“Funding a Technology Startup – Insights into the World of Venture Capital”

Tom Weithman

Managing Director, CIT GAP Funds

Remarks to Capital Technology Management Hub

November 10, 2009

Overview

• What VC Is … How It Works

• Changes in Venture Capital

• What It Means for Regional Start-Ups

What Is Venture Capital?Private Equity Class Focused on Funding and Building Early Stage, High-Growth Enterprises

Sources of New Venture Financing

• Self, Friends, and Family

• Federal Government Grants & Contracts

• Business Angels

• Venture Capital 2008 Volume: $28.4B Invested in 3832 Deals

• Small Business Investment Companies (SBICs)

• Trade Credit and Factoring

• Asset-based Lending

• Mezzanine Capital

• Private Placements of Equity (Relational Investors)

• IPOs

• Public Debt

VC Fund Structure

Asset Allocation

Alternative Assets

Capital Call

Carried Interest

Management Fee

Fund Life

Deployment Period

Key Concepts

Illustration Source: Wikipedia

Why do VCs Invest?

• Create Extraordinary Returns for the General Partnership and its Limited Partners

– Compensation for Illiquidity, Technology Risk and Business Risk

• Large Multiple “Exit” or “Liquidity Event” that Transforms Ownership into Financial Return

– M&A or IPO at 5-15X within 3-5 Years

– Multiple Offsets New Venture Risks

What Do VCs Invest In?

Source: MoneyTree Report – NVCA/PWC/Thomson Reuters

Venture Capital Outcomes - NVCA• Big Name VC-Backed Companies

• Returns, 1988-2008– 17.0% Annualized IRR - All VC Funds – 21.6% Annualized IRR – “Early Stage” Funds

• VC-Backed Companies Spill-Overs, 1970-2005 – 10M Jobs– 17% of GDP

Major Changes in Venture Industry

Exit Markets and Liquidity• Near-Term Liquidity Problems Throughout the VC Food Chain• Cyclical Depression of M&A Market• Long-Term Structural Impediments to IPO Market

Institutional Investment Patterns • Shrinking Allocations to VC• Increasing Concentration of VC in Fewer Firms

Impact to VC Industry• Exit of Established Funds from Industry• Growth of “Mega-Funds” – National and International in Scope• Diminished Capacity to do Seed-Early Stage Investment

Institutional Investment Patterns

Portfolio Allocation, 1998-2008• Increased Allocation to Illiquid “Alternative Assets” – e.g.,

VC,LBO (4X+ Increase, 1998-2008)

Concentration of Funds in Fewer VCs• “Flight to Quality”• Larger Fund Sizes• Abetted by VC Compensation Model• Average VC Fund Sizes

– 1Q99: $112M– 1Q09: $250M

Proliferation of Private Equity

VC Investment Patterns • Proliferation of VC Funds, Post 1999

– Valuations Bid Up– Exit Multiples Pushed Down

• Trend Toward Larger Funds and Capital Deployments – Fostered by VC Fund Management Comp Model– Discouraging of Early-Seed Investing

• Seed/Early Stage Deals: 35% of 1Q99 VC Dollars v 18% in 1Q09

• Lower Valuations– Mean Round Valuations 2008: $46.7M v Preceding 14 Years: $72.9M

• Concentration in “Maturing” Tech Sector– Open Source, Off-shoring, Affordable Bandwidth, Internet-Based

Marketing– Decreasing Capital Requirements– Substandard Returns

“IPO Market Impairments”

“Why are IPOs in the ICU?” by David Weild and Edward Kim, Grant Thornton, 2009

“The Great Recession” – Immediate Impacts

VC Portfolio Consequences• Protracted Customer Buying Cycles• Longer Lead Follow-On Financings• Emphasis on Lowering Burn

Depressed Exit Climate for VC-Backed Companies - 2008• “IPO-Free” Quarter – 2Q08 – First Time in 30 Years!• IPO Volume (6) Lowest Since 1970s • M&A v 2007

– Volume (335) Dropped 11% – Disclosed Proceeds Dropped 59%

“The Great Recession” – Long-Term Impacts

Institutional Portfolio Consequences

• “High-Alternative” Allocation Strategy Compromised– Disproportionately Large Illiquid Holdings– Need to Cash to Cover Capital Call Obligations on LBO Funds

• Sell-Off of Illiquid Holdings Forces Value Declines

• Future Allocations to All Alternatives Likely to Suffer – Decreased VC Investment– Concentration in Smaller Number of Funds

For Entrepreneurs …Take-Away #1

Partnering with VCs will Be Challenging …• Entrepreneur’s Cost-of-Capital for VC Will Increase• VC Will Be Harder to Raise Than Ever• Seed/Early Stage Funds Will Be Hardest of All

But VC will Survive …• Large Funds will Offer Extraordinary Reach and Firepower • Non-Traditional Funds will Offer New, but Different Capacity • New Sector Cultivation – e.g., CleanTech

For Entrepreneurs … Take-Away #2 You Are in a Great Place to Build a Business

Strong Regional Economy• 4th largest economy in US• > Gross Regional Product = $454 billion

Federal Government Foundation• #1 in the world for government research & development spending per capita• > More than 50 federal labs focusing on science & technology• > Federal procurement of goods and services = $66.5 billion, the most in the US

Innovation and Entrepreneurship• Home to the most Inc. 500 fastest-growing companies in the US — for 12 consecutive years• > Nearly $6.9 billion of venture capital invested in regional companies from 2002–2008

Talented, Highly-Educated Workforce• Higher concentration of knowledge workers than any other major US metropolitan region• > #1 in the US: 47% of workforce has Bachelor’s degree; 22% has advanced degree• > Home to 6 of top 8 counties in nation with highest per capita college degrees

Strong Entrepreneurial Support Structures• CIT, NVTC, MAVA, Maryland TEDCO• Growing base of experienced entrepreneurs and service providers

For Entrepreneurs … Take-Away #3 Venture Capital Does Not Equal Innovation

Cash• Angels Investment• Bootstrapping• Debt• Federal Grants and Contracts

Guidance and Support, Access, Credibility• Board of Directors or Advisors• Seasoned Management Team • Blue-Chip Customers• Channel Partnerships and Strategic Alliances

“Funding a Technology Startup – An Insight

into the World of Venture Capital” Objectives Revisited• The Role of VC’s and the VC landscape• VC Business Models• Flavors of VC Investments• VC’s Investment Criteria and Objectives• Typical Investment Lifecycle• Main Players in the DC Metro Area• The Uniqueness of the DC Area• Opportunities Created by Federal Stimulus

Back-Up Slides

Factors Impacting IPO MarketFrom 1991-97, 80% of IPOs were under $50M. By 2000, this declined to less than 20%

Key Factors

• 1996 On-Line Brokerage Proliferates - Beginning with Charles Schwab, on-line brokerages usher in unprecedented levels of individual investment in stock market, erode margins of traditional retail brokerage houses, and push participants our of commission-based brokerage business

• 2001 Decimalization; SEC mandates that price changes be expressed in penny increments v fractions. The result was a savings on brokerage fees for consumers but significantly higher participation in arguably speculative investment activity. Wall Street’s sell-side research capacity is gutted.

• 2002 Sarbanes Oxley increases time and expense to go public

• 2003 Global Research Analyst Settlement Ruling requires Investment Bankers to insulate research analysts from investment banking transactions. Result has been that a larger number of co-managers and bookrunners must participate in transactions to guarantee research coverage.

VC Performance v Committed Capital

VC Performance V Investments

Institutional Commitment to PE

Bill Gurley, “What Is Really Happening to the Venture Capital Industry?”, abovethecrowd.com, posted August 24, 2009

Proliferation of Venture Capital

VC Capital Under Management, 1988-2008

Source: University of New Hampshire Center for Venture Research, Price Waterhouse Coopers

Early Stage Private Equity

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2007 Angel Investments 2007 VC Investments

$25+ Billion51,000 Deals

Average Deal Size:

$500,000

$25+ Billion3,416 Deals

Average Deal Size:

$7,500,000

Where Do VCs Invest?

Life Sciences

Clean Technology

InformationTechnology

Brief History of VC

• 1492 – Ferdinand & Isabella Fund Columbus

Post WWII• 1946 - American Research & Development (ARD) Corporation• J.H. Whitney – Minute Maid Orange Juice• Rockefeller Family – Eastern Airlines• 1957 – Federal SBIC Program• 1960s – Bull Market• 1970s – Market Slump; Legislation Against Pension Fund Abuses• 1980s – Capital Gains Rate Tax Cut

-- Bars to Pension Fund Investment Lifted • Prominent IPOs – FedEx (1978), Apple (1981), Genentech (1981)• Bubble• Post-Bubble

Investment Stage and Expected Return• Seed Financing (80%)

– Lone Inventor / Entrepreneur – Small Amount of Capital for “Proof-of Concept”– Early Product Development, Market Research, Team Formation

• Start-Up Financing (60%)– Capital to complete Product Development and Initial Marketing– Pre-Commercial Launch– Key Management and Business Plan in Place

• First-Stage (50%)– Capital for Full-Scale Manufacturing and Sales– Pre-Profit

• Second-Stage (40%)– Working Capital for Initial Expansion – Producing and Shipping Product– Pre-Profit to First Profits

• Third-Stage, Mezzanine (30%)– Capital for Major Expansion– Needs for Plant and Equipment, Marketing, Working Capital

• Bridge Financing (25%)– Pre-IPO

Time-to-LiquidityInvestor’s Expected ReturnTechnology RiskBusiness RiskEntrepreneur’s Cost of Capital

High

Low

VC Deal Structure

Preferred Stock

Key Terms• Valuation• Liquidation Preference• Option Pool• Board Representation• Anti-Dilution• Redemption and Dividends• Protective Provisions

VC Today … Facts, Rumors, and Allegations?

• VC Returns Not Rewarding Investors …– Low Exit Values– Delayed Realizations– Total Ten-Year Returns will Go Negative in 2010

• Larger Fund Sizes Pushing Out Early Stage Investment

• Established Funds Exiting the Business

• “VC Compensation Does Not Incentivize Results!”

• “The Venture Capital Model is Broken!”

Why Entrepreneurs Raise Venture Capital

Guidance & Support• Board Participants - Interim Executives• Product Management, Business Development and Financial Planning

Access• Industry Contacts• Leverage Portfolio

Credibility• Stamp of Approval with Customers, Partners and Vendors

Cash

For Entrepreneurs Seeking VC … • Does Your Plan Fit the Needs of the Venture Capital Fund?

• Are You Ready For Venture Capital?

• Are You Prepared to Become a Minority Stockholder?

• Can Your Target VCs Add Value?

• Are You at the Front End of the VCs Deployment Period?

• Are the VCs Compensation and Return Arrangements Aligned with Yours?

• Have You Spoken with Other Portfolio Company CEOs?

• Do Guidance, Access, and credibility Provided Justify the High Cost of Capital Incurred?

Alternatives to VC?

Cash• Angels Investment• Bootstrapping• Debt• Federal Grants and Contracts

Guidance and Support, Access, Credibility• Board of Directors or Advisors• Seasoned Management Team • Blue-Chip Customers• Channel Partnerships and Strategic Alliances

Washington Metro Area StrengthsEconomic Strength and Stability• 4th largest economy in US• > Gross Regional Product = $454 billion• > Consistent, steady GRP growth over last two decades; CAGR = 3.6%• > 1st nationally in net new job growth over last decade

Federal Government Foundation• #1 in the world for government research & development spending per capita• > More than 50 federal labs focusing on science & technology• > Federal procurement of goods and services = $66.5 billion, the most in the US• > Average annual procurement growth rate since 1988 = 11%

Innovation and Entrepreneurship• Home to the most Inc. 500 fastest-growing companies in the US —• for 12 consecutive years• > Top 20 venture capital firms have $17 billion under management• > Nearly $6.9 billion of venture capital invested in regional companies from 2002–2008

Talented, Highly-Educated Workforce• Higher concentration of knowledge workers than any other major• US metropolitan region• > #1 in the US: 47% of workforce has Bachelor’s degree; 22% has advanced degree• > Home to 6 of top 8 counties in nation with highest per capita college degrees