Venture Capital Investing A Primer
William Quigley Managing Director Clearstone Venture Partners william@clearstone.com
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V E N T U R E P A R T N E R S
Venture Capital
“I was seldom able to see an opportunity until it had ceased to be one”
Mark Twain
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V E N T U R E P A R T N E R S
Venture Capital
Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch
CLEAR STO N E
V E N T U R E P A R T N E R S
Venture Capital
Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch
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Industry Snapshot
400+ institutional VC firms in the U.S. Geographically concentrated Stage/Industry focused General partners/Limited partners 10 year investment horizon Co-investment with other VC’s common
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Typical Firm Profile
3 to 4 investment professionals Review 1000+ business plans a year Manage $50 to $200 million in capital Buy equity (preferred stock) - rarely make loans Investment horizon - 3 to 6 years Sources of capital: - Pension funds - Corporations - College endowments - Wealthy individuals
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Investment Stages
Most VC‟s have a preference for a particular investment stage. Five Stages:
– – – – – Seed Start-up Early Expansion Mezzanine/Bridge
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Stage/Characteristic
Stage
Seed
Investment
$50-500K
Characteristics
- Founder(s) only - No product - No customers - Primary risk: R&D - Mgmt. team incomplete - Prototype or beta product - No revenues - Limited customer interest - Some capital invested - Primary risk: market accept.
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Start-Up
$500K to $1MM
Stage/Characteristic
Stage
Early
Investment
$1MM - $3MM
Characteristics
- Most of team in place - Limited revenues - Not profitable - Primary risk:execution - Meaningful revenues - Achieving profitability - Growing customer base - Primary risk: competition
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Expansion $3MM - $10MM
Stage/Characteristic
Stage Investment Characteristics
Mezzanine/ $10MM - $20MM - Significant revenues Bridge - Profitable
- Industry player - IPO in 6-12 months - Risk much lower
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The Role of the VC
Board involvement Management recruitment Future capital raising Access to business network Strategy development Patience!
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Targeted Industries
Most of the $10 billion invested by VC‟s in 1997 was concentrated in five industries. Why these? • • • • • Information Technology Medical Services/Devices Communications Biotechnology Some Retail
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How Do VC’s Make Money?
Source of VC Income:
– Collect management fees from L.P.’s - 2 1/2% annually – Share profits with L.P.’s 20/80 split on investment gains How do VC’s earn their income?
5% 95%
Mgmt. Fee
Investment Gains
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Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch
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What Do VC’s Want to See?
Venture capitalists tend to focus on five specific areas when evaluating a company: Areas of Focus:
• Management
• Marketplace
• Competition • Business Economics
• Risks
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Management
The most important question: Has the team had experience and success in the same industry? VC Focus:
– – – – – – DIRECT sales experience? Prior P/L responsibility? Personal financial stake? Willingness to share equity “Fire in the belly”? Functional areas covered?
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Market
Can management demonstrate a thorough understanding of the marketplace dynamics? VC Focus:
– Market size and growth rate? – Market drivers? – Customer involvement in the R&D process? – Number of competitors?
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Competition
Does management have a clear understanding of the competitive landscape? VC Focus:
– Why are competitors successful? – What is the prevailing business model? – Barriers to entry?
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Business Economics
Does management have a deep understanding of the financial dynamics of the business and industry? VC Focus:
– Margins comparable to industry norm? – Break-even < 2 years ? – Appropriate sales model? – Moderate capital intensity?
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Risk
Does management recognize, accept, and have strategies to deal with key risks? VC Focus:
– – – – Reasonable financial projections? New technology adoption rate? Length of sales cycle? Best and worst case scenarios explored? – Regulatory hurdles?
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Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch
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The Venture Capital Process
Business Plan First Meeting Second Meeting Term Sheet Due Diligence Negotiations
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Business Plan
“Madam, enclosed please find the novel you commissioned. It is in two volumes. If I had had more time I could have written it in one.”
Voltaire
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Business Plan
#1 objective of the the business plan: Get the VC interested in hearing more about the opportunity. Business Plan Basics:
– Written by the entrepreneur – Keep it short – Financials (3-5 year proj.) • Income statement • Balance sheet • Cash flow • “What-ifs” helpful
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Business Plan
Magic Numbers?
50 5 10
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Business Plan
Business plan phrases that „spook‟ VC‟s...
We have no competition…. We conservatively project….. We only need a 10% market share…. We will offer the most features at the lowest price…. We valued our Internet start-up using multiples of comparable companies…like Netscape, Cisco, Microsoft.…
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First Meeting
„Skepticism‟ might best describe the venture firm‟s attitude in the first meeting. Don‟t be alarmed by this. The Details:
– – – – Location: VC’s office Duration: 2-3 hours Attendees: 1 to 2 VC’s Format: Formal presentation with Q/A
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Second Meeting
Getting to the second meeting is an important milestone. The team will now make its case to the entire partnership. Focus On :
• Business opportunity - not the technology • Addressing concerns of the skeptics - THIS IS CRITICAL! • Next steps
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What Went Wrong? - A Few Tips
Dont’s
• Make vague, ambiguous, or unsubstantiated statements • Make reference to unnamed/ mysterious people on the management team • Use statistical arguments for market penetration assumptions • Use technical jargon • Assume you have a deal if there is no term sheet
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What Went Wrong? - A Few Tips
Dos
• Involve the entire team • Discuss/disclose potential problems • Demonstrate financial commitment to the venture • Prepare realistic market and sales projections • Know your target investor (angel, bank, VC)
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What Went Wrong? - Getting Feedback
Getting honest feedback can be challenging… Some Guidelines:
“The greatest gift that – Needs to be solicited! God hath given us is – From knowledgeable sources to see ourselves as – Develop a dialogue first others see us.”
– Avoid answering, debating – Have a market-researcher mindset
Scottish Proverb
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Term Sheet
After the second meeting, the VC typically provides a term sheet to the entrepreneur. Term Sheet - Common questions:
– Is it a legally binding document? – What’s covered? – What is it designed to do? – Why participating preferred stock?
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Term Sheet Conditions
The term sheet is intended to embody the overall conditions of a business agreement. What‟s covered?
Post-money valuation $ amount of the financing Investors identified Size of employee option
pool Vesting periods Key-person insurance
Board representation Additions to management team, if any Monitoring covenants, Restrictive covenants Other deal specific issues
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Due Diligence
The “heavy lifting” for the venture capitalist starts with the due diligence process. Due Diligence Overview:
– Length: 6-12 weeks – Will perform up to 100 reference calls – Interview customers, former employees, competitors, industry experts – Intense legal, financial work
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Negotiations
Negotiations take place throughout the due diligence process. What is negotiable? Some flexibility in:
– Valuation – Total investment – Vesting periods – Size of option pool
Less flexibility in:
– Equity instrument type – Board make-up – Anti-dilution rights – Restrictive covenants
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The Business Plan
Executive Summary Main Body Appendix
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Executive Summary
What should the executive summary address? Mission statement Brief company history Description of investment opportunity Market overview Management team Product & technology Customers Strategy Competition Capital requirements
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Main Body
Management
Key Questions to Address:
Who are the key people in the company? Where did they come from, and why are they the right people to run the company? Have they had previous experience and success in growth companies?
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Main Body
Product/Technology/Service
Key Questions to Address:
What does the customer have access to today? How does it differ from competing offerings What is the superior value proposition to the customer?
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Main Body
Marketplace
Key Questions to Address:
What is happening in the marketplace? Is it growing, if so, why and at what rate? What is lacking from the market leaders that this product/tech/service will provide?
Which customers have been involved in the development of the product and are likely to purchase it? CLEAR STO N E
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Main Body
Strategy
Key Questions to Address:
Why will the customer be compelled to purchase the product? How will the company maintain its competitive differentiation?
What barriers exist/will be created to curtail new entrants?
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Appendix
Not all business plans require an Appendix section, but it can be useful. What to include?
Relevant industry articles to bolster management claims Major customer testimonials Other information likely to impress those not familiar with the market
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Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch
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Valuation
Stage Seed Criteria
- Mgmt. track record - Market size/growth - Competition - Investment to date - Market size/growth - Working prototype? - Team complete?
Methodology
Range
Comparables, $400K to $1.5MM Whats the “going rate” in the region
Start-up
Comparables
$750K to $2.0MM
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Valuation
Stage
Early
Criteria
- Market size/growth - Revenue run rate - Gross margin % - Performance to date
Methodology
Comparables
Range
$1.5 to $5.0MM
Expansion - Revenue run rate
- Profitability ratios - Performance vs. plan
- 1X sales - EBIT multiple
Varies
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Valuation
Stage Criteria Methodology
Multiples of proxy companies
Range
Varies
Mezzanine/ - Market share/size Bridge - IPO environment - Performance Relative to plan
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Exit Strategies
• Sale or Merger
– Most likely exit
• Initial Public Offering
– Small fraction go this way
• Redemption
– Least attractive
• Management buy-out
– Generally not possible
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Secrets of Success?
The Eight Commandments
CEO carried a bag Called on same customer base Gross margin > 50% Some degree of technology Cash flow break-even < $5M Sourced the deal 25% ownership or greater First institutional investor
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Odds of Getting a Deal Done?
Hurdle
1. Review the plan and
Likelihood of Occurring
- 1 in 15 - 6 in 10 - 7 in 10
conclude it makes sense 2. Meet the team and like them 3. Be attracted to the market opportunity and the company strategy 4. Introduce team to the other partners and get their buy-in
- 7 in 10
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Odds of Getting a Deal Done?
Hurdle
5. Complete the due diligence process satisfactorily 6. Get a term sheet agreed to in principle 7. Find co-investors - if necessary - 8 in 10 - 9.9 in 10
Likelihood of Occurring
- 7 in 10
8. Get legal documentation done
9. Fund the company
- 9 in 10
EQUATES TO 1%
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Commonly Asked Questions
“Will I have to give up control of my company?”
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Commonly Asked Questions
“Why don’t VC’s sign NDA’s?”
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Commonly Asked Questions
“Raising money - all at once or spread out over time?”
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Commonly Asked Questions
“Its a great invention, so why aren’t they interested?”
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Commonly Asked Questions
“Why do VC’s want to know the other firms that I am talking to?”
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Commonly Asked Questions
“When should I initiate contact with a VC?”
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Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch
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How do you Contact a VC?
Introductions are best:
– Attorney – Accountant
– Banker
– Angel Investor – Industry Executive
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Local Resources
The Michael Dingman Center at U of MD. The Morino Institute - Netpreneur Program Baltimore/Washington Venture Group NVTC - Emerging Business Network functions Silicon Valley Bank, other community banks Private Investors Network, Grubstakes (networks of angel investors) Pratts Guide to Venture Capital
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