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Private Equity Investment: Lecture 2 - VC and other financing


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Private Equity Investment: Lecture 2 - VC and other financing

  1. 1. Professional Equity Investment (Venture Capital and Angel) Lecture 2 EBD 481, Fall 2009 Galbraith
  2. 2. Equity Investment Process Seed Money 1st Round Financing (Series A) 2nd Round Financing (Series B) Clean-up Financing (Series C) Year 1 Year 3 Year 5 $50k $1 million $3 million $1 million Milestones and Benchmarks Private Investment Venture Capital Firms
  3. 3. Historical Development of Professional Venture Capital <ul><li>1946: Beginning of Professional VCs </li></ul><ul><li>Formation of American Research & Development (ARD) </li></ul><ul><li>ARD’s Performance </li></ul><ul><ul><li>$3.5 million was raised ($2 million from institutional investors) </li></ul></ul><ul><ul><li>By end of 1947, ARD had invested in eight ventures, six of which were startups </li></ul></ul><ul><ul><li>By 1951 the performance was still lack-luster (stock price was at $19 down from the initial offering price of $25 in 1946) </li></ul></ul><ul><ul><li>1957 Invested in Digital Electronic Corporation </li></ul></ul><ul><ul><li>ARD Sold 1972; made money, about 15.0% annual return for investors (v. 7.2% in stock market) </li></ul></ul>
  4. 4. Historical Development of Professional Venture Capital (cont’d) <ul><li>1953: </li></ul><ul><ul><li>Small Business Administration (SBA) was formed </li></ul></ul><ul><ul><li>Legislation permitted the federal government to actively engage in fostering new business formation </li></ul></ul><ul><li>1958: </li></ul><ul><ul><li>SBA Created Small Business Investment Companies (SBICs) </li></ul></ul><ul><ul><li>Due to tax and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital </li></ul></ul>
  5. 5. Corporate Venture Capital <ul><li>About 7 to 10% of VC dollars </li></ul><ul><li>Invest in technologies/deals that have transferability to the corporation </li></ul><ul><li>Don’t necessarily share the “profit” motive as Angels and fund-based VCs </li></ul><ul><li>Deal rate is much lower, but support is much higher for funded firms </li></ul><ul><li>Popular in pharmaceuticals, telecommunications, software and defense technologies </li></ul><ul><li>Microsoft, Intel, Merck, Qualcomm, and Millennium Pharmaceuticals </li></ul>
  6. 6. Qualcomm Ventures (QVC) <ul><li>Qualcomm Ventures (QCV) was formed and began funding in 2000, with a $500-million fund commitment to make strategic investments in early-stage high-technology ventures. Since then, QCV has funded numerous companies in the wireless sector, and set up several exclusive regional funds to spur development in key strategic markets, including a $60-million fund in Korea, a $30-million fund in Japan, a $100-million fund in China and a €100-million fund in Europe. </li></ul><ul><li>QCV makes strategic investments in wireless-industry ventures that provide both a strong potential return on investment (ROI) and complement existing Qualcomm products and services. When selecting portfolio companies, QCV seeks a balance between ROI and long-range strategic value to the company and the wireless industry. </li></ul>
  7. 7. Qualcomm Ventures – Investment Criteria <ul><li>Strategic Value Criteria </li></ul><ul><ul><li>A strong fit with Qualcomm's products and initiatives </li></ul></ul><ul><ul><li>The potential to significantly affect the wireless value chain </li></ul></ul><ul><ul><li>A significant and sustainable competitive advantage </li></ul></ul><ul><li>Financial Criteria </li></ul><ul><ul><li>Potential liquidity and financial returns - Comparable to VC investors </li></ul></ul><ul><ul><li>Investment stage - Expansion, typically the second round of financing </li></ul></ul><ul><ul><li>Investment size - Between $500,000 and $10M, based on the opportunity </li></ul></ul><ul><ul><li>Ownership - Typically investing in privately held entities </li></ul></ul><ul><ul><li>Syndication - A strong investor group and board; typically QCV co-invests with financial VCs </li></ul></ul>
  8. 8. SOLICITING INVESTMENTS: Suppliers of Venture Capital – 25-Year Average
  9. 9. Professional Venture Capital Investing Cycle
  10. 10. ORGANIZING THE FUND: VC Fund Placement Memorandum <ul><li>Front-matter Declarations </li></ul><ul><li>State Securities Disclosures </li></ul><ul><li>Offering Summary </li></ul><ul><li>Fund Overview </li></ul><ul><li>Executive Summary </li></ul><ul><li>Summary of Terms </li></ul>Fund is Formed, Investments Made, New Fund Created
  11. 11. Useful Terms <ul><li>Carried Interest: </li></ul><ul><li>portion of profits paid to the professional venture capitalist as incentive compensation </li></ul><ul><li>Two and Twenty Shops: </li></ul><ul><ul><li>investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest </li></ul></ul>
  12. 12. OBTAINING COMMITMENTS: Arrangements with Fund Investors <ul><li>Capital Call: </li></ul><ul><li>when the venture fund calls upon the investors to deliver their investment funds </li></ul><ul><ul><li>Common to require subsequent investments consistent with the levels of investors’ initial contributions </li></ul></ul>
  13. 13. DUE DILIGENCE AND ACTIVE INVESTING: VC Fund Management <ul><li>Deal flow: </li></ul><ul><li>flow of business plans and term sheets involved in the venture capital investing process </li></ul><ul><li>Due diligence (in venture investing context): </li></ul><ul><li>process of ascertaining the viability of a business plan </li></ul>
  14. 14. VC and Angel Screening - Venture Characteristics <ul><li>Proprietary </li></ul><ul><li>Growth </li></ul><ul><li>Founder Commitment </li></ul><ul><li>Experience </li></ul><ul><li>Track Record </li></ul><ul><li>Management </li></ul><ul><li>Fire Within </li></ul><ul><li>Business Model </li></ul><ul><li>Business Plan </li></ul><ul><li>Deal Structure </li></ul><ul><li>Exit Plan </li></ul>
  15. 15. Screening Outcomes <ul><li>Seek lead investor position </li></ul><ul><li>Seek a non-lead investor position </li></ul><ul><li>Refer venture to more appropriate financial market participants </li></ul><ul><li>SLOR (standard letter of rejection) the venture </li></ul>
  16. 16. Structuring an Equity Investment <ul><li>Term Sheet: </li></ul><ul><li>summary of the investment terms and conditions accompanying an investment </li></ul><ul><li>Typical Issues Addressed in a Term Sheet </li></ul><ul><ul><li>Valuation </li></ul></ul><ul><ul><li>Ongoing funding needs </li></ul></ul><ul><ul><li>Size and staging of financing </li></ul></ul><ul><ul><li>Preemptive rights on new issues </li></ul></ul><ul><ul><li>Commitments for future financing rounds and </li></ul></ul><ul><ul><li> performance conditions </li></ul></ul><ul><ul><li>Form of security or investment </li></ul></ul><ul><ul><li>Redemption rights and responsibilities </li></ul></ul>
  17. 17. Structuring (cont’d) <ul><li>Typical Issues Addressed in a Term Sheet </li></ul><ul><ul><li>Dividend structure (Number of VCs and outsiders) </li></ul></ul><ul><ul><li>Additional management </li></ul></ul><ul><ul><li>Board appointments </li></ul></ul><ul><ul><li>Conversion value protection </li></ul></ul><ul><ul><li>Registration rights </li></ul></ul><ul><ul><li>Exit conditions and strategy </li></ul></ul><ul><ul><li>IPO-dictated events (e.g. conversion) </li></ul></ul><ul><ul><li>Co-sale rights (with founders) </li></ul></ul><ul><ul><li>Lock-up provisions </li></ul></ul>
  18. 18. Structuring (cont’d) <ul><li>Typical Issues Addressed in a Term Sheet </li></ul><ul><ul><li>Employment contracts </li></ul></ul><ul><ul><li>Incentive options </li></ul></ul><ul><ul><li>Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock o termination, term of agreement, post-employment activities and competition </li></ul></ul><ul><ul><li>Founder stock vesting </li></ul></ul><ul><ul><li>Confidentiality agreements and protection for intellectual property </li></ul></ul>
  19. 19. Exit Strategies <ul><li>Acquisition -- least costly of exit strategies </li></ul><ul><li>Public Offering -- most costly, but exciting and maintain some control (Future Lecture?) </li></ul><ul><li>Joint Venture -- intermediate strategy </li></ul><ul><li>Equity Buyback -- expensive, but way to get venture capitalists out of business </li></ul>
  20. 20. Summary - Advantages and Disadvantages of VC Funding <ul><li>Equity </li></ul><ul><li>Oversight </li></ul><ul><li>Control </li></ul><ul><li>Over payment for funds </li></ul><ul><li>Need to have exit strategy </li></ul><ul><li>Contractual Commitments </li></ul><ul><li>Legal and paperwork </li></ul><ul><li>Marketing and Management Assistance </li></ul><ul><li>Leverage for debt financing </li></ul><ul><li>Networking for additional funds and contacts </li></ul>
  21. 21. Grant and Guerrilla Financing
  22. 22. Grant Financing <ul><li>Government and Private Grants for R&D and Commercialization </li></ul><ul><ul><li>No equity </li></ul></ul><ul><ul><li>Amount may be about $10billion per year in U.S. (angel financing about $20billion per year) – largest in segments which are funded </li></ul></ul>
  23. 23. Grant Financing <ul><li>Small Business Innovation Research (SBIR) </li></ul><ul><ul><li>DoD, NASA, DHS, DoC, EPA, DoT, DoEd, DoE, HHS (NIH), NSF & USDA </li></ul></ul><ul><ul><li>The SBIR Program provides up to $850,000 in early-stage R&D funding directly to small technology companies (or individual entrepreneurs who form a company); </li></ul></ul><ul><ul><ul><li>Phase 1 ($75,000) </li></ul></ul></ul><ul><ul><ul><li>Phase II ($750,000) </li></ul></ul></ul><ul><ul><ul><li>Phase III (sell product) </li></ul></ul></ul><ul><li>Small Business Technology Transfer & Research (STTR) </li></ul><ul><ul><li>The STTR Program provides up to $850,000 in early-stage R&D funding directly to small companies working cooperatively with researchers at universities and other research institutions; </li></ul></ul>
  24. 24. Grant Financing <ul><li>Department of Defense: SBIR/STTR/Fast Track - Main Page </li></ul><ul><li>TechLink : : Links to Department of Defense, DoD Component, and Related Websites for SBIR/STTR Information </li></ul>
  25. 25. Grant Financing <ul><li>Other Grants (CCAT, TechLink, BAAs, etc) </li></ul><ul><li>Local and Regional Economic Development Grants </li></ul><ul><ul><li>Industrial Development Bonds </li></ul></ul><ul><ul><li>Tax Breaks </li></ul></ul><ul><ul><li>Other Incentives </li></ul></ul><ul><li>Private Foundations </li></ul>
  26. 26. Guerrilla Financing <ul><li>Credit Cards </li></ul><ul><li>Relatives and Friends </li></ul><ul><li>Trade Credit </li></ul><ul><li>Revenue Financing </li></ul><ul><li>Small Shares, with buyback provision </li></ul><ul><li>Factoring </li></ul>BOOTSTRAPPING