Ken Montgomery, founder of XL NanoDevices, invested $50,000 as seed money from his personal funds when he started XL in April 2019. His co-founder, Steve Moore, invested $25,000 at the same time. Arbitrarily, they decided to issue 1,000,000 shares of common stock to themselves as founders and sole owners when they filed XLs incorporation papers with the state. Ken, who had the initial idea for XL and who had invested the greatest amount of sweat equity to date, received 750,000 shares of XL common stock while Steve received 250,000 shares. No other shares have been issued since.

What % of the company must Timberlake acquire in April 2021 if they fund the $3,000,000 Series A round?

Question #1b. How many shares of XL stock will Meg acquire at the time of conversion of her convertible note? What will be her effective price per share? Does the valuation cap on the convertible note affect the number of shares Meg acquires? Explain.

Question #1c. What % of the company must Timberlake acquire in April 2023 if they fund the full $7,500,000 Series B round? How many new shares of XL stock should they acquire? What should be the price per share? What are the pre-money and post-money valuations of this round?

Question #2. At the planned liquidity event in April 2026, what will Kens shares in XL be worth? What annual rate of return (compounded) on his original $50,000 investment does this represent? What will Steve Moores shares be worth? What annual rate of return (compounded) on his original $25,000 investment does this represent? Explain any difference between the rate of return earned by Ken and that earned by Steve.

Question #3. Ken is also considering the alternative of eliminating the Series B round and, instead, raising the total amount of $10,500,000 in the Series A round. He assumes the investors in this priced round would require a 50% p.a. (compounded) rate of return. After analyzing this alternative, Ken decided not to pursue it. Why did he decide this?

Question #4. Based on their prior experience, Timberlake believes that stock options will be needed as incentives to recruit a senior management team for XL. They convince Ken to plan for the future creation of a pool of new XL shares for such option incentives equal, in total, to 15% of the company at the time of the liquidity event in 2026. Given this plan to create a future pool of incentive stock options immediately prior to the liquidity event, recalculate your answers to questions #1a, #1b, #1c and #2.

Question #5. Immediately before the Series B round, it becomes apparent that the liquidity event will be delayed one year until April 2027 and that a third, Series C, round of financing for $1,000,000 will be required in April 2026. It is anticipated that the investors in this third, mezzanine or bridge round will require a 25% p.a. (compounded) rate of return. At the time this delay becomes apparent, Timberlakes Series A investment is already a done-deal and cannot be renegotiated. The future creation of a stock option pool, as described above, is still included in XLs plan. Despite the delay, the estimated terminal value of XL remains unchanged. How does this change your answers to question #4? Given this delay scenario, what compound annual rates of return are actually realized on the Series A, Series B and Series C rounds of investment?

Question #6. During the Series B term sheet negotiations, it is agreed that Timberlake will receive convertible preferred stock in return for its Series B investment (the founders shares, Megs shares, the Series A shares and the option pool shares are common stock). The difference here between common and preferred shares is that preferred shareholders receive a fixed annual dividend payment equal to a prescribed percentage of their original investment. In this case, Timberlake negotiates for a cumulative non-cash non-compounding dividend of 11% per annum. At the time of the liquidity event in 2026, each preferred share is convertible into one new XL common share and the accumulated dividends are convertible into new XL common shares at the original price per share paid by the Timberlake for its Series B shares. Timberlake priced the XL deal assuming that it received non-dividend bearing common stock (i.e., the same assumptions used for Question #4, above). Note: the option pool equals 15% of the company, including the new converted dividend shares, at the time of the liquidity event in April 2026. What will be the VCs actual annual rate of return on their Series B investment as a result of using this type of preferred stock? What is the effect on the rate of return realized by Timberlake on its Series A investment? What effect does the use of preferred stock in Series B have on the amount of cash distributed to the founders and to Meg? (In answering this question, ignore the delay scenario of Question #5).

Question #7. During Timberlakes Series B term sheet negotiations, they proposed using a hybrid security called participating preferred stock for its Series B investment. This security is like the convertible preferred stock described above, but it has an additional benefit in that, at conversion (i.e., at the liquidity event in 2026), the entire original Series B investment is also repaid to the shareholder in cash prior to any other cash distributions. Ken rejects this proposal. What compound annual rate of return would Timberlake have realized on its Series B investment as a result of using participating preferred stock? What compound annual rate of return would the use of participating preferred stock for Series B have had on the rate of return realized on Timberlakes Series A investment which would not be participating preferred? What will be the cash distributions under this proposal to the founders and to Meg? (In answering this question, ignore the delay scenario of Question #5). EAS545 21A Timberlake priced the XL deal assuming that it received non-dividend bearing common stock (i.e., the same assumptions used for Question #4, above). Note: the option pool equals 15% of the company, including the new converted dividend shares, at the time of the liquidity event in April 2026. What will be the VCs actual annual rate of return on their Series B investment as a result of using this type of preferred stock? What is the effect on the rate of return realized by Timberlake on its Series A investment? What effect does the use of preferred stock in Series B have on the amount of cash distributed to the founders and to Meg? (In answering this question, ignore the delay scenario of Question #5).

When the company was launched in April 2019, the founders also secured the backing of Meg Ferris, a local angel investor with substantial experience in their technology. Meg invested $300,000 in XL in the form of a convertible note. Terms of the note included: (i) a compounding interest rate of 6% per annum; (ii) a duration of 24 months; (iii) a conversion discount of 20% tied to the Series A share price; (iv) a $1,000,000 minimum future financing for conversion of the note; (v) a pre-money valuation cap on the note of $6,000,000; and, (vi) if XL is acquired prior to a Series A financing, Meg would receive 150% of the notes principal investment amount.

As of today, April 2021, Ken and Steve have successfully developed a working prototype of their revolutionary new drug delivery nanoparticles and are beginning to attract favorable attention from a number of research laboratories at large pharmaceutical companies.

Timberlake Associates, a regional venture capital firm with considerable experience in nanotechnologies, has been introduced to Ken by Meg and is considering an investment in XL. Timberlakes people have reviewed XLs business plan and have conducted enough due diligence to get comfortable with such an investment. The business plan calls for a first, Series A, round of financing of $3,000,000 in April 2021 and a second, Series B, round of $7,500,000 in April 2023. Timberlakes target rate of return is 50% per annum (compounded) for the Series A investment. They desire a target rate of return of 40% p.a. (compounded) for the Series B round.

XLs business plan anticipates that a strategic corporate investor will acquire XL in 5 years (i.e., in April 2026), this being the exit strategy for XLs investors. Proforma income statements provided in XLs plan project annual sales revenues to be $15,000,000 in 5 years under a success scenario. The investors believe that a typical price/revenues ratio for similar early-stage high-tech companies is about 5:1.