Early Stage Venture Capital Due Diligence and Valuations David M. Lee 2/12/2003
Agenda <ul><li>Due Diligence </li></ul><ul><li>Inside a Venture Fund </li></ul><ul><li>Valuations </li></ul>
Dual Mission <ul><li>DELETED </li></ul>
Investment Criteria <ul><li>Key Criteria: </li></ul><ul><ul><li>Fits within market focus and portfolio </li></ul></ul><ul>...
Investment Process
Process Documentation <ul><li>Investment Overview </li></ul><ul><ul><li>1-2 page document that provides a high-level summa...
Portfolio Management <ul><li>Increase funding potential </li></ul><ul><ul><li>Assist in refining business plans and financ...
Time Management <ul><li>GP has 3 full-time and 2 part-time partners </li></ul><ul><li>Limit of 6 portfolio companies per f...
Portfolio Allocation <ul><li>Target is 18 to 23 portfolio companies </li></ul><ul><li>$1.5 million average initial investm...
Investment Returns <ul><li>DELETED </li></ul>
Fund Management <ul><li>Fund managers bring over 100 years of operating experience: </li></ul><ul><ul><li>3 Full-time Part...
Fundamentals <ul><li>Block-n-Tackle Business Planning </li></ul><ul><ul><li>Revenue Growth, Expense Controls, and Profit F...
Current Focus <ul><li>High Technology (3-4 Month ROI): </li></ul><ul><ul><li>Enterprise Software </li></ul></ul><ul><ul><l...
Valuation’s Role in Financing <ul><li>Sets economic interests going forward. </li></ul><ul><ul><li>Establishes an intrinsi...
From the Term Sheet <ul><li>Terms </li></ul><ul><ul><li>Capitalization </li></ul></ul><ul><ul><li>Type of Security/Securit...
Initial Valuation Views <ul><li>The Technologist </li></ul><ul><li>The Technology </li></ul><ul><li>Personnel (Technical) ...
Methods of Valuation <ul><li>Methods: </li></ul><ul><ul><li>Discounted Cash Flows (DCF) </li></ul></ul><ul><ul><li>Compara...
Pros and Cons of DCF <ul><li>Pros </li></ul><ul><ul><li>Highly quantitative </li></ul></ul><ul><ul><li>Provides specific, ...
Comparables <ul><li>Most closely resembles Real Estate valuations </li></ul><ul><li>Look at prices of similar deals </li><...
Comparables Adjustments <ul><li>Current capitalization </li></ul><ul><ul><li>Cap table </li></ul></ul><ul><ul><li>Past inv...
Pros and Cons of Comparables <ul><li>Pros </li></ul><ul><ul><li>No need to adjust for risk or liquidity </li></ul></ul><ul...
Reality of Valuation <ul><li>First Round company </li></ul><ul><li>Some seed money in (Friends and family – 20%) </li></ul...
Reality of Valuation <ul><li>In year of comparison – Average Post-money valuations: </li></ul><ul><ul><li>Communications S...
Further Justification <ul><li>Adjustments to the valuation </li></ul><ul><ul><li>Large Stock Option plan needs to be creat...
Q&A
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© Copyright 2003 Sentient Ventures Early Stage Venture Capital

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  • Unable to maintain pro-rata interest in deals What happened? Other venture firms AV, TL, Dell, etc invested Control exit and destiny New fund allows: Control end game: great team Put more capital to work in very attractive deals
  • © Copyright 2003 Sentient Ventures Early Stage Venture Capital

    1. 1. Early Stage Venture Capital Due Diligence and Valuations David M. Lee 2/12/2003
    2. 2. Agenda <ul><li>Due Diligence </li></ul><ul><li>Inside a Venture Fund </li></ul><ul><li>Valuations </li></ul>
    3. 3. Dual Mission <ul><li>DELETED </li></ul>
    4. 4. Investment Criteria <ul><li>Key Criteria: </li></ul><ul><ul><li>Fits within market focus and portfolio </li></ul></ul><ul><ul><li>Significant market size </li></ul></ul><ul><ul><li>Headquarters in Texas </li></ul></ul><ul><ul><li>National or international in scope </li></ul></ul><ul><ul><li>Manageable competition </li></ul></ul><ul><ul><li>Fundamental sustainable differentiator </li></ul></ul><ul><ul><li>Top-tier management team </li></ul></ul><ul><ul><li>Good chemistry </li></ul></ul><ul><li>Priority: </li></ul><ul><ul><li>Insiders are willing to participate </li></ul></ul><ul><ul><li>Includes a syndication with value-added outside investors </li></ul></ul>
    5. 5. Investment Process
    6. 6. Process Documentation <ul><li>Investment Overview </li></ul><ul><ul><li>1-2 page document that provides a high-level summary </li></ul></ul><ul><ul><li>Enables the General Partner to relay first opinions back to sponsor </li></ul></ul><ul><li>Investment Due Diligence Document </li></ul><ul><ul><li>10-15 page document that answers questions in depth about the deal </li></ul></ul><ul><ul><li>Detailed summary about multiple aspects of the business and management team including risks and issues </li></ul></ul><ul><li>Investment Decision Document </li></ul><ul><ul><li>2-3 page document that contains a summary of the due diligence </li></ul></ul><ul><ul><li>Leads to the recommendation by the sponsor and records the final vote on whether or not to invest </li></ul></ul>
    7. 7. Portfolio Management <ul><li>Increase funding potential </li></ul><ul><ul><li>Assist in refining business plans and financial projections </li></ul></ul><ul><ul><li>Recruit management team and board members </li></ul></ul><ul><li>Facilitate follow-on funding </li></ul><ul><ul><li>Provide introductions to other VCs, funds, banks, and angels </li></ul></ul><ul><ul><li>Aid development of investor pitch and offering materials </li></ul></ul><ul><li>Validate market and technical strategies </li></ul><ul><ul><li>New product, business feasibility, and market research studies </li></ul></ul><ul><ul><li>Strategic market planning, periodic technical/marketing reviews </li></ul></ul><ul><li>Provide access to service provider network </li></ul><ul><ul><li>Referrals to legal, accounting, PR, and marketing firms </li></ul></ul><ul><ul><li>Contacts for executive consultants, industry experts, and analysts </li></ul></ul>
    8. 8. Time Management <ul><li>GP has 3 full-time and 2 part-time partners </li></ul><ul><li>Limit of 6 portfolio companies per full-time partner </li></ul><ul><li>Total money placed per full-time partner is < $25,000,000 </li></ul><ul><li>Each full-time partner reviews 400 deals w/in commitment period </li></ul><ul><li>Target fund size of up to $90,000,000 </li></ul>16.5 1/3 Investor Relations 16.5 1/3 Portfolio Management 16.5   1/3 Investing 50 Hours Per Week Per Partner 6 0.9 3.5 N/A 2.8 Hours / Company per Week 400 1.8 4.2 $ 24,666,667 6.0   Per Partner Reviewed Managed Managed Placed Made     Deals Passively Actively Money Deals     Total Companies Companies Total Total    
    9. 9. Portfolio Allocation <ul><li>Target is 18 to 23 portfolio companies </li></ul><ul><li>$1.5 million average initial investment </li></ul><ul><li>Active management of 70% of the portfolio companies </li></ul><ul><li>Lead investor for 40% of the investments </li></ul><ul><li>Over 50% of the fund reserved for follow-on investments </li></ul><ul><li>Establish up front funding milestones/trigger based budgets </li></ul>$2,000,000 $1,000,000 100% $1,000,000 6 30% Passive Follow-on Investor $4,000,000 $2,500,000 170% $1,500,000 5 30% Active Follow-on Investor $6,000,000 $4,000,000 200% $2,000,000 7 40% Active Lead Investor Per Deal Reserve Reserved Investment Deals Percent Management   Total   Percent Initial        
    10. 10. Investment Returns <ul><li>DELETED </li></ul>
    11. 11. Fund Management <ul><li>Fund managers bring over 100 years of operating experience: </li></ul><ul><ul><li>3 Full-time Partners - Managing Partner and 2 General Partners </li></ul></ul><ul><ul><li>2 Part-time Partners - Venture Partner and Fund Administrator </li></ul></ul><ul><li>Each principal was strategically selected: </li></ul><ul><li>Supporting Staff </li></ul><ul><ul><li>Venture Consultants, Contractors, Associates, and Interns </li></ul></ul>
    12. 12. Fundamentals <ul><li>Block-n-Tackle Business Planning </li></ul><ul><ul><li>Revenue Growth, Expense Controls, and Profit Focus </li></ul></ul><ul><li>Solution for a significant pain that a large group of people with money are willing to pay for </li></ul><ul><li>Experienced management team that knows how to make payroll </li></ul><ul><li>Sustainable differentiation with an emphasis on unique best-of-breed IP </li></ul><ul><li>Venture acceleration, not venture support </li></ul>
    13. 13. Current Focus <ul><li>High Technology (3-4 Month ROI): </li></ul><ul><ul><li>Enterprise Software </li></ul></ul><ul><ul><li>Telecommunications Utilization Software </li></ul></ul><ul><ul><li>Semiconductors and MEMs/Nanotechnology </li></ul></ul><ul><ul><li>Bioinformatics and Life Sciences/IT convergence </li></ul></ul><ul><li>Life Sciences: </li></ul><ul><ul><li>Diagnostic Tests </li></ul></ul><ul><ul><li>Pharmaceuticals </li></ul></ul><ul><ul><li>Genomics/Proteomics </li></ul></ul><ul><ul><li>Medical Devices </li></ul></ul>
    14. 14. Valuation’s Role in Financing <ul><li>Sets economic interests going forward. </li></ul><ul><ul><li>Establishes an intrinsic value for the company </li></ul></ul><ul><ul><li>Valuation is not transaction independent </li></ul></ul><ul><li>One of many terms under negotiation … </li></ul>
    15. 15. From the Term Sheet <ul><li>Terms </li></ul><ul><ul><li>Capitalization </li></ul></ul><ul><ul><li>Type of Security/Securities </li></ul></ul><ul><ul><li>Characteristics of the Security/Securities </li></ul></ul><ul><ul><ul><li>Anti-dilution </li></ul></ul></ul><ul><ul><ul><li>Liquidation preference </li></ul></ul></ul><ul><ul><li>Representations and Warranties of the Company </li></ul></ul><ul><li>Other Conditions to the Deal </li></ul><ul><ul><li>Governance Requirements </li></ul></ul><ul><ul><li>Reporting Requirements </li></ul></ul><ul><ul><li>Expenses </li></ul></ul><ul><ul><li>Non-solicitation </li></ul></ul><ul><ul><li>Changes to Management </li></ul></ul><ul><ul><li>Key-man Insurance </li></ul></ul>
    16. 16. Initial Valuation Views <ul><li>The Technologist </li></ul><ul><li>The Technology </li></ul><ul><li>Personnel (Technical) </li></ul><ul><li>The Market </li></ul><ul><li>Personnel (Business) </li></ul><ul><li>The VC </li></ul><ul><li>Personnel (Business) </li></ul><ul><li>Personnel (Technical) </li></ul><ul><li>The Market </li></ul><ul><li>The Technology – Must have IP! </li></ul>
    17. 17. Methods of Valuation <ul><li>Methods: </li></ul><ul><ul><li>Discounted Cash Flows (DCF) </li></ul></ul><ul><ul><li>Comparables </li></ul></ul><ul><ul><li>Target Ownership </li></ul></ul><ul><li>Reality for Early Stage Companies </li></ul><ul><ul><li>Use the first two to justify the third </li></ul></ul>
    18. 18. Pros and Cons of DCF <ul><li>Pros </li></ul><ul><ul><li>Highly quantitative </li></ul></ul><ul><ul><li>Provides specific, objective (?) numbers as a basis for negotiation </li></ul></ul><ul><ul><li>Speaks to “Intrinsic Value” of company </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>Too many variables </li></ul></ul><ul><ul><li>Depends upon accurate forecasting </li></ul></ul><ul><ul><li>Difficult to discount for risk and lack of liquidity </li></ul></ul>
    19. 19. Comparables <ul><li>Most closely resembles Real Estate valuations </li></ul><ul><li>Look at prices of similar deals </li></ul><ul><ul><li>Stage of business </li></ul></ul><ul><ul><li>Location of business </li></ul></ul><ul><ul><li>Industry </li></ul></ul><ul><li>Adjust up or down for specific circumstances </li></ul>
    20. 20. Comparables Adjustments <ul><li>Current capitalization </li></ul><ul><ul><li>Cap table </li></ul></ul><ul><ul><li>Past investment rounds </li></ul></ul><ul><li>Product development </li></ul><ul><ul><li>In Beta </li></ul></ul><ul><ul><li>General Availability </li></ul></ul><ul><li>Management </li></ul><ul><ul><li>Good or bad management </li></ul></ul><ul><li>Business Development </li></ul><ul><ul><li>Sales booked </li></ul></ul><ul><ul><li>Quality of sales pipeline </li></ul></ul><ul><ul><li>Profitability </li></ul></ul>
    21. 21. Pros and Cons of Comparables <ul><li>Pros </li></ul><ul><ul><li>No need to adjust for risk or liquidity </li></ul></ul><ul><ul><li>A common method that is fairly well understood within early stage companies </li></ul></ul><ul><ul><li>Fast </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>Highly subjective </li></ul></ul><ul><ul><li>Imperfect distribution of information </li></ul></ul>
    22. 22. Reality of Valuation <ul><li>First Round company </li></ul><ul><li>Some seed money in (Friends and family – 20%) </li></ul><ul><li>Networking Software space </li></ul><ul><li>Excites one of the Partners </li></ul><ul><li>Product in Beta </li></ul><ul><li>Missing management team members </li></ul><ul><li>No option pool </li></ul><ul><li>Based in New Mexico </li></ul><ul><li>$3M raise </li></ul><ul><li>Syndicate has target ownership of 33% </li></ul>
    23. 23. Reality of Valuation <ul><li>In year of comparison – Average Post-money valuations: </li></ul><ul><ul><li>Communications SW, Series A: $7.78M </li></ul></ul><ul><ul><li>SW & Rocky Mtn., Series A: $8.66M </li></ul></ul><ul><li>Average post-money valuation of $8.25M </li></ul><ul><ul><li>Pre-money valuation of $5.25M </li></ul></ul><ul><ul><li>$3M raise </li></ul></ul><ul><li>Resulting Ownership </li></ul><ul><ul><li>36% - New Investor ownership (Series A Preferred) </li></ul></ul><ul><ul><li>20% - Option pool forced before round </li></ul></ul><ul><ul><li>11% - Friends and Family Ownership </li></ul></ul><ul><ul><li>33% - Founder Ownership </li></ul></ul>
    24. 24. Further Justification <ul><li>Adjustments to the valuation </li></ul><ul><ul><li>Large Stock Option plan needs to be created </li></ul></ul><ul><ul><ul><li>Management team is incomplete </li></ul></ul></ul><ul><ul><li>Hot space </li></ul></ul><ul><ul><ul><li>Don’t forget the Run with the Pack mentality </li></ul></ul></ul><ul><ul><ul><li>We’ll be the lead investor </li></ul></ul></ul><ul><ul><li>> 1 additional financing round expected </li></ul></ul><ul><ul><ul><li>New investors will also be diluted </li></ul></ul></ul><ul><ul><li>Product in Beta </li></ul></ul><ul><ul><ul><li>Technology risk still exists </li></ul></ul></ul><ul><ul><ul><li>Not proven in the field (lack of customers) </li></ul></ul></ul><ul><ul><li>Claim to go from $0 to $250M in 4 years </li></ul></ul><ul><ul><ul><li>Several companies will put this in the plan, but very few can defend it </li></ul></ul></ul>
    25. 25. Q&A
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