Venture Capital Venture Capital Syndication and Firm Syndication and Firm Value: Value: Entrepreneurial financing of Entrepreneurial financing of Grand Junction NetworksGrand Junction Networks

Hoje JoHoje Jo

Santa Clara UniversitySanta Clara University

Outlines of presentationOutlines of presentation

MotivationMotivation ObjectivesObjectives HypothesesHypotheses Grand JunctionGrand Junction Field-based Field-based

InterviewsInterviews

IPO vs. AcquisitionIPO vs. Acquisition ValuationValuation The dealThe deal PerspectivesPerspectives ConclusionConclusion

Motivation of VC SyndicationMotivation of VC Syndication

Risk sharing [Wilson (1968)] Risk sharing [Wilson (1968)]

To lead to a superior selection of investments [Sah and To lead to a superior selection of investments [Sah and Stiglitz (1986)]Stiglitz (1986)]

To achieve a shared strategic goal [Lorange and Roos (1992)]To achieve a shared strategic goal [Lorange and Roos (1992)] To mitigate information asymmetry between early and late To mitigate information asymmetry between early and late

investors [Admati and Pfleiderer (1994)]investors [Admati and Pfleiderer (1994)] To network, collaborate, and align strategically [Stuart To network, collaborate, and align strategically [Stuart

(1998)](1998)]

To collude for window dressing to overstate VC’s To collude for window dressing to overstate VC’s performance [Lakonishok, Shleifer, Thaler, and Vishny performance [Lakonishok, Shleifer, Thaler, and Vishny (1991)](1991)]

Motivation of VC Syndication Motivation of VC Syndication (Continued)(Continued)

Syndication may increase the bargaining power Syndication may increase the bargaining power of the VCS [Gompers (1993).]of the VCS [Gompers (1993).]

The syndication of investment allows VC to The syndication of investment allows VC to diversify into more investments [Gompers diversify into more investments [Gompers (1998)].(1998)].

Second opinion hypothesis: Bringing other VCs Second opinion hypothesis: Bringing other VCs to do additional due diligence acts as a second to do additional due diligence acts as a second opinion on the investment opportunity. (Having opinion on the investment opportunity. (Having other VCs okay the deal makes it less likely other VCs okay the deal makes it less likely that bad deal get funded [Lerner (1994)].that bad deal get funded [Lerner (1994)].

Previous Literature of VC Previous Literature of VC syndicationsyndication

Syndication is a commonplace in biotech [Lerner (1994)]Syndication is a commonplace in biotech [Lerner (1994)] Changing syndication pattern may affect valuation Changing syndication pattern may affect valuation

[Gompers andLerner (1999)][Gompers andLerner (1999)] Evidence regarding the impact of VC syndication on firm Evidence regarding the impact of VC syndication on firm

value is scarce.value is scarce. Notable exception: Venture firms “endorsed/certified” Notable exception: Venture firms “endorsed/certified”

by prominent strategic alliance partners (i.e., by prominent strategic alliance partners (i.e., investment banks, equity investors, & joint venture investment banks, equity investors, & joint venture partners) perform better (I.e., go for public faster with partners) perform better (I.e., go for public faster with higher valuation) than otherwise comparable firms that higher valuation) than otherwise comparable firms that lacklack prominent associates. [Stuart, Hoang & Hybels prominent associates. [Stuart, Hoang & Hybels (1999)](1999)]

Objectives Objectives To examine the relationship between VC To examine the relationship between VC

syndication and firm value using a clinical case as a syndication and firm value using a clinical case as a preliminary step.preliminary step.

To formulate possible hypotheses regarding the To formulate possible hypotheses regarding the relationship.relationship.

To evaluate the relationship based on field-based To evaluate the relationship based on field-based interviews.interviews.

To evaluate Grand Junction from its inception to To evaluate Grand Junction from its inception to exit using valuation methods.exit using valuation methods.

VCs can add value in VCs can add value in general via:general via:

Strategic developmentStrategic development active board membershipactive board membership attract outside expertise, later round attract outside expertise, later round

investors, and other stakeholders, investors, and other stakeholders, i.e., managementi.e., management

provide contacts, access to provide contacts, access to information, people, and institution. information, people, and institution.

See Timmons (1999)See Timmons (1999)

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Allocation of Venture Capitalist Time

Source: Zider (1998)

Allocation of Venture Capitalist TimeAllocation of Venture Capitalist Time

Possible hypotheses : Possible hypotheses : Adding value by VC Adding value by VC syndication syndication

Effective Monitoring HypothesisEffective Monitoring Hypothesis::

When syndicated VCs have a When syndicated VCs have a superior investments, they provide superior investments, they provide best efforts in monitoring, financing, best efforts in monitoring, financing, advising, recruiting, networking, and advising, recruiting, networking, and consulting due to their reputation as consulting due to their reputation as well as their compensation.well as their compensation.

Alternative hypothesisAlternative hypothesis

Substitute Monitoring HypothesisSubstitute Monitoring Hypothesis;;

Because outstanding management Because outstanding management can outperform from the beginning can outperform from the beginning to the end, syndicated VCs will not to the end, syndicated VCs will not interrupt entrepreneurs unless interrupt entrepreneurs unless doing so is necessary. doing so is necessary.

Oversight Demand Oversight Demand HypothesisHypothesis

VC syndication tends to monitor VC syndication tends to monitor the portfolio firm more when the the portfolio firm more when the demand for oversight of private demand for oversight of private firms is greater [Lerner (1995)]firms is greater [Lerner (1995)]

Second opinion hypothesisSecond opinion hypothesis

Bringing other VCs to do additional due Bringing other VCs to do additional due diligence acts as a second opinion on the diligence acts as a second opinion on the investment opportunity. (Having other investment opportunity. (Having other VCs okay the deal makes it less likely VCs okay the deal makes it less likely that bad deal get funded [Lerner (1994)].that bad deal get funded [Lerner (1994)].

This hypothesis is related to leading to a This hypothesis is related to leading to a superior selection of investments [Sah superior selection of investments [Sah and Stiglitz (1986)]and Stiglitz (1986)]

Grand Junction NetworksGrand Junction Networks

Leader in the Ethernet LAN Switching Leader in the Ethernet LAN Switching MarketMarket

Private company funded through 3 Private company funded through 3 rounds of venture financingrounds of venture financing

Experiencing rapid growth in revenues – Experiencing rapid growth in revenues – over $65 million expected in 1996over $65 million expected in 1996

Founder’s equity is 18.2%Founder’s equity is 18.2% Critical decision: go for IPO or be Critical decision: go for IPO or be

acquiredacquired

Howard Charney, the Howard Charney, the founderfounder

One of the founders of 3Com.One of the founders of 3Com. B.S. & M.S. in M/E from M.I.T.B.S. & M.S. in M/E from M.I.T. J.D./MBA from J.D./MBA from Santa Clara UnivSanta Clara Univ.. Found Grand Junction in early 1992.Found Grand Junction in early 1992. ““Kind of guy people walk through Kind of guy people walk through

walls for” confirms Kathryn Gould. walls for” confirms Kathryn Gould.

The “Four Cornerstones”The “Four Cornerstones”

ManagementManagement: Founded in 1992 by : Founded in 1992 by Howard Charney and several colleaguesHoward Charney and several colleagues

TechnologyTechnology: Developed Fast Ethernet : Developed Fast Ethernet switching -10x faster data transferswitching -10x faster data transfer

MarketMarket: Currently using Ethernet, easily : Currently using Ethernet, easily upgraded, other products problematicupgraded, other products problematic

FinancialFinancial: Strong financial potential, : Strong financial potential, projected IPO in 1995, Profitable in projected IPO in 1995, Profitable in 1995 1995

Structuring the DealStructuring the Deal

ValuationValuation: Comparables most common : Comparables most common (95%) in Silicon Valley; Compared to 12 (95%) in Silicon Valley; Compared to 12 other companiesother companies

Preferred vs. Common StockPreferred vs. Common Stock: Common for : Common for employee benefits, Preferred for investorsemployee benefits, Preferred for investors

Present Value of Future StockPresent Value of Future Stock: Back into : Back into present stock price with dilution effectspresent stock price with dilution effects

Term SheetTerm Sheet: 2 Seats on board, anti-dilution : 2 Seats on board, anti-dilution provisions, West vs. East Cost Deals provisions, West vs. East Cost Deals

Financing Notes of VC Financing Notes of VC SyndicationSyndication

Series ASeries A: (i) Merrill, Pickard, Anderson & Eyre (MPAE) *; : (i) Merrill, Pickard, Anderson & Eyre (MPAE) *; Kathryn Gould, Kathryn Gould,

(ii) Technology Venture Investors (TVI); David Marquardt (ii) Technology Venture Investors (TVI); David Marquardt (Microsoft, Usoft, Sun, Adaptec, Auspex), (Microsoft, Usoft, Sun, Adaptec, Auspex),

(iii) Associated Venture Investors (AVI),(iii) Associated Venture Investors (AVI), (iv) Matrix Partners; Andrew Verhalen.(iv) Matrix Partners; Andrew Verhalen.

Series A-1Series A-1: Matrix Partners*, MPAE, TVI & AVI.: Matrix Partners*, MPAE, TVI & AVI.

Series BSeries B: Mezzanine round from same investors and : Mezzanine round from same investors and Sutter Hill Ventures and New Enterprise Associates.Sutter Hill Ventures and New Enterprise Associates.

Lead Investor: Kathryn Lead Investor: Kathryn GouldGould

U. Toronto B.A.in Physics & U. Toronto B.A.in Physics & U.Chicago MBAU.Chicago MBA

Marketing V.P. at OracleMarketing V.P. at Oracle One of the most successful VC One of the most successful VC General Partner of MPAEGeneral Partner of MPAE Founder of Foundation CapitalFounder of Foundation Capital ““Third Sex”Third Sex”

Summary of Entrepreneurial Summary of Entrepreneurial FinancingFinancing

FoundersFeb '92

Series AFeb '92

Series A-1Dec '92

Series BOct '93

Founders'Shares

2,340,000 - - -

Sharesissued

- 5,910,402 2,623,101 4,257,497

Paid inCapital

- $4,452,504 $3,497,470 $8,500,005

Total sharesissued

2,340,000 8,250,402 10,873,503 15,131,000

Price/Share NA $0.75 $1.33 $2.00

FoundersEquity

100% 28% 22% 15%

Series AEquity

- 72% 54% 39%

Series A-1Equity

- - 24% 17%

Series BEquity

- - - 28%

Post-moneyValuation

- $6,215,304 $14,498,012 $30,208,730

The Grand PlanThe Grand Plan

AchievementsAchievements Market acceptance Market acceptance Financial GrowthFinancial Growth Second Generation of ProductsSecond Generation of Products What’s Next…What’s Next… CFOCFO Investment BankerInvestment Banker Execution!Execution!

Field-based InterviewsField-based Interviews

VCs add the most value when they are VCs add the most value when they are members of the board and the organization members of the board and the organization must overcome a difficult time.must overcome a difficult time.

When the chosen distribution system of Grand When the chosen distribution system of Grand Junction was not working, Gould suggested a Junction was not working, Gould suggested a new distribution system and sales rose by 25%.new distribution system and sales rose by 25%.

But, Gould & other VCs took a laisses-faire role But, Gould & other VCs took a laisses-faire role until issues arose.until issues arose.

Field-based Interviews. Field-based Interviews. Continued.Continued.

Verhalen (Matrix) also said that the VCs did work Verhalen (Matrix) also said that the VCs did work together as a team, but they all played a fairly together as a team, but they all played a fairly passive role, as Grand Junction was doing very well.passive role, as Grand Junction was doing very well.

From these interviews, it seems that the substitute From these interviews, it seems that the substitute monitoring hypothesis is more relevant than the monitoring hypothesis is more relevant than the effective monitoring hypothesis. Additionally, effective monitoring hypothesis. Additionally, oversight demand and second opinion hypotheses oversight demand and second opinion hypotheses are also supported.are also supported.

The capability of CEO is also crucial.The capability of CEO is also crucial.

The Suitor – Cisco SystemsThe Suitor – Cisco Systems

Market cap of nearly $19 billion in Market cap of nearly $19 billion in 19951995

Rapid growth – aggressive acquisition Rapid growth – aggressive acquisition strategystrategy

Switching technology would Switching technology would complement Cisco’s router dominancecomplement Cisco’s router dominance

Strategic acquisition to keep Strategic acquisition to keep technology from competitors technology from competitors

Grand Junction – Exit Grand Junction – Exit StrategyStrategy

IPO or AcquisitionIPO or Acquisition Grand Junction files S-1 formGrand Junction files S-1 form

• Hot IPO marketHot IPO market Cisco’s initial offer is $325 millionCisco’s initial offer is $325 million Cisco raises the offer to $346 Cisco raises the offer to $346

millionmillion Is this a good deal?Is this a good deal?

Exit, stage left. . . .Exit, stage left. . . .AcquisitionsAcquisitionsAcquirerAcquirer TargetTarget Price ($ Mil)Price ($ Mil) DateDate

CiscoCiscoSystemsSystems Crescendo Crescendo $89$89 Sept. Sept. 1993 1993

Newport SystemsNewport Systems $83$83 July 1994July 1994KalpanaKalpana $204$204 Oct. Oct.

19941994LightsteamLightsteam $120$120 Dec. 1994Dec. 1994CombinetCombinet $115$115 Aug. 1995Aug. 1995Internet Junction $5.5Internet Junction $5.5 Sept. Sept.

19951995

3Com3Com SynerneticsSynernetics $107$107 Jan. 1994Jan. 1994NiceComNiceCom $59$59 Oct. 1994Oct. 1994SonixSonix $70$70 May 1995May 1995Primary AccessPrimary Access $170$170 June June

19951995ChipcomChipcom $721$721 Oct. 1995Oct. 1995

Bay NeyworksBay NeyworksCentillionCentillion $140$140 July 1995July 1995

IPO vs AcquisitionIPO vs Acquisition

IPO’sIPO’s PrestigePrestige Trading regulationsTrading regulations Lack of immediate liquidityLack of immediate liquidity Litigation exposureLitigation exposure Reporting requirementsReporting requirements Recruiting difficultiesRecruiting difficulties

AcquisitionsAcquisitions Positive change of pacePositive change of pace Loss of autonomy/authorityLoss of autonomy/authority Financial rewardFinancial reward

IPO vs. AcquisitionIPO vs. Acquisition

Positives Negatives

IPO Option - Attractive market for IPOs

- Prestige of taking a companypublic

- Some key employees thoughtgoing public was a goal

- May not be able to sustain longterm growth on its own if wentpublic, products may notprevail

- Hard to attract top technologytalent after the IPO without theequity incentives of a start up

- As an officer of public companyCharney would becomevulnerable and accountable forcompany’s actions

- Reporting to stockholders canbe a large distraction

- No immediate liquidity

IPO vs. AcquisitionIPO vs. Acquisition

Positives Negatives

AcquisitionOption

- Attractive mechanismthrough which technologycan be accepted

- Lifestyle at Cisco was likelyto be more relaxed andrequire fewer hours at work

- Several key employees wouldhave to leave

- Management team and Charneywould be demoted to middlemanagers giving lessautonomy and authority

Risks and OpportunitiesRisks and Opportunities

Changes in TechnologyChanges in Technology• Dynamic demandDynamic demand• Risk of obsolescenceRisk of obsolescence

Market AcceptanceMarket Acceptance• Greatly impacted by future standardsGreatly impacted by future standards

CompetitionCompetition• Strong established market leadersStrong established market leaders

Human CapitalHuman Capital

Valuation ApproachesValuation Approaches

Net Present Value MethodNet Present Value Method• Common industry approachCommon industry approach• Extremely sensitive to terminal value, WACCExtremely sensitive to terminal value, WACC• Cash flow assumptions may be difficultCash flow assumptions may be difficult

Comparables MethodComparables Method• Common industry approachCommon industry approach• Use for private company valuations can be difficultUse for private company valuations can be difficult• Generally adjusted based on capital structure, illiquidity, risksGenerally adjusted based on capital structure, illiquidity, risks

Real Options MethodReal Options Method• Not common in the industryNot common in the industry• Improves on NPV through valuing contingencies built into investmentImproves on NPV through valuing contingencies built into investment• Modeling real-life investment options can be difficultModeling real-life investment options can be difficult

Comparables MethodComparables Method

Six public companies chosenSix public companies chosento provide multiplesto provide multiples

Revenue, Book Value, EarningRevenue, Book Value, Earningmultiples chosenmultiples chosen

Cisco multiples weighed higherCisco multiples weighed higher Average of valuations based onAverage of valuations based on

multiples – $250 millionmultiples – $250 million

Net Present Value MethodNet Present Value Method

Assume:Assume:• 7% Terminal Growth,7% Terminal Growth,• 17% WACC17% WACC

Cash flows developed based onCash flows developed based on$1.5 billion Ethernet market in 1997$1.5 billion Ethernet market in 1997

Sensitivity analysis for WACC andSensitivity analysis for WACC andTerminal Growth Rate performedTerminal Growth Rate performed

Valuation = $372 millionValuation = $372 million

Real Options MethodReal Options Method

Black Scholes Model is used to value optionBlack Scholes Model is used to value option Base Assumptions:Base Assumptions:

• S=$483.2 millionS=$483.2 million• X=$346.0 millionX=$346.0 million• T= 3 months, 1 year, and 2 yearsT= 3 months, 1 year, and 2 years• Std Dev of Returns= 50%Std Dev of Returns= 50%• Risk Free Rate= 5%Risk Free Rate= 5%

Valuations = 536 millionValuations = 536 million• Average of $500 million, 536 million, 571 millionAverage of $500 million, 536 million, 571 million

Valuation SummaryValuation Summary

Weighting of valuation approachesWeighting of valuation approaches

ValuationApproach

Valuation Weighting Solutions Weighted Averages

A B C A B C

Comparables $205.40 X 33.3% 40% 50% = $68.46 $82.16 $102.70

Net PresentValue

$372.06 X 33.3% 30% 20% = $124.20 $111.79 $74.50

Real Options $535.36 X 33.3% 30% 30% = $178.37 $160.60 $160.60

Weighted Total per Solution $371.03 $354.55 $337.8

Average $354.46

The DealThe Deal

Early Aug, 95 - Cisco offered $200MEarly Aug, 95 - Cisco offered $200M Late Aug, 95 - Offered $325M, 5M Late Aug, 95 - Offered $325M, 5M

sharesshares Sept. 11 - Filed S-1 with the SECSept. 11 - Filed S-1 with the SEC Sept. 16 - Chambers re-submitted Sept. 16 - Chambers re-submitted

$325M$325M Charney countered with 5M shares, Charney countered with 5M shares,

$346M$346M

Perspectives of various Perspectives of various stakeholdersstakeholders

Employees of Grand Junction: were not Employees of Grand Junction: were not in favor of an acquisition strategy.in favor of an acquisition strategy.

VCs are favorable in the acquisition VCs are favorable in the acquisition since they will receive a fair value for since they will receive a fair value for their interests as well as immediate their interests as well as immediate liquidity.liquidity.

Management is favorable of an Management is favorable of an acquisition because they want the acquisition because they want the technology to succeed.technology to succeed.

ConclusionsConclusions

Final Valuation = $354.46 millionFinal Valuation = $354.46 million(Range : $337.8 million and $371.03 million)(Range : $337.8 million and $371.03 million)

The final Cisco offer falls within the range of The final Cisco offer falls within the range of determined valuationsdetermined valuations

VC syndication does play a role in building VC syndication does play a role in building up the equity value of Grand Junction.up the equity value of Grand Junction.

VC’s role was generally passive.VC’s role was generally passive. This preliminary evidence awaits formal This preliminary evidence awaits formal

tests.tests.