Professional Equity Investment (Venture Capital and Angel) Lecture

EBD 481, Fall 2007Galbraith

History of Venture Capital1960s to early 1980s

IndividualsMoney for equityBased upon technology

Early 1980s to late 1980s

Real estate moneyFormed partnerships to spread riskRequired business plan

Late 1980s to present time

Institutional moneyOPM (other people money)Risk adverseInvest primarily in track recordMoney finders v. VC firms

Professional VC v. Angel Investment

Angel NetworksFormal groups of individual investorsDifferent from “individual investors”Angel Fund v. Individual Allocation within NetworkTypically Investment between $250K to $1mOften pool with other angel networks for a deal

VCProfessionally managed fundsTypical investment great than $1m (more often $5m)

Example of Angel Network

Wilmington Investor Network (WIN)

Equity Investment Process

SeedMoney

1st RoundFinancing

2nd RoundFinancing

Clean-upFinancing

Year 1 Year 3 Year 5

$50k $1 million $3 million $1 million

Milestones and Benchmarks

Private InvestmentVenture Capital Firms

Historical Development of Professional Venture Capital

1946: Beginning of Professional VCsFormation of American Research & Development (ARD)

ARD’s Performance$3.5 million was raised ($2 million from institutional investors)By end of 1947, ARD had invested in eight ventures, six of which were startupsBy 1951 the performance was still lack-luster (stock price was at $19 down from the initial offering price of $25 in 1946)1957 Invested in Digital Electronic CorporationARD Sold 1972; made money, about 15.0% annual return for investors (v. 7.2% in stock market)

Historical Development of Professional Venture Capital (cont’d)

1953: Small Business Administration (SBA) was formed

Legislation permitted the federal government to actively engage in fostering new business formation

1958:SBA Created Small Business Investment Companies (SBICs)

Due to tax and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital

SOLICITING INVESTMENTS: Suppliers of Venture Capital – 25-Year Average

Professional Venture Capital Investing Cycle

ORGANIZING THE FUND:VC Fund Placement Memorandum

Front-matter DeclarationsState Securities DisclosuresOffering SummaryFund OverviewExecutive SummarySummary of Terms

Fund is Formed, Investments Made, New Fund Created

Useful TermsCarried Interest:portion of profits paid to the professional venture capitalist as incentive compensation

Two and Twenty Shops:investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest

OBTAINING COMMITMENTS:Arrangements with Fund Investors

Capital Call:when the venture fund calls upon the investors to deliver their investment funds

Common to require subsequent investments consistent with the levels of investors’ initial contributions

DUE DILIGENCE AND ACTIVE INVESTING: VC Fund Management

Deal flow:flow of business plans and term sheets involved in the venture capital investing process

Due diligence (in venture investing context):process of ascertaining the viability of a business plan

VC and Angel Screening - Venture Characteristics

ProprietaryGrowthFounder CommitmentExperienceTrack Record

ManagementFire WithinBusiness ModelBusiness PlanDeal StructureExit Plan

Screening Outcomes

Seek lead investor positionSeek a non-lead investor positionRefer venture to more appropriate

financial market participantsSLOR (standard letter of rejection) the venture

Structuring an Equity InvestmentTerm Sheet:summary of the investment terms and conditions accompanying an investment

Typical Issues Addressed in a Term SheetValuationOngoing funding needsSize and staging of financingPreemptive rights on new issuesCommitments for future financing rounds and performance conditionsForm of security or investmentRedemption rights and responsibilities

Structuring (cont’d)Typical Issues Addressed in a Term Sheet

Dividend structure (Number of VCs and outsiders)Additional managementBoard appointmentsConversion value protectionRegistration rightsExit conditions and strategyIPO-dictated events (e.g. conversion)Co-sale rights (with founders)Lock-up provisions

Structuring (cont’d)Typical Issues Addressed in a Term Sheet

Employment contracts

Incentive options

Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock o termination, term of agreement, post-employment activities and competition

Founder stock vesting

Confidentiality agreements and protection for intellectual property

Exit Strategies

Acquisition -- least costly of exit strategiesPublic Offering -- most costly, but exciting and maintain some control (Future Lecture?)Joint Venture -- intermediate strategyEquity Buyback -- expensive, but way to get venture capitalists out of business

Summary - Advantages and Disadvantages of VC Funding

EquityOversightControlOver payment for fundsNeed to have exit strategy

Contractual CommitmentsLegal and paperworkMarketing and Management AssistanceLeverage for debt financingNetworking for additional funds and contacts

Grant and Guerrilla Financing

Grant FinancingGovernment and Private Grants for R&D and Commercialization

No equityAmount may be about $10billion per year in U.S. (angel financing about $20billion per year) – largest in segments which are funded

Grant FinancingSmall Business Innovation Research (SBIR)

DoD, NASA, DHS, DoC, EPA, DoT, DoEd, DoE, HHS (NIH), NSF & USDA The SBIR Program provides up to $850,000 in early-stage R&D funding directly to small technology companies (or individual entrepreneurs who form a company);

• Phase 1 ($75,000)• Phase II ($750,000)• Phase III (sell product)

Small Business Technology Transfer & Research (STTR)

The STTR Program provides up to $850,000 in early-stage R&D funding directly to small companies working cooperatively with researchers at universities and other research institutions;

Grant Financing

Department of Defense: SBIR/STTR/Fast Track - Main PageTechLink : : Links to Department of Defense, DoD Component, and Related Websites for SBIR/STTR Information

Grant FinancingOther Grants (CCAT, TechLink, BAAs, etc) Local and Regional Economic Development Grants

Industrial Development BondsTax BreaksOther Incentives

Private Foundations

Guerrilla Financing

Credit CardsRelatives and FriendsTrade CreditRevenue FinancingSmall Shares, with buyback provisionFactoring

BOOTSTRAPPING