Topic outline

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  • 1. Why Deal Structuring?

    Welcome to "Deal Structuring!" The purpose of the module is to learn how to get from the valuation of a company to the actual financing deal. This introductory section motivates the topic and presents the logic of the module.

     

    Deal Structuring

      

    The main learning goals of this module are:
    • Learn how to get from a valuation to the actual deal.
    • Know the key elements of financial deal making, namely returns, control, and liquidity.
    • Learn how to read or draft financing term sheets.
    • See how deal structuring makes deals possible and more valuable.
    • Learn how to use deal structuring as a "truth serum" and to align the incentives of the deal parties.
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  • 2. Staged Capital Contribution

    New ventures do typically not receive all the necessary funding upfront. Most firms go through various rounds of financing during their early life and these rounds of financing are generally tied to specific milestones in their business plans. This section takes a closer look at such staged capital contribution (SCC) plans. We look at a specific example of SCC at work and discuss the costs and benefits of such plans for the entrepreneurs as well as the investors. While SCC provides investors with a rather powerful tool to manage the exposure to their portfolio companies, it constitutes a horse race between greed (achieve better deal terms if you finance later) and fear (constant threat of running out of money) for the entrepreneurs.

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  • 3. Financing and Experimentation

    The preceding section has shown that staged financing can have many advantages in the entrepreneurial setting. The convincing element is that staged financing allows investors to learn about the venture before committing significant investment funds to, say, build production facilities or finance market entry.

    The simple logic of learning before committing is also the basic idea behind experimentationExperimentation allows investors and entrepreneurs to reduce the riskiness of the project before committing the full capital. As a result, projects that are not feasible with full up-front investments often become financially very attractive once we allow for experimentation.

    This section shows how and why experimentation is so valuable in an environment with large uncertainty. It also looks into the key value drivers of experimentation

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  • 4. Financial Deal Making: General Considerations

    In the previous section, we have seen that the structure of the deal can have far-reaching value and incentive implications. The purpose of this section is to take a step back and discuss more generally what the investors and the entrepreneurs actually want from a deal, where they have common interests, and where there are potential sources of disagreement. Based on this, we then derive the three major elements of financial deals:

    • Division of financial returns
    • Dynamic allocation of control
    • Clear path to exit

     

    We investigate whether traditional financing instruments like debt and common equity can incorporate these deal elements. We see that common equity is not so common after all and that it offers many features to accommodate important deal elements. However, we still need more sophisticated financial contracting to address the basic concerns of the investors and the entrepreneurs.

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  • 5. Division of Financial Returns

    Let us now look at the first major deal element, the allocation of the financial returns of a venture between the entrepreneur and the investor. Four sections of the term sheet are typically dedicated to this topic, namely:

    • Dividend terms
    • Liquidation preference
    • Conversion rights
    • Redemption rights

     

    We discuss the most important deal terms of these sections and show how they affect the return allocation during the investment period as well as at the end of the investment period. As we will see, liquidation preference and conversion rights introduce non-linearity to the return allocation between the entrepreneur and the investor. This non-linearity will allow us to kill multiple birds with one stone:

    • Bridge valuation gaps
    • Align the incentives of the investors and the entrepreneurs
    • Screen out less confident entrepreneurs.
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  • 6. Valuing Financing Alternatives

    In the previous section, we have introduced the most popular instruments for venture financing. The purpose of this section is to learn how we can roughly assess the financial value of these different financing instruments. As we have seen, most of these instruments imply non-linearity in the return allocation between the entrepreneur and the investor. We will therefore use a standard option pricing models to incorporate such non-linearity in the valuation. This will allow us to understand how liquidation preference, participation rights, and convertibility affect the value of the deal. Ultimately, it will therefore allow us to structure "fair" deals.

     

    Before looking into the valuation of these instruments, we learn how to extract the (implied) valuation from the information provided in the Offering Terms of a term sheet.

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  • 7. Valuation Protection and Participation Rights

    With the second main set of deal terms, the VC attempts to achieve two main goals:

    • Anti-dilution provisions: These provisions protect the ownership stake of the VC against (excessive) dilution from future rounds of financing.
    • Participation rights: With these rights, the investors make sure that they can (but do not have to) participate in attractive stock transactions or future rounds of financing.

     

    Together with the preferred returns from the previous course sections, these rights and privileges help the investor limit the financial risk of investments in new venture and thereby make deals possible. 

    The purpose of this course section is to introduce and to learn how to apply the specific anti-dilution provisions and participation rights that are commonly used in term sheets.

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  • 8. Corporate Governance Provisions

    The third major deal element deals with broader aspects of the governance of the new venture. Key issues are the allocation of control between the entrepreneur and the investor as well as the incentivization of the entrepreneurial team. 

    In the context of control terms, this course section discusses the following main topics:

    • Investors' voting and information rights
    • Board representation
    • Performance-dependent governance provisions

     

    With respect to employment terms, the main topics will be:

    • Pool of reserved shares
    • Vesting of founder and employee shares
    • Key person insurance
    • Non compete clauses, confidentiality, proprietary information, and invention agreements.

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  • 9. Exit Provisions (Liquidity)

    Last but not least are the exit provisions. As we have seen at the beginning of this module, a clear path to exit is one of the most crucial deal elements for investors. With the appropriate exit provisions in the term sheet, investors make sure that there are no (legal) obstacles on this path. These provisions generally include:

    • Redemption rights
    • Registration rights
    • Participation rights
       

    The purpose of this module is to show how these provisions work and what implications they have for the investors and the entrepreneurs. Ultimately, we will see that investors can, in principle, use these rights to force a liquidity event upon the company. This is important for entrepreneurs to remember before signing a term sheet, as  entrepreneurs might have different long-term plans with "their" company.

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  • 10. Simple Agreement for Equity (SAFE)

    This section looks at a financing instrument that has become increasingly popular for seed financing: The Simple Agreement for Equity, or SAFE. The logic of a SAFE is indeed very simple: Instead of negotiating all the deal terms today, the company and the investor agree that the investor will receive company stock at a later date, in connection with a priced liquidity event such as the issuance of Preferred Stock or the liquidation of the company

    In this section we discuss the key terms of a SAFE, namely the Valuation Cap and the Discount Rate and we provide various examples for how a SAFE works in different scenarios. We conclude with a discussion of the advantages and the disadvantages of this innovative security.

     

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  • 11. Summary

    The purpose of this module was to understand the three major elements of financial deal making and to learn how these elements are reflected in the so-called "Term Sheet:"

    • The division of returns
    • The allocation of control
    • Exit considerations.

     

    We have covered the relevant deal terms from different perspectives. On the "bright" side, we have seen that many of these terms can be extremely beneficial to the parties of the deal, because they help us bridge valuation gaps, align incentives, and reveal preferences and expectations. On the "dark" side (from the point of view of the entrepreneur), we have also seen that there are many deal provisions that shift significant power and decision rights to the investors, including liquidation preference, voting and board provisions, redemption rights, and exit rights

     

    As in all negotiation situations, the terms of the deal ultimately determine whether a deal is good or bad. It is therefore extremely important that the founders have a profound understanding of the relevant deal terms and their possible implications. As in all legal documents, every single word counts. For example, in the formulation of a drag along provision, the fate of the entrepreneurial firm could be significantly altered depending on whether the provision is triggered by a majority of "Common" Stock or a majority of "Preferred" stock!