Syllabus

Module 1: Foundations

The Why of Entrepreneurship

This first module is to simply acquaint the student with how projects come to be entrepreneurial endeavors - the why of entrepreneurship. Within the context of this case study, the why is obvious - deep subject-matter expertise and a developed prototype make stepping out of the corporate environment easier.

I highlight with my own students the social privilege that this kind of entrepreneurship requires. Not only does it require the time/education to develop the deep expertise, but, more importantly, it requires the family and social privilege of leaving a good-paying job, being able to forego health insurance, and having corporate or personal connections that will make this endeavor significantly easier than if none of these factors exist.

Conceptual Basics

Moreover, this first module introduces basic concepts in high-growth entrepreneurship. While there are numerous concepts that could be brought up here, this case study highlights two: the role of different kinds of equity (cash v assets v labor) and basic cap-table management. The cap-table management piece can get as crazy as you want with this (as it does in real life :\ ), but it stays relatively simple here (at least until Module 5, but even then it only introduces Employee Stock Option Plans and its impact on the cap-table). A legal class might choose to take a deep dive on the tax consequences of cash/assets v. labor in exchange for equity. My experience with entrepreneurship is that founders are often very willing (and able) to exchange labor for equity, but as the company gains value this trade-off may become prohibitive. A short diversion down the 83b rabbit hole might be fun, if you consider that kind of thing fun.

Module 2: The Deal

Term Sheet Analysis

The large thrust of this module is digging into the nuts and bolts of a high-growth term sheet. Depending on the students there are a lot of approaches to take with this. If the audience is first-time entrepreneurs simply identifying the basic elements and the major points of tension are probably sufficient. For more advanced students, digging into term sheet math, the full consequences of anti-dilution, and the different effects of corporate governance levers might be appropriate.

Valuation is always a big teaching moment. Many students enter into this case study not fully understanding how valuations are arrived at. Critically few realize that there isn’t “a” valuation but rather a “who’s asking and why” approach with valuation. They rarely have the insight or language to understand the information asymmetry present in these negotiations. Having the students think through how BigTech might approach valuation and the information they might have and then jumping to the other side and thinking about how NewCo might approach the valuation question is a valuable exercise in its own right.

A second order analysis might ask the students to think about valuations in the future contemplated funding round and thinking about how the company gets from where it is (negotiating for IP rights) to there ($2M+ in funding presumably at a valuation somewhere near $6-10-ish Million) within the timeframe that the term sheet contemplates (which is nothing explicit, but it is clear that BigTech intends that this technology develop with some pace). What would a company with that valuation look like? What assets? How many people? What kinds of people? How much in sales? How much money will it cost to build that company (hopefully $2-ish Million!)?

I highly recommend Brad Feld’s “Venture Deals” book. It walks through a term sheet’s terms from the entrepreneur’s point of view. It explains what each potential term might mean and provides justification for both sides negotiating the clause, why, and how that clause to read the way it does in the usual course. He walks through countless examples. It is a perfect text for entrepreneurs, business students, and law students.

Intellectual Property

Similar to valuation, students often have little appreciation for the complexity of intellectual property development and ownership. When students see the IP terms in the term sheet, almost unanimously they jump to the conclusion that NewCo should take ownership rather than continue to license and initial redlines for negotiation often start with that premise. Not only is this approach unlikely to be fruitful for obvious reasons (BigTech is unlikely to simply give them the IP for a whole host of reasons), students rarely appreciate that NewCo may not actually want to own the IP; they do not appreciate the cost of defending that IP in the context of potential infringement. And, especially in this industry where there are numerous big, established players, having BigTech owning the IP and responsible for its defense is a far stronger deterrent to potential infringement than NewCo’s ownership of the IP.

Secondly, students often place too much value on IP as it sits in an early stage. While this IP may be “foundational” for creating the business, the simple reality is that it is likely change signficantly before the finished product hits a market. Thus, the IP in its current stage is likely very different from the IP just even a few years from now. Indeed, given the pace of innovation, it could be so wildly different as to be practically meaningless in the context of the future product. Thus, students spend a lot of time thinking about the IP they are getting, but thinking very little about the IP they are developing. A license that permits development and ownership of the derivative/new works might in fact be far more valuable than ownership and prosecution of a patent application that may be obsolete by the time it issues.

Module 3: The Exercise

This exercise is a lot of fun for the students. It was developed in the Law & Entrepreneurship Clinic at University of Wisconsin. At the time we were not particularly time constrained, so I didn’t really give much thought to timing. As I led this case study in other settings, I had to fit it into a more structured class timing. Our law school classes tend to be in 55 minute timings. So, giving the assignment at the beginning of class (about 5-ish minutes), 40 minutes to discuss the problem amongst themselves (total: 45 minutes), and other 10-ish minutes to report out has worked pretty well. I recommend teams no bigger than 4; 2 or 3 is ideal. You want an even number of teams, though, because in Part II teams will negotiate against each other.

I think you’ll find that in the report out most teams center around the same things; so, after the first team reports their major terms you can just solicit where other teams’ discussion differed or got into different issues. I find it helpful to circulate amongst the teams and listen in and help guide the conversation a little as students can sometimes get lost in irrelevant or non-productive holes. If you want the environment a little more competitive you can skip the reporting out period for this first part so that the teams don’t hear how the others marked up the term sheet.

Remember: everyone represents NewCo at this point. The term sheet is, at some points, fairly vague or open to interpretation about what it means. This is not a bug, it is a feature of information asymmetry and imperfect language that sometimes you have to guess about what something means before you can actually get on the phone with the other side. It can be useful to think about how the teams might use that imperfect language to their advantage.

There are two parts to this exercise: Part I takes 40 minutes or so and can be expanded to fill a longer class period, though I would be reluctant to let it go much longer than an hour and to take much more than 15-20 minutes for reporting out.

Part II includes 3 different timings for the exercise depending on how much time you have in class to do this. I have found more time typically results in better negotiations. But, it may not be practical to have teams negotiating outside of class.

In Part II, I take half the teams and declare them to be BigTech; the remaining teams remain as NewCo. Once they are paired up, the NewCo team will present their redline to BigTech and you’re off to the races. If they aren’t negotiating outside of class, I find it helpful, again, to circulate amongst the teams to help them stay on track and move the conversation forward. One fun part about these negotiations is that students almost never have experience with this kind of negotiation, so they have very funny ideas about how the terms can and should be negotiated. I encourage this and then talk about it later during a debrief session that might bring up points about professionalism and balance of power in negotiation.

In the longer class session and outside negotiation, I will have students upload their “final” redline to a document repository (Google Drive, for example). Then each set of teams can talk through how and why they arrived at their final draft. What concessions had to be made, what as their BATNA, etc. This report out can take anywhere from 30 minutes to a full class period depending on how detailed you want to get with the review and other discussions. I will often use this as an opportunity to discuss some of the finer points on valuation, intellectual property, venture capital norms, etc.

Module 4: Pro Forma Financials and Projections

There are a variety of ways you can handle this module. The material covered is pretty standard corporate finance 101 kind of stuff. Much like the legal side of this case study, you can get as complicated as you want with it.

This exercise will really let you dive as much as you want into playing with the numbers and doing the kind of research that a startup would have to do to prepare this information. The limiting factor with the exercise is simply that you aren’t given much hard data (lease rates, salaries, benefit packages, equipment costs, etc.) so students will need to get creative in developing that material (Module 5 is the financial statement exercise). This isn’t that unusual from the research that the startup (NewCo) would have to do themselves. They might know what their immediate costs are, but they still need to go out and look at office space, ask a corporate real estate person about standard lease rates for what they are looking for, calculate that cost over their financing period, and the go out and raise that money.

I think the key thing that this module focuses on that might be unusual is the sources and uses of funds statement. I started using this document in the non-profit context. But increasingly my work with startups has focused on the “capital stack” which is really just “corporate-speak” for Source and Uses of Funds.

More importantly, the focus should be on the fact these don’t need to be exact. At this stage, there is no quarterly annual report requirement that has to comply with SEC standards. So, students don’t really need to learn that. But they should learn and be somewhat engaged with a balance sheet, but really understand the P&L and Cash Flow documents as they relate to investor metrics such as burn-rate, monthly recurring revenue, fixed costs, and cost of goods (or services) sold.

Even more importantly students should understand financials in the entrepreneurial context (as will be required in Module 5) to tell a story about the company. What is important and how is that represented in the financials? Which pieces of financial data are particularly important? etc.

There are a lot of great resources available for this stuff. But the real hero is Prof. Aswath Damodaran at NYU’s Stern School of Business. He publishes all of his materials online and it is a trove of information about the basics of corporate finance and has all of the right information for this case study.

Somewhat coincidentally, the NYU School of Law’s Institute for Policy Integrity has a powerpoint presentation looking at how to use financials to tell a story. There isn’t much context around it, but I think the slides are pretty self-explanatory as to what is going on with the data to tell the story. I really like the slides on performance ratios. Plus, the deck also goes into really interesting detail about how to think about complex regulatory or industry environments. I would not use this deck as a model for investor pitching, though :D

Module 5: Pitch Competition

Shark Tank

The end result of this exercise is built on an in-class exercise that we have done in the L&E Clinic for years and was one of the first in-class exercises I created as an educator. Students always have a lot of fun with it. In the original exercise, I assigned Shark Tank videos on YouTube for the students to watch, then students would adopt that product as their own and give a pitch. The other students acted as the “sharks” as they were each given $50,000 to “invest” in any of the other teams; they were required to invest all $50,000 to prevent students from just not investing. Like Shark Tank the “sharks” could ask questions at any time. At the end of the exercise we totalled up the amount that each shark invested and the team that came closest to their ask was named “the winner.” Unfortunately, I had to end this competition when ABC/the owner of Shark Tank started methodically removing all of the “full pitch” videos from YouTube. Boo!

This current exercise adopts the pitch and investor piece of the Shark Tank exercise, but increases the difficult substantially to be much more realistic for a startup just getting started. To properly prepare this pitch deck the startup needs to have a solid understanding of not just current financials (generally pretty straightforward), but projected financial (far less straightforward). They need to be able to justify to investors that the money invested will be well-spent (capital stack/sources and uses). They need to have solid understanding of their customer and of the current competitive environment. All of this data is hard to develop and present coherently.

There are a few solutions to the difficulty of this exercise: Least Difficulty: simply adopt a more “shark tank” style approach. I’d recommend finding accelerator pitches on YouTube or wherever and assigning those to student teams.

Modest Difficulty: provide all teams with a competitive analysis and some basic projected financials to work from. There is no reason why all teams can’t start wtih the same data, so you would only need to create this once (or you could even have AI generate it for you; perhaps a future iteration of this case study I will do exactly that).

Most Difficulty: The exercise as proposed. This should be a relatively straightforward financial/competitive analysis for anyone in the second year of an MBA program. Upper level undergrads could probably get through it if they have a background in finance and/or strategy and/or entrepreneurship. Any other audience will probably need some to significant help or classroom education before taking it on at this difficulty.