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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 Less $ to Big Deals Drives Decline $ Invested by Transaction Size; Atlantic Region $75M $53M $53M $48M $33M $23M Technology Almost Exclusive Focus Disbursements in Canada $6,629M $4,874M $2,986M $1,774M $1,751M $1,089M 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 High-Growth Firm Moderate-Growth Firm VC Prospects Low-Growth Firm 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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