How Venture Capitalist (VC) Firms Screen Deals

Venture Capital Investing
A Primer
William Quigley
Managing Director
Clearstone Venture Partners
[email_address]
C L E A R S T O N E V E N T U R E P A R T N E R S

Venture Capital “ I was seldom able to see an opportunity until it had ceased to be one” Mark Twain C L E A R S T O N E V E N T U R E P A R T N E R S

Venture Capital
Industry Overview
Screening Venture Opportunities
The Venture Capital Process
The Business Plan
Valuation
Exit
Getting in Touch

Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch C L E A R S T O N E V E N T U R E P A R T N E R S

Industry Snapshot
400+ institutional VC firms in the U.S.
Geographically concentrated
Stage/Industry focused
General partners/Limited partners
10 year investment horizon
Co-investment with other VC’s common

Typical Firm Profile
3 to 4 investment professionals
Review 1000+ business plans a year
Manage $50 to $200 million in capital
Buy equity (preferred stock) - rarely make loans
Investment horizon - 3 to 6 years
Sources of capital:
- Pension funds - Corporations
- College endowments - Wealthy individuals

Investment Stages
Five Stages:
Seed
Start-up
Early
Expansion
Mezzanine/Bridge
Most VC’s have a preference for a particular investment stage. C L E A R S T O N E V E N T U R E P A R T N E R S

Stage/Characteristic
Stage Investment Characteristics
Seed $50-500K - Founder(s) only
- No product
- No customers
- Primary risk: R&D
Start-Up $500K to $1MM - Mgmt. team incomplete
- Prototype or beta product
- No revenues
- Limited customer interest
- Some capital invested
- Primary risk: market accept.

Stage/Characteristic Stage Investment Characteristics Early $1MM - $3MM - Most of team in place - Limited revenues - Not profitable - Primary risk:execution Expansion $3MM - $10MM - Meaningful revenues - Achieving profitability - Growing customer base - Primary risk: competition C L E A R S T O N E V E N T U R E P A R T N E R S

Stage/Characteristic Stage Investment Characteristics Mezzanine/ $10MM - $20MM - Significant revenues Bridge - Profitable - Industry player - IPO in 6-12 months - Risk much lower C L E A R S T O N E V E N T U R E P A R T N E R S

The Role of the VC
Board involvement
Management recruitment
Future capital raising
Access to business network
Strategy development
Patience!

Targeted Industries
Information Technology
Medical Services/Devices
Communications
Biotechnology
Some Retail
Most of the $10 billion invested by VC’s in 1997 was concentrated in five industries. Why these? C L E A R S T O N E V E N T U R E P A R T N E R S

How Do VC’s Make Money?
Collect management fees from L.P.’s - 2 1/2% annually
Share profits with L.P.’s - 20/80 split on investment gains
How do VC’s earn their income? Source of VC Income: C L E A R S T O N E V E N T U R E P A R T N E R S

What Do VC’s Want to See?
Areas of Focus:
Management
Marketplace
Competition
Business Economics
Risks
Venture capitalists tend to focus on five specific areas when evaluating a company: C L E A R S T O N E V E N T U R E P A R T N E R S

Management
VC Focus:
DIRECT sales experience?
Prior P/L responsibility?
Personal financial stake?
Willingness to share equity
“ Fire in the belly”?
Functional areas covered?
The most important question: Has the team had experience and success in the same industry? C L E A R S T O N E V E N T U R E P A R T N E R S

Market
VC Focus:
Market size and growth rate?
Market drivers?
Customer involvement in the R&D process?
Number of competitors?
Can management demonstrate a thorough understanding of the marketplace dynamics? C L E A R S T O N E V E N T U R E P A R T N E R S

Competition
VC Focus:
Why are competitors successful?
What is the prevailing business model?
Barriers to entry?
Does management have a clear understanding of the competitive landscape? C L E A R S T O N E V E N T U R E P A R T N E R S

Business Economics
VC Focus:
Margins comparable to industry norm?
Break-even < 2 years ?
Appropriate sales model?
Moderate capital intensity?
Does management have a deep understanding of the financial dynamics of the business and industry? C L E A R S T O N E V E N T U R E P A R T N E R S

Risk
VC Focus:
Reasonable financial projections?
New technology adoption rate?
Length of sales cycle?
Best and worst case scenarios explored?
Regulatory hurdles?
Does management recognize, accept, and have strategies to deal with key risks? C L E A R S T O N E V E N T U R E P A R T N E R S

The Venture Capital Process
Business Plan
First Meeting
Second Meeting
Term Sheet
Due Diligence
Negotiations

Business Plan “ Madam, enclosed please find the novel you commissioned. It is in two volumes. If I had had more time I could have written it in one.” Voltaire C L E A R S T O N E V E N T U R E P A R T N E R S

Business Plan
Business Plan Basics:
Written by the entrepreneur
Keep it short
Financials (3-5 year proj.)
Income statement
Balance sheet
Cash flow
“ What-ifs” helpful
#1 objective of the the business plan: Get the VC interested in hearing more about the opportunity . C L E A R S T O N E V E N T U R E P A R T N E R S

Business Plan
50
5
10
Magic Numbers? C L E A R S T O N E V E N T U R E P A R T N E R S

Business Plan
We have no competition….
We conservatively project…..
We only need a 10% market share….
We will offer the most features at the lowest price….
We valued our Internet start-up using multiples of comparable companies…like Netscape, Cisco, Microsoft.…
Business plan phrases that ‘spook’ VC’s... C L E A R S T O N E V E N T U R E P A R T N E R S

First Meeting
The Details:
Location: VC’s office
Duration: 2-3 hours
Attendees: 1 to 2 VC’s
Format: Formal presentation with Q/A
‘ Skepticism’ might best describe the venture firm’s attitude in the first meeting. Don’t be alarmed by this. C L E A R S T O N E V E N T U R E P A R T N E R S

Second Meeting
Focus On :
Business opportunity - not the technology
Addressing concerns of the skeptics - THIS IS CRITICAL!
Next steps
Getting to the second meeting is an important milestone. The team will now make its case to the entire partnership. C L E A R S T O N E V E N T U R E P A R T N E R S

What Went Wrong? - A Few Tips
Dont’s
Make vague, ambiguous, or unsubstantiated statements
Make reference to unnamed/ mysterious people on the management team
Use statistical arguments for market penetration assumptions
Use technical jargon
Assume you have a deal if there is no term sheet

What Went Wrong? - A Few Tips
Dos
Involve the entire team
Discuss/disclose potential problems
Demonstrate financial commitment to the venture
Prepare realistic market and sales projections
Know your target investor (angel, bank, VC)

What Went Wrong? - Getting Feedback
Some Guidelines:
Needs to be solicited!
From knowledgeable sources
Develop a dialogue first
Avoid answering, debating
Have a market-researcher mindset
“ The greatest gift that God hath given us is to see ourselves as others see us.”
Scottish Proverb
Getting honest feedback can be challenging… C L E A R S T O N E V E N T U R E P A R T N E R S

Term Sheet
Term Sheet - Common questions:
Is it a legally binding document?
What’s covered?
What is it designed to do?
Why participating preferred stock?
After the second meeting, the VC typically provides a term sheet to the entrepreneur. C L E A R S T O N E V E N T U R E P A R T N E R S

Term Sheet Conditions
Post-money valuation
$ amount of the financing
Investors identified
Size of employee option pool
Vesting periods
Key-person insurance
Board representation
Additions to management team, if any
Monitoring covenants, Restrictive covenants
Other deal specific issues
The term sheet is intended to embody the overall conditions of a business agreement. What’s covered? C L E A R S T O N E V E N T U R E P A R T N E R S

Due Diligence
Due Diligence Overview:
Length: 6-12 weeks
Will perform up to 100 reference calls
Interview customers, former employees, competitors, industry experts
Intense legal, financial work
The “heavy lifting” for the venture capitalist starts with the due diligence process . C L E A R S T O N E V E N T U R E P A R T N E R S

Negotiations
Some flexibility in :
Valuation
Total investment
Vesting periods
Size of option pool
Less flexibility in:
Equity instrument type
Board make-up
Anti-dilution rights
Restrictive covenants
Negotiations take place throughout the due diligence process. What is negotiable? C L E A R S T O N E V E N T U R E P A R T N E R S

The Business Plan
Executive Summary
Main Body
Appendix

Executive Summary
Mission statement
Brief company history
Description of investment opportunity
Market overview
Management team
Product & technology
Customers
Strategy
Competition
Capital requirements
What should the executive summary address? C L E A R S T O N E V E N T U R E P A R T N E R S

Main Body
Key Questions to Address:
Who are the key people in the company?
Where did they come from, and why are they the right people to run the company?
Have they had previous experience and success in growth companies?
Management C L E A R S T O N E V E N T U R E P A R T N E R S

Main Body
What does the customer have access to today?
How does it differ from competing offerings
What is the superior value proposition to the customer?
Product/Technology/Service C L E A R S T O N E V E N T U R E P A R T N E R S

Main Body
What is happening in the marketplace? Is it growing, if so, why and at what rate?
What is lacking from the market leaders that this product/tech/service will provide?
Which customers have been involved in the development of the product and are likely to purchase it?
Marketplace C L E A R S T O N E V E N T U R E P A R T N E R S

Main Body
Why will the customer be compelled to purchase the product?
How will the company maintain its competitive differentiation?
What barriers exist/will be created to curtail new entrants?
Strategy Key Questions to Address: C L E A R S T O N E V E N T U R E P A R T N E R S

Appendix
Relevant industry articles to bolster management claims
Major customer testimonials
Other information likely to impress those not familiar with the market
Not all business plans require an Appendix section, but it can be useful. What to include? C L E A R S T O N E V E N T U R E P A R T N E R S

Valuation Stage Criteria Methodology Range Seed - Mgmt. track record Comparables, $400K to $1.5MM - Market size/growth Whats the “going - Competition rate” in the region - Investment to date Start-up - Market size/growth Comparables $750K to $2.0MM - Working prototype? - Team complete? C L E A R S T O N E V E N T U R E P A R T N E R S

Valuation Stage Criteria Methodology Range Early - Market size/growth Comparables $1.5 to $5.0MM - Revenue run rate - Gross margin % - Performance to date Expansion - Revenue run rate - 1X sales Varies - Profitability ratios - EBIT multiple - Performance vs. plan C L E A R S T O N E V E N T U R E P A R T N E R S

Valuation Stage Criteria Methodology Range Mezzanine/ - Market share/size Multiples of Varies Bridge - IPO environment proxy companies - Performance Relative to plan C L E A R S T O N E V E N T U R E P A R T N E R S

Exit Strategies
Sale or Merger
Most likely exit
Initial Public Offering
Small fraction go this way
Redemption
Least attractive
Management buy-out
Generally not possible

Secrets of Success?
CEO carried a bag
Called on same customer base
Gross margin > 50%
Some degree of technology
Cash flow break-even < $5M
Sourced the deal
25% ownership or greater
First institutional investor
The Eight Commandments C L E A R S T O N E V E N T U R E P A R T N E R S

Odds of Getting a Deal Done?
Hurdle Likelihood of Occurring
1. Review the plan and - 1 in 15
conclude it makes sense
2. Meet the team and like them - 6 in 10
3. Be attracted to the market - 7 in 10
opportunity and the company strategy
4. Introduce team to the other
partners and get their buy-in - 7 in 10

Odds of Getting a Deal Done? Hurdle Likelihood of Occurring 5. Complete the due diligence - 7 in 10 process satisfactorily 6. Get a term sheet agreed to - 8 in 10 in principle 7. Find co-investors - if necessary - 9.9 in 10 8. Get legal documentation done - 9 in 10 9. Fund the company EQUATES TO 1% C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions
“ Will I have to give up control of my company?”

“ Why don’t VC’s sign NDA’s?”

“ Raising money - all at once or spread out over time?”

“ Its a great invention, so why aren’t they interested?”

“ Why do VC’s want to know the other firms that I am talking to?”

“ When should I initiate contact with a VC?”

How do you Contact a VC?
Introductions are best:
Attorney
Accountant
Banker
Angel Investor
Industry Executive

The Michael Dingman Center at U of MD.
The Morino Institute - Netpreneur Program
Baltimore/Washington Venture Group
NVTC - Emerging Business Network functions
Silicon Valley Bank, other community banks
Private Investors Network, Grubstakes (networks of angel investors)
Pratts Guide to Venture Capital
Local Resources C L E A R S T O N E V E N T U R E P A R T N E R S

Venture Capital C L E A R S T O N E V E N T U R E P A R T N E R S

How Venture Capitalist (VC) Firms Screen Deals

by Mark Feldman on May 09, 2009

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How Venture Capitalist (VC) Firms Screen Deals — Presentation Transcript