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The case study discusses two entrepreneurs willing to set up their own business based on development and implementation of new idea with regard to fashion retailing. To weight all pros and cons of this alternative, the businessmen have to evaluate term sheets from two of the VCs (Alpha Ventures and Mega fund), and make their decision upon that.
Term sheets offered by both venture capital funds contain a good number of provisions having a clear focus on control over the future company.
This can be referred to conditions related to initial public offering and the convertible option of Preferred stock, Liquidation condition (for example in Alphas sheet, in case of liquidation three times the initial price should be paid on Preferred Stock), provision on antidilusion protection on additional issuance of shares, as well as the voting right with the condition on the fact that 60% of Preferred stock is needed to have a approval on certain decisions (Alpha Ventures) or given consent of the majority of Preferred Series A Stock holders for certain corporate actions (as it is in Mega funds term sheet)
The main learning is that the majority holder of the Preferred stock (external investor) has the most portion of power exercisable over 2 the future company.
Alpha VC
Investment: $ 5 million: Alpha:$ 2.25 million SV: $2.25 million Other investors: $0.50 million
Mega VC
Single investor is better than different ones
Investment: $ 5 million
Pre&post-money valuation
Pre-money Valuation : The valuation of the company or asset prior to an investment or financing. Post-money valuation : The value of a company after the VC investment has been made. Pre-Money Valuation = Post-Money Valuation New Investment
Alpha VC
Premoney Valuation:$ 7,35 Million. Postmoney Valuation:12,35 million.
Founder share: 59.5% VC Share: 40.5%
Mega VC
Premoney Valuation: $7 million. Postmoney Valuation: $12 million.
Founder share: 58.3% VC share: 41.7%
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Types of Securities
Common stock: Securities that represent equity ownership in a company. They give the owner the right to vote for the company's BOD and benefit from its financial success. Convertible preferred Stock: Preferred stock that can be converted into common stock at the option of the holder. It has relatively low-risk investment because of the guaranteed dividends, but it affords the investor a great amount of leeway because he/she can exchange it for common shares. Convertible Participating preferred stock: In contrast,the value of the preferred stock is refunded to the holder. That is, one gets conversion plus the value of the stock. Escrowed shares:shares held in an account and in most cases cannot be traded or transfered until certain circumstances like time horizon have been reached.
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Securities structure
Alpha VC
Convertible preferred stock.
Escrowed shares: If sales target of $500,000 is not achieved in year 2000 another 501,253 shares will be allocated to VC Share price $1.05
Mega VC
Convertible participating perferred stock. Share price $ 1 Participating preferred stock get their money back with interest plus the money that is distributable with respect to the percentage of common shares into which their preferred stock can convert.
Both Alpha and Mega protect them selves. Alpha with Escrowed shares and Mega with Convertible participating preferred stock. But in case of Alpha, if the company doesnt achieve the $ 500,000 other shares will be allocated to VC.
Dividend
A cumulative dividend stipulates that if the company doesn't pay it when it is due, must be paid in future periods. Non cummulative dividend:Type of preferred stock that does not pay the holder any unpaid or omitted dividends. If the corporation chooses to not pay dividends in a given year, the investor does not have the right to claim any of those forgone dividends in the future.
Dividend
Alpha VC
As converted basis: If dividends are paid to common stocks preferred stocks will get the same amount as BOD declared. Noncumulative dividend: $0,08 (8%)
Mega Fund
As converted basis: If dividends are paid to common stocks preferred stocks will get the same amount as BOD declared. Cumulative dividend at 10% Dividends cease above treshold of 25% of purchase price
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Dividend
Mega has a cumulative dividends with a 10% rate, while Alpha has an 8% rate noncumulative dividends.
If the Company does not pay this declared but not paid dividends will be used for a price adjustment in conversion and liquidation preference.
Liquidation
Mega VC
Alpha VC
Initial pay issuance Price + declared but unpaid dividend on Series A Preferred. Series A Pref. and Common Stock on an as-converted basis will be allocated until: Series A Preferred has received 3 times of initial pay issuance (3*1,05= $ 3,15)
Series A will be entitled to receive in preference of common the sum of: - One-and-one-quarter ($ 1,25). - all declared but unpaid dividends on Series Preferred.
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Liquidation
Alpha VC
Mega VC
Alpha can gain more negotiation power, because it has the ability to call on liquidation in case of any merger. This essentially implies that managers cannot make any independent steps without consulting with Alpha.
After paying all Series A the remaining amount should be distributed ratably to common holders and Series A preferred on an as-if converted basis.
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Conversion
Alpha VC
Series A Preferred can be converted into shares of common stock with initial rate of 1:1. Subject to change. Automatic Conversion: Majority of Pref. holders consent the conversion. IPO price >$5 and Total offering>$15 Million.
Mega VC
Series A preferred can be converted at anytime into shares of common stock. Subject to change Automatic conversion in IPO: IPO price > $20 and Total Offering ) $25 Million.
Conversion The conversion can increase total return by providing capital gains on top of previously received fixed income.
Alpha VC We have a higher conversion ratio (1,05/50,21). If the price increases the gain for the investor increases. Mega VC
We have a lower conversion ratio (1/20=0,05). We have lower gain in this case.
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Anti-Dilution Provision
Anti-Dilution Provision
Full Ratchet
An anti-dilution provision that, for any shares of common stock sold by a company after the issuing of an option (or convertible security), applies the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders. Full-ratchet anti-dilution protection allows an investor to have his or her percentage ownership remain the same as the initial investment.
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Anti-Dilution Provision
Alpha offers better anti-dilution provision for the founders
Alpha VC
Mega VC
Broad based anti dilution protection. No adjustment will be made to the issuance of 3 Mill common Stock to employee stock option. Weighted Average antidilution protection is more favorable to common stock holders, their shares percentage remains higher than in Full Ratchet.
Weighted average anti-dilution rights if: 100% > Price>50% of the Series A Purchase Price. Full Ratchet if: Price < 50%, only if the share holder of series A Preferred invests its Pro Rata Share. No adjustment will be made for the reserved shares of 2,5 Mill. Full Ratchet is very severe form of punishment for common stock holders. Their shares are diluted. Mega protects its self.
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Voting Rights
Alpha VC
Mega VC
Series A Preferred votes in an as-converted basis. Requires approval of at least 60% of series A Preferred for : Issuance of any senior or pari pasu security Increase of shares Transfer of control, etc.
Series A Preferred will vote together with the common holders on an as-converted basis on all matters. In addition to other issues, will be required certain corporate actions which should be agreed by the parties and will be more specifically set in the closing documents.
Mega VC gives voting right to the Common holder for every issue, and they make more than 58,3% (according to Mega).
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Board of Directors
Alpha VC
Mega VC
Series A preferred elect 2 representative (Alpha has the right to elect one). Common stock elect one representative. Common Stock + Series A preferred in an as-converted basis elect 2. In case of release of escrowed shares Investors replace the 5th.
Common stock elect one representative Series A Preferred elect 2 representative. One outsider company is nominated One outsider Company nominated and acceptable to all.
They offer almost the same conditions. The only advantage is that Founders can commend an outsider director in Case of Alpha Term Sheet.
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Vesting
Alpha VC
Vesting means to give someone control over their stock or stock options
Mega VC
Reserve shares for founders 2,5 Mill shares. Reserved shares have 48 month vesting. Vesting a small portion for 12 month, and than the other until 48 months. Founders share vest 25% on closing. Right to repurchase in case of early termination.
Reserved shares for founders 3 Mill shares. Reserved shares have 48 month vesting. Vesting a small portion for 12 month, and than the other until 48 months. Founders share vest 25% on closing. In case of early termination the company can repurchase unvested shares at cost. Founders will receive six months additional vesting in the event of a termination without cause and also they will receive 6 months salary.
Conclusions
We can say that both Term Sheets from Mega VC and Alpha VC have their advantages and disadvantages from the Founders point of view. As we analyzed above it is impossible to decide that Mega VC offer is the best or vice versa. We come to the conclusion that in different situation Alpha VC Term Sheet is a better alternative and in others Mega VC Term Sheet is better.
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