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					VCPE Industry Overview


        Heidi Henson


         •   VCPE Market Overview
         •   Research Resources

     Total U.S. Capital Markets
  Private Equity is just a sliver of total capital markets, but plays an important role in driving economy

         For-Profit Capital Market by Segment
         Total = $48.4 trillion

                                                                                     Private Equity = 2%
                                          Public Debt

                                                              Bank Deposits             LBO Funds
               Equity Securities                                  12%                     $740B

                                                Private Debt                             VC Funds
                                                    35%                                   $260B

Sources: ―The Economics of Private Equity Funds‖, Private Equity Analyst, McKinsey
Forces at Work in Industry

                                   Investment opportunities
                                    reliant on new ideas—
                                     both in technology/IP
                                     and business models

 Market Trends                                                              Liquidity
 Market forces and                    Private Equity Industry               Successful exit
 social/economic        Industry fills critical role in American economy—   reliant on
 trends create and             enables entrepreneurs to take risks.         potential buyers
 influence              Banks constrained by risk parameters and usury      and/or ability to
 opportunities (e.g.,   laws; VCPE firms provide necessary capital and      list in the public
 Baby Boomers &           industry/ management experience to fledgling      markets
 Healthcare)                                  companies

                                      Availability of Capital
                                      Ability to access funds
                                     can be dictated by fickle
                                       markets and shifting
                                       priorities of investors                                   4
   Segments of Private Equity

                                                                   Late-stage VC          Leverage
                                                Early- to mid-
                     Angel Investors                               and small              Buyout (LBO)          Hedge Funds
                                                stage VC
                                                                   buyouts                firms

Description         – Wealthy           – Limited                 – LPs or              – LPs or                – Generally invest in
                      individuals         partnerships              corporations that     corporations that       public markets, but
                      (approx. 240k       (LPs) or                  invest in later       buys control of         occasionally make
                      active) who         corporations that         stage private         companies using         private investments
                      typically invest    typically invest          companies that        private capital         in PIPEs (Private
                      $50k-$1.5mm in      between $250k             have revenue          combined with           Investment in
                      nascent             and $20mm in              traction;             debt (leverage)         Public Equities)
                      companies           seed companies            investment            financing from        – A number of
                    – Sometimes invest    in exchange for           generally ranges      third-party banks;      strategies from
                      as groups (e.g.,    equity.                   from $5mm to          generally $4 debt       macro- (directional
                      Band of Angels)   – Some corporate            hundreds of           to every $1 cash        bets on markets &
                    – Highly fragmented   VCs (e.g., Intel          millions            – Transactions            currencies) to
                      market—51k          Capital)                                        generally multi-        value investing
                      investments made                                                    million to billions     (picking
                      in ‗06                                                              of dollars              undervalued stocks

Stage of            – Seed                  – Seed                – Growth/             – Mature private        – Private and public
Investment                                  – Start-up              expansion stage       and public              companies

Example firms       • Band of Angels        •   KPCB              • Summit Capital      • KKR                   • Moore Capital
                    • Ron Conway            •   Sequoia Capital   • TA Associates       • Blackstone Group      • Tudor Capital
                                            •   Mayfield Fund                           • Bain Capital
                                            •   Bessemer
                                                Ventures                                                                          5
Sources: WSJ, VentureOne, Wikipedia, NVCA
   Segments of Private Equity cont..

                                                                    Late-stage VC          Leverage
                                              Early- to mid-
                      Angel Investors                               and small              Buyout (LBO)          Hedge Funds
                                              stage VC
                                                                    buyouts                firms

Size of Market
(2006)              – $25.6B under                 – Raised $29B in 2006                – Raised $212B           – Raised $126.6B
                      mgmt across                  – $260B under management             – Approx. $740B          – $1.4 trillion assets
                      240k investors                                                      under mgmt               under mgmt

Risk Profile        – Highly risky;        – Over 50% fail or     – Higher rate of      – ―Club‖ deals           – Very
                      many failures          barely survive         success (but          common: in               opportunistic—
                                                                    lower returns)        2006, 2+ firms           capitalize on
                                                                                          invested together        market
                                                                                          in 91% of deals          inefficiencies
                                                                                          over $5B

Return              – Goal of very high    – 10x return over 5 – Approximately 5x – Target 20-25%                – Avg return of 13%
Objective             returns—20+x–          yrs from            return in 2-5 yr      return                      in ‗06, below S&P
                      on successful          investments, to     period, also target – Rising interest             return of 15.8%
                      investments            return 25-35% per 15-35% return           rates may affect          – Top funds return
                                             year to LPs                               returns                     30-40%

Trends              – Greater                 – For first time, U.S. – VC firms that      – Deals getting        – Private
                      organization in           firms aggressively      traditionally       larger (e.g. $15B      endowments
                      the industry and          seeking foreign         focused on early    buyout of Hertz        increased
                      insight into best         opportunities in        stage (e.g.,        Corp in 2006)          allocation to
                      practices                 China and India         Highland Capital, – Firms starting to      hedge funds in
                                              – Hot areas include       BVP) starting to    explore options to     2006 from 7.3%
                                                ―Web 2.0‖ and           also pursue later   raise money in         to 8.7% of capital;
                                                ―Greentech‖             stage               public markets for     universities
                                                                        opportunities                              allocate average
                                                                                            lower cost of
Sources: The Deal, Congressional Testimony, Center for Venture Research                     capital                of 22.4%
   Investment Activity in Venture Capital Market
  Investments in venture capital deals peaked in 2000 with a greater number of large, later-stage deals
                     Amount Invested in VCPE by Year & Stage, with # of Deals per year
                     $ Billions (left axis), # deals (right axis)




                80                                                                                                          6,000

                                                                                                                                    # of deals



                40                                                                                                          3,000




           $-                                                                                                               -
                         1995      1996      1997      1998         1999   2000   2001   2002   2003   2004   2005   2006               7
Source: PriceWaterhouse Coopers
   Sector Focus in Venture Capital
  Information Technology is consistently over 50% of funds invested, but Healthcare has been growing
  in importance after tech/dotcom frenzy of 2000 as Baby Boomers age
                      % Invested in Sectors of VC by Year
                      Total = 100%

        Sector        $94.8B         $36.4B   $22.1B   $19.7B   $22.4B   $23.8B   $25.7B   2006 Median Deal Size

       Information                                                                               $7.0mm

       Healthcare                                                                                $8.0mm

       Business/                                                                                 $5.7mm

          Other                                                                                  $7.5mm
                        2000          2001     2002     2003     2004     2005      2006
Source: VentureOne
Market Opportunity Affects Potential for VC Funding

Common traits of attractive               Subsequently, certain sectors are
investment opportunities include:         more ―VC-friendly‖ than others:
 • Barriers to entry                        • High-growth tech companies with
 • Solid founder and/or management            patented IP trade on public markets
   team in place                              and are valued in venture capital
                                              with higher revenue multiples than
 • Large, rapidly growing addressable         slow-growth capital-intensive retail
   market                                     companies—~3-7x for the former,
 • High margins                               and closer to ~1-2x for the latter
 • Ability to scale business quickly        • Subsequently, to attain returns
 • Customer demand established—               commensurate with risk, most VC
   limited education needed                   firms focus on technology—be it
                                              software, semiconductors, biotech,
 • Clear potential acquirer and/or path
                                              or medical devices
   to IPO

   Old Favorites and Hot New Sectors
 Software still dominates new investments, though a few sectors have shifted in priority, particularly
 energy (over half a billion was invested in ―Clean Tech‖—alternative fuels and fuel-efficient devices)

       Top Ten Sectors, by $ invested, 1997-2006                     Top Ten Sectors, by 1st round $ invested, 2006
       Total = $347.8B, $ Billions                                   Total = $5.8B, $ Billions
                       -             20   40   60   80                          -     0.2        0.4   0.6   0.8   1.0   1.2

           Software                                                Software

Telecommunications                                            Biotechnology

    Networking and
      Equipment                                          Telecommunications

     Biotechnology                                          Industrial/Energy

      Media and
                                                         Medical Devices and

         IT Services                                           Media and

                                                                 IT Services

Medical Devices and
                                                          Business Products
                                                            and Services
 Business Products
   and Services                                             Semiconductors

                                                         Healthcare Services


Source: VentureOne
    Recovery from Internet Bubble
    Public markets are recovering from turmoil…

                Nasdaq Index Historical Closing Price*











                      1990   1991   1992   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007

*1/2/1990-4/2/07, Adjusted Closing Price
Source: Yahoo! Finance
   Recovery from 2000 Bubble
    …and commitments to venture capital firms have been rebounding. In 2001, 25% of active VC firms
      were new funds—scarcity of capital in ensuing years weeded out poor performers

  Commitments to U.S. VC Funds in Past 10 Years                                             Survival of the fittest
  $ Billions
                                                                                            • In 1990, there were
                                                                                              just 398 VC firms.
                                                                                            • This grew to 1,200
   80                                                                                         active funds in 2000
                                                                                            • By the end of 2006,
                                                                                              the number of active
                                                                                              funds had dropped to
                                                                                              837 (50 less than in
                                                                                            • Even with less funds,
                                                                                              capital commitments
                                                                                              firms raising larger
                                                                                              pools of capital
   20                                                                                       • With mega-deals,
                                                                                              LBO firms outraised
   10                                                                                         VC‘s by 3.5x in ‘06
                                                                                              (vs. 1-2x in ‗98-‘00)
          1997    1998     1999     2000    2001     2002     2003     2004   2005   2006                    12
Source: VentureOne, Harvard Business Review, Dow Jones,, NVCA
   Sources of Funding in Private Equity
       Key sources                             Percentage                          Portfolio Profile

                                                                                   CalPERS example:
         Pension Funds                              42%                            •   Public equity - 61.2%
                                                                                   •   Bonds/fixed income - 24.5%
                                                                                   •   Real estate- 7.2%
                                                                                   •   Private equity - 5.7%
                                                                                   •   Cash equivalents - 1.4%

                                                                                   • Varies greatly by institution and goals
           Financial &                                                             • Generally weighted towards low-risk
        Insurance Firms                                                              debt/notes, but some private equity

                                                                                   Educational Institution Mean:
         Endowments &                                                              • Public equity – 49.1%
          Foundations                                                              • Debt/notes – 32.9%
                                                                                   • Real assets & cash – 11.7%
                                                                                   • Private equity – 6.4%
          Individuals &
            Families                                10%                            • Varies greatly by risk tolerance and
                                                                                     sophistication of investment managers     13
Source: NVCA , CalPERS Annual Report 2006, Yale University Endowment Report 2006
  Case Study of Funding Source: Yale Endowment
     Shrewd management and access to top VCPE firms = superior returns:
        • Yale University‘s Endowment pioneered diversification into alternative asset classes—only 16% of
          assets are invested in traditional U.S. marketable securities, vs. 50% in average endowment.
        • The University‘s target allocation to private equity of 17.0% far exceeds the 6.4% actual allocation of
          the average educational institution.

   Asset Allocation – Yale vs. Peers

                         Yale           Educational
                       University     Institution Mean
     Real Assets         27.80%            8.40%
     Absolute Return     23.30%           18.60%
     Private Equity      16.40%            6.40%
     Foreign Equity      14.60%             20%
     Domestic Equity     11.60%           28.10%
     Fixed Income         3.80%           14.30%
     Cash                 2.50%            3.30%

Sources: Yale Endowment Report 2006
   Private Equity Pipeline and Diligence Process
  Private Equity investments result from robust pipeline and rigorous filtering process:

                          100 Business Plans

                          Initial Diligence
 Dealflow                 • Initial meeting with   10 Promising Opportunities
                          • Total Addressable      Intensive Due Diligence
                            Market (TAM)           • In-depth meetings with
                          • Competitive              management                            1 Investment
                            landscape              • Analysis of potential returns
 Industry                 • Barriers to entry        based on industry comparables
 Events                     (patented IP, head       and probability of successful exit
                            start on R&D,          • Reference calls with customers,
                            founder/                 industry experts,
                            management               management/board contacts
                            expertise)             • Modeling of financials
                          • Initial review of
 Founder                    projections

Source: NVCA, HBS materials
   Success Not Guaranteed

    Due to number of factors, even with rigorous diligence process, over half of start-ups fail

    Factors affecting success of start-up:                        Outcomes of Companies First Funded 1991-2000
                                                                  Total = 11,688 companies
    •     Company has sufficient capital
    •     Management is capable and focused
                                                                                               Acquired - 33%
    •     Product development goes as planned                     Went/Going
    •     Production and component sourcing goes                  Public - 14%
          as planned
    •     Competitors behave as expected
    •     Customers want product
    •     Pricing is forecast correctly
    •     Patents are issued and are enforceable

        Combined probability of success = 17%                    Still private or
                                                                 unknown* - 35%                 Known Failed - 18%

*Of those whose outcome is unknown, most have ―quietly failed‖
Source: Harvard Business Review, NVCA
   Portfolio Performance
  According to a study in the Harvard Business Review, the typical performance of $1,000 invested by a
  VC firm breaks out as follows:

                                     Payout in Year 5      Gross Return        Net Return

 Great - $100                              20x                 $2,000            $1,900

 Good - $100                               10x                 $1,000             $900

 Okay - $200                                5x                 $1,000             $800

 Alive - $400                               1x                  $400               $-

 Bad - $200                                 0                    $-              $(200)

                                                  TOTAL        $4,400             $3,400        17
Source: Harvard Business Review
   Liquidity in Venture Capital Market
        M&A has long provided greatest opportunity for liquidity of private investments, particularly
        following internet bust of 2000-01, amid increased regulation and scrutiny of public companies

  Amount Raised/Paid for Venture-backed Companies, by Market
  $ Billions
  $120                                                                                Only 12% of 2006
                                                                                      transactions were IPOs
                                                                                      • In 2006, 404 VC-
  $100                                                                                  backed companies
                                                                                        were sold through
                                                                                        M&A, while just 56
   $80                                                                                  companies were
                                                                                        listed on public
                                                                          M&A         • The median time for
                                                                                        a venture-backed
                                                                                        business to go
   $40                                                                                  public is now 6.2
                                                                                        years, up from 3.1
                                                                                        years in 1997

        1999    2000       2001   2002    2003    2004     2005    2006
Sources: WSJ, VentureOne
Key Practices of VCPE Investors
To mitigate risk and increase likelihood of success, VCPE investors adhere to key practices:

 Key activities                 Key practices

     Lifecycle                   –    Personal networks for dealflow and conferences
     alignment                   –    Deal pipeline & screening
                                 –    Meetings with management to review business plan

      Risk/return                 –   Review & discussion by partnership
      alignment                         • Valuation and Investment presentation
                                  –   Due diligence
                                        • Analysis of projections versus market forces/trends,
                                           achievability, demand
                                        • Analysis of likely return based on valuation
                                  –   Investment memo

     Co-funding                   –   Form syndicate when applicable
     alignment                    –   Align interests and skillsets between existing and new
                                        • Different types of investors and board members for
                                           difference stages of lifecycle                        19
  Importance of Private Equity Managers
  Success of private equity investments highly correlated to skill of investors:

     • The Yale University Endowment analyzed and ranked investment returns across a range of asset
       classes between first and third quartile managers over a 10 year period.
     • While fixed income and public equities had a fairly narrow band of potential returns, VCPE returns
       varied greatly, dependent on dealflow and skill of investors
     • Despite wide variance, VCPE firms above median still outperformed other asset classes

          Investment Returns Over 10 Year Period*

                                                Active Management Returns1

                                          0%     5%           10%     15%      20%           25%    30%
          US Fixed Income
          US Large Cap
          US Small Cap
          International Equity
          Real Estate
          Private Equity
          Venture Capital

                                                    Third Quartile    Median         Top Quartile

*Analysis conducted for years 1987-1997
Source: Yale University Endowment 2000 Report
  Skills of Top VCPE Investors
     Following are ideal skillsets for investor to add value to portfolio companies:

           Skill/Experience           Description

                 Personal             Strong personal networks enable investors to generate dealflow, be the first
                 Networks             to learn about industry developments, help portfolio companies secure
                                      talent, and provide critical business development introductions.

                                      With large pipeline of deals and limited time and resources, must efficiently
               Selectivity &          sift through potential investment opportunities.       Critical to leverage
               Specialization         technical knowledge and to prioritize opportunities based on anticipated
                                      return. Each Partner in a firm generally actively manages only around 5-10
                                      investments at a time, depending on lifecycle, so must choose wisely.

                                      Investor generally sits on Board and serves as close advisor to CEO and
                                      management team. When company faces tough decisions (e.g., firing vs.
                                      making payroll in a down quarter), it is helpful for investor to be able to
                                      draw on personal experience and serve as advisor.

                                      Important for investor to know lay of the land—key competitors, industry
                                      developments, technical specifications—to make informed decision about
                                      making investment, as well as how to manage development and exit.

                                      Unlike public companies, ownership and management are generally
                 Focus on             aligned because of shared economic interests, focused on an exit. It is in
               Value Creation         investor‘s best interest to remain involved and watchful, guiding strategic
                                      decisions to create value.
   Case Study of Personal Networks: PayPal
     PayPal was a highly successful start-up founded in 1998 and sold in 2002 to eBay for $1.5B. The
     founders and top management have gone on to significant success and remain interconnected:

    Max Levchin                 Peter Thiel                 Roelof Botha             Jeremy Stoppelman              Russel Simmons
    Co-founder                  Co-founder                     CFO                     VP Engineering                  Engineer

    Founded web               Started hedge                    Joined top VC
      property:            fund, Clarium, & vc                  firm Sequoia                                Co-founded
                             firm, Founders                    Capital in 2003                           successful internet
                           Capital. Personally                                                            site yelp in 2004
                               invested in:
   Involved with:                                                   Advised:

                                                               Invested in
                                                               YouTube in
                                                              2005—sold to
     Invested in:                                            Google for $1.6B

Sources: Wikipedia, Sequoia Capital, PayPal, Facebook, LinkedIn, Slide, Thank You for Smoking, YouTube

         •   VCPE Market Overview
         •   Research Resources

Key Individuals and Organizations
   Category       Individual           Organization                Description                                           Location
    Angels        Ron Conway                             -         Top angel investor in Silicon Valley--Google,           CA

 Hedge Funds      Bruce Kovner         Caxton                      Founder of one of world's top hedge funds,              NY
                                                                   Caxton; also very civic minded--particularly the
                                                                   arts (Lincoln Center)
                  Paul Tudor Jones     Tudor Group                 Founder of top fund, Tudor; also founder of Robin       NY
                                                                   Hood Foundation

Industry Expert   Daniel Primack       PE Week Wire                Publishes daily newsletter on industry                  MA
                                                                   developments read by most in VCPE community

                  John Lerner          HBS                         Professor at HBS and expert in VCPE                     MA
                  William Sahlman      HBS                         Professor at HBS and expert in entrepreneurship         MA

 Organization                   -      Kauffman Fellows            Awards fellowships each year to encourage VC            KS
                                                                   firms to hire recent MBA grads; focused on
                                                                   venture education
                                -      NVCA                        VC Industry Association                                 VA
                                -      Keiretsu Forum              Angel Investor group                                    CA

      PE          George Roberts       KKR                         Private equity pioneer and Co-Founder of KKR            CA
                  Henry Kravis         KKR                         Private equity pioneer and Co-Founder of KKR            NY
                  Stephen Schwarzman   Blackstone                  Founder of Blackstone; very civic minded                NY
                                                                   (Kennedy Center)
                  David Rubenstein     Carlyle Group               Co-Founder of Carlyle Group; extensive                  DC
                                                                   Washington network

      VC          Arthur Rock          Davis & Rock                One of first VCs in U.S.; funded Apple, Intel, etc.     CA
                                                                   Endowed HBS with Arthur Rock Center for
                  Brook Byers          KPCB                        Top VC and Co-Founder of KPCB                           CA
                  Felda Hardymon       Bessemer Venture Partners   Experienced VC investor and professor in VCPE           MA
                                                                   at HBS
                  Henry McCance        Greylock                    VC industry pioneer; Co-Founder of Greylock             MA
                  John Doerr           KPCB                        Top VC and Co-Founder of KPCB                           CA
                  Roelof Boetha        Sequoia Capital             Young, rising VC at Sequoia Capital; involved with      CA       24
                                                                   Full Circle Fund
 Key Documents & Data Sources
    Subject       Title                                      Author                                    Description
    Angels        "Angel Investing Group Best Practices"     Mike Franks and James Geshwiler           7 pgs; overview of angel investing practices
                                                             (Kauffman Foundation)
                  "Angles on angels: financing technology- John Freear, Jeffrey E. Sohl, and William   13 pgs; historical perspective on angel
                  based ventures - a historical perspective" Wetzel (Whittemore School of Business)    investing

     Data         "Global Trends in Venture Capital: 2006 Deloitte & Touche and NVCA                   28 pgs; survey of investment trends in
                  Survey"                                                                              2006
                  "MoneyTree Report 2006"                 PricewaterhouseCoopers                       12 pgs; powerpoint slides outlining results
                                                                                                       of 2005-06 MoneyTree report on PE deals

                  "Venture Impact 2007"                    Global Insight & NVCA                       24 pgs; summary of data and analysis of
                                                                                                       VC's impact on U.S. economy
Funding Sources   Yale University Endowment Annual         Yale University Endowment                   28 pgs; 2006 report on performance of
                  Report 2006                                                                          Yale University endowment and analysis of
                                                                                                       investment opportunities
 Methodology      "How Venture Capital Works"              Bob Zider (Harvard Business Review,         12 pgs;
                  "Note on Angel Investing"                Tuck School of Business                     18 pgs; teaching materials explaining angel
                  "Note on Due Diligence in Venture        Tuck School of Business                     11 pgs; teaching materials explaining due
                  Capital"                                                                             diligence process
                  "Note on Leveraged Buyouts"              Tuck School of Business                     23 pgs; teaching materials explaining LBOs

                  "Note on Private Equity Asset Allocation" Tuck School of Business                    18 pgs; teaching materials explaining asset
                  "Note on Private Equity Deal Structures" Tuck School of Business                     15 pgs; teaching materials explaining PE
                                                                                                       deal structures
                  "Note on Venture Capital Portfolio       Tuck School of Business                     18 pgs; teaching materials explaining VC
                  Management"                                                                          portfolio management
                  "Private Equity Glossary"                Tuck School of Business                     30 pgs; definitions of key private equity
                  "The Syndication of Venture Capital      Josh Lerner (Financial Management,          23 pages; seminal article that examines 3
                  Investments"                             September 1994)                             key rationales for syndicates in vc investing

Key Documents & Data Sources cont…
  Subject     Title                                  Author                                    Description
Methodology   "Trends in Terms of Venture Financings Fenwick & West, LLP                       4 pgs; analysis of standard terms in vc
              in the San Francisco Bay Area"                                                   deals in Bay area

              "Valuation Survey Results 2002"         Tuck School of Business                  108 pgs; analysis of the results of a survey
                                                                                               on guidelines, policies and practices for
                                                                                               valuation in the vc industry
              Venture Capital and Private Equity: A   Josh Lerner (HBS Press)                  540 pgs; coursebook for VCPE class at
              Casebook                                                                         HBS; includes description of vcpe process
                                                                                               and numerous case studies of principles in
News/Blog     Infectious Greed blog                   Paul Kedrosky                            Blog by vc professional providing
                                                            commentary/analysis of industry
              PE Hub                    Thomson                                  News blog on industry by Thomson;
                                                                                               distribute daily newsletter by Dan Primack
                                                                                               (PE Week Wire) summarizing deals and
                                                                                               industry developments
              The Daily Deal                                                   Daily industry publication providing news
                                                                                               and analysis
              VentureWire                                                                      Daily newsletter providing in-depth analysis
                                                                                               of recent VCPE deals and industry
 Nonprofit    "Virtuous Capital: What Foundations Can Christine W. Letts William Ryan Allen    10 pgs; analysis of vc practices that can be
              Learn from Venture Capitalists"         Grossman (Harvard Business Review,       used in nonprofit sector
    PE        "The Economics of Private Equity"       Andrew Metrick and Ayako Yasuda          45 pgs; graduate paper by Wharton
                                                      (Wharton)                                students analyzing economics of PE
    VC        "On the fundamental role of venture     Thomas Hellmann and Manju Puri           8 pgs; analysis by Federal Reserve
              capital"                                (Economic Review, Federal Reserve Bank   economists of VC's impact on economy
                                                      of Atlanta, 2002)
              "Patient Capital"                       David Goodman and Anthony Stolis         44 pgs; analysis of impact of private equity
                                                      (NVCA)                                   in healthcare market
              "What Venture Trends Can Tell You"      Matthew R. Cohler, William F. Meehan,    2 pgs; analysis of vc industry and
                                                      and Ron Lemmens (Harvard Business        prediction of impact on economy in coming
                                                      Review, 2003)                            years
              Nothing Ventured: The Perils and        Robert J. Kunze (HarperBusiness          252 pgs; written in 1990; provides
              Payoffs of the Great American Venture Publishing)                                                                       26
                                                                                               anecdotal guide to vc process and analysis
              Capital Game                                                                     of important early deals (e.g., Apple,
                                                                                               Microsoft, Intel)

Glossary of Terms
•   ―A‖ round – a financing event whereby angel groups and / or venture capitalists become involved in a fast growth company that was previously
    financed by founders and their friends and families.
•   Angel – a wealthy individual that invests in companies in relatively early stages of development. Usually angels invest less than $1 million per
•   Anti-dilution – a contract clause that protects an investor from a substantial reduction in percentage ownership in a company due to the issuance by
    the company of additional shares to other entities. The mechanism for making adjustments is called a Ratchet.
•   ―B‖ round – a financing event whereby investors such as venture capitalists and organized angel groups are sufficiently interested in a company to
    provide additional funds after the ―A‖ round of financing. Subsequent rounds are called ―C‖, ―D‖ and so on.
•   Bootstrapping – the actions of a startup to minimize expenses and build cash flow, thereby reducing or eliminating the need for outside investors.
•   Bridge financing – temporary funding that will eventually be replaced by permanent capital from equity investors or debt lenders. In venture cap ital,
    a bridge is usually a short term note (6 to 12 months) that converts to preferred stock. Typically, the bridge lender has the right to convert the note to
    preferred stock at a price that is a 20% to 25% discount from the price of the preferred stock in the next financing round.
•   Broad-based weighted average ratchet - a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of
    the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally
    received. Investor A‘s preferred stock is repriced to a weighted average of investor A‘s price and investor B‘s price. A broad-based ratchet uses all
    common stock outstanding on a fully diluted basis (including all convertible securities, warrants and options) in the denomin ator of the formula for
    determining the new weighted average price.
•   Burn rate – the rate at which a startup with little or no revenue uses available cash to cover expenses. Usually expressed on a monthly or weekly
•   Business plan – a document that describes a new concept for a business opportunity. A business plan typically includes the following sections:
    executive summary, market need, solution, technology, competition, marketing, management, operations and financials.
•   Buyout – a sector of the private equity industry. Also, the purchase of a controlling interest of a company by an outside investor (in a leveraged
    buyout) or a management team (in a management buyout).
•   Capital call – when a private equity fund manager (usually a ―general partner‖ in a partnership) requests that an investor in the fund (a ―limited
    partner‖) provide additional capital. Usually a limited partner will agree to a maximum investment amount and the general partner will make a series
    of capital calls over time to the limited partner as opportunities arise to finance startups and buyouts.
•   Capitalization table – a table showing the owners of a company‘s shares and their ownership percentages as well as the debt holders. It also lists
    the forms of ownership, such as common stock, preferred stock, warrants, options, senior debt, and subordinated debt.
•   Carried interest – a share in the profits of a private equity fund. Typically, a fund must return the capital given to it by limited partners plus any
    preferential rate of return before the general partner can share in the profits of the fund. The general partner will then receive a 20% carried interest,
    although some successful firms receive 25%-30%. Also known as ―carry‖ or ―promote.‖
•   Catch-up – a clause in the agreement between the general partner and the limited partners of a private equity fund. Once the limited partners have
    received a certain portion of their expected return, the general partner can then receive a majority of profits until the previously agreed upon profit
    split is reached.
Glossary of Terms cont…
•   Clawback – a clause in the agreement between the general partner and the limited partners of a private equity fund. The clawback gives limited
    partners the right to reclaim a portion of disbursements to a general partner for profitable investments based on significant losses from later
    investments in a portfolio.
•   Closing – the conclusion of a financing round whereby all necessary legal documents are signed and capital has been transferred.
•   Co-investment –either a) the right of a limited partner to invest with a general partner in portfolio companies, or b) the act of investing by two or more
    entities in the same target company (also known as a Club deal).
•   Common stock – a type of security representing ownership rights in a company. Usually, company founders, management and employees own
    common stock while investors own preferred stock. In the event of a liquidation of the company, the claims of secured and unsecured creditors,
    bondholders and preferred stockholders take precedence over common stockholders. See Preferred stock.
•   Comparable – a publicly traded company with similar characteristics to a private company that is being valued. For example, a telecommunications
    equipment manufacturer whose market value is 2 times revenues can be used to estimate the value of a similar and relatively n ew company with a
    new product in the same industry.
•   Conversion – the right of an investor or lender to force a company to replace the investor‘s preferred shares or the lender‘s debt with common
    shares at a preset conversion ratio. A conversion feature was first used in railroad bonds in the 1800‘s.
•   Convertible debt – a loan which allows the lender to exchange the debt for common shares in a company at a preset conversion ratio
•   Convertible preferred stock – a type of stock that gives an owner the right to convert to common shares of stock. Usually, preferred stock has
    certain rights that common stock doesn‘t have, such as decision-making management control, a promised return on investment (dividend), or senior
    priority in receiving proceeds from a sale or liquidation of the company. Typically, convertible preferred stock automatically converts to common stock
    if the company makes an initial public offering (IPO). Convertible preferred is the most common tool for private equity funds to invest in companies.
•   Covenant – a legal promise to do or not do a certain thing. For example, in a financing arrangement, company management may agree to a negative
    covenant, whereby it promises not to incur additional debt. The penalties for violation of a covenant may vary from repairing the mistake to losing
    control of the company.
•   Cram down round – a financing event upon which new investors with substantial capital are able to demand and receive contractual terms that
    effectively cause the issuance of sufficient new shares by the startup company to significantly reduce (―dilute‖) the ownership percentage of previous
•   Cumulative dividends – the owner of preferred stock with cumulative dividends has the right to receive accrued (previously unpaid) dividends in full
    before dividends are paid to any other classes of stock.
•   Deal flow – a measure of the number of potential investments that a fund reviews in any given period.
•   Demand rights – a type of registration right. Demand rights give an investor the right to force a startup to register its shares with the SEC and
    prepare for a public sale of stock (IPO).
•   Dilution – the reduction in the ownership percentage of current investors, founders and employees caused by the issuance of new shares to new
•                                                                                                                                                     29
    Distribution – the transfer of cash or securities to a limited partner resulting from the sale, liquidation or IPO of one or more portfolio companies in
    which a general partner chose to invest.
    Glossary of Terms cont…
•   Dividends – payments made by a company to the owners of certain securities. Typically, dividends are paid quarterly, by approval of the board of
    directors, to owners of preferred stock.
•   Down round – a round of financing whereby the valuation of the company is lower than the value determined by investors in an earlier round.
•   Drag-along rights – the contractual right of an investor in a company to force all other investors to agree to a specific action, such as the sale of the
•   Due diligence – the investigatory process performed by investors to assess the viability of a potential investment and the accuracy of the
    information provided by the target company.
•   Early stage – the state of a company after the seed (formation) stage but before middle stage (generating revenues). Typically, a company in early
    stage will have a core management team and a proven concept or product, but no positive cash flow.
•   Earn out- an arrangement in which sellers of a business receive additional future payments, usually based on financial performance metrics such
    as revenue or net income.
•   Employee Stock Ownership Program (ESOP) – a plan established by a company to reserve shares for employees.
•   Exit strategy – the plan for generating profits for owners and investors of a company. Typically, the options are to merge, be acquired or make an
    initial public offering (IPO). An alternative is to recapitalize (releverage the company and then pay dividends to shareholders).
•   Expansion stage – the stage of a company characterized by a complete management team and a substantial increase in revenues.
•   Founders stock – nominally priced common stock issued to founders, officers, employees, directors, and consultants.
•   Friends and family financing – capital provided by the friends and family of founders of an early stage company. Founders should be careful not
    to create an ownership structure that may hinder the participation of professional investors once the company begins to achieve success.
•   Full ratchet – an anti-dilution protection mechanism whereby the price per share of the preferred stock of investor A is adjusted downward due to
    the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A‘s preferred stock is
    repriced to match the price of investor B‘s preferred stock. Usually as a result of the implementation of a ratchet, company management and
    employees who own a fixed amount of common shares suffer significant dilution.
•   Fully diluted basis – a methodology for calculating any per share ratios whereby the denominator is the total number of shares issued by the
    company on the assumption that all warrants and options are exercised and preferred stock.
•   Fund-of-funds – a fund created to invest in private equity funds. Typically, individual investors and relatively small institutional investors participate
    in a fundof- funds to minimize their portfolio management efforts.
•   General partner (GP) – a class of partner in a partnership. The general partner retains liability for the actions of the partnership. In the private
    equity world, the GP is the fund manager while the limited partners (LPs) are the institutional and high net worth investors in the partnership. The
    GP earns a management fee and a percentage of profits.
•   Going-private transaction – when a public company chooses to pay off all public investors, delist from all stock exchanges, and become owned by
    management, employees, and select private investors.
•                                                                                                                                             30
    Growth stage – the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service.
    Also known as ―middle stage.‖
    Glossary of Terms cont…
•   Hedge fund – an investment fund that has the ability to use leverage, take short positions in securities, or use a variety of derivative instruments in
    order to achieve a return that is relatively less correlated to the performance of typical indices (such as the S&P 500) than traditional long-only
    funds. Hedge fund managers are typically compensated based on assets under management as well as fund performance.
•   Hockey stick – the general shape and form of a chart showing revenue, customers, cash or some other financial or operational measure that
    increases dramatically at some point in the future. Entrepreneurs often develop business plans with hockey stick charts to impress potential
•   Hurdle rate – a minimum rate of return required before an investor will make an investment.
•   Initial public offering (IPO) – the first offering of stock by a company to the public. New public offerings must be registered with the Securities and
    Exchange Commission. An IPO is one of the methods that a startup that has achieved significant success can use to raise additional capital for
    further growth.
•   Inside round – a round of financing in which the investors are the same investors as the previous round. An inside round raises liability issues
    since the valuation of the company has no third party verification in the form of an outside investor. In addition, the terms of the inside round may be
    considered self-dealing if they are onerous to any set of shareholders or if the investors give themselves additional preferential rights.
•   Institutional investor – professional entities that invest capital on behalf of companies or individuals. Examples are: pension plans, insurance
    companies and university endowments.
•   Internal rate of return (IRR) – the interest rate at which a certain amount of capital today would have to be invested in order to grow to a specific
    value at a specific time in the future.
•   Investment thesis / Investment philosophy – the fundamental ideas which determine the types of investments that an investment fund will
    choose in order to achieve its financial goals.
•   Later stage – the state of a company that has proven its concept, achieved significant revenues compared to its competition, and is approaching
    cash flow break even or positive net income. Typically, a later stage company is about 6 to 12 months away from a liquidity event such as an IPO or
    buyout. The rate of return for venture capitalists that invest in later stage, less risky ventures is lower than in earlier stage ventures.
•   Lead investor – the venture capital investor that makes the largest investment in a financing round and manages the documentation and closing of
    that round. The lead investor sets the price per share of the financing round, thereby determining the valuation of the company.
•   Letter of intent – a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the
    subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as a ―Term Sheet‖.
•   Leverage – the use of debt to acquire assets, build operations and increase revenues. By using debt, a company is attempting to achieve results
    faster than if it only used its cash available from pre-leverage operations. The risk is that the increase in assets and revenues does not generate
    sufficient net income and cash flow to pay the interest costs of the debt.
•   Leveraged buyout (LBO) – the purchase of a company or a business unit of a company by an outside investor using mostly borrowed capital.
•   Leveraged recapitalization – the reorganization of a company‘s capital structure resulting in more debt added to the balance sheet. Private equity
    funds can recapitalize a portfolio company and then direct the company to issue a one-time dividend to equity investors. This is often done when the
    company is performing well financially and the debt markets are expanding.                                                                    31
•   Limited liability company (LLC) – an ownership structure designed to limit the founders‘ losses to the amount of their investment. An LLC does
    not pay taxes, rather its owners pay taxes on their proportion of the LLC profits at their individual tax rates.
Glossary of Terms cont…
•   Limited partnership – a legal entity composed of a general partner and various limited partners. The general partner manages the investments and
    is liable for the actions of the partnership while the limited partners are generally protected from legal actions and any losses beyond their original
    investment. The general partner receives a management fee and a percentage of profits, while the limited partners receive income, capital gains
    and tax benefits.
•   Limited partner (LP) – an investor in a limited partnership. The general partner is liable for the actions of the partnership while the limited partners
    are generally protected from legal actions and any losses beyond their original investment. The limited partner receives income, capital gains and
    tax benefits.
•   Liquidation – the sale of a company. This may occur in the context of an acquisition by a larger company or in the context of selling off all assets
    prior to cessation of operations (Chapter 7 bankruptcy). In a liquidation, the claims of secured and unsecured creditors, bondholders and preferred
    stockholders take precedence over common stockholders.
•   Liquidation preference – the contractual right of an investor to priority in receiving the proceeds from the liquidation of a company. For example, a
    venture capital investor with a ―2x liquidation preference‖ has the right to receive two times its original investment upon liquidation.
•   Liquidity event – a transaction whereby owners of a significant portion of the shares of a private company sell their shares in exchange for cash or
    shares in another, usually larger company. For example, an IPO is a liquidity event.
•   Lock-up agreement – investors, management and employees often agree not to sell their shares for a specific time period after an IPO, usually 6
    to 12 months. By avoiding large sales of its stock, the company has time to build interest among potential buyers of its shares.
•   Management buyout (MBO) – a leveraged buyout controlled by the members of the management team of a company or a division. Often an MBO
    is conducted in partnership with a buyout fund.
•   Management fee – a fee charged to the limited partners in a fund by the general partner. Management fees in a private equity fund typically range
    from 0.75% to 3% of capital under management, depending on the type and size of fund.
•   Mezzanine – a layer of financing that has intermediate priority (seniority) in the capital structure of a company. For example, mezzanine debt has
    lower priority than senior debt but usually has a higher interest rate and often includes warrants. In venture capital, a mezzanine round is generally
    the round of financing that is designed to help a company have enough resources to reach an IPO.
•   Middle stage – the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service.
    Also known as ―growth stage.‖
•   Multiples – a valuation methodology that compares public and private companies in terms of a ratio of value to an operations figure such as
    revenue or net income. For example, if several publicly traded computer hardware companies are valued at approximately 2 times revenues, then it
    is reasonable to assume that a startup computer hardware company that is growing fast has the potential to achieve a valuation of 2 times its
    revenues. Before the startup issues its IPO, it will likely be valued at less than 2 times revenue because of the lack of liquidity of its shares.
•   Narrow-based weighted average ratchet – a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of
    the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally
    received. Investor A‘s preferred stock is repriced to a weighed average of investor A‘s price and investor B‘s price. A narrow-based ratchet uses
    only common stock outstanding in the denominator of the formula for determining the new weighted average price.
    Glossary of Terms cont…
•   Non-cumulative dividends – dividends that are payable to owners of preferred stock at a specific point in time only if there is sufficient cash flow
    available after all company expenses have been paid. If cash flow is insufficient, the owners of the preferred stock will not receive the dividends
    owed for that time period and will have to wait until the board of directors declares another set of dividends.
•   Non-disclosure agreement (NDA) – an agreement issued by entrepreneurs to protect the privacy of their ideas when disclosing those ideas to
    third parties.
•   Outstanding shares – the total amount of common shares of a company, not including treasury stock, convertible preferred stock, warrants and
•   Pay to play – a clause in a financing agreement whereby any investor that does not participate in a future round agrees to suffer significant dilution
    compared to other investors. The most onerous version of ―pay to play‖ is automatic conversion to common shares, which in essence ends any
    preferential rights of an investor, such as the right to influence key management decisions.
•   Pari passu – a legal term referring to the equal treatment of two or more parties in an agreement. For example, a venture capitalist may agree to
    have registration rights that are pari passu with the other investors in a financing round.
•   Participating dividends – the right of holders of certain preferred stock to receive dividends and participate in additional distributions of cash, stock
    or other assets.
•   Participating preferred stock – a unit of ownership composed of preferred stock and common stock. The preferred stock entitles the owner to
    receive a predetermined sum of cash (usually the original investment plus accrued dividends) if the company is sold or has an IPO. The common
    stock represents additional continued ownership in the company. Participating preferred stock has been characterized as ―having your cake and
    eating it too.‖
•   Placement agent – a company that specializes in finding institutional investors that are willing and able to invest in a private equity fund.
    Sometimes a private equity fund will hire a placement agent so the fund partners can focus on making and managing investmentsin companies
    rather than on raising capital.
•   Portfolio company – a company that has received an investment from a private equity fund.
•   Post-money valuation – the valuation of a company including the capital provided by the current round of financing. For example, a venture
    capitalist may invest $5 million in a company valued at $2 million ―pre-money‖ (before the investment was made). As a result, the startup will have a
    post-money valuation of $7 million.
•   Preferred stock – a type of stock that has certain rights that common stock does not have. These special rights may include dividends,
    participation, liquidity preference, anti-dilution protection and veto provisions, among others. Private equity investors usually purchase preferred
    stock when they make investments in companies.
•   Pre-money valuation – the valuation of a company prior to the current round of financing. For example, a venture capitalist may invest $5 million in
    a company valued at $2 million pre-money. As a result, the startup will have a ―post-money‖ valuation of $7 million.
•   Price earnings ratio (PE ratio) – the ratio of a public company‘s price per share and its net income after taxes on a per share basis.
•   Private placement – the sale of a security directly to a limited number of institutional and qualified individual investors. If structured correctly, a
    private placement avoids registration with the Securities and Exchange Commission.                                                                    33
    Glossary of Terms cont…
•   Redemption rights – the right of an investor to force the startup company to buy back the shares issued as a result of the investment. In effect, the
    investor has the right to take back his/her investment and may even negotiate a right to receive an additional sum in excess of the original
•   Registration rights – the rights of an investor in a startup regarding the registration of a portion of the startup‘s shares for sale to the public.
    Piggyback rights give the shareholders the right to have their shares included in a registration. Demand rights give the shareholders the option to
    force management to register the company‘s shares for a public offering. Often, registration rights are hotly negotiated among venture capitalists in
    multiple rounds of financing.
•   Round – a financing event usually involving several private equity investors.
•   Scalability – a characteristic of a new business concept that entails the growth of sales and revenues with a much slower growth of organizational
    complexity and expenses. Venture capitalists look for scalability in the startups they select to finance.
•   Secondary market – a market for the sale of limited partnership interests in private equity funds. Sometimes limited partners chose to sell their
    interest in a partnership, typically to raise cash or because they cannot meet their obligation to invest more capital according to the takedown
    schedule. Certain investment companies specialize in buying these partnership interests at a discount.
•   Seed capital – investment provided by angels, friends and family to the founders of a startup in seed stage.
•   Seed stage – the state of a company when it has just been incorporated and its founders are developing their product or service.
•   Series A preferred stock – preferred stock issued by a fast growth company in exchange for capital from investors in the ―A‖ round of financing.
    This preferred stock is usually convertible to common shares upon the IPO or sale of the company.
•   Stock option – a right to purchase or sell a share of stock at a specific price within a specific period of time. Stock purchase options are commonly
    used as long term incentive compensation for employees and management of fast growth companies.
•   Strategic investor – a relatively large corporation that agrees to invest in a young company in order to have access to a proprietary technology,
    product or service. By having this access, the corporation can potentially achieve its strategic goals.
•   Syndicate – a group of investors that agree to participate in a round of funding for a company. Alternatively, a syndicate can refer to a group of
    investment banks that agree to participate in the sale of stock to the public as part of an IPO.
•   Tag-along right – the right of a minority investor to receive the same benefits as a majority investor. Usually applies to a sale of securities by
•   Term sheet – a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the
    subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as ―Letter of Intent‖.
•   Venture capital – a segment of the private equity industry which focuses on investing in new companies with high growth rates.
•   Venture capital method – a valuation method whereby an estimate of the future value of a company is discounted by a certain interest rate and
    adjusted for future anticipated dilution in order to determine the current value. Usually, discount rates for the venture capital method are
    considerably higher than public stock return rates, representing the fact that venture capitalists must achieve significant returns on investment in
    order to compensate for the risks they take in funding unproven companies.                                                                        34
    Glossary of Terms cont…
•   Vesting – a schedule by which employees gain ownership over time of a previously agreed upon amount of retirement funding or stock options.
•   Warrant – a security which gives the holder the right to purchase shares in a company at a pre-determined price. A warrant is a long term option,
    usually valid for several years or indefinitely. Typically, warrants are issued concurrently with preferred stocks or bonds in order to increase the
    appeal of the stocks or bonds to potential investors.
•   Weighted average ratchet – an anti-dilution protection mechanism whereby the conversion rate of preferred stock is adjusted in order to reduce an
    investor‘s loss due to an increase in the number of shares in a company. Without a ratchet, an investor would suffer from a dilution of his or her
    percentage ownership. Usually as a result of the implementation of a weighted average ratchet, company management and employees who own a
    fixed amount of common shares suffer significant dilution, but not as badly as in the case of a full ratchet.


Description: Leveraged Management Buyout Agreement Terms Example document sample