We've studied participating preferred equity securities. We've learned how to build a capitalization table that reflects the evolving ownership of the firm through time, as it continues to raise capital. Now, we want to consider how to exit a VC investment, when an exit opportunity occurs. So this capitalization table that we've built is going to be critical for understanding how to exit the investments, because it lays out the ownership structure of the firm, and it also spells out the rights that different securities have over others. Let's dig in, and learn how to think about how exit occurs, when an exit opportunity arises. Before we dig in there we should stop and ask what is an exit? When I use the term exit opportunity, what do I mean? Well, the term sheet itself, will typically define an exit event. But in broad terms we can think about an exit event as any liquidation, or sale of assets, or merger in which the shares that the investors own are deemed for cash, or potentially for shares in another company. Our sample term sheet, it describes exactly what is referred to as a deemed liquidation event. So the live copied the language of their sample term sheet there below. Most term sheets will spell out in plane details exactly, what they mean when they speak of a liquidation event. Just as it's important to ask, what is an exit? It's also important to ask what is not an exit? What's not an exit? Well, an initial public offering is not an exit. An IPO is not an exit event, it's a fundraising event. The firm is raising money from public capital markets, and in that sense an IPO is more analogous to an additional round of equity investment than an exit event. When an IPO occurs, remember the VC shares will automatically convert to common shares. The exit event is selling these shares in the public market, after the lock-up period has expired. The exit event is not the IPO itself. So that's very important to bear in mind, when we're considering these exit scenarios that we're going to walk through, we want to understand that, these are liquidation events, these are sales of the company to another company or to another investor, these are not IPOs. In the event of an IPO, we no longer hold this right to choose whether we're a preferred equity holder or a common equity holder. Instead the term sheet will invoke that automatic conversion provision, will be automatically converted to common equity, and will be waiting until after the IPO occurs to sell that common equity in the public market. Okay. Let's walk through a variety of exit scenarios using Blue Devil Enterprises as our example. Let's remember the cap table that we built in the previous lesson. We've got three million founder shares, two million options. We have a series A round of five million shares invested by VC1, VC2. We have a series B round of 10 million shares invested by VC1, VC2, and a new VC, VC3. VC1 owns half of the series B round and 60 percent of the series A round. VC2 owns 30 percent of the series B round and 40 percent of the series A round. VC3 has 20 percent of the series B round, and nothing of the series A round. So if we go when we look on a fully diluted basis, we can see that VC1 has 40 percent ownership stake in the company. VC2 has 25 percent ownership stake in the company. VC3 has 10 percent ownership stake in the company. Altogether, they own 75 percent of the company, founders with their three million shares have 15 percent of the company, and 10 percent of the company is reflected by this option pool. So that's the fully diluted ownership structure of the firm. That's what the firm would look like if every investor had converted their series of preferred equity into common equity, and if all the options had been given out, and were exercised. If not that then what, will the series B has a one times liquidation preference to both series A in common. But their participation is capped at three times their investment, as a preferred equity holder. The series A preferred equity has a one times preference to common equity, but is also capped at three times their initial investment. So let's take this capitalization table, and let's walk through a variety of exit scenarios to see how the proceeds will be divvied up between the various stakeholders, depending on the size of the exit. To do that, we're going to consider what's called a liquidation waterfall. What is the liquidation waterfall? Well, it's the order of events that occurs, when we face a liquidation. How do we pay out people? People stand line, and are paid in order they stand in the line. The first standing in line is unpaid debt. If the firm has unpaid debts, those will be paid first from a liquidation. After unpaid debts have been served, then any liquidation preferences would come out next. Typically, these would be paid out by series with the most senior series being paid out first, that's last-in first-out. That'll also typically include accumulated dividends. Now, it's important to pause for a moment, because why is it that we would pay the most senior series first? It seems like the earlier investors took on a lot more risk, shouldn't we reward them for taking that extra risk? The answer is yes, we absolutely should reward them, and we will reward them, bear in mind that the earlier investors invested at a lower price per share. So that one reason why we're going to serve the liquidation preference at the most senior security first, is because that was the most expensive security purchased. It's the typical rationale for why we have LIFO liquidation preferences. We pay the most senior first, that's typically the most expensive security on the cap table, and then by walking from most senior, to least senior, to common, we're walking through the cap table in descending order of price per share. After we serve all the liquidation preferences, we're then going to offer participation alongside the common equity holders up until the cap. To determine that cap what we're going do, is we're going to think about paying out by class of stock first, and then, we'll worry about allocating to owners inside that class. In other words, we care about whether series B is going to convert to common or not, we don't need to worry about whether VC1 is going to make a different decision than VC2. We're going to treat series B as a pool, and it's going to make a single decision. We'll assume that decision applies to each VC in that round. We'll think about series B, what they want to do then, we'll think about what series A wants to do, given what series B wants to do and so forth. So to summarize, if there's enough money, how does this waterfall work? We're going to pay liquidation preferences. The shareholder agreements, the term sheets will give us the exact order in which the liquidation preferences are paid, but it's typically, LIFO senior first then junior in order. After we've paid the liquidation preference is the money that's left over, is the money that will be distributed to common shareholders. We then ask, is it optimal for the option holders to exercise their options? If they don't exercise their options, they're not common equity holders, and they will not receive a distribution. But they'll have to pay a strike price often, in order to convert their options into common shares. So this step is very important, the option holders will look at the strike price of their options, that's the amount of money that they have to pay, in order to convert their option into a common share. They'll ask, is the strike price I'm paying more or less than the price per share I'm receiving in payout? If the strike price is low relative to the price per share, than I would like to exercise my options, we'll adjust the cap table accordingly, and the exit values will be divided up among the correct number of shares. Afterwards, we'll pay out pro-rata to all the series that are participating in the distribution. Of course, will have to be mindful, to remember when each series caps out as a preferred equity holder, and then once a series caps out, then we'll remove them from the cap table, and pay out the remaining distribution to those who are still there.