Venture Capital
The Investment Process
and Great Investment
What is Venture Capital?
• Money invested:
– By professionals (venture capitalists)
– In early-stage companies
– In order to produce financial returns.
• Does not include:
– Buyout investing
– Mezzanine investing
– Angel investors.
What is Venture Capital?
• Funds are usually:– Raised from the investors (limited partners)
– By the firm (general partners)
– For a set period of time (around 12-years)
• Supposed to return above-average interests (during bubble, 40%,50%, 90% yearly)
• By investing in private companies and exiting via IPO or buyout.
Money Flow in Venture Capital
Limited Partners commit to $x million– Participate in draw-downs on regular basis
– Money is not given to the VC’s all up front.
The VC charges a few percent of the money committed, to pay for salaries and expenses.
Usually, first liquidity events go to repaying investors.
When investors are fully repaid, limited and general partners share the proceeds (80%-20% or 85%-15%). – The general partner share is called “carry.”
Many permutation of arrangements with limited partners.
Players in Venture Capital
Limited Partners Typical investors in venture capital funds:– Pension funds
– Foundations
– Local governments
– Universities – Universities
– Wealthy individuals
General Partners– Ex-CEOs
– Ex-investment bankers
– Ex big-8 consultants
– The occasional scientist or MD
Types of Venture Capital Funds
Funds tend to specialize by stage, industry, or geography– Stage:
• Seed Funds (the earliest institutional funds)
• Early Funds (will go in right after seed)
• Mezzanine Funds (prefer funding just prior to liquidity, IPO or buyout)
– Industry• Oxford Biosciences (Medical)
• Trident, Northpoint (IT, telecom)
• NEA – Company is a generalist but individual general partners specialize
– Geography (Samller Funds tend to stay in a region)• Anthem Capital – Local here
Early Investments Lifecycle
concept
M&S
Plan V0.1
Eng. Specs Prototype
Plan V1
Alfa Beta V1Res. &
Develop.
Marketing
& Sales
Prod.
Plan V2
CUSTOMERS
V1.1
Start-up
P&O Plan V0.1 Plan V1
Prod.
& Ops Plan V2
Seed (< € 1 mil) Early Stages (€ 1 - 10 mil) Expansion/ (€ 10+ mil)
development
Angels Incubators Accelerators Venture Capital Private Equity &
Merchant Banks
‘Death valley’ is a serious problem
capital needs
'DEATH VALLEY'
idea seed and start-up growth mature growth, expansion
time
owner, family
funding
Source: Wissema, Technostarters, why and how?
Where does VC fit in?Sources of New Venture Financing
Seed Start-up Early Growth Rapid Growth Exit
Entrepreneur
Friends and Family
Angel Investors
GrantsGrants
Strategic Partner
Venture Capital
Asset-based Lender
Equipment Lessor
SBIC
Mezzanine Lender
IPO
Public Debt
Acquisition, LBO, MBO
Red shading indicates primary focus of investor type. Blue shading indicates secondary focus, or focus of a subset of investors of the type.
Venture Capital
Where the money is invested (Q1’07)
• Silicon Valley $2.1 billion
• New England $976 million• New England $976 million
• Southeast $579 million
• Greater DC $197 million
Venture capital is clearly
associated with innovation…
Correlation between VC and ICT
12%
14%IC
T s
har
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GD
P
Israel
Korea
Sou
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afte
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IVC
Re
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11/13
4%
6%
8%
10%
0,0% 0,1% 0,2% 0,3% 0,4% 0,5% 0,6% 0,7% 0,8%
VC investment in ICT as % of GDP
ICT
sh
are
in G
DP
UK
Ireland
Japan
USA
Canada
Sweden
France
Korea
ICT = Information and Communication Technologies
USA
Ce
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VC Investment in ICT
Relative to GDP
0.4%
0.5%
0.6%
0.7%
0.8%
Source: OECD 1999-2002, IVC Research Center 2002, CBS (Isr.)
0.0%
0.1%
0.2%
0.3%
0.4%
Israel
USA
Canada
Korea
Sweden UK
Netherlands
Ireland
France
Finland
Belgium EU
Norway
New
Denmark
Germany
Australia
Italy
Switzerland
Greece
Spain
Portugal
Austria
Japan
Venture Capital
What venture capitalists do:
– Finance rapidly growing companies
– Typically buy equity rather than lend money
– Often sit on the board of directors – Often sit on the board of directors
– Help management teams (but also direct)
– Take a long-term view
What Venture Capitalists do ...
Sift through thousands of (good and bad) investment propositions
Identify a few valid initiatives and finance them
– in exchange for private equity (usually a minority stake)
– structure the deal
Support the entrepreneurs in succeeding. E.g.:
– providing financial advice–– in headhunting and setting up advisory boards
– in contacting customers, channels, …
– in steering and positioning the company
– in managing PRs activities
– in managing IP and legal issues
Look after value creation
– further round of financing
– merger and acquisition, IPO, …
A Day in the Life of a VC
VCs travel 60-90% of time
Network with other VCs, lawyers, I-bankers, CEOS they funded in past – and limited partners
Attend industry conferences for market intelligence and deal flow
Meet companies, read biz plansMeet companies, read biz plans
Heavy due diligence, phone and in person
Attend industry conferences
Negotiate deals
Participate on boards of directors
The Venture Capital Process
• Find Deals
• Research Deals – A 3-6 Month Process
• Structure and Close Deals
• Manage The Investment• Manage The Investment
• Exit The Investment
VC Investment process
•Preparation of tender terms
•Tender announcement
(offer form, key
Tender launch
•Negotiations of investment
agreement
•Signing of investment
Deal fulfilment
•Accomplishment of investment
agreement
•VC fund financials•Complying with
MonitoringAnalysis of Offers
•Formal analysis (checking out for completeness of required
documents)
• Primary financial & legal analysis of documents (VC
Exit
•Exits from portfolio funds
conditions of
investment
agreement)
•Gathering of offers
agreement
•Transfer of financial resources
to the fund
according to the
drawdown schedule
•Complying with information
standards by VC
fund
•Use of state aid
funds resulting in a short list
that includes 1 to 5 best offers
•In-depth financial & legal analysis (meetings with
management teams from short
list and presentation of their
offers, due diligence of offers
•Final choice of offers
Most Appreciated VCs Contributions
• Financial Advice 44%
• Corporate Strategy & Direction 43%
• Sounding board for ideas 41%
• Challenging status quo 32%
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• Challenging status quo 32%
• Contacts or market information 26%
• Management recruitment 10%
• Marketing strategy 7%
• Money only 12%
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Venture Capital
Characteristics of “venture fundable” companies:
– Experienced management
– Defensible market
– Good business model (can make money)
– Proprietary intellectual property
– Manageable funding requirements
– Valuation expectations in line with market
Venture Capital in the EU
What does a VC asks for
– VC investors’ stake
• 2% have 1 - 9%
• 38% have 10 - 33%
So
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• 38% have 10 - 33%
• 21% have 34 -49%
• 39% have 50+ %
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How to approach a venture capitalist
• The Business Plan
• A Team
• A Presentation and an “Elevator’s Pitch”
• References• References
• An NDA (if required)
The Business PlanA Product/Service description
– Pros and cons of the solution– Market needs it satisfies– Barriers to Competition
Business Model– Market Analysis (strategic and tactical)
• Competitors
– Execution Plan • Marketing and Sales Plan• Research and Development Plan• Research and Development Plan• Operations Plan
TeamFinancials
– Valuation Model & Placement Terms– Income Statement, Balance Sheet & Cash Flow
• 3 years minimum, quarterly breakdown• 1st year in monthly breakdown
The Term Sheet
• The parties
• Securities to be issued
• Amount of financing & disbursement schedule
• Pre-financing valuation
• Option plan & earn-out
• Use of proceeds
• Liquidation Preference• Liquidation Preference
• Protective Provisions, Voting Rights and BoD participation
• Anti-dilution
• Lock-ups
• Tag along and drag along
• Exclusivity
• Reporting
• ...
How does a VC think
IRR (Internal Rate of Return)
– Company’s Current and Future Valuation
• Comparables (P/E,P/S,…), “Number of”, DCF, …
– What’s The Best Strategy To Create Value
• Which are the achievable milestones and what’s the financing
needed ?
When is the break-even expected ? With which margins and • When is the break-even expected ? With which margins and
revenues.
– Exit Strategy
• Trade sale, IPO, Nth+1 round of financing, ..
Minimizing Risks
– Diluting the investment
– Liquidation Preference rights
A possible valuation scenario
Company X. Quoted on Stock Exchange Z.
Valuation € 100mil, Sales € 50 mil, Earnings € 5 mil.
P/E = 100/5 = 20, P/S = 100/50 = 2.
Company Y. Acquired for € 20 mil with sales of € 10 mil. P/S = 20/10 = 2.
Your “UnwiredCo” plan forecasts € 30 mil in sales and € 5 mil in earnings in 2014.
Its buss. model is “similar” to X and Y.
– Lower Valuation of UnwiredCo in 2009 using P/S of 2 is 30*2 = € 60mil
– Higher Valuation in 2009 using P/E of 20 is 5*20 = € 100 mil
Present Post-Money1 valuation (discount-rate2 of 50%) is between Present Post-Money1 valuation (discount-rate2 of 50%) is between
60/(150%)5years = € 8mil and 100/(150%)5years = € 13.3mil
The “UnwiredCo” requires a € 4 mil financing round.
The Pre-Money valuation is between € 8-4=4mil and € 13.3-4= 9.3mil.
An agreement is reached at a pre-money valuation of € 6mil.
hence the Investor will obtain a 4 / (6 + 4) = 40% stake in the company.
1 Valuation of the company after the investment.2Target Annualized Return of Investment
European Private Equity Funds Net IRRs to Investors
Stage 1 YR 3 YR 5 YR 10 YREarly Stage 26,0 14,5 24,0 14,3Development 31,5 21,4 19,4 11,8Balanced 40,4 56,4 45,4 20,7
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Balanced 40,4 56,4 45,4 20,7All Venture 35,6 36,3 33,6 17,2Buyouts 10,9 30,6 26,2 18,0Generalist 1,9 12,6 17,8 12,3All Private Equity 15,6 29,2 25,8 16,3
IRR: Internal Rate of Return. “Rate of discount which equates the present value of the cash outflows associated with an investment with the sum of the present value of the cash inflows accruing from it and the present value of the valuation of the unrealized portfolio”.
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Some Statistics
• 99%+ of All Startups Do Not Require Institutional
Venture Capital
• VCs average initial investment is $3M+
• Average Dilution from Initial VC Investment is 40%+• Average Dilution from Initial VC Investment is 40%+
• VCs look at over 100 business plans for every one
they finance
When Is VC Good
• Heavy R&D Component of the business
– Seminconductors
– Biotech
– Datacomm Equipment
• Very Large Opportunity Requiring A Lot of Working • Very Large Opportunity Requiring A Lot of Working Capital
– Federal Express
– Amazon.com
The Cost of Venture Capital
• Dilution
– Average founder who uses VC owns less than 10% of the business upon exit
• Liquidation Preference
– The VCs will want to take their money out first– The VCs will want to take their money out first
• Control
– It is a marriage and divorce is messy. You don’t always get to take the kids
When is VC Wrong
• Too Early – You Don’t Have Enough to Show Yet
(Revenues, Product, Team)
• Too Small – You Only Need A Couple Million to Get
Profitable
• Not Proprietary – Your Business Has No Barriers to
Entry. It is Just An Execution Game.
What Are The Alternatives?
• Bootstrap
• Self-Finance
• Friends and Family
• Find Partners To Share The Risk• Find Partners To Share The Risk
• Don’t Start A Business, Buy A Business
© Equity Fingerprint 2006
SKYPE – a case study.
All information from searching on Google and estimates
The beginnings…
Skype was started in 2002 by the founders of
Kazaa:
– Nikalas Zennstrom (37 yrs)
– James Friis (27 yrs)
Copyright Equity Fingerprint, 2006
– James Friis (27 yrs)
The beginnings…
Kazaa was founded in 2000:
A file sharing program.
315 million downloads
“most downloaded program in the world in 2003”
Copyright Equity Fingerprint, 2006
“most downloaded program in the world in 2003”
Had problems with music industry due to piracy.
Global free market for music, video and p***n.
Skype Funding
2002 $2M 3 Angels + Tom Draper
Angel round Draper Investment Co. (VC)
Copyright Equity Fingerprint, 2006
2004 $18M Draper Fisher Jurvetson
VC round Bessemer Venture Partners
Index Ventures
Mangrove Capital Partners
All VCs
Milestones and Product
Easy install
Easy use (5 minutes after installation)
No firewall issues
Reliable connection
Copyright Equity Fingerprint, 2006
Reliable connection
“Worked 100x better than anything else we had
seen” – Rob Stavis of Bessemer.
Money
Charging for
– Voicemail
– Connection to a landline
– Reselling arrangement with ISPs
Copyright Equity Fingerprint, 2006
– Reselling arrangement with ISPs
Multibillion $$$ potential
Making the EF - Data
The Economist – “Giving Ideas Wings”
16th September, 2006
“The earliest investors (i.e. from angel round) saw a huge return,
350 times or so, on their estimated $2 M investment.”
Copyright Equity Fingerprint, 2006
VC’s return 40x on 18 M investment.(Estimate - PSB)
Skype sold to for $2.6 bn– $1.3 bn in shares + $1.3 bn in cash (+ $1.5 bn earn out)
Making the EF
Final equity:
Buy-out value $2,600 M
Less: Angels ($2 M x 350) $700 M
VCs ($18 M x 40) $720 M
Copyright Equity Fingerprint, 2006
VCs ($18 M x 40) $720 M .
So: Founders + team $1,180 M
Approx.
Equity split
Control of equity (millions)
Percentage ownershipAt buy-out After angel
roundinitial
Founders $1,180 45 %
Copyright Equity Fingerprint,
2006
Founders + team
$1,180 45 %
Angels $700 27 %
VCs $720 28 %
TOTAL $2,600 100 % 100 % 100 %
Equity split
Control of equity (millions)
Percentage ownershipAt buy-out After angel
roundinitial
Founders $1,180 45 % 62 %
Copyright Equity Fingerprint,
2006
Founders + team
$1,180 45 % 62 %
Angels $700 27 % 38 %
VCs $720 28 %
TOTAL $2,600 100 % 100 % 100 %
Equity split
Control of equity (millions)
Percentage ownershipAt buy-out After angel
roundinitial
Founders $1,180 45 % 62 % 100 %
Copyright Equity Fingerprint,
2006
Founders + team
$1,180 45 % 62 % 100 %
Angels $700 27 % 38 %
VCs $720 28 %
TOTAL $2,600 100 % 100 % 100 %
After Angel Round…
From the table above, we can find pre- and post-
money valuations for the company:
$2 M brought the angels 38 % of Skype :
So, post-money valuation is
Copyright Equity Fingerprint, 2006
So, post-money valuation is
$2 M x100/38 = $5.3 M
And pre-money valuation is
$5.3 M - $2 = $3.3 M
After VC Round…
Again, we can find pre- and post-money
valuations for the company:
$18 M brought the VCs 38 % of Skype :
So, post-money valuation is
Copyright Equity Fingerprint, 2006
So, post-money valuation is
$18 M x100/38 = $47 M
And pre-money valuation is
$47 M - $18 = $29 M
Equity Fingerprint
Copyright Equity Fingerprint, 2006
TIME
Dilution
$2 M $18 M
Angel Round VC Round
Equity Fingerprint
TIME8 million downloads of Skype
3.3M
5.3 M 27 M6x
Angel Round VC Round
Copyright Equity Fingerprint, 2006
Dilution
5.3 M 27 M
47 M 2.6 bn
6x
55x
Equity Fingerprint
TIME8 million downloads of Skype
3.3M
6x
Angel Round VC Round
5.3 M 27 M
Copyright Equity Fingerprint, 2006
Dilution
6x
55x
5.3 M 27 M
47 M 2.6 bn
Founders + Team
Angels
VCs
So, who are the winners?
Founders and start team
Zennstrom 40 %
This is typical of
Copyright Equity Fingerprint, 2006
Friis 40%
Team 20 %
Total 100 %
This is typical of
the equity split of
a start up
company
So, who are the winners?
Angel investors
Tom Draper 12.5 % 250 k
Angel 1 12.5 % 250 k
Angel 2 12.5 % 250 k
Copyright Equity Fingerprint, 2006
Angel 2 12.5 % 250 k
Angel 3 12.5 % 250 k
Draper Investments Co.
50 % 1 M
Total 100 % 2 M
So, who are the winners?
VC round
4 VC investors 25 % each Total
4.5 M each $ 18 M
Copyright Equity Fingerprint, 2006
4.5 M each $ 18 M
So, who are the winners?
Final equity split: Share Equity / millions $
Invest-ment /
millions $
20% VC cut /
millions $
Returns / $
Founders 45 % 1,180 0 n/a 1,180
Zennstrom 18 % 472 0 n/a 472
Friis 18 % 472 0 n/a 472
Team 9 % 236 0 n/a 236
Angels 27 % 700 2 n/a 698
Copyright Equity Fingerprint, 2006
Angels 27 % 700 2 n/a 698
Tom Draper 3 % 88 0.250 n/a 87.75
Three Angels 13 % 263 0.750 n/a 262.25
VC (Draper Investment Co.) 14 % 350 1 70 279
VCs 28 % 720 18 144 558
VC1 (Draper Fisher Jurvetson) 7 % 180 4.5 36 139.5
Three VCs 21 % 540 13.5 108 418.5
TOTAL 100 % 2,600 20 n/a 2,590
Final equity split: Share Equity / millions $
Invest-ment /
millions $
20% VC cut /
millions $
Returns / $
Founders 45 % 1,180 0 n/a 1,180
Zennstrom 18 % 472 0 n/a 472
Friis 18 % 472 0 n/a 472
Team 9 % 236 0 n/a 236
Angels 27 % 700 2 n/a 698
So, who are the winners?
Copyright Equity Fingerprint, 2006
Angels 27 % 700 2 n/a 698
Tom Draper 3 % 88 0.250 n/a 87.75
Three Angels 13 % 263 0.750 n/a 262.25
VC (Draper Investment Co.) 14 % 350 1 70 279
VCs 28 % 720 18 144 558
VC1 (Draper Fisher Jurvetson) 7 % 180 4.5 36 139.5
Three VCs 21 % 540 13.5 108 418.5
TOTAL 100 % 2,600 20 n/a 2,590
Tom Draper: 87.75 + 70 + 36 = $200 M + any money
invested in his own VC company, as is normal!
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