Examples Class I

1
Examples Class I

• 2007

2
2007

• a) Give five criteria an investor might apply to
  a start-up proposal. 5 marks
• b) What are the differences between debt and
  equity finance ? 5 marks
• c) A software start-up company is developing
  computer games software. They believe their game
  will have potential market of a million units
  selling at a retail price of 49.99. They have
  already raised 1M from Angel investors for 33
  of the company, which has been mostly spent on
  development. They estimate they can complete
  development and become cash flow positive
  following initial marketing, but that this will
  cost a further 1M and take another year. They
  intend to raise this money by selling further
  equity. Price this issue 5 marks
• d) They receive a letter of intent from a
  publisher confirming their market estimation and
  offering 10 royalty on the retail price with
  500K recoupable but non-refundable advance
  (where the publisher will take the first 500k of
  royalty earned to recoup the advance, but will
  not demand a refund if the game fails to sell).
  Should the company take this offer and how does
  this affect the proposed share offer? 5 marks
•  
•  

3

• Give five criteria an investor might apply to a
  start-up proposal. 5 marks
• Global, sustainable, under-served, market need
• Top Team
• Defensible Technological advantage
• Believable plans
• 60 IRR

4

• What are the differences between debt and equity
  finance ? 5 marks
• Equity finance, represented by shares, is where
  a proportion of the ownership of the company is
  sold to investors. They usually, but may not,
  include voting, dividend and other rights. There
  may be additional rights (preference shares)
  such as liquidation options, tag and drag
  provisions. Convertable shares may be converted
  to debt under specified conditions.
• Debt finance is a loan to the company, for
  example a debenture or a bond. It may be secured
  on additional assets. It may be accompanied by
  periodic interest payments (coupons), and may
  have conversion rights to shares in the company
  if the debt is not paid or under other
  conditions.

5
Example preference terms

• 1                    Rights of Series A
  Preference shares 1.1               The
  Preferred Shares shall rank senior to all
  OrdinaryShares of the Company in right of
  receipt of dividends and otherdistributions and
  in right of redemption. 1.2               In
  the event of a merger, liquidation, sale of all
  orsubstantially all of the assets of the
  Company, or winding up of theCompany, the
  holders of Preference Shares shall be entitled to
  receive,prior to the holders of Ordinary Shares,
  an amount equal to 1 (one) time thePurchase
  Price (as adjusted for stock splits, combinations
  and anti-dilutionadjustment), plus any declared
  but unpaid Dividends. After such payment,
  theholders of Ordinary Shares and the holders of
  Preference Shares shall beentitled to any
  remaining proceeds on an as converted basis.
  Thisliquidation preference shall cease to exist
  should the returns to Investorsexceed 25
  IRR. 1.3               Holders of Preference
  Shares (Holders) acting as a groupshall have
  the right to treat any merger which results in a
  change ofcontrol, where control shall mean more
  than 50 voting interest in thecombined entity,
  reorganisation (including sale of substantially
  all assetsof the Company) or other transaction
  in which control of the Company istransferred as
  a liquidation for purposes of the foregoing
  liquidationpreference.  1.4              
  The Preference Shares may be redeemed (as
  adjusted forstock splits and combinations), at
  the option of the holder, anytime after1/01/2011
  but before 1/01/2013 if not converted. If the
  holder elects tohave the Preference Shares
  redeemed, the Company shall redeem the
  PreferenceShares in eight equal quarterly
  payments. Upon exercise of this right,
  suchholders shall be entitled to a redemption
  price per share equal to thegreater of (i) the
  original Purchase Price, plus all accrued and
  unpaidDividends from the date of purchase, or
  (ii) fair market value as determinedby a 3rd
  party appointed by the Board of Directors at the
  time theredemption option is exercised. 1.5
                No other shares of the Company are
  redeemable and/orpurchasable prior to the
  Preference Shares without the prior written
  consentof holders of a 60 of the Preference
  Shares. 1.6               The Preference
  Shares are convertible into Ordinary Sharesat
  any time at the option of the holder at a ratio
  of 11 (the ConversionRatio), subject to
  adjustment in the event of stock splits,
  anti-dilutionadjustments and combinations. 1.
  7               The Preference Shares shall
  automatically be convertedinto Ordinary Shares,
  at the Conversion Ratio, in the event of either
  (i)the closing of a firm commitment underwritten
  public offering of shares ofthe Company on an
  recognised exchange with an aggregate offering
  netproceeds to the public of not less than 10
   million and at an offeringprice not less than 2
  times the Purchase Price (as adjusted for stock
  splitsand combinations) (a Qualifying IPO) or
  (ii) the election of the holdersof at least 60
  of the outstanding Preference Shares. 

6

• c) ) A software start-up company is developing
  computer games software. They believe their game
  will have potential market of a million units
  selling at a retail price of 49.99. They have
  already raised 1M from Angel investors for 33
  of the company, which has been mostly spent on
  development. They estimate they can complete
  development and become cash flow positive
  following initial marketing, but that this will
  cost a further 1M and take another year. They
  intend to raise this money by selling further
  equity. Price this issue 5 marks

7

• Liquidation/asset value zero
• Cost to date 1m
• Total market 50M say 10 achievable 5M, less
  costs of 2M 3M
• Previous round equity value (1M for 33) 3M
• Rule of thumb say 33 per round, raising 1M 2M
  pre money
•  

8

• Thus 1M for 33 of the company is defensible.
• However computer game development is a high risk
  area, with only something like 3 in 100 games
  being successful enough to earn royalties over
  and above advances and cost to develop, so the
  price of the issue will critically depend on the
  company being to show evidence of customer
  acceptance. Such evidence might be a ringing
  endorsement from a preview in a trade magazine, a
  successful beta test, past track record, or other
  industry endorsement

9

• They receive a letter of intent from a publisher
  confirming their market estimation and offering
  10 royalty with 500K advance, How does this
  affect the proposed share offer? 5 marks
•  
• A publisher offer is good evidence to reduce the
  apparent market risk. Even if the company do not
  take the offer it is confirmation of the
  potential market.
• A publisher also has established routes to
  market, which is more likely to make the game
  successful and reduce the companys marketing
  spend. The publisher will add marketing prowess,
  marketing budget, established channels to market
  and the ability to trade off between titles in
  their portfolio to ensure that retailers take a
  new title.
•  
• However there may be concerns over the timing of
  this income the publisher will be in no hurry
  to pay over the royalty, and indeed delays of 6m
  to 12m from release before payment of royalties
  net of advances might be a serious concern to the
  company and its investors
•  
• The deal suggests a total income of about 5M,
  but external cash need is now only 500K. The
  cash can be raised by the company later when
  development and market risk may be lower. Thus
  the expected income is 5M against costs of
  1.5M, valuing the company at 3.5M, so 500K
  represents 14.2. of the company.
•  
• More radically, since the company is near income,
  with an assured publishing customer debt
  financing should be considered. 500K for 1 year
  would cost say 50K, which would be a cheaper
  option. Loans for this sort of development are
  possible from specialised media investment teams
  in the UK and EU, but they will usually require
  some lien over the technology IPR and the
  creative IP as well as substantial fees (which
  might approach 20 of the funds raised).

10

• Taking the publishers offer reduces the risk and
  the cash need. However, it means the company
  does not establish an independent brand and
  distribution for its products, both of which are
  expensive and difficult, even online. Taking the
  offer may constrain future directions.
• In particular it may lessen the options for
  future acquisition. Limiting the scope, for
  example in time, or geographically, or to boxed
  product only may help.
• Whether to take the publishers offer depends to
  some extent on the ambition of the directors
  however the independent route may take
  considerably more cash (and hence dilution) than
  they currently budget. For a first product it
  would be wise take the offer, but negotiate terms
  that allow the establishment of an independent
  brand at a future date. After all, if successful,
  the team would have 4.5M of cash on hand (5M
  less 500k advance) with which to reward
  investors and invest in the next game.