PROFESSIONAL VENTURE CAPITAL ENTREPRENEURIAL FINANCE Leach & Melicher Chapter 12 PROFESSIONAL VENTURE CAPITAL © 2003 South-Western College Publishing

Chapter 12: Learning Objectives Discuss the history & current status of venture investing in the U.S. Explain the professional venture investing cycle and its relevance to entrepreneurs seeking professional venture capital List major elements in the design & structure of a venture capital fund

Chapter 12: Learning Objectives Describe the venture capital screening process & list characteristics that will determine whether a VC will invest Discuss the various roles a venture capitalist can take in providing financing and services to an emerging venture Enumerate several terms or conditions to be negotiated with structuring venture capital financing

Historical Development of Professional Venture Capital Professional Venture Capitalists (VCs) >Raise capital from investors, in addition to their personal funds, to invest in a portfolio of risky ventures Pre-World War II Era >Most venture investing came from wealthy individuals and families 1946: Beginning of Professional VCs >Formation of American Research & Development (ARD)

Historical Development of Professional Venture Capital (cont’d) ARD’s Early Performance >$3.5 million was raised ($2 million from institutional investors) >By end of 1947, ARD had invested in eight ventures, six if which were startups >By 1951 the performance was still lack-luster (stock price was at $19 down from the initial offering price of $25 in 1946)

Historical Development of Professional Venture Capital (cont’d) 1953: Small Business Administration (SBA) was Formed >Legislation permitted the federal government to actively engage in fostering new business formation 1958: SBA Created Small Business Investment Companies (SBICs) >Due to taxs and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital

Historical Development of Professional Venture Capital (cont’d) ARD’s Later Performance >In 1957, ARD had invested $70,000 in the startup company Digital Equipment Corporation (DEC) 1972: ARD was sold for $813 Per Share >Original ARD investors received a compound annual return of 14.7% due primarily to DEC >Without the DEC investment, the rate of return would have been only 7.4%

Historical Development of Professional Venture Capital (cont’d) Late 1960s-Early 1970s Boom-Bust Cycle >Many SBICs began having operating problems due to the mixing of risky venture investments & high financial leverage (debt service commitments) 1970s: Professional VC Organizational Structure Changes >Movement to private partnerships from public firms & volatile financial markets

DETERMINING (NEXT) FUND OBJECTIVES & POLICIES Professional Venture Investing Cycle

ORGANIZING THE NEW FUND Carried interest: portion of profits paid to the professional venture capitalist as incentive compensation Two and twenty shops: investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest

ELEMENTS of VC FUND PLACEMENT MEMORANDUM Frontmatter Declarations State Securities Disclosures Offering Summary Fund Overview Executive Summary Summary of Terms

SUPPLIERS OF VENTURE CAPITAL: 15 Year Average 40% Pension Funds 13% Individuals 12% Corporations 12% Insurance Companies 12%Endowments 12% Foreign

CAPITAL CALL Capital call: when the venture fund calls upon the investors to deliver their investment funds Subsequent investments consistent with the levels of investors contributions

CONDUCTING DUE DILIGENCE AND ACTIVELY INVESTING Deal flow: flow of business plans and term sheets involved in the venture capital investing process Due diligence (in venture investing context): process of ascertaining the viability of a business plan

VC SCREENING CRITERIA 1. Venture Capital Firm Requirements 2. Characteristics of the Proposal 3. Characteristics of the Entrepreneur/Team 4. Nature of the Proposed Industry 5. Strategy of the Proposed Business

VC SCREENING CRITERIA 1. Venture Capital Firm Requirements a. Cash out potential b. Equity share c. Familiarity with technology, product, market d. Financial provisions for investors e. Geographic location f. Investor control

VC SCREENING CRITERIA 1. Venture Capital Firm Requirements g. Investor control h. Investor group i. Rate of return j. Size of investment k. Stage of development

VC SCREENING CRITERIA 2. Characteristics of the Proposal a. Requirement for additional material b. Stage of plan

VC SCREENING CRITERIA 3. Characteristics of the Entrepreneur/Team a. Ability to evaluate risk b. Articulate regarding the venture c. Background/experience d. Capable of sustained effort e. Managerial capabilities f. Management commitment g. References h. Stake in firm

VC SCREENING CRITERIA 4. Nature of the Proposed Industry a. Market attractiveness b. Potential size c. Technology d. Threat resistance

VC SCREENING CRITERIA 5. Strategy of the Proposed Business a. Product differentiation b. Proprietary product

OUTCOMES OF THE SCREENING PROCESS 1. Seek lead investor position 2. Seek a non-lead investor position 3. Refer venture to more appropriate financial market participants 4. SLOR (standard letter of rejection) the venture

ARRANGING HARVEST OR LIQUIDATION Typical Issues Addressed in a Term Sheet Valuation Ongoing funding needs Size and staging of financing Preemptive rights on new issues Commitments for future financing rounds and performance conditions Form of security or investment Redemption rights and responsibilities

ARRANGING HARVEST OR LIQUIDATION Typical Issues Addressed in a Term Sheet Dividend structure (Number of VCs and outsiders) Additional management Conversion value protection Registration rights Exit conditions and strategy IPO-dictated events (e.g. conversion) Co-sale rights (with founders) Lock-up provisions

ARRANGING HARVEST OR LIQUIDATION Typical Issues Addressed in a Term Sheet Employment contracts Incentive options Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock o termination, term of agreement, post-employment activities and competition Founder stock vesting Confidentiality agreements and protection for intellectual property