Venture Capital Financing

MBA 6314/TME 3413

October, 2003

Overview

• VC and corporate finance

• Overview of VC industry

• The VC life cycle• The VC investment

process• Negotiations

• Valuation and pricing• Deal structure• The “Venture Capital

Method”• The Shareholder’s

Agreement• Growing the business• The exit

Conventional Financing

• Assets

• Inventory & receivables

• Land & buildings• Equipment & vehicles• Other

• Liabilities & Equities

• Operating line of credit

• Mortgage• Term loan• Share capital &

retained earnings

VC Financing

• Fills the cash gap between cash needs to finance high growth and cash available from earnings and conventional financing

• Giving up a piece of the pie to grow a bigger pie

Overview of VC Industry

• Angel investors

• Private equity funds

• Labor sponsored funds

• Institutional investors

• Diversified versus focused

• Venture Capital Trends

Gap With U.S. Has ClosedDisbursements 1995-2001; Canada & U.S.

$0

$20

$40

$60

$80

$100

$120

$140

$160

1995 1996 1997 1998 1999 2000 2001

$0

$2

$4

$6

$8

$10

$12

$14

$16

U.S.A.

CDN

$ Invested by Canadian VCs - $ Billions$ Invested by US VCs - $ CDN Billion

Less $ to Big Deals Drives Decline$ Invested by Transaction Size; Atlantic Region

$0

$10

$20

$30

$40

$50

$60

$70

$80

$Millions

1996 1997 1998 1999 2000 2001

<$500K $500-$999K $1000K-$4999K >$5000K

$33M

$23M

$48M$53M

$75M

$53M

Technology Almost Exclusive Focus Disbursements in Canada

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$Millions

1996 1997 1998 1999 2000 2001

Technology Traditional

$1,089M

$1,774M $1,751M

$2,986M

$6,629M

$4,874M

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Capital Markets Playing FieldCapital Markets Playing Field

ConceptConceptInvestigationInvestigation

BasicBasicDesignDesign

PrototypePrototypeBuildingBuilding

MarketMarketEntryEntry

ManufacturingManufacturingRamp-upRamp-up

KnowledgeKnowledgeAcquisitionAcquisition

Government ProgramsGovernment Programs

Public IssuesPublic Issues

Commercial BanksCommercial Banks

Non-Financial CorporationsNon-Financial Corporations

Venture Capital FundsVenture Capital FundsSeed FundsSeed Funds

Wealthy Family FundsWealthy Family Funds

Private InvestorsPrivate Investors

Faminly and FriendsFaminly and Friends

Personal SavingsPersonal Savings

Phase IPhase I Phase IIPhase II Phase IIIPhase III

The VC Life Cycle

• Submit business plan• Preliminary assessment• Meet the people• Light due diligence• Term sheet• Heavy due diligence• Investment memorandum• Commitment letter• Shareholder’s agreement• Grow the company• Exit

The Business Life Cycle

Typical SME Growth Profiles

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

Years

Sale

s ($

mil

lion

s)

High-Growth Firm

Moderate-Growth Firm

Low-Growth Firm

VC Prospects

VC Investment Criteria

• Exponential growth potential• Attractive industry• Sustainable advantage platform• Excellent team “execution”• Owners receptive to involvement of outsiders• Owners willing to share the wealth creation• Credible exit alternatives (4-7 years out)

The Ingredients- Good CEO

• Good CEO is the most critical element– Best is “been there and done that”– Has specific domain experience/expertise– “Knows what he/she doesn’t know & locates

resources to fill gaps.– Shows “fire in the belly”– Recognizes urgency-revenue generation/ burn rate– Knows the difference between being an employee

and being a shareholder

The Ingredients-Strong Management Team

• Characteristics Include:– Honesty/Integrity/Competence/Discipline– Have specific domain experience– Ability to self-assess– Motivated– “Fire in the belly”– Plans and communicates effectively– Develops appropriate MIS

• Caveat-beware the “family ties”

The Ingredients-Technology/Core

Competence• Ability to define and enunciate what it is• Ability to relate core technology-/competence to a

variety of significant market applications-(must be balanced by focus)

• Strong “in house” R&D capability with the mechanisms to fund it. – Equity/loans– Customer Pays (direct or through margins)

The Ingredients-The Business Model

• Implies having a well defined business model that says, “I know who my customers are, what they need, how I will meet their needs, how I will reach them, how I will service them, how I will continue to best my competition and how I will make money.

• Avoid “if we build it they will come!”

Ingredients-The Value Proposition

• Why will/do our customers buy or product?

– Ease the Pain– Improve Revenue/ Productivity/Profitability

The Ingredients-The Strategic Alliance

• A “must” for most emerging companies– distribution– product development (perhaps)

• Can accelerate success or hasten demise

Venture Capital Valuation & PricingInternal Rate of Return (IRR)

VC Investments and IRR

VC Target IRR

• Seed• Startup• First stage• Second stage• Bridge• Restart

• IRR>80%• 50-70%• 40-60%• 30-50%• 20-35%• ??

23

What are they prepared to pay for?

What are they prepared to pay for?

• In later stage companies VC’s can value the “cake” as well as the “ingredients”. This is a luxury they do not have in funding emerging technology companies.

• The “cake” represents companies with demonstrable and sustained patterns of growth in revenue (30%+/annum compounded) and profitability (commensurate)

• In early stage companies VC’s have to value the ingredients and estimate what the “cake” might look like in 3 to 5 years!

• sGood CEO is the most critical element

• “Knowing what you don’t know” and locating the resources to fill the gaps

• Having a strong board of directors with good mix of skillsets/properly motivated, i.e. financial

• Having a strong & motivated management team

• Having a strong core technology/competence applicable to variety of market applications

• Building the right strategic alliances in the right way

Why so High?

• Base IRR =risk free rate

• Plus premiums

Why so High?

• Systematic risk in capital markets

• Unsystematic (unique) risk diversified away

• VC firms more vulnerable to market swings

Why so High?

• Liquidity premium

• 4-7 year investment time horizon

• Not easy to liquidate investment

Why so High?

• Value added premium

• Recruitment of key personnel

• Strategy

• Board of Directors

• Network

• Deep pockets

Why so High?

• Portfolio average return

• 2-6-2 rule

Valuation and Pricing

• Magnitude of investment• Staging of investment• Syndication• Target IRR• Investment time horizon• Terminal value of firm• % ownership required• Deal structure• Future financing and dilution – “The Venture Capital

Method”

Magnitude of Investment

• Typically >$1.0 million for institutional

• Small deals too costly

• Typically less than $10 million in Canada

• Based on business plan pro forma

Staging of Investment

• All up front

• Two or three tranches

• Contingent on meeting milestones/targest

• Option to abandon

Syndication

• Sharing the deal with other VC firms

• Diversify the risk

• Broaden the network

• Increase size of portfolio

Target IRR

• 25-80 %

• Stage of company

• Use of funds

• Deal structure

Investment Time Horizon

• 4-7 years

• How long will it take to create value?

• Years to cash flow breakeven

Terminal Value of Firm

• Projected earnings at exit

• Price/earnings ratio (PER)

• Projected TV=Projected Earnings x PER

% Ownership Required

• Magnitude of investment

• Duration of investment

• Target IRR

• Terminal value of firm

• Room for future investment?

VC Investments and IRR

% Ownership Required

Deal Structure

• Shares

• Shares and subordinated debt

• Shares and convertible subordinated debt

• What is the upside?

• What is the downside?

• Does the structure affect the risk to the VC?

40

Typical Investment StructuresTypical Investment Structures

• Early Stage– Common Shares- Maybe “Put” requirement

or “Forced Sale” provision on commons if no exit within 5 to 7 years

– Preferred Shares-convertible into common or with warrants attached, frequently with cumulative dividend- 5 yr. term

– %tage of equity required tied directly to valuation and amount of capital being sought

41

Typical Investment StructuresTypical Investment Structures

• Later Stage Investments (Mezzanine)

– Convertible Debentures/Debentures with Warrants

– Debentures with nominal cost equity– Debentures may be unsecured or secured (back

of the bus) and usually carry an interest coupon– Straight debentures may or may not be sinking

fund”

Deal Structure SpreadsheetsThree Scenarios

• $1.0 m VC investment

• 5 year time horizon

• Target IRR 40%

• Terminal value $11.25 m

• Three different deal structures

• Varying % ownership

Scenario A

Scenario B

Scenario C

The Venture Capital MethodStep 1

• Given the VC investment, the target IRR and the investment time horizon, determine the future value of the VC investment

• FV = PV(1+i)^n

• i = target IRR

• N = time horizon to exit

• Eg. FV = $1.0m(1+0.35)^5 = $4.5m

The Venture Capital MethodStep 2

• Given the projected earnings at exit and an appropriate Price Earnings ratio (PER) for the company, calculate the projected terminal value of the company at exit

• Eg. TV = $1.0m(15) = $15m

The Venture Capital MethodStep 3

• Determine the % ownership required by dividing the required future value of the investment at exit by the projected terminal value of the company at exit

• Eg. FV= $4.5m/TV$15m = 30%• Or divide the VC investment by the present value

of the projected terminal value of the company at exit

• Eg. PV=$15m/(1+0.45)^5=$3.33m ; $1.0m/$3.33m=30%

The Venture Capital MethodStep 4

• Determine number of new shares (NS) to be issued to VC.

• Find number of shares outstanding before investment (old shares (OS) eg. 1.0m)

• VC % Ownership = NS/(NS +OS)• Eg. 30% = NS/(NS + 1.0m) NS= 430,000 Price per share = $1.0m/430,000 = $2.33

The Venture Capital MethodStep 5

• Determine pre and post-money valuation• If 30% of the company is acquired for a $1.0 VC

investment, this implies a post-money valuation of $1.0/0.30 = $3.33m

• Give a post-money valuation of $3.33m and an investment of $1.0m, the pre-money valuation is $2.33m

• Does this valuation make sense? Is it realistic?

The Venture Capital MethodStep 6

• Assess future dilution due to issuance of additional shares prior to exit.

• Shares to management, future investors• Estimate retention ratio = 100% - % of

ownership issued to others in future• Eg. If a future investor negotiates a 10%

ownership, the retention ratio is 100%-10%=90%

The Venture Capital MethodStep 7

• Calculate adjustment to required ownership % due to expected future dilution

• Adjusted ownership % = % ownership without dilution divided by retention ratio

• Eg. Adjusted % = 30%/90% = 33.3%• If VC owns 33% after investment and gets diluted

by 10% before exit, the final ownership % will be 30%, ie. the required ownership % to realize target IRR given projected terminal value

Venture Capital MethodSpreadsheet

The Venture Capital MethodMultiple Rounds of Financing

• Often subsequent rounds of financing are anticipated before the round 1 VC investor plans to exit

• Each subsequent round will negotiate an ownership position based on their own magnitude of investment, target IRR and investment time horizon

• The round 1 VC investor has to anticipate these future investments and adjust required ownership % for expected future dilution

• Typically future investments have a lower target IRR• The round 1 investor retention ratio is 100% minus the %

owned by future round investors at exit

Sensitivity Analysis

• Terminal Value– Future Earnings (Sales, Expenses, Profits)– PER

• Target IRR– Risk– Deal Structure– Liquidity

• Dilution– Future Rounds (Amounts, IRR, Horizon)– Management incentives

The VC-Company Relationship

• VC Fees

• The Shareholder’s Agreement

• Corporate Governance

• Exit

VC Fees

• Commitment fee

• Termination fee

• Due diligence expenses

• Legal expenses

• All paid by company

Shareholder’s Agreement

• Defacto control over critical decisions– Hiring/firing key management personnel– Budgets and capital expenditures– Financing– Strategic changes– Veto rights– Dispute resolution

Shareholder’s Agreement

• Exit Provisions– “Put”/ “Call” Rights– “Drag Along” Rights– “Tag Along” Rights– “Right of First Refusal” Rights– Valuation formula/process

Shareholder’s Agreement

• Corporate Governance– Board of Directors– Independent members– Swing vote to independents– Help create value

Corporate Governance

• No interference in day-today operations

• Regular reporting (monthly)

• Regular Board meetings

• Annual audits

• Performance assessment

• Help out when needed

Exit Alternatives

• Sale to company treasury

• Sale to equity partners

• Sale to owners/management/employees

• Sale to third party (VC shares or all)

• IPO

• Hold and “milk”

• Liquidate

The Initial Public Offering (IPO)

• Address capital needs beyond limits of VC’s• Liquidity for VC’s• “Quiet period”• “Lock up” period• Legal, accounting and investment banking fees• Prospectus and road show• Public scrutiny• Focus on stock price, short term results

What Should You Expect From Your V.C?

• An investment in size, scope and structure consistent with the execution requirements of your business plan

• Ability to bring other V.C.’s and financiers to the table

• Active, value adding board of directors involvement

• Access to network and other resources

• A fair deal that creates a win/win for everybody and recognizes the value of monetary and non monetary contributions of key stakeholders

• Ongoing financial support where business case warrants

• Do your homework, v.c. money is not homogeneous

Realities of the Current Market

• Financing based on “Napkin” business plans is “out”

• Fundamentals are back “in”• Companies must show more evidence of market

acceptance of product, value proposition and business model before funding

• Tough with no sales• Valuations are down 50-75% • V.C.’s are staying closer to home

Investors Active in Atlantic Canada

ACF Equity Atlantic Inc.

BMO Capital

BDC Venture Capital Group

Canadian Science and Technology Group

Roynat

Manulife

EDC

CDP – Accés Capital

CDP - Sofinov

Genesys Capital Partners

Latitude Partners

Ventures West Management Inc ETSIF

Skypoint

RBCP.