© copyright 2003 sentient ventures early stage venture capital

© Copyright 2003 Sentient Ventures

Early Stage Venture CapitalDue Diligence and Valuations

David M. Lee

2/12/2003


Agenda

Due Diligence

Inside a Venture Fund

Valuations


Dual Mission

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Investment Criteria

Key Criteria:• Fits within market focus and portfolio• Significant market size• Headquarters in Texas• National or international in scope• Manageable competition• Fundamental sustainable differentiator• Top-tier management team• Good chemistry

Priority:• Insiders are willing to participate• Includes a syndication with value-added outside investors


Investment Process


Process Documentation

Investment Overview• 1-2 page document that provides a high-level summary• Enables the General Partner to relay first opinions back to sponsor

Investment Due Diligence Document• 10-15 page document that answers questions in depth about the

deal• Detailed summary about multiple aspects of the business and

management team including risks and issues

Investment Decision Document• 2-3 page document that contains a summary of the due diligence• Leads to the recommendation by the sponsor and records the final

vote on whether or not to invest


Portfolio Management

Increase funding potential• Assist in refining business plans and financial projections• Recruit management team and board members

Facilitate follow-on funding• Provide introductions to other VCs, funds, banks, and angels• Aid development of investor pitch and offering materials

Validate market and technical strategies• New product, business feasibility, and market research studies• Strategic market planning, periodic technical/marketing reviews

Provide access to service provider network• Referrals to legal, accounting, PR, and marketing firms• Contacts for executive consultants, industry experts, and analysts


Time Management

Hours Per Week Per Partner 50

1/3 Investing 16.5

1/3 Portfolio Management 16.5

1/3 Investor Relations 16.5

Total Total Companies Companies Total

Deals Money Actively Passively Deals

Made Placed Managed Managed Reviewed

Per Partner 6.0 $ 24,666,667 4.2 1.8 400

Hours / Company per Week 2.8 N/A 3.5 0.9 6

• GP has 3 full-time and 2 part-time partners

• Limit of 6 portfolio companies per full-time partner

• Total money placed per full-time partner is < $25,000,000

• Each full-time partner reviews 400 deals w/in commitment period

• Target fund size of up to $90,000,000


Portfolio Allocation

• Target is 18 to 23 portfolio companies

• $1.5 million average initial investment

• Active management of 70% of the portfolio companies

• Lead investor for 40% of the investments

• Over 50% of the fund reserved for follow-on investments

• Establish up front funding milestones/trigger based budgets

Initial Percent Total

Management Percent Deals Investment Reserved Reserve Per Deal

Lead Investor Active 40% 7 $2,000,000 200% $4,000,000 $6,000,000

Follow-on Investor Active 30% 5 $1,500,000 170% $2,500,000 $4,000,000

Follow-on Investor Passive 30% 6 $1,000,000 100% $1,000,000 $2,000,000


Investment Returns

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Fund Management

Fund managers bring over 100 years of operating experience:• 3 Full-time Partners - Managing Partner and 2 General Partners• 2 Part-time Partners - Venture Partner and Fund Administrator

Each principal was strategically selected:

Supporting Staff• Venture Consultants, Contractors, Associates, and Interns

Enterprise Communication SemiconductersSoftware Software Nanotechnology Fund

and Services and Services and MEMs AdministratorPartner 1 X XPartner 2 X XPartner 3 X XPartner 4 XPartner 5 X X


Fundamentals

Block-n-Tackle Business Planning• Revenue Growth, Expense Controls, and Profit Focus

Solution for a significant pain that a large group of people with money are willing to pay for

Experienced management team that knows how to make payroll

Sustainable differentiation with an emphasis on unique best-of-breed IP

Venture acceleration, not venture support


Current Focus

High Technology (3-4 Month ROI):• Enterprise Software• Telecommunications Utilization Software• Semiconductors and MEMs/Nanotechnology• Bioinformatics and Life Sciences/IT convergence

Life Sciences:• Diagnostic Tests• Pharmaceuticals• Genomics/Proteomics• Medical Devices


Valuation’s Role in Financing

Sets economic interests going forward.• Establishes an intrinsic value for the company• Valuation is not transaction independent

One of many terms under negotiation …


From the Term Sheet

Terms• Capitalization• Type of Security/Securities• Characteristics of the Security/Securities

Anti-dilution Liquidation preference

• Representations and Warranties of the Company

Other Conditions to the Deal• Governance Requirements• Reporting Requirements• Expenses• Non-solicitation• Changes to Management• Key-man Insurance


Initial Valuation Views

The TechnologistThe Technologist

The Technology

Personnel (Technical)

The Market

Personnel (Business)

The VCThe VC

Personnel (Business)

Personnel (Technical)

The Market

The Technology – Must have IP!


Methods of Valuation

Methods:• Discounted Cash Flows (DCF)• Comparables• Target Ownership

Reality for Early Stage Companies• Use the first two to justify the third


Pros and Cons of DCF

Pros• Highly quantitative• Provides specific, objective (?) numbers as a basis for negotiation• Speaks to “Intrinsic Value” of company

Cons• Too many variables• Depends upon accurate forecasting• Difficult to discount for risk and lack of liquidity


Comparables

Most closely resembles Real Estate valuations

Look at prices of similar deals• Stage of business• Location of business• Industry

Adjust up or down for specific circumstances


Comparables Adjustments

Current capitalization• Cap table• Past investment rounds

Product development• In Beta• General Availability

Management• Good or bad management

Business Development• Sales booked• Quality of sales pipeline• Profitability


Pros and Cons of Comparables

Pros• No need to adjust for risk or liquidity• A common method that is fairly well understood within early stage

companies• Fast

Cons• Highly subjective• Imperfect distribution of information


Reality of Valuation

First Round company

Some seed money in (Friends and family – 20%)

Networking Software space

Excites one of the Partners

Product in Beta

Missing management team members

No option pool

Based in New Mexico

$3M raise

Syndicate has target ownership of 33%


Reality of Valuation

In year of comparison – Average Post-money valuations:• Communications SW, Series A: $7.78M• SW & Rocky Mtn., Series A: $8.66M

Average post-money valuation of $8.25M • Pre-money valuation of $5.25M• $3M raise

Resulting Ownership• 36% - New Investor ownership (Series A Preferred)• 20% - Option pool forced before round• 11% - Friends and Family Ownership • 33% - Founder Ownership


Further Justification

Adjustments to the valuation• Large Stock Option plan needs to be created

Management team is incomplete• Hot space

Don’t forget the Run with the Pack mentality We’ll be the lead investor

• > 1 additional financing round expected New investors will also be diluted

• Product in Beta Technology risk still exists Not proven in the field (lack of customers)

• Claim to go from $0 to $250M in 4 years Several companies will put this in the plan, but very few can

defend it


Q&A

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