venture capital investing a primer william quigley managing director clearstone venture partners...

Venture Capital InvestingVenture Capital Investing

A PrimerA Primer

William QuigleyWilliam Quigley

Managing DirectorManaging Director

Clearstone Venture PartnersClearstone Venture Partners

william@clearstone.comwilliam@clearstone.com

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Venture CapitalVenture Capital

“I was seldom able to see an opportunity until it had ceased to be

one”

Mark Twain

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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Industry SnapshotIndustry Snapshot

400+ institutional VC firms in the U.S. Geographically concentrated Stage/Industry focused General partners/Limited partners 10 year investment horizon Co-investment with other VC’s common

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Typical Firm ProfileTypical Firm Profile

3 to 4 investment professionals Review 1000+ business plans a year Manage $50 to $200 million in capital Buy equity (preferred stock) - rarely make loans Investment horizon - 3 to 6 years Sources of capital:

- Pension funds - Corporations

- College endowments - Wealthy individualsC L E A R S T O N EV E N T U R E P A R T N E R

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Investment StagesInvestment Stages

Five Stages:– Seed

– Start-up

– Early

– Expansion

– Mezzanine/Bridge

Most VC’s have a preference for a particular investment stage.

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Stage/CharacteristicStage/Characteristic

Stage Investment CharacteristicsSeed $50-500K - Founder(s) only

- No product- No customers- Primary risk: R&D

Start-Up$500K to $1MM - Mgmt. team incomplete- Prototype or beta product- No revenues- Limited customer interest- Some capital invested- Primary risk: market accept.

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Stage/CharacteristicStage/Characteristic

Stage Investment CharacteristicsEarly $1MM - $3MM - Most of team in place

- Limited revenues- Not profitable- Primary risk:execution

Expansion $3MM - $10MM - Meaningful revenues- Achieving profitability- Growing customer

base- Primary risk:

competition

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Stage/CharacteristicStage/Characteristic

Stage Investment CharacteristicsMezzanine/ $10MM - $20MM - Significant revenues

Bridge - Profitable- Industry player- IPO in 6-12 months- Risk much lower

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The Role of the VCThe Role of the VC

Board involvement Management

recruitment Future capital raising Access to business

network Strategy development Patience!

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Targeted IndustriesTargeted Industries

• Information Technology• Medical Services/Devices• Communications• Biotechnology• Some Retail

Most of the $10 billion invested by VC’s in 1997 was concentrated in five industries. Why these?

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How Do VC’s Make Money?How Do VC’s Make Money?

– Collect management fees from L.P.’s - 2 1/2% annually

– Share profits with L.P.’s - 20/80 split on investment gains 5%

95%

Mgmt. Fee Investment Gains

How do VC’s earn their income?

Source of VC Income:

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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What Do VC’s Want to See?What Do VC’s Want to See?

Areas of Focus:• Management• Marketplace• Competition• Business Economics• Risks

Venture capitalists tend to focus on five specific areas when evaluating a company:

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ManagementManagement

VC Focus:– DIRECT sales experience?

– Prior P/L responsibility?

– Personal financial stake?

– Willingness to share equity

– “Fire in the belly”?

– Functional areas covered?

The most important question: Has the team had experience and success in the same industry?

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MarketMarket

VC Focus:– Market size and growth

rate?

– Market drivers?

– Customer involvement in the R&D process?

– Number of competitors?

Can management demonstrate a thorough understanding of the marketplace dynamics?

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CompetitionCompetition

VC Focus:– Why are competitors

successful?– What is the prevailing

business model?

– Barriers to entry?

Does management have a clear understanding of the competitive landscape?

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Business EconomicsBusiness Economics

VC Focus:– Margins comparable to

industry norm?

– Break-even < 2 years ?

– Appropriate sales model?

– Moderate capital intensity?

Does management have a deep understanding of the financial dynamics of the business and industry?

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RiskRisk

VC Focus:– Reasonable financial projections?

– New technology adoption rate?

– Length of sales cycle?– Best and worst case scenarios

explored?– Regulatory hurdles?

Does management recognize, accept, and have strategies to deal with key risks?

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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The Venture Capital ProcessThe Venture Capital Process

Business Plan First Meeting Second Meeting Term Sheet Due Diligence Negotiations

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Business PlanBusiness Plan

“Madam, enclosed please find the novel you commissioned. It is in two volumes.

If I had had more time I could have written it in one.”

Voltaire

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Business PlanBusiness Plan

Business Plan Basics:– Written by the entrepreneur– Keep it short– Financials (3-5 year proj.)

• Income statement• Balance sheet• Cash flow• “What-ifs” helpful

#1 objective of the the business plan: Get the VC interested in hearing more about the opportunity.

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Business PlanBusiness Plan

50 5 10

Magic Numbers?

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Business PlanBusiness Plan

We have no competition…. We conservatively project….. We only need a 10% market share…. We will offer the most features at the lowest price…. We valued our Internet start-up using multiples of

comparable companies…like Netscape, Cisco, Microsoft.…

Business plan phrases that ‘spook’ VC’s...

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First MeetingFirst Meeting

The Details:– Location: VC’s office

– Duration: 2-3 hours

– Attendees: 1 to 2 VC’s

– Format: Formal presentation with Q/A

‘Skepticism’ might best describe the venture firm’s attitude in the first meeting. Don’t be alarmed by this.

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Second MeetingSecond Meeting

Focus On :• Business opportunity - not

the technology

• Addressing concerns of the skeptics - THIS IS CRITICAL!

• Next steps

Getting to the second meeting is an important milestone. The team will now make its case to the entire partnership.

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What Went Wrong? - A Few TipsWhat Went Wrong? - A Few Tips

Dont’s• Make vague, ambiguous, or unsubstantiated

statements• Make reference to unnamed/ mysterious people on

the management team• Use statistical arguments for market penetration

assumptions• Use technical jargon• Assume you have a deal if there is no term sheet

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What Went Wrong? - A Few TipsWhat Went Wrong? - A Few Tips

Dos

• Involve the entire team

• Discuss/disclose potential problems

• Demonstrate financial commitment to the venture

• Prepare realistic market and sales projections

• Know your target investor (angel, bank, VC)

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What Went Wrong? - Getting FeedbackWhat Went Wrong? - Getting Feedback

Some Guidelines:– Needs to be solicited!

– From knowledgeable sources

– Develop a dialogue first

– Avoid answering, debating

– Have a market-researcher mindset

“The greatest gift that God hath given us is to see ourselves as others see us.”

Scottish Proverb

Getting honest feedback can be challenging…

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Term SheetTerm Sheet

Term Sheet - Common questions:– Is it a legally binding

document?– What’s covered?– What is it designed to do?– Why participating preferred

stock?

After the second meeting, the VC typically provides a term sheet to the entrepreneur.

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Term Sheet ConditionsTerm Sheet Conditions

Post-money valuation $ amount of the financing Investors identified Size of employee option

pool Vesting periods Key-person insurance

Board representation Additions to management

team, if any Monitoring covenants,

Restrictive covenants Other deal specific issues

The term sheet is intended to embody the overall conditions of a business agreement. What’s covered?

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Due DiligenceDue Diligence

Due Diligence Overview:– Length: 6-12 weeks

– Will perform up to 100 reference calls

– Interview customers, former employees, competitors, industry experts

– Intense legal, financial work

The “heavy lifting” for the venture capitalist starts with the due diligence process.

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NegotiationsNegotiations

Some flexibility in:

– Valuation

– Total investment

– Vesting periods

– Size of option pool

Less flexibility in:

– Equity instrument type

– Board make-up

– Anti-dilution rights

– Restrictive covenants

Negotiations take place throughout the due diligenceprocess. What is negotiable?

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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The Business PlanThe Business Plan

Executive SummaryMain BodyAppendix

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Executive SummaryExecutive Summary

Mission statement Brief company history Description of

investment opportunity

Market overview

Management team Product & technology Customers Strategy Competition Capital requirements

What should the executive summary address?

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Main BodyMain Body

Key Questions to Address:

Who are the key people in the company?

Where did they come from, and why are they the right people to run the company?

Have they had previous experience and success in growth companies?

Management

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Main BodyMain Body

Key Questions to Address:

What does the customer have access to today?

How does it differ from competing offerings

What is the superior value proposition to the customer?

Product/Technology/Service

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Main BodyMain Body

Key Questions to Address:

What is happening in the marketplace? Is it growing, if so, why and at what rate?

What is lacking from the market leaders that this product/tech/service will provide?

Which customers have been involved in the development of the product and are likely to purchase it?

Marketplace

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Main BodyMain Body

Why will the customer be compelled to purchase the product?

How will the company maintain its competitive differentiation?

What barriers exist/will be created to curtail new entrants?

Strategy

Key Questions to Address:

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AppendixAppendix

Relevant industry articles to bolster management claims

Major customer testimonials

Other information likely to impress those not familiar with the market

Not all business plans require an Appendix section, but it can be useful. What to include?

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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ValuationValuation

Stage Criteria Methodology Range

Seed - Mgmt. track record Comparables, $400K to $1.5MM - Market size/growth Whats the “going - Competition rate” in the region - Investment to date

Start-up - Market size/growth Comparables $750K to $2.0MM - Working prototype? - Team complete?

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ValuationValuation

Stage Criteria Methodology Range

Early - Market size/growth Comparables $1.5 to $5.0MM - Revenue run rate - Gross margin % - Performance to date

Expansion - Revenue run rate - 1X sales Varies - Profitability ratios - EBIT multiple - Performance vs. plan

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ValuationValuation

Stage Criteria Methodology Range

Mezzanine/ - Market share/size Multiples of VariesBridge - IPO environment proxy companies

- Performance Relative to plan

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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Exit StrategiesExit Strategies

• Sale or Merger– Most likely exit

• Initial Public Offering– Small fraction go this way

• Redemption– Least attractive

• Management buy-out– Generally not possible

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Secrets of Success?Secrets of Success? CEO carried a bag Called on same customer base Gross margin > 50% Some degree of technology Cash flow break-even < $5M Sourced the deal 25% ownership or greater First institutional investor

The Eight Commandments

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Odds of Getting a Deal Done?Odds of Getting a Deal Done?

Hurdle Likelihood of Occurring

1. Review the plan and - 1 in 15 conclude it makes sense

2. Meet the team and like them - 6 in 10

3. Be attracted to the market - 7 in 10 opportunity and the company strategy

4. Introduce team to the other partners and get their buy-in - 7 in 10

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Odds of Getting a Deal Done?Odds of Getting a Deal Done?

Hurdle Likelihood of Occurring5. Complete the due diligence - 7 in 10

process satisfactorily

6. Get a term sheet agreed to - 8 in 10 in principle

7. Find co-investors - if necessary - 9.9 in 10

8. Get legal documentation done - 9 in 10

9. Fund the company EQUATES TO 1%

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Commonly Asked QuestionsCommonly Asked Questions

“Will I have to give up control of my company?”

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Commonly Asked QuestionsCommonly Asked Questions

“Why don’t VC’s sign NDA’s?”

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Commonly Asked QuestionsCommonly Asked Questions

“Raising money - all at once or spread out over time?”

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Commonly Asked QuestionsCommonly Asked Questions

“Its a great invention, so why aren’t they interested?”

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Commonly Asked QuestionsCommonly Asked Questions

“Why do VC’s want to know the other firms that I am talking to?”

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Commonly Asked QuestionsCommonly Asked Questions

“When should I initiate contact with a VC?”

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Venture CapitalVenture Capital

Industry OverviewIndustry Overview

Screening Venture OpportunitiesScreening Venture Opportunities

The Venture Capital ProcessThe Venture Capital Process

The Business PlanThe Business Plan

Valuation Valuation

ExitExit

Getting in TouchGetting in TouchC L E A R S T O N EV E N T U R E P A R T N E R

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How do you Contact a VC?How do you Contact a VC?

Introductions are best:– Attorney

– Accountant

– Banker

– Angel Investor

– Industry Executive

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The Michael Dingman Center at U of MD. The Morino Institute - Netpreneur Program Baltimore/Washington Venture Group NVTC - Emerging Business Network functions Silicon Valley Bank, other community banks Private Investors Network, Grubstakes (networks

of angel investors) Pratts Guide to Venture Capital

Local Resources

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Venture Capital Venture Capital

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