dynamics and structure of venture rounds

© Copyright 2003 Sentient Ventures

Dynamics and Structureof Venture Rounds

David M. Lee

29 January 2003


Agenda

Sources of Funding

Rounds of Financing

Liquidation of a Company

Stock Option Plan

State of Venture Capital

Alternative Funding Sources


Idea

Business Plan

Prototype

Beta

Sales

Profitability

Decreasing RiskDecreasing Risk

$ 1M

$ 50M

$ 100M

Dec

reas

ing

Ret

urn

Dec

reas

ing

Ret

urn

Venture Capital Banks

AngelsFFF Gov’t

IPOStrategic Partners

Sources of Funding


Building the Syndicate

Getting a Lead investor is always the hardest part• Once a VC is in, he/she wants to get friends and others• No re-negotiation of most of the terms

However, there is still work to do:• Additional due diligence• Presentations and meetings

The syndicate needs to be one that is going to help the company with more than just money.


When to Raise Money

0 1 2 3 4 5 6

Val

uati

on0

5

0

100

150

20

0 2

50

300

Years

Balance Conservative Cash Needsvs.

Valuation

Based on Funding Milestonesplus

At Least 6 Months ToRaise the Next Round


Early StageStage: Early Stage

Financing Seed First Round

Stage Development Revenue

Management Team Partial Complete

Employees 1 - 10 10 - 25

Product Idea - Beta Beta - GA version 1

Cash Management:Burn Rate (Monthly) $5,000 - $50,000 $75,000 - $187,500

Revenue (Annual) $0 - $0 $0 - $2,000,000

Customers 0 - 0 0 - 4

Earnings Before Tax (%) - - - - - -

Earnings Before Tax (A) - - - - - -

Funding $50,000 - $750,000 $1,500,000 - $5,000,000

Cash/Burn Rate (Months) 10 - 15 20 - 27

Valuation (Post-Money) $500,000 - $3,000,000 $3,000,000 - $15,000,000

Ownership: (Best Case)Employee Ownership 20% 13%

Founder Ownership 55% 37%

Founder Value $1,650,000 $5,500,000

Investor Ownership 25% 50%

Investor Acq. In Round 25% 33%

Expense/Employee Breakdown:Board of Directors 3 to 5 internal 2 int., 2 inv., and 1 ind.

R&D 85% 70%

Cost of Maintenance 0% 3%

Sales 0% 5%

Services 0% 4%

Marketing 0% 5%

G&A 15% 13%


Early Stage

Seed Stage• Should be convertible debt• Salaries are for the most part deferred (personally need 18 months cash)• Develop Beta product• FFF funding – friends, families, and fools• R&D line share of expense (85%)• Initial option pool (25%) – dilution created beyond investor ownership• Lose control of the board (2,2,1)

First Round• Series A Preferred• First opportunity for real payroll (be ready for this – CEO last paid)• Develop first GA product• Financing commitments milestone based• Initiates longest growth cycle (up to 2 years)• Founders still own 1/3rd of company• R&D remains the line share of expense, but Sales & Marketing execs hired• Lose control of company (50% owned by investors, preferred rights)


Expansion/StrategicStage: Expansion/Strategic

Financing Second Round Third Round

Stage Breakeven Profitability

Management Team Upgraded Complete

Employees 25 - 75 75 - 150

Product GA version 2 GA version 3

Cash Management:Burn Rate (Monthly) $250,000 - $750,000 $750,000 - $1,500,000

Revenue (Annual) $2,000,000 - $6,000,000 $6,000,000 $15,000,000

Customers 4 - 12 12 - 30

Earnings Before Tax (%) 0% - 5% 5% - 15%

Earnings Before Tax (A) $0 - $300,000 $300,000 - $2,250,000

Funding $5,000,000 - $7,500,000 $7,500,000 - $15,000,000

Cash/Burn Rate (Months) 20 - 10 10 - 10

Valuation (Post-Money) $15,000,000 - $20,000,000 $20,000,000 - $50,000,000

Ownership: (Best Case)Employee Ownership 12% 12%

Founder Ownership 21% 14%

Founder Value $4,283,333 $7,045,833

Investor Ownership 66% 74%

Investor Acq. In Round 38% 30%

Expense/Employee Breakdown:Board of Directors 2 int. 2 inv. and 1 ind. 2 int., 4 inv., and 1 ind.

R&D 55% 40%

Cost of Maintenance 5% 7%

Sales 10% 15%

Services 6% 8%

Marketing 12% 19%

G&A 12% 11%


Expansion/Strategic

Second Round• Breakeven is key to round• Management team upgraded (1st major transition, gain traction)• Version 2.0 – real product ready (death march)• Must have at least half a dozen reference accounts to move forward• Already need to increase option pool• CFO and direct sales channel developing (indirect sales secondary)

Third Round• Strategic investor often comes in (be careful)• Enhancements requests clump to make new GA release• Earnings only on paper because still investing for growth• Another option pool increase• Services, Sales, and Marketing now 50% of the budget• Amount of money now invested will force an exit, regardless


Later StageStage: Later Stage

Financing Mezzanine

Stage Growth

Management Team Upgraded

Employees 150 - 300

Product GA version 4+

Cash Management:Burn Rate (Monthly) $1,500,000 - $3,000,000

Revenue (Annual) $15,000,000 - $80,000,000

Customers 30 - 160

Earnings Before Tax (%) 15% - 20%

Earnings Before Tax (A) $2,250,000 - $16,000,000

Funding $15,000,000 - $20,000,000

Cash/Burn Rate (Months) 10 - 7

Valuation (Post-Money) $50,000,000 - $75,000,000

Ownership: (Best Case)Employee Ownership 9%

Founder Ownership 10%

Founder Value $7,750,417

Investor Ownership 81%

Investor Acq. In Round 27%

Expense/Employee Breakdown:Board of Directors 3 int., 5 inv., and 1 ind.

R&D 25%

Cost of Maintenance 8%

Sales 20%

Services 15%

Marketing 21%

G&A 11%


Exit Preparation

Mezzanine Round• Optional round (generally taken out by M&A)• Another upgrade of management team (IPO, >$30M)• No longer able to develop one-off products• Not a time to be conservative and limit funds raised• R&D now 25% or less of the company• Founders own 10%, but remain paper millionaires – over $7.5M• Employees own 9%• VCs/Investors own 81%

$200M Exit• VCs make $160M for $50M invested• Founders make $20M for 6 years of sweat equity• Employees split $18M for various investments of up to 6 years


Liquidation of a Company

“Waterfall” for payout

Example, $50M deal with $23M invested• $500K - Accounts Payable• $7.5M - Incentive Pool and Bankers Fees (15%)• $3M - Bridge Note Holders with Interest• $39M - ($20M x 3 = $60M) - Preferred Share Holders (In Reverse

Order with Liquidation Preferences)• $0 - Common Share Holders, Warrants, and Options


Purpose of S.O.P.

Alignment of Interests• Distribute enterprise value to employees

Provide incentives to employees to work harder• More effective in early-stage companies

Conserve cash• Allows start-ups to be competitive with established companies

Retention


Size of the S.O.P.

Generally 10% - 25% of the overall equity• Depends upon stage of the company• Depends upon how many founders are part of management• Depends upon how much additional funding is required

For public companies, this is generally 10% to 15%


Type of employee-ownership

Founders’ shares (outright ownership)

Stock grants

Stock Options• Incentive Stock Options (ISO)• Non-qualifying (NQ)


Purpose of “Vesting”

Hand-Cuffs - Force founders and employees to remain part of the company to receive the full value of their stock

• Especially “Golden” Hand-Cuffs

Reinforce the idea that enterprise value is built going forward


Elements of a Vesting Schedule

Total vesting time• Typically 3-5 years; 4 is typical

The “cliff”• Period of time during which none of the stock (or options) vests.

Typically the first year of employment.

Monthly vesting• Percentage of the stock (or options) which vests at the end of each

month of employment. Depends upon total vesting time.

Hint: Ownership percentage!!!


Vesting vs. Reverse Vesting

Reverse vesting generally only applies to “founders’ stock”• It really is a stock repurchase agreement with a similar schedule to

vesting• Founders typically get 1/4 to 1/3 vested up-front• Founders own and can vote all shares as long as employed by the

company


Pricing Stock Options

For public companies – current market value• Different specific methods, but basically a ten day trailing average

For private companies - ????• With venture backed firms, can use =>10% of last round price


Region – Q3 ‘02 – PWC Moneytree

Regions Invested Percent Deals

Silicon Valley $1362M 30.01% 160 New England $560M 12.34% 83

Southeast $469M 10.33% 68 NY Metro $284M 6.27% 52

Texas $276M 6.09% 41 DC/Metroplex $274M 6.05% 51

LA/Orange County $263M 5.79% 32 Northwest $203M 4.48% 39

Midwest $199M 4.39% 40 San Diego $176M 3.88% 25

North Central $147M 3.25% 12 SouthWest $99M 2.18% 12

Philadelphia Metro $93M 2.06% 19 Upstate NY $50M 1.10% 7

Colorado $46M 1.02% 13 Sacramento/N.Cal $31M 0.67% 4

South Central $3M 0.07% 3 AK/HI/PR $1M 0.01% 1

$4.5B and 662 deals


Industry – Q3 ’02 – PWC Moneytree

Industries Invested Percent Deals

Software $1048M 23.10% 193 Telecommunications $637M 14.03% 71

Biotechnology $476M 10.49% 49 Medical Devices and Equipment $433M 9.54% 49 Networking and Equipment $340M 7.49% 39

Semiconductors $273M 6.03% 30 IT Services $236M 5.21% 42 Computers and Peripherals $213M 4.70% 23 Industrial/Energy $179M 3.96% 30 Financial Services $148M 3.27% 20

Media and Entertainment $132M 2.92% 31 Business Products and Services $122M 2.70% 25 Healthcare Services $99M 2.19% 14

Consumer Products and Services

$78M 1.73% 16 Retailing/Distribution $78M 1.72% 15

Electronics/Instrumentation $40M 0.88% 14 Other $2M 0.04% 1


Stage – Q3 ’02 – PWC Moneytree

Stages Invested Percent Deals

Expansion $2604M 57.38% 371

Early Stage $948M 20.88% 162

Later Stage $929M 20.48% 94

Startup/Seed $57M 1.26% 35


Alternatives

SBIR Grants

Consulting

Garage

Virtual Team/Contingency Contracts

University Research

Joint Development

dynamics and structure of venture rounds

Documents

investor ownership

employee ownership ownership

founder ownership

round management team

round breakeven

early stage seed stage

round series

optional round