Venture Capital_3_

Venture Capital Investing A Primer William Quigley Managing Director Clearstone Venture Partners william@clearstone.com CLEARSTO NE 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 CLEARSTO NE 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 CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S Investment Stages Most VC‟s have a preference for a particular investment stage. Five Stages: – – – – – Seed Start-up Early Expansion Mezzanine/Bridge CLEARSTO NE V E N T U R E P A R T N E R S Stage/Characteristic Stage Seed Investment $50-500K Characteristics - Founder(s) only - No product - No customers - Primary risk: R&D Start-Up $500K to $1MM - Mgmt. team incomplete - Prototype or beta product - No revenues - Limited customer interest - Some capital invested - Primary risk: market accept. CLEARSTO NE V E N T U R E P A R T N E R S Stage/Characteristic Stage Early Investment $1MM - $3MM Characteristics - Most of team in place - Limited revenues - Not profitable - Primary risk:execution Expansion $3MM - $10MM - Meaningful revenues - Achieving profitability - Growing customer base - Primary risk: competition CLEARSTO NE V E N T U R E P A R T N E R S Stage/Characteristic Stage Investment Characteristics Mezzanine/ $10MM - $20MM - Significant revenues Bridge - Profitable - Industry player - IPO in 6-12 months - Risk much lower CLEARSTO NE V E N T U R E P A R T N E R S The Role of the VC       Board involvement Management recruitment Future capital raising Access to business network Strategy development Patience! CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S The Venture Capital Process       Business Plan First Meeting Second Meeting Term Sheet Due Diligence Negotiations CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S Business Plan Magic Numbers?    50 5 10 CLEARSTO NE V E N T U R E P A R T N E R S 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.… CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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) CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S Negotiations Negotiations take place throughout the due diligence process. What is negotiable? Some flexibility in: – Valuation Less flexibility in: – Equity instrument type – Total investment – Vesting periods – Size of option pool – Board make-up – Anti-dilution rights – Restrictive covenants CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S The Business Plan Executive Summary Main Body Appendix CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S  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? CLEARSTO NE V E N T U R E P A R T N E R S 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? CLEARSTO NE V E N T U R E P A R T N E R S   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? CLEARSTO NE V E N T U R E P A R T N E R S   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 CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S Valuation Stage Criteria - Market size/growth - Revenue run rate - Gross margin % - Performance to date Methodology Comparables Range $1.5 to $5.0MM Early Expansion - Revenue run rate - Profitability ratios - Performance vs. plan - 1X sales - EBIT multiple Varies CLEARSTO NE V E N T U R E P A R T N E R S Valuation Stage Criteria Methodology Multiples of proxy companies Range Varies Mezzanine/ - Market share/size Bridge - IPO environment - Performance Relative to plan CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S 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. Get legal documentation done Likelihood of Occurring - 7 in 10 - 8 in 10 - 9.9 in 10 - 9 in 10 9. Fund the company EQUATES TO 1% CLEARSTO NE V E N T U R E P A R T N E R S Commonly Asked Questions “Will I have to give up control of my company?” CLEARSTO NE V E N T U R E P A R T N E R S Commonly Asked Questions “Why don’t VC’s sign NDA’s?” CLEARSTO NE V E N T U R E P A R T N E R S Commonly Asked Questions “Raising money - all at once or spread out over time?” CLEARSTO NE V E N T U R E P A R T N E R S Commonly Asked Questions “Its a great invention, so why aren’t they interested?” CLEARSTO NE V E N T U R E P A R T N E R S Commonly Asked Questions “Why do VC’s want to know the other firms that I am talking to?” CLEARSTO NE V E N T U R E P A R T N E R S Commonly Asked Questions “When should I initiate contact with a VC?” CLEARSTO NE 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 CLEARSTO NE V E N T U R E P A R T N E R S How do you Contact a VC? Introductions are best: – Attorney – Accountant – Banker – Angel Investor – Industry Executive CLEARSTO NE V E N T U R E P A R T N E R S 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 CLEARSTO NE V E N T U R E P A R T N E R S Venture Capital CLEARSTO NE V E N T U R E P A R T N E R S