venture capital

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

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Korea

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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

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UK

Ireland

Japan

USA

Canada

Sweden

France

Korea

ICT = Information and Communication Technologies

USA

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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%

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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”


“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)


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


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


– 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.”


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


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



roundinitial

Founders $1,180 45 % 62 %


2006

Founders + team

$1,180 45 % 62 %

Angels $700 27 % 38 %

VCs $720 28 %

TOTAL $2,600 100 % 100 % 100 %

Equity split



roundinitial

Founders $1,180 45 % 62 % 100 %


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



$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 :




$18 M x100/38 = $47 M

And pre-money valuation is

$47 M - $18 = $29 M

Equity Fingerprint


TIME

Dilution

$2 M $18 M

Angel Round VC Round

Equity Fingerprint

TIME8 million downloads of Skype

3.3M

5.3 M 27 M6x



Dilution

5.3 M 27 M

47 M 2.6 bn

6x

55x

Equity Fingerprint

TIME8 million downloads of Skype

3.3M

6x


5.3 M 27 M


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


Friis 40%

Team 20 %

Total 100 %

This is typical of

the equity split of

a start up

company


Angel investors

Tom Draper 12.5 % 250 k

Angel 1 12.5 % 250 k

Angel 2 12.5 % 250 k


Angel 2 12.5 % 250 k

Angel 3 12.5 % 250 k

Draper Investments Co.

50 % 1 M

Total 100 % 2 M


VC round

4 VC investors 25 % each Total

4.5 M each $ 18 M


4.5 M each $ 18 M


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


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



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!

venture capital

Economy & Finance

venture capital process

venture capitalwhere

investors limited partners

seed funds

seed mezzanine funds

vc vcs

geography samller funds

region anthem capital