BUSI 5908 and 5900
Effects of Terms and Conditions of Venture Capital Financing
                      on Firm Strategy



...
Table of Contents

TABLE OF CONTENTS.........................................................................................
Management Team..............................................................................................................
APPENDIX A – SAMPLE TERM SHEET .......................................................................................... ...
Section 1 - Introduction


Research Problem

       The purpose of this study is to determine how the terms and conditions...
Section 2 - Literature Review

      The literature review for this research project is presented in an

unconventional ma...
defining attributes and probable outcomes. Figure 1, depicts, the Carlile and

Christensen (2005) Theory Building Process....
literature will not be further pursued. New phenomena and anomalies will be

compared to extant literature and used to dev...
researcher had to be satisfied with only one piece of primary data. The

information hurdle for case inclusion was one of ...
cases were in the National Capital region, two were from the U.S. and one was

based in British Columbia. All but one of t...
Prior to the initial interview, an email was sent outlining the goals of the

study and the initial lines of questioning. ...
nature of the information being divulged. Two of the cases under analysis here

use Harvard Cases as the basis for the ana...
Case 1 (C1)
Data Collected
       This case was developed with a VC interview, a follow-up interview, an

email with the V...
future. The company was finally petitioned into receivership and their assets

were sold.


Management Team
        The ma...
terms and the investors could not come to a consensus regarding a course of

action.

          The solution was that all ...
Case 2 (C2)
Data Collected
       This case was developed with a VC interview, a follow-up interview, an

email with the V...
contact, but lacks financial experience. The VC team augments this very well

with their inclusion on the board and by pro...
was a condition of the financing. The new board member is a very well

connected industry representative, is the only inde...
companies solve their ‘information overload’ problems. The company has gone

through two prior funding rounds.

       The...
Endeca’s current CTO. Gourley was also part of the founding team at Inktomi

and helped to build their caching product. Go...
Business/History
      Founded in 1998 during the dot-com boom, the business model of EXP

Systems was based on a novel de...
A subsequent funding round three years after company inception added

more corporate venture capital funding arms. Some of...
Business/History
       This company, founded in 2001, is a specialized network infrastructure

provider. Its board consis...
Left Hand Side
       Less than three months after receiving the third round funds, the company

announced a large-scale c...
$10 million by year-end. This is a tier one customer requirement in order to

ensure the continued viability of the compan...
Left Hand Side
       Company 6 is very interesting in that it confirms some previous findings

about the success of a com...
The company was founded in 2001, and has received five injections of

capital since inception. The board consists of five ...
The second round of funding was disbursed on the condition that C7

execute their business plan and achieve their financia...
founding partner in a previous organization. The SVP of business development

was selected for his in-depth knowledge of t...
experienced as a VC and a CFO with a venture capital backed firm and two

founders were interviewed post-case and pre-prop...
stakeholder groups exist. From the stakeholder analysis, cases and follow-up

interviews, several propositions have been d...
Venture
                                                   Employees
                         Capitalist

                ...
Table 4 - Specific Stakeholders
                    Venture Capitalist           Entrepreneur
                    Partner ...
Table 5 - Stakeholder Grid for Selected Stakeholders
      Stakeholder Grid for selected stakeholders


      Stakeholder ...
organisation. Economic power could be the power to provide new capital, the

power to provide specialized skills or to wit...
People

       The first area of influence, people, is comprised of:

       1.) Employees

       2.) Management

       ...
board control to replace CEOs. In only one of the cases developed here (C1)

was the CEO replaced. This represents somewha...
1.) Product Strategy

       2.) Market Strategy

       These two categories are further expanded below. Following the

d...
products. Specifically, it was found that products in prototype, beta or release 1.0

stages had to be released and tested...
tier one customers, release of products in new markets and acceptance of

product standards in a new market.

Circumstance...
record of a firm, as determined by their ability to meet previous milestones, the

quality of a product or idea and the si...
Model Development

       The following figure 2 depicts the relationships between the terms and

conditions of a specific...
markets. Similarly, deals exhibiting disruptive characteristics as opposed to

sustaining characteristics will be structur...
conditions provided below are not from the cases developed above, however

they are similar enough to represent the types ...
common shares for each preferred share. Conversely, if C2 meets its revenue

goal, the VC will receive more common share f...
Company five had a good example of the term sheet referring to the

contents of a shareholders agreement. In this case, th...
conditions are stipulated in advance they can be altered, added and enforced

through the board.

       Every case under ...
The term sheets collected for cases all contained liquidation rights,

however none seem to have affected the firm strateg...
constitutes grounds for termination and, finally, what compensation is paid in the

event of termination. The incentives f...
with fewer stipulations in order to increase the likelihood of firm success. Our VC

contact on several of the other deals...
Proposition 1: Ceteris Paribus - The product development stage of a firm’s

product affect the terms and conditions of a f...
A firm with good bargaining power, Company 6, demonstrated that by

meeting previous milestones and by strengthening their...
relates to the two market extremes. The concept of sustaining versus disruptive

innovations, is presented in The Innovato...
Proposition 5: Ceteris Paribus – The more homogenous and aligned an

investor base is, the less restrictive the market rel...
The preceding propositions and model represent the end product of this

research project. The propositions are meant to pr...
phenomena observed here. Another limitation is the lack of term sheet,

shareholder agreements and business plans availabl...
References
Brown, S.L.,  Eisenhardt, K.L., (1995). Product development: past research,
 present findings, and future direc...
Gompers, P., (1995). Optimal Investment, Monitoring, and the Staging of Venture
 Capital. Journal of Finance, vol. 50 , pp...
Research Websites

http://www.canadavc.com

http://www.convergedigest.com

http://www.factiva.com

http://www.google.com

...
Appendix A – Sample Term Sheet
           Source (www.drm.com/newstand/presentations/VC.Model_TS.pdf)

                   ...
BUSI 5908 and 5900 Effects of Terms and Conditions of Venture ...
BUSI 5908 and 5900 Effects of Terms and Conditions of Venture ...
BUSI 5908 and 5900 Effects of Terms and Conditions of Venture ...
BUSI 5908 and 5900 Effects of Terms and Conditions of Venture ...
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BUSI 5908 and 5900 Effects of Terms and Conditions of Venture ...

  1. 1. BUSI 5908 and 5900 Effects of Terms and Conditions of Venture Capital Financing on Firm Strategy Submitted by: Ryan J. Riordan Student ID: 100234855 In Partial Fulfillment of the Degree of Master of Business Administration Supervised by: Dr. John Callahan July 08, 2005
  2. 2. Table of Contents TABLE OF CONTENTS........................................................................................................................ 2 LIST OF FIGURES & TABLES ............................................................................................................ 4 SECTION 1 - INTRODUCTION ........................................................................................................... 5 SECTION 1 - INTRODUCTION ........................................................................................................... 5 RESEARCH PROBLEM ............................................................................................................................ 5 RATIONALE .......................................................................................................................................... 5 CONTRIBUTION ..................................................................................................................................... 5 SECTION 2 - LITERATURE REVIEW................................................................................................ 6 METHODOLOGY .................................................................................................................................... 6 SECTION 3 - RESEARCH DESIGN ..................................................................................................... 7 CASE SELECTION AND DEVELOPMENT ................................................................................................... 8 SECTION 4 - CASES ........................................................................................................................... 11 OVERVIEW OF CASES .......................................................................................................................... 11 CASE 1 (C1)........................................................................................................................................ 13 Data Collected............................................................................................................................... 13 Business/History ............................................................................................................................ 13 Management Team......................................................................................................................... 14 Funding......................................................................................................................................... 14 Left Hand Side............................................................................................................................... 15 CASE 2 (C2)........................................................................................................................................ 16 Data Collected............................................................................................................................... 16 Business/History ............................................................................................................................ 16 Management Team......................................................................................................................... 16 Funding......................................................................................................................................... 17 Left Hand Side............................................................................................................................... 18 ENDECA ............................................................................................................................................. 18 Data Collected............................................................................................................................... 18 Business/History ............................................................................................................................ 18 Management Team......................................................................................................................... 19 Funding......................................................................................................................................... 20 Left Hand Side............................................................................................................................... 20 EXP SYSTEMS .................................................................................................................................... 20 Data Collected............................................................................................................................... 20 Business/History ............................................................................................................................ 21 Management Team......................................................................................................................... 21 Funding......................................................................................................................................... 21 Left Hand Side............................................................................................................................... 22 CASE 5 (C5)........................................................................................................................................ 22 Data Collected............................................................................................................................... 22 Business/History ............................................................................................................................ 23 Management Team......................................................................................................................... 23 Funding......................................................................................................................................... 23 Left Hand Side............................................................................................................................... 24 COMPANY 6 (C6) ................................................................................................................................ 24 Data Collected............................................................................................................................... 24 Business Overview......................................................................................................................... 24
  3. 3. Management Team......................................................................................................................... 25 Funding......................................................................................................................................... 25 Left Hand Side............................................................................................................................... 26 COMPANY 7 (C7) ................................................................................................................................ 26 Data Collected............................................................................................................................... 26 Business Overview......................................................................................................................... 26 Management Team......................................................................................................................... 27 Funding......................................................................................................................................... 27 Left Hand Side............................................................................................................................... 27 COMPANY 8 (C8) ................................................................................................................................ 28 Data Collected............................................................................................................................... 28 Business Overview......................................................................................................................... 28 Management Team......................................................................................................................... 28 Funding......................................................................................................................................... 29 Left Hand Side............................................................................................................................... 29 CONFIRMING FINDINGS ....................................................................................................................... 29 SECTION 5 – ANALYSIS, PROPOSITIONS AND MODEL DEVELOPMENT .............................. 30 STAKEHOLDER ANALYSIS ................................................................................................................... 31 PROPOSITION DEVELOPMENT .............................................................................................................. 35 PEOPLE ............................................................................................................................................... 36 FINANCE ............................................................................................................................................. 37 BUSINESS ........................................................................................................................................... 37 Product Strategy............................................................................................................................ 38 Comparison to Literature....................................................................................................................... 38 Effects observed .................................................................................................................................... 38 Market Strategy ............................................................................................................................. 39 Comparison to Literature....................................................................................................................... 39 Effects observed .................................................................................................................................... 39 Circumstances ....................................................................................................................................... 40 Bargaining Power .................................................................................................................................. 40 Product................................................................................................................................................... 41 Market .................................................................................................................................................... 41 Investor Alignment and Orientation ...................................................................................................... 41 Model Development ....................................................................................................................... 42 Stipulation of Terms and Conditions............................................................................................... 43 Security Design...................................................................................................................................... 44 Staging of Investments.......................................................................................................................... 45 Shareholder agreements....................................................................................................................... 45 Equity allotment ..................................................................................................................................... 46 Board rights............................................................................................................................................ 46 Liquidation rights.................................................................................................................................... 47 Sale of share restrictions....................................................................................................................... 48 Stock option pools, warrants................................................................................................................. 48 Employment Contracts.......................................................................................................................... 48 PROPOSITION DEVELOPMENT .............................................................................................................. 49 General Propositions..................................................................................................................... 49 Product Strategy Propositions........................................................................................................ 50 Market Strategy Proposition .......................................................................................................... 51 SECTION 6 – ANALYSIS, PROPOSITIONS AND MODEL DEVELOPMENT .............................. 55 KEY FINDINGS AND CONTRIBUTIONS ................................................................................................... 55 LIMITATIONS AND FUTURE STEPS ........................................................................................................ 55 REFERENCES ..................................................................................................................................... 57 COMPANY WEBSITES .......................................................................................................................... 58 RESEARCH WEBSITES.......................................................................................................................... 59
  4. 4. APPENDIX A – SAMPLE TERM SHEET .......................................................................................... 60 APPENDIX B - INTERVIEW OUTLINE............................................................................................ 65 List of Figures & Tables FIGURE 1 - CARLILE & CHRISTENSEN (2005) THEORY BUILDING PROCESS................................................... 7 FIGURE 2 - STAKEHOLDER MAP ............................................................................................................... 32 FIGURE 3 - RELATIONSHIPS BETWEEN THE TERMS AND CONDITIONS ......................................................... 42 TABLE 1 - ALL THE DATA SOURCES USED .................................................................................................. 9 TABLE 2 - CASES SUMMARY .................................................................................................................... 12 TABLE 3 - TYPE OF INFORMATION USED TO DEVELOP EACH CASE ............................................................. 12 TABLE 4 - SPECIFIC STAKEHOLDERS ......................................................................................................... 33 TABLE 5 - STAKEHOLDER GRID FOR SELECTED STAKEHOLDERS ................................................................ 34 TABLE 6 - POWER VERSUS STAKES ........................................................................................................... 35
  5. 5. Section 1 - Introduction Research Problem The purpose of this study is to determine how the terms and conditions of venture capital funding deals affect the strategy of the receiving firm. Specifically, the study seeks to identify effects in areas that have not been extensively explored, or in areas where previous exploration has identified anomalies. Rationale No similar studies have been found linking the terms and conditions of financing to firm strategy. The terms and conditions can have a significant effect on the strategy and operations of a firm. Studying and documenting these effects will afford future researchers the ability to develop theory surrounding these phenomena. The theories developed can subsequently help to guide entrepreneurs and VCs when formulating the terms and conditions of venture capital financing. Contribution This study has contributed several items of importance. The study has identified fruitful areas of future research in venture capital. The study has identified, developed and presented several plausible propositions to be tested in later studies. The final contribution of this study is the identification of the circumstances that effect the terms and conditions of venture capital financing.
  6. 6. Section 2 - Literature Review The literature review for this research project is presented in an unconventional manner. The front-end literature review covers the methodology used to develop the cases. The remaining literature is presented in context when the findings of the study are compared to extant literature regarding those subjects. Methodology To this researchers knowledge there are no case studies of the effects of venture capital financing terms and conditions on firm strategy. Case studies research is specifically useful in developing theory around phenomena that are not well understood (Eisenhardt, 1989). The design of the current research is multiple case study (Yin, 1989) with some qualitative cross-case analysis (Miles & Huberman, 1994). The theory building methods are similar to Eisenhardt’s (1989) recommendations and Carlile and Christensen’s (2005) inductive research design. Normative, case-based, inductive research was selected over deductive research to help identify phenomena not previously discovered in other deductive studies. Carlile and Christensen (2005) make the distinction between descriptive theory (finding correlations) and normative theory (finding causes) with an emphasis on anomaly discovery. This study is geared towards the third stage of the descriptive theory building process. The third stage is commonly called the models step. This stage seeks to make associations between category
  7. 7. defining attributes and probable outcomes. Figure 1, depicts, the Carlile and Christensen (2005) Theory Building Process. Figure 1 - Carlile & Christensen (2005) Theory Building Process To facilitate cross case comparison and subsequent theory development, the same template is used to develop each case (Miles and Huberman, 1984; Eisenhardt, 1989; Brown & Eisenhardt, 1997). This approach helps to identify similarities as well as differences amongst several cases. Section 3 - Research Design The goal of the study is to observe, describe and measure venture capital related financing phenomena and to categorize and develop a model based upon the observed phenomena and anomalies. Observations simply confirming extant
  8. 8. literature will not be further pursued. New phenomena and anomalies will be compared to extant literature and used to develop several propositions and a preliminary model. The study of venture capital in literature is, in the researcher’s opinion, in the normative theory development stage. Normative theory, as opposed to descriptive theory, seeks to answer the question of what causes something. Descriptive theory seeks to determine correlations. Carlile and Christensen (2005, p. 7) state that “…normative theory has much greater predictive power than descriptive theory does…” because it allows researchers to assert which actions managers should take given the current circumstance. The unit of analysis in this study is the venture capital financing deal. Eight cases are developed and examined. Each case is treated as an independent experiment from which factors affecting the venture are identified based on the evidence discovered during case study development, follow-up interviews and stakeholder analysis. Case Selection and Development Cases were selected using theoretical sampling (Glaser, 1978), the goal being to reach theoretical saturation and completeness. The eight cases develop fall within the guidelines set by Eisenhardt (1989) of between four and 10 cases. Table 1 lists all the data sources used in this study. The nature of the research requires divulgence of highly sensitive financial and legal information to the researcher. In practice, this often meant that the
  9. 9. researcher had to be satisfied with only one piece of primary data. The information hurdle for case inclusion was one of the following: i) an interview with a VCF or principal; ii) a complete term sheet or; iii) a summarized term sheet and a pre-existing case write-up. Five cases were developed using interviews as the primary data source, one case was developed using a complete term sheet, and two cases were developed using summarized term sheets and pre-existing case data. Other secondary data was used to augment the available primary data. Secondary data included company press releases, VC press releases, articles in the press and proprietary databases, specifically the Mary Macdonald Canada VC database. Table 1 - All the Data Sources Used Source of Evidence Type Code Description Interviews I1 Informal interviews with VCs or entrepreneurs I2 Specific follow-up interviews with VCs or entrepreneurs Documents D1 Correspondence with VCs or entrepreneurs D2 Term Sheet D3 Summarized Term Sheet D4 Articles in press D5 Internet search results D6 Firm or VC press releases D7 Case Data D8 CanadaVC Database D9* Management Plan (never saw document incl. In TS) Each case involved the receipt of seed, start-up, early stage or expansion venture capital funding, as listed in the Mary Macdonald VC database. Five of the
  10. 10. cases were in the National Capital region, two were from the U.S. and one was based in British Columbia. All but one of the cases were in the field of high- technology. An effort was made to restrict the cases to high-technology firms in the National Capital region. The researcher was opportunistic however, and cases were not excluded provided they contained rich data. The cases involved funding between 1999 and April 2005. Although the April 2005 funding is quite recent, a case was deemed acceptable if enough data were present and enough time had elapsed in order for an effect to be observed. The time frame of the study comprises one entire cycle in the venture capital industry. Therefore, observed effects will likely not be attributable solely to industry fluctuations. The VC and founder interviews were conducted via telephone and notes were made and confirmed throughout the interview. Careful attention was paid to the amount of time between the VC deal under analysis and the case preparation. Specifically, enough time had to have elapsed in order to observe any influences the deal may have had on strategy. In addition, the elapsed time needed to be sufficiently short such that a significant retrospective bias was not introduced into the study. Initially, the study time frame was set between the beginning of the year 2000 and the end of 2004. The pre-2000 cases were developed from existing case studies around the same period of time, thereby eliminating retrospective bias. The case in which a deal was included post 2004 also contained a deal in 2004, for which an interview was provided, and was therefore included.
  11. 11. Prior to the initial interview, an email was sent outlining the goals of the study and the initial lines of questioning. Interview duration ranged from 15 to thirty minutes; one interview was conducted over two separate days. Several follow-up interviews were conducted to clarify points and issues that presented themselves during case preparation. After each interview, subjective comments were added to the key points while the conversation was still fresh. A ninth deal was under consideration, but could not be included in the final project. The insights gained from the two founders of this deal, however, were included in the hypothesis development and validation of information phases along with the initial eight cases. Each case was developed using the same template: company portrait, historical timeline, funding information, strategy effects and other interesting points. Appendix B contains an interview outline that was used to guide each interview. Questions were also included regarding board composition, management changes, business model churn, product, market and research and development strategies. Every effort was made to triangulate (Eisenhardt 1989) data to ensure that there were no discrepancies. No discrepancies were observed. Section 4 - Cases Overview of Cases Six of the cases were written such that companies and personalities remain anonymous, as this was a requirement of the participants given the
  12. 12. nature of the information being divulged. Two of the cases under analysis here use Harvard Cases as the basis for the analysis. Table 2 below details some summary information regarding the cases developed. Table 2 - Case Summary Case Name Code Description Artefacts Company 1 C1 Industrial I1, I2, D1, D4, D5, D8 I1, I2, D1, D4, D5, D6, Company 2 C2 Network Infrastructure D8 Endeca C3 Enterprise Internet Software D3, D4, D5, D6, D7 EXP Systems C4 Internet Service D3, D4, D5, D6, D7 Company 5 C5 Server Infrastructure D2, D4, D5, D6, D8 Company 6 C6 Network Infrastructure I1, D4, D5, D6, D8 Company 7 C7 Mobile Data Software I1, I2, D4, D5, D6, D8 Company 8 C8 Network Infrastructure I1, D4, D5, D6, D8 In Table 3, the artefact codes correspond to the type of information used to develop each case. Table 3 - Type of Information Used to Develop each Case Source of Evidence Type Code Description Interviews I1 Informal interviews with VCs or entrepreneurs I2 Specific follow-up interviews with VCs or entrepreneurs Documents D1 Correspondence with VCs or entrepreneurs D2 Term Sheet D3 Summarized Term Sheet D4 Articles in press D5 Internet search results D6 Firm or VC press releases D7 Case Data D8 CanadaVC Database
  13. 13. Case 1 (C1) Data Collected This case was developed with a VC interview, a follow-up interview, an email with the VC, some articles that were available in the press, some Internet search results and data contained in the Mary Macdonald database. Business/History The company was very interesting in terms of strategy. They developed a novel technology with applications in many fields. The technology also has applications in industries that have previously not been able to afford it. The company was founded in 1995 and remains a private company. They received three rounds of funding, including the one under analysis, with the same VCs each time. They had initial success in their first target market, but fell short of expectations in terms of new business development. Even though the company had an excellent value proposition, their sales seemed to stagnate and remain dependent on their initial market. The board was comprised of seven members. Five of the board members were VCs, one was from the management team and the remaining member was a mutually agreed upon independent member. Over the past two years, the company has had major problems. Management began to miss agreed revenue milestones and new market development targets. There were few signs that this would change in the near
  14. 14. future. The company was finally petitioned into receivership and their assets were sold. Management Team The management team was weak in terms of marketing and business development. According to the VC, the management team had trouble remaining objective. At the end, they “…seemed to focus on saving themselves, rather than the company.” They did a good job of dividing the investor base in order to promote a stasis at the board level. Funding The first two rounds of funding were secured in years six and eight. Subordinated debt and warrants were used in the first deal, while preferred shares were used in the second round. The final round occurred exactly one year after the round two funding. The company needed new money, and no one was interested in providing it. Some investors wanted to switch the management team but could not get 75% board approval. One VC came in with what our contact described as a ‘cram- down1’ term sheet, which was rejected. The problem was at the board level, where our VC had a seat. Management was doing a good job of splitting the investor base. The result was that the company wasn’t moving forward on its own 1 Cram down round – a financing event upon which new investors with substantial capital are able to demand and receive contractual terms that effectively cause the issuance of sufficient new shares by the startup company to significantly reduce (“dilute”) the ownership percentage of previous investors. (http://mba.tuck.dartmouth.edu/pdf/2002-5-0007.pdf)
  15. 15. terms and the investors could not come to a consensus regarding a course of action. The solution was that all of the investors put together a ‘debt piece’ to fund the company for six months. After the six-month period, any creditor could petition C1 into receivership for failure to pay. This did happen at exactly the six- month mark. Two very interesting points presented themselves in this case. The first interesting point was the lack of consensus and the split in the board of directors. Although the board was dominated by term sheet stipulated investor board members, they could not reach a consensus and make a decision. The management team was also restricted from finding new investors or seeking debt from other sources. The addition of the debt piece is quite common, according to our VC. In the end, a company that was a heavy user of C1’s product purchased its assets. Left Hand Side This funding round was designed to allow C1 to accelerate market penetration. The release of funds was multi-stage and dependent upon meeting certain market penetration milestones. Post receipt of financing, C1 introduced derivations of their original product to new market segments. They presented their adapted technologies at two distinct and separate market tradeshows. C1 had not done this prior to receiving this round of funding.
  16. 16. Case 2 (C2) Data Collected This case was developed with a VC interview, a follow-up interview, an email with the VC, firm and VC press releases, some articles that were available in the press, some Internet search results and data contained in the Mary Macdonald database. Business/History C2 operates in the semiconductor industry. They managed to develop two break through networking chips as well as network management software that drives the operations of the chips. They have solved a problem in the industry that, according to one expert, “…a lot of people have been trying to solve.” Their chips are now integrated with products in the consumer electronics market and the network provider market. C2 has been in operation for four years and is currently a private company. The company had very good patent and IP protection. The VC commented that the IP protection the company had was overkill and certainly was not a requirement to invest. IP protection rarely is, and was certainly not required for this company. According to our VC contact, this company could IPO in 2006 or 2007 at the latest. Management Team Former employees of a leading high tech firm formed the company. The company has good connections in the venture capital market as well as within their own industry. The founding team is very strong, according to our VC
  17. 17. contact, but lacks financial experience. The VC team augments this very well with their inclusion on the board and by providing periodic advice to company management. Funding The deal under analysis for C2 is a third round VC financing deal. The deal occurred three years after company inception. All of the original venture capital companies that funded C2 in the first two rounds also participated in the round three funding. The amount infused was roughly equal to the total amount previously invested in C2 in the first two rounds. The VC that spoke to the researchers regarding C2 was brought into the over-subscribed third round for strategic reasons. The previous partners all had “powder still in the keg,” but thought that the VC could add something extra to the company. The terms and conditions of the round were laid out to our VC contact in a take-it-or-leave-it fashion, and no new board seat was offered to our contact. The investor-management relation was described as very amicable. According to our contact, there have been no contentious issues raised at, or by, the board. The board consists of three members. VCs hold two of the seats, while C2 management appointed the third. Although there have been no overt displays of power, two very key management and board changes happened directly after the third round funding. The change in management happened in the same week as the board change and involved the CFO of the organization. The CFO was, according to our VC contact, a ‘virtual CFO’, and needed to be replaced by someone permanent. This
  18. 18. was a condition of the financing. The new board member is a very well connected industry representative, is the only independent on the board and has had experience as a board member with one of the VCs portfolio companies. Our VC contact had some interesting comments regarding restrictive clauses in term sheets. “There are no restrictive clauses in the deal. You have to be careful because there are usually other VCs involved in the same term sheet and the restrictions set can back-fire.” Left Hand Side The funding for this round was to “… allow the company to take its technology to the next stage in preparation for releasing products next year.” Directly after receipt of funding, C2 released a new wireless chip. The release of funds was made contingent upon the completion and release of the wireless chip that was under development. Endeca Data Collected This case was developed using primarily the Harvard case data and the summarized term sheet included in the cases, but also made use of articles in the press, internet search results and firm and VC press releases. Business/History Endeca was founded in the summer of 1999, with headquarters in Cambridge, MA. Their product is an information discovery tool that helps
  19. 19. companies solve their ‘information overload’ problems. The company has gone through two prior funding rounds. The first trial of the product was a success and the company managed to demonstrate that it could be implemented without excessive customer implementation costs. Subsequent to their initial success, they have implemented their products at many large multinational corporations, including, Wal-Mart, IBM and Bank of America. At the time of the new deal, C3 required funds to continue their ‘aggressive product development, and to expand marketing and sales’ of its product line. The previous investors dominated the board. The investors controlled three of the five board members while management controlled two. One of the management controlled board seats was required to be occupied by an independent board member presented by management and accepted by the investors. Management Team The company was co-founded by Steve Papa, a respected and successful Internet industry professional. Papa had worked for Inktomi, where he was responsible for creating the information caching business which generated 60% of their revenue. Papa holds an MBA from Harvard and was part of the original Akamai business team, another successful Internet company. Steve also has experience working as a VC for Venrock, and managed AT&T’s $500 million high-end enterprise computing line. Endeca’s co-founder, David Gourley, is also
  20. 20. Endeca’s current CTO. Gourley was also part of the founding team at Inktomi and helped to build their caching product. Gourley has a B.A. in Computer Science from the University of California at Berkeley. The founding team of Endeca was the strongest of all of the cases. They possess excellent industry, financial and VC knowledge. Funding This Series C funding round took longer than anticipated. Two VC groups were bidding for the term sheet. The term sheet that offered the highest pre- money valuation was accepted, even though it was with a different group of investors. Left Hand Side After the receipt of Series C funding, C3 opened its first international office. The company also released a new version of their software within three months of receipt of funding. Later in the following year, but less than one calendar year later, the research and development department of C3 released software that addressed an entirely new market. EXP Systems Data Collected This case was developed using primarily the Harvard case data and the summarized term sheet included in the cases, but also made use of articles in the press, internet search results and firm and VC press releases.
  21. 21. Business/History Founded in 1998 during the dot-com boom, the business model of EXP Systems was based on a novel derivation of an existing Internet sales model. The company offers online access to professionals for individuals seeking advice. The company is located in Menlo Park, California, and is now defunct. The company released the first beta version of their product in 1999. The company was 50% owned by the investors, 26% by management and advisers. The remaining 24% of equity was set-aside for employees, at the instruction of the investors. The board consisted of five members; three were appointment by the investors and two by management. Management Team The CEO of EXP Systems was a well-respected industry figure who had had success in previous ventures. It was through that success that he was introduced to the VCs that ultimately funded EXP Systems. Funding The initial round of funding was specifically to fund the development of the prototype. The receipt of series B funding was made contingent upon meeting the prototype release milestone. Series B funding came from some new investors, including the corporate venture capital arms in the high tech industry. The new VCs also had portfolio company experience in the consumer market, which EXP Systems was targeting. The funds were earmarked for operating expenses, to fund a product launch and to support a major advertising campaign.
  22. 22. A subsequent funding round three years after company inception added more corporate venture capital funding arms. Some of the new partners were included for their financial strength while others were included for strategic reasons. Left Hand Side Each of the funding rounds had an interesting interaction with the product, market and partner selection. The first round of funding was directed at prototype development. Receipt of the second round of funding seemed to be contingent upon the successful release of the beta site, which occurred. The second round funds were earmarked to fund a full product launch, which occurred within three months, and for marketing and operating expenses. The third round was the most interesting in terms of the partners EXP Systems selected. Directly after receiving third round funding, EXP Systems announced partnerships with the parent companies of the corporate VCs that were involved in the deal. Case 5 (C5) Data Collected Case 5 was developed with complete term sheet, articles in the press, Internet search results, firm press releases and information contained in the Canada VC database.
  23. 23. Business/History This company, founded in 2001, is a specialized network infrastructure provider. Its board consists of seven members, with four seats controlled by investors. Two seats are held by the management team and there is one independent board member. Company 5 has gone through four financing rounds to date. The financing deal in question is the third round, early stage funding. The company has their product installed worldwide and continues to be successful in their target market penetration. Management Team The co-founder, President and CEO is an industry expert with many years of experience in the sector. The CTO, and co-founder, has over 20 years of industry experience and designed C5’s initial product. The CFO has spent the past several years of his career, prior to C5, with venture funded start-ups in the National Capital Region. Funding The first two funding rounds were designed to bring C5’s product through beta testing and customer trials, which occurred. This third round funding deal was designed to ‘ramp-up’ production of its flagship product.
  24. 24. Left Hand Side Less than three months after receiving the third round funds, the company announced a large-scale customer trial of their products. Two months after the trials, an announcement was made that the product was ‘generally available.’ One day prior to announcing a new financing deal with new strategic investors, C5 announced the expansion of their product line. The strategic investors announced that they were pleased with the milestones the company had met and were also interested in integrating the product into their own infrastructure. Company 6 (C6) Data Collected This case was developed using information from an interview with the VC, a founder interview, Internet search results, press releases and Canada VC deal information. Business Overview Company 6’s business revolves around software solutions for network and service providers. Company 6 has very good IP protection for their software. The company managed to release the first version of their software, and have it implemented, with a tier one service provider in the United States. The software is slated for customer trials with two other tier one U.S. service providers. Our founder contact indicated that the company is in very good shape. Company 6 has $5 million dollars in the bank from customers and intends to increase this to
  25. 25. $10 million by year-end. This is a tier one customer requirement in order to ensure the continued viability of the companies they deal with. Company 6 has undergone three rounds of funding. The initial lead investor has participated in every round and led the round in question. The company has five board seats, of which investors hold two, management holds one and independent board members hold the remaining two seats. Management Team The founder of the company has many years of experience in the local area. He has experience with other start-ups as well as experience with an optical networking company. The CFO of the company has extensive experience with venture-backed start-ups. Funding The initial funding rounds were relatively close together, indicating a strong desire to stage investments with C6. The first funding round was dispersed in two tranches each with distinct milestones. The first tranche was released with the stipulation that management provide an “...acceptable business and operating plan.” The second tranche was dependent upon successful customer lab trials. An interesting point regarding this funding round is the inclusion of a U.S. based VC, which caused some difficult company legal manoeuvring in order to accommodate the new partner. The second series, third round of funding, was made virtually condition free, due to the success of the company and a good understanding between investors and company regarding product and market direction.
  26. 26. Left Hand Side Company 6 is very interesting in that it confirms some previous findings about the success of a company influencing the terms and conditions, as well as confirming findings about the stage of product development influencing terms and conditions. The first two rounds were made contingent upon terms and conditions that stipulated product and market goals, in the form of an ‘acceptable’ business plan. Acceptable was defined as in line with the strategies presented and negotiated at prior investor/entrepreneur meetings and presentations. The second tranche was dependent on market acceptance of the product in the form of a successful customer trial. Successful was determined to be a commitment from the customer to purchase the product. Company 7 (C7) Data Collected Case 7 was developed with the help of a VC interview, a follow-up VC interview, Internet search results, articles in the press, and firm and VC press releases. Business Overview The company has developed a novel piece of integrated infrastructure management software. The software offers a single point of contact for various network service providers. The software also facilitates the delivery of mobile content to a wide array of mobile devices.
  27. 27. The company was founded in 2001, and has received five injections of capital since inception. The board consists of five members and is investor dominated with four seats controlled by the investors and one seat controlled and filled by management. The company has successfully launched new versions of their product and has recently won several industry awards. The company’s headquarters are in Toronto and they have offices in London and a new office in Asia. Management Team The founder, and current president and CEO of company 7, has had extensive experience in the U.S., Europe and Canada over his career. The CFO of the company has worked for numerous venture and non-venture backed companies both in Canada and the U.S. Funding The deals in questions are both the 4th and 5th rounds of funding. The 4th round came early in 2004 and the most recent round came exactly 12 months later. The deals were both dependent upon C7 attaining certain milestones in market penetration and new product releases. Left Hand Side The new cash is to promote sales, operations and development of their flagship product. Some of the new strategic investors stipulated that they would invest on the condition that their flagship product would be ready for implementation within a certain timeframe.
  28. 28. The second round of funding was disbursed on the condition that C7 execute their business plan and achieve their financial goals. Company 8 (C8) Data Collected The final case was developed with a VC and founder interview, Internet search results, firm and VC press releases and Canada VC database deal information. Business Overview Established in 2002, Company 8 has set out to solve one of the most vexing computing problems for users of large-scale computing. The goal is to provide a scalable and robust environment to the industry. To date, company 8 has undergone two rounds of venture financing. The company has its headquarters in the National Capital Region. The board has seven seats, four of which are VC controlled, while two are held by the founders. An independent board member holds the final seat. Management Team The founder, and CEO of company 8, has an excellent record developing systems for a well-known National Capital Area telecommunications supplier. He has considerable experience developing products as well as businesses, and has hands-on knowledge in various business areas. The co-founder of C8 has almost 24 years of industry experience and has worked extensively with his
  29. 29. founding partner in a previous organization. The SVP of business development was selected for his in-depth knowledge of the requirements of C8’s customers. Funding The first round of funding was to develop a prototype of the company’s product. The same investors from the first round were involved in the second round, and one additional investor was been added for strategic reasons. The second round of funding came one year after C8’s first round, and three years after company inception. The funds were to be used to complete development of their breakthrough product. Left Hand Side The first round of funding was classified as onerous in terms of the restrictions placed upon strategy. The first round contained stipulations on spending limits, hiring and product development. The second round was regarded as “generous” by our founder contact. The strategy proposed by the company was in line with what the investors wanted. The terms and conditions regarding product and market are almost non-existent. The investors wanted to structure the round such that the company had enough latitude to pursue opportunities wherever they presented themselves. Confirming Findings The results and findings from the case studies were further confirmed via follow-up interviews and interviews with industry experts with insight into the venture capital funding process. Specifically a VC industry consultant
  30. 30. experienced as a VC and a CFO with a venture capital backed firm and two founders were interviewed post-case and pre-proposition development to confirm findings, provide insight and validate the findings of the study. The industry contacts confirmed the findings and provided examples of these findings in other firms in the National Capital Region. The founder of Company 6 provided an interesting confirmation in the form of an example from another company in which he is an insider. The company, after receiving an investment from a single investor (he called this ‘scared money’), required bridge financing. The terms and conditions of the bridge financing were so onerous that they caused the company to fail. The requirements were that the company produce three sales of their product to tier two customers. The problem was that the product was geared towards tier one customers. The company had to subsequently change their entire strategy and ultimately failed because of the confusion caused in the market, and the lack of suitability of the product to its new target market. This is interesting in that it confirms the previous findings that the bargaining power of a firm can have a substantial effect on the terms and conditions and how these affect strategy. Section 5 – Analysis, Propositions and Model Development This chapter is divided into two sections. The first section, stakeholder analysis, is used to analyze the information contained in the eight case studies. The stakeholder analysis highlights areas where stakes and power are in conflict and where possible disconnect between the goals, power and stakes of specific
  31. 31. stakeholder groups exist. From the stakeholder analysis, cases and follow-up interviews, several propositions have been developed. The model development is found in section 2 of this chapter. Stakeholder Analysis The venture funding process is a competitive, free-market process that includes and affects various stakeholders in competition for scarce financial resources. There are varying degrees of power between numerous internal and external stakeholders. Stakeholders are defined as ‘those groups without whose support the organization would cease to exist’ (Freeman 1984). The analysis was performed according to Freeman’s model presented in his landmark book, Strategic Management: A Stakeholder Approach (1984). The steps performed include: i) Developing a stakeholder map ii) Preparing a chart of stakeholders iii) Identifying stakes of stakeholders iv) Preparing a power versus stake grid In order to identify the impact on a new venture that is attributable to receipt and structure of venture capital financing, it is necessary to determine the stakeholders, their stakes and their power. See figure 1 for stakeholder map.
  32. 32. Venture Employees Capitalist Other Entrepreneur Investors/ Creditors Venture Capital Funding Deal Subsequent Customers Providers of Capital Board Suppliers Members Figure 2 - Stakeholder Map The stakeholders identified are identical to those venture capital stakeholders listed in Muegge (2004). While not comprehensive, these stakeholders represent those relevant in the context of this study. Subsequently, each of these relationships was articulated in a stakeholder chart of specific venture capital deal stakeholders. See table 4 for a list of the specific stakeholders.
  33. 33. Table 4 - Specific Stakeholders Venture Capitalist Entrepreneur Partner Founder/Co-founder Investment Analyst Fund Investors Board Members Current Employees Past Management Operational Suppliers Current Other Investors/Creditors Potential Angels Previous VC Customers Friends and Family Existing Banks Prospective Other Creditors The above stakeholders represent the specific and relevant actors included in each group. Other specific actors may exist depending on the Venture Capital Deal. Such specific stakeholders were explicitly present in at least one of the venture capital deals under analysis. The stakes, defined as ‘an interest for which a normative claim can be advanced’ (Reed 1999), are listed for each stakeholder in table 5.
  34. 34. Table 5 - Stakeholder Grid for Selected Stakeholders Stakeholder Grid for selected stakeholders Stakeholder Group Venture Capital Firm (VCF) Employees Stakeholder Partner Management Value of investment/equity held, Reputation, monetary reward, Stakes reputation, employment employment Stakeholder Fund Investors Operational Stakes Value of fund Employment, monetary reward Stakeholder Group Suppliers Customers Stakeholder Current Existing Product support, warranty, Stakes Payment, continued business upgrades, continued usage Stakeholder Potential Prospective Stakes Future business, terms and conditions Terms and conditions, availability Stakeholder Group Other Investors/Creditors Other Investors/Creditors Stakeholder Angels Banks Stakes Value of equity held Loan Stakeholder Other equity investors Other Creditors Stakes Value of equity held Loan Stakeholder Friends and Family Stakes Value of equity held Stakeholder Group Entrepreneur Board Stakeholder Founder/Co-founder Current Members Employment, monetary reward, value of Stakes equity, reputation Reputation, compensation Stakeholder Former Stakes Reputation The value in understanding the stakes by stakeholders is found by articulating the stakes held by each stakeholder for which we can surmise, or at least begin to understand, the motive thereof. The power vs. stake grid below plots stakeholder power (formal, economic or other) against their respective stakes (power, economic or other). Formal power is defined as power supported by contract. Relevant contracts include shareholder agreements, term sheets and other contracts. Economic power is defined as the power to withhold or provide something of economic value to the
  35. 35. organisation. Economic power could be the power to provide new capital, the power to provide specialized skills or to withhold payment. Other power encapsulates power that is neither formal nor directly economic, such as the power to advise or promote a new venture. The power versus stakes table 6 is presented below. Table 6 - Power versus Stakes Power versus Stake grid Power Formal (contract, shareholders agreement, Stake term sheet) Economic Other VCF, other equity investors (angels, friends and family), entrepreneurs, management, current board Equity members VCF, other equity investors Operational employees Bank, other creditors, Existing customers, bank, Suppliers, operational Economic current board members other creditors employees Other Current board members Prospective customers Former board members Much research has been directed at understanding the venture capital funding process (Gompers and Lerner 2001) but very little has been directed towards understanding how VC financing terms and conditions affect the strategy of a firm. Proposition Development The purpose of this study is to identify potential influences that the terms and conditions of venture capital financing deals have upon the strategy a firm employs. Three general areas of influence were identified: 1.) People 2.) Finance 3.) Business
  36. 36. People The first area of influence, people, is comprised of: 1.) Employees 2.) Management 3.) Board Members Specifically, the ability to attract, retain and motivate these groups of people is critical to the success of a firm. The cases developed above demonstrated that this area can be affected by the terms and conditions of venture capital financing. The affect of venture capital financing on the ‘people’ strategy of a firm has been well documented and studied. Byers (1997), Bygrave and Timmons, (1992), Gorman and Sahlman (1989) and Hellman (1998) all detail how venture capitalists help to attract key personnel. Two of the cases described how the VCs imposed an equity compensation scheme for employees through Employee Stock Option Programs (ESOP). Bygrave and Timmons noted that ESOPs are used extensively by VCs in their portfolio companies (1992). Venture capitalists often exert control over management composition. The cases developed in this study demonstrated several examples of this VC role in appointing members of the management team. In Case 1, the entire management team was replaced. In several other cases, key chief level (although not CEO level) positions were driven by VC demands. Hellman (1998) found that VCs typically play a large role in corporate governance, often replacing the CEO. Gorman and Sahlman (1989) found that VCs typically use
  37. 37. board control to replace CEOs. In only one of the cases developed here (C1) was the CEO replaced. This represents somewhat of an anomaly when compared to the literature. The role of VCs on the boards is well researched in the literature. Clark (1987), Fenn, Liang and Prowse (1995), Fried and Hisrich (1995), Gompers (1995), Lerner (1995), and Sahlman (1991) all confirmed the findings regarding board composition and role found in the cases developed herein. Specifically, the fact that VCs effectively dictated board composition and that VCs used their control of the board to control a firm was demonstrated. Finance The cases demonstrated two specific effects in the area of finance. The first was the increase in financial oversight and reporting a VC requires and, therefore, imposes. The second was the VC role in raising new funds. The affects venture capitalists have upon the financial strategy of a firm are well understood. Gorman and Sahlman (1989) found that after making the initial investment, VCs tend to be very active in raising additional funds. Little research exists regarding the imposition of financial reporting and oversight required by VCs, and there is little evidence in the cases that the affects in this area were great. Business The following two categories were developed from evidence of affects found in the cases.
  38. 38. 1.) Product Strategy 2.) Market Strategy These two categories are further expanded below. Following the description of these categories, propositions are developed regarding the affect of the terms and conditions of venture capital financing upon the two strategies. Product Strategy Comparison to Literature The product strategy of a firm includes the release of the product, the decision to develop new products, revenue from new products and the feature set of a product. Other product related strategies include time to market, generic versus specific strategies, whether to develop modular or integrating products and whether or not to develop and release derivative products. The literature surrounding the role of venture capital in the product strategies of a firm is sparse. Hellman and Puri (2000) published a paper outlining the effects of product market and the financing of a firm. The article specifically found that the receipt of venture capital funds is correlated with a significant reduction in time to market. What the article does not do is outline the circumstances under which this is true and what other affects the receipt of VC funding may have on product strategies. Effects observed Product strategy effects and potential effects were observed in several cases. The most common affect was upon the timing of release of certain
  39. 39. products. Specifically, it was found that products in prototype, beta or release 1.0 stages had to be released and tested before the next round of funding would be released. Other effects observed included the creation of derivative products for application in related markets. The features of a product were stipulated in several cases; in one case, a strategic investor made the stipulation that the product had to include features that were specific to the parent company of the corporate VC arm. Market Strategy Comparison to Literature The market strategy of a firm includes the product mix in a market, target markets, revenue, customers, sales leads, implementations at key customers, number of customers in a certain tier, revenue from a target market and market penetration. Other more generic market strategies revolve around market leadership and market penetration and product releases in new markets. Studies have been conducted (Jaworski & Kohli, 1993; Slater & Narver, 1994) relating market orientation and firm performance, but very few studies exist that detail the affects of venture capital on a firm’s market orientation. Effects observed The most common stipulations and effects seen were in the area of market strategies. Industry experts further confirmed this as common in venture capital deals. Effects observed included number of reference customers from certain vertical markets, the amount of revenue generated from specific markets,
  40. 40. tier one customers, release of products in new markets and acceptance of product standards in a new market. Circumstances The circumstances of a deal have a direct affect on the terms and conditions of venture capital financing. The following categories of circumstances were identified: 1.) Bargaining Power 2.) Stage of Product Development 3.) Market Orientation 4.) Investor Alignment and Orientation All of these circumstances affected the types and nature of the terms of conditions as well as their restrictiveness. Bargaining Power Bargaining power can be distilled into the weak and strong extremes on a continuum. Bargaining power is determined by several factors, according to the VCs, entrepreneurs and industry experts consulted. The factors observed were: 1.) Supply 2.) Demand 3.) Quality The supply describes the amount of VC money available to be invested. Demand describes the number of firms seeking funding at a given time. The quality of a firm is determined by the strength of a management team, the track
  41. 41. record of a firm, as determined by their ability to meet previous milestones, the quality of a product or idea and the size of the potential market. Product The stage of product development directly affected the type and nature of terms and conditions. A firm with a product in prototype development stage will have different terms and conditions than one that has product ready for release 1.0. Market The market orientation of a firm will also have an affect on the terms and conditions, and therefore the strategies, of a firm. A firm that is targeting a new market will have different circumstances, and therefore terms and conditions, when compared to firms targeting existing markets. Investor Alignment and Orientation The alignment of investors, both within their ranks and with the entrepreneurs, was seen to be important in the cases. A firm that has a split investor base will find its terms and conditions to be more onerous. Similarly, a firm whose goals are not aligned with those of the investors will also find that the terms and conditions of financing are more onerous. The researcher identified all of these as circumstances that may have an affect on a deal. They are presented in a model below.
  42. 42. Model Development The following figure 2 depicts the relationships between the terms and conditions of a specific venture capital financing deal and the strategy affects of the deal. Figure 3 - Relationships Between the Terms and Conditions The model depicts the venture capital financing deal as the central component. The venture capital financing deal is affected by the relative bargaining power of the firm. A firm in a strong position to bargain will be able to negotiate less onerous or restrictive terms and conditions; this will likely reduce the strategic effects of the deal. The market orientation affects the deal in that firms pursuing new markets will have different contract stipulations than would firms targeting existing
  43. 43. markets. Similarly, deals exhibiting disruptive characteristics as opposed to sustaining characteristics will be structured differently; this also affects the strategy effects of the deal. Investor alignment is important in that it will affect how the investors view the deal and hence structure it. The product development stage is important in that products in different stages of development have different funding requirements and the stipulations should reflect the reality of the product development cycle. All of these factors affect the deal, which subsequently affects the product and market strategies of a firm, which ultimately affects the full strategy of a firm. The manner in which investors stipulate the terms and conditions of deals is detailed below. Stipulation of Terms and Conditions The terms and conditions of receiving venture capital are typically stipulated in the form of a term sheet. A term sheet is essentially an offer to purchase equity in a venture under certain terms and conditions. An accepted term sheet has the same legal status of any other form of written contract. A venture can accept extremely onerous terms and conditions or it can negotiate terms and conditions that are more favourable. Appendix A shows a sample term sheet. The following list outlines several ways in which venture capital firms stipulate the terms and conditions of a deal. Any one of these can be used to influence the strategic decisions of a firm. An example of each will be presented below from the cases developed previously. The examples of terms and
  44. 44. conditions provided below are not from the cases developed above, however they are similar enough to represent the types of terms and conditions found in the eight cases. i) Security design ii) Staging of investments iii) Shareholder agreements iv) Equity allotment v) Board rights vi) Liquidation rights vii) Sale of share restrictions viii) Stock option pools, warrants ix) Employment contracts Security Design Several types of securities can be used in a venture capital deal. Preferred shares are the most common type of security used (Kaplan and Stromberg 2003) A preferred share is a share that can have many assigned restrictions and rights. The conversion of the shares can be made contingent upon liquidation events (described below), revenue milestones or other events. The example used is from Company 2 and the security used is a convertible preferred share. The preferred shares have different conversion factors depending upon the attainment of certain revenue goals. If C2 meet its revenue goals, the conversion factor is lower -- that is, the VC receives less
  45. 45. common shares for each preferred share. Conversely, if C2 meets its revenue goal, the VC will receive more common share for each preferred share held. According to industry sources, this is a common practice but is not universal. This phenomenon was observed in only two of the cases under analysis. Staging of Investments The most common manner identified in which a VC attempts to influence a firm is through the staging of investments. Staging, in the form of funding rounds, was found in all of the previously developed cases. Other industry contacts confirmed that the release of subsequent funds was almost universally contingent upon meeting certain milestones. Cornelli and Yosha (2003) Gompers (1995) and Repullo and Suarez 1999 confirm this in the literature). Company 6 provides an example of this. C6 received three injections of capital in 10 months; each investment was exactly five months apart. At each funding round, only enough funds were dispersed to reach the goals set in the business during the next five months. If the goals were met, the next injection would occur. The company attained the goals set out in its business plan. Shareholder agreements Shareholder agreements are made between the holders of equity in a firm and the firm itself. Often conditions that are not present in a term sheet are included in such agreements. Usually the restrictions and rights set forth in a shareholder agreement revolve primarily around the transfer of shares and voting rights. There can, however, be other factors.
  46. 46. Company five had a good example of the term sheet referring to the contents of a shareholders agreement. In this case, the shareholder agreement was not seen and was not a factor in our study. See Chemla, Habib, M. Ljungqvist (2003) for an excellent analysis of shareholder agreements and the clauses contained therein. Equity allotment Venture Capital firms can also influence firms via an equity allotment. The equity allotment is simply another way to align VC goals with incentives for the entrepreneurs. The equity allotment functions in much the same way as does the security design. The equity allotment is made dependent upon a firm meeting certain milestones. If the milestones or stipulations are met, then the equity allotment is more favourable for the entrepreneurs. If they are not met, it is more favourable for the VC. This is essentially the same as free call options for the VC in the case that the company is not as successful as originally planned. This reduces VC risk and increases entrepreneur incentives. They was no specific case where this occurred, however the post-case interview subjects indicated that this is a quite common practice, and provided examples of this happening in the industry. Board rights The relevancy of board rights are that in the case where investors, VCs, angels, or others control the board, conditions can be placed upon financing and restrictions from receiving further financing can be made contingent upon executing a business plan or achieving milestones. Although the terms and
  47. 47. conditions are stipulated in advance they can be altered, added and enforced through the board. Every case under analysis had a board of directors where the investors controlled the majority of seats; in every case except one, the investors were VCs. The other seat was for an angel investor. Liquidation rights The liquidation rights are the rights that holders of certain groups of securities have upon a liquidation event. The typical term sheet definition of a liquidation event is as follows: “A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.” 2 In the event of liquidation, several terms and conditions can be stipulated in the term sheet that have an affect on the product, market and R&D strategies of a firm. The following is a sample liquidation preference term: “Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).”3 2 6RXUFH KWWSZZZIHOGFRPEORJDUFKLYHVWHUPBVKHHW 3 Source: http://www.feld.com/blog/archives/term_sheet/
  48. 48. The term sheets collected for cases all contained liquidation rights, however none seem to have affected the firm strategy. Sale of share restrictions Another way in which VCs influence strategy is via the use of sale of share restrictions. These restrictions usually apply to the sale of shares by the firm’s founders or entrepreneurs. This clause essentially locks the founders into the firm by tying their personal wealth to staying with the company. This is a very common stipulation and was seen in each of the three term sheets used to develop cases, as well as in one sample term sheet. Stock option pools, warrants Stock option pools and warrants are securities that, given certain criteria, can be converted into common shares in a firm. The size of a pool, and the numbers of warrants, are usually made contingent upon the company achieving certain goals. Company 6 used founder’s options to provide incentives to the founders to adhere to the content of a business plan and presentation made to the investors. The option pool would increase depending on the number of goals met and the timing of achieving those goals. Employment Contracts The founders of a venture are usually required to negotiate employment contracts, either before (if they are smart) or after the acceptance of a term. The employment contracts stipulate what happens in the event of a termination, what
  49. 49. constitutes grounds for termination and, finally, what compensation is paid in the event of termination. The incentives for founders are therefore tied directly to the terms and conditions of their employment contract. Proposition Development This section develops 9 propositions from the cases developed in the previous sections. No propositions have been developed for People and Finance strategies as there was only one minor anomaly found in these areas and the areas themselves have been well researched. Propositions have been developed around: 1.) Product Strategies; and 2.) Market Strategies. The propositions presented here relate to observations made in the cases regarding effects and the circumstances surrounding a deal. The propositions have been confirmed as likely to occur through using cross-case analysis and post-case development interviews. General Propositions One general proposition affects neither product nor market strategy directly. The proposition relates to the existence of milestones, budgets and other stipulations included in venture capital contracts and forms the basis for the subsequent propositions. Every case demonstrated that the greater the number of stipulations in the financing deal, the less flexibility management had in the operations of the firm. Both Harvard cases specified that a deal was structured
  50. 50. with fewer stipulations in order to increase the likelihood of firm success. Our VC contact on several of the other deals noted that they (the VC) prefer to structure deals where the firm has the latitude to make decisions without having to consult legal documents on a daily basis. Only as deals become less likely to succeed do VCs prefer to include more stipulations in a deal. The following proposition was developed from this observation. Proposition 0: Ceteris Paribus – The greater the number of stipulations in the terms and conditions of a venture capital financing deal, the lesser the degree of firm decision making latitude and therefore the greater the strategy effects of those stipulations. Product Strategy Propositions The following proposition stems from the observation that the terms and conditions of certain deals were significantly different in their effects, both potential and observed, upon strategy given the stage of product development a firm’s product is in. A firm with a product in the prototype development stage was observed to have very onerous and restrictive terms and conditions stipulated in the deal. These conditions stipulated exactly what funds were to be used for, how much could be used and technical requirements a product was required to meet. In the same case in the second funding round, after having completed prototype development, the terms and conditions were different and considerably less onerous. Only the time frame for beta release was stipulated. The following proposition is the result of these observations:
  51. 51. Proposition 1: Ceteris Paribus - The product development stage of a firm’s product affect the terms and conditions of a financing deal and the resulting product strategies driven by them. The next proposition revolves around the alignment of investor and entrepreneur goals. Regardless of the past and current success of a firm, the alignment of investor goals with entrepreneur goals has an affect on the development of a product. In one of the cases developed herein, an obvious misalignment of goals was observed. As a result, the investors wished to have a product line discontinued whereas the entrepreneurs wished to continue development. The ultimate result was bankruptcy. The following proposition is based upon these observations: Proposition 2: Ceteris Paribus – The alignment of investor and entrepreneur goals reduces the product restrictions in the terms and conditions of financing. The implication is that if investors are not aligned, terms and stipulations will be required in order to cover eventual splits in the investor base. The result of this is likely a reduction in firm flexibility. Market Strategy Proposition The effects of the terms and conditions of financing were more pronounced for market strategy than they were for product strategy. The following proposition relates to bargaining power and its affects on market strategy.
  52. 52. A firm with good bargaining power, Company 6, demonstrated that by meeting previous milestones and by strengthening their management team, they could significantly limit the affect of financing terms and conditions on market strategy. Company 6 was able to negotiate much less onerous terms and conditions and thereby limit the effects on the company’s market flexibility. Firms with less bargaining power, like Company 1, had much more onerous market restrictions than did other companies. The following proposition was developed based upon this observation: Proposition 3: Ceteris Paribus – The degree of bargaining power a firm possesses determines the restrictiveness of market terms and conditions and therefore their effects. A company that is targeting a new market, like EXP Systems, will have different terms and conditions than a company seeking to enter an existing market with an incumbent, like Company 8. Specifically, the terms and conditions observed at C8 were directed at getting enough reference customers to talk to the investors about the product. The requirements for EXP Systems were related to technical quality and were unrelated to the market. The following proposition was developed based upon these observations: Proposition 4: Ceteris Paribus – The characteristics of the market targeted by a firm will determine the types of terms and conditions and their affect on the market strategies of a firm. A more precise proposition, based upon the above proposition, is that market characteristics will determine investment terms and conditions; this
  53. 53. relates to the two market extremes. The concept of sustaining versus disruptive innovations, is presented in The Innovator’s Solution (Christensen, 2003), where sustaining innovations target existing markets and disruptive innovations target new markets. The following proposition was developed based upon the sustaining versus disruptive innovations, or products: Proposition 4a: Ceteris Paribus – Firms with sustaining innovations will have more restrictive market related terms and conditions in their deal than will firms with a disruptive innovation. This phenomenon was observed in comparing Company 6 with Company 2. Company 6’s product could be classified as a sustaining innovation. The investors required that C6 prove that they could penetrate an existing market with their product. C2, with a disruptive innovation, were required by investors to prove the technology, but no market related restrictions were made. The following propositions relates to investor type. Strategic investors, or the venture capital arms of corporations, have different goals for their portfolio companies than do typical venture capitalists. Company 8 provides an example where one of the investors attempts to push the development of a market in the direction of the parent company’s target market. This meant that both the investors, between themselves, and management, were not aligned in their goals. The result was very restrictive terms and conditions of financing for Company 8. This proposition also relates to the type of investor investing in a firm, as well as investor homogeneity. The following proposition was developed based on these observations:
  54. 54. Proposition 5: Ceteris Paribus – The more homogenous and aligned an investor base is, the less restrictive the market related terms and conditions of financing. This proposition can be separated into two more specific propositions. The more homogenous the investor base in terms of market orientation and specialization and in terms of investor type i.e. corporate versus institutional, the less likely was a split in the base that required additional deal terms and conditions to control for the split. The following proposition was developed to capture this observation. Proposition 5a: Ceteris Paribus – The more homogenous an investor base, the less restrictive the market related terms and conditions of financing to control for investor split. The second proposition is built upon the previous observation but introduces the idea of investor/entrepreneur alignment. The case demonstrated that if the investor base was homogeneous in goals and type, their was little chance for a split in their ranks. This affected the alignment with the entrepreneurs as well. An unaligned investor base also caused a misalignment with the entrepreneurs. Proposition 5b: Ceteris Paribus – The more aligned the investors are with the entrepreneurs, the less likely are onerous and numerous market related terms and conditions.
  55. 55. The preceding propositions and model represent the end product of this research project. The propositions are meant to provide the basis for more extensive research into the phenomena discussed here in future studies. Section 6 – Analysis, Propositions and Model Development Key Findings and Contributions This study identified several issues not previously researched in the field of venture capital investing. The affects of the terms and conditions on product and market strategies have been identified. Specifically, the affects of deal terms and conditions on product development, market goals and company product and market milestones have been identified. The circumstances that can occur and how they influence a deal have been identified as well. Issues surrounding product development stage, market type, investor entrepreneur alignment and bargaining power and their effects upon a venture capital financing deal have been identified. Specific terms and conditions found in venture capital financing deals have been identified and their use analyzed is the cases developed. The study may not have proven that an effect exists, but it does highlight areas of probable influence and areas for fruitful future research, as outlined below. Limitations and Future Steps This study is limited in several ways. The most obvious limitation of this study is the lack of investor and entrepreneur involvement in each case. Only two of the cases were developed with the benefit of the involvement of both. By involving both parties, a more accurate picture could be developed regarding the
  56. 56. phenomena observed here. Another limitation is the lack of term sheet, shareholder agreements and business plans available to the researcher to corroborate investor and entrepreneur depictions of events. Another limitation is the heterogeneity of participant industry and geography. The issue lies in that not enough heterogeneity exists to make the result generalisable, nor is their enough industry and region concentration to make generalisations in either of those areas. The study does provide a very good basis for future work in this area. Fruitful areas of inquiry have been identified. The potential pitfalls have also been identified. Interesting next steps include undertaking a research project with the intention of researching the previously less-researched phenomena identified above. The time should be taken to select participant where both the investors and entrepreneurs are willing and able to talk about the deal and where relevant legal documentation is being provided. This study outlines the relevant documents and clauses that can be used to determine the actual terms and conditions of a venture capital financing deal. This is important given that venture capital deals often have different legal documentation and the terms and conditions may be in different documents depending on the deal under analysis. The most important contribution of the study is to confirm this area of research as a potential fruitful and viable avenue to pursue for future researchers.
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  59. 59. Research Websites http://www.canadavc.com http://www.convergedigest.com http://www.factiva.com http://www.google.com 59
  60. 60. Appendix A – Sample Term Sheet Source (www.drm.com/newstand/presentations/VC.Model_TS.pdf) [Company Name] Series A Convertible Preferred Stock Summary of Terms and Conditions _________, 2000 Amount of Investment: $_________ (subject to the Company obtaining commitments from additional Purchasers which commitments will be for a minimum of $_________) Purchasers: VC Capital, LC (“VC”) and other investors acceptable to VC Company: [Company Name], a [Delaware] corporation Security: Series A Convertible Preferred Stock (the “Series A”) Purchase Price: To be determined. The share price will be set at a level that results from a preinvestment valuation for the Company of $___ million and will take into account the option pool and all common stock and securities convertible into common stock on a fully diluted, common stock equivalent basis). Closing: The closing of the Purchaser’s purchase of the Series A stock (the “Closing”) is expected to occur on or about __________, 2001. The Closing will be contingent upon the satisfactory completion of due diligence and completion of documentation acceptable to VC and the Company. Pre-Closing The capital structure of the Company immediately prior to the Closing shall Capital Structure: consist solely of Common Stock. Option Pool Provision: As of the Closing, an allocation of Common Stock will be made to an option pool for the purpose of attracting a senior executive and other personnel which allocation will be equal to ___% of the fully diluted Common Stock (after giving effect to the issuance and conversion of the Series A). Post Closing Capitalization: Class Number of Shares Percent Common Stock/Founders ______________ __% 60

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