Venture capital 101 - Imran Almaleh

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an introduction to Venture Capital financing

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Venture capital 101 - Imran Almaleh

  1. 1. A walk through entrepreneurial financeBy Imran Almaleh
  2. 2. Chapter 1: IntroductionChapter 2: Financing start-upsChapter 3: Venture valuationChapter 4: Ownership & Legal issuesChapter 5: Exiting the venture Venture Capital 101 - by Imran Almaleh - January 2012
  3. 3. DefinitionsVC vs. DebtThe VC fundVC’s business modelVC risk pyramidScreening ventures
  4. 4.  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 101 - by Imran Almaleh - January 2012
  5. 5. Venture Capital Debt FinancingHolding Period Long term Short/medium term Instruments Common & preference shares Loans Collateral No YesImpact on B.S Reduce leverage Increase leverageExit Mechanism IPO, sale to 3rd parties Loan repayments Liquidity Low High Risk/Return High LowDiversification Low Medium Venture Capital 101 - by Imran Almaleh - January 2012
  6. 6. VC Fund (Closed Fund) General Partners Provide Work (VCs) (& some Cap.) Limited Partners (Investors) •Pension funds Legal Form: •Insurance companiesLimited Partnership Provide Capital •Private equity funds Company LPC •Individual investors •Endowment •etc… Venture Capital 101 - by Imran Almaleh - January 2012
  7. 7. Capital Capital 2% FeesInvestors Venture Capitalists EntrepreneursClosed fund GP LP 20% margin 6-8 Years Capital+Rest Capital+Profit from Later of profit+Fees Exit Venture Capital 101 - by Imran Almaleh - January 2012
  8. 8. Management teem Market Size FinancialProduct/Technical Economy Regulations Venture Capital 101 - by Imran Almaleh - January 2012
  9. 9.  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 Venture Capital 101 - by Imran Almaleh - January 2012
  10. 10. 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) Venture Capital 101 - by Imran Almaleh - January 2012
  11. 11. High = 3Avg. = 2Low = 1 Venture Capital 101 - by Imran Almaleh - January 2012
  12. 12. Venture’s life cycleFinancing through the cycleExample of venture financing
  13. 13.  Idea  IPO (5-8y)1. Development stageIdea, test feasibility, prototype, no market entrance2. Startup stageRevenue model, first sales3. Survival stagerevenue<expenses, formal financial statements, growth4. Rapid growth stageFast growth in revenue & cash-in flows, economies of scale5. MaturitySlow revenue growth, time to exit Venture Capital 101 - by Imran Almaleh - January 2012
  14. 14. Ventures Life Cycle Revenue Years-1.5 -0.5 0.5 1.5 2.5 3.5 4.5 5.5 6.5Development Startup Survival Rapid-Growth Maturity stage stage stage stage stage Venture Capital 101 - by Imran Almaleh - January 2012
  15. 15.  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 Venture Capital 101 - by Imran Almaleh - January 2012
  16. 16.  Major types of financing: ◦ Seed financing ◦ Start-up financing ◦ First-round financing ◦ Second-round financing ◦ Bank loans, Bond issues, Stock issues Venture Capital 101 - by Imran Almaleh - January 2012
  17. 17. Life Cycle Type of financing Major providersStageDevelopment Seed finance Founders assets Family and friendsStartup Startup finance Founders assets Family and friends Business angels VCsSurvival 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 bankersMaturity Bank loans Business Operations Bond issue Commercial banks Stock issue Investment bankers * Most banks will require 2y of operations Venture Capital 101 - by Imran Almaleh - January 2012
  18. 18. 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) Venture Capital 101 - by Imran Almaleh - January 2012
  19. 19. Overview of valuationInvestor’s rate of returnDCF PV modelVC methodFirst Chicago Method
  20. 20.  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) Venture Capital 101 - by Imran Almaleh - January 2012
  21. 21. Stage of venture Expected Holding Annual ROR %Financing PeriodSeed & start-up 50-100% > 10 yearsFirst-round 40-60% 5-10 yearsSecond-round 30-40% 4-7 yearsBridge 20-30% 1-3 yearsSource: Timmons, Spinelli, and Zacharkis – 2005 (Edited) Holding period: time between Investment and Exit Venture Capital 101 - by Imran Almaleh - January 2012
  22. 22.  To calculate the Required rate of return: Hurdle rate (RRR) = Re/PWhile:Re: required return on equityP: probability of success Venture Capital 101 - by Imran Almaleh - January 2012
  23. 23.  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 Venture Capital 101 - by Imran Almaleh - January 2012
  24. 24. CashFlows Discount CFs by RRR (variable CFs) Reversion value (sustainable G rate) Years 0 2 4 6 8 10 12 14 Venture Capital 101 - by Imran Almaleh - January 2012
  25. 25.  The formula:While:CF : Cash flows at end of yearr : Required rate of returnr ͚ : Expected rate of return (at/after maturity)G : sustainable Growth ratet : time of maturity Venture Capital 101 - by Imran Almaleh - January 2012
  26. 26.  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‟) Venture Capital 101 - by Imran Almaleh - January 2012
  27. 27. CashFlows Terminal Value (value at exit) Years 0 2 4 6 8 10 12 Venture Capital 101 - by Imran Almaleh - January 2012
  28. 28.  The formula:While:Et : Earnings(income) at Exit timeP/E ratio : for similar ventures (or Estimated)r : Required rate of returnt : time of Exit We can also substitute Earnings for CFs Venture Capital 101 - by Imran Almaleh - January 2012
  29. 29.  Uses a scenario approach to valuation  Example: (#s in millions of $) Success Sideway survival FailureRevenue in y 3 8.19$ 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 7Net 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$Probability of Scenario 40% 40% 20%Expected PV of the company 4.13$ Venture Capital 101 - by Imran Almaleh - January 2012
  30. 30. The Option poolCapitalization tableThe term-sheet
  31. 31. 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 Venture Capital 101 - by Imran Almaleh - January 2012
  32. 32. Title Range (%)CEO 5 – 10COO 2–5VP 1–2Independent Board Member 1Director 0.4 – 1.25Lead Engineer 0.5 – 15+ years experience Engineer 0.33 – 0.66Manager or Junior Engineer 0.2 – 0.33 Venture Capital 101 - by Imran Almaleh - January 2012
  33. 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 Venture Capital 101 - by Imran Almaleh - January 2012
  34. 34.  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 Venture Capital 101 - by Imran Almaleh - January 2012
  35. 35.  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) Venture Capital 101 - by Imran Almaleh - January 2012
  36. 36.  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) Venture Capital 101 - by Imran Almaleh - January 2012
  37. 37.  Liquidation preference: ◦ 1x preference + no participation ◦ 1x preference + full participation ◦ Participation w/Cap Drag-along right Redemption right (4-5 years) Venture Capital 101 - by Imran Almaleh - January 2012
  38. 38.  Exclusivity period Non-competition IP registration Vesting & Restricted Stock (4 years) Venture Capital 101 - by Imran Almaleh - January 2012
  39. 39. Exit strategyIPOM&ABuy-outsFranchising
  40. 40. "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 Venture Capital 101 - by Imran Almaleh - January 2012
  41. 41.  Sell the shares of the company to the public to be traded on a stock exchange Investment banking ◦ Valuation ◦ Underwriting ◦ Commissions (% of capital raised) Venture Capital 101 - by Imran Almaleh - January 2012
  42. 42. 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 Venture Capital 101 - by Imran Almaleh - January 2012
  43. 43.  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 Venture Capital 101 - by Imran Almaleh - January 2012
  44. 44.  Sell business concept to others to replicate Receive cash Retain current management Venture Capital 101 - by Imran Almaleh - January 2012
  45. 45. Imran Almaleh
  46. 46.  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 - by Imran Almaleh - January 2012

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