Exam 3 Content Materials

New Venture DevelopmentSpring 2013

Major content areas

1. How venture capital works2. How venture capitalists evaluate

opportunities3. The four pillars of growth4. Business model generation5. Business planning

How venture capital works

Zider, R. 1998. How venture capital works, Harvard Business Review, November-December, 131-139

VCs invest in high potential growth companies that will be game changers in their industries.

If you work in an industry that is attracting attention from VCs, be ready for radical change

VC system works for

• Entrepreneurs• Institutional investors• Investment bankers• Venture capitalists

Zider, 1998

Filling the void

• Venture capital plays an important role in the stage of the company’s innovation life cycle when it begins to commercialize its innovation

• > 80% of VC $ goes into building infrastructure needed to grow the business – in expense investments (mfrg capacity, marketing, sales) and the balance sheet (working capital and fixed assets)

Zider, 1998

Timing is everything

• > 80% $ invested by VCs goes into adolescent phase of a company’s life cycle

• During this phase the financials of eventual winners and losers look highly similar

Zider, 1998

The “adolescence” stage

Zider, 1998

Several moving parts in execution: Assume 80% probability of success each

Zider, 1998Failure on any single step is NOT an option

Logic of the deal

• Term sheets offer downside and upside protections

• Downside– Preferred stock gives VCs liquidation preference– Ratchets protect VCs from dilution if more $ needs to

be raised at lower valuation – they keep their same % ownership position

• Upside – can put additional $ into firm at predetermined prices – they can increase the stakes in successful firms below market prices

Typical portfolio payout per $1,000 invested

Zider, 1998

Zider, 1998

Profile of the ideal entrepreneur• Is qualified in a “hot” area of interest• Delivers sales or technical advances such as FDA

approval with reasonable probability• Tells a compelling story and is presentable to outside

investors• Recognizes the need for speed to an IPO for liquidity• Has a good reputation and can provide references

that show competence and skill• Understands the need for a team with a variety of

skills and therefore sees why equity has to be allocated to other people Zider, 1998

Profile of the ideal entrepreneur

• Works diligently toward a goal but maintains flexibility

• Gets along with the investor group• Understands the cost of capital and typical

deal structures and is not offended by them• Is sought after by many VCs• Has realistic expectations about process and

outcome

Zider, 1998

Value of an individual to a VC

• Is a function of these conditions:– # of people within the high-growth industry who are

qualified for the position– The position itself (CEO, CFO, CTO, technician)– Match of person’s skills, reputation, and incentives

to the VC firm– Willingness to take risks– Ability to sell oneself

• Entrepreneurs who satisfy these conditions have strong negotiating position with VCs

Zider, 1998

Entrepreneurs sought by multiple VCs should ask:

• Who will serve on board and what is that person’s position in the firm?

• How many other boards does the VC serve on?• Has the VC ever written and funded his or her own

business plan successfully?• What, if any, is the VC’s direct operating or technical

experience in this industry?• What is the firm’s reputation with entrepreneurs

who have been fired or involved in unsuccessful ventures?

Zider, 1998

Considerations for entrepreneurs

• Understand what VCs want and reduce the uncertainty in their decision making• Understand how VCs will structure

capitalization – you want 20% of a $500M company, not 100% of a $100,000 one• Innovate and sell into a new, high-growth

market

How venture capitalists evaluate potential venture opportunities

New Venture Development

Key questions

• How do you evaluate potential venture opportunities?

• How do you evaluate the venture’s prospective business model?

• What due diligence do you conduct?• What is the process through which funding decisions

are made?• What financial analyses do you perform?• What role does risk play in your evaluation?

How do you think about potential exit routes?

Evaluating potential venture opportunities

1. Large market opportunity in fast-growing sector

• Explosive growth – difficult for others to catch up and for incumbents to respond

• $100 to $300 M revenue stream within five years

• Market potential needs to be > $500M to get 25% market share

Evaluating potential venture opportunities

2. Competitive advantage – as unfair as possible

• Network effect like eBay or operating system lock-in like Microsoft

• Usually based on difficult engineering problem that takes years to solve

• Patents OK, but competitors work around them

Evaluating potential venture opportunities

3. Team• Strong technical founder for technical problem + a

sales-oriented entrepreneur• Founder understands thrusts of technology and

industry dynamics around it• Entrepreneur drives other parts of the business and

sells the vision to investors• Vision, execution, sales, and entrepreneurship

Evaluating potential venture opportunities

4. Other factors• How much pain does the customer feel, and

how much will he pay to solve it?• Market opportunities (2 types)– Replacement for existing product: better, faster,

cheaper– New-to-the-world product with less market

certainty and greater risk

Evaluating the business model

• Two kinds of investments opportunities• First is a company capable of executing better or

offering a better version of an existing product or service – market is proven

• Second, completely new markets or business models where they think they understand their bets: e.g., Friendster or Webvan

Due diligence

• VCs hire professors and technical experts to meticulously study a new technology. Too hard to be done? Or are they asking the right questions?

• Determine customers’ real needs and their willingness to pay

• Industry experts about the idea, team , market, and market need

• Entrepreneur and team – call references and blind references

• Some firms require 2 general partner sponsors and a devil’s advocate to raise objective questions

Financial analysis?

• Revenue and expense models• VCs look at expense model first to determine

break-even point [FC/(VR-VC)]• Create their own revenues models – not top-

down, but bottoms-up, which becomes a fraction of the top-down estimate in the business plan

Role of risk

• Consider technical, competitive, and market risks before investing in a company

• Track milestones around product, first beta customers, first revenue customers

Potential exit routes

• Market cap > $200 M, • + Revenues > $60 - $80 M• = large enough market for an exit• Plus consideration of likely acquirers• IPO always most profitable exit

The four pillars of organic growth

Summary of Joel Spolsky (CEO of Fog Creek Software) article in Inc. Magazine

http://www.inc.com/magazine/20080101/how-hard-could-it-be-the-four-pillars-of-organic-growth.html

The four pillars

• Revenue• Head count (i.e., employees)• PR (i.e., advertising and market growth)• QualityEach of these pillars must grow in tandem with the other

Revenue

• Scenario 1: Revenues grow faster than the rate at which you can hire.

• The result: poor customer service. • Staff members will probably become

overworked and demoralized. They will take days to get back to prospective customers, by which time those prospective customers will have gone to one of your competitors.

Employees

• Scenario 2: Hire employees faster than you can reasonably expect the quality of your product to improve

• The result: New hires don't have a chance to learn the company culture and the founder's values from experienced hands – the quality of work they do and the quality of service they provide are inferior

• The fastest you should hire employees is the rate at which they can learn to do their jobs

Advertising / market awareness

• Scenario 3: PR grows faster than the quality of your product

• If you haven't worked out the kinks, a lot of people who are interested in your business become tire kickers rather than paying customers

• Many of these customers will be permanently convinced that your product is simple and inadequate, even if you improve it drastically later on

Quality

• Scenario 4: You have a lot of money to promote your products and hire employees

• It is hard to improve product quality at the same pace, because that takes time – especially with high-tech products.

• It takes time for any new employee time to learn the business and how to play his or her role correctly.

• It takes years for a business to create sustainable and predictable market demand (e.g., repeat customers) so $ and people do not translate into a sustainable market

Take-aways

• A company that lands a big investment too early is often worse off, not better – it often finds itself in a situation where it is much harder to make that investment pay off

• Saying “no” to opportunities that promise your company a great leap forward is contradictory to what we’ve been taught – but if the result is that your business is easier to manage and more likely to please its customers, how can you afford not to?

Four pillars in action

Revenues

Quality

Employees

Advertising / market awareness

Business Models

Using the “business model canvas”

The business model canvas

1 Customer Segments

The Customer Segments Building Block definesthe different groups of people or organizations anenterprise aims to reach and serve

Customer Segments

Customer groups represent separate segments if:• Their needs require and justify a distinct offer• They are reached through different distribution

channels• They require different types of relationships• They have substantially different profitabilities• They are willing to pay for different aspects of the

offer

Examples of Customer Segments

• Mass market• Niche market• Segmented• Diversified• Multi-sided platforms (or multi-sided markets)

2 Value PropositionsThe Value Propositions Building Block describes the bundle of products and services that create value for a specific Customer SegmentThe Value Proposition is the reason why customers turn to one company over another.

Examples of Value Propositions

• Newness• Performance• Customization• “Getting the job done”• Design• Brand/status• Price

3 Channels

The Channels Building Block describes how a company communicates with and reaches its Customer Segments to deliver a Value Proposition

Channels

• Communication, distribution, and sales Channels comprise a company's interface with customers.

• Channels are customer touch points that play an important role in the customer experience.

Channels

• Channels serve several functions, including:– Raising awareness among customers about a

company’s products and services– Helping customers evaluate a company’s value

Proposition– Allowing customers to purchase specific

products and services– Delivering a Value Proposition to customers– Providing post-purchase customer support

Channels – Key Questions

• Through which Channels do our Customer want to be reached?

• How are we reaching them now?• How are our Channels integrated? • Which ones work best?• Which ones are most cost-efficient? • How are we integrating them with customer

routines?

Channel phases

1. Awareness: raise awareness about products and services

2. Evaluation: help customers evaluate product3. Purchase: how do customers purchase?4. Delivery: deliver the value proposition to the

customer5. After sales: provide post-purchase customer

support

4 Customer relationships

• The Customer Relationships Building Block describes the types of relationships a company establishes with specific Customer Segments

• Driven by customer acquisition, retention, and upselling

Categories of customer relationships

• Personal assistance• Dedicated personal assistance (bankers for high net

worth individuals)• Self-service (no direct relationship with customer)• Automated service (personal online profiles give

access to personalized services)• Communities (especially online)• Co-creation (e.g., Amazon’s customers write reviews,

eBay’s seller ratings)

5 Revenue Streams

1. Transactions from one-off customer payments

2. Recurring revenues from ongoing payments for continuous delivery of value proposition or post-purchase consumer support

Revenue Streams come from

1. Asset sales – sales of a physical product2. Usage fee – minutes on phone, nights in hotel room3. Subscription fees – selling continuous access to a service4. Lending/renting/leasing – temporarily grant exclusive

access to an asset5. Licensing – give customers permission to use protected IP6. Brokerage fees – intermediation services7. Advertising – fees for promoting product, service, or

brand

6 Key resources

• Allow the business to create and deliver the value proposition, reach customers, maintain relationships, and generate revenues

• Physical, financial, intellectual, human ; owned, leased, or borrowed

7 Key activities

• Actions a company must take to be successful• Microsoft – develop software, Facebook –

develop platforms, Dell – supply chain management, McKinsey – problem solving

• Categories: production, problem solving, platform/network

8 Key partnerships

• Alliances to optimize business models, reduce risk, or acquire resources

• Four types1. Strategic alliances between non-competitors2. Cooperation between competitors3. Joint ventures to develop new businesses4. Buyer-supplier relationships to ensure reliable

supplies

9 Cost structure

• The costs associated with the other 8 pieces of the business model

• Approaches: cost-driven versus value-driven• Characteristics: fixed, variable, economies of

scale, economies of scope

The Business Plan

Why write a business plan?

• Always when a new venture needs outside funding

• Early in the planning process when you are looking at a large-scale project

• Later or not at all when you are bootstrapping

Dollinger, 2008

Costs and benefits of planning

• Writing a plan takes considerable time, money, and energy

• Every plan deals with economic uncertainty and risks posed to new venture – founders may be uncomfortable confronting risks and uncertainties and avoid writing a plan

• Writing the plan helps founders confront risks and conflicts before they become serious problems

Dollinger, 2008

The plan demonstrates how you

1. Create or add significant value to a customer or end user

2. Solve a significant problem or meet a significant need for which someone is willing to pay a premium

3. Have robust market, margin, and money-making characteristics

4. Have a good fit with the founders, management team at time of market entry, and the risk/reward balance

Timmons, 1999

After you write the plan

• It becomes a point of departure for due diligence for potential investors and to determine risks of venture (technology, market, management, competitive, financial risks)

• This homework is crucial even if you don’t try to raise outside capital

• The most valuable investors will see weaknesses, even flaws, and will propose tactics and people to fix them

Timmons, 1999

Tips for business planning and raising outside funds

RE: Venture capitalists• There are a lot of them; don’t talk to all of them• Getting a “no” is as difficult as getting a “yes;”

qualify your targets and force others to say no• Be vague about which other VCs you are talking

to• Do not meet with an associate or junior

member twice without a partner

Timmons, 1999

Tips for business planning and raising outside funds

RE: The plan• Stress your business concept in the executive

summary• The numbers matter less than the economics (value

proposition and business model)• Make the business plan look and feel good w/o

using “filler”• Be prepared to provide copies of published articles,

contracts, market studies, purchase orders, resumes, etc.

Timmons, 1999

Tips for business planning and raising outside funds

RE: The Deal• Make sure investors want you as bad as you

want them• Create a market for your venture• Never say no to an offer price• Use a lawyer with venture deal experience• Don’t stop selling until the money is in the

bank

Timmons, 1999

Tips for business planning and raising outside funds

RE: The fund raising process• It is much harder than you ever thought it

would be• You can last much longer than you ever

thought you would• The venture capitalists have to do this the rest

of their careers

Timmons, 1999

Critiquing the plan – General criteria• Comprehensiveness – use a template to help• Analysis – resource, industry, competitor and

product analysis; financial projections with percentages, returns, and comparisons with analogs

• Reasonableness – assumptions are comparable to benchmarks and facts

• Writing and presentation – well written and organized

Dollinger, 2008

Critiquing the plan – Specific criteria• Management – experience, honesty, integrity• Resources – rare, valuable, hard to copy,

unique• Projections and returns – all data must have

solid foundation in reality, yet optimistic enough to attract investors

• Exit – how and when will investors recoup money?

Dollinger, 2008

Level 4Product/ svc fully developedMany users, established mkt

4/1 4/2 4/3 4/4

Level 3Product / svc fully developedFew users, mkt assumed

3/1 3/2 3/3 3/4

Level 2Product / svc pilot operable, not developed for production, mkt assumed

2/1 2/2 2/3 2/4

Level 1Product / svc idea but not operable, mkt assumed

1/1 1/2 1/3 1/4

EvaluationSystem

Level 1Single would-be entrep

Level 22 founders,

Level 3Partly staffed mgt team,

Level 4Fully staffed, experienced mgt team

Product / svc level

Management status and experience levels

Writing and editing the plan

• Steps: Prewriting, writing and rewriting/editing, editing – despite importance of good writing:

Research on 20 business plans in a competition:• 30% didn’t include specific strategy• 40% of teams had no marketing experience• 55% failed to discuss technical idea protection• 75% failed to identify details of competitor• 10% had no financial projections; 15% omitted balance

sheets; 80% failed to provide adequate details of the financial projections

Dollinger, 2008

Exercises

1. Draft an outline of your business plan– What information do you already have? – What information is still required? How will you get it?

2. Prepare as much of the executive summary as you can. Be concise and informative

3. Critique a business plan– How well does the plan address key issues?– What changes and improvements would you make to the

plan?– How well done is the presentation and writing?– Would you invest in this business? Why or why not?

Dollinger, 2008