ENTREPRENEURIAL FINANCE Professional Venture Capital Chapter 11 1

ENTREPRENEURIAL FINANCE Professional Venture Capital Chapter 11 1

Chapter 11: Learning Objectives Discuss the history & current status of venture investing in the U. S. � Explain the professional venture investing cycle and its relevance to entrepreneurs seeking professional venture capital � List major elements in the design & structure of a venture capital fund � Describe the venture capital screening process & list characteristics central to determining a venture capitalist’s willingness to invest � Discuss the various roles a venture capitalist can take in providing financing and services to an emerging venture � Enumerate several terms or conditions to be negotiated when structuring venture capital financing � 2

Historical Development of Professional Venture Capital �Venture Capitalists (VCs): individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing ventures �Pre-World War II Era: Most venture investing came from wealthy individuals and families � 1946: Beginning of Professional VCs Formation of American Research & Development (ARD) 3

Historical Development of Professional Venture Capital (cont’d) �ARD’s Early Performance $3. 5 million was raised ($2 million from institutional investors) By end of 1947, ARD had invested in eight ventures, six of which were startups By 1951 the performance was still lack-luster (stock price was at $19 down from the initial offering price of $25 in 1946) 4

Historical Development of Professional Venture Capital (cont’d) � 1953: Small Business Administration (SBA) was formed Legislation permitted the federal government to actively engage in fostering new business formation � 1958: SBA Created Small Business Investment Companies (SBICs) Due to tax and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital 5

Historical Development of Professional Venture Capital (cont’d) �ARD’s Later Performance: In 1957, ARD had invested $70, 000 in the startup company Digital Equipment Corporation (DEC) 1972, ARD was sold for $813 Per Share Original ARD investors received a compound annual return of 14. 7% due primarily to DEC Without the DEC investment, the rate of return would have been only 7. 4% 6

Historical Development of Professional Venture Capital (cont’d) �Late 1960 s-Early 1970 s: Boom-Bust Cycle: Many SBICs began having operating problems due to the mixing of risky venture investments & high financial leverage (debt service commitments) � 1970 s: Professional VC organizational structure changes Movement to private partnerships from public firms & volatile financial markets 7

Dot. Com Bust and Recent History 8

Professional Venture Capital Investing Cycle 9

Useful Terms �Carried Interest: portion of profits paid to the professional venture capitalist as incentive compensation �Two and Twenty Shops: investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest 10

Organizing The Fund: VC Fund Placement Memorandum �Frontmatter Declarations �State Securities Disclosures �Offering Summary �Fund Overview �Executive Summary �Summary of Terms 11

Soliciting Investments: Suppliers of Venture Capital – 25 -Year Average 12

Obtaining Commitments: Arrangements with Fund Investors �Capital Call: when the venture fund calls upon the investors to deliver their investment funds Common to require subsequent investments consistent with the levels of investors’ initial contributions 13

Due Diligence and Active Investing: VC Fund Management �Deal flow: flow of business plans and term sheets involved in the venture capital investing process �Due diligence (in venture investing context): process of ascertaining the viability of a business plan 14

VC Screening Criteria � 1. Venture Capital Firm Requirements � 2. Characteristics of the Proposal � 3. Characteristics of the Entrepreneur/Team � 4. Nature of the Proposed Industry � 5. Strategy of the Proposed Business 15

VC Screening Criteria 1. Venture Capital Firm Requirements Cash out potential Equity share Familiarity with technology, product, market Financial provisions for investors Geographic location Investor control 16

VC Screening Criteria Venture Capital Firm Requirements (cont’d) Investor control Investor group Rate of return Size of investment Stage of development 17

VC Screening Criteria 2. Characteristics of the Proposal Requirement for additional material Stage of plan 18

VC Screening Criteria 3. Characteristics of the Entrepreneur/Team a. Ability to evaluate risk b. Articulate regarding the venture c. Background/experience d. Capable of sustained effort e. Managerial capabilities f. Management commitment g. References h. Stake in firm 19

VC Screening Criteria 4. Nature of the Proposed Industry Market attractiveness Potential size Technology Threat resistance 20

VC Screening Criteria 5. Strategy of the Proposed Business Product differentiation Proprietary product 21

Screening Outcomes � 1. Seek lead investor position � 2. Seek a non-lead investor position � 3. Refer venture to more appropriate financial market participants � 4. SLOR (standard letter of rejection) the venture 22

Structuring a VC Investment � Term Sheet: summary of the investment terms and conditions accompanying an investment � Typical Issues Addressed in a Term Sheet Valuation Ongoing funding needs Size and staging of financing Preemptive rights on new issues Commitments for future financing rounds and performance conditions Form of security or investment Redemption rights and responsibilities 23

Structuring (cont’d) Typical Issues Addressed in a Term Sheet Dividend structure (Number of VCs and outsiders) Additional management Conversion value protection Registration rights Exit conditions and strategy IPO-dictated events (e. g. conversion) Co-sale rights (with founders) Lock-up provisions 24

Structuring (cont’d) Typical Issues Addressed in a Term Sheet Employment contracts Incentive options Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock at termination, term of agreement, post-employment activities and competition Founder stock vesting Confidentiality agreements and protection for intellectual property 25