venture capital 101 - imran almaleh

A walk through entrepreneurial finance

By Imran Almaleh

Venture Capital 101 - by Imran Almaleh - January 2012

Chapter 1: Introduction

Chapter 2: Financing start-ups

Chapter 3: Venture valuation

Chapter 4: Ownership & Legal issues

Chapter 5: Exiting the venture

Definitions

VC vs. Debt

The VC fund

VC’s business model

VC risk pyramid

Screening ventures


Venture Capital:

is money provided by an outside investor to finance a new, growing, or troubled business

Venture Capitalists (VCs):

Individuals join in formal, organized Venture capital firms to raise venture capital to new and fast-growing ventures. Leach, Melicher – 2006


Venture Capital Debt Financing

Holding Period Long term Short/medium term

Instruments Common & preference shares Loans

Collateral No Yes

Impact on B.S Reduce leverage Increase leverage

Exit Mechanism IPO, sale to 3rd parties Loan repayments

Liquidity Low High

Risk/Return High Low

Diversification Low Medium


Limited Partners(Investors)

•Pension funds•Insurance companies•Private equity funds•Individual investors•Endowment•etc…

Legal Form:Limited Partnership

Company LPC

VC Fund(Closed Fund)

General Partners(VCs)

Provide Work(& some Cap.)

Provide Capital


InvestorsClosed fund

LP

EntrepreneursVenture

CapitalistsGP

Capital Capital

Capital+Profit fromExit

20% margin

Capital+Restof profit+Fees

2% Fees

6-8 YearsLater


Management teem

Market Size

Financial

Product/Technical

Economy

Regulations


Assessment of an idea‟s commercial potential. (finding caterpillars that are likely to turn into butterflies)

1. Qualitative assessment (systematic interview):

◦ Founder

◦ Marketing

◦ Operations

◦ finance


2. Quantitative assessment (VOS™ indicator):◦ Industry/market

◦ Pricing/profitability

◦ Financial/harvest

◦ Management/team

Scoring:◦ 2.34-3.00: home-run (5X)

◦ 1.67-2.33: average (1-2X)

◦ 1.00-1.66: strike-out (0)


High = 3Avg. = 2Low = 1

Venture’s life cycle

Financing through the cycle

Example of venture financing


Idea IPO (5-8y)

1. Development stageIdea, test feasibility, prototype, no market entrance

2. Startup stageRevenue model, first sales

3. Survival stagerevenue<expenses, formal financial statements, growth

4. Rapid growth stageFast growth in revenue & cash-in flows, economies of scale

5. Maturity Slow revenue growth, time to exit


-1.5 -0.5 0.5 1.5 2.5 3.5 4.5 5.5 6.5

Venture's Life Cycle

Developmentstage

Startupstage

Survivalstage

Rapid-Growthstage

Maturitystage

Revenue

Years


First 3 stages: NO successful operating history low credit, hard to obtain ordinary financing

Last 2 stages (seasoned firm): Successful op. history new & large sources financial

capital


Major types of financing:◦ Seed financing

◦ Start-up financing

◦ First-round financing

◦ Second-round financing

◦ Bank loans, Bond issues, Stock issues


Life Cycle Stage

Type of financing Major providers

Development Seed finance Founders assetsFamily and friends

Startup Startup finance Founders assetsFamily and friendsBusiness angelsVCs

Survival First-Round Business OperationsVCsSuppliers and customersGovernment programsCommercial banks*

Rapid growth Second-RoundLiquidity stage financing

Business OperationsVCsCommercial banksInvestment bankers

Maturity Bank loansBond issueStock issue

Business OperationsCommercial banksInvestment bankers

* Most banks will require 2y of operations


Stage 1: Seed financing (by an Angel Investor)

Stage 2: Series A round (by VC 1)

Stage 3: Series B round (by VC 2)

Stage 4: Exit (IPO)

Valuation (pre- & post-money)

% ownerships and dilution

IPO issues (7%Commissions, Lockup for 6m)

Overview of valuation

Investor’s rate of return

DCF PV model

VC method

First Chicago Method


Value = Present Value (all future cash flows)

To make projections better, you need comparables

Main methods:1. Fundamental (DCF PV)

2. VC method (P\E)

3. First Chicago method (probability)


Stage of venture Financing

Annual ROR %Expected Holding Period

Seed & start-up 50-100% > 10 years

First-round 40-60% 5-10 years

Second-round 30-40% 4-7 years

Bridge 20-30% 1-3 years

Source: Timmons, Spinelli, and Zacharkis – 2005 (Edited)

Holding period: time between Investment and Exit


To calculate the Required rate of return:

Hurdle rate (RRR) = Re/P

While:

Re: required return on equity

P: probability of success


The idea:

Value = Σ PV(future cash flows)

Ingredients:◦ Future cash flows

◦ RRR for the early years

◦ ERR for after maturity years

◦ Sustainable G rate at maturity

Terminal value – Reversion value


0 2 4 6 8 10 12 14

CashFlows

Years

Discount CFs by RRR(variable CFs)

Reversion value (sustainable G rate)


The formula:

While:CF : Cash flows at end of year

r : Required rate of return

r ͚ : Expected rate of return (at/after maturity)

G : sustainable Growth rate

t : time of maturity


The idea

Value = Discounted Terminal value

Ingredients:◦ Income or CF at maturity

◦ P\E or P\CF ratio for similar ventures

◦ Required rate of return (Discount factor „r‟)


0 2 4 6 8 10 12

CashFlows

Years

Terminal Value(value at exit)


The formula:

While:Et : Earnings(income) at Exit time

P/E ratio : for similar ventures (or Estimated)

r : Required rate of return

t : time of Exit

We can also substitute Earnings for CFs


Uses a scenario approach to valuation

Example: (#s in millions of $)

Success Sideway survival Failure

Revenue in y 3 8.19$ 3.04$ 2$ (liquidate)

Revenue in y 5 20.97$(IPO) 4.02$

Revenue in y 7 5.32$ (Acquisition)

P/E ratio (at liq.) 17 7

Net income (at liq.) 3.15$ 0.37$

Value of company (at liq.) 53.55$ 2.61$ 0.69$

PV (at rrr=40%) 9.96$ 0.25$ 0.25$

Probability of Scenario 40% 40% 20%

Expected PV of the company 4.13$

The Option pool

Capitalization table

The term-sheet


Definition:

Shares of stock reserved for employees of a private company

Mostly, it comes out from the Pre-money valuation

Around 20% for startups

Use a hiring plan to justify a small option pool

Example: 10$m Post, 8$m pre (3m Shares), 20% post OP.

Calc: share price(pre&post), % ownership, % pre OP


Title Range (%)

CEO 5 – 10

COO 2 – 5

VP 1 – 2

Independent Board Member 1

Director 0.4 – 1.25

Lead Engineer 0.5 – 1

5+ years experience Engineer 0.33 – 0.66

Manager or Junior Engineer 0.2 – 0.33


A table that shows ownership stakes in a startup or early stage venture

Key elements:◦ Founder‟s ownership (% and Shares)◦ Option pool size◦ Investors stake

Main calculations:◦ Pre-money + investment = post-money◦ Share price = pre-money / # of existing shares◦ Investment / share price = # shares to investor

Go to Excel


A non-binding agreement setting forth the basic terms and conditions under which an investment will be made

Main Terms categories:1. Getting into the deal

2. During the deal

3. Exiting the deal


Investment amount

Instrument:◦ Convertible preferred stocks

◦ Participating convertible preferred stocks

◦ (angels use Convertible Debt)

Valuation◦ Pre-money value

◦ Post-money value

◦ Option pool

Dividends (cash, shares)


Board seats ◦ 2 pref. + 2 common + 1 independent

◦ CEO dilemma

Protective provisions (Vito rights)◦ On liquidation, board seats, raising cap, debt, ..

Pro-rata rights◦ % of old ownership

◦ For outside financing

Anti-dilution◦ full ratchet, weighted average (norm)


Liquidation preference:◦ 1x preference + no participation

◦ 1x preference + full participation

◦ Participation w/Cap

Drag-along right

Redemption right (4-5 years)


Exclusivity period

Non-competition

IP registration

Vesting & Restricted Stock (4 years)

Exit strategy

IPO

M&A

Buy-outs

Franchising


"harvest strategy" or "liquidity event“:

The method by which a VC intends to get out of an investment (i.e. "cashing out“)

Common Exit strategies:1. Initial Public Offering (IPO)

2. M&A3. Buy-out4. Franchise

Usually occurs before maturity

To insure market share and expansion


Sell the shares of the company to the public to be traded on a stock exchange

Investment banking◦ Valuation

◦ Underwriting

◦ Commissions (% of capital raised)


Acquisition:

Business bought outright by another existing company (larger, strategic partner)◦ Receive cash or stock

◦ Waiting for the IPO

Merger:

Join with and existing company◦ Receive some cash or stock


One or more stockholders buy out the others

Types:◦ Management Buyout (MBO)

Management buys the shares of the private owners

◦ Leveraged Buyout (LBO)

An external entity takes debt to buy the shares of the company owners


Sell business concept to others to replicate

Receive cash

Retain current management

Imran Almaleh


asktheVC.com askventure.com AVC.com Bothsidesofthetable.com Docstoc.com Feld.com Harvard innovation lab Leach & Melicher: “Entrepreneurial finance”, 2nd ed. Macabacus.com National Venture Capital Assosiation (NVCA) Stanford technology venture program Timmons, Spinelli, & Zacharakis: “how to raise capital” Wikipedia.com ThisWeekIn.com

venture capital 101 - imran almaleh

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