f317 – venture capital & entrepreneurial finance why venture capital exists

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F317 – Venture Capital & Entrepreneurial Finance Why Venture Capital Exists

Author: olivia-sanders

Post on 21-Jan-2016




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F317 Venture Capital & Entrepreneurial Finance Why Venture Capital Exists

F317 Venture Capital & Entrepreneurial FinanceWhy Venture Capital Exists

The learning outcomes for this lecture:

Understand what Venture Capital invests in;Difference between Debt & Equity;How Venture Capital comes into a company;Why Banks wont invest while VCs will;The payoff for Venture Capitalists1

All successful businesses get paid to:

1) Solve a problem; or

2) Meet an unmet need.10,000 FT ViewThe purpose of this slide is to convey the basic tenant that successful businesses solve problems to meet a need in the marketplace.

Ask the students spitball the answer and then introduce the answers by clicking on the mouse.2Example #1

Ask the class what problem Google is solving..

Organizing the Internet so the rest of us can find almost anything within a a few seconds

Given that there are billions of webpages, this represents a huge undertaking.3Example #2

Ask the class what problem is Apple solving + what needs is is meeting?

Problem Solved Allowing us to keep close to our data at all times (i.e. iTunes, iPhone, iPads). Make it easy for each of us to be near our data at all times;

Need being Met The need to look/feel cool and hip. Apples Designs intentionally invoke feelings of cutting edge. Similar to what apparel brands do with apparel.4

and the greater the problem or unmet need,the greater the opportunity to make a lot of

$$MONEY$$10,000 FT ViewHave the students fill in the blank

Going back to the primary tenant of business, generally speaking, the greater the problem of unmet need, the more money entrepreneurs (and investors) can make.

5Heres the problemThe greater the Business Opportunity..

1) The more competitive it will be to capitalize on the business opportunity

However, there are three challenges when going after big opportunities:

The first challenge is that if its a big enough opportunity, it will attract the interest of some of the smartest people and largest companies in the world.

With them will come significant resources and capital to go after the opportunity.

As an example, Elon Musk, Jeff Bezos, and Richard Branson each are investing hundreds of millions in space exploration. And, this isnt their main jobs.

The good news, however, is that if you are relevant, chances are a bigger player will acquire your company at a significant premium.6Heres the problemThe greater the Business Opportunity..

2) The higher the risk of failure(Too Early)

(Too Late)

(Miss on Product)

A second challenge is that, with big opportunities, there is a high risk of failure. So many things have to happen in your favor including market timing and getting the product right.

For example, Apple launched the first Tablet back in the early 1990s called Newton. It was a cutting edge product but way before its time. Consumers were not ready to compute on the go.

Microsoft launch Bing three years ago in order to take away some of the market share in search from Google. Theyve made limited gains, but its been at the expense of Yahoo. They have not made a dent in Googles market share.

And Myspace reach success for a brief period of time until Facebook made online sharing a 2-way street as opposed to MySpace having fan pages with limited interaction.7Heres the problemThe greater the Business Opportunity..and

3) The more money it will take to succeed

> $17 Billion

> $4 Billion> $5.5 Billion

The last challenge entrepreneurs face is that it can be very expensive to solve a big problem.meaning that its going to require a ton of investment capital to capitalize on the opportunity.

For example,

Facebook has raised $17B

Twitter $4B

And even Microsoft has invested more than $5.5 Billionin Bing.

These are crazy numbers, but the capital is there for promising startups that have credible opportunities.8So where does an aspiring young entrepreneur find the necessary capital to go out and solve big problems?

The truth is that not all business opportunities rise to the level of a Facebook or Twitter..there are a ton of business opportunities in the areas of:

- Life Sciences;- Business Applications;- Consumer Applications;- Mobile, etc.

That would attract high risk / high return investors..otherwise known as Venture Capitalists.9Venture Capitalist DefinedA Venture Capitalist is a professional investor who deploys third-party funds into relatively early-stage companies with both high potential and a relatively high degree of risk.So lets define a Venture Capitalistread thru.

Basically, there is billions of dollars of capital available to entrepreneurs that are seeking to solve big problems or creating new markets within existing large markets.

Later in the Semester, were going to talk about how Venture Capitalists set up funds, how they get paid, etc. Its a very cushy job if you can get it.

10Lets see how Venture Capital gets injected into a startup(using a bathtub example)This exercise is designed to take the students through a visual example of how VCs participate in the capitalization process.11Initial Capitalization of the BusinessRevenueExpensesCash in the BusinessVenture Capital(Make sure that you go through the PPT so see how picture changes)

So every business needs cash to operate. In most companies, cash is generated from realized revenue and then the company incurs expenses as part of generating that revenue.

The challenge with most venture-backed companies is that millions must be invested in building a product before significant revenue is realized.

Thus, an entrepreneur has to present a compelling story to a Venture Capitalist. If he or she agrees, then the fund will dump a bucket of cash into the bathtub.providing the requisite capital to begin building the product and revenue.12The Start-up immediately invests the capital in product, management, and initiating some revenue. Incurs a sizable Burn RateRevenueExpensesCash in the Business(Click once and the graphics should work on their own)

Early on, most Venture-Backed company incur a sizable Burn Rate meaning that they are spending a ton more money than they are generating in revenue.

In most instances, its necessary to incur the expenses to develop a product or service that is scalable enough to generate significant revenues down the road.13At this point, the company will either have to: 1) Raise More Capital; 2) Dramatically cut expenses; or 3) Shut DownRevenueCash in the BusinessVenture Capital(One click should move the graphics)

So, inevitably, the entrepreneur (and the VC) both know that the company will have to raise more capital to survive and advance to the next level.

The idea of cutting back expenses may seem appealing, but if the expenses are necessary to get to a scalable product or service.then its not an option.

So how do you get the Venture Fund to throw in another bucket of water? You better have hit certain milestones with the first round of capital to justify additional investments. This can be a tricky situation because VCs will cut their losses if they feel they are throwing good money after bad.14ExpensesThe process will continue until the company can generate enough revenue to cover the costs to grow at an optimal levelRevenueCash in the Business(Click once and the graphics should work on their own)

Hopefully, after 2-3 Rounds of Venture Capital, the company is now generating significant revenue.enough to cover operating expenses and reinvest in the business.

This may take 4-6 years following the initial round of Venture Capital.15The ultimate goal is that the revenue pipe is much bigger than the drain pipe and lots of $$$ is returned to the Venture Capital Investors.RevenueVenture CapitalRevenueExpensesCash in the BusinessReturn Cash to VC with big profit(Click once and the graphics should work on their own)

Ultimately, the objective is for the revenue pipe to increase significantly to a point that the company is now ready for an Initial Public Offering or to be acquired by another large company.

And then, the Venture Fund gets repaid by selling its ownership during the IPO or to an acquiring company.

16When do VCs invest?

TIMERISKCompany LaunchVenture CapitalSale or IPO(one click and graphic will pop in)

So the real question is when do Venture Funds usually invest in companies?

The answer is that they will only invest when a requisite amount of risk has been taken off the table and the company is ready for commercialization.

This begs the question, how does an entrepreneur raise the necessary capital to get the company ready for Venture Capital? Well discuss this in later class sessions.suffice to say, its not easy.17Why dont banks invest in high potential ventures?

Ask the question to the class: Why dont banks invest in high potential ventures?

See what they come up with..and then move to next slide184 Reasons Banks dont invest in start-upsBanks are not in the business of losing money (4 out 5 start-up companies fail within the first 5 years);

Start-ups have limited assets to pledge to the bank.

Banks are not set up to take equity in companies;

Usury laws prevent Banks from charging a high enough interest rate to compensate for loans that go bad.There are 4 reasons banks dont invest in high potential startups (Click through)

Banks are not in the business of betting.4 out of 5 start-ups fail in the first 5 years, banks dont like the odds;

Most start-ups that fail dont have assets of any value a bank can liquidate to get their money back;

Banks are not set up to take equity in companies; and

Usury laws prevent banks from charging a high enough interest rate to compensate for loan losses on failed companies.19Whats the difference between Debt & Equity Capital?Debt Capital: Capital that is borrowed and repaid within a specified period of time. Debt comes with a fee (in the form of interest) and is usually secured by the assets of the company.

Equity Capital: Capital used to acquire ownership in the company. Investors hope to sell their ownership in the future at a price much higher than what they originally paid. (Click)

So lets discuss the difference between debt and equity capital.

What is Debt Capital (have class define)?

What is Equity Capital (have class define)?20Why Banks cannot invest (Example)$1,000,000$1,000,000$1,000,000$1,000,000$1,000,000$5,000,000InvestmentSuppose a Bank invests $1MM in 5 high potential Mobile App Start-ups in the form of a 5-Year Term loan at 10% Interest (Estimated income of $132,000 Per Loan)Failed after 12 monthsFailed after 24 monthsFailed after 24 monthsFailed after 36 monthsAcquired for $200MM in Yr 5Outcome$254,964 $509,928 $509,928 $764,892 $1,132,000 $3,171,712 Returned(click thru)

So lets take a look at an example of bank that chooses to invest in 5 High Potential Mobile App startups. The only tool they have in their tool belt is a loan and lets suppose they charge the highest rate possible on the loan (10%).

The bank estimates that it will earn $132,000 on each loan over the 5-year period if in fact the companies succeed.

Based on statistics, if you fast forward 5 years, youll see that 4 out of the 5 companies probably have failed to gain traction in the marketplace and have liquidated. The one that succeeded was able to repay the loan. To the bank, it doesnt matter if the company was acquired for $200MM.the bank only gets it note repaid + interest.

But the losses from the other failed companies are too big, creating significant losses for the bank. Its not sustainable.21Why VCs will invest$1,000,000$1,000,000$1,000,000$1,000,000$1,000,000$5,000,000InvestmentSuppose a VC invests $1MM in 5 Mobile App Startups and receives 25% Equity in each of the investmentsOutcome$0$0$0$0$50,000,000$50,000,000ReturnedFailed after 12 monthsFailed after 24 monthsFailed after 24 monthsFailed after 36 monthsAcquired for $200MM in Yr 5However, lets take a look at the Venture Capital Model. Lets suppose a VC takes a 25% ownership stake in each of the 5 companies.

The Venture Fund now gets paid on the equity and that one deal alone can pay off handsomely to the Venture Capitalistsuch that it compensates for 4 losses and still provides and outsized return on the $5MM invested.22So what has to be the #1 criteria for a Venture Capitalist Investment?Every investment MUST have grand slam potential!!!(Click)

To the question becomes, what is the #1 criteria for a Venture Capitalist to invest in a company????

It must have grand slam potential. This means that every deal a VC invests in must have a large enough upside to compensate for all of the losses it know it will incur over the life of a Venture Fund.

Lots a entrepreneurs get frustrated when a VC passes on their deal even if the company is profitable.the reality is that they are passing most likely because a big enough problem isnt being solved and they cannot see a path to a huge payoff.23Example #1$250,0002010$78 MM2012

(Click thru)

So lets take a look as some examples.more to the point, what Venture Capitalist aspire to in terms of investments they are hoping to make.

Andreessen Horowitz is a top Venture Fund in Silicon Valley. Mark Andressen was the founder of Netscape, the first internet browser.

They made a $250,000 investment in Instagram in 2010. About 18 months later, Instagram was acquired by Facebook, and Andressen earned $78MM on the deal.24Example #2$12.5MM1999$3.7 Billion2004

(Click thru)

IN 1999, Kleiner Perkins launched a $500MM Early Stage Internet fund that was immediately underwater by late 2001 following the market crash in April of 2000.

The only successful investment from that fund was a $12.5MM investment in Google.

In 2004, that investment yielded them $3.7Billion, making it the most successful fund in Kleiner Perkins History.25Example #3

$6.7MM1997$5 Billion1999And lastly,

Benchmark capital invested $6.7MM in Ebay in 1997.

Two years later, Ebay went public and Benchmarks take was an astounding $5 Billion.26Example #3 (In Perspective)

$25,0001997$18.7 MM1999IF YOUR PARENTS HAD INVESTEDTo put this in perspective. Had you parents invested $25,000 in the same round as Benchmark, they would have earned $18.7 Million on the investment in just two years.

These are the kinds of returns VCs are looking for and the limited partners that fund the VCs.27What doesnt get funded by Venture Capital?

Restaurants & Bars

Real Estate DevelopmentsFinancial ServicesCommodity Food Products

Its also important to note what Venture Capitalists do not fund:

Restaurants & Bars;

Real Estate Projects;

Financial Services;

Commodity Food Products28This Semester, youre going to learn:What types of companies raise Venture Capital;How Venture Capital Funds are formed;How Venture Capital deals are structured; and then.

Spend 6 weeks playing the:So, this semester, you are going to learn:

What types of companies raise venture capital;

How VCs create and manage their funds;

And how Venture Capital deals are structured

Then you are going to play interactive Venture Capital game for about a 1/3 of the class periods.

29Questions?End of Lecture30