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The Financing Food Chain


									The Financing Food Chain

        Dr Peter Kelly
        22 April 2004
          The Capital Pyramid
 Prospector funds
   government grants, employer, foundations
 Personal funds
 Professional funds
   business angels
   venture capital funds
   banks
 Public equity funding

            Founder, family,
             friends, fools

                           Business Angels

                                        Venture Capitalists


                                                              Public Equity

                                             Commercial Banks

      START-UP                                                         MATURITY
        Fund Raising Advice
 Think small: what do I really need?
 Wear “investor eyeglasses”
 Specify milestones
 Do your homework before approaching
 Do not be put off by the word “no”
 Respect Murphy’s Law of Venture Building
           Prospector Funds
 Entrepreneurs often start their business on
  back of market research “bought” by their
 Myriad of grants, foundations, funding
  bodies that fund:
   prototypes
   patents
   business development
              Prospector Funds
 However, you need to understand:
     who to approach
     how to approach
     what they want to hear
     the “magic words” (in addition to please)
 In my experience, the quality of tactical
  advice provided is highly variable
 Ideally no strings, hastles, forms or
            Personal Funds
 Golden Rules ...
   You need to signal to others your belief in the
    business by giving “until it hurts (some)!”
   In the absence of personal capital, sweat
    equity will do
   Your sacrifices have to be made BEFORE
    approaching investors
   Project a start-up personal lifestyle
   Spouses/partners need to be 100%
          Friends, Family, Fools
 Friends and family that know you are
    largest source of capital next to personal
   If you use them prepare to lose them
   Do not get them involved in the business
    unless their experience warrants
   Prepare the divorce papers in advance
   Ideally you want “silent partners”
           Professional Funds
 Grants, soft money, personal funds, and
  capital provided by friends, family and
  fools is bedrock to raise outside capital ...
 Early on, many entrepreneurs view the
  bank as the next logical port of call
 In fact, business angels are the ONLY
  viable and valuable route in the early
         Angels Are Big News ...
 Some of the firms backed by angels ...
     Bell Telephone (1874)
     Ford Motor Company (1903)
     Apple Computer (1977)
     Amazon (1995)
 Some notable angels ...
   Paul Allen (Microsoft), Ben Rosen (Compaq)
   Ross Perot (EDI), John Sculley (Apple)
   Jim Barksdale (Netscape)
           A “Typical” Profile
 middle aged male
 reasonable net worth and income
 new venture experience
 typically invest in 1 deal a year
 usually invests close to home
 usually invests as part of group/syndicate
 invests small and early
 leverage & exit appeal
        By Some Estimates ...
United States:
 2 million + business angels
 invest $100 billion + per year
 invest in 40,000 + ventures
United Kingdom:
 50,000 business angels
 invest £5 billion + per year
 in 30-40x more ventures than vc funds
  Hearing About Opportunities ...
 Described as “reveal and referral” market
 Best referrals come from ...
     people they have invested with before
     business associates
     personal friends
     business introduction services
 Many investors also actively search out
 investment opportunities
      Business Angels ≠ Charity
 Seek capital gains on invested capital
 They want exit in reasonable time frame
 Want to be involved in situations that can
  benefit from leveraging their experience
  and contacts (full contact sport)
 Relive the entrepreneurial dream
 Excitement
 Do not have to invest
           Investment Criteria

“There are many parallels between private
  investing and betting on the horses. To
  make money, you need to assess the
  condition of the track (industry), the horse
  (strategy) and the jockey (people).
  Experienced punters always bet on the
    Why Be Actively Involved ...
 It is my kid’s inheritance on the line!
 Business can genuinely benefit from my
  experience as well as capital
 They have the time to be involved unlike
  many venture capital fund managers
 Entrepreneurs genuinely appreciate the
          An Invisible Market ...
 aptly described as “a giant game of hide-
  and-go-seek with everyone playing
 how to locate them ...
     use your network
     from entrepreneurs who have raised money
     through business angel matching services
     via specialized publications (VCR)
            Market Insights
 surveyed 110 active business angels
 completed 835 deals to date
 75%+ had started a business, on average
  more than 3 each
 overwhelmingly middle aged males
 provided detailed information on their most
  recent investment made
             A “Typical” Deal
 management invests £70k and retains
    53% of business post investment
   outside investors invest £320k
   70%+ deals are early stage
   70%+ involved syndicates
   40% investor employed in some capacity
   almost all located < 1 hour from home
   almost all documented with contract
      Contract Non-Negotiables
 Veto rights over acquisitions or divestment
 Investor approval of strategic plans/budget
 Share option issuance restrictions
 Non-compete contracts
 Restrictions on ability to raise additional
 debt or equity finance

         Contract Negotiables
 Forced exit provisions
 Investor approval hiring/firing decisions
 Investors need to co-sign cheques
 Management equity ratchets
 Dispute resolution mechanisms

           Additional Insights
 More experienced business angels
  behave like venture capitalists
 Syndicates need thicker contracts
 Trusted referrers shape the deal in
  favourable ways
 Defining roles is the true value of the
  contract – it in fact does not offer true legal
  protection ...
      Venture Capital: A History
 Queen Isabella can be considered first
  venture capitalist (Columbus)
 Institutional venture capital started shortly
  in mid 1940s
 Industry took off on the back of a single
  big hit investment (Digital Equipment)
 Industry growth stimulants ...
      regulations (Prudent Man rule), capital gains tax
      exhuberant IPO markets
            Venture Capital
 Team of professional managers (general
  partners) raise money from institutional
  investors & individuals (limited partners)
 Closed end versus evergreen funds
 Limited partners get repaid first
 General partner receives an annual fee for
  managing fund (2%-3%) + carried interest
  in capital gains realized (20%-30%)
             Venture Capital
 General partners make all investment
 Limited partners can not be actively
  involved with investee companies
 Typical 10 year closed end fund
   spends 3 years making new investments
   3-4 years making follow-on investments
   3-4 years grooming exits (IPO, trade sale)
         Classic Venture Capital
 Read Bill Bygrave’s timeless classic
  Venture Capital at the Crossroads (1992)
 Time honoured principles
     invest small amounts of capital
     at formative stages of venture development
     working with syndicates of funds
     with a lead investor “getting dirty”
     getting exit with 5 to 7 years
     then raise more money
   Classic Venture Capital (2000)

 Bubble economics 101 ...
     invest large amounts of capital
     at formative stages of venture development
     often alone, particularly in early stages
     to groom a company for IPO within 18 months
     while constantly fund raising
            Venture Capital
 Perfect + correlation between funds raised
  by vc’s and IPO activity on public markets
 Perfect + correlation between funds
  invested and IPO activity
 When financial opportunity costs approach
  zero, funds flow into venture capital
 Valuations go hand-in-hand with number
  of funds and capital overhang
   Venture Capital: The Process
 With other people’s money at risk, venture
 capitalists signal competence by ...
   relying on well defined processes to screen
    and evaluate potential opportunities
   having numerous eyes look at deals
   conducting extensive due diligence
   relying on extensive contracts
   documenting everything they do
      VCs: Visible But Accessible?
 Every country has an online directory of
 venture capital funds ...
     investment focus (stage, sector, size)
     partners names
     investee companies
     office locations
 Easy to identify ≠ Easy to approach ...
   referrals are absolutely necessary
  Venture Capital: The US Scene
 $350 billion + capital under management
 80% raised since 1997
 Number of funds 600-700
 Growing number of $1 billion + funds
 40% of all investments Silicon Valley
 $100 billion capital overhang right now
 Many funds are returning capital to LPs
US VC Industry: On Wild Side



                                           Investments ($b)


      1997 1998 1999 2000 2001 2002 2003
        Contemporary Challenges
 Too much money chasing too few deals
 Too many funds exist but “barriers to exit” are
    huge (Jim Breyer, Accel Partners)
   Are limited partners in fact “patient”?
   Do mediocre performers “drag down the whole
    industry with it”?
   Is it possible to scale up a “cottage industry”?
    (Bruce Dunlevie, Benchmark)
   Will the IPO market recover?
            Angels vs VCs:
      Highlighting the Differences

                Business Angels      Venture Capitalists

PERSONAL        Entrepreneurs            Investors
FIRMS FUNDED    Small, early stage       Large, mature
DUE DILIGENCE   Minimal                  Extensive
LOCATION        Close to home            Not important
CONTRACT        Simple                   Comprehensive
MONITORING      Active, hands-on         Strategic
EXIT            Of lesser concern        Highly important
RETURN (IRR)    Of lesser concern        Highly important

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