Countdown to Launch Venture Capital 101 Sept 9

Countdown to Launch Venture Capital 101 Sept. 9, 2013 Patrick Vernon Clinical Asst. Professor, Executive Director Center for Entrepreneurial Studies UNC Kenan-Flagler Business School pvernon@unc. edu © 2013 Patrick Vernon

Have an IDEA for a new business? Attend an Information Session! Tuesday, Sept. 17 th 5: 30 pm UNC Kenan-Flagler | Mc. Coll 2250 Get your questions answered about the upcoming year and meet potential teammates! $50, 000 in prize mon ey

Startup Intelligence Series (starts 10/2) 10/2: “Mission Possible”- Identifying Your Value Proposition Michael Fern, Associate Chair, Department of Computer Science 10/8: Startup ‘Agents’ of Change- Turning Your Ideas into Reality Alec Guettel (UNC ’ 91), Founder, Sungevity 10/23: “Cracking the Code”- Getting Customer Traction w/ $0 Marketing Chip Royce, Director of Global Alliances, Lenovo 11/6: “Making Your Case”- Delivering an Effective Venture Pitch Tim Flood, Associate Professor of Management and Business Comm.

Agenda • Sources of startup funding • VC job cycle • Angels

Sources of Startup Capital Bootstrapping Other People’s Money

Bootstrapping • “Self-Funded” – Savings accounts – Credit cards, 2 nd mortgage – “Skin in the game” • Revenue – Get early customers and build Bootstrapping

Typical Growth of Bootstrap Venture Normal bootstrap business grows steadily (if you’re lucky).

Other People’s Money • • Strategic Partners Grants Debt Equity

“Friends, Family and Fools” Are they bootstrapping or other people’s money?

Strategic Partners • Perhaps best and most overlooked option • May make strategic investment • Target partners: – Future customer(s) – Potential acquirer Strategic Partners ● Grants ● Debt ●

Strategic Partners • Potential benefits to partner – Exclusivity – Reduced price – Outsourcing – Early access to acquisition • Benefit to you – Generous valuation – Access to resources/markets Strategic Partners ● Grants ● Debt ●

Grants • “Free” money (no payback, no equity) • Can give credibility • Drawbacks – Mistake to overvalue cash and undervalue time – Potential to lose customer focus • Social ventures: should also try to find a diverse revenue model Strategic Partners ● Grants ● Debt ●

Commercial Loans Strategic Partners ● Grants ● Debt ●

Commercial Loans • In startups, only possible for… – Cap Ex (property, big equipment, vehicles, etc. , required as collateral) – Or with a personal guarantee (which makes it a personal loan, see bootstrapping) • Expect low LTV (loan-to-value) • May cause liquidity crisis Strategic Partners ● Grants ● Debt ●

Types of Equity Investors • Accelerators ($25 -$50 k for 6 -8%) • Angels – Individuals – Loosely affiliated groups – Funds • Venture Capitalists (institutional) – Early stage – Later stage Strategic Partners ● Grants ● Debt ●

Rounds of Equity Funding Early Late $500, 000 - $25 M+ $50, 000 - $500, 000 $25, 000 -$100, 000 $1, 000 -$50, 000 Friends/Family Seed or Pre-Seed Angel VC Rounds 1, 2, 3… or A, B, C… (Institutional) IPO or M&A or Later Stage PE

Is it Time for Equity Investors? “You can’t raise money until you don’t need money. ” Why is this true? Strategic Partners ● Grants ● Debt ●

Is it Time for Equity Investors? • Are you offloading risk or sharing opportunity? • The more you believe in your opportunity, the less you want equity investors. Strategic Partners ● Grants ● Debt ●

Debt vs. Equity • Take out a loan • Sell stock • Cost = __% interest • Cost = __% ownership • Potential for bankruptcy • No potential for bankruptcy • Regular cash payments • No cash payments unless dividend, IPO or acquisition

Debt or Equity Which is better?

Building Equity • • Investing in growth $$ now for future $$$$ Tends to be very expensive Driven by milestones

Real Estate Example • $100, 000 house; rental income $500/month • How to grow? • Invest $25, 000 for extra bedroom, +$500/mo. • Buy another house: $100, 000, $1, 500/mo. • What is today’s value of future earnings?

Agenda • Sources of startup funding • VC job cycle • Angels

What does a VC do?

What is a VC’s Job? • • Professional money manager Private (vs. public) equity investing Portfolio of ventures Only 1 bottom-line duty: Return 20 -25% to “LPs” (explained later)

VC’s Job Duties 1. 2. 3. 4. 5. Fundraising Sourcing deals Investing Growing ventures Exiting

VC’s Job Cycle 1. Close Fundraise 1. Close Fund Source Deals Fundraise Source Deals 2. Invest Grow Ventures 3. Exit 2. Invest Fundraise… Grow Ventures

VC’s Job Cycle 1. Close Fundraise 1. Close Fund Source Deals Fundraise Source Deals 2. Invest Grow Ventures 3. Exit 2. Invest Fundraise… Grow Ventures

Raising a Fund • VC fund is a partnership • GPs (general partners) are the VCs who actively invest the fund in startups • LPs (limited partners): – Financial investors with no active role – “Institutional”: pension funds, university endowments, insurance companies, etc.

LP 1 LP 2 LP 3 LP 4 Pl ed ge Raising a Fund $$ Pled ge $ $ Pledge $$ $ e g led Fund 1 $$$$ $ P $ $ e g led P LPn VC Firm (GPs) Commitments only. No actual cash changes hands.

UNC Endowment NC Pension Fund Cal. PERS Parish Capital Pl ed ge Raising a Fund $$ ge $ $ Pledge $$ $ e g led $ P $ $ e g d e l P AIG Example Pled VC Firm (GPs) Fund 1 $$$$

VC Firm vs. VC Fund • One firm manages multiple funds • Funds are LLPs with 10 -year lifespans • Firms are LLCs with no end date

Fund Size • Large: – New Enterprise XIII, $2. 2 B, 12 GPs – Kleiner Perkins XIII, $700 M • www. Capitaliq. com • Local – Intersouth IV, $275 M – Southern Capitol II, $15 M

Fund Life: 10 Years Harvest Follow-On Rounds Invest and Reserve “Raise” Fund Year 0 5 10

Hit Milestones EXIT Series B Due Diligence Series A Find Startup Example Successful Investment Hit Milestones Harvest Follow-On Rounds Invest and Reserve 0 2 3 5 8 10

Exit 2 B 0 A A Pattern That Repeats 3 5 8 10

0 2 Exit B A One of Many 3 5 8 10

0 2 3 5 Bust B A Exit B A Big Exit C B A Bust B A D C B A Portfolio of 10 -25 Investments 8 10

0 2 1 3 8 5 Exit Big Exit A Bust B A Bust 9 10 B C B A D 3 B A 7 B B C A Exit A 6 Bust B 4 B Bust A 5 A A A 2 Exit B A Portfolio of 10 -25 Investments 11 8 10

0 2 3 5 Bust B A Exit B A Big Exit C B A Bust B A D C B A Exit Scenario Bust Exit 8 ? ? 10

First Fund Harvest Follow-On Rounds Invest and Reserve “Raise” Fund Year 0 5 10

First Fund 1 Raise $$ Year Invest 0 Follow-On 5 Harvest 10

Multiple Funds Fund 3 Raise $$$$ Invest Follow-On 0 Fund 2 Raise $$$ Invest 0 Fund 1 Raise $$ Invest 0 5 Follow-On 5 Harvest 10 Always fundraising Always investing Always growing

Fun d 2 Now Always fundraising Always investing Always growing Fund 3 d 1 Fun

Multiple Deals in Multiple Funds Fund 3 Raise $$$$ Invest Follow-On Fund 2 Fund 1 Raise $$$ Invest Follow-On Harvest 11 Deals Harvest

Multiple Deals in Multiple Funds 25 Deals Fund 3 Raise $$$$ Invest Follow-On Harvest Fund 2 16 Deals Fund 1 Raise $$$ Invest Follow-On Harvest Imagine you are this entrepreneur Raise $ Invest Follow-On Harvest 11 Deals

VC’s Job Cycle 1. Close Fundraise 1. Close Fund Source Deals Fundraise Source Deals 2. Invest Grow Ventures 3. Exit 2. Invest Fundraise… Grow Ventures

Source Deals: Focus • Sector – Life Sciences – IT – Cleantech • Stage – Seed/early – Later stage • Geography – Active investing requires proximity

Source Deals: Network • • • Lawyers, CPAs, CFOs, bankers Other VCs (syndication) Serial entrepreneurs Conferences Universities – Technology transfer – Teach, coach, mentor, judge

How Does a Round Work? Pre-Money Valuation $ + + Investment $ = = Post-money Valuation $$

Simplified Example: “ 1 on 2” Investment $1 M Pre-Money Valuation $2 M Pre-Money + $1 M Investment = $3 M Post

Simplified Example: 1 on 2 Investors 33% Founders 67%

Mechanics Include Shares 1, 000 Preferred Shares at $1/ea. Shares created in articles of incorporation 2, 000 Founders Shares @ $1/ea. New shares created and assigned to investors

How Does a Round Work? Negotiated Pre-Money Valuation $ + + Negotiated Investment $ = = Post-money Valuation $$

Valuation • How much the company is worth (akin to market cap) • Friends and family rounds are notoriously overpriced, creating potential for “down round” • Solution: convertible debt

Convertible Debt • Avoids “pricing the round” • Includes discount in next round • Eliminates “down round”

Milestones • Valuations should be tied to value creating events = milestones • Rounds should also be tied to milestones: raise only as much capital needed to hit milestone, thereby increasing valuation and decreasing dilution

Example $100 K $1 M Hit Milestones $5 M EXIT Series B Hit Milestones Series A Due Diligence Angel Round Find Deal Example Successful Investment Hit Milestones $50 M

VC’s Job Cycle 1. Close Fundraise 1. Close Fund Source Deals Fundraise Source Deals 2. Invest Grow Ventures 3. Exit 2. Invest Fundraise… Grow Ventures

Growing Ventures: Connecting VCs have vast networks to help with: • Forming strategic partnerships • Finding customers • Recruiting new management • Bringing in future investors “Active” participation = VCs on your board of directors

Board Seats • Board of directors controls the venture (unlike board of advisors) • Small ventures have small boards that meet often (quarterly), 3 -7 members • Odd number to prevent ties • % ownership should be reflected on board, majority controls

Dilution Added Shares Original Shares New Share Pool Same quantity of blue. Lower percentage.

Why Dilution is Bad Original Pool Every 1% you lose of a 20 X Exit is going to hurt 20 times more

VC’s Job Cycle 1. Close Fundraise 1. Close Fund Source Deals Fundraise Source Deals 2. Invest Grow Ventures 3. Exit 2. Invest Fundraise… Grow Ventures

VC Return • “Top Quartile” venture firms return >20% average ROI to LPs • Fund has life of 10 years • Average investments are 5 -7 years

LP 1 Invest Ca pit a $$ l Ca Portfolio ll LP 2 LP 3 LP 4 LPn Startup Cap $$ ital C $$ all Capital Call $$ all C l ita Cap $$ ll a l. C a t pi $ a $ C Startup $$ VC Firm (GPs) Startup $$ Fund 1 $$$$ Startup $$ Startup

LP 2 LP 3 LP 4 $$ $$ $$ LPn Exits dud Single dud $ LP 1 dud $ $$ $ $ VC Firm (GPs) Fund 1 $$$$ dud $$ Triple dud Single $$ $$$ $$ $ Double Home Run

Getting to 20% ROI • Rule of thumb: 3 X on entire fund • However, each investment is not 10 years – Money not “put to work” until a capital call – Exit could happen before end of fund • You could reach 20% with only 1. 5 X

Example • • $150 M fund 20% ROI for $150 M is $30 M/year 10 years = $300 M Plus original $150 M investment Need $450 M total! • Assuming $10 M per deal. . . two ventures need to exit at 20 X!!

How do GPs/VCs Make Money? • Management fee (~2%/year to cover expenses) for 10 years • “Carry” – % of capital gain that VCs keep – 20% benchmark – Requires liquidity event(s)

Angels • Rose from obscurity along with VCs during tech boom – New high net worth people – New interest from old high net worth people • Nowadays, tend to be VC, Jr. – Groups are common, loosely or highly organized • Used to be any high net worth individual

Angel / VC Conflict • • Not enough seed capital VCs have gone upstream Angels were pummeled after bust Need for early stage investing, but difficulty pricing the risk fairly (later money wins)

What is Venture Capital? • • • Startup cash Growth financing Equity investment Institutional funding “Hit driven” business model – Almost has to be tech – Not appropriate for 99% of startups

Questions? Coming up: Thursday: Idea Roundtable Next Monday: MBA 101 www. launch. unc. edu Patrick Vernon Clinical Asst. Professor, Interim Executive Director Center for Entrepreneurial Studies pvernon@unc. edu