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Venture Capital Financing

MBA 6314/TME 3413

October, 2003

VC and corporate finance Overview of VC industry The VC life cycle The VC investment process Negotiations Valuation and pricing Deal structure The Venture Capital Method The Shareholders Agreement Growing the business The exit

Conventional Financing
Inventory & receivables Land & buildings Equipment & vehicles Other

Liabilities & Equities Operating line of credit Mortgage Term loan 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

$160 $140 $120 $100

$16 $14 $12 $10 $8 $6 $4 $2 $0

$80 $60 $40 $20 $0 1995 1996 1997 1998 1999 2000 2001


Less $ to Big Deals Drives Decline

$ Invested by Transaction Size; Atlantic Region
$80 $70 $60
$48M $53M $53M $75M


$50 $40 $30 $20 $10 $0 1996 1997 1998 1999 2000 2001 >$5000K
$33M $23M




Technology Almost Exclusive Focus Disbursements in Canada


$7,000 $6,000 $5,000


$4,000 $3,000 $2,000 $1,000 $0 1996 1997 1998

$1,089M $1,774M $1,751M







Capital Markets Playing Field

Phase I Phase II Phase III

Knowledge Acquisition

Concept Investigation

Basic Design

Prototype Building

Market Entry

Manufacturing 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 Shareholders agreement Grow the company Exit

The Business Life Cycle

Typical SME Growth Profiles

High-Growth Firm

Sales ($ millions)

50 40 30 20
VC Prospects Moderate-Growth Firm

10 0 1 2 3 4 5 6 Years

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 doesnt 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 IngredientsTechnology/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 Startup First stage Second stage Bridge Restart IRR>80% 50-70% 40-60% 30-50% 20-35% ??

What are they prepared to pay for?

In later stage companies VCs 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 VCs have to value the ingredients and estimate what the cake might look like in 3 to 5 years!

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

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 40 sought

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 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

Future Rounds (Amounts, IRR, Horizon) Management incentives

The VC-Company Relationship

VC Fees The Shareholders Agreement Corporate Governance Exit

VC Fees
Commitment fee Termination fee Due diligence expenses Legal expenses All paid by company

Shareholders Agreement
Defacto control over critical decisions
Hiring/firing key management personnel Budgets and capital expenditures Financing Strategic changes Veto rights Dispute resolution

Shareholders Agreement
Exit Provisions
Put/ Call Rights Drag Along Rights Tag Along Rights Right of First Refusal Rights Valuation formula/process

Shareholders 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 VCs Liquidity for VCs 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. BMO Capital BDC Venture Capital Group Canadian Science and Technology Group Roynat Manulife EDC

CDP Accs Capital CDP - Sofinov Genesys Capital Partners Latitude Partners Ventures West Management Inc ETSIF Skypoint RBCP.