fbpx

The Perils of Liquidation Waterfall – Part 2

In our last post, we discussed investment scenarios with only a single investor. However, in reality, most companies have multiple investors investing in multiple financing rounds. In such a case, determining liquidation waterfall becomes extremely challenging. With multiple investors in play, a new clause enters the term sheets – “Seniority”

Simply put, seniority is the preference order in which investors get their money back. Also, the seniority ranking is usually allotted to share classes and not individual investors. For instance, Series B would get a seniority ranking of 3 and Series A would get a seniority ranking of 2. Common shareholders usually have the lowest seniority ranking of 1.

Higher the Seniority ranking, Higher the preference in liquidation waterfall.

 

Usually seniority preferences flow downward. That is, later investors get higher preference. So, Series B are paid back their dues before Series A investors receive their share of the pie and so on.

Let us assume that FW raises Series B, with VC firm ISA Ventures investing $5m for 37.5% stake in FW. The updated captable would look like this.

Investor Share Class Investment (in USD) Fully Diluted Stake
ISA Series B $ 5,000,000 37.5%
MPG Series A $ 3,000,000 25%
Founder Common $ 10,000 37.5%

 

The share class details would be as follows

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series B 1x Yes Yes 2x 3
Series A 1x Yes Yes 2x 2
Common No No N/A 1

 

In case of an liquidation event, first the Series B shareholders would be paid back followed by Series A shareholders followed by common shareholders

Seniority

FIGURE 1

As seen in figure 1, till a value of $5m only Series B shareholders are paid back. After that Series A shareholders join in. Common shareholders join in the last – at an exit value of $9.8m

Sometimes, this structure might be reversed – later investors might be paid after early investors. Series A would be paid back before Series B. This structure is not very prominent and rarely practiced.

Finally, seniority might be pari passuInvestors across all stages have the same seniority status. In this situation both Series A and Series B would have same preferential rights over exit proceeds.

Pari Passu

FIGURE 2

Here, both Series A and Series B start sharing proceeds at the beginning itself. Initially, as the exit proceeds are insufficient to cover liquidation preferences of both Series A and Series B, exit proceeds are shared in proportion of amount invested till $8m, at which point the exit proceeds are sufficient to cover liquidation preferences of both the share classes. Common shareholders join at an exit value of $8m after which the proceeds are shared on a proportionate basis of the FD stake.

Finally, there might also be a hybrid of pari-passu and usual seniority – i.e some classes might be pari passu within themselves but senior to other classes. Let’s take a hypothetical example.

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series E 1x Yes No N/A 4
Series D 1x Yes Yes 3x 3
Series C 1x Yes Yes 3x 3
Series B 1x Yes Yes 2x 2
Series A 1x Yes Yes 2x 2
Common No No N/A 1

 

Here, Series E holds the highest seniority among all classes. Series E shareholders would take their share of the proceeds before other shareholders can take their share. After that shareholders of Series B, C and D would take their proceeds on a proportionate basis. Thus, Series C is senior to Series A but equivalent to Series B and Series D in terms of seniority.

Clearly, seniority makes a lot of difference, especially if the exit value of the company is not high as expected. Senior classes will take the lion’s share of the proceeds and leave nothing on the table for junior classes. That said, seniority makes little difference if the exit value is really high and comfortably covers all liquidation preferences and preferred participation. Also, in case of an IPO, all the preference shares usually convert into common shares automatically, eliminating all the liquidation preferences.

Gap in expected proceeds and actual proceeds increases as more and more financing rounds happen due to stacking up of seniority levels and liquidation preferences of late investors. You might expect 30% of the proceeds due to holding 30% of shares but in reality, receive a much lower percentage due to liquidation preferences of later investors.

 

The best way to minimize this gap is to know beforehand the impact of future investors’ liquidation preferences and seniority are going to have on your returns and use this knowledge to negotiate accordingly.

Analyze your portfolio company’s liquidation waterfall

And the impact of various term sheet clauses on your own returns via a free trial of Fundwave.
By |April 24th, 2018|Fundwave Blogs, portfolio management|

OUTSOURCE OR IN-HOUSE? THE THIRD OPTION

Perhaps the largest inhibitor to the growth of private equity and venture model of investing has been the scarcely available knowledge of this niche industry and the kind of structures it employs. The niche nature of waterfalls, fees-structures and investment instruments has meant that fund managers have traditionally outsourced their operations to expensive experts or hired specialist internal teams to run their fund operations.

OUTSOURCE

The list price on the services of third party administrators are useful to attract young fund managers who rightly wish to focus on their core competencies of managing investors’ money. Indeed, hiring the right internal team can be time-consuming, expensive and with a delayed return on investment.

However, indirect overheads such as those related to liaisons with the fund administrator, quality control and running parallel operations to verify reporting are easy to miss. These hidden costs make outsourcing cost effective only for funds in a narrow band of commitment sizes.

IN-HOUSE

Fund managers lean towards in-house operations because of their greater transparency, higher data-control and mitigation of third party risk. A high rating in the above factors help fund managers offer better aligned and future ready operations, which are especially important for long term managers planning to launch subsequent funds.

However, any manually run team is bogged down with complicated spreadsheets that are rendered difficult to use over time, are susceptible to errors, and are infamous for hiding errors in plain sight. Also, thanks to lack of knowledge management practices at most internal teams, operations can be temporarily handicapped on the departure of a key person.

                                        Figure 1

THE THIRD OPTION- FUNDWAVE

Fundwave helps managers take control of their data and operate their funds with best practices at a fraction of cost of either outsourcing or hiring a specialist in-house team. Figure 1 summarizes the various costs associated when outsourcing fund operations, administering internally manually and administering internally with Fundwave. Note that the funds continue to spend on internal teams even when operations are outsourced, which is often not evident at purchase.

Figure 2 compares the key value add factors to consider in the outsource versus in-house debate. Clearly, Fundwave brings the best of both worlds by lowering cost, reducing errors and increasing the control of fund data.

CONCLUSION 

By helping managers take control of their data, reduce administration costs and follow best practices, Fundwave presents a natural evolution to fund managers who want to keep fund administration in-house for the benefits of greater transparency and control of their data but lack the expertise, budget or resources to do so.

                                              Figure 2

A common myth surrounding fund administration is that outsourcing fund administration is a regulatory requirement or helps the investors of the fund perceive greater corporate governance. The truth is that these are not the functions of the administrator but of the fund’s auditor.
Another rumor related to fund operations is that outsourcing fund administration helps save the fund manager’s time compared to an in-house process. This may be true if the in-house process is manual. However, with Fundwave, you spend less time entering the same information on a software than you’d to send it to a third party.

Sign up for a free trial on Fundwave or contact us for more information.
By |September 22nd, 2017|Fundwave Blogs|

The Perils of Liquidation Waterfall – Part 1

What good is your investment if you cannot calculate your returns, or worse, calculate them incorrectly. It would become a classic situation of counting your eggs before they hatch.

Times were simpler when gains were distributed in the proportion of individual contribution but unfortunately, times are not so simple anymore. With clauses like Liquidation Preferences and Preferred Participating, term sheets have become complicated and calculating your returns is equivalent to untangling a pair of headphones, it’s just not possible in 30 seconds.

In this post, basic clauses shall be explored. The more complicated ones will be untangled in another post. Let us try to make sense of the basic clauses one by one.

  1. Liquidation Preference: Simply put, it is the amount of proceeds which the investor is guaranteed before the common shareholders in case of a liquidation event. Stated as a multiple of amount invested in the company, this can go as high as you want, but is usually restricted to 1x, considering the fact that this clause was initially created to safeguard investors in case the company was sold for a value less than expected. A 1x liquidation preference ensures that the investor recovers at-least the initial investment.

Let us take an example to explain this. Investment firm MPG invests $3m USD in series A for a 40% stake in FW, a fintech company. Let us assume there is no preferred participation and MPG is the sole investor in FW.

Table 1

Liquidation Preference Investment (in USD) Company Valuation Proceeds to MPG % of Proceeds
1x $3,000,000 $7,000,000 $3,000,000 42.85%
2x $3,000,000 $7,000,000 $6,000,000 85.71%
2x $3,000,000 $5,000,000 $5,000,000 100%

 

As one can see, despite having a 40% stake in FW, MPG pocketed more than 40% in each scenario.  In the last case, MPG pockets everything, leaving nothing for FW founders.

If preferred shareholders simply have a liquidation preference, they are also called non-participating preferred. In that case, the investor might choose to convert to common stock, if payout from common stock is more than liquidation preference. In our example, MPG will convert their liquidation preference stock of 1x to common stock if the company is sold for more than $7.5m.

Non Participating Shares

  1. Participating Preference: In contrast, participating preferred, also known as double-dip, allows the investor to participate in the remaining proceeds as well on a pro-rata basis in addition to the liquidation preference. Continuing with the above example, MPG would get 40% of the remaining proceeds as well.

Table 2

Liquidation Preference Investment (in USD) Company Valuation Proceeds due to Liquidation Preference Proceeds due to Participating Preference Total Proceeds to MPG
1x $3,000,000 $10,000,000 $3,000,000 $2,800,000 (40% of $7m) $5,800,000
2x $3,000,000 $10,000,000 $6,000,000  $1,600,000 (40% of $4m) $7,600,000

Participating preferred holders will never convert to common stock since they are adding their participation on top of the liquidation preference, something which common shareholders don’t get.

Preferred Participating Shares

 

As you can see, this would be highly unfavorable for entrepreneurs, And thus, the cap was born.

  1. Participation Cap: The participation cap provides protection to the entrepreneurs the same way liquidation preferences protect the investor. Also, stated as a multiple of the invested amount, it provides a conversion threshold for participating preferred shareholders. For instance, a 3x cap would ensure that the investor can only receive up to 3 times the invested amount and would have to convert to common shares to receive a higher payout.

Let us continue with the MPG example, wherein MPG has a liquidation preference of 1x.

Table 3

Participation Cap Investment (in USD) Company Valuation Proceeds due to Liquidation Preference Proceeds due to Participating Preference Total Proceeds to MPG
2x $3,000,000 $12,000,000 $3,000,000 $3,000,000 $6,000,000
3x $3,000,000 $12,000,000 $3,000,000 $3,600,000 (40% of $9m) $6,600,000

 

As seen in the first case, the total proceeds are capped at 2x ($6m). This ensures that the common shareholders get an additional $600k.

Participation Cap

Till $3m, MPG will get all of the proceeds due to Liquidation Preference. Afterwards, till $10.5m exit value, both series A and common will share the remaining proceeds in 40:60 ratio, till the 2x cap of $6m is reached. Post that common takes all the value till $15m, after which it is advantageous for MPG to convert to common shares and get more than $6m.

As seen throughout the post, cash flows vary widely depending upon the rights your share class has. The distribution varies even more when there are multiple investors in multiple series of investments and clauses like seniority come into play. We will explore the seniority clause in another post.

Analyze your portfolio company’s liquidation waterfall

Sign Up for a free trial to calculate your share of the pie on Fundwave.
By |June 7th, 2017|Fundwave Blogs, portfolio management|

The Mechanics Behind Investing in Convertible Notes

Historically, traditional debt and common equity have been prominent investment instruments used by venture capitalists. Gradually, preferred equity took prominence due to the various safeguards and benefits it offered. Post the dot-com boom, investors came up with a new instrument known as Convertible Notes. Primarily used by angel investors, convertible notes have become so popular that incubators such as YCombinator and 500Startups have come up with own standardized convertible note instruments called SAFE and KISS respectively.

Now what exactly is a convertible note?

A convertible note is primarily a short term debt instrument which can be converted into equity at a future date, typically when a new financing round occurs. Though these notes earn interest, most of the returns are earned by converting the debt into stock, usually preferred.

One of the primary challenges with early stage investing is agreeing upon a valuation of the company. This is further complicated by the fact that some of the early investors are friends and family. A convertible note allows the investors and the founders overcome this challenge by delaying valuation of the company till the next financing round i.e. Series A when the company is in a position to be valued more accurately due to availability of data.

The next question arises is how do convertible note holders generate returns if they are not getting any equity at the time of investment and the interest charged is not high enough to compensate for the risk taken?

There are three mechanisms through which the noteholders earn from their investment.

  1. Interest Rate: Fundamentally, the convertible note is a debt instrument and earns interest over time. However, unlike traditional debt instruments, the interest is not usually repaid and instead accumulates and is added to the principal value at the time of conversion.

Therefore if the $200k note had an interest rate of 5% and was converted after one year of issue, then the noteholders would convert an additional $10k ($200k multiplied by 5%).

However, as mentioned above, interest earnings are a small portion of the overall returns generated by convertible notes and alone are insufficient to compensate for the amount of risk taken by the investor.

  1. Conversion Discount: The conversion discount is a mechanism to compensate the noteholders for their risk by allowing them to convert the note value (principal, plus interest) at a discounted price compared to the price paid by the incoming investors.
For example, if the investors in a $200k convertible note financing round were granted a discount of 20%, and the incoming investors are buying the company shares at $2 in a new round, then the noteholders would convert the note at an effective price (conversion price) of $1.6 and thus receive 125k shares ($200k, divided by $1.6) worth $250k (125k shares at $2 each).
  1. Conversion Valuation Cap: The third mechanism allows the noteholders to be compensated for their efforts in increasing the value of the startup due to their advise, funds, etc. Basically, the valuation cap puts a ceiling on the value of the startup, thereby permitting investors to convert their loan, plus interest at a discounted price compared to the price paid by the incoming investors.

Continuing with the same example, let’s assume the valuation cap was $1 million and the premoney valuation at Series A is $2 million. If the noteholders invested $200k and the incoming investors are buying the shares at $2, the noteholders would receive a 50% discount ($1 million/$2 million) and thus convert at a price of $1, thereby receiving 200k shares ($200k/$1) which is twice what the incoming investor would receive for his $200k investment. The note would be worth $400k (200k shares at $2 each). (See Table 1)

Table 1

Investor Investment (in USD) Share Price Number of Shares Value of Investment
Note Holder $ 200,000 $ 1 200,000 shares $ 400,000
Series A $ 200,000 $ 2 100,000 shares $ 200,000

As you can see below in Table 2, noteholders with simply a discount and no cap would receive a fixed amount of shares irrespective of the pre-money valuation

Table 2

Instrument Investment (in USD) Discount Discounted Share Price Number of Shares Value of Investment
Uncapped Note $ 200,000 20% $ 1.6 125,000 shares $ 250,000
Note with $1m cap $ 200,000 50% $ 1.0 200,000 shares $ 400,000

 

Thus, noteholders holding a note without a valuation cap

  1. are penalized as investors are unable to share in any increase in value of the startup ,and
  2. the interests of the founder and the investor are misaligned as the founder would want to maximize the valuation whereas the investor would want to minimize the valuation in order to obtain a larger part of the company.

Therefore,usually, the investor negotiates for both a discount as well as a valuation cap, in which case the lower conversion price (higher discount rate) would be applicable. Thus in our example, the conversion price of $1 (50% discount) would be applicable to calculate the number of shares issued upon conversion despite the discount rate agreed to initially being 20%.

Interestingly, note that even if the valuation of the company is more than $1 million, say $1.25 million, even then the noteholder would receive a discount of 20% and the cap would trigger only post $1.25 million

Historically, convertible debt were instruments created in the mid-19th century issued by companies with low credit ratings to keep a lower coupon rate due to its flexible convertible nature. These instruments converted into shares at a later time for a fixed share price. Later on, this instrument was picked up by Venture Capitalists and used as a source of “bridge financing” during later financing rounds. However, the true evolution has come by way of its use in angel investing.

We have tried to explain the basic mechanics of the convertible note and how the discount rate and especially the valuation cap have a visible impact on the shareholding pattern after the next financing round. However, the convertible note valuation also depends on other factors such as the size of the option pool and whether the note is being converted pre-money or post-money.

Build Your Own Convertible Note Model

Sign Up for a free trial to model your convertible notes on Fundwave.

Further Reading

How Convertible Debt Works – Brad Feld

By |May 10th, 2017|Fundwave Blogs, portfolio management|

Limited Partner Reporting Portal

 

Are you fund raising for your next investor close? What’s missing in your deck?

investor-1

Track record and investment thesis aside, a great deck needs to mention how the fund managers can provide a transparent and readily available reporting to their investors. In fact, such is the importance of a transparent reporting process that were there a trade off, a sophisticated investor would be willing to sacrifice some performance in favor of greater transparency. We invest in off market securities after all!

In response, a great wave of reporting standards have emerged recently such as the Institutional Limited Partners Association (ILPA) or European Venture Capital Association (EVCA) reporting standard. Of course, with Fundwave you can already report in a compliance to these and other similar standards. So we decided move to next piece of the puzzle with the Fundwave Investor Portal.

With the Fundwave Investor Portal, your investors can have their data with you neatly organized and available at a tap. On your end, you can easily upload reports, track investor views and make a great first impression to your investors. It’s out for beta now, so you can check it out right away!

By |June 7th, 2016|Fundwave Blogs, Limited partner reporting|

Tracking Portfolio Metrics

Your portfolio companies are all different. Some are pivoting, others are growing and yet a few are undergoing management changes. How can you help them where they need it?

Analyzing Growth Flat Illustration Concept

Track the metrics. Assume we’ve invested in a promising SaaS business. Finally, the product is starting to witness some uptake and our cashflow deficit seems to narrow each month. You have two options – pick-up the pace of customer acquisition or rake in the profitability. What will you advise your founders?

If your response is “it depends”, you’re absolutely right. Let’s take a look at the unit economics:

Customer Acquisition Cost: $5,000
Lifetime Value: $10,000
Monthly Churn: 3.5%

The LTV : CAC ratio here is just 2x. From the above numbers, the monthly churn rate appears to be a tad too high. Let’s bring it down to say, 2% so our LTV:CAC ratio improves enough to step on the on customer acquisitions.

Simple enough analysis there, but almost impossible if we work only with lagging indicators of success such as revenue and EBITDA. Each business will have it’s own key metrics to track and chances are that you’re already tracking a few metrics in your head or on a spreadsheet. But as you may already realize, no data equals no analysis. How can we make it smooth for our portfolio companies to submit these metrics to us?

Presenting the portfolio metrics add-in for Excel that helps portfolio companies easily submit metrics against your deliverables without leaving the comfort of their spreadsheets. Check it out on the Office Store.

By |February 19th, 2016|Fundwave Blogs, portfolio management|

What every fund manager needs to know about fund administration

fastAs fund managers, we leave no stone unturned in ensuring that we are working our investor’s capital optimally to ensure them a good return, because after all the investor commitments form the backbone of a fund. However, running a fund is not just about placing good bets or hunting those unicorns ;). As a professional fund manager, you need to maintain a reasonable drawdowns schedule, show early distributions and ensure all amounts are allocated to each investor correctly. The notices and reports that we send to investors tell them the progress of their capital investment and that’s why reporting transparency has remained the top priority among institutional investors, and lately individual investors too.

But what all exactly constitutes as fund administration and where does it fit the processes of a close ended fund? The answer is simpler than you think. Let me break it down for you:

1. Investor Allocations
Allocating amounts between your investors based on a variable, such as their commitment or undrawn commitment. Among common exceptions to the rule include ‘excused investors’ (investors don’t invest in particular geographies / industries). Also, capital returned within the defined period may be called back by the fund. Fundwave will let you allocate on variables defined by you and even excuse investors.

2. Investor Closes
When you do another close, new investors pay an late-interest to the fund, which in turn is passed to the investors who had joined in the previous closes. All previous transactions are reallocated as if all investors joined on the same date. Fundwave can do this at a tap!

3. Capital Notices
You don’t want to completely draw your commitments in advance if you want a good carry. Instead, you draw capital from time to time as you make investments. For every capital notice, you need to include bank details and investor contact details. Often you’re also calculating management fees for a drawdown notice and a performance fees / carry for a distribution notice. Fundwave can seamlessly allocate numbers, generate and send capital notices.

4. Management Fees
You need to be able to ask for different management fees from different investors, and the basis of calculation of management fees may switch from ‘commitment’ initially to ‘cost of investment’ or ‘net asset value’ during the later life of the fund. Fundwave can maintain different rates for different investors and calculate your management fees.

5. Carry / Waterfall
This is the money going to the ‘Carried Interest Partner’. You need to be able to calculate your carry based on ‘deal by deal’ and ‘fund as a whole’ basis and make a distinction between ‘hard’ and ‘soft’ hurdles. Some LPA’s have checks to ensure that a clawback situation is avoided. For example, for ‘fund as a whole’ carry, you may assume that all ‘undrawn commitment’ is valued at ‘0’ before you distribute a carry. Fundwave can calculate carry fees for various scenarios.

6. Quarterly Reporting
At the very least, LP’s will need a ‘Net Asset Value’ statement which shows an overview of the growth of their money for the period. You may supplement this by visuals and other supplemental data. Fundwave can automatically prepare your reports for each investor.

7. Fund Accounting
You need to maintain your books for your investments, so that your balance sheet, profit loss and trial balance can be generated. Since you’ll invest in portfolio companies, you will need keep track of number of shares purchased, and transaction currency amounts. When you realize an asset, Fundwave can calculate the cost of sales automatically.

8. Valuations
You will need to value your investments periodically. When you enter valuations, Fundwave will automatically calculate the unrealized gain, even when the transaction is done using a foreign currency.

9. CRM
You don’t want to send a drawdown notice to someone at your investor who has moved roles or is no longer working there. Effectively maintaining a single source of truth will save you from a lot of operational trouble down the line. Fundwave stores investor contacts, bank information and sends notifications.

10. Commitment Transfers
If an LP wants to exit, partially exit or simply invest using another of their SPV’s, you need to be able to transfer the commitment between LP’s. With Fundwave, you can transfer commitment between multiple LP’s at a tap!

So what isn’t fund administration? Apart from core functions of your team such as deal flow management and portfolio monitoring, fund administration typically doesn’t include incorporation of partnerships, legal expenses, and regulatory reporting.

By |September 15th, 2015|fund administration, Fundwave Blogs|

Fund administration for seed funds

This blog post is my original answer to the Quora question: What is the best way to set up a fund administrator for a seed fund that has Limited Partners?

blog

Source: Private Equity Demystified – Second Edition

The trouble is that seed funds are often smaller in their total assets under management, but not the number of limited partners. Hence, despite that they earn less in management fees, they have to still perform investor closes, commitment transfers, allocations on capital calls, quarterly NAV statements amongst the plethora of things that only a niche section of the industry, the fund administrators, understand. Unfortunately, the supply and demand mechanics have decided a price that may gobble up a significant portion of your management fees.

To solve this issue, we introduced Fundwave, our fund administration SaaS. With the number of small funds on an increasing trend, we realized that there has to be an automated way of doing things that have so far required expensive accountant billings. How automated you ask? Say you’re sending a capital call notice or a quarterly NAV statement. A typical fund administrator, if they are quite good at it, will take atleast 2 – 4 days to allocate, mail merge and send the reports. With Fundwave, 2 minutes is all you need to generate accurate and compliant reports that would make an institutional investor nod in appreciation. Finally, large PE fund administration software is available to everyone, leveling the playing field for access to institutional capital.

Of course, if you’re a new seed fund working out of a co-working space and have little accounting understanding in the team, you should go for a fund administrator. Ideally choose someone who is not running a spreadsheet allocation and running a mail merge everytime they are reporting for you. Manual processes are expensive not just because of the money you pay, but the reputation loss with your investors if an error occurs. Of course, I am happy to refer you to one of our fund administrator clients if you can’t do it internally with Fundwave.

By |April 9th, 2015|Fundwave Blogs, Seed Funds|

Tired of custom reporting? Drop the spreadsheet and delight investors.

Research shows that 76% of investors in private equity funds expect to increase their requests for customized reports. With the average headcount of the finance team already at 20% – 28% of the total, there is little bandwidth left to meet the increased volume of requests.

What if a ‘custom reporting request’ is no longer the horror word that sends your fund accountant into a tizzy at the quarter end? With Fundwave, we’ve made custom reports as natural as they could get. You define the variables, the report design and generate a so called ‘custom report’ in no time.

Yes, each investor can have a different reporting template. You can even ensure that your templates adhere to the reporting guidelines that your investors love, such as ILPA, IPEV or AVCL. Welcome to the next generation of private equity fund operations. Welcome to Fundwave.

visualreport
A sample report generated through Fundwave

By |March 26th, 2015|Limited partner reporting|