1 raising entrepreneurial capital chapter 6 venture capital

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1 Raising Entrepreneurial Capital Chapter 6 Venture Capital

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Page 1: 1 Raising Entrepreneurial Capital Chapter 6 Venture Capital

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Raising Entrepreneurial Capital

Chapter 6

Venture Capital

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Chapter Goals

Learn the characteristics of a firm appropriate for venture capital financing.

Understand the structure of the VC industry.

Understand a term sheet and the reasons for the terms.

Become familiar with legal documents typically required in the venture process.

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Venture Capital:Background

1946: First venture capital fund formed.

1979: Pension funds allowed to invest in venture capital for the first time. Today nearly half of all VC money comes from pension funds.

Volume of VC funding increased tenfold during the 1980s.

VC funding peaked in 2000 at the height of the dotcom frenzy.

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VC Investments

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Venture Capital Partnerships

VC Funds can range in size from $1 million to $1 billion and more. Average life of a fund is 10 years. One VC firm may oversee several funds.

Funds are usually limited partnerships. General partners compensation:1.5-3% of

committed capital plus a share of profits after limited partners have recovered their initial investment.

Limited partners have little direct influence.

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Types of Funds

Private Funds Goal is strictly financial gain. Exit via Trade Sale or IPO if possible.

Corporate VC Funds: subsidiaries of banks, insurance companies, and technology-intensive corporations. Goals are partly financial and partly to

achieve a market or technological advantage.

Intel and Microsoft are examples of corporate strategic VC investors.

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Strategic VC Investors

Offer substantial potential benefits to entrepreneurs, such as higher initial valuation, synergy with the investor company, and a ready-made exit route.

Problems can occur if your product directly competes with one of theirs. They might be protecting their market rather than investing in you.

Be careful: strategic investors do not always live up to their promises.

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Investment Characteristics

VC firms should provide more than cash. Management expertise Industry experience Valuable contacts

VC firms hope to grow your business to an industry leader in 3-5 years.

They seek strong management teams and defensible business models.

They expect high returns, depending upon stage and holding period.

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Expected Rates of Return Required for Funding

Actual rates of return are always less than the required rates due to risk.

You must still have a defendable rationale to justify the required rate.

Required annualized rates of return range from as high as 100% for seed capital start-ups to about 25% for late stage bridge and mezzanine financing 1-3 years prior to IPO or other exit.

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Venture Capital Returns The compounded Venture Capital Return Rate over many years

is approximately 17.8%.

In order for a Venture Fund to be profitable, it must assume at least 50% of its investments will at best make only a small profit.

Approximately 25% of the investments will be sold or liquidated.

Of the remaining 25%, about half will go public, and generate compounded returns exceeding 60-120%.

http://www.ventureplan.com/venture.capital.basics.html

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Credible Financial Proposals

Most credible approach is to project future capital requirements in terms of stages of development.

Each stage will have its own specific funding requirements and measurable milestones. Examples: completion of prototype,

successful pilot project, first sale.

Enables the entrepreneur to pick the best form of financing for each stage.

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Financial Projections

Investors expect to see projections in a format that is familiar to them. Don’t fight it. Give it to them the way they want to see it.

Use standard accounting principles. Explain all assumptions used in

preparing financial projections. Think Ahead! Explain any anomalies in

the numbers before being asked.

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Investors’ Expectations

You must demonstrate a thorough understanding of the market for your products or services through: Market research Competitive analysis

Strong and experienced management is mandatory.

Previous success with a start-up or with taking a company public is a big plus.

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Investor Expectations:Three Key Criteria

Capability for sustained intense effort. Thorough familiarity with the target

market. Demonstrated leadership ability in

previous, and preferably similar, ventures.

Note: Be prepared to provide references to back up any claims you make.

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What Every Investor Wants to Know (6 key questions), First 3

How much can I make? (40% ROI expected)

How much can I lose? (All of it plus any loan guarantees, law suits, time)

Who says this thing will work? (Third party verification of all business plan items)

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What Every Investor Wants to Know (6 key questions), Remaining 3

Who else is in the deal? (The management and investment team and their qualifications in this field)

How big is the market, and how will the company reach the clients? (Verification of marketability)

How do I get my money out and when? (Exit strategy for IPO, Acquisition or Merger)

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Approaching Private Investors

Your odds improve greatly if you are recommended to a VC firm by: a legal or accounting firm a bank or other financial institution another firm in their existing portfolio a reputable professional finder

Presenting at a VC forum is a great way to practice and refine your pitch, but the odds of finding an investor this way are small. Still, it is a good way to network.

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Management Factors Most Critical to Investors Can the team maintain a sustained effort? 67%

Does the team have extensive market familiarity? 67%

Is the entrepreneur a leader? 31%

Can I get at least a 10 times ROI in 5 to 7 years? 28%

http://www.ventureplan.com/venture.capital.basics.html

http://www.ventureplan.com/venture.capital.basics.html

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Developing Your Pitch:It’s All About the Audience

Learn everything you can about the firm and people to whom you will be presenting.

Anticipate their objections and have credible answers ready in advance. These people see hundreds of pitches. They will be brutally blunt if you are poorly prepared.

Explain to them why you are a good fit for their fund and portfolio.

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Developing Your Pitch:Best Foot Forward

Convince the investor that your company is a real solution to a real problem and represents a real opportunity, not magical thinking.

Demonstrate a superior grasp of the competition and you will stand head and shoulders above a typical pitch.

Clearly demonstrate management strengths. Do not exaggerate.

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Developing Your Pitch:Nothing Succeeds Like Success

Act “Presidential” and they will be more likely to believe you.

Everyone CLAIMS to be different from the herd. You must PROVE it.

NEVER GO OVER TIME! This is death. At best it demonstrates sloppiness, and at worst, contempt for the audience.

Be precise, specific, and clear. No “fuzzy thinking” allowed!

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Due Diligence:Investor Verifies Your Claims

Expect a lengthy, tedious and frustrating process, including an intense technology evaluation.

Expect the VC firm to contact your customers, suppliers, competitors, and your competitors’ customers.

VC firms almost never sign confidentiality agreements. If you don’t trust them, don’t start the process.

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The Venture Capital Process:Letter of Intent (LOI)

The LOI is an interim step between initial negotiations and formal financing agreements. They are not always used.

LOIs are rarely legally binding in total, but they must not be taken lightly. Seek advice before signing anything.

Some clauses are legally binding, such as prohibiting management from seeking financing elsewhere for a period of time.

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The Venture Capital Process:Valuation Issues

Valuation is generally computed as a multiple of earnings after the investment, discounted by the desired rate of return.

Valuation is a negotiation process and largely depends upon market conditions at the time.

Valuations are just educated guesswork.

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The Term Sheet:Objective

The term sheet is a funding offer from the VC firm to the entrepreneur.

It specifies the terms and conditions of the offer to fund, often in great detail.

It typically encompasses allocation of cash flow rights, board rights, voting rights, liquidation rights and other control rights.

The initial terms sheet is an offer subject to negotiation.

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The Term Sheet:Important Considerations

The entrepreneur will want to address: Loss of control Dilution Restrictions on future financing Termination conditions and rights

Strive to avoid any ambiguity. Failure to be clear and precise will cause problems later, sometimes very serious problems.

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The Term Sheet:Typical Structure

Page One typically states the dollar amount offered and the instruments (bond, common stock, preferred stock, promissory note, or a combination).

It must state the dollar value of ownership as this will be the investor’s cost basis for tax purposes.

Specify post-closing capitalization: value of the enterprise after the investment.

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The Term Sheet:Typical Structure

Capitalization Table: summary of the entire capital structure of the company, including all investors up to that point and their ownership percentages.

VCs typically receive preferred shares, granting them priority in case of liquidating the business, and other preferences over the founding shareholders.

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The Term Sheet:Other Provisions

Procedure and schedule for conversion of preferred into common shares.

Anti-dilution provisions. Voting rights and other protections Investor information rights, especially

financial reporting requirements. Terms for selection of board members

and officers, and insurance for directors, officers and senior managers.

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Key Term Sheet Clauses:Structure of the Financing

Preferred Shares generally offer the greatest protection to investors, especially if anti-dilution rights are included.

Convertible Debentures are sometimes favored in high risk transactions because the investor can receive additional protection as a creditor. It also gives the company a tax deduction for interest paid.

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Key Term Sheet Clauses:Structure of the Financing

Debt Securities with warrants offer similar advantages to convertible debt.

Common Shares are almost never issued to VCs at the outset. They offer no rights or control and could create a taxable event for employees if shares were later issued to them at a cost lower than the per share price paid by the VC firm.

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Key Term Sheet Clauses:Ratchet Clauses

A ratchet clause is a mechanism to protect the VC investor against having his ownership percentage reduced, or diluted, by the issuance of new shares.

A “full ratchet” would protect the VC against any dilution.

A “partial ratchet” will allow some dilution and be fairer to the founders.

You may want to exempt employee stock options from the ratchet provision.

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Key Term Sheet Clauses:Liquidation Preferences

Liquidation preferences refer to the number of “times” the investor must be repaid their initial investment in the event the company is liquidated.

VC investors can have rights to be repaid 1, 2, 3 or more times their original investment before other shareholders receive anything. This is usually called the double or triple “dip.”

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Understanding Legal Documents:Subscription Agreement

Representations and Warranties include the financial and other information made available to the investors.

These describe conditions which must be met prior to closing.

Affirmative covenants specify what the entrepreneur must do.

Negative covenants specify what the entrepreneur can not do.

Covenants are in force until the VC sells.

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Understanding Legal Documents:Amending Corporate By-Laws

Each issuance of preferred shares will probably require amending the corporate by-laws.

Investors in each new series of preferred shares will want the same, or greater, rights and preferences as were awarded the initial, or Series A, investors.

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Understanding Legal Documents:Shareholders’ Agreement

VC firms will normally require at least the principal shareholders to sign a shareholder’s agreement prior to closing.

Typically it will restrict the transfer of securities and sale of founder’s shares, among other things.

Investors also often want to reserve the right to buy additional shares.

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Understanding Legal Documents:Employee-Related Agreements

Key employees will also be required to sign certain documents, such as: Employment agreements Non-disclosure and Intellectual Property

Assignment agreements Share Repurchase agreements

Given the critical importance of management talent to a new venture, defining a proper relationship is essential.

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Understanding Legal Documents:Other

Contingent Proxy: provides for transfer to the VC of voting rights associated with any shares owned by a key principal in the company who dies, or is in serious breach of covenants.

Registration Rights Agreement: Preserves the VC’s right to participate in any future public offering of the company’s shares.