Venture capital 101 - Imran Almaleh

A walk through entrepreneurial finance

By Imran Almaleh

Chapter 1: Introduction
Chapter 2: Financing start-ups
Chapter 3: Venture valuation
Chapter 4: Ownership & Legal issues
Chapter 5: Exiting the venture

Venture Capital 101 - by Imran Almaleh - January 2012

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


VC Fund
(Closed Fund)
General Partners Provide Work
(VCs) (& some Cap.)

Limited Partners
(Investors)
•Pension funds
Legal Form:
•Insurance companies
Limited Partnership Provide Capital
•Private equity funds
Company LPC
•Individual investors
•Endowment
•etc…


Capital Capital

2% Fees

Investors Venture
Capitalists Entrepreneurs
Closed fund GP
LP

20% margin
6-8 Years
Capital+Rest Capital+Profit from Later
of profit+Fees Exit


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 = 3
Avg. = 2
Low = 1


Venture’s life cycle
Financing through the cycle
Example of venture financing

 Idea  IPO (5-8y)
1. Development stage
Idea, test feasibility, prototype, no market entrance
2. Startup stage
Revenue model, first sales
3. Survival stage
revenue<expenses, formal financial statements, growth
4. Rapid growth stage
Fast growth in revenue & cash-in flows, economies of scale
5. Maturity
Slow revenue growth, time to exit


Venture's Life Cycle

Revenue

Years

-1.5 -0.5 0.5 1.5 2.5 3.5 4.5 5.5 6.5

Development Startup Survival Rapid-Growth Maturity
stage stage stage stage stage


 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 Type of financing Major providers
Stage
Development Seed finance Founders assets
Family and friends
Startup Startup finance Founders assets
Family and friends
Business angels
VCs
Survival First-Round Business Operations
VCs
Suppliers and customers
Government programs
Commercial banks*

Rapid growth Second-Round Business Operations
Liquidity stage financing VCs
Commercial banks
Investment bankers
Maturity Bank loans Business Operations
Bond issue Commercial banks
Stock issue Investment 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 (PE)
3. First Chicago method (probability)


Stage of venture Expected Holding
Annual ROR %
Financing 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


Cash
Flows Discount CFs by RRR
(variable CFs)

Reversion value
(sustainable G rate)

Years

0 2 4 6 8 10 12 14


 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
◦ PE or PCF ratio for similar ventures
◦ Required rate of return (Discount factor „r‟)


Cash
Flows Terminal Value
(value at exit)

Years
0 2 4 6 8 10 12


 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&A
3. Buy-out
4. 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


 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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