This technical note introduces convertible note financing for early-stage start-up companies. These unpriced securities offer significant advantages related to delayed valuation, greater speed, and lower cost of completion compared to venture capital financing. As a result, the number of early-stage companies raising capital through convertible notes over the past decade has greatly increased. The note discusses the most frequently used terms and arrangements of early-stage convertible notes, the estimation of noteholders' equity ownership from delayed valuation, and the costs and risks of this form of financing to both entrepreneurs and investors. It offers a number of numerical examples that walk students through calculations of convertible note payoffs under different success scenarios and different valuation caps. It also explores how convertible notes affect subsequent equity rounds' pricing. Finally, the note offers statistical data on the state of convertible note issuance. This note is a successor to an older note, ""Convertible Notes: A Form of Early-Stage Financing"" (UVA-F-1925). The cases ""Should udu a Convertible Note?"" (UVA-F-2025) and ""MedMetri
In late November 2017, Roark Capital Group (Roark) must decide on a last, best offer to purchase Buffalo Wild Wings (BWW) in a leveraged buyout (LBO) for $157 per share. That bid had followed a series of offers that began in August 2017, at $150 per share, after a protracted proxy fight by activist investor Marcato Capital (Marcato) ended with the resignation of BWW's longtime CEO, Sally Smith. Marcato had accumulated a sizeable stake in BWW and several board seats as part of the proxy contest and had been pushing BWW's board to seek a higher price. Roark must now decide if the returns to its investors merit the $157 per share offer. This case is meant to follow cases in which the topic of residual cash flows and LBOs have been introduced. We typically assign it after teaching an earlier case that introduces that material and how private equity (PE) sponsors typically evaluate LBOs, such as "DuPont Corporation: Sale of Performance Coatings" (UVA-F-1709) (DPC). DPC provides an opportunity to evaluate an LBO from a company's and sponsor's perspective, but the cash flows and debt structure are simplified to focus on the conceptual differences in how the parties might view the deal. BWW focuses on the sponsor's (Roark's) perspective and includes a richer set of operating synergies and a more complex debt structure. The debt structure features existing debt that must be refinanced and multiple tranches of debt. As such, the case introduces students to several types of debt that are commonly used to finance LBOs and their related terms. It also introduces students to the pros and cons of LBOs of franchise-model businesses, an area of strong PE investor interest. We also typically assign a technical note, "Valuing Late-Stage Companies and Leveraged Buyouts" (UVA-F-1846), to be read in conjunction with cases that cover LBOs. The note provides a basic overview of the primary sources of financing and the metrics used to gauge LBO capital structures and a step-by-step example
several companies competing to win the mandate to manage F&M's assets. Investure's approach is to pool the assets of "like-minded" institutions and significantly increase their allocations to PE. Miller and his team are preparing to meet with the F&M board's investment committee to describe Investure's services and approach to investment management. This case is designed to introduce students to AA and the distinctions among PE, hedge funds, and private capital within this asset class. It focuses primarily on why PE is a difficult asset class to manage and describes several channels available to small endowments like F&M to access PE. The case introduces students to the core vocabulary of PE investing and limited partnership agreements. To make the concepts and terms more concrete, it provides a simple exercise that asks the students to calculate the expected internal rate of return (IRR) on an investment made through a traditional limited partnership (primary fund commitment) and a fund of funds and compare those to Investure's approach. Students must evaluate and discuss the feasibility and attractiveness of each alternative to F&M. In doing so, the case creates an opportunity for students to discuss the current trends and issues many E&Fs confront as they attempt to increase allocations to PE. The case is appropriate for use in an introductory or early class in courses focusing on PE, venture capital (VC), and entrepreneurial finance, as well as in specialized courses for fund trustees interested in AA. The case can be used for the following purposes: 1. To introduce students to AA and how they differ from public equities and fixed income.
Cinda Klickna, trustee of the State of Illinois Teachers' Retirement System (TRS), was preparing to vote in June 2019 on a proposed $75 million investment in a new fund being raised by First Light Capital (FLC), a midsized buyout firm. Illinois had been under financial pressure for some time, and TRS, the state's largest public pension, was seriously underfunded. In 2012, TRS's board began a plan to strategically increase its allocations to private equity (PE). By 2018, the target allocation to PE had reached 15%, well above the 10% average of other public pensions. The increase in PE was undertaken in an attempt to close the funding gap necessitated by insufficient state funding and the generally low-interest-rate environment. The strategy had not gone unnoticed, and many now openly questioned the higher risk and costs of these investments. In the face of this greater scrutiny, Klickna believed it was important that the pension's PE investments earn a satisfactory return, by looking to invest in funds that had upper-quartile returns and public market equivalents (PMEs) greater than one. This case is appropriate for courses that cover PE investments, such as those typically covering topics on venture capital or PE, or courses on asset management that include alternative assets. It introduces students to some of the commonly used PE performance metrics and the challenges associated with measuring performance for an illiquid asset class. Students are introduced to the Global Investment Performance Standards (GIPS) and their purposes and limitations in evaluating performance. Students are asked to calculate the gross and net since-inception internal rate of return (SI-IRR), DPI, RVPI, TVPI, and PME for the same pending investment in FLC Fund IV and compare how performance is assessed across these metrics. The case also discusses the push for greater disclosure in the PE industry as it grows in its influence and public investors seek to know more about its performance.
In November 2017, John Fruehwirth, managing partner of Rotunda Capital Partners (RCP), was considering the final terms of a Series B offer to StreetShares, Inc. (StreetShares), a fintech platform lending company whose principal business was lending to veteran-owned businesses. StreetShares was cofounded by Mark L. Rockefeller and Mickey Konson-both veterans themselves-in 2013, with the mission to provide better access to credit for veteran-run businesses. Since the financial crisis in 2008, banks had been reducing small-business lending, and the founders believed there were over a million veteran-run businesses that could benefit from better access to small loans and other forms of credit. When Fruehwirth first met the two founders in the spring of 2017, initially he thought the company was too early in its development to satisfy his investment criteria-but he was impressed with the company's management and mission. His view changed in October 2017, when StreetShares beat out Kabbage and several other online lenders to pilot a program for MILBANK, Inc., a large military affinity-focused bank, to offer small-business loans to its members. If successful, the pilot would significantly accelerate loan growth. But if the pilot failed, it would leave the firm with more expensive channels for growth and raise doubts about its small-loan business. Fruehwirth was contemplating a Series B-round investment of $20 million for 40% of the company's equity, but needed to determine whether the returns would satisfy his investors, knowing they were highly dependent on the success of the pilot. The case contains RCP's offering memorandum summarizing the merits of the StreetShares investment and Fruehwirth's proposed deal terms. Students are asked to qualitatively evaluate the potential benefits and risks of the investment from the perspective of RCP's investors, and to quantitatively calculate the investment's returns.
In April 2016, Mark Parker, an experienced private-equity investor, is considering an investment in MedMetric, LLC (MedMetric), a seed-stage health care information technology company. The company has a Software-as-a-Service (SaaS) product that facilitated reimbursement for Medicare Advantage companies (MAs), private firms that provided an alternative way for senior citizens in the United States to receive Medicare coverage. The Centers for Medicare and Medicaid Services (CMS) reimbursed these companies using risk-adjusted metrics submitted by the MAs that increased their payments for higher-risk patients. Since 2012, CMS had been transitioning from a simpler data-entry process to a more complex data system called the Encounter Data Processing System (EDPS). Smaller and medium-sized MAs struggled to adjust to EDPS and MedMetric's product targeted these MAs to facilitate the transition to EDPS and ensure accurate reimbursement from CMS. MedMetric's product is in development and has several contracts pending, but no revenues are expected until July 2016. Based on the difficulty of valuing the company at this stage, Parker is considering making a $1 million convertible note offering to bridge the company to a later Series A venture round. The terms of the note seem relatively standard to Parker, but he is unsure whether they will provide him with the equity stake and influence he is seeking from the company. Students are asked to evaluate whether the terms of the note are sufficient to grant him the 10%-to-15% equity ownership he is seeking. Seed-stage convertible notes have increased in recent years as a form of financing for early-stage companies. This case provides an introduction to convertible note offerings, their terms and structure, and how the equity ownership can be estimated when the valuation of the company is delayed until a later round of financing.
Convertible notes are often used to raise early-stage financing for start-up companies, frequently due to their advantages related to delayed valuation, greater speed, and lower cost of completion compared to venture capital financing. As a result, there has been a large increase in the number of early-stage companies raising capital through convertible notes over the past decade. Investors have made this form of financing more available, believing that small amounts of money can significantly advance the development of young companies. Entrepreneurs often find that convertible notes are easier to raise than a first round of venture capital. The ease of convertible note financing, however, sometimes belies the hidden risks and costs associated with its use. This technical note discusses the most frequently used terms and arrangements of early-stage convertible notes, the estimation of the noteholder's equity ownership from delayed valuation, and the costs and risks of this form of financing to both entrepreneurs and investors. The case "MedMetric, LLC: Seed-Round Convertible Note Financing" (UV7929) can be assigned with the note as an application of this form of financing.
Assessing the performance of private equity (PE) investments is a challenging task. It starts with the fact that the assets are privately held and illiquid. By contrast, public equity valuations are determined in a vast open market populated largely by disinterested investors acting on publicly available information. Therefore, to make an informed assessment about PE performance, investors should be aware of the areas where general partners' discretion can most influence fund performance. As PE has grown as an asset class, investors have pushed for greater disclosure and more standardization of performance metrics and benchmarks. Although this has resulted in greater standardization of the reported information, considerable opportunity remains for general partners to influence fund returns. This note summarizes the key metrics used in assessing PE performance and discusses important areas of general partners' influence on reported returns.
This note replaces "Valuation of Late-Stage Companies and Buyouts" (UVA-F-1639). This note focuses on the valuation of late-stage companies with a particular emphasis on leveraged buyouts (LBOs). In contrast to venture capital, where firms are typically at an early stage of development, late-stage investments involve more-established businesses that have an ability to take on higher levels of debt to augment investor returns. The note provides a description of LBOs, an overview of the commonly used sources of financing and the metrics used to assess LBO capital structures, a discussion of the value drivers of buyouts, and a step-by-step example of an LBO analysis. This note takes the perspective of private equity (PE) investors and assumes some basic familiarity with the structure of PE investing. Their approach is compared to other discounted cash flow valuation methods based on the weighted-average cost of capital or adjusted present value.
In February 2013, John Carroll and Alexander Whittemore, both managing directors at Summit Partners (Summit), are considering an investment in RoboSoft, LLC (RoboSoft), a provider of data-center automation, business intelligence, and security software solutions, primarily for the IBM i operating system. Summit had previously invested in RoboSoft, and did well when it exited the company in 2007. Over the ensuing years, Summit had followed RoboSoft and was considering a second investment in the company when it was put up for sale again in late 2012. This time, Summit planned to invest $103.6 million from its growth equity fund and $43.9 million from its subordinated debt fund to buy out the company. This case is designed to introduce students to mezzanine investments. Because the deal involves both an equity and a subordinated debt investment, students can compare the investment considerations and return expectations of both types of investors. The case contains the actual deal team's investment memorandum summarizing the merits of the RoboSoft investment. The students are asked to qualitatively evaluate the potential benefits and risks of the investment from the perspective of a debt investor and an equity investor, and to quantitatively calculate the internal rate of returns (IRRs) and cash-on-cash returns (CoCs) of Summit's equity and subordinated debt fund investments. This case is appropriate for classes that survey private equity investments, or for corporate financing classes that wish to compare the risk and return of equity and debt investments. It is assumed that students have taken valuation courses and understand residual equity cash flow valuation methods. There are Excel files-one for students, one for instructors-to support analysis of this case.
Master limited partnerships (MLPs) are limited partnerships that trade on public exchanges in the form of units, similar to common stock. MLPs have several advantages relative to traditional C corporations (C-corps) that have resulted in their frequent use to finance energy-infrastructure assets. The general partners (GPs) retain control of the assets placed in the MLP, can drop down assets to the MLP, often at advantageous prices, and receive incentive distribution rights (IDRs). IDRs increase the GPs' share of the distributions over time, which in turn affects the MLPs' cost of capital. MLPs do not pay taxes at the entity level, which increases the amount of cash that can be paid to GPs and unitholders. MLPs trade on the basis of their yield and the stability and growth of their distributions. This technical note provides a brief history of MLPs, a description of their key features and terms, and several approaches to valuing them.
"OptiGuard. Inc.: Series A-Round Term Sheet" focuses on an entrepreneur in the cybersecurity industry who is attempting raise a first round of venture financing in November 2015. To date, the firm has been unsuccessful in attracting funding from venture capitalists (VCs) and has instead relied on a small seed round from local investors. With funds running short, the entrepreneur is again attempting to raise funds from VCs. During this process, it receives a bridge loan from a reputable venture capital firm to tide it over until it can complete a Series A round with the same firm. In November 2015, it receives the terms for a $5 million Series A round, and the students must evaluate the adequacy of the offer in light of other comparable financing rounds and how the terms will affect the future performance and other aspects of the firm in light of the high likelihood of future financing rounds. The case's main teaching purpose is to provide a basic understanding of the legal and financial issues encountered in early-stage investments. The case incorporates the term sheet for the proposed Series A round, and the pre-Series A capitalization of the company. The study questions pose several direct questions to the students to help them focus on the features of the term sheet that have the largest impact on the company's valuation and control. The case has been used successfully in an MBA-level entrepreneurial finance and private equity course, and a JD/MBA course in private equity. To facilitate preparation of the case, the materials include a student spreadsheet file (UVA-F-1798X) of the case exhibits, a detailed teaching note (UVA-F-1798TN), and an instructor file (UVA-F-1798TN). The companion note, "Early-Stage Term Sheets" (UVA-F-1730), is a useful background reading for the case.