How Venture Capital is Like a Relationship


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Presentation about how a venture capital investment has attributes just like a romantic relationship. Originally written and presented by Lisa Suennen to the UC Berkeley Haas School of Business

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  • My focus today is to tell you how a deal gets done, from search to exit What I mean by exit is when you, the investor, cash out your shares in the company through their sale to another company or after an IPO; these are the principal ways that a venture fund makes money
  • As I was thinking about my presentation, I wanted to come up with a simple paradigm for what we do and what occurred to me is this: Venture deals are just like relationships…. You cast around and see lots and lots of ideas, from the sublime to the ridiculous You fall in love, and believe me, you do fall in love with deals. You break up if the engagement doesn ’t go as planned or you get “married” and have what is often an 5-10 year business relationship; or You argue, even when you still love each other You deal with the stress of daily life and see the stretch marks and gray hair that didn ’t seem to be there before and work around it; sometimes others join the family as you need new investors You either grow old and meet the end smiling or kicking and screaming. Every one of these stages is present in a venture deal.
  • Don ’t forget: what am I NOT looking for
  • As you develop your investment model, there are a few other considerations to bear in mind There is a major bifurcation in healthcare investment: Bio-tech/pharma model: Life saving drugs will be paid for Not economically sensitive Highly binary outcome: the molecule works or it doesn’t A few “home-runs” more than return the fund Not much the VC can do while the science happens Generally requires the public market or a major strategic partner to get the product to market financially Healthcare model More incremental businesses than discovery of new molecule Highly economically sensitive Potential for all companies to make it, theoretically Likely broad array of outcomes resulting in the returns More focus on business operations, revenue, profitability Should be more capital efficient You have sold your investors on a targeted return and timeline…this drives your thinking on a number of fronts, particularly risk management
  • Example: OmniGuide Focus : medical devices Model : enables surgeries that could not be done and does some surgeries in a much cheaper and more effective way (e.g., brain surgery, stapes surgery) Stage : product launch Structure : invested $17mm of a $27mm round so we have majority in that round and have voting rights to control many aspects going forward Ownership : board member, manage hiring committee, audit committee, actively introduce them to customers and bankers and industry leaders
  • Generally true that a known source is the best source Active Health InSound Medical Sometimes you are surprised by what comes from elsewhere Example: Soccer dad brought me Estech Revolution Health brought us Extend Health Portfolio company brought us Click4Care
  • So now you have your target, and frankly, this is where the hard work starts. You have to prove to yourself and, more challenging, your partners, that you are right about your hunch. For Psilos, it is usually 12-16 weeks from identification of a hot deal (to us) to closing.
  • Now you are in the dating phase, where you are basically sniffing each other out and poring over every nook and cranny of that company. Due diligence means looking at everything they say and do and figuring out what works, what doesn ’t and what can be done to improve their prospects. It is also the time for really getting to know management, how responsive they are, how honest they are and, do you really want to work with these people. The truth is, every great company has some pretty crappy times-can you work with these people side by side for the next 7 years, because you will be. Don ’t fall prey to conventional wisdom as you enter due diligence But don ’t ignore your gut feelings
  • Hand out a sample term sheet. Generally we give a term sheet when we are ready to say to ourselves: we think we want to do this deal—time to prove to ourselves that there is a reason not to do it. Eg—Gamma Medica—most recent deal; talked for months before we gave them terms…tested first..etc. I will point out some highlights, but the main things to remember is, this is the road map for the ultimate relationship, the rules of the road not just for making the investment, but for managing it and exiting it…a critical document. The first road test of the relationship. Gives you the opportunity to really test the mettle and style of management and the board.
  • I am not going to go over it in extensive detail because it would take an hour or more. If there are people who want to hear that, I can set up time to do it another day. Equity and Debt Valuation Capitalization and investment amount Terms of the security Preferred Participating preferred Convertible Seniority Future rounds of financing…what happens Preemptive rights Antidilution Voting rights
  • As in any relationship, sometimes you wake up and say to yourself, I have to get the hell out of here . The due diligence process is designed exactly to help you figure out if there is reason to run. Sometimes you find out information that leads you to renegotiate the deal . The most important thing to ask yourself during those times is: if I had known this day 1, would I have given them a term sheet. If not, then run. One of the tools I find very useful is background checks. I have them fill out a paper form by hand where they have to write true or false to a number of questions. Then I do a full background check. I am amazed at some of the stuff I have seen over the years. Resume doesn ’t match what they told you Bankruptcy Gambling debts Don ’t take shortcuts—EXAMPLE: Canopy Health Raised over $88mm in venture capital (Foundation, Spectrum, Granite Global) $9mm in 2007 revenue; $60mm in 2008 Tax statements and audits were bogus (6 months after close Fatal error: not speaking with the accountants Don ’t fall in love with falling in love…know when your live one is a dead duck
  • Certificate =basic document that lists all the capital stock and its terms, board construct, what happens on liquidation, voting rights, lays out Board construct, conversion, anti-dilution, etc. Purchase Agreement =what you are buying for how much and what is being represented to you as part of that sale ( Schedule of Exceptions ) Shareholder Agreement =Board voting, stock transfers, tags and drags, etc. Investor Rights Agreement =special rights, such as registration rights, protective provisions, inspection, pre-emptive rights, rights of information, insurance, Management Rights = basically meets Dept of Labor requirements enabling you to engage with portfolio companies and maintain your VC standing Indemnification = company indemnifies board member for lawsuit
  • It is amazing to me, considering how much money VCs invest, how few of them actively shepherd their investment . We have found that a successful outcome directly correlates to activism on the part of the investors. It ’s like a family…if the parents don’t pay attention, the kids can go off the reservation. Don ’t be a drive by board member . Act like you own the place , because you do! And since it ’s your place too, keep it running well . Help management identify and solve problems. Be a resource. You aren’t there to run the place or take the role of management over, but you are their to help steer the course, apply your experience and keep everyone honest and looking forward . EXAMPLE: introduced a portfolio company to a new client recently—SeeChange; OmniGuide Don ’t forget the importance of long range planning . Too many boards get caught up in the quarter and forget it’s a long ride. It is critical to actively speak about product road map, capital needs, management succession, etc. even when it is allegedly too early too worry about those things. It is never too early. Example: Patient Safe CEO change For instance: Spend three years bringing a product to market and then look up and realize they don ’t have a “next product” but the ultimate exit value is significantly enhanced if you are not just a one trick pony.
  • If there is one universal truth in venture capital it is: it will take longer and need more money than anyone originally thought. A critical part of being a board member and investor is thinking about the next round well in advance of its occurrence Before that a critical piece of running a fund is RESERVE STRATEGY Example: Capital reserves for Patient Safe Solutions
  • At the end of a deal ’s life, you want to be the guy on the left, not the guy on the right. The guy on the left exited at the value peak for his company, meeting his IRR objectives. The guy on the right got forced to exit because he ran out of money and the predators swept in and blew the investors away. These things happen all the time. There is some luck involved in a good exit, but you mostly make your own luck. This is the main reason that activism as a board member and investor is so critical. You can stop the train wreck, often, through great leadership and planning (give HealthEdge example ).
  • At this stage of the game, you are the Mom hoping to ensure your daughter marries well. Part of it is teaching the skills to be ready when the time comes and to make sure she knows that you want her to marry rich! Part of it is being honest about her flaws so you can teach her to present her best side. Some of it is about protecting your own interests…this is the time when everyone ’s true colors really come out….it is amazing how mis-aligned the incentives of everyone involved can be. EXAMPLE: InSound VC ’s want to exit because they need some points on the board and others don’t because they don’t like the price Mgmt doesn ’t want to exit because they will have to find another job, or Management wants to exit because they will walk away with $$ VC ’s don’t want to exit because there is still huge value creation in front of you It is important to keep everyone ’s incentives reasonably aligned or at least as out in the open as possible.
  • So here we are at Berkeley so I thought I could get away with getting a little “ideological” on you. Since we are in healthcare, which allegedly has some “greater good” associated with it, what is our responsibility to consider that greater good when we invest? Is it acceptable to back a new drug when you know it has potentially dangerous side effects? Is it acceptable to back a new medical device when you know it is no better than one already out there but costs more? Is it acceptable to foster a new healthcare service that costs a lot but doesn ’t really improve quality of care, such as old school disease management? Is it ok to support a new product that payers love but which makes physicians ’ lives more complicated thus reduces their time with patients?
  • How Venture Capital is Like a Relationship

    1. 1. 2011 Copyright by Lisa Suennen Innovation in Healthcare - Haas School of Business Meet, Fall in Love, Then What? How Doing a Venture Deal is Like a Relationship
    2. 2. The Venture Deal—Start to Finish
    3. 3. How a Venture Deal is Like a Relationship Dating Scene The Courting Phase Engagement & the Prenuptual Agreement Building the Family Golden Anniversary Things go badly Break up Things go badly Break up Things go badly Divorce Deal Due Term Due Deal Portfolio Positive or Identification Diligence Sheet Diligence Closing Management Negative Exit Things go well Marriage Things go well Things go well Things go well Defining Your Perfect Match The Pick-Up
    4. 4. Defining Your Perfect Match <ul><li>When starting a venture fund, you have to think like eHarmony: </li></ul><ul><ul><li>What do I want in a mate, er, I mean deal? </li></ul></ul><ul><ul><li>What age/stage </li></ul></ul><ul><ul><li>What size/shape/structure </li></ul></ul><ul><ul><li>What are my “gotta haves”? </li></ul></ul><ul><ul><li>What are my “no ways”? </li></ul></ul><ul><ul><li>How do I know the deal of my dreams when I see it? </li></ul></ul><ul><ul><li>How am I going to communicate with my mate ‘til exit? </li></ul></ul><ul><li>Ultimate output of this process is an investment model that is more specific than: “big target market and it will make lots of money” </li></ul><ul><ul><li>What am I looking for, conceptually and culturally? </li></ul></ul><ul><ul><li>What attributes does it need to have? </li></ul></ul><ul><ul><li>What corporate governance structures do I want to utilize </li></ul></ul>
    5. 5. The Perfect Match: Refining Deal Selection <ul><li>Key considerations as you form your investment model and select deals: </li></ul><ul><ul><li>Healthcare vs. Life Sciences </li></ul></ul><ul><ul><ul><li>Two very different types of investing </li></ul></ul></ul><ul><ul><li>What are your specific financial goals? </li></ul></ul><ul><ul><li>What is your time horizon? </li></ul></ul><ul><ul><li>Risk tolerance (belt & suspenders vs. “cowabunga, dude!”) </li></ul></ul><ul><ul><ul><li>Innovation (transformational vs. evolutionary) </li></ul></ul></ul><ul><ul><ul><li>Stage (lower valuation vs. lower risk) </li></ul></ul></ul><ul><ul><ul><li>Deal Size (runway vs. dilution) </li></ul></ul></ul><ul><ul><ul><li>Syndicate (risk sharing vs. control) </li></ul></ul></ul>
    6. 6. Psilos Investment Model: Investing to Improve the Healthcare Economy <ul><li>Sole focus on healthcare:  services, IT and medical technology </li></ul><ul><li>Identification of businesses that improve the healthcare economy: </li></ul><ul><ul><ul><li>Lower cost and improve quality </li></ul></ul></ul><ul><ul><ul><li>Align the incentives of payers, providers and patients   </li></ul></ul></ul><ul><ul><ul><li>Contribute to transforming the healthcare system into a value-based economy </li></ul></ul></ul><ul><li>Later stage venture and growth equity </li></ul><ul><ul><ul><li>Series B or later </li></ul></ul></ul><ul><ul><ul><li>Invest to finance market adoption of proven business models and technologies </li></ul></ul></ul><ul><ul><ul><ul><li>Avoid: clinical/technology risk </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Accept: market/execution risk </li></ul></ul></ul></ul><ul><ul><ul><li>Approximately 5-6 year holding period </li></ul></ul></ul><ul><li>Structure </li></ul><ul><ul><ul><li>Purchase majority of senior security </li></ul></ul></ul><ul><ul><ul><li>Maintain voting power over key decisions </li></ul></ul></ul><ul><ul><ul><li>Limited syndication </li></ul></ul></ul><ul><li>“ Ownership” approach to portfolio company monitoring and selection </li></ul><ul><ul><li>Always the lead investor </li></ul></ul><ul><ul><li>Highly active and value-added board members  </li></ul></ul><ul><ul><li>Strong partnership with management </li></ul></ul>
    7. 7. Entering the Dating Scene <ul><li>Where deals come from: </li></ul><ul><ul><li>Referrals from known sources (VCs, industry colleagues, etc.) </li></ul></ul><ul><ul><li>Investment banks and placement agents </li></ul></ul><ul><ul><li>Other portfolio companies </li></ul></ul><ul><ul><li>Original research </li></ul></ul><ul><ul><li>Over the transom </li></ul></ul><ul><li>Managing the “funnel”—welcome to speed dating </li></ul><ul><ul><li>An average year at Psilos: </li></ul></ul><ul><ul><ul><li>800 or so plans in the door </li></ul></ul></ul><ul><ul><ul><li>300 or so company meetings </li></ul></ul></ul><ul><ul><ul><li>20-25 serious looks </li></ul></ul></ul><ul><ul><ul><li>2-3 deals closed </li></ul></ul></ul><ul><li>Portfolio “balancing” </li></ul>
    8. 8. The Pick-up: Now What? <ul><li>You think you ’ve got a live one…now what do you do to advance the relationship? </li></ul><ul><li>Here ’s where the real work begins </li></ul>
    9. 9. The Courting Phase: Doing Your Due Diligence <ul><li>The due diligence process </li></ul><ul><ul><li>Create a due diligence plan and checklist </li></ul></ul><ul><ul><li>Data vs. conventional wisdom </li></ul></ul><ul><ul><li>There ’s no way you know everything so hire experts who know what you don’t </li></ul></ul><ul><li>Rules of the road </li></ul><ul><ul><li>Everything they tell you is only sort of true </li></ul></ul><ul><ul><li>Nothing is sacred – don ’t be shy </li></ul></ul><ul><ul><li>Don ’t check only the references they give you </li></ul></ul><ul><ul><li>Talk to lost customers not just current ones </li></ul></ul><ul><ul><li>Don ’t be afraid to speak with the competitors </li></ul></ul><ul><ul><li>Don ’t be seduced by the “brand name” investors </li></ul></ul><ul><ul><li>Talk to the rank and file, not just management </li></ul></ul><ul><ul><li>No one gets to $100MM in 4 years, but every business plan says they will </li></ul></ul><ul><ul><li>With respect to market adoption, assume everyone ’s interests are financial first </li></ul></ul><ul><ul><li>It always takes longer and more money than they say it does </li></ul></ul><ul><ul><li>Remind the CEO you will probably fire him/her someday and note the response </li></ul></ul><ul><ul><li>Be extremely respectful of their confidential information </li></ul></ul>
    10. 10. The Pre-Nup: Term Sheets and Setting the Deal Ground Rules <ul><li>The Term Sheet: </li></ul><ul><ul><li>Defines the financial terms on which you will invest. </li></ul></ul><ul><ul><li>Sets for the “rules” for the due diligence process, deal timeline, closing, and life after closing </li></ul></ul><ul><ul><li>Outlines the fundamental understanding between the company and the investor about how the relationship will be conducted </li></ul></ul><ul><ul><li>Lays out what happens if due diligence leads to deal break-up </li></ul></ul><ul><ul><li>Is the first test of how the parties get along </li></ul></ul>
    11. 11. The Pre-Nup: Term Sheets and Why Structure Matters <ul><li>Key Term Sheet Features: </li></ul><ul><ul><li>Who is investing (syndicate) </li></ul></ul><ul><ul><li>Price and valuation and capitalization </li></ul></ul><ul><ul><ul><li>Equity </li></ul></ul></ul><ul><ul><ul><li>Debt </li></ul></ul></ul><ul><ul><li>Use of funds </li></ul></ul><ul><ul><li>Terms of the security you are buying </li></ul></ul><ul><ul><ul><li>liquidation preferences </li></ul></ul></ul><ul><ul><ul><li>seniority </li></ul></ul></ul><ul><ul><ul><li>dividends </li></ul></ul></ul><ul><ul><ul><li>conversion and redemption rights </li></ul></ul></ul><ul><ul><li>What happens in future financings </li></ul></ul><ul><ul><ul><li>pre-emptive rights </li></ul></ul></ul><ul><ul><ul><li>anti-dilution protection </li></ul></ul></ul><ul><ul><li>Voting and protective provisions </li></ul></ul><ul><ul><li>Board structure and other corporate governance terms </li></ul></ul><ul><ul><li>Employment agreements and stock options </li></ul></ul><ul><ul><li>Definition of exit (liquidation) </li></ul></ul><ul><ul><li>Exclusivity and no-shop provisions (binding terms) </li></ul></ul><ul><ul><li>Conditions to close the financing (due diligence) </li></ul></ul>
    12. 12. The Break-Up: Knowing When to Leave Them at the Altar <ul><li>You must always reserve the right to change your mind </li></ul><ul><ul><li>Never sign a binding term sheet (unless you have to) </li></ul></ul><ul><ul><li>It ain ’t over ‘til the fat lady signs the deal documents </li></ul></ul><ul><li>Reasons to run, not walk, from a deal: </li></ul><ul><ul><li>You find out your original hypothesis was just plain wrong—don ’t drink your your own Kool-Aid </li></ul></ul><ul><ul><li>Dishonesty on the part of management </li></ul></ul><ul><ul><li>Questionable intellectual property claim </li></ul></ul><ul><ul><li>Squirrelly clinical data </li></ul></ul><ul><ul><li>Squirrelly financial audit </li></ul></ul><ul><ul><li>Worrisome lawsuit </li></ul></ul>
    13. 13. Marriage: Getting the Deal Inked <ul><li>Starts with a very detailed term sheet </li></ul><ul><li>Use an experienced lawyer with good business savvy </li></ul><ul><li>Get to know your deal documents </li></ul><ul><ul><li>Certificate of Incorporation </li></ul></ul><ul><ul><li>Purchase Agreement </li></ul></ul><ul><ul><li>Schedule of Exceptions </li></ul></ul><ul><ul><li>Shareholder Agreement </li></ul></ul><ul><ul><li>Investor Rights Agreement </li></ul></ul><ul><ul><li>Management Rights Agreement </li></ul></ul><ul><ul><li>Indemnification Agreements </li></ul></ul><ul><ul><li>Insurance Certificates </li></ul></ul><ul><li>Stay in close touch </li></ul><ul><ul><li>What changes between term and closing? </li></ul></ul>
    14. 14. Building the Family: Activism is Key to Successful Portfolio Management <ul><li>“ You get what you inspect, not what you expect” </li></ul><ul><li>Don ’t be a drive-by board member – venture capital vs. “advisory capital” </li></ul><ul><li>Be smart money – use your experience and contacts to help the company </li></ul><ul><li>Stay in touch with the numbers and team </li></ul><ul><ul><li>Befriend the CFO </li></ul></ul><ul><li>Don ’t forget long-term planning </li></ul><ul><ul><li>Product road map </li></ul></ul><ul><ul><li>Capital formation </li></ul></ul><ul><ul><li>Management succession </li></ul></ul><ul><ul><li>Exit planning </li></ul></ul>
    15. 15. Building the Family: The [Inevitable] Next Round of Financing <ul><li>Long term capital planning is a key responsibility of management and the Board </li></ul><ul><li>Critical issues: </li></ul><ul><ul><li>Milestones </li></ul></ul><ul><ul><li>How much? </li></ul></ul><ul><ul><li>When? </li></ul></ul><ul><ul><li>Reserves in the investor base </li></ul></ul><ul><ul><li>What expertise is needed in syndicate? </li></ul></ul><ul><ul><li>What is the “personality” of the new investor? How will they fit with the family? </li></ul></ul><ul><li>What special rights can the early investor retain? </li></ul><ul><li>What does the early investor have to give up, if anything? </li></ul>
    16. 16. Golden Anniversary vs. Divorce: The Exit <ul><li>The “Good Way” (M&A, IPO, Other sale) </li></ul><ul><li>In the timeframe you want to go </li></ul><ul><li>At the price you want to get (meets your fund ’s IRR/multiple goals </li></ul><ul><li>With terms you can live with </li></ul><ul><li>So you can get your money out fast </li></ul><ul><li>The “Bad Way” (fire sale, bankruptcy) </li></ul><ul><li>Because you have to go </li></ul><ul><ul><li>Business idea failed </li></ul></ul><ul><ul><li>Lost the race to a competitor </li></ul></ul><ul><ul><li>Ran out of money; inadequately capitalized </li></ul></ul><ul><li>At a lousy price without a return </li></ul><ul><li>Money held hostage in lengthy escrow/earn-out </li></ul>
    17. 17. Your Role in Helping the Company Exit Well <ul><li>Internal </li></ul><ul><ul><li>Set clear expectations about your exit goals </li></ul></ul><ul><ul><li>Set clear expectations about milestones you expect to see and when </li></ul></ul><ul><ul><li>Be brutally honest about management ’s capabilities; act fast when it’s time for a change </li></ul></ul><ul><ul><li>Advise management on resources (bankers, accountants, lawyers) that facilitate a more effective exit </li></ul></ul><ul><ul><li>Assist in negotiation of the exit </li></ul></ul><ul><li>External </li></ul><ul><ul><li>Know the buyers and ask them what they are looking to buy </li></ul></ul><ul><ul><li>Introduce management to the players that affect their potential exit </li></ul></ul><ul><ul><li>Know the investment bankers and understand the public and M&A market requirements and conditions </li></ul></ul>
    18. 18. And Now for Something Ideological…. <ul><li>If you have two companies that make similar products, which is worth more: the one that has a better clinical outcome or the one that has higher sales? </li></ul><ul><li>If you know you can get a great deal on the cheap by blowing up your fellow investors (diluting their equity value), should you do it? </li></ul><ul><li>The U.S. healthcare system is a mess: should venture capitalists have a responsibility to add value to the system or just make money? </li></ul>