Chapter 11Professional Venture Capital
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© 2012 South-Western Cengage Learning
ENTREPRENEURIAL FINANCE Leach & Melicher
Chapter 11: Learning Objectives Discuss the history &
current status of venture investing in the U.S.
Explain the professional venture investing cycle and its relevance to entrepreneurs seeking professional venture capital
List major elements in the design & structure of a venture capital fund
Describe the venture capital screening process & list characteristics central to determining a venture capitalist’s willingness to invest
Discuss the various roles a venture capitalist can take in providing financing and services to an emerging venture
Enumerate several terms or conditions to be negotiated when structuring venture capital financing
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Historical Development of Professional Venture Capital
Venture Capitalists (VCs):individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing ventures
Pre-World War II Era:Most venture investing came from wealthy individuals and families
1946: Beginning of Professional VCsFormation of American Research & Development (ARD)
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Historical Development of Professional Venture Capital (cont’d)
ARD’s Early Performance $3.5 million was raised ($2 million
from institutional investors) By end of 1947, ARD had invested in
eight ventures, six of which were startups
By 1951 the performance was still lack-luster (stock price was at $19 down from the initial offering price of $25 in 1946)
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Historical Development of Professional Venture Capital (cont’d)
1953: Small Business Administration (SBA) was formed Legislation permitted the federal government to
actively engage in fostering new business formation
1958: SBA Created Small Business Investment
Companies (SBICs) Due to tax and leverage advantages, the SBIC
became the primary vehicle for professionally managed venture capital
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Historical Development of Professional Venture Capital (cont’d)
ARD’s Later Performance: In 1957, ARD had invested $70,000 in
the startup company Digital Equipment Corporation (DEC)
1972, ARD was sold for $813 Per Share
Original ARD investors received a compound annual return of 14.7% due primarily to DEC
Without the DEC investment, the rate of return would have been only 7.4% 6
Historical Development of Professional Venture Capital (cont’d)
Late 1960s-Early 1970s: Boom-Bust Cycle: Many SBICs began
having operating problems due to the mixing of risky venture investments & high financial leverage (debt service commitments)
1970s: Professional VC organizational structure
changes Movement to private partnerships from
public firms & volatile financial markets 7
Dot.Com Bust and Recent History
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Professional Venture Capital Investing Cycle
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Useful Terms
Carried Interest:portion of profits paid to the professional venture capitalist as incentive compensation
Two and Twenty Shops:investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest
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Organizing The Fund:VC Fund Placement Memorandum
Frontmatter Declarations State Securities Disclosures Offering Summary Fund Overview Executive Summary Summary of Terms
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Soliciting Investments: Suppliers of Venture Capital – 25-Year Average
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Obtaining Commitments:Arrangements with Fund Investors
Capital Call:when the venture fund calls upon the investors to deliver their investment funds Common to require subsequent
investments consistent with the levels of investors’ initial contributions
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Due Diligence and Active Investing:VC Fund Management
Deal flow:flow of business plans and term sheets involved in the venture capital investing process
Due diligence (in venture investing context):process of ascertaining the viability of a business plan
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VC Screening Criteria
1. Venture Capital Firm Requirements 2. Characteristics of the Proposal 3. Characteristics of the
Entrepreneur/Team 4. Nature of the Proposed Industry 5. Strategy of the Proposed Business
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VC Screening Criteria
1. Venture Capital Firm Requirements Cash out potential Equity share Familiarity with technology, product, market Financial provisions for investors Geographic location Investor control
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VC Screening Criteria
Venture Capital Firm Requirements (cont’d) Investor control Investor group Rate of return Size of investment Stage of development
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VC Screening Criteria
2. Characteristics of the Proposal Requirement for additional material Stage of plan
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VC Screening Criteria
3. Characteristics of the Entrepreneur/Team a. Ability to evaluate risk b. Articulate regarding the venture c. Background/experience d. Capable of sustained effort e. Managerial capabilities f. Management commitment g. References h. Stake in firm
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VC Screening Criteria
4. Nature of the Proposed Industry Market attractiveness Potential size Technology Threat resistance
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VC Screening Criteria
5. Strategy of the Proposed Business Product differentiation Proprietary product
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Screening Outcomes
1. Seek lead investor position 2. Seek a non-lead investor
position 3. Refer venture to more
appropriate financial market participants
4. SLOR (standard letter of rejection) the venture
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Structuring a VC Investment
Term Sheet:summary of the investment terms and conditions accompanying an investment
Typical Issues Addressed in a Term Sheet Valuation Ongoing funding needs Size and staging of financing Preemptive rights on new issues Commitments for future financing rounds and
performance conditions Form of security or investment Redemption rights and responsibilities
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Structuring (cont’d)
Typical Issues Addressed in a Term Sheet Dividend structure (Number of VCs and outsiders) Additional management Conversion value protection Registration rights Exit conditions and strategy IPO-dictated events (e.g. conversion) Co-sale rights (with founders) Lock-up provisions
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Structuring (cont’d)
Typical Issues Addressed in a Term Sheet Employment contracts Incentive options Founder employment conditions: compensation,
benefits, duties, firing conditions, repurchase of stock at termination, term of agreement, post-employment activities and competition
Founder stock vesting Confidentiality agreements and protection for
intellectual property
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