On Entrepreneurial Finance MGT 709 New Venture Creation

Agenda Adams How VCs evaluate deals Funding New Ventures Note on Valuation of VC deals Allen Lane Walnut Venture Associates

Adams On Finance Myth: Investors want their money back quickly Reality: Good investors are in it for the long haul You want smart money not ‘green’ money Smart investors will do whatever is necessary to create value If you want status quo or safety don’t seek investment capital

Pick your investors Domain expertise Chemistry & staying power Core competencies – do they improve execution intelligence? Sophistication Prior successes

Types of investors Venture investors Strategic investors Sophisticated, high hurdles Launch your business as if you are seeking VC funds Prove the opportunity – deep down knowledge of pain Strategic investors Provide market validation and industry insight Target internal venture groups – outline the benefit to them Angel investors Should be as savvy as any other investor – make sure they can add real value They can be important mentors

Value-added of smart investors Fund-raising know-how and contacts Recruiting, Industry contacts and networking potential strategic partners and customers Unbeatable market intelligence Technological know-how Ability to redirect the team or refocus the business A vested interest in the startup’s success

How VCs evaluate opportunities Siegelman, KPCB Big markets, competitive edge, great team Technical due diligence is big, some customer and industry diligence, background checks on team $500K smallest investment, $3-$5m to $10m, FAST deals – a week or two Don’t invest in low price products without a low price channel, $200K price tag for enterprise software 50% gross margin on hardware Looking for IPO

Hoel, Menlo Ventures Market first, $500m to $1bn, Fortune 100 customers, vertical markets are difficult Favorite is a company doing well in spite of itself – boost the team Aim for market share leaders Market and developed product best predictors Not team or proprietary technology Founder must be willing to upgrade the team and in it for the lifestyle Deal size $20-25m per co., 2-3 mths to work out, IPO or acquisition for “liquidity event” Direct sale or telesales- understand required margins

Wang, Trinity Ventures Team, market opportunity, value proposition/product Focus on the CEO It’s a sector bet – thesis process every quarter Everything looks like its going to be a multi-billion dollar market We avoid arm-wrestling with ‘wild eyed technologists’ Focus on smaller opportunities with less uncertainty 18 month window, Series A Lot of time on financial model – bottom up

Simon, Alta Partners I think markets trump people and technology I look for big opportunities, big painful problems that customers have We don’t target market shares, we target revenue $60-$80m in 3 years Ideal case – four PhDs solve a problem after a year or two and it’s 2 orders of magnitude better than whatever else is out there Lot of focus on personal motivations of people are they in it for the long haul (with passion) Need to “monetize” customers (e.g. Skype) One or two “brave new world” investments Bet on marketing or technology side 1-6 month decision frame Exit at $200m market and $60-$80m company size Advise clients to not dilute a good business which won’t grow to that size (and thus is not a good venture opportunity) Check out Sand Hill Road, Menlo Park, CA

Funding New Ventures How to get rich Start a business that is either: Managing dilution effects in an important skill Start a business that is either: Self-funded growth or not capital intensive Uses debt instead of equity Has a huge ROE potential A business generating 25% ROE must sell 100% of its shares to an investor seeking a 25% ROE Bottom up valuation, alternatives, complications See next slide Capitalization Tables See Exhibit 1

Note on Valuation SpiffyCalc Post money valuation = NPV of T = $4.9m Expect to sell for terminal value (T) of $25m in 4 years Need to raise $3m investment (I) Vulture Ventures discount rate ( r ) =50% Number of existing shares (x) = 1m Post money valuation = NPV of T = $4.9m Pre money valuation = POST – I Ownership fraction (F) = I/POST New shares (y): y/(x+y)=F => y=x/[F/(1-F)] Share price = I/y

Special Cases Complications Estimating terminal value Employee Stock Options Add the option pool to the entrepreneur share Preference shares can be tricky Look for total share of future value being obtained Estimating terminal value P/E ratios and other multiples – see 2006 estimates Accounting for risk Expected values Higher discount rates Scenario analysis Multiple financing rounds Changing discount rates and time periods Effect of future dilution must be factored in

Allen Lane Evaluate Allen Lane and his search for a business What did he do right? What did he learn as the process progressed? Is he suited to running his own business? How should Allen value Plas-Tek? How much should be bid? Why? What conditions should he place on his bid? How should he finance and structure the purchase?

Walnut Venture Associates (D) What do you think the investors are trying to accomplish with the vesting provisions? What would you try to renegotiate if you were O’Connor? What is a reasonable valuation for RBS in June 1998? Assume RBS is liquidated in 5 years for $3m – who would get the money according to the term sheet? How about $10m or $30m?