Venture Capital Financing - PowerPoint

Document Sample
Venture Capital Financing - PowerPoint Powered By Docstoc
					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.