investment capital

							                Venture capital

             Wijnand vd Calseijde
       Jaap Gordijn (some technicalities)


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                       Content
• What is venture capital, largely based on
  – The Twinning concept: Wijnand van de Calseijde
  – Financing & Business Plans: Roel Pieper
     • (both presentations are on the course website)
• Some financial technicalities (company
  valuation, exit strategies)

• These lecture slides are compulsory for the
  examination!
                                                        2




                                                            1
Characteristics of Venture Capital
• High risk
• High return
• Long term
• Equity
• Illiquidity
• Often investments in new technology, new
  marketing concepts or new product application
  possibilities
• Close involvement of investor


                                                          3




                     Rationale
• Negative cash-flow is financed in one or multiple
  rounds


        Cumulative
         cashflow
                                         Gap to finance




                                         Break even
                                time



                                                          4




                                                              2
   Stages of Financing (1)
• Seed Financing
  – Initial capital for a start-up venture

  – Provided by friends and family, informal investors or
    by seed venture capital firms

  – Often used to develop a business concept before a
    company is really started




                                                             5




   Stages of Financing (2)
• First Round Financing
  – Capital for a venture that has successfully passed the
    initial start-up phase. The business plan has been
    written and the product is under development.

  – Usually provided by informal investors and / or seed
    venture capital firms

  – Often used to further develop the product or service
    and in some cases to attract the first customers

                                                             6




                                                                 3
          Stages of Financing (3)
• Second Round Financing
   – Capital for a venture that already has paying
     customers but is not yet profitable

   – Usually provided by venture capital firms and
     (investment) banks

   – Often used for marketing purposes and growth of
     the company

• Third Round Financing
   – Sometimes another round of financing is necessary
     before being profitable. In other cases the money is
     used by profitable companies to be able to expand
                                                             7
     more aggressively than they could do otherwise.




            ‘Parallel’ Financing

• Subsidies
  – Dependent on the laws and regulations in a specific
    country, (start-up) companies can often apply for
    subsidy by the public sector

• Loans
  – In some cases banks are willing to provide loans to
    start-up companies, e.g. for financing working capital



                                                             8




                                                                 4
   Raising Finance


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           The Business plan
• Writing a business plan is a process in which the
  entrepreneur is forced to think about all aspects of
  the business

• Write it yourself

• Focus on
   – The people, the opportunity / business model

   – Risk and reward

• Write down the exit options (the investor wants
  to get money out of it as well) but don’t focus too
                                                      10
  much on the “IPO within 3 years”




                                                             5
  Characteristics of Funders (1)
• Family, Friends …. and Fools
  – Their goal: to help you, not necessarily interested in
    the return on investment

  – They don’t ask you difficult questions and don’t do a
    due diligence

  – They would like to get information from you, they
    don’t want control in your company

  – Hands-off, even when things don’t go very well

  – Small amounts of money
                                                             11




  Characteristics of Funders (2)
• Venture Capitalists (and incubators)
   – Focus on future and return on investment

   – Focus on large, fast growing markets

   – Professionals and Selective

   – They want some control in your company and request
     detailed monthly or quarterly reports

   – Hands-on

   – 100K Euro up to 20M Euro

   – Examples: NIB Capital, NPM, Gilde, Nesbic, 3i,
     General Atlantic, Kleiner Perkins Caufield & Byers      12




                                                                  6
  Characteristics of Funders (3)
• Informal Investors (business angels)
   – Often (ex)-entrepreneurs who invest their own money

   – They like to work with entrepreneurs and return on
     investment is not always first priority

   – Want some control in your company

   – Hands-on

   – Focus on small companies

   – 10k Euro up to 1M Euro

                                                           13




  Characteristics of Funders (4)
• Banks
   – Loans, not equity

   – Pledge

   – Avoid high risk

   – Low return on investment (interest)

   – Focus on mature companies with a history

   – Good management necessary


                                                           14




                                                                7
     Characteristics of Funders (5)

  • Corporate Ventures
     – Strategic investors in own industry

     – Long term

     – Acquire whole company when successful

     – Hands-on even when things don’t go very well

     – Examples: Cisco, Intel


                                                        15




              Which one to choose?
• Fund raising can be a tough and lengthy process.
  Therefore, do carefully select possible funders
   – Type of money (loan / equity)

   – Amount

   – Market or technology focus of investor

   – Added value and involvement of investor

   – Reputation of investor

• When your plan is rejected, try to find out why
  without showing any resentment

• When your plan is rejected several times, adjust or
  reconsider your proposition                           16




                                                             8
       The Investor’s
        Perspective

                                                           17




         How the money flows
            Investors

Fundraising             Returns (Cash)
                                  Cash
                                           Third Party /
      Private Equity Fund
                                           Stock Market
                                  Equity
     Cash               Equity


              Company


                                                           18




                                                                9
          The Investment Process
Deal Flow Generation


              Assessment &
                selection


                        Deal making


                                 Monitoring


                                              Exit

                                                     19




     Assessment & Selection (1)
 • Process
     – Screening businessplan

     – Interview(s)

     – On site visit

     – Second opinion

     – Research

     – Due Diligence

     – Investment Proposal
                                                     20
     – Internal Approval




                                                          10
    Assessment & Selection (2)

• Business plan and Interview
   – “We have a six-month lead” … means … “we tried not
     to find out how many other people have a six-month
     lead”

   – “Customers are clamoring for our product” .. means
     … “We have not yet asked them to pay for it. Also,
     all of our current customers are relatives”

   – “We only need a 10% market share” … means … “So
     do the other 50 entrants getting funded”
                                                            21




    Assessment & Selection (3)
• Often, the most important selection criteria are the
  quality of the entrepreneur and the
  management team, “bet the jockey, not the
  horse”
   – Working definition of entrepreneur: “The relentless
     pursuit of opportunity without regard to resources
     currently controlled”
   – Is able to build a relationship based on trust
   – Not only knows his/her strengths but also knows when
     to put others in action hence knowing his/her
     shortcomings
   – Is market driven, not product driven
   – Is willing to take risks
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                                                                 11
    Assessment & Selection (4)
• “bet the jockey, not the horse”….. continued:
   – Negotiation skills

   – Ability to raise next round financing

   – Ability to attract and motivate staff

   – An entrepreneur is not necessarily a good manager

   – Complementary skills in management team

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    Assessment & Selection (5)
• Other criteria often applied:
   – Innovativity. Some economists say that the main
     driver of the strong US economy is innovation backed
     by venture capital.

   – Scalability. This implies a large market and ultimately
     high return.

   – Intellectual Property Rights. This implies a high
     entry-barrier for possible competitors. Important
     criterion in Life Sciences investments.


                                                               24




                                                                    12
                Dealmaking (1)
• Negotiate
• Collect termsheet(s)
• Select termsheet
• Negotiation
• Concept contract
• Negotiation
• (Lawyers)
• Final contract
• Deal closing - Signature
                                                               25
• First payment




                Dealmaking (2)
• Negotiation
   – Transparency required

   – Maintain trust

   – Balance risk with reward (entrepreneur and investor)

   – Look for solutions that satisfy all parties involved (a
     compromise is often not a good deal)

   – Stay focused, don’t drown in all these clauses...

                                                               26




                                                                    13
           Dealmaking (3)
• Valuation
  – Depends on the aforementioned criteria, but
  – Many methods
  – Rules of thumb
  – Valuations of start-up companies tend to be
    unsteady/uncertain
  – Market sentiment has much influence
  – The financing market for start-ups is not really
    transparent which makes it difficult to get a ‘fair
    market value’ (illiquidity)
  – However, the more mature a company is, the better
    valuation methods apply, e.g. the discounted cash flow
                                                             27
    (DCF) method




              Dealmaking (4)
• Contract: Business plan
   – The business plan is the basis for the contract. The
     entrepreneur must execute the plan

• Contract: Milestones
   – The investment is paid in tranches which depend on
     milestones achieved

• Contract: Control of investor
   – The investor doesn’t want daily control but wants a
     (blocking) vote when important decisions are being
     made, like large investments by the company, a merger
                                                           28
     with another company or a change of strategy




                                                                  14
                Dealmaking (5)
• Contract: anti-dilution
   – If the company later issues new shares with a share
     price below the share price the investor has paid, the
     investor wants to be compensated

• Contract: reporting & information rights
   – Usually the company has to report on a monthly or
     quarterly basis and has to inform the shareholders
     about all important matters

• Contract: salaries & management fees
   – In the start-up phase employee-salaries are usually
     modest, especially for those who are shareholder as
                                                                  29
     well




                Dealmaking (6)
• Contract: incentives & terms
   – The great Russian pole vaulter, Sergei Bubka, received
     a modest salary from the government, plus expenses.
     He also received a substantial bonus for every world
     record he set at a track and field event.

   – In an industrialized country pollution standards for
     rivers by water consuming firms are set by the national
     government. Local municipalities have the option to
     set tougher standards.
     One municipality rules that any firm who takes water
     out of a river must do so at a location at least 200 yards
     downstream from the location where the firm pumps
     water back into the river                                    30




                                                                       15
                   Monitoring
• After the deal is closed, investors should conduct
  the following activities:
   – Help you with operational or strategic issues

   – Use their network

   – Form Supervisory Board

   – Read the company reports and discuss it with the
     management

   – Monitor milestones

   – Look for exit opportunities

   – “Pull the plug” when necessary
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   – Warn when to raise new financing




                          Exit
• For an investor an exit means selling the shares
  in a company.

• 2 most common ways to realize an exit are
   – Trade sale

   – Initial Public Offering (IPO)

• With some companies an exit is not realized
  because
   – it was decided and agreed with the investor that there
     was no reason to continue business (“stop before
     bankruptcy”)
                                                              32
   – the company goes bankrupt




                                                                   16
       Tips for the business plan
• Think which kind of financing you need
  (seed financing, first round financing, …),
  select a specific type of investor and keep this
  in mind while writing the business plan




                                                          33




What should be in the business plan (1)
• A statement how much money you need
  (from the VC): the investment (possibly
  spread over time)
  – Based on the money flows, operational expenses,
    and investments (you can ignore taxes and such)

         Cumulative                      Gap to finance
          cashflow




                                         Break even       34
                                Time




                                                               17
What should be in the business plan (2)
•   A statement what (and when) the VC gets in return for investing in your
    company:
     – Initially mostly equity shares:

     – Equity sharevc =Investmentvc/(Investmentvc+pre-money-valuecompany)


     – Share value = (Investmentvc+ pre-money-valuecompany)/Total number of shares after
        investment


     – Total number of shares after investment= Total number of shares before investment/(1- Equity
       sharevc )

     – Number of shares for VC = Equity sharevc x Total number of shares after investment

     – Finally (at IPO) money for shares

•   So, how do we know the pre-money value?

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What should be in the business plan (3)
• How to determine the pre-money-value?
     – Very subjective in general
     – Depends on the stage the company is in
• Techniques:
     – Comparables
     – Discounted Cash Flows
     – Venture Capital Method


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                                                                                                           18
  Pre-money-value: Comparables
• Find a similar company (in terms of product,
  market size, and financial ratios) for which
  valuation is already known
• Value can be calculated as:
   – # outstanding shares X share value
• In most cases, it is not possible to find a
  reasonable similar company (because you are
  requesting venture capital).
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                 Intermezzo
             Time-value of money
• A same amount of money we have in the future has a
  different (lower) amount of value now
• Suppose we have Euro 1,000.- Euro to invest
• We can do so risk-free in state-bonds, e.g. with an
  interest of 5%
   – After a year, we have guaranteed 1,000.- x 1.05 = 1,050.-
• Or: if we have Euro 1,050.- next year it is worth now
   – 1,050/(1+0.05) = 1,000.- (1/(1+i), where i=interest-rate)


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                                                                      19
  Pre-money-value: Discounted Cash
               Flows
• Sums up future present value of
    – free cash flows
    – terminal value of the enterprise
• For the period: investment – exit
• Value = PV1(FV(free cash flow))+
  PV2(FV(free cash flow)) + … + PVexit(FV(net
  cash flow)) + PVexit(FV(terminal value))
• PVn=FV/(1+i)n
                                                                                            39




 Pre-money-value: VC method (1)
• Estimate terminal future value (FV) (at exit year n):
    – Usually: FV = P/E ratio x Net income exit date
         • P/E ratio = market value share/earnings share
         • Examples: P/E ratio’s (as of 29/11/05) Google: 93.48, Cisco: 20.33, MS: 23.52,
           IBM: 17.34
    – Example: 300 ME (FV) = 15 x 20 MEyear 7
• Discount the terminal future value to the present terminal value:
    – PV = FV/(1+i)n
    – i = interest rate and is very high (40 – 100 %)
    – Example: 17.5 ME (PV) = 300/(1+0,5)7
• Calculate Required Ownership Percentage:
    – Ownership vc = Investment vc /present terminal value
    – Example: 28.5 % (ownershipvc)= 5 ME / 17.5 ME
    – (at IPO, the VC gets 28.5% x 300 ME = 85.5 ME)




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                                                                                                 20
    Pre-money-value: VC method (2)
•   Price per share:
     –   # shares after investment = # shares before investment/(1- ownershipvc)
     –   Example: 700,000 = 500.000 / (1 – 0.285)
     –   VC will own 200,000 shares
     –   Price per share = Investment vc / shares vc
     –   25 E (price per share) = 5 ME/200,000
•   Pre money valuation:
     – # shares before investment x price per share
     – Example: 12.5 ME (pre money valuation) = 500,000 x E 25,-
•   Post money valuation:
     – # shares after investment x price per share
     – Example: 17.5 ME (pre money valuation) = 700,000 x E 25,-

•   For more information, see
    http://www.unb.ca/web/jhsc/TME_courses/FIN320_content/Valuations/valuations.
    pdf


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                  For your business plan
• State
     – required investment(s)
     – # shares the VC gets (using the VC method)
     – IPO or other exit strategy, plus projected result for VC
• Use:
     – Assume a P/E ratio (e.g. 25)
     – Assume an interest rate, depending on the risk of your
       venture (20 – 100 %)
     – Estimate projected cash flow at IPO
     – Choose the number of shares you have before financing
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            More information
• www.cs.vu.nl/~gordijn/ecommerce contains
  some additional presentations and pointers
• For technicalities:
  – http://www.unb.ca/jhsc/resourcectr/TME_cours
    es/FIN320_content/Valuations/valuations-
    01.htm
  – Venture Capital – The Definitive Guide for
    Entrepreneurs, Investors and Practitioners, Joel
    Cardis, Sam Kirschner, Stan Richelson, Jason,
    Kirschner, Hildy Richelson
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