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Venture Capital Financing

Thomas Chemmanur

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VENTURE CAPITAL FINANCING

MANY FIRMS GO THROUGH A LIFE-CYCLE:

1. START OUT AS SMALL PRIVATE FIRMS

2. EXPAND THROUGH VARIOUS STAGES OF V.C/PRIVATE EQUITY FINANCING (ALSO: BANK-DEBT).

3. GO PUBLIC (HAVE AN INITIAL PUBLIC OFFERING-IPO).

4. FURTHER EXPAND THROUGH ADDITIONAL ROUNDS OF PUBLIC EQUITY/DEBT FINANCING.

FOCUS ON STAGE (2), VENTURE CAPITAL FINANCING HERE.

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SOURCES OF V.C FINANCING

1. PRIVATE PARTNERSHIPS AND CORPORATIONS SET UP TO PROVIDE FUNDS.ORGANIZER BEHIND THE PARTNERSHIP MAY

OBTAIN FUNDING FROM INSTITUTIONS (INSURANCE COMPANIES AND PENSION FUNDS) OR INDIVIDUALS.

PRATT’S GUIDE TO VENTURE CAPITAL LISTS 2000 SUCH FIRMS.

AVERAGE AMOUNT INVESTED BY THESE PER FIRM: $1 TO 2 MILLION

E.g: ARTUR ROCK & COMPANY OF SAN FRANCISCO PROVIDED VENTURE FUNDS TO APPLE COMPUTERS

ONLY 2% OF REQUESTS RECEIVE FINANCING.

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SOURCES OF V.C FINANCING

2. VENTURE CAPITAL SUBSIDIARIES OF LARGE INDUSTRIAL OR FINANCIAL CORPORATIONS.E.g: CITICORP VENTURE CAPITAL, CHEMICAL

VENTURE CAPITAL CORP. ONLY SMALL PORTION OF V. C. MARKET.

3. HIGH NET-WORTH INDIVIDUALS AND FAMILIES (“ANGELS”), WITH EXPERIENCE AND KNOWLEDGE IN THAT INDUSTRY. (TYPICAL ANGEL NET WORTH OVER $1 MILLION).ANGELS TEND TO INVEST ONLY SMALLER AMOUNTS

ON AVERAGE ($250,000) THAN V.C. FIRMS.HOWEVER, THE AGGREGATE INVESTMENTS FROM

THIS SOURCE IS MUCH LARGER (AT LEAST TWICE AS MUCH) AS FROM VENTURE CAPITAL FIRMS.

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WHAT DO VENTURE CAPITALISTS DO?

1. PROVIDE FINANCING

2. MONITOR THE ENTREPRENEUR: MANY VENTURE CAPITALISTS SPEND SEVERAL HOURS A WEEK WITH THE FIRM THEY HAVE INVESTED IN.

3. PROVIDE EXPERTISE TO FIRM MANAGEMENT (AND CONTACTS, OBTAINED FROM BEING INVOLVED IN SIMILAR FIRMS BEFORE).

4. HELP THEM WITH ADDITIONAL FINANCING FROM OTHER SOURCES, INCLUDING INITIAL PUBLIC OFFERINGS (IPOs).

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WHAT DO VENTURE CAPITALISTS DO?

IPO’S WITH VENTURE BACKED FINANCING:EVIDENCE INDICATES THAT VENTURE-BACKED

DEALS TEND TO BE LESS “UNDERPRICED” THAN NON-VENTURE BACKED DEALS.

ALSO, VENTURE CAPITALISTS (MANY) SEEM TO HAVE EXCELLENT “TIMING” ABILITY (i.e., THE TIMING OF THE GOING-PUBLIC DECISION).

EXAMPLE: KAPOR STARTED LOTUS IN 1981 WITH FINANCING FROM SEVIN-ROSEN

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LOTUS EXAMPLE

WHAT EACH PARTY BROUGHT TO THE DEAL: KAPOR (ENTREPRENEUR)

(I) RECOGNIZED A MARKET NEED (II) TECHNICAL ABILITIES AND TEAM (III) HAD A REASONABLE BUSINESS PLAN

SEVIN-ROSEN (V.C) (I) CAPITAL (II) EXPERIENCE (III) INDUSTRY CREDIBILITY

SOMETIMES, THE V.C’S CONTACTS CAN BE SO CRUCIAL THAT FROM WHOM CAPITAL IS RAISED CAN BE MORE IMPORTANT THAN TERMS ON WHICH RAISED.

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POTENTIAL ISSUES WITH V.C. FINANCING

1. POTENTIAL FOR EXCESSIVE DILUTION OF EQUITY (OBVIOUS).

2. POTENTIAL INTERFERENCE IN THE DAY-TO-DAY RUNNING OF THE FIRM.

3. MAY FORCE PRE-MATURE ABANDONMENT OF PROJECT(S) IF V.C IS SOLE SUPPLIER.

4. FIRM MAY HAVE TO TRY TO GO PUBLIC TOO EARLY.

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EXIT STRATEGIES ADOPTED BY V. C.’S

1. GOING PUBLIC TYPICALLY THE MOST DESIRABLE ROUTE - SO THE ONE THE V.C. AIMS AT; MOST COMMON

2. SALE TO ANOTHER COMPANY

3. SALE OF OWNERSHIP STAKE TO ANOTHER INVESTOR: - OFTEN TO A “WORKING PARTNER”.

4. SALE BACK TO ENTREPRENEUR.- RARE, BUT USED IF ENTREPRENEUR CAN BORROW FROM BANK OR HAS CASH.

5. REORGANIZING THE COMPANY (CHAPTER 11)

6. LIQUIDATION OF ASSETS.

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FINANCIAL CONTRACTING WITH V. C.’S

A V.C DEAL IS ANY AGREEMENT BETWEEN PARTIES FOR THE ALLOCATION OF ECONOMIC VALUE.A DEAL ALLOCATES CASH FLOWS BY AMOUNT AND

TIMING, AS WELL AS RISK.THE STRUCTURE OF A V.C. DEAL CAN RESULT IN THE

SUCCESS OR FAILURE OF THE FIRM/PROJECT.

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FINANCIAL CONTRACTING WITH V. C.’S

A VENTURE-CAPITAL CONTRACT OR DEAL SHOULD: (I) ALLOCATE CASH FLOWS APPROPRIATELY. (II) ALLOCATE THE RISKS INVOLVED IN THE FIRM (III) GIVE RISE TO THE “RIGHT” INCENTIVE EFFECTS

BETWEEN THE ENTREPRENEUR AND VENTURE CAPITALIST. (i.e., IT SHOULD MOTIVATE THE ENTREPRENEUR

TO PUT FORTH OPTIMAL EFFORT AND PUT-FORTH REALISTIC CASH FLOW PROJECTIONS)

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DESIGNING DEALS

DESIGNING DEALS INVOLVES CHALLENGES AND OPPORTUNITIES:

(1) UNCERTAINTY ABOUT CASH FLOWS

(2) DISCOUNT RATES DIFFICULT TO DETERMINE.

(3) PARTIES MAY DISAGREE ABOUT EXPECTED CASH FLOWS, THEIR RISKS AND THE APPROPRIATE RATES.

(4) PARTIES AFFECTED DIFFERENTLY BY TRANSACTION (TAX EFFECTS, FOR EXAMPLE).

(5) ASYMMETRIC INFORMATION

(6) CONFLICTS OF INTERESTS

(7) INCENTIVE EFFECTS OF DEAL ITSELF.

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ADDRESSING DIFFICULTIES

DIFFICULTIES ARE DEALT WITH BY:

(A) STAGE FINANCING FINANCING THE PROJECT (INVESTING IN THE FIRM) IN STAGES.

(B) USE OF APPROPRIATE FINANCIAL CONTRACTS:

(I) DEBT WITH WARRANTS

(II) CONVERTIBLE DEBT

(III) PREFERRED EQUITY, ESPECIALLY CONVERTIBLE PREFERRED EQUITY.

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VENTURE CAPITAL VALUATION

PRE-MONEY VALUATION PRODUCT OF PRICE PAID BY V.C PER SHARE AND

THE NUMBER OF SHARES OUTSTANDING PRIOR TO V.C’S INVESTMENT.

POST-MONEY VALUATION: PRODUCT OF PRICE PAID PER SHARE BY V.C AND

THE TOTAL NUMBER OF SHARES (INCLUDING NEW SHARES ISSUED TO V.C) OUTSTANDING AFTER V.C’S INVESTMENT.

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EXAMPLE OF A V.C VALUATION

POST-MONEY VALUATION EXAMPLE:ASSUME:

INVESTMENT FROM V.C = $300,000 EQUITY PARTICIPATION OF V.C = 15%

IMPLIED EQUITY OF FIRM = 300,000/0.15 = 2 MILLION POST-MONEY BALANCE SHEET

ASSETS LIABILITIES

CASH $300,000 EQUITY $2,000,000

OTHER 100,000

INTANGIBLES 1,600,000

$2,000,000 $2,000,000

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EXAMPLE OF A V.C VALUATION

VC EXPECTED RETURN: RISKLESS RATE (LTG) 6.0%MARKET PREMIUM 5.0%

11%SMALL CAPITAL PREMIUM 2%

13%LIQUIDITY PREMIUM + VALUE

ADDED PREMIUM+ CASH FLOW

ADJUSTMENT = 30% V.C EXPECTED RETURN 40 TO 50%

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EXAMPLE OF A V.C VALUATION

ASSUME THAT THE V.C EXPECTS A RETURN OF 50%. THEN, IN FIVE YEARS: VALUE OF V.C’S INVESTMENT

= $300,000 * (1.50)5 = $2.3 MILLION

(1+r)5 EQUITY VALUE OF ENTIRE FIRM = 2.3/0.15 = $15.3

MILLION.

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EXAMPLE OF A V.C VALUATION

IS THIS REALISTIC? ASSUME (BUSINESS PLAN PROJECTS): (FOR YEAR FIVE)

SALES $37.4 MILLIONEBIT (10% OF SALES) = 3.7 MILLIONPROFITS (NO DEBT ASSUMED) = 1.8 (AFTER Tc = 0.5)

HENCE, REQUIRED PRICE/EBIT MULTIPLE = 15.3/3.7 = 4.2AND PRICE/EARNINGS MULTIPLE = 15.3/1.8 = 8.5BOTH OF WHICH ARE REASONABLE.

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FLOW OF MONEY & VALUATIONS

FLOW OF MONEY INTO V.C FUNDS SEEMS TO FOLLOW A BOOM-BUST PATTERN; ALSO PRE-MONEY VALUATIONS SEEM TO FOLLOW SUCH VARIATIONS IN INFLOWS

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STAGES OF PRIVATE FINANCING

A. FIRST ROUND: START-UP; R&D, TESTS, MARKET RESEARCH.

B. SECOND ROUND: PROTOTYPES. FURTHER TESTING; EARLY EXPANSION.

C. THIRD ROUND: FULL SCALE MANUFACTURING & MARKETING

D. FOURTH ROUND: CONVENTIONAL FINANCING (PRIVATE PLACEMENT, MEZZANING FINANCING, AND IPO).

(V.Cs TYPICALLY INVOLVED IN 2nd AND 3rd ROUNDS).ANOTHER CLASSIFICATION OF INVESTMENT STAGES BENEFIT OF STAGE FINANCING: INCREASED NPV

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STAGED FINANCING: OPTION TO ABANDON

ONE ADVANTAGE OF STAGED FINANCING IS THAT THE V.C HAS THE OPTION NOT TO PROVIDE FUNDING AS MORE INFORMATION BECOMES AVAILABLE.

CASE-I (SINGLE-ROUND FINANCING)

PV = 500 (NEWS = GOOD)

INVEST 0.5

UPFRONT

-200 0.5

PV = 10 (NEWS = BAD)E[NPV] = -200 + 0.5(500) + 0.5(10) = $55

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STAGED FINANCING: OPTION TO ABANDON

CASE-II: STAGED FINANCING

INVEST $100, PV = 500

GOOD NEWS

INVEST 0.5 DON’T INVEST, PV = 0

UPFRONT

$100 0.5 INVEST $100, PV = 10

BAD NEWS

DON’T INVEST, PV = 0

E[NPV] = -100 + 0.5[500 - 100] + 0.5(0) = $100 NPV HAS GONE UP IN STAGED FINANCING!

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VALUATION & V.C. OWNERSHIP STAKE

EXAMPLE: PRE-AND POST-MONEY VALUATION AND V.C OWNERSHIP STAKE $5 MILLION INVESTMENT REQUIRED IN BIO-TECH

VENTUREPROJECTED NET-INCOME IN YEAR 7 = 20 MILLION.AVERAGE P/E OF PROFITABLE BIO-TECH FIRMS

(COMPARABLES) = 15CURRENT NO. OF SHARES OUTSTANDING = 500,000ASSUME EXPECTED RETURN 50%

CASE-I: NO FURTHER FINANCING NEEDED UNTILL FIRM GOES PUBLIC (IN YEAR 7) NO NEW SHARES ISSUED BEFORE V.C EXITS

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VALUATION & V.C. OWNERSHIP STAKE

CASE-IDISCOUNTED TERMINAL VALUE

= TERM. VAL./(1 + r)7 = 20 * 15/1.57 = $17.5 MREQUIRED EQUITY OWNERSHIP

= INVESTMENT/DISCOUNTED TERMINAL VALUE = 5/17.5 = 0.285 OR 28.5%

TOTAL SHARES AFTER VALUATION= 500,000/(1 - 0.285) = 700,000

NO. OF NEW SHARES ISSUED TO V.C = 200,000PRICE PER NEW SHARE = $5 M /200,000 = $25 /SHARE

IMPLIED PRE-MONEY VALUATION = (25)500,000 = $12.5 M IMPLIED POST-MONEY VALUATION = (25)700,000 = $17.5 M

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VALUATION & V.C. OWNERSHIP STAKE

CASE-II: TWO ROUNDS OF FINANCING BEFORE V.C EXITS; THREE MORE SENIOR EXECUTIVES NEED TO BE HIRED (10% OF EQUITY GIVEN AS STOCK OPTIONS TO THEM); ALSO, 30% OF EQUITY SOLD IN A SUBSEQUENT FINANCING ROUND.

CASE-II: CALCULATIONS NEED TO BE AMENDED AS FOLLOWS

RETENTION RATIO:

AFTER FIRST ROUND 1/1.1 = 90.9%

AFTER SECOND ROUND = (1/1.1)/1.3 = 70% OF EQUITY REQUIRED CURRENT OWNERSHIP = REQUIRED FINAL

OWNERSHIP/RETENTION RATIO = 0.285/0.7 = 40.7%.

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VALUATION & V.C. OWNERSHIP STAKE

NO. OF NEW SHARES = 500,000/(1 - 0.407) - 500,000

= 343,373 SHARESPRICE PER NEW SHARE = $5 MILLION/343,373

= $14.56/SHARE IMPLIED PRE-MONEY VALUATION

= 14.56 * 500,000 = 7.28 MILLION IMPLIED POST-MONEY VALUATION

= $7.28 + $5 = 12.28 MILLIONCURRENT VALUATION HAS FALLEN (WHY?)

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RISK ALLOCATION - DEBT WITH WARRANTS

EXAMPLE OF RISK-ALLOCATION, USING DEBT WITH WARRANTS.

ASSUME INVESTMENT BY V.C = $10000.5 MEDIOCRE (I)0.5 VERY SUCCESSFUL (II)

YEAR 0 1 2 3CASH FLOW

-1000CASE-I 250 300 1000CASE-II 350 700 5000EXPECTED -1000 300 500 3000

SAMPLE CALCULATION OF CASH FLOW IN YEAR 0:= 0.5(250) + 0.5(350) = 300

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RISK ALLOCATION - DEBT WITH WARRANTS

ASSUME EXPECTED RETURN OF V.C IS 40% IN ORDER TO INVEST, THE V.C IS GOING TO DEMAND

AN EQUITY PARTICIPATION WHICH WILL GIVE HIM A PV OF $1000 (AMOUNT INVESTED) AT AN EXPECTED RETURN OF 40%.

PV OF PROJECT EXPECTED CASH FLOW (AT 40% RETURN) = $1562.6 (CHECK!)

EQUITY PARTICIPATION IF V.C TAKES STRAIGHT EQUITY = 1000/1562.5 = 0.64 OR 64%

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RISK ALLOCATION - DEBT WITH WARRANTS

ALTERNATIVE TO EQUITY FINANCING: DEBT WITH WARRANTS

TWO PARTS IN SECURITY PACKAGE:BOND: GIVES V.C A CASH FLOW OF $250 AT t = 1, $300 AT

t = 2, AND $1000 AT t = 3. (THUS, THE V.C GETS ALL THE CASH FLOW IN THE LOW

SCENARIO; THE ENTREPRENEUR GETS NONE).THE BOND PAYS OFF THE SAME AMOUNT IN EITHER

SCENARIO (IN THE HIGH SCENARIO, THERE WILL BE SOME MONEY LEFT OVER AT EACH DATE FOR THE ENTREPRENEUR).

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RISK ALLOCATION - DEBT WITH WARRANTS

CASH FLOW TO V.C (FROM BOND ALONE)

t = 0 1 2 3

HIGH SC 250 3001000

LOW SC 250 300 1000

E(CASH FLOW) 250 3001000

PRESENT VALUE AT 40%

= 250/1.4 + 300/1.42 + 1000/1.43

= 696

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RISK ALLOCATION - DEBT WITH WARRANTS

REMAINING PRESENT VALUE TO BE PROVIDED TO V.C

= 1000 - 696 = 304 THIS CAN BE PROVIDED TO THE V.C IN THE FORM OF A

WARRANT, WHICH CAN BE CONVERTED TO 41.8% OF FIRM’S EQUITY IN HIGH SCENARIO AT t = 3. (THE V.C GETS ALL THE FIRM’S MONEY IN THE LOW SCENARIO, ANYWAY, THROUGH THE BOND).

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RISK ALLOCATION - DEBT WITH WARRANTS

CALCULATING THE FRACTION OF EQUITY TO BE PROVIDED TO V.C THROUGH WARRANT IN HIGH SCENARIOPRESENT VALUE TO BE PROVIDED (CALCULATED

BEFORE) = 304. t = 3 EXPECTED CASH FLOW TO BE PROVIDED =

304(1.4)3 = $835 (SINCE DISCOUNT RATE = 40%).SINCE WARRANTS ARE WORTHLESS IN LOW

SCENARIO, EXPECTED CASH FLOW TO V.C = 835 = 0.5 (LOW-SCENARIO CASH FLOW = 0) + 0.5 (HIGH-SCENARIO CASH FLOW).

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RISK ALLOCATION - DEBT WITH WARRANTS

SOLVING:HIGH-SCENARIO CASH FLOW = 835/0.5 = $1670NOW, TOTAL CASH FLOW AVAILABLE TO EQUITY IN

HIGH SCENARIO = $5000 -$1000 = $4000

PAID TO BOND EQUITY TO BE PROVIDED TO V.C WARRANTS =

1670/4000 = 41.8%

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RISK ALLOCATION - DEBT WITH WARRANTS

SUMMARY: TOTAL CASH FLOW TO V.CYEAR 0 1 2 3

LOW SCEN: BOND: - 250 300 1000WARR: - - - -

HIGH SCEN: BOND: - 250 300 1000WARR: - - - 1670

EXPECTED CASH FLOW: BOND: - 250 300 1000WARR: - - - 835TOTAL: - 250 300 1835

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RISK ALLOCATION - DEBT WITH WARRANTS

BOND PLUS WARRANTS: SPLIT-UP OF PRESENT VALUE V.C ENTREPRENEUR TOTAL

CASH % CASH % CASHPV: 696 = 100% 0 = 0% 696(LOW SCENARIO)

PV: 1305 = 54% 1125 = 46% 2429(HIGH SCENARIO)

PV (ECF): 1000 = 64% 563 = 36% 1563

SAME AS IN EQUITY CASE

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RISK ALLOCATION - DEBT WITH WARRANTS

NOTE:

1. INCENTIVE-EFFECTS: THE ENTREPRENEUR WORKS HARD (HE GETS NOTHING IN LOW SCENARIO).

2. INFORMATION-EFFECTS: ENTREPRENEUR HAS NO BENEFIT FROM OVERSTATING PROBABILITY OF HIGH SCENARIO.

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EARNOUT AGREEMENTS:

SIMILAR TO STAGED FINANCING IN THAT A PORTION OF THE PURCHASE PRICE IS PAID IN THE FUTURE CONTINGENT ON THE TARGET’S FUTURE EARNINGS.

EXAMPLE:WHEN COMPANY A ACQUIRES B, THE SELLER WILL

BE PAID FOUR TIMES TARGET FIRM’S EBIT FOR THAT YEAR.

THUS, WHEN GM ACQUIRED EDS AND HUGHES ELECTRONICS, IT PAID FOR THE ACQUISITIONS WITH A SEPARATE CLASS OF SHARES, WITH DIVIDENDS CONTINGENT ON PROFITS.

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EARNOUT AGREEMENTS:

ADVANTAGES OF EARN-OUT AGREEMENTS: PARTICULARLY USEFUL IN ACQUIRING PRIVATE

FIRMS, DIFFICULT TO VALUESCREENS OUT SELLERS WHO TRY TO MISREPRESENT

THE EARNINGS POTENTIAL OF THEIR BUSINESSPROVIDES INCENTIVES TO THE

SELLER/ENTREPRENEUR IF HE STAYS ON AS A MANAGER (OFTEN THE CASE).

DIMINISHES UP-FRONT COMMITMENT OF BUYERPROTECTS BUYER FROM NEGATIVE SURPRISES