Question 1:
Wendy Borg and Jason Kushdog were two entrepreneurs who came together to form Trendsetters Inc. trendsetter Inc. was a startup aimed at providing new warehousing and distribution solutions to clothing retailers. They however had a major challenge of capital as they only had six weeks of operations before they could run out of the initial seed capital they had invested. This prompted them to seek for alternative sources of capital, venture capital being one of the most lucrative one.
Neither of them had knowledge in how venture capitals work since Wendy had her background in supply chain management and Jason in the fashion industry. They therefore needed advice from a legal personnel as well as the networks they had created in the term of their service to pull through. The challenge came in choosing which VC gave them the best deal since both term sheets were quite appealing. Both of the term sheets looked similar and due diligence needed to be conducted so as to establish who between the two was the best choice. The following section is an analysis of the two term sheets and also of the company before and after the VC’s in terms of valuation, liquidation preference, corporate governance and vesting and employment.
Valuation
According to Ramsinghani (2011), valuation refers to the estimation of a monetary worth of something. In terms of valuation, Alpha ventures offer a better deal compared to Mega Fund because the founders get a higher ownership stake than the investors. This is evidenced from the following calculation.
Mega Fund
They offer a pre money valuation of trendsetters is 7 million dollars and they are willing to invest 5 million dollars. This gives a total valuation of 12 million dollars at a share price of 1 dollar per share.
In terms of capitalization, trendsetters have $4.5M of common stock and $2.5M of preferred stock. These means required share capitalization is $5M. This however gives a higher ownership stake of 41.67% to the VC than to the owners who have 37.5% hence making the deal not as lucrative as it should be.
Alpha Ventures
On the other hand, Alpha has a pre money valuation of $7.35m and are willing to invest $5M at a share price of $1.05. In terms of capitalization, they have an option of escrow share that go at a price of $0.95. These escrow shares are worth 501,253 and are to be released in case Trendsetters do not achieve revenues of $5,000,000 in their first fiscal year, $4M common stock and $3M option pool shares.
Valuation
Capitalization
Liquidation preference and anti- dilution
Alpha Ventures offers a liquidation preference that allows the VCs to choose between equity returns in the event of a liquidation that could be triggered by the transfer of control, merger or acquisition. If the investors decide to collect liquidation preference, they will receive initial pay issued as well as declared but unpaid dividends on the preferred stock and after that on as converted basis up to three times of the initial preferred stock. This could result in a payoff of $15M from their initial $5M. For anti-dilution, Alpha makes provisions that no adjustment should be made for the issuance of up to three million shares of common stock. Megafund, on the other hand, offers a liquidation preference whereby the holders of preferred stock will receive 1.25 times the share price and all declared and unpaid dividends to common stockholders and to participate in the remaining funds on pro rata basis. This gives the investor a competitive advantage as he can dip into almost 8% of total ownership. From this, we see that Alpha ventures are still the best choice for Wendy and Jason as it safeguards their risks.
Corporate governance
There is no much difference between the management of the two VCs. Both require a board of five members, one being the CEO, two others the investor share representatives and two outsiders nominated by founders as well as the board. The only difference arises in the case of Alpha who have put a restriction on the 5th member of the board. They can freely replace the outside member with the candidate of their choice so as to safeguard risk in case Trendsetters Inc. doesn’t meet their $500,000 target in the first year. Concerning the compensation committee, Alpha requires a three people committee with two representatives from the investor. Mega Fund, however, does define such clauses hence an indication that Alpha wants to have greater control in the governance of the company.
Vesting and employment.
The vesting and employment schedules for both VCs are similar in nature. Employees are expected to serve for longer as they get a 12 month 25%, and the remainder spreads over a 48 month period. Wendy and Jason can vest 25% when they purchase and spread the rest over a 36 month period. This will allow the entrepreneurs to get early returns.
Question 2:
If I were an entrepreneur and were unable to negotiate either of the term sheets, I would prefer Mega funds. This is because, even though their valuation is lower compared to that of Alpha Ventures, there will always be some equity returns even if the firm does not succeed (Madura, 2014). Moreover, owing to the participating nature of Mega’s term sheet, the entrepreneurs have some pro rata ownership to divide among them in the case of liquidation. This is as opposed to Alpha ventures who express little confidence in the investment by basing their term sheet on high-risk factors.
Question 3:
In my negotiations with the venture capitalists, I would negotiate for the removal of the unattractive escrow clause from Alpha investments. I would also suggest a change in the governing structure as it is tilted towards favoring the investors (Cumming, 2010 and Tracy & Tracy, 2013). In the case of Mega, the only change I would suggest would change in the anti-dilution clause as it causes a lot of damage. Mega should also make an improvement on their vesting plans to reduce unemployment.
Question 4:
It makes a big difference whether or not the company grows slowly or quickly because in both cases it would mean faster termination of the agreement. However, it would be dangerous if the firm chose Alpha ventures then failed to grow quickly as they would make hugely loses.
Question 5:
Additionally, it does make a difference in the wealth created when the agent of change is an IPO and when the agent of change is a merger. The ideal choice is an IPO under Mega Fund’s VCs as they would give the entrepreneurs a higher pro rata in a worst case scenario. This is because a merger will leave the firm's valuation lower than it already is.
References
Cumming, D. (2010). Venture capital: Investment strategies, structures and policies. Hoboken, N.J: Wiley.
Madura, J. (2014). International financial management. Australia: South-Western, 2014
Tracy, J. A., & Tracy, T. C. (2013). Small business financial management kit for dummies. Hoboken, N.J: John Wiley & Sons.
Ramsinghani, M. (2011). The business of venture capital: Insights from leading practitioners on the art of raising a fund, deal structuring, value creation, and exit strategies. Hoboken, N.J: John Wiley & Sons
