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Venture Capital Financing
MBA 6314/TME 3413
October, 2003
Overview
• VC and corporate • Valuation and pricing
finance • Deal structure
• Overview of VC • The “Venture Capital
industry Method”
• The VC life cycle • The Shareholder’s
• The VC investment Agreement
process • Growing the business
• Negotiations • The exit
Conventional Financing
• Assets • Liabilities &
Equities
• Inventory & • Operating line of
receivables credit
• Land & buildings • Mortgage
• Equipment & vehicles • Term loan
• Other • Share capital &
retained earnings
VC Financing
• Fills the cash gap between cash needs to
finance high growth and cash available
from earnings and conventional financing
• Giving up a piece of the pie to grow a
bigger pie
Overview of VC Industry
• Angel investors
• Private equity funds
• Labor sponsored funds
• Institutional investors
• Diversified versus focused
• Venture Capital Trends
Gap With U.S. Has Closed
Disbursements 1995-2001; Canada & U.S.
$ Invested by US VCs - $ CDN Billion $ Invested by Canadian VCs - $ Billions
$160 $16
$140 $14
$120 $12
$100 $10
$80 $8 U.S.A.
$60 $6 CDN
$40 $4
$20 $2
$0 $0
1995 1996 1997 1998 1999 2000 2001
Less $ to Big Deals Drives Decline
$ Invested by Transaction Size; Atlantic Region
$75M
$80
$70
$60 $48M
$53M $53M
$50
$Millions
$40 $33M
$30 $23M
$20
$10
$0
1996 1997 1998 1999 2000 2001
<$500K $500-$999K $1000K-$4999K >$5000K
Technology Almost Exclusive
Focus Disbursements in Canada
$6,629M
$7,000
$6,000 $4,874M
$5,000
$4,000
$Millions
$2,986M
$3,000 $1,774M $1,751M
$2,000 $1,089M
$1,000
$0
1996 1997 1998 1999 2000 2001
Technology Traditional
Capital Markets Playing Field
Phase I Phase II Phase III
Knowledge Concept Basic Prototype Market Manufacturing
Acquisition Investigation Design Building Entry Ramp-up
Government Programs
Public Issues
Commercial Banks
Non-Financial Corporations
Seed Funds Venture Capital Funds
Wealthy Family Funds
Private Investors
Faminly and Friends
Personal Savings
9
The VC Life Cycle
• Submit business plan
• Preliminary assessment
• Meet the people
• Light due diligence
• Term sheet
• Heavy due diligence
• Investment memorandum
• Commitment letter
• Shareholder’s agreement
• Grow the company
• Exit
The Business Life Cycle
Typical SME Growth Profiles
60
High-Growth Firm
50
Sales ($ millions)
40
30
20 Moderate-Growth Firm
VC Prospects
10 Low-Growth Firm
0
1 2 3 4 5 6 7 8 9 10
Years
VC Investment Criteria
• Exponential growth potential
• Attractive industry
• Sustainable advantage platform
• Excellent team “execution”
• Owners receptive to involvement of outsiders
• Owners willing to share the wealth creation
• Credible exit alternatives (4-7 years out)
The Ingredients- Good CEO
• Good CEO is the most critical element
– Best is “been there and done that”
– Has specific domain experience/expertise
– “Knows what he/she doesn’t know & locates
resources to fill gaps.
– Shows “fire in the belly”
– Recognizes urgency-revenue generation/ burn
rate
– Knows the difference between being an
employee and being a shareholder
The Ingredients-Strong
Management Team
• Characteristics Include:
– Honesty/Integrity/Competence/Discipline
– Have specific domain experience
– Ability to self-assess
– Motivated
– “Fire in the belly”
– Plans and communicates effectively
– Develops appropriate MIS
• Caveat-beware the “family ties”
The Ingredients-
Technology/Core Competence
• Ability to define and enunciate what it is
• Ability to relate core technology-/competence to a
variety of significant market applications-(must
be balanced by focus)
• Strong “in house” R&D capability with the
mechanisms to fund it.
– Equity/loans
– Customer Pays (direct or through margins)
The Ingredients-The Business
Model
• Implies having a well defined business
model that says, “I know who my customers
are, what they need, how I will meet their
needs, how I will reach them, how I will
service them, how I will continue to best my
competition and how I will make money.
• Avoid “if we build it they will come!”
Ingredients-The Value
Proposition
• Why will/do our customers buy or product?
– Ease the Pain
– Improve Revenue/ Productivity/Profitability
The Ingredients-The Strategic
Alliance
• A “must” for most emerging companies
– distribution
– product development (perhaps)
• Can accelerate success or hasten demise
Venture Capital Valuation & Pricing
Internal Rate of Return (IRR)
VC Investments and IRR
VC Target IRR
• Seed • IRR>80%
• Startup • 50-70%
• First stage • 40-60%
• Second stage • 30-50%
• Bridge • 20-35%
• Restart • ??
What are they prepared to pay
for?
• In later stage companies VC’s can value the “cake” as
well as the “ingredients”. This is a luxury they do not
have in funding emerging technology companies.
• The “cake” represents companies with demonstrable
and sustained patterns of growth in revenue
(30%+/annum compounded) and profitability
(commensurate)
• In early stage companies VC’s have to value the
ingredients and estimate what the “cake” might look
like in 3 to 5 years!
23
Why so High?
• Base IRR =risk free rate
• Plus premiums
Why so High?
• Systematic risk in capital markets
• Unsystematic (unique) risk diversified away
• VC firms more vulnerable to market swings
Why so High?
• Liquidity premium
• 4-7 year investment time horizon
• Not easy to liquidate investment
Why so High?
• Value added premium
• Recruitment of key personnel
• Strategy
• Board of Directors
• Network
• Deep pockets
Why so High?
• Portfolio average return
• 2-6-2 rule
Valuation and Pricing
• Magnitude of investment
• Staging of investment
• Syndication
• Target IRR
• Investment time horizon
• Terminal value of firm
• % ownership required
• Deal structure
• Future financing and dilution – “The Venture Capital
Method”
Magnitude of Investment
• Typically >$1.0 million for institutional
• Small deals too costly
• Typically less than $10 million in Canada
• Based on business plan pro forma
Staging of Investment
• All up front
• Two or three tranches
• Contingent on meeting milestones/targest
• Option to abandon
Syndication
• Sharing the deal with other VC firms
• Diversify the risk
• Broaden the network
• Increase size of portfolio
Target IRR
• 25-80 %
• Stage of company
• Use of funds
• Deal structure
Investment Time Horizon
• 4-7 years
• How long will it take to create value?
• Years to cash flow breakeven
Terminal Value of Firm
• Projected earnings at exit
• Price/earnings ratio (PER)
• Projected TV=Projected Earnings x PER
% Ownership Required
• Magnitude of investment
• Duration of investment
• Target IRR
• Terminal value of firm
• Room for future investment?
VC Investments and IRR
% Ownership Required
Deal Structure
• Shares
• Shares and subordinated debt
• Shares and convertible subordinated debt
• What is the upside?
• What is the downside?
• Does the structure affect the risk to the VC?
Typical Investment Structures
• Early Stage
– Common Shares- Maybe “Put” requirement
or “Forced Sale” provision on commons if no
exit within 5 to 7 years
– Preferred Shares-convertible into common
or with warrants attached, frequently with
cumulative dividend- 5 yr. term
– %tage of equity required tied directly to
valuation and amount of capital being
sought 40
Typical Investment Structures
• Later Stage Investments (Mezzanine)
– Convertible Debentures/Debentures with
Warrants
– Debentures with nominal cost equity
– Debentures may be unsecured or secured
(back of the bus) and usually carry an
interest coupon
– Straight debentures may or may not be
41
sinking fund”
Deal Structure Spreadsheets
Three Scenarios
• $1.0 m VC investment
• 5 year time horizon
• Target IRR 40%
• Terminal value $11.25 m
• Three different deal structures
• Varying % ownership
Scenario A
Scenario B
Scenario C
The Venture Capital Method
Step 1
• Given the VC investment, the target IRR
and the investment time horizon, determine
the future value of the VC investment
• FV = PV(1+i)^n
• i = target IRR
• N = time horizon to exit
• Eg. FV = $1.0m(1+0.35)^5 = $4.5m
The Venture Capital Method
Step 2
• Given the projected earnings at exit and an
appropriate Price Earnings ratio (PER) for
the company, calculate the projected
terminal value of the company at exit
• Eg. TV = $1.0m(15) = $15m
The Venture Capital Method
Step 3
• Determine the % ownership required by dividing
the required future value of the investment at exit
by the projected terminal value of the company at
exit
• Eg. FV= $4.5m/TV$15m = 30%
• Or divide the VC investment by the present value
of the projected terminal value of the company at
exit
• Eg. PV=$15m/(1+0.45)^5=$3.33m ;
$1.0m/$3.33m=30%
The Venture Capital Method
Step 4
• Determine number of new shares (NS) to be
issued to VC.
• Find number of shares outstanding before
investment (old shares (OS) eg. 1.0m)
• VC % Ownership = NS/(NS +OS)
• Eg. 30% = NS/(NS + 1.0m)
NS= 430,000
Price per share = $1.0m/430,000 = $2.33
The Venture Capital Method
Step 5
• Determine pre and post-money valuation
• If 30% of the company is acquired for a $1.0 VC
investment, this implies a post-money valuation of
$1.0/0.30 = $3.33m
• Give a post-money valuation of $3.33m and an
investment of $1.0m, the pre-money valuation is
$2.33m
• Does this valuation make sense? Is it realistic?
The Venture Capital Method
Step 6
• Assess future dilution due to issuance of
additional shares prior to exit.
• Shares to management, future investors
• Estimate retention ratio = 100% - % of
ownership issued to others in future
• Eg. If a future investor negotiates a 10%
ownership, the retention ratio is 100%-
10%=90%
The Venture Capital Method
Step 7
• Calculate adjustment to required ownership % due
to expected future dilution
• Adjusted ownership % = % ownership without
dilution divided by retention ratio
• Eg. Adjusted % = 30%/90% = 33.3%
• If VC owns 33% after investment and gets diluted
by 10% before exit, the final ownership % will be
30%, ie. the required ownership % to realize target
IRR given projected terminal value
Venture Capital Method
Spreadsheet
The Venture Capital Method
Multiple Rounds of Financing
• Often subsequent rounds of financing are anticipated
before the round 1 VC investor plans to exit
• Each subsequent round will negotiate an ownership
position based on their own magnitude of investment,
target IRR and investment time horizon
• The round 1 VC investor has to anticipate these future
investments and adjust required ownership % for expected
future dilution
• Typically future investments have a lower target IRR
• The round 1 investor retention ratio is 100% minus the %
owned by future round investors at exit
Sensitivity Analysis
• Terminal Value
– Future Earnings (Sales, Expenses, Profits)
– PER
• Target IRR
– Risk
– Deal Structure
– Liquidity
• Dilution
– Future Rounds (Amounts, IRR, Horizon)
– Management incentives
The VC-Company Relationship
• VC Fees
• The Shareholder’s Agreement
• Corporate Governance
• Exit
VC Fees
• Commitment fee
• Termination fee
• Due diligence expenses
• Legal expenses
• All paid by company
Shareholder’s Agreement
• Defacto control over critical decisions
– Hiring/firing key management personnel
– Budgets and capital expenditures
– Financing
– Strategic changes
– Veto rights
– Dispute resolution
Shareholder’s Agreement
• Exit Provisions
– “Put”/ “Call” Rights
– “Drag Along” Rights
– “Tag Along” Rights
– “Right of First Refusal” Rights
– Valuation formula/process
Shareholder’s Agreement
• Corporate Governance
– Board of Directors
– Independent members
– Swing vote to independents
– Help create value
Corporate Governance
• No interference in day-today operations
• Regular reporting (monthly)
• Regular Board meetings
• Annual audits
• Performance assessment
• Help out when needed
Exit Alternatives
• Sale to company treasury
• Sale to equity partners
• Sale to owners/management/employees
• Sale to third party (VC shares or all)
• IPO
• Hold and “milk”
• Liquidate
The Initial Public Offering (IPO)
• Address capital needs beyond limits of VC’s
• Liquidity for VC’s
• “Quiet period”
• “Lock up” period
• Legal, accounting and investment banking fees
• Prospectus and road show
• Public scrutiny
• Focus on stock price, short term results
What Should You Expect From
Your V.C?
• An investment in size, scope and structure consistent
with the execution requirements of your business plan
• Ability to bring other V.C.’s and financiers to the table
• Active, value adding board of directors involvement
• Access to network and other resources
• A fair deal that creates a win/win for everybody and
recognizes the value of monetary and non monetary
contributions of key stakeholders
• Ongoing financial support where business case
warrants
• Do your homework, v.c. money is not homogeneous
Realities of the Current Market
• Financing based on “Napkin” business plans is
“out”
• Fundamentals are back “in”
• Companies must show more evidence of
market acceptance of product, value
proposition and business model before funding
• Tough with no sales
• Valuations are down 50-75%
• V.C.’s are staying closer to home
Investors Active in Atlantic Canada
ACF Equity Atlantic Inc. CDP – Accés Capital
BMO Capital CDP - Sofinov
BDC Venture Capital Group Genesys Capital Partners
Canadian Science and Latitude Partners
Technology Group
Ventures West Management Inc
Roynat ETSIF
Manulife Skypoint
EDC RBCP.
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