SESSION 2 - DOING VENTURE CAPITAL DEALS

Lecture Presentation Slides

8 March 2012

Edgar Miller Senior Visiting Fellow

Alternative Investments MSc Investment Management Programme 2012 Term 2 Cass Business School

SESSION 2

I.

Problem Set 1 Solutions - Valuing and Structuring Venture Capital Deals II. Valuing Buyout Deals The Adjusted Present Value Method III. Case Discussion Centex Telemanagement, Inc IV. Guest Lecturer Richard Anton: Chairman, BVCA and General Partner, Amadeus Capital Partners

I PROBLEM SET 1 SOLUTIONS (Target Return Approach

Question 1 (Share of Company Required for 5m Financing - 50% IRR?)
5 Year Excite value = 5m x 20 = 100m Value required by fund in Year 5 = 5m x (1.5)5 = 37.97m Required share of Excite = 37.97m/ 100m = 37.97%

I PROBLEM SET 1 SOLUTIONS (Target Return Approach

Question 1 (Share of Company Required for 5m Financing - 50% IRR?)
5 Year Excite value = 5m x 20 = 100m Value required by fund in Year 5 = 5m x (1.5)5 = 37.97m Required share of Excite = 37.97m/ 100m = 37.97%

Question 2 (Number of Shares to Purchase?)

0.3797 = x/(x + 1,000,000 shares) Required shares = x = 612,123 shares

I PROBLEM SET 1 SOLUTIONS (Target Return Approach

Question 1 (Share of Company Required for 5m Financing - 50% IRR?)
5 Year Excite value = 5m x 20 = 100m Value required by fund in Year 5 = 5m x (1.5)5 = 37.97m Required share of Excite = 37.97m/ 100m = 37.97%

Question 2 (Number of Shares to Purchase?)

0.3797 = x/(x + 1,000,000 shares) Required shares = x = 612,123 shares

Question 3 (Price per Share?)

Share price = 5m/612,123 shares = 8.17 per share

I PROBLEM SET 1 SOLUTIONS (Target Return Approach

Question 1 (Share of Company Required for 5m Financing - 50% IRR?)
5 Year Excite value = 5m x 20 = 100m Value required by fund in Year 5 = 5m x (1.5)5 = 37.97m Required share of Excite = 37.97m/ 100m = 37.97%

Question 2 (Number of Shares to Purchase?)

0.3797 = x/(x + 1,000,000 shares) Required shares = x = 612,123 shares

Question 3 (Price per Share?)

Share price = 5m/612,123 shares = 8.17 per share

Question 4 Post-Money Valuation)

Post-money valuation = 5m/0.3797 = 13.2m

I PROBLEM SET 1 SOLUTIONS (Target Return Approach

Question 1 (Share of Company Required for 5m Financing - 50% IRR?)
5 Year Excite value = 5m x 20 = 100m Value required by fund in Year 5 = 5m x (1.5)5 = 37.97m Required share of Excite = 37.97m/ 100m = 37.97%

Question 2 (Number of Shares to Purchase?)

0.3797 = x/(x + 1,000,000 shares) Required shares = x = 612,123 shares

Question 3 (Price per Share?)

Share price = 5m/612,123 shares = 8.17 per share

Question 4 Post-Money Valuation)

Post-money valuation = 5m/0.3797 = 13.2m

Question 5 (Pre-Money Valuation?)

Pre-money valuation = 13.2m - 5m = 8.2m

PROBLEM SET 1 (Target Return Approach)

Question 6 (Share of Company Required for 12m Financing 7 Years?)
7 Year Excite value = 8m x 20 = 160m Value required by fund in Year 7 = 12m x (1.5)7 = 205m Required share of Excite = 205m/ 160m = 128%

PROBLEM SET 1 (Target Return Approach)

Question 6 (Share of Company Required for 12m Financing 7 Years?)
7 Year Excite value = 8m x 20 = 160m Value required by fund in Year 7 = 12m x (1.5)7 = 205m Required share of Excite = 205m/ 160m = 128%

Question 7 (Preferred Strategy?)

Prefer 5m strategy - cannot achieve 50% IRR with 12m strategy

PROBLEM SET 1 (Target Return Approach)

Question 6 (Share of Company Required for 12m Financing 7 Years?)
7 Year Excite value = 8m x 20 = 160m Value required by fund in Year 7 = 12m x (1.5)7 = 205m Required share of Excite = 205m/ 160m = 128%

Question 7 (Preferred Strategy?)

Prefer 5m strategy - cannot achieve 50% IRR with 12m strategy

Question 8 (Share of Company Required for 5m Financing 15% Options?)

10

Without options fund must own 37.97% (from Question 1) When exercised, options will dilute all shareholders by 15% - ie, existing shareholders share of company will be 85% of what it was before options exercised Required ownership on fully-diluted basis ie, after options exercised = 37.97%/0.85 = 44.67%

PROBLEM SET 1 (Target Return Approach)

Question 9 (Pre-Money Valuation?)
Pre-money valuation = 5m/0.4467 - 5m = 6.19m

11

PROBLEM SET 1 (Target Return Approach)

Question 9 (Pre-Money Valuation?)
Pre-money valuation = 5m/0.4467 - 5m = 6.19m

Question 10 (Nice Guy Ownership for 3m Investment)

5 Year Excite value = 5m x 20 = 100m Value required by Nice Guys in Year 5 = 3m x (1.3)3 = 6.59m Nice Guys required share of Excite on fully-diluted basis = 6.59m/ 100m/0.85 = 7.75%

12

PROBLEM SET 1 (Target Return Approach)

Question 9 (Pre-Money Valuation?)
Pre-money valuation = 5m/0.4467 - 5m = 6.19m

Question 10 (Nice Guy Ownership for 3m Investment)

5 Year Excite value = 5m x 20 = 100m Value required by Nice Guys in Year 5 = 3m x (1.3)3 = 6.59m Nice Guys required share of Excite on fully-diluted basis = 6.59m/ 100m/0.85 = 7.75%

Question 11 (Our Ownership if Nice Guys Make 3m Investment?)

All existing shareholders will be diluted 7.75% by Nice Guys ie, existing shareholders will own 92.25% of what they owned before Nice Guy investment Your funds new ownership = 44.67% x .9225 = 41.21%

13

PROBLEM SET 1 (Target Return Approach)

Question 9 (Pre-Money Valuation?)
Pre-money valuation = 5m/0.4467 - 5m = 6.19m

Question 10 (Nice Guy Ownership for 3m Investment)

5 Year Excite value = 5m x 20 = 100m Value required by Nice Guys in Year 5 = 3m x (1.3)3 = 6.59m Nice Guys required share of Excite on fully-diluted basis = 6.59m/ 100m/0.85 = 7.75%

Question 11 (Our Ownership if Nice Guys Make 3m Investment?)

All existing shareholders will be diluted 7.75% by Nice Guys ie, existing shareholders will own 92.25% of what they owned before Nice Guy investment Your funds new ownership = 44.67% x .9225 = 41.21%

Question 12 (New Pre-Money Valuation?)

14

Pre-money valuation = 3m/0.0775 - 3m = 35.71m

PROBLEM SET 1 (Target Return Approach)

Question 13 (Investment Required to Maintain Original Ownership?)
From Basic Principals If Nice Guys invest 3m, your fund is diluted to 41.27% ownership. You want to maintain existing 44.67% ownership. Therefore, you must invest enough in the second round to obtain an incremental 3.46% ownership (44.67% - 41.21%) Since the total 3m investment buys 7.75%, you must invest 3.46%/7.75% x 3m = 1.34m General Rule Note that 1.34m/3m = 44.67%. Thus, to maintain existing ownership percentage, one must invest the same percentage of the new investment amount as ones existing ownership percentage. Thus, the Funds required new investment to maintain original ownership of 44.67% = 44.67% x 3m = 1.34m (Nice Guys would invest remaining 1.66m)

15

PROBLEM SET 1 (Target Return Approach)

Question 14 (Ownership Percentages After Year 3 Financing?)

By definition, your fund owns 44.67% Before the Year 3 financing, Nigel owned 100% - 44.67% = 55.33%. The Year 3 financing dilutes him by 7.75%, leaving him with 55.33% x 0.9225 = 51.04% Options cannot be exercised until end of Year 3; therefore, Management has 0% Nice Guys own the rest = 100% - 44.67% - 51.04% = 4.29%

16

EVOLUTION OF EXCITE LTD SHAREHOLDING

Shareholders

Start Point

Initial 5m Financing (No Options)

Effect of Options

Nice Guys Invest 3m 51.0% 41.2% 7.8% 100% (15%)

We Avoid After Dilution Options By Exercised Investing 1.34m 51.0% 44.7% 4.3% 100% (15%) 43.3% 38.0% 3.7% 85% 15% 100%

Nigel Smith Our Fund Nice Guys Subtotal Management Option Pool Total

100%

62.0% 38.0% 100%

55.3% 44.7% 100% (15%)

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II VALUING BUYOUT DEALS (The Adjusted Present Value Method)

Three approaches often used for valuing private equity companies
1. 2. Use of Industry Comparables Target Return Approach

3. Discounted Cash Flow Analysis

18

DISCOUNTED CASH FLOW BASICS

1. The value of an enterprise is independent of its capital structure (Modigliani
& Miller - Nobel Prizes 1985/90) Company Enterprise Value = Value of Equity + Value of Net Debt

2.

Normal DCF approach (as prescribed by CAPM) to calculating Enterprise Value is: a. Calculate forecast annual post-interest, post-tax cash flows b. Calculate Terminal Value c. Use weighted average cost-of-capital (WACC) - ie, weighted average cost of equity and
debt capital - as discount rate to calculate NPV of cash flows and terminal value

3.

But - this approach is awkward to use with leveraged buyouts High debt level invalidates underlying assumptions of WACC

Assumed values of Equity Beta are inappropriate WACC changes every year as debt is paid down

19

Value of debt-related interest tax shields vary year-to-year

Adjusted Present Value Method (APV) solves the problem . . .

APV = NPV of CF From Assets + NPV of Side Effects From Financial Structure

1. Calculate the NPV of the companys cash flows as if the company had no debt, using Equity Discount Rate (EDR) instead of WACC
a. Calculate after tax cash flows as if the company were financed entirely by equity b. Calculate Terminal Value c. Use EDR to calculate the combined NPV of the all-equity cash flows and Terminal Value

2. Calculate the NPV of Interest Tax Shields using the debt interest rate as the discount rate (same approach can be used for net operating losses)
20

3. Add (1) and (2) to obtain Enterprise Value

ADJUSTED PRESENT VALUE METHOD Equity Discount Rate Calculation

Equity Discount = (Risk Free Rate) + (Asset Beta) x (Equity Market Premium) Rate

Where:

Asset Beta = [ Equity Beta ] x [ Equity/(Equity + Debt) ] = Equity Beta x Percent Equity in Capital Structure And: Equity = Balance Sheet Book Value (Not Market Capitalisation)

21

TERMINAL VALUE

Terminal Value often calculated using a multiple of profits or cash flows in the last year of the forecast eg, PE-Ratios, EBIT/EBITDA Multiples

Terminal Value also can be calculated using the Cash-Flow-in-Perpetuity Model. Useful when good comparables are unavailable. Inputs are: Cash flow of the last forecasted year Assumed future growth rate (Perpetual Growth Rate)

Terminal Value =

(Last Year Cash Flow) x (1+ Perpetual Growth Rate) (Cost-of Capital Perpetual Growth Rate)

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EXAMPLE BUYOUT TO VALUE

Revenue Growth = 12.0% EBITDA @ 15.0% Less: Depreciation & Amortisation EBIT Total Interest Expense @ 9.0% Pre-Tax Income Taxes @ 40.0% After-Tax Income Year 0 600 Year 1 672.0 100.8 21.1 79.7 27.0 52.7 21.1 31.6 Year 2 752.6 112.9 21.8 91.1 26.7 64.4 25.8 38.7 Year 3 843.0 126.4 24.4 102.0 24.8 77.3 30.9 46.4 Year 4 944.1 141.6 28.1 113.5 22.2 91.3 36.5 54.8 Year 5 1057.4 158.6 29.5 129.1 18.8 110.3 44.1 66.2

Cash Flow After-Tax Income Plus: Depreciation & Amortisation Less: Working Capital Requirements Less: Capital Expenditure After Tax Cash Flow DEBT BALANCES Beginning Debt Debt Repayment Ending Debt BALANCE SHEET ITEMS Net Working Capital @ 18.0%
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31.6 21.1 -26.0 -23.0 3.8

38.7 21.8 -14.5 -25.0 20.9

46.4 24.4 -16.3 -26.0 28.5

54.8 28.1 -18.2 -27.0 37.7

66.2 29.5 -20.4 -28.0 47.3

300.0 3.8 296.2

296.2 20.9 275.3

275.3 28.5 246.8

246.8 37.7 209.1

209.1 47.3 161.8

95.0

121.0

135.5

151.7

169.9

190.3

EXAMPLE BUYOUT TO VALUE

Revenue Growth = 12.0% EBITDA @ 15.0% Less: Depreciation & Amortisation EBIT Total Interest Expense @ 9.0% Pre-Tax Income Taxes @ 40.0% After-Tax Income Year 0 600 Year 1 672.0 100.8 21.1 79.7 27.0 52.7 21.1 31.6 Year 2 752.6 112.9 21.8 91.1 26.7 64.4 25.8 38.7 Year 3 843.0 126.4 24.4 102.0 24.8 77.3 30.9 46.4 Year 4 944.1 141.6 28.1 113.5 22.2 91.3 36.5 54.8 Year 5 1057.4 158.6 29.5 129.1 18.8 110.3 44.1 66.2

Cash Flow After-Tax Income Plus: Depreciation & Amortisation Less: Working Capital Requirements Less: Capital Expenditure After Tax Cash Flow DEBT BALANCES Beginning Debt Debt Repayment Ending Debt BALANCE SHEET ITEMS Net Working Capital @ 18.0%
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31.6 21.1 -26.0 -23.0 3.8

38.7 21.8 -14.5 -25.0 20.9

46.4 24.4 -16.3 -26.0 28.5

54.8 28.1 -18.2 -27.0 37.7

66.2 29.5 -20.4 -28.0 47.3

300.0 3.8 296.2

296.2 20.9 275.3

275.3 28.5 246.8

246.8 37.7 209.1

209.1 47.3 161.8

95.0

121.0

135.5

151.7

169.9

190.3

APV METHODOLOGY Step 1 Calculate All Equity Cash Flows

STEP 1 - CALCULATE ALL EQUITY CASH FLOWS EBITDA Less Depreciation & Amortisation EBIT Less Taxes at 40% After-Tax Income With Equity Financing Plus Depreciation & Amortisation Less: Working Capital Requirements Less: Capital Expenditure Cash Flow With Equity Financing Year 1 100.8 21.1 79.7 31.9 47.8 21.1 -26.0 -23.0 20.0 Year 2 112.9 21.8 91.1 36.4 54.7 21.8 -14.5 -25.0 36.9 Year 3 126.4 24.4 102.0 40.8 61.2 24.4 -16.3 -26.0 43.4 Year 4 141.6 28.1 113.5 45.4 68.1 28.1 -18.2 -27.0 51.0 Year 5 158.6 29.5 129.1 51.6 77.5 29.5 -20.4 -28.0 58.6

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APV METHODOLOGY Step 2 Calculate Equity Discount Rate

STEP 2 - CALCULATE EQUITY DISCOUNT RATE Risk Free Rate (10 Year Treasury Bond) 5.2% Asset Beta of comparable companies 1.2 Asset Beta = (Equity Beta) x % Equity in Company Capital Structure) Equity Market Premium 7.7% (1926-2000 difference betw een stocks and intermediate bond yields) Equity Discount Rate = 5.2%+1.2 x 7.7% = 14.4%

26

APV METHODOLOGY Step 3 Calculate Present Value of Equity Cash Flows

Cash Flow With Equity Financing Equity Discount Rate = 5.2%+1.2 x 7.7% = 14.4% 20.0 36.9 43.4 51.0 58.6

STEP 3 - CALCULATE PRESENT VALUE OF EQUITY CASH FLOWS (Use Equity Discount Rate) Step 3a - Calculate Present Value of Annual Equity Cash flows Equity Discount Factor 0.874 0.764 0.667 0.583 PV of Year 1-5 Equity Cash Flow 134.2 17.4 28.2 28.9 29.7 Step 3b - Calculate Present Value of Terminal Value of Equity Cash Flows Growth Rate In Perpetuity 5.0% Terminal Value = 58.6m x 1.05%/(14.4%-5%) = PV of Terminal Value 331.9

0.509 29.8

651.5

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APV METHODOLOGY Step 4 Calculate Present Value of Interest Tax Shield

STEP 4 - CALCULATE PRESENT VALUE OF INTEREST TAX SHIELD (Use Interest Rate Discount) Interest Expense 27.00 26.66 24.78 22.21 Interest Tax Shield (Tax @ 40%) 10.80 10.66 9.91 8.88 Interest Rate 9.0% 9.0% 9.0% 9.0% Discount Factor 0.917 0.842 0.772 0.708 PV of Interest Tax Shield 37.7 9.91 8.98 7.65 6.29

18.82 7.53 9.0% 0.650 4.89

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APV METHODOLOGY Step 5 Sum Present Values to Obtain Enterprise Value

STEP 5 - SUM PRESENT VALUES TO OBTAIN ENTERPRISE VALUE PV of Year 1-5 Equity Cash Flow 134.2 PV of Terminal Value 331.9 PV of Interest Tax Shield 37.7 Enterprise Value 503.8 Less Initial Debt -300.0 Equity Value 203.8

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Terminal Value Considerations

Beware Terminal Value usually dominates total NPV (50%+) regardless of calculation approach used Cash-Flow-In-Perpetuity model can be used when difficult to determine appropriate multiples (eg, PE ratio) but is very sensitive to small changes in assumptions eg, perpetual growth rate

Conceptually, the impact of interest tax shields, NOLs, and other effects of the financial structure beyond the forecast period should be calculated and included in APV - but doing so is not straightforward and usually can be ignored Declining debt balance (theoretically declining to zero) and consequent declining
interest tax shields invalidates normal terminal value calculations Forecasting tax shields, NOLs beyond forecast period may be unreliable Fortunately, usually has small impact on total valuation (c 5%)
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III - CENTEX TELEMANAGEMENT

Jeff Drazan

Peter Wendell

31

THE PROPOSED DEAL (11 April 1985)

$350K loan to Centex (convertible into equity) to support immediate cash requirements. Additional VC no longer required Centex must agree to following:
Terms of contingent $2m financing - $0.45 per share (54% ownership), private investors
convert warrants at same price as Sierra Achieve key operating benchmarks ie, CEO search, recruit CFO & Mktg/Sales VP, improve key systems, fire marginal sales people, develop business plan Drazen to join Board and become temporary VP Finance & Development Wendell/Tobkin have board observation rights Drazen/Stephens approve all expenditures > $10K and all hire/fire decisions

When new CEO recruited, Sierra invests $1m equity (converting $350K loan into equity) and provides $1m loan guarantee - thereby obtaining 54% ownership position ($0.45/share) If new CEO not recruited by 120 days, Sierra can withdraw from contingent investment
32

Must loan Centex $115K for 2 months - to be repaid from Reg A financing Centex to repay $350K loan by 30 Nov (7+ months)

SIERRAS PROPOSED VALUATION (Problem Set 1, Question 15)

Considering Loan Guarantee as Debt ($1m equity)/0.54 = $1.85m Post-Money Valuation $0.85m Pre-money Valuation
(Enterprise Valuation = $1.85m + $1m = $2.85m)

33

SIERRAS PROPOSED VALUATION (Problem Set 1, Question 15)

Considering Loan Guarantee as Debt ($1m equity)/0.54 = $1.85m Post-Money Valuation $0.85m Pre-money Valuation
(Enterprise Valuation = $1.85m + $1m = $2.85m)

Considering Loan Guarantee as Equity ($2m equity)/0.54 = $3.7m Post-Money Valuation $1.7m Pre-Money Valuation
(Enterprise Valuation = $3.7m + $0m = $3.7m)

34

CENTEX FINANCING HISTORY

Date Jul-83 Oct-83 1983 Dec-83 Mar-84 1984 Apr-84

Investor Three Founders Three Founders Reg A Investors Jim Gallaway Jim Gallaway Reg A Investors Sierra

Amount of Investment New Secondary Money Purchase $15.0 $31.0 $75.0 $1.8 $5.0 $403.25 $1,000.00

Share Price $0.0278 $2.2500 $0.10 $0.0125 $2.25 $0.45

Shares Ownership Purchased Purchased 539.348 100.00% 1,114.652 67.39% 33.333 1.98% 18.000 1.06% 400.000 23.46% 179.222 9.51% 2,222.222 54.11%

Valuation of Round PrePostMoney Money $0.0 $15.0 $15.0 $46.0 $3,721.5 $3,796.5 $168.7 $170.5 $16.3 $21.3 $3,837.0 $4,240.3 $848.1 $1,848.1

NB: Above figures do not include exercise of Reg A warrants

35

CENTEX INVESTOR OWNERSHIP

Ownership

Date Jul-83 Oct-83 1983 Dec-83 Mar-84 1984 Apr-84

Investor Three Founders Three Founders Reg A Investors Jim Gallaway Jim Gallaway Reg A Investors Sierra

Founders 100.00% 100.00% 98.02% 96.99% 73.53% 66.54% 30.53%

Gallaway

Reg A

Sierra

1.06% 24.51% 22.18% 10.18%

1.98% 1.95% 1.95% 11.28% 5.18%

54.11%

Total 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

NB: Above figures do not include exercise of Reg A warrants

36

DRAZENS ADDED VALUE

Grasped subtleties - understood Centex potential! Convinced Wendell that deal had merit Brought Sierra as a customer Created accounting and financial control system Met with customers and regulators Created sales brochure Rewrote business plan with help from Stanford MBA students Convinced Pacific Bell to view Centex as a large customer rather than as a competitor Provided realistic view of future financing requirements
37

CENTEX SCENARIO A1
Only 3 Switches Installed No Dilution Equity=$1m (Problem Set 1, Question 16)

Switches Revenue (per switch =) Net Income Equity Value (PE = )

$10.0 10.0% 20

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

Investment $1 Sierra Initial Ownership 54.0% Sierra's 5 Year Dilution 0.0% Sierra Year 5 Ownership Sierra's Year 5 Equity Value Cash Flow IRR
38

54.0% $32.4 0 0 0 0 $32.4 100%

-$1

CENTEX SCENARIO A2
Only 3 Switches Installed No Dilution Equity=$2m (Problem Set 1, Question 16)

Switches Revenue (per switch =) Net Income Equity Value (PE = )

$10.0 10.0% 20

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

3 $30 $3.0 $60.0 $0

Investment $2 Sierra Initial Ownership 54.0% Sierra's 5 Year Dilution 0.0% Sierra Year 5 Ownership Sierra's Year 5 Equity Value Cash Flow IRR
39

54.0% $32.4 0 0 0 0 $32.4 75%

-$2

CENTEX SCENARIO B1
3 Switches Installed Annually 25% Dilution Equity=$1m (Problem Set 1, Question 16)

Switches Revenue (per switch =) Net Income Equity Value (PE = )

$10.0 10.0% 20

3 $30 $3.0 $60.0 $1

6 $60 $6.0 $120.0 $1

9 $90 $9.0 $180.0 $0

12 $120 $12.0 $240.0 $0

15 $150 $15.0 $300.0 $0

Investment $1 Sierra Initial Ownership 54.0% Sierra's 5 Year Dilution 25.0% Sierra Year 5 Ownership Sierra's Year 5 Equity Value Cash Flow IRR
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40.5% $121.5 -1 -1 0 0 $121.5 138%

-$1

CENTEX SCENARIO B2
3 Switches Installed Annually 25% Dilution Equity=$2m (Problem Set 1, Question 16)

Switches Revenue (per switch =) Net Income Equity Value (PE = )

$10.0 10.0% 20

3 $30 $3.0 $60.0 $1

6 $60 $6.0 $120.0 $1

9 $90 $9.0 $180.0 $0

12 $120 $12.0 $240.0 $0

15 $150 $15.0 $300.0 $0

Investment $2 Sierra Initial Ownership 54.0% Sierra's 5 Year Dilution 25.0% Sierra Year 5 Ownership Sierra's Year 5 Equity Value Cash Flow IRR
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40.5% $121.5 -1 -1 0 0 $121.5 114%

-2

Hypothetical Centex Returns (Scenario B2)

Sensitivity To Investment & Dilution

Net Income =10%

Centex Investment Centex Dilution 1X

($2m)

3X
($6m)

5X
($10m)

0%
25% 50% 75%

128%
114% 96% 69%

80%
69% 55% 32%

61%
51% 38% 19%

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Hypothetical Centex Returns

Sensitivity To Investment, Dilution & Profit Margin

Net Income = 10%

Net Income = 5%

Centex Investment Factor Centex Dilution 1X

($2m)

Centex Investment Factor Centex Dilution 1X

($2m)

3X
($6m)

5X
($10m)

3X
($6m)

5X
($10m)

0%
25% 50% 75%

128%
114% 96% 69%

80%
69% 55% 32%

61%
51% 38% 19%

0%
25% 50% 75%

96%
85% 69% 45%

55%
45% 32% 13%

38%
29% 18% 0%

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MANAGEMENTS POTENTIAL CAPITAL GAINS

Potential Year 5 Proceeds To Each Founder and Gallaway
(Each Owns Approximately 10% After Proposed Sierra Financing)

Dilution
None 25% 50% 75% 90%

Scenario A Scenario B

$6m $4.5m $30m $22.5m

3m 15m

$1.5m $0.6m $7.5m $3.0m

44

DECISION TIME

Walk away from deal?

Convince Centex to accept proposed deal? If so, how?

Improve deal from Centexs perspective? If so, what changes should be proposed?

45

What Happened?

46

What Happened?
A. New financing proposal agreed with Centex
1. Previously offered $350K loan now to be provided up-front on an equity-basis (buying just
over 20% of company)

2. An additional $650K of equity to be invested at $0.45 per share and an additional

receivable loan guarantee of $1m contingent upon recruitment of a new CEO (Sierra would own approximately 54% after completion of Step 2)

3. Sierra to invest an additional $500K in equity and an additional $500K in loan guarantees
if following performance targets are met during the 1 May to 1 November, 1985 period:

Cumulative revenues of $3.3m achieved Net operating loss not greater than $980K Maximum drawdown of $150K on receivables guarantee

Plus, all preferred shares purchased by Sierra would be recapitalised retroactively at $0.67 per share (Sierra would own approximately 54% upon completion of Steps 2 and 3)

4. Debt owed to Founders to be repaid after 3 years once Centex profitable for two quarters
47

What Happened?
B. Peter Howley recruited as CEO Successful 8 year period as head of Citizens Arizona Telephone Division MCI National Operations Manager established first two switches in NYC AT&T experience in operations, data processing, and sales

48

What Happened?
B. Peter Howley recruited as CEO Successful 8 year period as head of Citizens Arizona Telephone Division MCI National Operations Manager established first two switches in NYC AT&T experience in operations, data processing, and sales

C. IPO on Nasdaq in 1987

49

What Happened?
B. Peter Howley recruited as CEO Successful 8 year period as head of Citizens Arizona Telephone Division MCI National Operations Manager established first two switches in NYC AT&T experience in operations, data processing, and sales

C. IPO on Nasdaq in 1987

D. First profits in 1988 on sales of $57 million (March quarter revenue of $13.5m and Net Income of $668K (5%))

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What Happened?
B. Peter Howley recruited as CEO Successful 8 year period as head of Citizens Arizona Telephone Division MCI National Operations Manager established first two switches in NYC AT&T experience in operations, data processing, and sales

C. IPO on Nasdaq in 1987

D. First profits in 1988 on sales of $57 million (March quarter revenue of $13.5m and Net Income of $668K (5%) E. Acquired for $198 million in 1994 by MFS Communications (became MCI/Worldcom)
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Revenue in excess of $200m 11,000 clients Operating in nine states

Sierra Ventures
Sierra - still a successful Silicon Valley VC firm headed by Peter Wendell
Over $1.5 billion invested - more than 200 successful technology-based companies - 46 current
portfolio companies 7 Partners, 4 Principals, and 2 Associates Peter Wendell teaching MBA Entrepreneurship Course at Stanford Business School since 1991(with Eric Schmidt)

Jeff Drazen became a mega-successful VC some of his successes

Centex Telemanagement (CNTX Acquired by MFS), Stratacom (STRM Acquired by Cisco), On Assignment (ASGN), Micromuse (MUSE Acquired by IBM), ConvergeNet (Acquired by Dell), Combinet (Acquired by Cisco), Quinta (Acquired by Seagate), Vertel (VRTL), ParAcer (Acquired by Stratos Lightwave), FrontBridge (Acquired by MicroSoft), Sychip (Acquired by Murata), Micro Power (Acquired by Westin Presidio) and Digital Generation Systems (DGIT)

Drazen left Sierra in 2007 to start his own mid-market buyout-oriented fund (Bertram Capital) offering unusually strong value-added capability

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Vince Tobkin left Sierra shortly after Centex financing - is now a Senior

Partner at Bain & Company

TAKE-AWAYS FROM CENTEX

Start-up funds come from friends & family founders can spend most of their time raising money (or not) rather than ruining business VC deals are like getting married must be based on a feeling of partnership Entrepreneurs must understand VC money is not just a commodity (assuming the VC is
good) valuation is not the most important factor VCs must empathise with strains/angst of (inexperienced) entrepreneurs, foster a meaningful dialogue, and truly add value to the company relevant experience vital

No such thing as a perfect deal

All VC deals come with problems Ability of VCs to recognise diamonds in the rough critically important hard facts often
unavailable

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Management, management, management!!

A calm approach and creative deal structuring often saves the day emotions are as important as hard issues Very difficult to predict winners vs losers

How Do VC-Backed Companies Really Get Valued?

IRR and target return methodologies provide a framework and good discipline but . . .
Market feel of VCs is critical
o o o
o

Step-Ups Rules-of-Thumb
Half for capital, half for management for raw start-ups

Comparable VC deal provide a guide current state of equity markets critical

Valuation is an art, not a science emotions play big role many factors
involved - large egos on both sides
o o o o o o

Greed versus fear of losing deal Different perceptions of risk by both sides Different perceptions of value to be added by VC Managements share ownership - size of managements option pool Competition from other VCs Sense of fair play

Competition and company cash position often the deciding factors

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NEXT CLASS SESSION (15 March) Doing Buyout Deals

Guest Lecturer Jon Moulton: Founder and Chairman, Better Capital (1210 Sharp!) Discuss Solutions to Problem Set 2 Valuing Buyout Deals Explain mechanics of Modelling and Structuring Buyout Deals

Class discussion of Berkshire Partners: Bidding for Carters - be prepared to present your view of what bid if any - Berkshire Partners should make for Carters

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HOMEWORK FOR NEXT TIME

Pre-Class Reading The Adjusted Present Value Method for Capital Assets Case Preparation and Analysis Berkshire Partners: Bidding for Carters
Study Guide will be available in Moodle

Problem Set 2 - Valuing Buyout Deals

Assignment will be available in Moodle Answers to questions 11-13 to be submitted online via Moodle by 12pm,
Wednesday, March 14th

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IV AMADEUS CAPITAL PARTNERS

Early stage venture fund focused on

Communications Networking hardware and software Media e-commerce Computer hardware and software Medtech Cleantech

470m under management, 10 person investment team, about 40 companies in portfolio across Europe and Israel

10m Amadeus and Angels Seed Fund plus 10m coinvestment

Offices in London and Cambridge
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RICHARD ANTON
Chairman, BVCA Amadeus Capital Partners, General Partner focused on software and IT-related cleantech Autonomy, Director Business Development & Finance Apax Turnaround mamangment, finance/business development, management consulting MBA, INSEAD BA & MA Mathematics, Cambridge University
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