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  • #8 from LVG
  • Update with 2001
  • 10 Update with 2001
  • 2
  • Need to update – get help from Christian if you need it

Transcript

  • 1. Venture Capital Financing MBA 6314/TME 3413 October, 2003
  • 2. Overview
    • VC and corporate finance
    • Overview of VC industry
    • The VC life cycle
    • The VC investment process
    • Negotiations
    • Valuation and pricing
    • Deal structure
    • The “Venture Capital Method”
    • The Shareholder’s Agreement
    • Growing the business
    • The exit
  • 3. Conventional Financing
    • Assets
    • Inventory & receivables
    • Land & buildings
    • Equipment & vehicles
    • Other
    • Liabilities & Equities
    • Operating line of credit
    • Mortgage
    • Term loan
    • Share capital & retained earnings
  • 4. VC Financing
    • Fills the cash gap between cash needs to finance high growth and cash available from earnings and conventional financing
    • Giving up a piece of the pie to grow a bigger pie
  • 5. Overview of VC Industry
    • Angel investors
    • Private equity funds
    • Labor sponsored funds
    • Institutional investors
    • Diversified versus focused
    • Venture Capital Trends
  • 6. Gap With U.S. Has Closed Disbursements 1995-2001; Canada & U.S. $ Invested by Canadian VCs - $ Billions $ Invested by US VCs - $ CDN Billion
  • 7. Less $ to Big Deals Drives Decline $ Invested by Transaction Size; Atlantic Region $33M $23M $48M $53M $75M $53M
  • 8. Technology Almost Exclusive Focus Disbursements in Canada $1,089M $1,774M $1,751M $2,986M $6,629M $4,874M
  • 9. Capital Markets Playing Field Concept Investigation Basic Design Prototype Building Market Entry Manufacturing Ramp-up Knowledge Acquisition Government Programs Public Issues Commercial Banks Non-Financial Corporations Venture Capital Funds Seed Funds Wealthy Family Funds Private Investors Faminly and Friends Personal Savings Phase I Phase II Phase III
  • 10. The VC Life Cycle
    • Submit business plan
    • Preliminary assessment
    • Meet the people
    • Light due diligence
    • Term sheet
    • Heavy due diligence
    • Investment memorandum
    • Commitment letter
    • Shareholder’s agreement
    • Grow the company
    • Exit
  • 11. The Business Life Cycle
  • 12. Typical SME Growth Profiles High-Growth Firm Moderate-Growth Firm Low-Growth Firm VC Prospects
  • 13. VC Investment Criteria
    • Exponential growth potential
    • Attractive industry
    • Sustainable advantage platform
    • Excellent team “execution”
    • Owners receptive to involvement of outsiders
    • Owners willing to share the wealth creation
    • Credible exit alternatives (4-7 years out)
  • 14. The Ingredients- Good CEO
    • Good CEO is the most critical element
      • Best is “been there and done that”
      • Has specific domain experience/expertise
      • “ Knows what he/she doesn’t know & locates resources to fill gaps.
      • Shows “fire in the belly”
      • Recognizes urgency-revenue generation/ burn rate
      • Knows the difference between being an employee and being a shareholder
  • 15. The Ingredients-Strong Management Team
    • Characteristics Include:
      • Honesty/Integrity/Competence/Discipline
      • Have specific domain experience
      • Ability to self-assess
      • Motivated
      • “ Fire in the belly”
      • Plans and communicates effectively
      • Develops appropriate MIS
    • Caveat-beware the “family ties”
  • 16. The Ingredients-Technology/Core Competence
    • Ability to define and enunciate what it is
    • Ability to relate core technology-/competence to a variety of significant market applications-(must be balanced by focus)
    • Strong “in house” R&D capability with the mechanisms to fund it.
      • Equity/loans
      • Customer Pays (direct or through margins)
  • 17. The Ingredients-The Business Model
    • Implies having a well defined business model that says, “I know who my customers are, what they need, how I will meet their needs, how I will reach them, how I will service them, how I will continue to best my competition and how I will make money.
    • Avoid “if we build it they will come!”
  • 18. Ingredients-The Value Proposition
    • Why will/do our customers buy or product?
      • Ease the Pain
      • Improve Revenue/ Productivity/Profitability
  • 19. The Ingredients-The Strategic Alliance
    • A “must” for most emerging companies
      • distribution
      • product development (perhaps)
    • Can accelerate success or hasten demise
  • 20. Venture Capital Valuation & Pricing Internal Rate of Return (IRR)
  • 21. VC Investments and IRR
  • 22. VC Target IRR
    • Seed
    • Startup
    • First stage
    • Second stage
    • Bridge
    • Restart
    • IRR>80%
    • 50-70%
    • 40-60%
    • 30-50%
    • 20-35%
    • ??
  • 23. What are they prepared to pay for?
    • In later stage companies VC’s can value the “cake” as well as the “ingredients”. This is a luxury they do not have in funding emerging technology companies.
    • The “cake” represents companies with demonstrable and sustained patterns of growth in revenue (30%+/annum compounded) and profitability (commensurate)
    • In early stage companies VC’s have to value the ingredients and estimate what the “cake” might look like in 3 to 5 years!
    • sGood CEO is the most critical element
    • “ Knowing what you don’t know” and locating the resources to fill the gaps
    • Having a strong board of directors with good mix of skillsets/properly motivated, i.e. financial
    • Having a strong & motivated management team
    • Having a strong core technology/competence applicable to variety of market applications
    • Building the right strategic alliances in the right way
  • 24. Why so High?
    • Base IRR =risk free rate
    • Plus premiums
  • 25. Why so High?
    • Systematic risk in capital markets
    • Unsystematic (unique) risk diversified away
    • VC firms more vulnerable to market swings
  • 26. Why so High?
    • Liquidity premium
    • 4-7 year investment time horizon
    • Not easy to liquidate investment
  • 27. Why so High?
    • Value added premium
    • Recruitment of key personnel
    • Strategy
    • Board of Directors
    • Network
    • Deep pockets
  • 28. Why so High?
    • Portfolio average return
    • 2-6-2 rule
  • 29. Valuation and Pricing
    • Magnitude of investment
    • Staging of investment
    • Syndication
    • Target IRR
    • Investment time horizon
    • Terminal value of firm
    • % ownership required
    • Deal structure
    • Future financing and dilution – “The Venture Capital Method”
  • 30. Magnitude of Investment
    • Typically >$1.0 million for institutional
    • Small deals too costly
    • Typically less than $10 million in Canada
    • Based on business plan pro forma
  • 31. Staging of Investment
    • All up front
    • Two or three tranches
    • Contingent on meeting milestones/targest
    • Option to abandon
  • 32. Syndication
    • Sharing the deal with other VC firms
    • Diversify the risk
    • Broaden the network
    • Increase size of portfolio
  • 33. Target IRR
    • 25-80 %
    • Stage of company
    • Use of funds
    • Deal structure
  • 34. Investment Time Horizon
    • 4-7 years
    • How long will it take to create value?
    • Years to cash flow breakeven
  • 35. Terminal Value of Firm
    • Projected earnings at exit
    • Price/earnings ratio (PER)
    • Projected TV=Projected Earnings x PER
  • 36. % Ownership Required
    • Magnitude of investment
    • Duration of investment
    • Target IRR
    • Terminal value of firm
    • Room for future investment?
  • 37. VC Investments and IRR
  • 38. % Ownership Required
  • 39. Deal Structure
    • Shares
    • Shares and subordinated debt
    • Shares and convertible subordinated debt
    • What is the upside?
    • What is the downside?
    • Does the structure affect the risk to the VC?
  • 40. Typical Investment Structures
    • Early Stage
      • Common Shares- Maybe “Put” requirement or “Forced Sale” provision on commons if no exit within 5 to 7 years
      • Preferred Shares-convertible into common or with warrants attached, frequently with cumulative dividend- 5 yr. term
      • %tage of equity required tied directly to valuation and amount of capital being sought
  • 41. Typical Investment Structures
    • Later Stage Investments (Mezzanine)
      • Convertible Debentures/Debentures with Warrants
      • Debentures with nominal cost equity
      • Debentures may be unsecured or secured (back of the bus) and usually carry an interest coupon
      • Straight debentures may or may not be sinking fund ”
  • 42. Deal Structure Spreadsheets Three Scenarios
    • $1.0 m VC investment
    • 5 year time horizon
    • Target IRR 40%
    • Terminal value $11.25 m
    • Three different deal structures
    • Varying % ownership
  • 43. Scenario A
  • 44. Scenario B
  • 45. Scenario C
  • 46. The Venture Capital Method Step 1
    • Given the VC investment, the target IRR and the investment time horizon, determine the future value of the VC investment
    • FV = PV(1+i)^n
    • i = target IRR
    • N = time horizon to exit
    • Eg. FV = $1.0m(1+0.35)^5 = $4.5m
  • 47. The Venture Capital Method Step 2
    • Given the projected earnings at exit and an appropriate Price Earnings ratio (PER) for the company, calculate the projected terminal value of the company at exit
    • Eg. TV = $1.0m(15) = $15m
  • 48. The Venture Capital Method Step 3
    • Determine the % ownership required by dividing the required future value of the investment at exit by the projected terminal value of the company at exit
    • Eg. FV= $4.5m/TV$15m = 30%
    • Or divide the VC investment by the present value of the projected terminal value of the company at exit
    • Eg. PV=$15m/(1+0.45)^5=$3.33m ; $1.0m/$3.33m=30%
  • 49. The Venture Capital Method Step 4
    • Determine number of new shares (NS) to be issued to VC.
    • Find number of shares outstanding before investment (old shares (OS) eg. 1.0m)
    • VC % Ownership = NS/(NS +OS)
    • Eg. 30% = NS/(NS + 1.0m)
    • NS= 430,000
    • Price per share = $1.0m/430,000 = $2.33
  • 50. The Venture Capital Method Step 5
    • Determine pre and post-money valuation
    • If 30% of the company is acquired for a $1.0 VC investment, this implies a post-money valuation of $1.0/0.30 = $3.33m
    • Give a post-money valuation of $3.33m and an investment of $1.0m, the pre-money valuation is $2.33m
    • Does this valuation make sense? Is it realistic?
  • 51. The Venture Capital Method Step 6
    • Assess future dilution due to issuance of additional shares prior to exit.
    • Shares to management, future investors
    • Estimate retention ratio = 100% - % of ownership issued to others in future
    • Eg. If a future investor negotiates a 10% ownership, the retention ratio is 100%-10%=90%
  • 52. The Venture Capital Method Step 7
    • Calculate adjustment to required ownership % due to expected future dilution
    • Adjusted ownership % = % ownership without dilution divided by retention ratio
    • Eg. Adjusted % = 30%/90% = 33.3%
    • If VC owns 33% after investment and gets diluted by 10% before exit, the final ownership % will be 30%, ie. the required ownership % to realize target IRR given projected terminal value
  • 53. Venture Capital Method Spreadsheet
  • 54. The Venture Capital Method Multiple Rounds of Financing
    • Often subsequent rounds of financing are anticipated before the round 1 VC investor plans to exit
    • Each subsequent round will negotiate an ownership position based on their own magnitude of investment, target IRR and investment time horizon
    • The round 1 VC investor has to anticipate these future investments and adjust required ownership % for expected future dilution
    • Typically future investments have a lower target IRR
    • The round 1 investor retention ratio is 100% minus the % owned by future round investors at exit
  • 55. Sensitivity Analysis
    • Terminal Value
      • Future Earnings (Sales, Expenses, Profits)
      • PER
    • Target IRR
      • Risk
      • Deal Structure
      • Liquidity
    • Dilution
      • Future Rounds (Amounts, IRR, Horizon)
      • Management incentives
  • 56. The VC-Company Relationship
    • VC Fees
    • The Shareholder’s Agreement
    • Corporate Governance
    • Exit
  • 57. VC Fees
    • Commitment fee
    • Termination fee
    • Due diligence expenses
    • Legal expenses
    • All paid by company
  • 58. Shareholder’s Agreement
    • Defacto control over critical decisions
      • Hiring/firing key management personnel
      • Budgets and capital expenditures
      • Financing
      • Strategic changes
      • Veto rights
      • Dispute resolution
  • 59. Shareholder’s Agreement
    • Exit Provisions
      • “ Put”/ “Call” Rights
      • “ Drag Along” Rights
      • “ Tag Along” Rights
      • “ Right of First Refusal” Rights
      • Valuation formula/process
  • 60. Shareholder’s Agreement
    • Corporate Governance
      • Board of Directors
      • Independent members
      • Swing vote to independents
      • Help create value
  • 61. Corporate Governance
    • No interference in day-today operations
    • Regular reporting (monthly)
    • Regular Board meetings
    • Annual audits
    • Performance assessment
    • Help out when needed
  • 62. Exit Alternatives
    • Sale to company treasury
    • Sale to equity partners
    • Sale to owners/management/employees
    • Sale to third party (VC shares or all)
    • IPO
    • Hold and “milk”
    • Liquidate
  • 63. The Initial Public Offering (IPO)
    • Address capital needs beyond limits of VC’s
    • Liquidity for VC’s
    • “ Quiet period”
    • “ Lock up” period
    • Legal, accounting and investment banking fees
    • Prospectus and road show
    • Public scrutiny
    • Focus on stock price, short term results
  • 64. What Should You Expect From Your V.C?
    • An investment in size, scope and structure consistent with the execution requirements of your business plan
    • Ability to bring other V.C.’s and financiers to the table
    • Active, value adding board of directors involvement
    • Access to network and other resources
    • A fair deal that creates a win/win for everybody and recognizes the value of monetary and non monetary contributions of key stakeholders
    • Ongoing financial support where business case warrants
    • Do your homework, v.c. money is not homogeneous
  • 65. Realities of the Current Market
    • Financing based on “Napkin” business plans is “out”
    • Fundamentals are back “in”
    • Companies must show more evidence of market acceptance of product, value proposition and business model before funding
    • Tough with no sales
    • Valuations are down 50-75%
    • V.C.’s are staying closer to home
  • 66. Investors Active in Atlantic Canada ACF Equity Atlantic Inc. BMO Capital BDC Venture Capital Group Canadian Science and Technology Group Roynat Manulife EDC CDP – Accés Capital CDP - Sofinov Genesys Capital Partners Latitude Partners Ventures West Management Inc ETSIF Skypoint RBCP.