FIN 435 Exam 1

What are the income and asset (should be net worth) requirements for an accredited investor?

$200K income ($300K for married) / $1 million net worth

You are interviewing for a position at a start-up. You expect to receive options as part of your compensation package. If you receive options on 100 shares, how many of these shares would you expect to vest after one year based on the market standard vesting schedule?

25

A VC says he'll invest $10 million for a 25% stake, but will need a 5% option pool. How much will the current investors own on a fully diluted basis after this investment based on these terms?

70%

Pay to play:

A lead investor may want to require that all investors must continue to participate in future rounds or lose certain rights, such as their liquidation preference.

Name two angel groups in Kentucky.

Bluegrass angels (Lexington), Enterprise angels (Louisville)

Global Humanity Fund is managed by Global Humanity Managers LLC. The managers make a fee of 2% a year and 20% of profits. What is the 20% called?

Carried interest

20. Investors always require audited financial statements for start-ups. True/False

False

20. Investors always require directors and officers insurance for start-ups. True/False.

False

20. It takes over one week to obtain a Federal taxpayer ID number. True/False

False

25. The expected return of public company stock is higher than that of a start-up. True/False

False

25. To qualify as an Accredited Investor an individual must have at least $5 million in assets. True/False

False

Compensatory options for start-up employees usually vest over three years. True/False

False

Drag along rights:

If one group of shareholders agrees to a sale, all of the other investors must agree as well.

Preemptive rights:

Investors typically have the right to invest in future rounds to preserve their percentage ownership.

Anti-dilution provision:

Investors typically will want to be protected from dilution from shares being issued in the future for less than the amount that they pay, often called a "down round." This is generally accomplished by issuing the existing investors additional shares in such an event.

Protective provisions:

It is common that certain major corporate events, such as a sale, must be agreed to by a majority or super-majority of each class of shares. This allows a minority investor to be protected from the unilateral will of the majority. Note that there is always some degree of protection in the form of fiduciary duties owed by directors and officers to all shareholders.

Name two local resources (people or organizations) in Lexington that could help Dina raise a seed round.

KSTC, Bluegrass Angels, Awesome Inc., Von Allmen Center for Entrepreneurship, Kentucky Innovation Network

1. Mike forms an entity, does some research, builds a prototype for his platform and realizes he needs more money to hire developers. He is based in Lexington, KY. He asks you for the name of two organizations in Lexington that may be able to give him some guidance as to how to go about raising money. What two organization do you point him to?

KY Innovation Network, VonAllmen Center, Awesome Inc, Bluegrass Angels, KSTC

Describe how Limited Liability Companies are different from Corporations for tax purposes.

LLCs are taxed as pass through entities so there is not separate layer of tax as with corporations. See study guide for more.

Circle early stage or late stage next to each type of funding source as appropriate. IPO Private Equity Fund Angel Strategic Investor Accelerator

Late Late Early Late Early

1. Are investments in venture capital funds liquid? Yes / no

No

20. Does "de-risking" usually reduce valuation? Yes/no

No

Are the terms of a term sheet such as pre-money valuation and voting rights usually legally binding once the term sheet is signed? Yes / no

No

Are venture capital funds usually public? Yes / no

No

Dina goes to a local bank and asks for a loan for Dina's Directory. She does not want to personally guarantee the loan. Is the bank likely to make this loan? (yes/no)

No

Dina is concerned that VC's might steal her idea. Is a VC likely to sign a Non-Disclosure Agreement (NDA) with her? (yes/no)

No

Part 3: With the funding from Eric Dina hires a few tech people to grow the platform. She also has a big idea for how to monetize the platform - Reverse Applications. Users of Dina's Directory will never again have to apply for credit cards, jobs, schools, etc. Organizations will anonymously screen users and make blind offers that users can chose to accept or not. The user's data never leaves the platform. She'll charge the organization big bucks for the use of this efficient advertising/selection platform. She gets significant customer traction with this new business model and now has significant VC interest. Would all VC firms be interested in a firm at this stage and business model?(yes/no)

No

What is the benefit of getting a grant versus selling equity?

No dilution

Name one reason why Dina might consider a sale of tokens rather than equity.

No dilution. Network effect.

Name one example of how Dina might be personally liable for the company's actions even though she incorporated.

She does not follow all of the steps to ensure that the entity is respected as separate - piercing the corporate veil. She doesn't pay payroll tax. She is sued for workers comp without insurance. Breach of fiduciary duties.

Name one benefit to a company of issuing debt instead of equity.

Tax deductions, no dilution

You are given stock options with net share settlement. You have the option to buy 5,000 shares at $20 per share. The current price of the shares is $25 per share. How many shares would you be given to settle the option?

The build in gain is 5,000 * ($25 - $20) = $25,000. This equal 1,000 shares at $25 per share.

Name one situation in which a token sale would likely be treated as the sale of a security?

The investment is promoted to increase in value. The proceeds are used to build the service being used by the token.

Name two reasons why Dina might choose to fund the company with her own money rather than taking funding from others.

To avoid dilution; she thinks the valuation is too low; to show that she is committed (skin in the game)

20. The expected return of public company stock is lower than that of a start-up. True/False

True

Cap tables are shown on a fully diluted basis to reflect the potential exercise of employee options and warrants. True/False

True

Could Dina form her company in Delaware if it is based in Lexington. (Yes/No)

Yes

If you own 100% of a single member LLC, is it possible for this LLC to be disregarded for U.S. Federal income tax purposes? Yes/No

Yes

1. Eric is interested in investing $1,000,000 for 30% of the company. a. What is the post-money valuation? b. What is the pre-money valuation? c. How many shares will Eric receive (remember Dina issued herself 1,000,000 shares).

a. $1,000,000 / .3 = $3,333,333 b. $3,333,333 - $1,000,000 = $2,333,333 c. 1,000,000 / .7 = 1,428,571 - 1,000,000 = 428,571

There are 10,000,000 million shares outstanding before the Series A round. The investors in the Series A round will invest $8,000,000 for $15% of the company. a. How many shares will the investors receive? b. What is the post money valuation?

a. 1,764,706 = (10,000,000/(1-.15) - 10,000,000) b. $53,333,333 = $8,000,000/15%

22. Global Humanity Fund is interested in Dina's Directory. They are thinking of investing $10,000,000 for 25% and they'll need a 10% option pool. a. What percentage of the company would Dina own after this round? b. What would Dina's shares be worth after this round?

a. 45.5% = 70% * 65% b. Post money value = $40,000,000 45.5% of $40,000,000 = $18,200,000

1. Who is primarily responsible for fundraising at a startup? a. CEO b. Board of directors c. CFO d. Advisors e. Founders

a. CEO

What do you call the compensation that a VC fund manager receives as a percentage of positive returns on the investments? a. Carried Interest b. Kicker Interest c. Bonus Interest d. Gravy Interest

a. Carried Interest

1. What does it mean for a term sheet term to be "on market": a. Common b. Liquid c. Over the counter d. Exchange traded

a. Common

1. Which type of investor gets paid first in a liquidation of the company? (2 pts) a) Holder of preferred stock b) Holder of common stock c) Holder of tokens

a. Holder of preferred stock

1. Why would an investor prefer debt to equity? a. More certainty of repayment. b. Tax benefits. c. Voting rights.

a. More certainty of repayment.

1. Eric asks for the right to invest in future rounds to maintain his 30% ownership. What is this term called? (2 pts) a. Preemptive right b. Acceleration right c. Leveling right d. Peremptory right

a. Preemptive right

1. Mike wants to sell some of the equity in his company to individuals. How would this likely be done from a securities law perspective? a. Private placement b. Registered public offering

a. Private placement

Who usually delivers the first draft of a term sheet? a. Start up CEO b. Start up CFO c. Investor

a. Start-up CEO

1. Which of these documents is a VC more likely to sign? a. Term sheet b. Non-disclosure agreement

a. Term sheet

1. Which of these terms could be triggered by a down round (circle all that apply)? 4 pts a. Anti-dilution provision b. Preemptive rights c. Liquidation preference d. Pay-to-play

all except for c. Liquidation preference

1. Which of these are reasons why start-up investments require high expected returns (circle all that apply). a. Lack of liquidity b. Execution risk c. Funding risk

all of them

25. Additional shares are given to the investor in the event of a down round.

anti-dilution protection

25. A term for the transfer of property that starts with an "A".

assignment

1. Mike successfully raises $1,000,000 for 20% of his company in the seed round. What was the pre-money valuation? a. $3,000,000 b. $4,000,000 c. $5,000,000

b. $4,000,000

1. What is a common discount rate to use with convertible debt used as a bridge? (2 pts) a) 0% to 10% b) 10% to 30% c) 20% to 50% d) 30% to 60%

b. 10% to 30%

What is a market standard dividend rate on preferred stock? a. 2% b. 6% c. 15%

b. 6%

22. An anti-dilution term protects an investor against dilution from a: (2pts) a. An up round b. A down round c. A step down round d. A low down round

b. A down round

20. ABC Program is a competitive 12 week program that helps start-ups with mentorship and networking. At the end of the program there is a demo day with investors. What is the best way to describe the ABC Program? a. Starter b. Accelerator c. Catalyst

b. Accelerator

1. Mike gets a grant for $100,000 from the state of Kentucky to develop the idea. Why might Mike like this grant better than issuing equity? a. Because it requires him to hire people in Kentucky? b. Because it does not dilute his ownership? c. Because he will need to pay it back at some point?

b. Because it does not dilute his ownership

20. When would it be normal for a compensatory stock option to accelerate vesting? a. Termination for cause b. Change of control c. Change in management d. Force Majeure event

b. Change of control

1. Which of these services can be used to research start-up company fundraising (circle all that apply)? a. TD funding b. Crunchbase c. Angel list d. Techmoney e. CB insights

b. Crunchbase c. Angel list e. CB insights

1. Dina builds a basic version of her people directory to prove that people will sign up for the service. Based on the vocabulary we used in class, this is a form of: (2 pts) a) Safening b) De-Risking c) De-Threatening d) Unfurling

b. De-risking

25. Which of these is likely to be a strategic investor? a. An angel b. IBM c. Sequoia Capital

b. IBM

25. Which people are not high profile venture investor that we discussed in class (circle all that apply) : a. Fred Wilson b. John Meyers c. Paul Graham d. Erick Lycan

b. John Meyers d. Erick Lycan

Part 2: Dina is able to get information on over 200 million people for her directory, including celebrities from all over the world and a large part of the US population. People are starting to use the directory for things like genealogy, alumni relations, finding employees, etc. Dina has a bigger idea. What if the directory could serve as people's digital identity. It could be the definitive source of truth about people online and represent the whole digital person, rather than the fragmented identities that people have today. She decides she needs to bring in funds from investors to make this happen. 1. When she raises money from investors, what type of instrument will she likely use? (2 pts) a) Common stock b) Preferred stock convertible into common stock c) Debt

b. Preferred stock convertible into common stock

A public issuance of shares normally must be registered with the SEC. What is the common name for the type of securities offering that is exempt from registration requirements: a. Primary Placement b. Private Placement c. Privileged Placement d. Preemptive Placement

b. Private Placement

1. Which of these is more likely to invest in a start-up that expects to IPO in two years? a. Angel investor b. Private equity fund

b. Private equity fund

1. We talked a lot about the importance of de-risking. What does this term mean in the start-up context? a. Insuring against funding risk b. Reducing risk to increase valuation c. Shifting risk to competitors Spreading risk to employees

b. Reducing risk to increase valuation

25. Which comes first? a. Series A Round b. Seed Round c. IPO

b. Seed round

1. What is the post-money valuation with these terms? a. $2,500,000 b. $30,000,000 c. $40,000,000 d. $42,500,000

c. $40,000,000

1. Mike's identity platform goes viral with customer acquisition growing at 40% per month for the past 12 months. Many investors are interested in investing in the A round. Mike wants to raise $10,000,000 for 25% of the company. How much of the company would Mike own after this deal, assuming no option pool. Remember that Mike sold 20% in the seed round and he was the only investor prior to that round. a. 20% b. 50% c. 60% d. 70% e. 75%

c. 60%

What is a reason why an early stage start-up would issue equity rather than debt? a. Because the dividends are deductible for tax purposes b. Because investors like the certainty of equity c. Because they can't raise debt

c. Because they can't raise debt

What is the term that requires an event to occur prior to funding? a. Conditional President b. Contractual Prefect c. Condition Precedent d. Confrontational Precept

c. Condition Precedent

1. The investors require that Mike get D&O insurance prior to closing the deal. This type of term is referred to in legal language as a: a. Threshold term b. Gating term c. Condition precedent d. Conditional antecedent

c. Condition precedent

1. Which type of investment is most likely to be the cause of bankruptcy? (3 pts) a) Common stock b) Preferred stock c) Debt d) Convertible preferred stock

c. Debt

1. Mike thinks that he will never need to raise funds for this company and he wants to use the tax losses from the business personally in the year that they are created. What type of entity should he form? a. Corporation b. Sole proprietorship c. Limited Liability Company

c. Limited Liability Company

What is the name of the legislation that made equity crowd funding possible? a. The START Act b. The SMART Act c. The JOBS Act d. The MOBS Acts

c. The JOBS Act

25. A tool for keeping track of investments through multiple rounds.

cap table

25. VC's will make this to request pre-committed funding from an LP in a VC fund.

capital call

25. The compensation to the VC manager in the form of a percentage of profits.

carried interest

25. An event that must occur prior to the closing of a deal.

condition precedent

Do VCs generally prefer Corporations or LLCs?

corporations

1. How many shares will need to be issued to the investor under these terms? Assume Mike founded the company with him owning 1,000,000 shares. 4 pts a. 133,333 b. 250,000 c. 333,333 d. 416,667 e. 500,000 f. 616,667

d. 416,667

1. Dina creates Dina's Directory as a Delaware Corporation. She issues herself 1,000,000 common shares. How would you describe Dina. (3 pts) a) Angel b) Venture Capitalist c) Grantor d) Founder

d. Founder

1. Queen City Angels gives Mike a term sheet. They want to help raise a round of $1 million and invest $250,000 themselves. They will lead the due diligence and take a seat on the board. What would you call Queen City Angels in this case. a. Prime investor b. Main investor c. First investor d. Lead investor e. Head investor

d. Lead investor

22. Which of these describes a Network Effect (3 pts) a. The more volatile the returns the lower the value b. The higher the frequency of the network the great then number of users c. The higher the price per unit the higher the value per unit d. The more users the more valuable the service to each user

d. The more users the more valuable the service to each other

25. A round in which the stock price has fallen from the previous round.

down round

1. How much would Mike's ownership interest be worth after this round? 4 pts a. $8,000,000 b. $18,000,000 c. $21,500,000 d. $22,500,000 e. $24,000,000 f. $28,000,000 g. $30,000,000

e. $24,000,000

Name two components of the Howey test?

i. Investment of money ii. Common enterprise iii. Expectation of profit iv. From the efforts of others

Name two reasons why Dina would want to create a legal entity to hold this business.

limited liability; facilitate fundraising

25. A term given to investors in start-ups that puts the investor in front of common stockholders in terms of return of investment in a liquidation.

liquidation preference

An alternative form of settling an option contract in which the holder of the option is not required to buy the shares.

net share settlement

25. Existing investors are required to invest more or they lose certain rights.

pay to play

25. The right to purchase shares in future rounds to maintain percentage ownership.

preemptive rights

25. These terms provide special voting rights to certain classes of shares in extraordinary events such as a sale of the company.

protective provisions

Money that a VC will set aside to make future investments in start-up companies that it invests in.

reserve

What is the term for the money that a VC fund holds to make additional investments in start-ups following the first investment.

reserve

25. If one group of investors sell, another group has the right to join them.

tag along

25. Another name for an option to buy company stock. These are often given to investors.

warrant