5-815-106 2015 Fast Ion Battery TN-2

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Santa Clara University *

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Finance

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Feb 20, 2024

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Teaching Note — Fast Ion Battery 815- 106 Pedagogical Overview At HBS, this case is taught in the elective course, Entrepreneurial Finance, in a module on “Experimentation and Real Options in Entrepreneurial Finance”. The module focuses on the benefits and the frictions associated with multi-stage financing, with an aim to help students match with the most appropriate investors, given their location, industry and the point in the funding cycle. Fast Ion Battery is the first case in this module and introduces students to the issues associated with multi- stage financing from the perspective of investors. The objective is to help students appreciate the sets of issues their counterparts are considering, and hence be better prepared to anticipate the same issues in their own ventures. The module note, “Experimentation and Real Options in Entrepreneurial Finance” (Harvard Business School Module Note for Instructors 815- 056) places the case in the academic literature as well as relative to other cases in the module. Instructors can also teach this as a stand-alone case related to venture capital financing. The Fast Ion case helps to drive home several key insights. First, the case helps students appreciate how multi-stage financing is best seen as series of sequential experiments, where each stage of financing is tied to achieving a set of milestones. As outlined in greater detail in the note on “Multi-Stage Financing of High-Potential Ventures”, experiments that meet their milestones increase the probability that the venture will be successful and therefore increase the value of the company, allowing the entrepreneur to seek the next round of funding without giving up as much equity. On the other hand, experiments that reveal negative information about the prospects of the startup allow investors to abandon their investment without investing the full amount. Fast Ion Battery provides examples in of such milestones and how they evolve across the life of a science-based venture. It simultaneously documents how the valuation of the company is projected to rise as they are met. A particular aspect of this perspective on multi-stage financing is that it allows students to understand how the “venture capital valuation method”, where investors use a high IRR to discount a success scenario, is equivalent to a decision tree framework where the probabilities of success are low. The second insight that students get from the case is the particular impact that the cost and ‘quality’ of experiments have on startup valuations. While it is more apparent that factors that increase the value of startups (such as a higher exit value, a lower funding requirement and a higher probability of success) lead to less dilution for entrepreneurs, the less obvious, but equally important insight arises from how the nature of experimentation impacts founder equity, even if the unconditional probability of success, ultimate value and total funding amount is the same . Students see that industries where experiments are expensive and not as discriminating (e.g., biotech or clean energy) will be ones in which startups have lower initial valuations and lower step- ups across rounds of funding. Founders will be left with a lower share the firm, so that even if the ultimate exit is the same as a successful consumer internet startup, the dollar value of their return will be less. They also see why such industries are not as attractive from the perspective of investors because investors require larger overall investments to maintain the same ownership percentage, thereby potentially compromising the portfolio dynamics entailed in their funds. The third insight relates to financing risk and its interaction with the value of abandonment options. The investment cycles that are inherent to venture capital imply that there may be sector- specific shocks to the availability of capital, making it hard for even promising startups associated with certain sectors to access capital. This seems to be the case for clean energy in December 2011, where VCs that had once rushed to include at least one cleantech startup in their portfolio were now shying away from the sector. The large sums of money required to get Fast Ion to cash flow positive (another $65 million) are more than the current syndicate can finance; they will depend on future investors to continue funding Fast Ion to prevent it from going bankrupt. A rise in financing risk (that

Teaching Note — Fast Ion Battery 815- 106 3

815- 106 Teaching Note — Fast Ion Battery is the risk that shocks to capital may lead Fast Ion to go bankrupt even if the experiments look promising) will reduce the value of the bridge round of funding, as financing risk in effect lowers the probability of success conditional on meeting milestones, and hence is equivalent to reducing the value of the real option embedded in the bridge round of funding. In fact, the calculations in this case highlight an important insight that in some circumstances, the benefits of taking all the money up front (and hence reducing the vulnerability of the startup from the state of the capital markets) outweighs the benefits of the abandonment option! The final insight relates to how the real world is inherently more complicated than the decision tree framework. Often, information that comes back from early experiments is mixed – ventures have met some milestones but not others, yet investors need to make binary decisions based on incomplete information about whether to continue funding a startup or whether to shut it down. The specific incentives facing individual investors and contextual factors governing the financing landscape at the time can therefore have important interactions with the results of experiments. In the case of Fast Ion, the structure and stage of WSC compared to Bluelock ventures, combined with the funds’ returns and personal success of the individual partners involved in the deal might have an important bearing on the decisions of individuals to either continue funding the startup or exercise the abandonment option. Understanding that these decisions are not black and white, and that there may be systematic factors that may lead some investors to be more “quick on the trigger” that others is useful for entrepreneurs to understand, as it helps them position themselves with the investors who are best suited for their needs. Beyond these core objectives, the Fast Ion case allows instructors to focus on the technical details associated with calculating the value of real options using simple decision trees, and on delving into the mechanics of capitalization tables that span several rounds of financing. In particular, it allows students to understand how the extended time and greater investment associated with a potential bridge round would impact investor IRRs, and how the choice of whether or not to exercise a pay-to- play clause in the term sheet would change these. The case also has a term sheet, that allows instructors to introduce students to the concepts related to cash flow rights and control rights, the notion of contingent control and also terms that relate specifically to multi- stage financing (such as anti-dilution protection and pay-to-play clauses). Lastly, the case allows for interesting role plays that help shed light on the dynamics of partnership meetings as well as the role of relationships across individuals in different venture capital firms. Discussion and Analysis There are three key areas of discussion in this case. An outline for this discussion is illustrated in the board plan shown in TN Exhibit 1 of this note. 1. What are the relative benefits and costs associated with extending a Bridge round of funding to Fast Ion? Given these, should WSC extend a Bridge round to Fast Ion Battery? 2. Suppose that they decide to extend a Bridge. How do the terms related to the warrants and pay-to-play clause impact the ownership of the VCs who continue to participate, and what impact does this have on cash returns and IRRs to investors? 3. Given the findings on the cash returns and IRRs above, should they exercise the pay-to-play clause? These areas of discussion tend to occupy about 30, 40, and 10 minutes of discussion respectively. 4

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