GPs

Main goal: Alignment of LP and GP financial interests


Limited partnership agreement

Structure of the funds

Minimum investment amount

Minimum and maximum size of the fund

“Takedown” schedule

Extreme conditions under which LPs can terminate their investment before the 10-year limit

Key man provisions (key GP exits)


Majority of LPs vote that GPs are damaging the fund

Penalty on LPs failing to meet their capital commitments

Charge interest for late payments

Seize LP’s stake; Sue LP


Limited partnership agreement

Management of the Fund

Activities of the General Partners

Types of Investments



What is a VC fund?

Each fund is structured as a Limited Partnership

Typically the fund life is 10 years with possible extensions

Life science funds are often established as 12-year funds

Invest in the first 3-5 years

Exit in the second half

Reality life of funds can be much longer than 10 years.

Typical fund consists of 12-24 investments


What is a VC fund?

Funds typically have a stage or industry focus:

Stage: Seed/Early, Growth/Expansion, Later

Industry: Internet, healthcare, clean tech, etc.

A VC firm can manage several funds, which are typically raised a few years apart.

In 2008, KPCB raised its 13th fund: KPCB XIII, $700 mn

In 2012, KPCB raised its 15th fund of $525mn

Flow of funds: Fees & Carry



Fund terminology

Committed capital: amount of money promised by LPs over the fund life

Only a portion (10-30%) of the committed capital is transferred to VC right after the fund closes

The rest will be called down as the need arises

Capital calls: Request from GP to LP for pledged capital

Typically, takes 2 weeks for capital to arrive from time of call

Lifetime fees: the total amount of fees paid over the lifetime of a fund

Fund terminology

Investment capital: committed capital - lifetime fees

Invested capital: cost basis for the investment capital of the fund that has already been deployed

Net invested capital: invested capital - cost basis of all exited and written-off investments

Investment period (commitment period): Period of time during which the fund can make new investments

Typically, the first 5 years


Simple Example

ABC Ventures raised its first fund – ABC I

Committed capital: $100M

Management fees: 2% (level) of committed capital (basis) annually

Fund life: 10 years

What are the lifetime fees and investment capital of this fund?

Lifetime fees = 2% x 100M x 10 = $20M

Investment capital = $100M - $20M = $80M


Slightly less Simple Example

ABC Ventures raised its first fund – ABC 1

Committed capital: $100M

Same management fee and carried interest

Invests $5M per company in 10 companies

Sells 2 companies for $200M a piece

What are the invested capital and net-invested capital of this fund?

Invested capital = $5M x 10 = $50M

Net-invested capital = $50M - $10M = $40M


Practice problem

Greylock Partners raised its 15th fund in 2008

Committed capital of $400M

2% Management fee on committed capital

12 year fund life, 5-year commitment period

Greylock has made 10 investments of $30 million each by 2012, and

Greylock has exited 5 deals with a total cost basis of $150M

It is now 2015


Lifetime fees

Investment capital

Invested capital

Net-invested capital

Practice Problem Solution

Formula Calculation ($M)
Step 1 Lifetime fees:
Committed Capital x Fee % x years $400 x 2% x 12 = $96
Step 2 Investment Capital
Committed Capital – Lifetime fees $400 – 96 = $304
Step 3 Invested Capital
Sum of all investments made to date 10 investments x 30 = $300
Step 4 Net Invested Capital
Invested Capital – Cost basis of all exited or written off investments $300 – 150 = $150


Computation of fees in practice

Requires two values:

Level (%)

Variation among funds

Variation over fund life


Committed capital

Invested capital

Implication on VCs’ behaviors?

In roughly 40% of firms, management fee base changes from committed capital to net invested capital after 5 year investment period


Practice problem #2

Fund XYZ has committed capital equal to $500M and is 7 years into its fund life of 10 years. Management fees for XYZ are 2% of committed capital during the first 5 years of the fund's life, and 2% of net invested capital after its initial 5 year investment period. XYZ has invested $400M and has experienced 3 firm exits at the end of year 5 which totaled a cost basis of $125M.

Calculate fund XYZ’s lifetime fees assuming no more exits by year 10

Practice Problem #2 Solution

Formula Calculation ($M)
Part 1 Fees for the first 5 years:
Committed Capital x Fee % x years $500 x 2% x 5 = $50
Part 2 Fees for last 5 years:
Net Invested Capital x Fee % x years
1 Invested Capital
Sum of all investments made to date $400
2 Net Invested Capital
Invested Capital – Cost basis of all exited or written off investments $400 – 125 = $275
3 Calculate fees for last 5 years
Net Invested Capital x Fee % x years $275 x 2% x 5 = $27.5
Part 3 Lifetime Fee
Part 1 + Part 2 $50 + $27.5 = $77.5


Computation of carried interest

Carried interest (carry): portion of profit that goes to GPs

Carry = Carry percentage * Profit

Profit = Exit Proceeds – Carry Basis

Carry percentage: typically 20%

Carry Basis: Threshold that must be exceeded before GP can claim a profit

Committed capital (used by about 70% of funds)

Investment capital (i.e., committed capital - fee)

May include a hurdle rate


Practice problem

Fund Z has carry percentage of 15% and a carry basis equal to committed capital.

If committed capital is equal to $100M how much will the GPs make after selling all the funds portfolio companies for


GP carry = (250 – 100)*0.15 = 22.5

How much would the LPs make?

LP profit = 250 – 100 – 22.5 = 227.5


Practice problem

Fund VII has committed capital equal to $350M. The carry percentage is 20% and the carry basis is equal to committed capital plus a 10% hurdle rate. At the end of the funds life exit proceeds equal


Calculate the GPs carry.

Carry = (560 – (350 x 1.1)) x 0.2 = $35M


Computation of carried interest

Timing of distributions:

Deal-by-deal (most popular)

Real-estate model --- wait till LPs get their money back

Deal-by-deal: What could possibly go wrong?


Lecture 10 – The Investment Process


Due diligence

Due diligence: Investigation of a business or person prior to signing a contract

Rigorous process that determines whether or not the venture capital fund or other investor will invest in your company

Primary purpose is to confirm valuation and identify material risks.

The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity.


Preliminary due diligence

For firms that successfully pass the pitch meeting, the next step is preliminary due diligence

Primarily focuses on an in-depth analysis of company’s management and market potential.

If other VCs are also interested in the firm, preliminary due diligence is short

If the results of the preliminary due diligence is positive, the VC prepares a term sheet that includes a preliminary offer.


Warren Buffet due diligence

4 simple criteria:

Can I understand it? (Buffet defines “understanding a business” as “having a reasonable probability of being able to assess where the company will be in ten years”)

Does it look like it has some kind of sustainable competitive advantage?

Is the management composed of able and honest people?

Is the price right?


Final due diligence

Further analysis of management, market, customers, products, technology, competition, projections, partners, burn rate of cash, legal issues etc.

Legal due diligence: “I’m interested in learning how well formed the company is, if there are skeletons in the closet like fired co-founders or large debts or consultants who are owed shares or pending lawsuits.”


Lecture 11 – Term Sheets I

Term sheet

A term sheet is a non-binding agreement setting forth the basic terms and conditions under which an investment will be made

A term sheet is NOT a legal promise to invest, rather it’s a reference point in future negotiation

“Think of it as a blueprint for your future relationship with your investor” – Brad Feld, Foundry Group


Term sheet

The primary goal of the term sheet is to outline the economic and control terms of the entrepreneur – investor relationship

Economic terms: Terms which determine how the money will be split between the entrepreneurs and investors when the firm is sold or goes public

Control terms: Terms which explain how the control of the start-up is split between the entrepreneurs and investors


Timeline of a VC investment

Company presents business plan to VC

VC performs preliminary due diligence on company

Business model, management team, competition, technology, capital intensity, etc.

VC proposes a term sheet to the company

VC and company negotiate the terms of the term sheet

Company signs term sheet, exclusivity period starts (No- Shop provision)


Timeline of a VC investment

VC performs legal due diligence on company

IP filing, customer and supplier contracts, organizational documents

VC prepares definitive investment documents (the “5 documents”) based on the signed term sheet

More negotiations

Things not addressed in term sheet

New information found in due diligence

Closing of the transaction

Both company and VC sign definitive investment documents

Transfer funds


No Shop Provision

A term sheet is NOT a legal promise to invest

Once signed the only legally binding portion of the term sheet is the “No Shop Provision”

The No Shop Provision it requires the company to:

Keep the negotiations confidential

Stop looking for other investors for a period (say 30-60 days)



The term sheet is critical and is much more than a simple letter of intent

It will provide the basis for your future relationship with your investor and will influence your ability to get future financing

Outlines trade-off between economic and control rights

The best way to negotiate higher valuation is to have multiple VCs interested in investing in your company


Term sheet

Economic terms

Valuation—pre-money valuation

Liquidation preference

Anti-dilution provisions


Option pool


Control terms

Board of directors

Protective provisions

Drag-along agreement (M&A)


Key negotiating points


Key term sheet provisions for negotiation

Pre-money valuation

Key determinant of ownership structure

Size of unallocated employee option pool

Also impacts ownership structure

Governance provisions

Board Structure & Voting rights determine who controls the company

Ideal outcome is a balanced Board

Participating preferred

VC’s best friend when the business generates a sub-optimal outcome

Capitalization table

Outlines pre-money and post-money valuation

Ownership is recorded on a “fully diluted basis” – i.e., it assumes all preferred stock is converted and all options are exercised



Pre-money and post-money valuation

Pre-money valuation is the company’s valuation before it accepts the new investment

Post-money valuation is the company’s valuation after the new investment.

Pre- and Post-money valuations are implied valuations

Post-money valuation =

$ investment / ownership percentage

Pre-money valuation =

Post-money valuation – $ investment

Example: $5M for 33.33% of firm

Post-money valuation = $5M/0.3333 = $15M

Pre-money valuation = $15M - $5M = $10M

Capitalization table

Term sheet states: $1M for 50%

Post-money = $1M/0.5 = $2M

Pre-money = $2M - $1M = $1M



Pre-money vs. post-money

When a VC says, “I’ll invest $5 million at a valuation of

$20 million”

The smart entrepreneur says “Is that a pre- or post- money valuation?”


If $20 million is a pre-money valuation, then

 VC owns 20% after financing (post-money, 5/25)

If $20 million is a post-money valuation, then

 VC owns 25% of $20M post-money (5/20)


Practice problem

Assume the following:

2,000,000 shares held by founders before investment

$10M pre-money valuation

$5M investment by VC

What % ownership does the VC have?

Class Shares Price per share Valuation Percentage
Founders 2,000,000 A
Employee pool B 20.00%
VC C D $5M 33.33%
Total E D $15M 100.00%


Practice problem - Solution

A = 100% - 33.33% - 20% = 46.67%

E = 2,000,000/0.4667 = 4,285,408

B = E*0.2 = 4,285,408*0.2 = 857,081

C = E*0.3333 = 4,285,408*0.3333 = 1,428,326

D = 5,000,000/1,428,326 = $3.50 per share

Class Shares Price per share Valuation Percentage
Founders 2,000,000 A
Employee pool B 20.00%
VC C D $5M 33.33%
Total E D $15M 100.00%


Option pool


Typically 10-20% of fully diluted shares following the new issuance to VC

The bigger the pool the better?


Not necessarily…

Large pool  unlikely to run out of available options, but

Large pool  dilution, since pool is typically carved out of owners equity pre-financing

Negotiation strategies:

Try to trade off pool size for higher pre-money valuation,

Try to get pool added to the deal post-money

Entrepreneurs should come armed with an options budget (i.e., a list of all planned hires)


Liquidation preference

Specifies which investors get paid first and how much they get paid when a liquidation event occurs

Liquidation event: when the firm is acquired, merges, or sells most of its assets, but NOT an IPO

An IPO is a funding event

Helps protect VCs from losing money by making sure they get their initial investments (plus profit) back before other parties

Especially important for VCs when company is sold for less than what they’ve invested


Liquidation preference

Each series of preferred stock will have its own liquidation preference

This can get complicated when there are multiple rounds

Typically, latest-round investors get money back first

Two components that make up Liquidation preference:

The actual preference – who gets paid first

The participation – how much they get paid



Three ways to structure liquidation preference for preferred stock:

Non-participating preference

Participating preference without a cap

Participating preference with a cap

1. Non-participating preference

The preference holder gets back its original investment (or multiple) plus, in some cases, unpaid accrued or declared dividends.

The non-participating preference is like an option.

At the time of liquidation, investor must choose to either:

Receive the liquidation preference, or

Share in the proceeds in proportion to his or her equity ownership after converting his or her preferred shares into common stock

Investor would choose whichever option provides the better return


Non-participating preference example

Ali Corp is raising a $250K seed round at a $1M “pre-money valuation” through the issuance of preferred stock with non-participating liquidation preferences. Assuming $250K is raised, the seed investors would own 20% of the company ($250K / $1.25M).

Holding all else equal, what happens in each of the following scenarios if the company either does well and is acquired for $3M, is mediocre and sells for $2M, or performs worse-than-expected and sells for only $1M:

1X liquidation preference (most common)

1.5X liquidation preference

2X liquidation preference


Investor Exercises Liquidation Preference
Liquidation Preference
Exit Value 1.0x 1.5x 2.0x
$3,000,000 250,000 375,000 500,000
$2,000,000 250,000 375,000 500,000
$1,000,000 250,000 375,000 500,000
Investor Elects Return Based on Ownership
Exit Value 1.0x 1.5x 2.0x
$3,000,000 600,000 600,000 600,000
$2,000,000 400,000 400,000 400,000
$1,000,000 200,000 200,000 200,000

2. Participating preference without a cap

Participating Liquidation Preferences are sometimes referred to as “Double-Dip Preferred” and are the most favorable preference to investors.

After the VC fund gets its original investment (or multiple), the VC fund then shares in the balance of the sale proceeds with the common stock holders on an as-converted basis (e.g. as if their preferred shares were converted to common stock).


3. Participating preference with a cap

After the VC fund gets its original investment (or multiple), the VC fund then shares in the balance of the sale proceeds with the common stock holders on an as- converted basis up until their aggregate return reaches a pre-negotiated cap (usually some multiple of the original purchase price per share).

Note: The cap includes the original investment. For example, if the cap is at 15M and the original investment is $5M then the investors will participate until they receive an additional $10M


Quick note: Conversion Provision

Preferred stock can convert to common stock at any time!!!

This is non-negotiable



Liquidation preference example 1

Suppose only 1 round of financing equal to $5M at $10M pre-money  VC owns 33.33%

Assume company has an offer to be acquired for $30M

CASE VC Entrepreneur
1) Non-participating 33% = $10M 67% = $20M
2) Participating First $5M, then 33%*$25M = $8.3M 67% of $25M = $16.7M
3) Participating w/ 3X cap Won’t reach cap of $15M, so same as 2) Same as 2)


Liquidation preference example 1

Suppose only 1 round of financing equal to $5M at $10M pre-money  VC owns 33.33%

Assume company has a offer to be acquired for $100M

CASE VC Entrepreneur
1) non-participating 33% = $33M 67% = $67M
2) Participating First $5M, then 33%*$95M = $36.35M 67% of $95M = $63.65M
3) Participating w/ 3X cap Series A makes better than 3X  Convert shares, same as 1) Same as 1)



Participation has a lot of impact at relatively low outcomes, but little impact at high outcomes

Which liquidation preference will start-ups prefer?

Non-Participating Preferred Stock

Which liquidation preference will VCs prefer?

Participating Preferred Stock without a cap

Middle ground: Participating Preferred Stock with a cap

about 25% of deals


Liquidation preference practice problem

Suppose Company X receives 1 round of financing equal to $2M at a $10M pre-money valuation

The VC receives participating preferred stock without a cap

If the company is acquired for $50M how much will the VC receive?

Value of PS = 2 + (2/12)*(50 – 2) = $10M


Terminology: Down round

A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the company by earlier investors.

Down rounds cause dilution of ownership for existing investors  BAD!

Unfortunately, sometimes the only other option is going out of business. In this case down rounds are necessary and welcomed.


Anti-dilution provision

Protects investor’s stake in down rounds

Two types:

Full ratchet anti-dilution: Earlier round preferred stock can only convert at new price

E.g. Series A 1000 shares at $2 per share, new share price $1 per share  convert at $1 per share, get 2000 shares

Weighted-average anti-dilution: the number of shares issued at the reduced price are considered in the repricing of the Series A


Participation rights

Investors have the right of first refusal to invest in future rounds, usually their pro rata portion of the new financing

Note: This is a market term and is in most every VC deal you will see


Board of directors

Key control mechanism is the process for electing board of directors

Board of directors (Early stage, typically 5 members)




A second VC

Outside board member (chosen by the board or by the common and preferred shareholders voting together as a single class)

Key: Balance of control

Later stage will have 7-9 board members


What does the board of directors do?

Typical duties include:

Select, appoint, support, and review CEO

Set the salaries and compensation of company management

Establish broad policies and objectives

Ensure the availability of adequate financial resources

Approve annual budgets

Account to the stakeholders for the organization's performance

Approve any transactions above an agreed upon threshold.

Your board is your judge, jury, and executioner all in one – so be careful who you choose to be on it!


Board of directors

VC as board of director has fiduciary duty to the company


VC is also an investor



Protective provisions

Veto rights that investors have on certain actions by the company:

Issuing new shares

Change the terms of the stock owned by VCs

Issue stocks senior or equal to VCs

Buy back common shares

Sell the company

Change the certification of incorporation or bylaws

Change the size of board of directors

Pay or declare a dividend

Borrow money in excess of a threshold (e.g., 100K)

Why do protective provisions exist?

Mandatory conversion

Most underwriters require outstanding preferred stock to convert before IPO

Rather than negotiate at time of IPO with preferred holders, Qualified Public Offering (QPO) provisions force conversion prior to IPO



Qualified public offering (QPO)

QPO is an IPO surpassing:

Minimum offering price (e.g., X times original purchase)

Minimum offer amount

Minimum market cap (sometimes)

All convertible preferred stocks are subject to mandatory conversion in case of QPO

If a proposed IPO is not a QPO, mandatory conversion can still happen as long as a majority of preferred holders agree

In that case, preferred holders may be able to receive more common shares as an incentive for them to agree to convert


How to negotiate QPO

What will entrepreneurs want?

Entrepreneur will want lower conversion thresholds to ensure more flexibility

What will the VC want?

VCs will want higher thresholds to give them more control over the timing and the terms of the IPO

VCs want to set the QPO requirement high enough to prevent founders from pushing the firm public too early

Minimum price: ensure a decent return for VC; a thinly traded stock makes it harder for VCs and their LPs to trade out of the stock.

Minimum offering amount: An IPO with small offering amount (i.e.,

$ raised in IPO) will not attract established underwriters, which can hurt the success of the IPO.


Drag along rights

Allows subset of investors to force the other investors and the founders to agree to a sale or liquidation of a company

Prevent holdout problem (esp. when the sale value is below the liquidation preference)

Requires majority of preferred holders


Negotiating drag along rights

Get the drag-along rights to pertain to the majority of the common stock, not the preferred;

The investors can convert some of their preferred to common stock to create a majority (which would lower the liquidation preference).

Negotiate a higher threshold (e.g. 2/3 instead of 51%) to trigger the drag-along rights


Other terms of the Term Sheet

Redemption rights – Conditions under which investors may redeem their initial investment

E.g. prespecified length of time to reach milestones

Rarely exercised due to legal difficulties

Registration rights – Provide a contractual right for investors to demand that the company register their shares with the SEC. Following a registration, the investor can sell their shares on the public market.

Important since US law permits the company, but not the …