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DERMOT BERKERYnil

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$49.95 USA$61.95 CAN/28.99 UK

Have the Negotiating

Edge When Getting

Your New Business

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r / ritten by Dermot Berkery, an internationallyknownventurecapitalist with Delta Partners,

this complete sourcebook details how venturecapitalists arrange thefinancing fora company, whatthey look for in a business plan, how they value abusiness, and how they structure the terms of anagreement. Within its pages, you'll find everythingyou needto successfully raise newbusiness capital onthe most attractive termspossible.

Using informative case studies, detailed charts, andterm sheet exercises, Raising Venture Capitalfor theSerious Entrepreneur discusses the basic principles ofthe venture capital method, strategies for raisingcapital, methods of valuing the early-stage venture,and proven techniques for negotiating the deal. Theauthor leads you step-by-step through:

Developing a Financing MapComprising 4 to 5 Stepping-Stones

Getting to the First Stepping-Stone

Understanding the Unique CashFlow and Risk Dynamics ofEarly-StageVentures

Determining the Amount ofCapitalto Raise and What to Spend It On

Learning How Venture CapitalFirms Think

" Creating aWinning Business Plan

J Valuing Early-StageCompanies

- Agreeing on aTerm Sheet with aVenture Capitalist

Setting Terms for Splittingthe Rewards

(continued on backflap)

- Raising -

VentureCapital

FOR THE

SeriousENTREPRENEUR

- Raising -

Venture

CapitalFOR THE

SeriousENTREPRENEUR

McGrain/Hill

New York Chicago San Francisco Lisbon London Madrid Mexico CityMilan New Delhi San Juan Seoul Singapore Sydney Toronto

The McGraw-Hill Companies

Copyright 2008 by DermotBerkery. All rights reserved. Printed in the United States of America.Except as permitted under the United States Copyright Act of1976, nopartofthispublication may bereproduced ordistributed inanyform orbyanymeans, orstored ina databaseor retrieval system,without the priorwritten permission of the publisher.

234567890 DOC/DOC 0 9 8

ISBN-13: 978-0-07-149602-5

ISBN-10: 0-07-149602-5

This publication is designed to provide accurate andauthoritative information in regard to the subjectmattercovered. Itis sold with the understanding that neither the authornorthe publisher is engagedin rendering legal, accounting, futures/securities trading, orotherprofessional service. Iflegal adviceor other expertassistance is required, the services ofa competentprofessional person should besought.

-From a Declaration of Principles jointlyadopted bya Committeeof the American BarAssociation and a Committee ofPublishers

McGraw-Hill books are availableat special quantitydiscountsto use as premiums and salespromotions, or foruse in corporate training programs. For moreinformation, please writeto theDirector of SpecialSales, Professional Publishing, McGraw-Hill, Two Penn Plaza, New York, NY 10121-2298. Or contact your local bookstore.

This book is printed on acid-free paper.

Library of Congress Cataloging-in-Publication Data

Berkery, DermotRaising venture capital forthe serious entrepreneur / Dermot Berkery.

p. cm.

ISBN-13: 978-0-07-149602-5 (hardcover: alk. paper)ISBN-10: 0-07-149602-5

1. Venturecapital. 2. Small businessFinance. 3. New business enterprises-Finance. I. Title.

HG4751.B468 2007

658.15'224dc22 2007008993

To my mother, Josie. Much missed.

CONTENTS

Foreword xiii

Preface xv

Acknowledgments xvii

INTRODUCTION 1

CPJEDITICA SOFTWARE INC. CASE STUDY 7

part I UNDERSTANDING THE BASICS OFTHE VENTURE CAPITAL METHOD

CHAPTER 1 DEVELOPING A FINANCING MAP 19Creating a Set of Stepping-Stones for a New Business 20Matching the Financing Strategy to the Stepping-Stones 21Developing a Map of Possible Stepping-Stones 23Capturing as Much of the Prize as You Can 31

chapter 2 GETTING TO THE FIRST STEPPING-STONE 33

Why New Ventures Are Not Fully Funded from the Start 34Fleshing Out the First Stepping-Stone 35Options at the End of Each Stage of Investment 38The Chief Financial Officer as Strategist 39Why Corporations Fail in Creating New Businesses 43

vn

viii CONTENTS

chapter 3 THE UNIQUE CASH FLOW AND RISKDYNAMICS OF EARLY-STAGE VENTURES 47

Costs KnownRevenues Unknown 48

J Curves and Peak Cash Needs 53

Milestone Funding: Option or Investment? 59A 12- to 24-Month Ticking Clock 63Timing Is EverythingBuy Low, Sell High 65A Five- to Seven-Year Marathonin Three to Four Stages 66Gross Margins of 80 to 100% 68No Correlation between the Amount of Money Raisedand

the Company's Success 70A Tension between the "Lemons Ripening Early" and

the "Valleyof Death" 70A Binary Payoff Profile 72

part 11 RAISING THE FINANCE

CHAPTER 4 DETERMINING THE AMOUNTOF CAPITAL TO RAISE AND WHAT

TO SPEND IT ON 77

An Established CompanyEstimating the Amount ofCapital to Raise 78

A New CompanyEstimating the Amount of Capital to Raise 78Activities in a New Business That Absorb Capital 79Investors' Views of the Five Capital-Absorbing Activities 90Businesses with Different Capital-Absorbing Profiles 93

chapter 5 GETTING BEHIND HOW VENTURECAPITAL FIRMS THINK 97

Structure of Venture Capital Funds 97Types of Investors in Venture Capital Funds 100Size and Internal Structure of VC Firms 102

CONTENTS ix

How VC Firms Are Compensated 103Valuation of Investments within a VC Portfolio 106

Cash Flows and J Curve at a Fund Level 108

Expected Returns on a VC Fund 111Expected Returns on Individual Investments in a VC Fund 114It's All about BigWinners 117Portfolio Construction 118

Sorting Out Conflicts of Interest 120

chapter O CREATING A WINNING BUSINESS PLAN 123

Market Powerthe Key Ingredient Missing in Most BusinessPlans 124

Evidence to Include in the Business Plan 125

1. Potential for Accelerated Growth in a Big, Accessible Market 1252. Achievable Position of Market Power 130

3. Capable, Ambitious, Trustworthy Management 1354. Plausible, Value-Enhancing Stepping-Stones 1365. Realistic Valuation 137

6. Promising Exit Possibilities 137

part 111 VALUING THE EARLY-STAGE VENTURE

CHAPTER 7 VALUING EARLY-STAGE COMPANIES 141Traditional ValuationMethodsWhy They Don't Work for

Early-Stage Ventures 142Are Valuations of Technology Companies Crazy? 145Corporate Finance TheoryTechnology Company Valuation 147Triangulation Process of Venture Capitalists 150How the Company Can Maximize Its Valuation 160Why Big Companies Buy Small Companies 161Value of Small Companies Compared to Large Companies 162

CONTENTS

part 1 f NEGOTIATING THE DEAL: TERM SHEETS

chapter 8 AGREEING ON ATERM SHEET WITH AVENTURE CAPITALIST 169

Percentage Ownership of the CompanyGranted to the Investor 169What Each Side Tries to Achieve in a Term Sheet 173

Why It Isn't Like Investing in a Public Company 175

chapter 9 TERMS FOR SPLITTING THE REWARDS 1771. Exit Preferences, Linked to the Type of Preferred Stock 1782. Staging of Investment againstMilestones 1913. Options to Invest More Money at a Defined Price per Share 1924. Preferred Dividends 193

5. Antidilution 194

Problems with Ratchets 204

Pay-to-Play Clauses 207Washout Financing RoundsDown (and Out!) Rounds 210

chapter 10 ALLOCATING CONTROL BETWEENFOUNDERS/MANAGEMENT AND

INVESTORS 213

Restricted Transactions/Protective Covenants 213

Structure of the Board of Directors 219

Redemption 226Forced Sale 227

Registration Rights 229TagalongRights, Dragalong Rights 230Information Rights 233Right of Access to the Premises and Records and Right to

Appoint a Consultant 233Preemption Rights 233Transfer Provisions 234

Exclusivity Clause 235

:hapter 11 ALIGNING THE INTERESTS OFFOUNDERS/MANAGEMENT AND

INVESTORS

Founders' Stock

Option PoolVesting ArrangementsNoncompete AgreementsIntellectual Property AssignmentWarranties and Representations

PART EXERCISES

:hapter 12 TERM SHEET EXERCISES

CONTENTS xi

237

238

238

240

245

246

246

251

APPENDIX A: SECURITY PORTAL INC. 267

APPENDIX B: STANDARD TERM SHEET CLAUSES 273

Index 281

FOREWORD

The worldhas changed dramatically overthe past 30years. We havewitnesseda number of remarkable technological revolutions rang

ing from the creation of the biotech and personal computer industriesto nascent formation of the nanotech industry. During that period, theventure capital industry has evolved into a major force in financingnewventures. What used to be a tiny cottage industry with only a few players is now a global financial force that helps propel new technologies tosuccessful commercialization.

The roots of the modern venture capital industry trace back to themid-1940s when General Georges F. Doriot, a renowned professor atHarvard Business School, helped launch American Research & Development (ARD), a publiclytraded venture capitalfirm. ARD started withunder $5M in capital. It struggled for several years, partly because ittakes time for early-stage investments to get traction.

In 1956, ARD provided $70,000 to a team of scientists at MIT whohad a plan to build powerful minicomputers, machines that would compete effectivelywith the dominant mainframe computers of the day byoffering superior performance at a fraction of the cost. In return forthat investment, ARD ended up with 70% of the company. The company was Digital Equipment Corporation, which went on to great success. Indeed, ARD eventually made hundreds of times its investment inthe company.

But, think about the fact that Ken Olsen and his team had to give up70% of the company's stock to raise a trivial amount of money. Does

FOREWORD

that seem reasonable? At the time, Olsen and his colleagues had nochoices. Therewere few investors willing to back such a risky company.Moreover, Olsen and his colleagues had no reasonable ways tobenchmark their dealthey didn't have many colleagues starting upcompanies at the same time.

Today, OlsencouldreadRaising Venture Capitalfor the Serious Entrepreneur by Dermot Berkery and learn how to level the playing fieldbetween venture capitalists and entrepreneurs. He would understandhow and why the investors would want to stage their commitment ofcapital. He would be able to compare the terms he was getting withthose being offered similar teams and ideas. He would have a bettersense of how growth companies are valued in the publicmarkets.

Berkery's work on financing early-stage, high-potential ventureswalks the aspiring entrepreneur through all the steps from conceivingthe idea to selling the business. It arms the entrepreneur for negotiations with vastly more experienced venture capitalists and gives theentrepreneurs tools for thinking about their business in productiveways. In short, he increases the likelihood of success for any and allventures.

If you're an entrepreneur,you should read this book. If you're a venture capitalist, you should read this book. And, certainly, if you're aneducator, you should assign this book.

Professor William A. SahlmanDimitri V D'Arbeloff-MBA Class of 1955

Professor ofBusiness AdministrationSenior Associate Dean for External Relations

Harvard Business School

PREFACE

Every experienced entrepreneur knows that the process of financinghis or her business is a great gamefull of high drama. Road shows to

raise investment are gruelingand utterly distracting from the main goalof succeeding in the marketplace. Investors try to grab ownership in thecompany andarefullof promises regarding the value-added theycanbringto the fledgling company. Large companies, putting themselves forwardas possible strategic investors, are often trying to get control sneakilytostaveoff their competitors. Different classes of investors in the companypursue different agendas, often dysfunctional from the perspectiveof thecompanyas a whole. The legal documents governingthe investment aremind-numbingly boring and densebut they can't be ignored. Mistakesin the legal documents can comebackto haunt youaveto granted to aminor investor (sometimes by oversight) can escalate into an intractablestandoffa year or two later. Latenightsporing overinch-deeplegaldocuments are a far cry from the popular image of entrepreneurs.

If only it were as simple as investing in public companies, where aninvestment of so-many millions of dollars gives you X% of the company, and all stock is created equal. It's not. There is little alternativebut to play the game on the field set out by the investors. They are theones with the experience and the money.

The first-time entrepreneur is at a huge disadvantage. While thegreat game is frustrating and exhilarating, it is also complex and needsto be mastered. You can get advice from your lawyers. But they oftenunderstand the words, not the commercial implications. The entrepreneur needs to lessen the learning curve, without taking five to seven

xvi PREFACE

years to do it. The venture capitalist has been through it many timesbefore. The old adage applies: "When playing poker, if you don't knowwho at the table is the fool, it might be you."

In short, entrepreneursneed to get smarterabout the rules and the tacticsquickly. Mastering the venture capital (VC) method is the keyto this.

The VC method has stood the test of time and has proven its worththrough extreme peaks and valleys of investment cycles. The shape ofa VC deal on the West Coast is much the same as it would be on the

East Coast and in Europe. The shape has evolved over the past fewdecades and will no doubt continue to evolve as investors and entre

preneurs learn and innovate.Asthe VC methodhasbeenhoned andmaturedthrough experience,

so the business has becomeinstitutionalized. There are manyVC firms,designed around a standardized limited partner/general partner structure (more on this structure in the chapter on venture capital firms).VC is now a defined investment asset class for pension funds, investment managers, and endowments.

But, while VC has become institutionalized, it is still largely an artrather than a science. Writers on the subject descriptively cover themechanics of how it works rather than why it works the way it does.Venture capitalists like the fact that the business is opaque; this opacity keeps the market very inefficient. Early-stage investing can sustainthe venture capital firms (with a generous fee and profit participationstructure as it is) only because the market is extremelyinefficient. If themarket was truly efficient and the VC process a science, extremelybright 25-year-olds would be throwing the darts instead.

Thankfully for venture capitalists, VC doesn't work this way. Wisdom and judgment are more important than are smarts. The potentialto build a companyaround good technology or a good team is extremelydifficult to spot and immensely harder to make happen. Long-in-the-tooth venture capitalists joke that it takes five years and $5M in failedinvestments to train a new venture capitalist. Many ventures that shouldget funded do not get funded and vice versa. First-class venture capitalmanagers exploit this inefficiency in the market to earn supernormalreturns for their investors and to build their personal wealth. Demystifying the process is not in their interest. Nor is it fully possible.

DermotBerkery

ACKNOWLEDGMENTS

Many thanks to everyone who helped along the way in pullingtogether this book.

Becoming a venture capitalist is a long apprenticeship in whichmoneyis lost and tears are shed.There are lots of discussions along thewaythat begin with the phrase: "Well,I won't make that mistake again."My colleagues at Delta Partners helped me to avoid some of the mostegregious mistakes along the waywith gentle suggestions, such as, "Youmight want to think about. . ." We have been in the business too longand are humbled too often not to value the opinions of others werespect. Frank Kenny, our managing partner, is a long-term investorwho has been in the business for decades. Maurice Roche, Shay Gar-vey, Joey Mason, Rob Johnson, and John O'Sullivan have all helped intheir own specialwaysto make me to be a better investor. Karen Clarke,my secretary, has kept me in line for many years.

In the spirit of learning in the school of hard knocks, I owe a lot tothe CEOs and senior executives of companies in which I invested, all ofwhom endured (and some continue to endure) me as I go through thelifelong apprenticeship of becoming a better investor. Sometimes thingsworked out great, and sometimes things got uglyat no time was itever dull. Every new company was a baptism of fire for all of us. Thanksto Garry Moroney, Tony McEnroe, Joe Gantly, Joe O'Keeffe, CarlJackson, Charles NichoUs,Andy Walker, Adrian Cuthbert, Jon Billing,Vincent Browne, Peter Branagan, Mark Suster, and many others. Someof them still send me a Christmas card.

xviii ACKNOWLEDGMENTS

Thanks also to Professors Mike Roberts and Bill Sahlman of

Harvard Business School for their input and support.I owe Dianne Wheeler, my executive editor at McGraw-Hill, a debt

of gratitude. Her thoughts on the bookstructure in particular wereexcellent, and I listenedassiduously to all her advice.

My dad,John Berkery, and father-in-law, Doug Mason, sorted outthe worst of my grammar.Jane Palmieri at McGraw-Hill sorted out therest.

Sally, my other half in all the best senses of the phrase, toleratedmethrough prolonged periods of radio silence while I was writing thisbook. Where would I be withouther? My three wonderful, zanychildren, Cormac, Rory, andKathleen, did everything possible to disruptthe writing of this book. Byso doing, they forced me to write quicklyandto get it right the first timeasmuch aspossible. For this, I supposethey deserve some gratitude.

- Raising -

VentureCapital

FOR THE

SeriousENTREPRENEUR

INTRODUCTION

Neew companies are guilty until proven innocent.Most of them fail. Investors know this. Entrepreneurs don'tor at

least choose not to believe this. Their company will be different fromall the others.

Is this clash of viewsa problem? Businesses need capital so that theycan invest in people, physical assets, inventory, and so on. But investorsare gripped by the fear of failure and the possible loss of their preciouscapital. Of course, they are intrigued by (yes, greedy for) the prize ifthe venture succeeds. Entrepreneurs are captivated by the opportunityand are blind to the possibility of failure. They have to be. Otherwise,they wouldn't set out on the crazy journey of building a new company.

How can the two sides come together? Is it a zero-sum game inwhich either the investor buys the entrepreneur's story hook, line, andsinker or the entrepreneur submits to the investor's view and abandonsthe project? Regardless of which, the two minds will seldom meet,and great opportunities to launch new businesses will be missed. Weall lose.

The venture capital (VC) method of investing solves this conundrum. It acts as a bridge between the fears of the investor and the hopesof the entrepreneur. Neither party needs to accept the other's viewentirely. Rather, the VC method recognizes that both points of view

INTRODUCTION

are valid, and it provides a dynamic financing structure for navigatingbetween the two.

This book covers the primary elements of this dynamic financingstructure. It startswitha case studyofa fictional company called Credi-tica Inc. Creditica is a software company with a very generic businessplan. It intends to start with a betaproduct, gatherearlyreference customers, and build the business from there. Throughout the book theVC method is applied to Creditica; therefore, it is important to get afeel for Creditica prior to jumping into most of the chapters.

Chapter 1 outlines how the long journey (5 to 7 years or more) ofbuilding a valuable business should be broken into a series of stepping-stoneswith typically a 12- to 18-month gap between the stepping-stones. Each stepping-stone comprises an integrated group ofmilestones (related to the product, market, customers, management,etc.). These stepping-stones are analogous to resting points on a longjourney. They representdemonstrable progress on the way to the goal.They also are a goodplace to stopandthink aboutthe remaining journey. Is the planned route still the correct one? Have other less risky orshorter routes opened up? In fact, is the destination wewereoriginallyheading toward still the best one?

The stepping-stones provide a structure that can be financed.Investorsdo not haveto signup to finance the wholejourneyfacingthebusiness; they will rarely have enough confidence in the plan up frontto do this. They need to provide only enough capital to finance thecompany to the next stepping-stone. Entrepreneurs get enough capitalto start moving on their journey and to achieve milestones that shouldentice more investment later which in turn finances the journey farther.As new stepping-stones are reached, the chances of reaching the prizeare improved and the cost of the investment capital should decline.

Chapter 2 focuses on the first of the stepping-stones. What sort ofmilestones should be included in it? What are the different first stepping-stones that might be open to the company? What role should theCFO play in the development of the strategy of the company?

The next 12 to 18 months on the wayto reaching the first stepping-stone will be very telling. Will the entrepreneur execute well and getthe business to the first stepping-stone thereby reaching important

INTRODUCTION

milestones with the initialcapital? If so, willnewinvestors buy into thedreamat that pointandinvest morecapital to takethe business further?If not, should the earlyinvestors abandon the journeyand let the companyfail? Or should the company be restructured (making the entrepreneur a casualty in the process)?

Breaking the journey into a series of stepping-stones offers innumerable options for midcourse shifts in strategy, financing approaches,and personnel.

Because of the stepping-stone structure, an early-stage company hasonly, at most, 12 to 18months of financing available to it. This createsa series of unusual cash flow and risk dynamics. There is always a ticking clockat work in the background. Each company has a time runway;if the airplanedoesn't take off and buildvalue before the end of the runway, the consequences will be severeperhaps catastrophic. Chapter 3enumerates 10 unique cash flow and risk dynamicsall of which arederived from the stepping-stone financing structure.

Chapter 4 establishes how much capital a company should seek toraise in a round of funding and, more importantly,what it should spendthe capital on. Simply categorized, entrepreneurs can spend their VCinvestmenton five itemscapital assets, product development overhead,leadership and administration expenses, working capital, and sales ramp-up costs. The return on investment of some of these items is inherentlyvery low. Only some have the potential to create enormous value. Entrepreneurs need to know which items have the potential to yield a venture return; they must avoid or minimize the others or, even better, getsomeone else to pay for them.

Venture capital funds are normally fixed-term partnerships. Thecompensation for the venture capitalists comes in two formsa management fee and a share in the gains ("carry"). Chapter 5 describes howthe structure of a fund and the compensationapproach drives a venturecapitalist's behavior and thought process.

There have been far too many books and articles written about business plans, listing the topics to include. Most miss the point. A businessplan is simply a vehicle for outlining how a business will create andexploit market power in its target market. The business plan needs toidentify the source of market power, marshal the evidence to support

INTRODUCTION

the case as to why the company cancapture and sustain it, and presentthe evidence in a simple, absorbable form. Chapter6 covers the blocksof evidence a typical investor will want.

Valuation of newcompanies is a black art to most peoplewho are notinvolved in the business on an ongoing basis. The traditional methodsof discounted cashflow andearnings/revenue multiples don'twork. Yet,investors and entrepreneurs need to agree on a valuation. How does ithappen in practice? What arethe rules of thumb, andwhydo theymakesense? Chapter 7 addresses the area fudged by other books on VChow to set a fair valuation for a newor early-stage company.

Chapter 8 introduces the concept of term sheets. In a public company, allunitsof stockare created equal. In aventure-backed company,the investors typicallybuy preferred stock. This preferred stock givesthem three primary advantages. First, it allows the returns to be skewedin favor of the preferred stockholderat the expense of the commonstockholder. The mechanisms for achieving this are covered in Chapter 9. Second, it enables investors to exercise control that is disproportionate to their level of shareholding. Retainingcertain decision rightsor appointing board members can achieve this. All these issues are covered in Chapter 10. Third, it helps to closelyalign the economic interests of the investor and the entrepreneur through techniques such asvesting and warranties; this is addressed in Chapter 11. Chapters 8through 11 also provide the entrepreneur with tips regarding pitfalls tolook out for and suggestions for negotiating tactics on each point.

The last chapter of the bookChapter 12, Term Sheet Exercisespulls together the lessons from across all the chapters into a series offinancing situations facing companies. If you can figure out theinvestor's thought processes in each of these mini cases (without reading the answers!), you are well on the way to being versed in the VCmethod. It doesn't make sense to go through these exercises until youhave at least covered the chapters on term sheets and venture capitalcompanies.

There are two appendixes. The first is a case study called SecurityPortal Inc.; it illustrates another stepping-stone map. The second is areal-life term sheet used in practice by venture capitalists. This termsheet supports the term-by-term review in Chapters 8, 9, and 10.

INTRODUCTION

Let's be clear. The VC method is not a smooth, seamless step-by-step production line for funding new ventures successfully. It is messy,complicated, legalistic, dynamic, and often acrimonious. It is not surprising that it is this way. It is not a cooperative arrangement in whichinvestors benignly help entrepreneurs to realize their dreams. It is ahard-nosed bargain in which investors and entrepreneurs carve outenough to satisfy their incompatible hopes along the journey.

If you can develop an appreciation for the stepping-stone approach,valuingstart-ups based on future multiples, venture capitalistpsychology, and the nuances of term sheets, you should acquit yourself well inthe cut and thrust of the great financing game.

CREDITICA SOFTWARE

INC. CASE STUDY

Although the software industry is starting to mature, many investorscontinue to view it as an attractive target investment sector. Soft

ware companies offer the potential for high growth with only a modest amount of capital required. They fulfill the criterion of "write-once,use-often" necessary for the business to be scalable. They have veryhigh gross margins. They are knowledge-based businesses in whichdomain knowledge is more important than physical assets. For thesereasons, they continue to consume a large share of the capital of venture capital companies and will do so until the sector fully matures.

Introduction

Creditica Software Inc. is a hypothetical software companywith all thechallenges of a typical early-stage venture. It intends to develop algorithms to identify good credit risks for credit card issuers and to package the algorithms as a software product. It starts with some greatassetspeople who deeply understand their domain, a track record ofpreviouslydeveloping a good product (albeit for a large company), anda highly important problem on which to focus.

The financing side of the business is a blank sheet of paper. Thefounders have never encountered the venture capital industry before.They haveyet to realize that the dominant axisof their lives for the nextfive to seven yearswillbe the navigation of the company through several

CREDITICA SOFTWARE INC. CASE STUDY

rounds of investment. The companywill at all times look forward andsee a cliff where the funding might run out and where the team needsto meet milestones in order to excite investors enough to support thecompany to the next stage.

This is the essence of the venture capital methoda treadmill forthe companyon which it needs to meet milestones relentlesslyand periodically in order to justify the value of the prize to new or existinginvestors.

This case study is referred to throughout the book. So it is advisableto familiarize yourself with all the details.

The Creditica case is wholly fictional. Any similarities to any existing company are purely coincidental.

Creditica Software Inc.

Background

It is June 2008.

Creditica was incorporated in March 2008 when four senior technology professionals resigned from the credit card division of a largemidwestern bank. At the bank, the four had created a scorecard for

determining to whom the bank should offera credit card, how much ofa balance to allocate to them, and how to monitor the ongoing risk ofnonrepayment. This scorecard had been extremelysuccessful in helping the bank reduce bad debts and ferret out new low-risk customersignored by other credit card companies.

With the blessingof the bank, the four had decidedto leaveto forma new venture. Their ambition was to design a next generation score-card, building on the lessons learned from their work at the bank.

Product Proposition

Creditica aims to be the first dedicated third-party scorecard companyutilizing prior financial history, sociodemographic data, behavioralpatterns, and prior mailing addresses.

CREDITICA SOFTWARE INC. CASE STUDY

Scorecards are not new. Credit card issuers have used them for yearsas a means of speeding up the process of approving new card applications and eliminating the vagaries of human judgment. However, thescorecards tended to focus purely on financial data and payment/credithistory. These scorecards had been developed in-house at each bank,which meant that it was impossibleto transfer lessons learned from onecredit card issuer to another. In fact, many issuers viewed their in-housescorecards as their competitive weapon (our scorecard is better thaneveryone else's).

Creditica's mission is to prove that its algorithms and software willperform far better than the in-house algorithms of any individual creditcard issuer. Its founders want the scorecard to yield the lowest level ofbad debts and to be smarter at identifying good-quality, overlookedcustomers. The scorecard will draw on prior financial history, sociodemographic data, behavioral patterns, and other new information sources todevelop a best-in-class scorecard to sell to all the credit card issuingcompanies.

Creditica's secret weapon is a history of prior mailing addresses.Thecompany aims to predict poor credit risks better than any other financial institution by tracking different addresses (and the length of timespent at each address) and cross-referencing the payment patterns ofindividuals in each locality. To achieve this, Creditica has built an enormous database of prior addresses. Built up over the previous 10 years,this database has been enriched each week with address changes andnew sources of information on old addresses. This database would be

very difficult to replicateitwould take a competitor five or more yearsto attain anything comparable. In addition, Creditica plans to maintainits advantage by capturing the lessons learned by eachissuerthat boughtits scorecardthese lessons would be used to tweak the scoring algorithms, thereby making the scorecard ever more effective over thecourse of time. Creditica will tailor the algorithmsby country to ensurethat they are fully optimized to the local environment.

Creditica is alsoplanning to issue newscorecardalgorithmseachyear(on the same software platform) to customers for an annual fee (seebelow). These algorithms will take into account the lessons learnedfrom the use of the scorecard by all its customers.

10 CREDITICA SOFTWARE INC. CASE STUDY

All in all, the companyplans to attain an unassailable position bydeveloping better algorithms, capturing richer data on customers, andcontinuing to tweak the algorithms based on the lessons learned acrossan ever-increasing customer base of credit card issuers.

Target Market Size

Creditica will sell its products to banks and to nonbank institutions(e.g., supermarkets, specialist card issuers, affinity schemes) that issuecredit cards or that are interested in entering the credit card business.

The total number of potential customers and the expected pricingper customer are presented in Exhibit C.l.

The market forms a classic pyramid. A large number of less valuablecustomers at the base of the pyramid dwarf a relatively small group ofhighly valuable ones at the top.

Exhibit C. I Market Segments for Creditica

Number of

Nonbank

Number of Issuers in Potential New

Banks in the World Issuers of Projected Pricing tothe World (Today) Credit Cards Creditica

Large 500 200 7 $ 1Myear-one license fee$400,000 annual feefor updated algorithms20% maintenance

revenues each year oninitial license

Medium 1,000 500 7 $500,000 year-onelicense fee

$200,000 annual feefor updated algorithms20% maintenance

Small 10,000 8,000 7 $300,000 year-onelicense fee

$100,000 annual feefor updated algorithms20% maintenance

CREDITICA SOFTWARE INC. CASE STUDY 11

One noticeable feature about the business is that the largest bankissuers of credit cards are not necessarily the largest banks in the country. Clearly it would be easy to become the largest credit card issuer inthe country by issuing credit cards to all applicants regardless of theirability or willingness to pay their balances. This is a recipe for losing alot of money very quickly. A profitable credit card business should bebuilt on brains rather than brawn.

Surprisingly, a small number of modestly sized banks have becomelarge, highly profitable issuers of credit cards based on their ability toidentify, target, and capture the best customers. The best customers arethose who revolvelarge outstanding credit balanceson their cards frommonth to month and accrue high interest payments but who have agood payment history. The best revolversas they are knownalwaysmake the minimum required payment each month and maybe onceevery year pay the entire balance on the card.

Creditica's management team believes that its algorithms will besuited best to medium- and small-sized issuers. The biggest existingissuers of cards already have the best statisticians in-house and wouldguard their algorithms jealously. Smaller, hungrier credit card issuersor banks with a small credit card operation would be keen to move outof the also-ran group. On the other hand, they wouldn't be willing toinvestin large teamsof mathematicians andstatisticians to develop proprietary algorithms. Creditica wants to be the vehicle through whichthese types of institutions can become big profitable card issuersbasedon better identification and targeting of prospects.

This is the value proposition.

Timing and Key Milestones

The business plan put together by the four founders is based on theusual model pursued by a software company. They will build an earlybeta versionof the product, engage with a fewcustomers that could begood references, use these references to seed the market, and grow thecompany from there.

12 CREDITICA SOFTWARE INC. CASE STUDY

Exhibit C.2 Elements of the Business Plan

Q3 2008 Make initial hires to technical team. Start product design.

Q4 2008 Ramp up product development team to 10 people(including founders).

QI 2009 Hire new CEO who will act as interim head of sales.

Q2 2009 Finalize beta version of product. Sign up two banks as developmentpartners (i.e., they won't pay up front, but they will commit toproviding feedback and testing product against their data).

Q3 2009 Make first customer release available for sale.

Q4 2009 Make two initial, small sales (perhaps to development partners) of$200,000 each. Quantify savings to each development partner clearly.

In 2010 Make I sale to a large customer (see price list above in Exhibit C.I).Make I sale to a medium-sized customer. Make 2 sales to small

customers.

In 2011 Make 6 sales to a large customer. Make 5 sales to medium-sizedcustomers. Make 7 sales to small customers.

In 2012 Make 30 sales to large customers. Make 15 sales to medium-sizedcustomers. Make 50 sales to small customers.

The specific steps set out in the business plan are presented inExhibit C.2.

Resources Required

Like an army marching on its stomach, an early-stage companyneedsto pay for product development and other monthly overhead. Thiscreates a need for investment capitalbecausesales are generally one tothree years away from the start-up date.

The planned hires are presented in Exhibit C.3.The cost structure of the company is made up of the following

elements:

Up-front capital expenditure and company setup $100,000Fully loaded cost per developer/founder(including, premises, travel, etc.) $100,000 eachFullyloaded cost of CEO/senior executives $200,000 eachFully loaded cost per salesperson $150,000 each


Exhibit C.3 Planned Hires

Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q42008 2008 2009 2009 2009 2009 2010 2010 2010 2010

CEO/senior

executives II I 12 2 2 2

Technical

team 4 4 10

Salespeople

10 10 10 15 15 20 20

2 2 2 10 10 10 10

Ownership

The company founders have raised only $100,000 from friends andfamily to cover the basic expenses associatedwith the establishment ofthe company. Friends and family now own 8% of the company's common stock.Each of the four founders owns23% of the company, issuedto them as common stock. In any future round of finance, they willsuffer dilution in their ownership position.

Valuation of Companies in the Sector

It is always verydifficult to find comparable companies. Eachnewearly-stage technology company is interesting to investors precisely becauseit is uniquedoing things that no other company is currently doing.But there are a few companies that havesome similarities to Creditica.See Exhibit C.4.

The first two companies named in Exhibit C.4 are large softwarecompanies from the enterprise resource planning (ERP) and customerrelationship management (CRM) sectors. The other three companiesare specifically from the financial services software sector:

Company 1. This company sells credit card processing software tocredit card companies. Transactions by customers are processedand checked by this system. It has been the leader in its field for thepast five years. The average sale value per customer is about $1M.

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Company 2. This company sells leasing management systems tofinancial institutions. It manages the establishment of lease financethrough car dealers when the car is sold initially, then processesthe payments as they are received, and handles the termination ofthe lease. It links car retailers to the financial institution over the

Internet. Average sale value per customer is $500,000, but it alsosells software to car dealers at a much lower price.

Company 3. It develops and sells bank administration systems.This front office software handles new sales and also does the

initial checking and processing of customer transactions. Averagesales price per branch is $100,000.

Thoughts on Possible Exits

While there is the hope of an initial publicoffering, Creditica's foundersbelievethat it is more realistic that the companymight be sold to a largecredit card software company, such as one of the large companies thatprocesses transactions. Alternatively, a sale to a general financialservicessoftware companymight be a possibility.

PA RT I

UNDERSTANDING

THE BASICS OF

THE VENTURE

CAPITAL METHOD

DEVELOPING A

FINANCING MAP

CHAPTER

There is a clear destination, and the prize for reaching it is intoxicatingthe fabled initial public offering (IPO) or the successful

trade sale of the company that turns the founders and investors into latter-day robber barons. There is a generic five- to seven-year map thathas been established by prior generations of entrepreneurs regardinghow to build a business.

But this is new terrain. Everynew business that has world-beatingaspirations is unique.There are lots of issues. What competitorsare outthere lurking in the tall grass? If a competitoror someother roadblockthwarts the company, is there a way around? Are there small steps thatthe company might take up front to blockcompetitors? Is the destination as clear as it seems at first glance? Or are there multiple possibledestinationsmight some of them be even more interesting than themost obvious destination?

Take the example of Creditica. Clearly, it is a modest creation today.At its simplest, it is a 20-page slide presentation containing insightfulperspectives on the opportunity, put together by some smart mathematicians. It is plausible to lookforward five to sevenor more years andto see it as a good-sized company capable of undertaking an IPO. Thesituation is pregnant with possibilities. But it is dizzying to think ofeverything that needs to be done on the journey from here to there.What should be done first? Who should be hired and when? Which

19

20 BASICS OF THE VENTURE CAPITAL METHOD

customers should be approached first? What happens if competitors getto the market first? How is Creditica going to be financed?

Communicating the complexity of all these execution issues toinvestors,while still conveying the senseof opportunity, is very difficult.

An early-stageventure should simplifyits businessplan by breakingthe planned development of the company into three to four major stepping-stones on the way to the prize. These stepping-stones shouldbecome the financing blueprint for the business. This concept of building a valuable businessthrough multiple staging posts, each of which isfinanced separately, is the core tenet underpinning entrepreneurialfinance. All the complexities and incongruities on the way are derivedfrom this one concept.

The best place to start is to showhow the five- to ten-year plan fora business can and should be split into a series of major stepping-stones,normally three to four.

Creating a Set of Stepping-Stones fora New Business

The founders of Creditica have set out a four- to five-year high-levelplan for their business. They expect the business to achieve its potentialwithinthis period. What theyhave also done implicitly in the plan(even though they might not have intentionally done so) is to split thejourney into three to fourmajor stepping-stones. Exhibit 1.1 shows theimplied steps from the establishment of the business in early 2008 tothe possible exitof the business in 2012 or later.

Creditica's is a straightforward path of stepping-stones. It is a classic software company path seen by venture capitalists in hundreds, ifnot thousands,of business planseveryyear.It has proven itself over theyears. Many companies have followed such a path and built valuablebusinesses. Of course, many have also failed.

Stepping-stones represent groups of major milestones for the company. The milestones mightrelate to productdevelopment, acquisitionof customers, recruitment of top-class management, and so forth. Thegroups of milestones then become stepping-stones. Eachstepping-stone

DEVELOPING A FINANCING MAP

Exhibit I. I Creditica Stepping Stones

Stepping-stone 4: 2012+

Stepping-stone 3: 2011

Stepping-stone 2: Q3'09

Market size: $XM Four to six plausible

buyers of the company

Proven sales economics

Aggressive market rolloutInternationalization

Stepping-stone 1: Q1'09 Two development partners First general release Early revenues Full team build-out

Ten technologists Beta product Commercial CEO

provides an integrated perspective on the progress (and potential valuation) of the company.

The beststepping-stones are ones that the company canpoint to withhard evidence andthat demonstrate realmomentum in the progress ofthe business. It is the team's task to articulate the major stepping-stonesbecause it is impossible for an investor to absorb all of the micro stepsa companywill take in the course of its development.

Matching the Financing Strategy tothe Stepping-Stones

The stepping-stones should then seamlessly match the financing strategy for the business.

Consider the example of Creditica in Exhibit 1.2. If the team hasestablished a workable set of stepping-stones and if the company executes the plan well, it will raise four rounds of investment in the courseof its development. In the VC business these are called Series A, B, C,and D and so forth.

21


Exhibit 1.2 Link to Funding Strategy

Stepping-stone4: 2012+

f Trade sale JStepping-stone 3: 2011

f Market \ 1Series D investment

\penetration.Stepping-stone 2: Q3'09 .^r

/Seed the^^ 'V market } -J

Stepping-stone 1: Q1'09 i^ ^ Series Cinvestment

( Early ^ 11 1

Series B investmentV product y

Creditica:1

1Series A inves

Q2'08tment

Manysoftwarecompanies beforeCrediticahave proventhat movingfrom stepping-stone to stepping-stone, while continuing to convinceinvestors of the size of the ultimate prize, is a good financing strategyfor a company.

The Series A round should be big enough to get the company tostepping-stone 1 (with some margin of error since plans generally takelonger to execute than expected). In theory, fromstart-up, the companycould consider raisingenoughmoney to take itself to stepping-stone 2or beyondif it canfind a willing investor. Butthis misses the point.Atstart-up the company willprobably be at the lowest valuation of its existence. Therefore, if it raised the capital to get it all the way to stepping-stone2 or beyond, the initial shareholders would sufferfar more dilutionin their ownership percentages than is necessary. Better to raise justenough capital now and raise more later at a highervaluation.

This is the essence of the early-stage venture gameraising justenough to get to the nextstage of development of the company (withareasonable margin of error) in the hope and expectation of raisingmorecapital on much more attractive terms later. This trade-off is coveredmore extensivelyin subsequent chapters.

DEVELOPING A FINANCING MAP 23

To get started, the entrepreneur needs to convince the investors ofthree propositions:

1. The ultimate prize is worth going for. (The opportunity is bigenough for early investors to get a 10 to 20 times multiple returnon their investment.)

2. There are logical, achievable stepping-stones between start-upand the prize. (There are future points in the development of thecompany where new investors can be enticed to come on boardand where the risks of the business have been progressivelystripped away.)

3. The first stepping-stone on the way to the prize, by itself, is astepping-stone worthy of investment by the investor. (A second-round investor will pay a price per share two to four times theprice the early investor paid.)

Developing a Map of Possible Stepping-Stones

Given the way in which business plans are prepared and written, theyalmost inevitably set out the future development of the business in a linear fashion. The earlier approach of thinking in terms of stepping-stones seems to reinforce this. This linearity does not do theentrepreneur justice.

No business is linear. It is a living entity full of possibilities and dangers. There aremany possible destinations and many possible sequencesof stepping-stones for getting to each destination. The prize beingsought by Creditica in Q2 2008 might not end up being the prizeattained in 2012 and beyond.

If therewere only one way for Creditica to pursue its business plan,investors would be concerned. Every entrepreneurial business goesthrougha series of existential crises. The best-laid plans oftendon'tsurvive the first contact with customers or competitors. Executing strategies in the realworld takes longer thanit does on paper. It is extremelydifficult to predict the futurefora business five to seven years down theroad. If the path beingpursued terminates (e.g., because of the emergence of a dominant competitor), the business could die.


What is needed is a map of possible stepping-stones rather than adeterministic singlepath. A good map will excite an investor much morethan a path. A map should communicate options and possibilities. Asany financial theorist will tell you, options havevalue.

All investors usually ask themselves the following questions:

1. What are the big things that could go wrong (and how will thebusiness handle them)?

2. What are the big options that might open up further down theroad (and how might the business take advantage of them)?

Big Things That Could Go Wrong

If there are a few big potential roadblocks aheadeven if there is onlya small chance of them happeninginvestors will want to see a plan B.In fact, they will want to know that there are manyplan Bs.

An investormight look at Creditica and see the following potentialroadblocks (no doubt you will see others):

Credit card issuers mightview their proprietary algorithms asso fundamental to their competitive advantage that they will notutilize third-party algorithms from a company such asCreditica.

Creditica's algorithms are a "black box" giving out results(target customer names). The results, although accurate, arehard to rationalize simply. Therefore, the results might not betrusted.

New personal privacy legislation might prohibit sharing of datafrom one company to another.

The bank from which the team originated might change its mindand attempt to block the business.

All businesses have inherent risks. The business plan should establish howto mitigate the likelihood of themoccurring, but it should alsoestablish the possibilities thatmight stillbe opento the company in theevent that they materialize.


Big Options That Might Open Up Later

On the positive side, the entrepreneur and the investors might foreseeways in which the sequence of stepping-stones the company is pursuing might lead to new possibilities that will open up later.These optionsmust have some value for the investor considering an investment today.These options might not be open to the company today, but the company, having reached the first few stepping-stones along a chosen path,might find them open at a later stage. For Creditica these might include:

Becoming a credit card issuer itself. If Creditica genuinelydevelops the best algorithms in the world, then maybe the bestway of monetizing this advantage is to set up its own credit cardissuing company. It could exploit the algorithms itself rather thanselling them to others. More plausibly, Creditica might set up ajoint venture with one of the smaller credit card issuers to attackthe market.

Developing managed servicefor issuers. If Creditica's softwarebecomes complex to administer, perhaps Creditica could run amanaged service. The customer could set broad parameters (e.g.,only customers in the northwest with a lowerrisk exposure thanother issuers are willing to accept), and Creditica could generate alist of target names. Maybe the customer would pay per nameinstead of paying an up-front license fee.

Expanding to become a database marketing company. IfCreditica couldstart to collect the transactional purchase data(what people purchased) on the credit cards issued resultingfromCreditica's targeting software, perhaps it could become a world-class database companyselling slices of data to companies inmany different industries.

Becoming an expert source on targetsforfinancial productsotherthan credit cards. The excellent data gathered andenriched by Crediticamight be usable to identify target customersfor other financial productscredit products such as mortgages orpersonal loans or even asset products such as mutual funds andsavings products.


Each of these four possible endgames for Creditica could yield aprize significantly larger than the basic prize of trying to become theleadingindependentcredit card scorecard company.

The point here is not to show that there are infinite paths open toCreditica. Rather, it is to convey to the investor that there are futureoptions that might open up as a result of developing the business in acertain way. Also, the potential roadblocks that might arise can bebypassed in some way.

Generating a Map

It is impossible to articulate all the twists and turns that might occurthroughout the future life of the business. But it should be possible todevelopa high-level map of the major alternative sequences of stepping-stones. At a minimum, all entrepreneurs should develop their thoughtprocesses alongthese lines, evenif they haven'tput them down on paper.

One advantage of putting ideas down on paper is that it encouragesthe team to think laterally. The sequence of stepping-stones for Creditica presented in Exhibit 1.1 is typical of most software companies. Butmaybe there is a completely different wayto chart the future development of the business.

Exhibit 1.3 shows that there is a very early choice for Creditica thatwasnot discussed in the casestudy. Insteadof raisingcapitalfrom financial investors and advancing to the "early-product" stepping-stone, thecompanycould decide instead to go with a primary development partner. Under this strategy, the companywould raise capital from a customer (a credit card issuer) and develop the product in conjunction withthat customer. This would have the advantage of getting valuable customer input at the start of the project. It might be possible to perfectthe algorithms by running ongoing pilots with the development partner on live data. Of course, this strategy also has the disadvantage ofthe company being seen as compromised by its close relationship withone large issuer. Such compromises are often dealtwith by early-stagecompanies.

If Creditica decides to go ahead with the early-product stepping-stone without working with a development partner, then once again it

DEVELOPING A FINANCING MAP

Exhibit 1.3 Creditica Map of Possible Stepping-Stones

Creditica:

Q2'08

Possible prizes

has a fundamental choice. Should it seed the market and make some

licensesalesof the software? Or shouldit keep the algorithms in-houseand run a pilot program to issue some credit cards itself (in conjunction with a partner)? If the softwareprovides huge advantages in issuing cards, then it might be more valuable to Creditica to be an issuerrather than a technology provider. One advantage of the stepping-stoneapproach is that the companydoesn't have to make this decision rightaway; it can decide in a year or so.

The map shownin Exhibit 1.3 is clearly very simplified. It should beoverlaid with the specific steps that should be taken and a preliminaryview of the capital required to progress from stepping-stone to stepping-stone.

One advantage of the stepping-stone approach is that only the jumpto stepping-stone 1 needs to be costed out to a very low level of detail.This is the part that the initial investor will be asked to finance. TheSeriesA investorwill need to be convinced that it will get an economicreturn for financing the jumpto the first stepping-stone. In practice theSeries A investor will need to be convinced that the company will be

21


attractive to new investors if it gets to the first stepping-stone and thatthe Series B investor will pay a price per share that is two to four timesgreater than the price the Series Ainvestorpays. If the SeriesA investorcannot convince itself of this, it should not invest and perhaps wait forthe opportunity to invest in the SeriesB round instead.

Convincingthe investorof this propositionis coveredin more detailin Chapter 7, "ValuingEarly-Stage Companies."

Action Steps for the Entrepreneur

In summary, the entrepreneur should think about taking the followingactions:

1. Identify the primary prize that the company is going after.2. Unearth other, potentially larger, prizes that might be possible

to pursue if the company is thwarted in pursuing the primaryprize because of competitors' actions, regulatory changes, andso forth.

3. Conceptualize, up front, the stepping-stones on the wayto theprimary prize and the stepping-stones that might branch thecompanyoff in the direction of the other prizes.

4. Figure out, at a high level, the amount of resources required tojump from stepping-stone to stepping-stone on the wayto theprize. In particular, develop an in-depth viewof the resourcesneeded to jump to the initial stepping-stone.

5. Find an investor to finance the jump to the first stepping-stone.Convince the investor that the value of the company will increaseby two to four times if the company can jumpto the firststepping-stone.

6. Negotiate a win-win deal with the investor that: Gives the investor a share in the ultimate prize compatible

with the risk that must be taken in funding the company. Gives the entrepreneur a continued strong interest in pursuing

the prize. Don't forget that all the investors who will financethe jumps to future stepping-stones will need to be allocated apiece of the prize as well.


Experienced entrepreneurs looking back on their company willdefine their lives to a large degree in terms of investment rounds andthe stepping-stones along the way.

At each stepping-stone, the company is materially different fromwhatit was at the priorstepping-stone. Andto jump from onestepping-stone to another probably requires a new round ofcapital. Raising eachround of capital represents a true test of character for the company. Itis enormously time-consuming and challenges a company to examineclosely what it is trying to achieve. Entrepreneurs tend to resent thehuge time commitment and the distraction from running the businessthat raising new capital requires.

Each stepping-stone is the true macro milestone for the companythat encapsulates commercial milestones such as reference sales, keyhires, product completions, new market entries, and an associatedinvestment round to finance all the activities on the wayto meeting thecommercial milestones. If goodcommercial milestones are met that areattractive to investors, the company can raise additional investment capital at a good price. If good milestones are met which investors do notvalue, the company is in trouble. It won'traise newfunds, or it will raisenew funds only at a punitive price.

Thus (in general, but not always) the best path for the entrepreneuris the one with clearly defined stepping-stones containing milestonesthat are attractive to investors and that will boost the price per unit ofstock at each stage. If a few valuable milestones can be met quickly, itmight make sense to raise a small amount of capital up front and raisemore at a high price later. Alternatively, if a lot of capital is availablenow at a good price, it might make sense to take it.

Each stepping-stone on the journey is made up of a series of challenges that provides an enhanced level of proof to the investor (and tothe entrepreneur) that the prizeis attainable. Designing the right bundle of challenges to overcome is the true creative task in the entrepreneurial process. At the start of the journey,the risks are enormous. Anyinvestor that puts up $100 at stage one of the journey for the right to10% of the prizewants to know that an investor wholaterputs up $100for stage two of the journey will get less than 10% of the prize. Otherwise the first investor will realize that waiting to fund the venture in


stage two would offer more oftheprize for less risk. The challengesundertaken need to improve the chances ofwinning the prize.

The entrepreneur has to figure outwhich challenges to overcomeand milestones to reach in stage one with investor one's money thatwill lessen the risks and catalyze investor two to provide money at alow cost. The range of possible challenges to undertake is limitless.The true art of entrepreneurial finance is to pinpoint the smallestnumber of achievable, yet valuable, challenges to overcome in theupcoming stage.

The challenges typically fall into the following groups:

Product. New ventures can happily lose themselves indeveloping their product. But entrepreneurs need to rememberthat building the product is a necessary but not sufficientmilestone. If the Series A investment just allows the company todevelop its product, it will often fail to garner Series Binvestment because the challenges that were overcome maynothave provided evidence sufficient to excite the Series B investorto support the project.

Market. The size of the prize, from a revenue perspective, isthe number of possible customers multiplied by the value thatcan be extracted from each customer. At every point along thejourney, the entrepreneur should be gathering evidenceregarding these two factors. One of the tasks to undertake withthe Series A capital mightbe to figure out howmuch an averagecustomer would be willing to pay. How much value would theentrepreneur's product or service provide to the customer? Ifinvestors perceive the marketas not particularly big, should partof the Series A capital be carved out to recraft the product toaddress a completely different market segment?

Team. Who are the critical people to hire? Which membersof the team are critical to the earlystages, but will be lessnecessary later? Since the most important members of the teamwill want a piece of the prize (a shareholding) and cost a lot ofresources along the way, which onesshould the entrepreneurtake on now? Of course, if the companywaits and takes them


on later, the risks willbe diminished, and the prizewillbe moreapparentand they will need to be given a lesser percentage ofthe prize. The ability ofentrepreneurs to hire people of a qualityfar superior to the norm (without paying them an excessive level ofcompensation) is a key attribute sought byinvestors. Investors seehiring great people as a significant milestone.

Competitors. In which customer accounts should the companyaim to prove that it has a superior value proposition? Are thereactions the company can take (partnerships signed, keyaccountscaptured, senior staffpoached, support from industry analysts,etc.) that can negate competitors' activities in the market?

Creatively combining different challenges canreveal new paths thatmightmake it easier to capture the attention of investors.

Most founders of a new business are not creative enough in designing alternative paths to the prize. They tend to follow approaches pursued by prior entrepreneurs.

Capturing as Much of the Prize as You Can

The popular image of early-stage venturing is of benign venture capitalistsworkingwith great entrepreneursas they buildworld-class businesses. Every entrepreneur knows that this isstretching the truth. Greatentrepreneurs build great businesses; occasionally an experienced venture capitalist can help.

The goal of every entrepreneur with regard to finance is to captureas many dollars out of the ultimate prize as is possible. This has a fewimplications:

It might be worth giving investors a larger share of the prize byusing more resources in the interest of getting to the prize beforecompetitors. On the other hand, if the competition provesrelatively benign, the entrepreneur might target consuming fewerinvestor resources along the way and holding onto a higher


percentage. Sometimes, it mightbe worth goingfor a smalleraggregate prize if the cost of the resources associated with chasingthe bigger prize is overwhelming.

The entrepreneur must structure the challenges and milestones foreach stepping-stone in order to provide the proofrequired bythelikely investor in the subsequent stage. In particular, themilestones met should besuch that investors will be encouraged toprovide the funds at a lowcostof capitalto minimize theinvestors' claimon the ultimate prize.

CHAPTER

GETTING TO THE FIRST

STEPPING-STONE

Getting to the basecampis the first step for anyteam that wants toconquerMount Everest. If Chapter 1set out a team'sbroad multi-

stepping-stone planfor scaling the mountain, then Chapter 2 covers thejourney to the base campthe first stepping-stone.

Once at the base camp, the possibilities open up. It is the jumping-off point for a variety of routes. Resources can be replenished, and intelligence on weatherand conditions gleaned. If the weatheris particularlyfavorable, the trip might be expedited. The merits of alternative routescan be explored. But there is a downside; the group funding the tripcan decide to abandon the trek to the summit if the possibility of reaching the summit is remote. Groups take the trip to the base camp withthe hope of getting to the top. But they know that the chancesof getting there are modest.

The same is true for the way in which early-stage companies arefinanced. Venture capitalistsaim to reach the top, but they hedge theirbets and stay flexible along the way. In short, early-stage ventures arenot assumed to be a going concern and to havean infinite life. Businessplans are rarely, if ever, fully funded to a cash flowbreakeven point. Inessence, the investor sets a test for a company: "Here is a definedamount of money to achieve some milestones (to jump to the next stepping-stone)." If the milestones are met, the value of the company willhave gone up and the company can probably raise more money from

33


the initial investor or others. Each round of funding is thereforetargeted at meeting certain milestones. If milestones are not met,the company can be liquidated, merged, financed again (if theprospects for the company continue to be perceived as attractive), orrestructured.

The company has no assumed life beyond the next important stepping-stone. It lives its life from round to round of investment. CEOsregularly claim that they are perpetually in fund-raising mode whichdistracts them from the business at hand of building the value of thecompany.

All thisemphasizes that the goal is to get to the first stepping-stone.

Why New Ventures Are Not Fully Funded fromthe Start

Entrepreneurs would like to have their business fully funded to thepoint where they are cash-flow-positive based on revenues. Once cashflow-positive, they should be able to sustain themselves, in the absenceof the need to finance a new growth curve. But there are a number ofgood reasonswhynewventures do not get (or deserve to get) up frontthe entire amount of capital required to sustain them up to the pointwhere they become cash-flow-positive.

1. The risksat the outset ofa business are daunting. No investoris likelyto cover the risks in one fully committed investment. Theend point is so far in the future and the level of risk on the waythere is so high that investors would shy away. The investor needsthe entrepreneur to break the project down into logical, plausiblesteps that demonstrate progress toward the end goal. Theselogical steps might then be financed.

Designing these steps is like designinga bundle of trials for thecompany to undertake. If designed correctly, the bundles of trialsinherent in each step progressively reduce the risk of the

GETTING TO THE FIRST STEPPING-STONE 35

projectthe quicker the better. The investors in each round getcomfort in knowing that the value of the company is beingenhanced with their investment. As the risks fall away, theentrepreneur can sell units of stock at a progressively higher priceand suffer less onerous dilution in his or her ownership.

2. The situation is too dynamic to make thefull commitmentupfront. The best investment opportunities are those that offer lotsof flexibility and multiple potential prizes. If one avenue closesoff, there are others to pursue. Investing all the capitalup frontmight put a company on a lockstep path toward one particularprize.

As well as giving flexibility regarding the prizes to pursue,staging the investment also gives the investor the chance to fixthe companymidstream if the company is not making sufficientprogress. Removing an underperforming CEO is very difficultwithout the threat of refusing to provide the investment requiredto keep the company going.

3. Ifsomeone was willing to coverall these risks in one singleinvestment, he or she would require a huge percentage oftheownership ofthe company\ leaving little for the entrepreneur.If an investor was willing to fund the entire development ofthe company in one go, then the essence of entrepreneurshipis lacking and the entrepreneur truly deserves only a smallownership position. The early stage of a business represents itslowest likely economic value. Raising all the capital at this point,at a low valuation, would lead to punitive levels of dilution.

Fleshing Out the First Stepping-Stone

The first stepping-stone is the most important. The entrepreneur needsto think carefully about the trials he or she is going to have to deal withon the way to this stepping-stone. It is a period for gathering evidenceregarding the attractiveness of the ultimate prize and the ability of thecompany to attain the prize. Consider the following mini case.


Mini Case: Chain of Audio-Video Equipment

Retail Stores

An entrepreneur wishes to set up a chain of 300 high-end audio-videoequipment stores across the United States. These stores will provide

a high-service experience forcustomers by employing expert staff. Approximately $I00M will be required to cover the capital and start-up costs ofrolling out 300 new stores.

Investors have refused to finance the full plan with one investmentitis simply too risky. But they are intrigued bythe opportunityand have askedthe team to recraft the plan so that the business will utilize less capital, butkeep the potential upside of rolling out 300 stores over time.

The first place for the audio-video entrepreneur to start isto establish anoverall set of stepping-stones for the business. One path of stepping-stones,assuming a successful one-store experiment, might be along the following lines:

1. Stepping-stone I: Prove the economics of one store. This involves

setting up a supply chain, creating a differentiable customer experience, building a customer base, figuring out the staffing model, and so

on. At the end of this stage, the entrepreneur and investors should be

able to run focus groups of customers to assess whether the custom

ers appreciated the higher level of service and determine the size of

the premium they are willing to pay for the service.

2. Stepping-stone 2:Prove the manageability ofa small group (10-20)of stores. This means that the repeatability of the format needs to be

determined. It involves creatingthe position of a professional store man

ager separate from the entrepreneur mastering multilocation logistics,controlling a more complex operation, and so forth.

3. Stepping-stone 3: Prove the ability to scale up to 300 stores andthe incremental economic advantages of size. This is the final rollout stage when the business model is clear and repeatable. A large

amount of capital can be committed at this point because the projectnow has much lower riskthan it did during the first stage.

Once the overall stepping-stones hove been identified, the entrepreneur needstohone in very precisely on the first stepping-stone and figure out thespecific bundle of trials thatmustbe undertaken on the way to it.


Crafting a Good First Stepping-Stone

Clearly, there is significant risk associated with the scale up from a smallnumber of stores to a large number of stores. These risks are execution

risks.

However, there are some basic first-stage risks that need to be testedup front. The smart investor andentrepreneurwill flush out these risks andpackage them into a work program while establishing milestones to beachieved on the way to the first stepping-stone. Proving the economics ofone store might involve testing the following issues:

Can the entrepreneur get a quality supply chain in place and

procure product at a price that will allow him or her to

achieve a 40%+ gross margin?

Can working capital terms (determined by days of

accounts receivable, days of accounts payable, and rate

of turning inventory) be set so that the business does not

consume significant amounts of working capital as sales

increase?'

Can a run rate on sales (and gross margin) be achieved that

will cover the overhead of running a shop and yield an annual

per-shop profit of, say, $250,000?

Can the entrepreneur find good sites for the stores that will

provide enough passing customers in the target segment?

Can the entrepreneur find and train high-quality staff at the

salaries established in the business plan?

Do customers appreciate and value the high level of service?

Most importantly, are they willing to pay a premium price

for this service? Will this premium cover the incremental

cost?

The investor and the entrepreneur might decide that, bysetting upjust one store,

these issues can be tested. The investment would then be structured to coverjust

the cost of testing these issues. This should require a very modest amount of

1 More on the capital implications of working capitalterms in Chapter 4.


capital, and the entrepreneur might have to give up a small amount ofownershipin return. Ifthe experiment with one store is not successful, then the plan can beabandoned without the waste oflarge amounts ofcapital.

Options at the End of Each Stage of Investment

By staging the investment to coincide with the stepping-stones, theinvestor is presented with a widevariety of options. Implicit in funding against stepping-stones is the expectation that the company willrun out of money at some point. When this point is reached, theinvestor can decide to fund it to the next stepping-stone, accelerate ordecelerate, abandon the investment, restructure it, and the like.

This sort of dynamic decision making is central to the VC method.If progress is swift toward milestones, the financing strategy might bepursued as set out in the initial plan. But things don't always go according to plan. Experienced investors factorslow performancewith respectto the plan into their thinking.

The investors in a private company have fairly limited power oncethe check is written and the investment is made. In theory they have abroad set of rights as set out in the shareholders' agreement. In practice it is hard for them to direct changes in the companythe entrepreneurs have the money, and, in the absence of fraud or grossincompetence, they can pretty much do with it as they see fit. But thisall changes when the company has an impendingneed for fresh capital.This is the point at which investors have the leverage to effect changesthat might be problematic for the entrepreneur. The investors have theimplied threat of not continuing to fund the company. If the CEOneeds to be changed, the cost base needs to be dramatically reduced orthe strategy adjustedagainst the wishes of the founders. The investorsmight be able to make this happen only when the issue of making a newinvestment arises.

The broad set of options open to the investors at the time of the newfunding round is presented in Exhibit 2.1.

GETTING TO THE FIRST STEPPING-STONE

Exhibit 2. I Finite Life of Businessthe Implications

\/Reached

^/^Stepping^N $ p Bringthirdpartyin to fund jumptoVstne i .y' stepping-stone 2

Accelerate faster than previouslyplanned

^/^Stepping-N p

* Abandon project, fold company

Restructure company and shareholdings

V stone 1 J

"\/ Not Bridge company to stepping-stone 1

Fund company to stepping-stone 2 withinternal or third-party investment

The wide variety of options provides a period of analysis at the endof each stage when the investors can take stock of the situation. Thegoal of the entrepreneur is to have collected sufficient "proof of theviability of the business to convince the existing investors or newinvestors to fund the company to the next stepping-stone, with a modest amount of dilution.

The Chief Financial Officer as Strategist

Chief financial officers (CFOs) in most established companies are numbers-focused and analytical.They translate the strategy of the companyinto its financial implications. Then they assess whether the businesswill generate sufficientcapital from its ongoing operations to fund thestrategy. If there is a gap, they arrange for the finance to be availablethrough debt or equity. In effect, the CFO generally plays a subsidiaryrole in the development of the strategy.

The CFO in an early-stage companyplays a different role. The strategy is not a given because the strategy is irrelevant unless the financeis available. The CFO becomes integral to strategy formulation.

39


Strategy and the finance to implement it are two sides of the samecoin in an early-stage venture.

Atits most simple, the best stepping-stonefor an early-stage company isthe one that allows it to capture the necessaryfunding inthe next investmentround at the highest price.

While thisisnot necessarily true in all instances, it is a good guideline fortheCFOofanearly-stage company to follow. The highest pricewill take into account factors such as progress with customers, movesto thwart competitors, andachieving productdevelopment milestones.

If CFOs are purely reactive to a strategy developed by a boardor aCEO, theyarenot doing their job. While the CEO mighthave an intuitive feel for the best strategyfor the company, the CFO needs to askthe hard questions:

Taking into account the cash resources on hand, which milestonesare likely to be attainable? What is the margin for error for eachof these milestones?

Byhow much will the valuation of the company increase in theeyes of the investmentworld if different types of milestones aremet?

If $5M, for example, is invested in the company, will themilestones reached by spending the $5M boost the valuation of thecompany by $20M or $30Mat least? If not, the entrepreneur isnot utilizing the capital efficiently, and the investors are not likelyto get a reasonable return on their investment.

Which milestones are most at risk of not being met? If the majoridentifiable milestones are not achieved, will the companyhaveestablished enough proof of its viabilityby reaching the othermilestones to convince the investors to invest more?

Some milestones tend to have all-or-nothing outcomes; others canbe achieved in part and still yieldvalue to the company. Do theCEO and CFO accept that all-or-nothing milestones might meanthat the company could fold if the milestones are not met?

What alternative sets of milestones could the companypossiblypursue? What impact might reaching the different sets ofmilestones have on the next round valuation of the company?


Should the company take on a lot of capital now or a smalleramount of capital now in the hope of boosting the valuation ofthe company prior to takingon more capital? How riskywouldthis be?

Many CFOs of early-stage companies are not creative enough indeveloping alternative setsof milestones to submit to a boardandCEO.Milestones tend to be created by the technical development group orthe sales and marketing division without explicitly assessing how theresources spent on these activities will earn a high enough return oncapital.

Most investors want the chance of earning a 10-times multiple ontheir investment. Consequently, on average every$1 of resources spentby the company today must boost the value of the company by at least$10 tomorrow. Most CFOs don't think about resource consumption

with this degree of discipline.Unfortunately, the cost budget in many early-stage companies is

often defined as follows.

Sales and marketing establish high-level sales targets for the nextyear or two.

Sales and marketing determine that to reach these targets theproduct needs to incorporate certain features to satisfy customers(or the next generation of the product will be required). Inaddition, sales and marketing decide how many people will berequired to meet the targets, given the typical sales level of aquota-carrying salesperson.

Product development translates these needs into a product roadmap and estimates how manypeople (and the requisite skills)are needed to achieve what's been established in the productroad map.

Finance costs out the increased resources.

If the capital is not available, there is an iterative process amongfinance, product development, and sales and marketing to reducethe projected costs or boost projected sales to fit the capitalavailable.

42 BASICS OF THE VENTORE CAPITAL METHOD

The CFO must bedeeply involved in developing the strategy alongside the CEO. Consider the following mini case concerning an early-stage software company that is developing its strategy and trying toidentify the best first stepping-stone.

Mini Case: A Software Company Developing

Alternative First Stepping-Stones

The software company has justclosed a $3M round of funding. The teamis primarily a technical team with plans to add a top-class CEO and a

head of sales overtime. Ifthe CFO is good, he or she will push the executive team to figure out alternative sets of milestones beyond the usualsequence of stepping-stones.

The alternatives might include the three below:

Alternative

. World-class

product first

2. Proof of

concept

Milestones and Actions

Over 18 to 24 months, build a

complete world-class productthat will be clearly superior tothat of the competition.

Aim to close some very earlydirect sales with trial customers

(value of $200,000).

Plan on hiring a CEO in18 months when the productis finished. Save the cost in the

meantime.

Hire the CEO immediately.

Build a simple proof-of-conceptproduct in 6 to 8 months.

Using the proof of concept,aim to sign up two companiesas development partners whowill work with the companyto specify the product (theywill get a good price on theproduct for their earlycommitment).

Considerations

Will the product be built on time?

Can the team build a world-class

product without closeengagement with the market?

Is it important to avoid havingcompetitors see the product priorto it being ready for market?

Ifthe product is late and no salesare made, how will investors in

the next round validate the

superiority of the product and itsmarket potential?

Without a CEO, will the companygo astray?

Can a great CEO be attractedwhen there is, as yet, limitedexternal validation of the

opportunity? Would the companybe better served by getting afirst-class CEO later?

Are there some good prospects inthe picture today that might bewilling to act as developmentpartners?

Will the development partnershelp to build a product that is

3. Originalequipmentmanufacturer

(OEM) route

GETTING TO THE FIRST STEPPING-STONE

Target one large softwarecompany that is likely to wantyour product included as partof its product line. Try tostrike an up-front OEM deal(where the early-stage companywill receive a royalty on eachsale of the larger company'sproduct).

Build the product to meet thelarge company's specifications.

Add the CEO later.

valid for the broad market or will

the company get pulled intoserving their unique needs?

Is there an OEM partner in thepicture today?

Ifthe company works with oneOEM, will that inhibit it from

selling its product directly tocustomers?

Will a close relationship with onelarge company be a barrier to thecompany working with itscompetitors later?

There are a large number of other alternatives available as well. By teasing outalternatives anddeveloping a broad view of the likely nextround valuation andthestrategic implications with respea to each alternative, thecompany canensure thatit uses its

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