Professional Venture Capital 1 ENTREPRENEURIAL FINANCE

 Venture Capitalists (VCs): individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing 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) 2

 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 of 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) 3

 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 tax and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital 4

 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% 5

 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 6

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 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 9

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 Capital Call: when the venture fund calls upon the investors to deliver their investment funds  Common to require subsequent investments consistent with the levels of investors’ initial contributions 11

 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 12

 1. The Industry  2. Stage of the Business  3. Size of the Investment  4. Geographic Area 13

 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 14

 Term Sheet: summary of the investment terms and conditions accompanying an investment  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 15

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 16

Typical Issues Addressed in a Term Sheet  Employment contracts  Incentive options  Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock at termination, term of agreement, post-employment activities and competition  Founder stock vesting  Confidentiality agreements and protection for intellectual property 17