Article about a company from startup to IPO
hebdny
ENTP325-Spring2018-Week71.pptx
ENTP 325 Early Stage Venture Financing Week #7
This week
Tuesday
Venture capital overview
Thursday
Term sheets 1: overview
Sunday
Quiz #3 (focus on angel
Team exercise: equity
investment simulation
investing)
Venture Capital Overview
Early-stage venture capital
Venture Capital Overview
Where Does Venture Capital Money Come From?
How are Venture Capital Funds Organized?
How do Venture Capitalists make money personally?
From where Does Venture Capital Money Come?
Professional Venture Capital Firms raise money from Insurance Companies, Educational Endowments, Pension Funds and Wealthy Individuals.
These organizations have an investment portfolio which they allocate to various asset classes such as stocks (equities), bonds, real estate etc.
One of the assets classes is called “Alternative Investments”- venture capital is such an investment.
Perhaps 5% to 10% of the portfolio might be allocated to Alternative Investments.
The portfolio owners seek to obtain high returns from these more risky Alternative Investments.
Most Venture Capital Funds are Limited Partnerships and are run by General Partners (GPs)
These are the “Venture Capitalists” you will deal with.
They may have been Entrepreneurs in a prior life or they might be financial types.
The GPs use an Offering Memorandum to raise a fund of a given size from the Limited Partners (LPs) by convincing them that the GPs have a unique strategy or expertise in a particular sector or sectors of the market.
If the GPs are successful they will convince enough LPs to invest enough money to achieve the size fund offered.
This is the “fund closing” point
Venture Capital Fund
Limited Partners
Pension Funds, Educational Endowments, Foundations, Insurance Companies, Wealthy Individuals
General Partners
How are Venture Capital Funds Organized?
What Do Venture Capitalists Do?
Source Deals
The GPs have to “source” deals- I.e. find investment opportunities.
Make Investment Decisions
From the opportunities identified the GPs pick the ones they think will be the “winners”.
They might look at 50 or 100 opportunities for each one they invest in.
This is done in a variety of ways- referrals from trusted sources (other funds, entrepreneurs they have invested in before, lawyers, accountants etc.)
What Do Venture Capitalists Do?
Manage The Investment
The GP/VCs have a fiduciary duty to the LPs to “manage” the investment.
Harvest The Investment
GP/VCs win only if they can get their money out of the investment (“harvest the investment”).
A VC might only be able to handle 6 to 10 portfolio investment companies at a time.
This usually takes the form of an acquisition of the portfolio company or taking the portfolio company public in an Initial Public Offering (IPO).
This means they usually sit on the Board of Directors.
VC’s have four principal objectives
16
Maximize the upside
1
Protect the downside
2
Monitor and influence the company’s progress and development
3
Assist with exit strategies and liquidity
4
Economics of the Venture Capital Fund - CAPITAL
Capital Commitments
The Limited Partners do not actually invest money in the Fund at the closing.
Capital Calls
When the General Partners find what they think is a good investment opportunity they make a “Capital Call” on the Limited Partners.
They legally commit to provide a certain amount of capital when they are called upon.
A Limited Partner with a Capital Commitment of $50M will be required to send $1M to the General Partners: 50M/500M = 10% times 10M = $1M
Example: a Fund has $500M of capital and the GP/VCs what to make an investment of $10M.
This is called a Capital Commitment.
VC Compensation
Management Fees
The General Partners receive an annual Management Fee, which is usually a percentage of the Capital Commitments to the Fund.
A typical fee is 2.5%. On a $400M fund this $10M per year.
The Management Fee is used by the General Partners to run the Fund business –e.g. it pays the salaries of the General Partners, the Associates, the Support Staff and the office rent.
Number of General Partners
The number of GP/VCs in a Fund is a function of the size of the Fund and the size of investments the Fund makes.
For example, a $500M Fund might have 5 GP/VCs, each investing $100M of the Fund’s Capital
VC Compensation
The GP/VCs make investments and they hopefully harvest some
The returns from the investment are split between the Limited Partners and the General Partners.
A typical arrangement is as follows:
The Limited Partners receive 99% of all the returns and the GP/VCs receive 1% of all returns until the Limited Partners receive back 100% of their Capital (plus in some cases “interest” on that Capital).
Thereafter the splits go 80% to the Limited Partners and 20% to the GP/VCs.
This 20% part is called the GP’s “Carried Interest”
Venture Capitalists with a great track record will receive a higher Carried Interest- e.g. 30%
VC Compensation
Compensation Drives Behavior
The Split Formula provides a heavy incentive for the GP/VCs to invest in situations that can be Big Hits.
Reason: They don’t make money unless they return Big Returns to the Limited Partners.
Example
Fund has invested $400M in 20 companies (average $20M per company)
Each investment provides it with a 50% ownership interest in a portfolio company.
25% of the companies exit at $200M value
Average exit returns to the fund 5X the amount invested which is a total of $500M ($100M per exit)
Recall: 99% of the returns go to the Limited Partners until they receive back their invested Capital then the upside is split with the General Partners
In this case the LPs are probably somewhat happy - they get a 19% return - and the GPs make $23M. (note: this example ignores the time value of money).
This is how the Return Splits would work
Very few venture returns make 5x or more
Notice what happens, however, if the 5 winning investments pay out at lower multiples
The reward system makes the VCs “swing for the fences” – they need to find companies that can be really big.
Fund Investment Cycle
Fund Life
Most Funds have a 10 year life. At the end of 10 years they are liquidated.
Funds plan to harvest winners in 5 to 7 years or less.
Initial and follow-on Investments
For Early Stage Funds it is typical for the Fund to reserve $2-$3 for every $1 invested.
For example if the Fund invests $2m in Round 1 they will reserve another $4m -$6m for follow-on rounds.
So a $400M Fund might invest $100M in the first rounds of portfolio companies and $300M in follow on rounds.
Timing of Initial Investments
A Fund usually makes its initial investments in the first 3 years of the Fund life cycle.
During the remaining life of the Fund follow-on investments are made and the portfolio companies are positioned for “harvest”
Follow-On Funds
Once the initial investments have been made in Fund 1, the VCs are motivated to raise Fund 2 so they can make investments in new opportunities and get additional Management Fees.
Hopefully there are some early successes in Fund 1 so they can go to their LPs and get them to invest in Fund 2.
Through this layering of Funds the GPs build up their total Capital Under Management.
Things For the Entrepreneur To Think About
Does Your Plan Fit the Needs of the Venture Capital Fund?
As you can see they need to see Big Returns.
If your financing plan can justify this and you need lots of capital to achieve your plan then VC may be the way to go.
You may be able to grow a successful company and make a lot of money without having to scale to the size that will interest Venture Capital.
Are You Ready For Venture Capital?
VCs have a relatively short time fuse to success- a 10 year fund and the need to show some “Winners” early in order to raise the next fund.
Result: You have to be ready to move quickly, there will not be much time to recover from errors in the plan or execution.
Things For Entrepreneurs To Think About
Are You Prepared to Become a Minority Stockholder?
As the examples show, in order to generate returns for their Limited Partners the GP/VCs have to invest a large amount and this usually means they will obtain a significant percentage of the company over time.
Make Sure the VC You Work With Can Add Value
Experienced Venture Capitalists can provide valuable advice and guidance, saving you time and preventing mistakes.
They also have contacts with potential customers, Wall Street and acquirers.
Things For Entrepreneurs To Think About
Understand Where in the Fund Life Cycle You Are
As shown, you want to catch a Fund during its initial investment phase so check out where the Fund is in its Life Cycle.
All Financing Sources Are Not The Same
The Compensation and Return arrangements in a VC Fund drives a certain type of behavior.
Learn and understand this so you make an informed decision.
Talk to Portfolio Company CEOs
You can answer these and other questions by talking to the CEOs of companies that the Venture Fund has invested in.
Most VC Firms have websites that list their current and past portfolio companies.
Investor and founder dynamics
Founder and angels fate are often in the hands of VC’s
Venture math usually only works favorably for “power law” companies
Once you take VC funds, you often lose control of your exit process
Misaligned incentives
VCs need 10X returns to drive the venture model
This is why there is some misaligned incentives between founders who might find an exit in the hundreds of millions to represent life-changing money and investors who want the company to keep pushing for an even bigger outcome.
Founders and early angels who have their ownership due to sweat equity may be very excited with a 10X return but investors may not, especially if their fund has many “dogs”
One option to protect ownership: follow-on investment (pro-rata)
One needs to consider all the dollars someone invests into a company at each round, not just the initial round, which is another form of dilution
Each time an investor puts money into a follow-on round, they preserves their ownership, but increases their cost basis and effective post money.
Team exercise: Equity investment simulation
Dilution and follow-on investments
Scenario: An angel investor puts $1M in a company’s first seed financing at a $10M post-money valuation
The company ultimately sold many years later for $200M.
What % of the company does the angel own?
What is the angel’s investment return in $’s?
What will be the return on investment %?
Let’s say the company raises a venture capital Series A round after the angel round. It’s a $10M round at a $50M post-money valuation, a 20% investment. And as part of the round, the option pool of the company is expanded by an additional 10%.
By how much is the angel investor’s ownership diluted?
What is the angel investor’s new ownership %?
After this round, the company now has their $200M exit.
What is the angel’s investment return in $’s?
What will be the return on investment %?
Let’s assume the angel investor decides to “lean-in” and write a $2M check as part of the above $10M round.
Not including the original $1M seed investment, what percentage of the company are they buying at the Series A?
What is the angel investor’s total investment?
As in the prior example, the angel investor’s seed dollars got diluted by 30%. What is the final angel investor new ownership %
The company then sells for $200M.
What is the angel’s investment return in $’s?
What will be the return on investment %?
Discussion questions
Which of the three return scenarios would you prefer and why?
What is the risk/reward of follow-on investments?
What are the risks of not doing a follow-on investment?
20X return resulting in $20M
14X return resulting in $14M
7.3X return resulting in $22M
38
Reminder: Quiz #3 due by Sunday midnight
In the Week 7 folder
Review instructions summary document
Term Sheets
overview
Typical investment process
Pitch to investors
Preliminary due diligence & value negotiation
Term sheet
Confidentiality
Deal due diligence
What is a term sheet?
A term sheet is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made.
A term sheet serves as a template to develop more detailed legal documents.
Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is then drawn up.
May differ somewhat for angel and VC deals
What is a term sheet?
43
Not a binding agreement to fund
Subject to actual documents
Subject to due diligence
Subject to other closing conditions (legal opinion, etc.)
Confidentiality
Term sheets usually have a binding confidentiality provision prohibiting disclosure of terms and existence of the term sheet
Exclusivity
Term sheets may give the investor some period of exclusivity (30 to 60 days)
Review term sheet handout: NVCA Model Document
Many term sheet elements
Securities offered
Post-financing capitalization
Dividend provisions
Liquidation preference
Redemption
Conversion and automatic conversion
Dilution clauses
Voting rights
Protective provisions
Vesting
Board composition
Special board approval items
Information rights
Registration rights
Right of first refusal
Conditions precedent
Purchase agreement
Employee matters
Closing date, legal counsel, expenses
Good news
Some of this can get quite detailed and you’ll read more about these in the Wilmerding book so we will not cover most in class.
However, some key ones we’ll cover
Vesting
Dividend provisions
Liquidation preference
Redemption
Dilution clauses
Voting rights and Board composition
Vesting
All stock and stock equivalents issued after the Closing to employees, directors, consultants and other service providers will be subject to vesting provisions below unless different vesting is approved by the majority (including at least one director designated by the Investors) consent of the Board of Directors (the “Required Approval”): 25% to vest at the end of the first year following such issuance, with the remaining 75% to vest monthly over the next three years.
The outstanding Common Stock currently held by _________ and ___________ (the “Founders”) will be subject to similar vesting terms provided that the Founders shall be credited with [one year] of vesting as of the Closing, with their remaining unvested shares to vest monthly over three years.
Dividend provisions
The holders of the Series A Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [8%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors].
Allows VCs to further protect their investment
Paid in stock or cash
Cumulative vs non-cumulative:
Non-cumulative are better for entrepreneur as if no dividend paid in a given year then the slate is clean for following year
Liquidation preference
In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
Enables favorable treatment for preferred shareholders in the event of a liquidation (shutdown)
Multiple on the value of initial investment that preferred and common shareholders will receive
Investor favorable approach – 3X investment
Middle of the road approach – original investment plus declared but unpaid dividends plus additional payouts to preferred and common
Redemption
At the election of the holders of at least majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.”
Puts finite number of years on the investment
Obligates company to repay investment even without liquidity (exit) event
Invented to allow the investor a guaranteed exit path.
However, any company that is around for a while as a going concern that is not an attractive IPO or acquisition candidate will not generally have the cash to pay out redemption rights.
Dilution clauses
The conversion price of the Series A Preferred will be subject to a [full ratchet / broad-based / narrow-based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities (other than shares (i) reserved as employee shares described under the Company’s option pool,, (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their anti-dilution rights) at a purchase price less than the applicable conversion price.
Protects investors by ensuring that any subsequent financing will, at the very least, not dilute the value of their investments below the price the paid in a prior round.
Full ratchet means that if the company issues shares at a price lower than the Series A, then the Series A price is effectively reduced to the price of the new issuance.
Middle of the road approach – weighted average conversion
Voting rights and Board composition
The size of the Company’s Board of Directors shall be set at [n]. The Board shall initially be comprised of ____________, as the Investor representative[s] _______________, _________________, and ______________. At each meeting for the election of directors, the holders of the Series A Preferred, voting as a separate class, shall be entitled to elect [x] member[s] of the Company’s Board of Directors which director shall be designated by Investor, the holders of Common Stock, voting as a separate class, shall be entitled to elect [x] member[s], and the remaining directors will be [Option 1: mutually agreed upon by the Common and Preferred, voting together as a single class.] [ or Option 2: chosen by the mutual consent of the Board of Directors].
Corporate Governance
1
2
1
Voting/Board Composition
How many?
Who are they?
Voting power?
Founder
VC
Other
Compensation
Corporate Governance
Committees
Committees
Management
and Dynamics
Duties
Composition
Founders
VC
Outside Directors
Board of Directors
Caution: VCs know more than you do
The entrepreneur negotiates a term sheet once every few years.
You negotiate your most important term sheet (the Series A) when you have the least experience.
You negotiate against a VC firm that issues two to three term sheets per month.
You negotiate against a “standard” term sheet that encapsulates decades of combined knowledge from hundreds of venture firms, with most terms favoring the investor
Learn, but have a lawyer!
Term sheet negotiations
In general, there are only two things that venture funds really care about when doing investments: economics and control.
The term “economics” refers to the end of the day return the investor will get and the terms that have direct impact on such return.
The term “control” refers to mechanisms which allow the investors to either affirmatively exercise control over the business or allow the investor to veto certain decisions the company can make.
If you are negotiating a deal and an investor is digging his or her feet in on a provision that doesn’t affect the economics or control, they are probably blowing smoke
Additional resources
Startup Company Lawyer post on how the YC seed docs differ from traditional Series A docs and this Series Seed post on the same topic.
Terms https://feld.com/archives/2005/08/term-sheet-series-wrap-up.html
Venture Hacks posts: Term Sheet Hacks, Option Pool Shuffle, Term sheet tune-up, & Terms that hurt.
The Challenge of The Ideal First Round Term Sheet
Ideal first round funding terms
This week’s readings (complete by end of week)
Venture Capital Guidebook (Bowne)
58
Reminder: Quiz #3 due by Sunday midnight
In the Week 7 folder
Review instructions summary document
Next week
Tuesday
Series A investing: guest speaker Terry Williams
Thursday
Term sheet 2: negotiation (team exercise)
Sunday
No paper/quiz
.MsftOfcThm_Accent1_Fill { fill:#4472C4; }
.MsftOfcThm_Accent1_Fill { fill:#4472C4; }
Venture Partners Fund 1
Capital Commitments: 400
Winning Investments:
Company
Amount
Invested% Ownership
Return
Multiple
Investment
Value at
Harvest
Value of
Company
12050% 5100200
22050% 5100200
32050% 5100200
42050% 5100200
52050% 5100200
100 500
Return Splits
Returns $
%
$
%
Return of Capital: 40440099% 41%
Upside, if any: 967780% 1920%
500
477 23
LP % Return: 19%
Limited Partners General Partners
Venture Partners Fund 1
Capital Commitments: 400
Winning Investments:
Company
Amount
Invested% Ownership
Return
Multiple
Investment
Value at
Harvest
Value of
Company
12050% 5100200
22050% 4 80160
32050% 4 80160
42050% 3 60120
52050% 3 60120
100 380
Return Splits
Returns $
%
$
%
Return of Capital: 380376.2 99% 41%
Upside, if any: 0080% 020%
380
376 4
LP % Return: -6%
Limited Partners General Partners
.MsftOfcThm_Accent1_Fill { fill:#4472C4; }
YearYear Year Year YearYearYearYearYearYear
12 3 4 5678910Totals
Fund 1 Initial Investments 3030 30 90
Fund 1 Follow On 50110 150 310
Fund 2 Initial Investments 30 3030 90
Fund 2 Follow On 50110150 310
Fund 3 Initial Investments 303030 90
Fund 3 Follow On 50110150310
.MsftOfcThm_Accent1_Fill { fill:#4472C4; }
.MsftOfcThm_Accent1_Fill { fill:#4472C4; }
.MsftOfcThm_Accent1_Fill { fill:#4472C4; }
