VC Investment Process by p9B4g4O


									VC Investment Process
     The investment process
       of a typical VC fund

Screening (vague)           100 to 1,000 firms

Preliminary due diligence             10 firms

Term sheet                             3 firms

Final due diligence                    2 firms

Closing                                 1 firm
• Takes a big chunk of the VC’s time:
   –   Search through proprietary private firm databases
   –   Deal flow from repeat entrepreneurs
   –   Referrals from industry contacts
   –   Direct contact by entrepreneurs

• Reputable VCs have easier time identifying better companies
  because of their big networks and entrepreneur's willingness to work
  with them.

• Most investments are screened using a business plan prepared by
  the entrepreneur. Two major areas of focus in screening:
   – Does this venture have a large and addressable market? (market test)
   – Does the current management have capabilities to make this business work?
     (management test)
                           Market Test
• Main focus: Possibility of exit with an IPO within 5 year with a
  valuation of several hundred million dollars

• The market for the firm’s products should be big enough
    – A company developing a drug to treat breast cancer is likely to have a bigger
      market than a company developing a drug for a disease with only 1,000 sufferers

• Barriers to entry should not be too high in the firm’s market
    – A company that developed a new operating system for PCs does not have much
      chance against Microsoft.

• Sometimes, there is no established market for the firm’s products
  and services (e.g., eBay, Netscape, Yahoo). In such cases, spotting
  potential winners is more of an art than science.
                  Management Test
• Ability and personality of the entrepreneur and the synergy of the
  management team is examined

• Repeat entrepreneurs with track records are the easiest to evaluate

• An often spoken mantra in VC conferences is that: “I would rather invest
   in strong management with an average business plan than in average management
   with a strong business plan”. Do you think this makes sense?
                          Due diligence
• Pitch meeting: The meeting of VC with company management
    – Management test

• For firms that successfully pass the pitch meeting, the next step is
  preliminary due diligence
    – If other VCs are also interested in the firm, preliminary due diligence is short
    – Due diligence is on management, market, customers, products, technology,
      competition, projections, partners, burn rate of cash, legal issues etc.

• If the results of the preliminary due diligence is positive, the VC
  prepares a term sheet that includes a preliminary offer.
                      Term Sheet
• Includes the preliminary offer of the VC fund and serves as an
  anchor for negotiations between the fund and the entrepreneur.

• Let’s review a sample term sheet together
                    Preferred Stock
• Most VC investments are in the form of convertible preferred stock
• Preferred stock is senior to common stock in terms of CF rights
• At the time of an exit (e.g., IPO), preferred stock holders decide
  whether to redeem (and get back what they invested) or to convert
  their shares into common stock and receive a fraction of the exit
• Based on the example in the term sheet, with exit proceeds = $W,
    – CP(conversion value) = ½ * $W
    – CP(redemption value) = Min($1m, $W)

• So, let’s examine graphically the conversion condition for CP→
Conversion vs. Redemption



    $1m                               Redemption

                    $1m   $2m     $W

 Rule: Redeem when $W < $2m; convert otherwise.
         Exit Value of CP



                   $1m   $2m   $W
          Alternative Securities
1. Redeemable preferred stock (RP) + Common stock (CS)
2. Participating convertible preferred stock (PCP)
3. Participating convertible preferred stock with a cap (PCPC)

   Now let’s examine the payoffs from these investments.
                                     RP + CS
                      Individually                                  Combined

  Payoff                                            Payoff

$1m                                          RP   $1m
      Slope=1                                           Slope=1

                $1m   $2m      $3m       $W                       $1m   $2m       $W
PCP with mandatory conversion
upon a qualified public offer with
price above $2.5/share (2.5 x OI)

                       QPO threshold = ½ * $2.5m = $5m




             $1m                     $5m                   $W
Comparison of Exit Proceeds
   W     CP     CS     RP    CS + RP   PCP

 0.50   0.50   0.25   0.50      0.50   0.50

 1.00   1.00   0.50   1.00      1.00   1.00

 3.00   1.50   1.50   1.00      2.00   2.00

 5.00   2.50   2.50   1.00      3.00   3.00

10.00   5.00   5.00   1.00      5.50   5.00
          Anti-dilution Provisions
• Suppose that EBV makes a $6m Series A investment in Newco for
  1M shares at $6 per share. Newco has fallen on hard times and
  receives a $6M Series B financing from Talltree for 6M shares at $1
  per share. The founders and the stock pool have claims on 3M
  shares of common stock.

• What % of the company will be controlled by Newco after the Series
  B investment? What would be the post-money and pre-money
          Case 1: No anti-dilution
•   Number of shares = 1M + 3M + 6M = 10M
•   So, EBV controls 1M/10M = 10%
•   Post-money valuation = 10M x $1 = $10M
•   Pre-money valuation = $10M - $6M = $4M
    Case 2: Full-rachet anti-dilution
• With full-rachet protection, Series A conversion price becomes $1
  (the price of Series B), and EBV would control 6M shares.

•   Number of shares = 6M + 3M + 6M = 15M
•   So, EBV controls 6M/15M = 40%
•   Post-money valuation = 15M x $1 = $15M
•   Pre-money valuation = $15M - $6M = $9M

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