The Financing Food ChainThe Financing Food Chain

Dr Peter KellyDr Peter Kelly

22 April 200422 April 2004

The Capital PyramidThe Capital Pyramid

Prospector fundsProspector funds government grants, employer, foundationsgovernment grants, employer, foundations

Personal fundsPersonal funds Professional fundsProfessional funds

business angelsbusiness angels venture capital fundsventure capital funds banks banks

Public equity fundingPublic equity funding

Founder, family,friends, fools

Business Angels

Public EquityMarkets

Commercial Banks

Corporates

Venture Capitalists

HIGH RISK

START-UP MATURITY

LOW RISK

Fund Raising AdviceFund Raising Advice

Think small: what do I really need?Think small: what do I really need? Wear Wear ““investor eyeglasses”investor eyeglasses” Specify milestonesSpecify milestones Do your homework before approachingDo your homework before approaching Do not be put off by the word Do not be put off by the word ““no”no” Respect Murphy’s Law of Venture BuildingRespect Murphy’s Law of Venture Building

Prospector FundsProspector Funds

Entrepreneurs often start their business on Entrepreneurs often start their business on back of market research back of market research ““bought” by their bought” by their employeremployer

Myriad of grants, foundations, funding Myriad of grants, foundations, funding bodies that fund:bodies that fund: prototypesprototypes patentspatents business developmentbusiness development

Prospector FundsProspector Funds

However, you need to understand:However, you need to understand: who to approachwho to approach how to approachhow to approach what they want to hearwhat they want to hear the the ““magic words” (in addition to please)magic words” (in addition to please)

In my experience, the quality of tactical In my experience, the quality of tactical advice provided is highly variableadvice provided is highly variable

Ideally no strings, hastles, forms or Ideally no strings, hastles, forms or involvementinvolvement

Personal FundsPersonal Funds

Golden Rules ...Golden Rules ... You need to signal to others your belief in the You need to signal to others your belief in the

business by giving business by giving ““until it hurts (some)!”until it hurts (some)!” In the absence of personal capital, sweat In the absence of personal capital, sweat

equity will doequity will do Your sacrifices have to be made BEFORE Your sacrifices have to be made BEFORE

approaching investorsapproaching investors Project a start-up personal lifestyleProject a start-up personal lifestyle Spouses/partners need to be 100% Spouses/partners need to be 100%

supportivesupportive

Friends, Family, FoolsFriends, Family, Fools

Friends and family that know you are Friends and family that know you are largest source of capital next to personal largest source of capital next to personal fundsfunds

If you use them prepare to lose themIf you use them prepare to lose them Do not get them involved in the business Do not get them involved in the business

unless their experience warrantsunless their experience warrants Prepare the divorce papers in advancePrepare the divorce papers in advance Ideally you want Ideally you want ““silent partners”silent partners”

Professional FundsProfessional Funds

Grants, soft money, personal funds, and Grants, soft money, personal funds, and capital provided by friends, family and capital provided by friends, family and fools is bedrock to raise outside capital ...fools is bedrock to raise outside capital ...

Early on, many entrepreneurs view the Early on, many entrepreneurs view the bank as the next logical port of callbank as the next logical port of call

In fact, business angels are the ONLY In fact, business angels are the ONLY viable and valuable route in the early viable and valuable route in the early stagesstages

Angels Are Big News ...Angels Are Big News ...

Some of the firms backed by angels ...Some of the firms backed by angels ... Bell Telephone (1874)Bell Telephone (1874) Ford Motor Company (1903)Ford Motor Company (1903) Apple Computer (1977)Apple Computer (1977) Amazon (1995)Amazon (1995)

Some notable angels ...Some notable angels ... Paul Allen (Microsoft), Ben Rosen (Compaq)Paul Allen (Microsoft), Ben Rosen (Compaq) Ross Perot (EDI), John Sculley (Apple)Ross Perot (EDI), John Sculley (Apple) Jim Barksdale (Netscape)Jim Barksdale (Netscape)

A A ““Typical” ProfileTypical” Profile

middle aged malemiddle aged male reasonable net worth and incomereasonable net worth and income new venture experiencenew venture experience typically invest in 1 deal a yeartypically invest in 1 deal a year usually invests close to homeusually invests close to home usually invests as part of group/syndicateusually invests as part of group/syndicate invests small and earlyinvests small and early leverage & exit appealleverage & exit appeal

By Some Estimates ...By Some Estimates ...

United States:United States: 2 million + business angels2 million + business angels invest $100 billion + per yearinvest $100 billion + per year invest in 40,000 + venturesinvest in 40,000 + venturesUnited Kingdom:United Kingdom: 50,000 business angels50,000 business angels invest £5 billion + per yearinvest £5 billion + per year in 30-40x more ventures than vc fundsin 30-40x more ventures than vc funds

Hearing About Opportunities ...Hearing About Opportunities ...

Described as Described as ““reveal and referral” marketreveal and referral” market Best referrals come from ...Best referrals come from ...

people they have invested with beforepeople they have invested with before business associatesbusiness associates personal friendspersonal friends business introduction servicesbusiness introduction services

Many investors also actively search out Many investors also actively search out investment opportunitiesinvestment opportunities

Business Angels Business Angels ≠ Charity≠ Charity

Seek capital gains on invested capitalSeek capital gains on invested capital They want exit in reasonable time frameThey want exit in reasonable time frame Want to be involved in situations that can Want to be involved in situations that can

benefit from leveraging their experience benefit from leveraging their experience and contacts (full contact sport)and contacts (full contact sport)

Relive the entrepreneurial dreamRelive the entrepreneurial dream Excitement Excitement Do not have to investDo not have to invest

Investment CriteriaInvestment Criteria

““There are many parallels between private There are many parallels between private investing and betting on the horses. To investing and betting on the horses. To make money, you need to assess the make money, you need to assess the condition of the track (industry), the horse condition of the track (industry), the horse (strategy) and the jockey (people). (strategy) and the jockey (people). Experienced punters always bet on the Experienced punters always bet on the jockey.”jockey.”

Why Be Actively Involved ...Why Be Actively Involved ...

It is my kid’s inheritance on the line!It is my kid’s inheritance on the line! Business can genuinely benefit from my Business can genuinely benefit from my

experience as well as capitalexperience as well as capital They have the time to be involved unlike They have the time to be involved unlike

many venture capital fund managersmany venture capital fund managers Entrepreneurs genuinely appreciate the Entrepreneurs genuinely appreciate the

helphelp

An Invisible Market ...An Invisible Market ...

aptly described as aptly described as ““a giant game of hide-a giant game of hide-and-go-seek with everyone playing and-go-seek with everyone playing blindfolded.”blindfolded.”

how to locate them ...how to locate them ... use your networkuse your network from entrepreneurs who have raised moneyfrom entrepreneurs who have raised money through business angel matching servicesthrough business angel matching services via specialized publications (VCR)via specialized publications (VCR)

Market InsightsMarket Insights

surveyed 110 active business angelssurveyed 110 active business angels completed 835 deals to datecompleted 835 deals to date 75%+ had started a business, on average 75%+ had started a business, on average

more than 3 eachmore than 3 each overwhelmingly middle aged malesoverwhelmingly middle aged males provided detailed information on their most provided detailed information on their most

recent investment maderecent investment made

A A ““Typical” DealTypical” Deal

management invests £70k and retains management invests £70k and retains 53% of business post investment53% of business post investment

outside investors invest £320koutside investors invest £320k 70%+ deals are early stage70%+ deals are early stage 70%+ involved syndicates70%+ involved syndicates 40% investor employed in some capacity40% investor employed in some capacity almost all located < 1 hour from homealmost all located < 1 hour from home almost all documented with contractalmost all documented with contract

Contract Non-NegotiablesContract Non-Negotiables

Veto rights over acquisitions or divestmentVeto rights over acquisitions or divestment Investor approval of strategic plans/budgetInvestor approval of strategic plans/budget Share option issuance restrictionsShare option issuance restrictions Non-compete contracts Non-compete contracts Restrictions on ability to raise additional Restrictions on ability to raise additional

debt or equity financedebt or equity finance

INVESTORS PROTECT VALUATION ...INVESTORS PROTECT VALUATION ...

Contract NegotiablesContract Negotiables

Forced exit provisionsForced exit provisions Investor approval hiring/firing decisionsInvestor approval hiring/firing decisions Investors need to co-sign chequesInvestors need to co-sign cheques Management equity ratchetsManagement equity ratchets Dispute resolution mechanismsDispute resolution mechanisms

MANAGEMENT IS LEFT TO MANAGE ...MANAGEMENT IS LEFT TO MANAGE ...

Additional InsightsAdditional Insights

More experienced business angels More experienced business angels behave like venture capitalistsbehave like venture capitalists

Syndicates need thicker contractsSyndicates need thicker contracts Trusted referrers shape the deal in Trusted referrers shape the deal in

favourable waysfavourable ways Defining roles is the true value of the Defining roles is the true value of the

contract – it in fact does not offer true legal contract – it in fact does not offer true legal protection ...protection ...

Venture Capital: A HistoryVenture Capital: A History

Queen Isabella can be considered first Queen Isabella can be considered first venture capitalist (Columbus)venture capitalist (Columbus)

Institutional venture capital started shortly Institutional venture capital started shortly in mid 1940sin mid 1940s

Industry took off on the back of a single Industry took off on the back of a single big hit investment (Digital Equipment)big hit investment (Digital Equipment)

Industry growth stimulants ...Industry growth stimulants ... regulations (Prudent Man rule), capital gains taxregulations (Prudent Man rule), capital gains tax exhuberant IPO marketsexhuberant IPO markets

Venture CapitalVenture Capital

Team of professional managers (general Team of professional managers (general partners) raise money from institutional partners) raise money from institutional investors & individuals (limited partners)investors & individuals (limited partners)

Closed end versus evergreen fundsClosed end versus evergreen funds Limited partners get repaid firstLimited partners get repaid first General partner receives an annual fee for General partner receives an annual fee for

managing fund (2%-3%) + carried interest managing fund (2%-3%) + carried interest in capital gains realized (20%-30%)in capital gains realized (20%-30%)

Venture CapitalVenture Capital

General partners make all investment General partners make all investment decisions decisions

Limited partners can not be actively Limited partners can not be actively involved with investee companiesinvolved with investee companies

Typical 10 year closed end fundTypical 10 year closed end fund spends 3 years making new investmentsspends 3 years making new investments 3-4 years making follow-on investments3-4 years making follow-on investments 3-4 years grooming exits (IPO, trade sale)3-4 years grooming exits (IPO, trade sale)

Classic Venture CapitalClassic Venture Capital

Read Bill Bygrave’s timeless classic Read Bill Bygrave’s timeless classic Venture Capital at the Crossroads (1992)Venture Capital at the Crossroads (1992)

Time honoured principlesTime honoured principles invest small amounts of capitalinvest small amounts of capital at formative stages of venture developmentat formative stages of venture development working with syndicates of fundsworking with syndicates of funds with a lead investor with a lead investor ““getting dirty”getting dirty” getting exit with 5 to 7 yearsgetting exit with 5 to 7 years then raise more moneythen raise more money

Classic Venture Capital (2000)Classic Venture Capital (2000)

Bubble economics 101 ...Bubble economics 101 ... invest large amounts of capitalinvest large amounts of capital at formative stages of venture developmentat formative stages of venture development often alone, particularly in early stagesoften alone, particularly in early stages to groom a company for IPO within 18 monthsto groom a company for IPO within 18 months while constantly fund raisingwhile constantly fund raising

Venture CapitalVenture Capital

Perfect + correlation between funds raised Perfect + correlation between funds raised by vc’s and IPO activity on public marketsby vc’s and IPO activity on public markets

Perfect + correlation between funds Perfect + correlation between funds invested and IPO activityinvested and IPO activity

When financial opportunity costs approach When financial opportunity costs approach zero, funds flow into venture capitalzero, funds flow into venture capital

Valuations go hand-in-hand with number Valuations go hand-in-hand with number of funds and capital overhangof funds and capital overhang

Venture Capital: The ProcessVenture Capital: The Process

With other people’s money at risk, venture With other people’s money at risk, venture capitalists signal competence by ...capitalists signal competence by ... relying on well defined processes to screen relying on well defined processes to screen

and evaluate potential opportunitiesand evaluate potential opportunities having numerous eyes look at dealshaving numerous eyes look at deals conducting extensive due diligenceconducting extensive due diligence relying on extensive contractsrelying on extensive contracts documenting everything they dodocumenting everything they do

VCs: Visible But Accessible?VCs: Visible But Accessible?

Every country has an online directory of Every country has an online directory of venture capital funds ...venture capital funds ... investment focus (stage, sector, size)investment focus (stage, sector, size) partners namespartners names investee companiesinvestee companies office locationsoffice locations

Easy to identify Easy to identify ≠ Easy to approach ...≠ Easy to approach ... referrals are absolutely necessaryreferrals are absolutely necessary

Venture Capital: The US SceneVenture Capital: The US Scene

$350 billion + capital under management$350 billion + capital under management 80% raised since 199780% raised since 1997 Number of funds 600-700Number of funds 600-700 Growing number of $1 billion + fundsGrowing number of $1 billion + funds 40% of all investments Silicon Valley40% of all investments Silicon Valley $100 billion capital overhang right now$100 billion capital overhang right now Many funds are returning capital to LPsMany funds are returning capital to LPs

US VC Industry: On Wild SideUS VC Industry: On Wild Side

0

20

40

60

80

100

120

1997 1998 1999 2000 2001 2002 2003

Investments ($b)

Contemporary ChallengesContemporary Challenges

Too much money chasing too few dealsToo much money chasing too few deals Too many funds exist but Too many funds exist but ““barriers to exit” are barriers to exit” are

huge (Jim Breyer, Accel Partners)huge (Jim Breyer, Accel Partners) Are limited partners in fact Are limited partners in fact ““patient”?patient”? Do mediocre performers Do mediocre performers ““drag down the whole drag down the whole

industry with it”?industry with it”? Is it possible to scale up a Is it possible to scale up a ““cottage industry”? cottage industry”?

(Bruce Dunlevie, Benchmark)(Bruce Dunlevie, Benchmark) Will the IPO market recover?Will the IPO market recover?

Angels vs VCs:Angels vs VCs:Highlighting the DifferencesHighlighting the Differences

Business Angels Venture Capitalists

PERSONAL Entrepreneurs InvestorsFIRMS FUNDED Small, early stage Large, matureDUE DILIGENCE Minimal ExtensiveLOCATION Close to home Not importantCONTRACT Simple ComprehensiveMONITORING Active, hands-on StrategicEXIT Of lesser concern Highly importantRETURN (IRR) Of lesser concern Highly important