1. Venture Capital Financing Thomas Chemmanur

2. 2 2 VENTURE CAPITAL FINANCING MANY FIRMS GO THROUGH A LIFE-CYCLE: 1. START OUT AS SMALL PRIVATE FIRMS 2. EXPAND THROUGH VARIOUS STAGES OF V.C/PRIVATE EQUITY FINANCING (ALSO: BANK- DEBT). 3. GO PUBLIC (HAVE AN INITIAL PUBLIC OFFERING- IPO). 4. FURTHER EXPAND THROUGH ADDITIONAL ROUNDS OF PUBLIC EQUITY/DEBT FINANCING. FOCUS ON STAGE (2), VENTURE CAPITAL FINANCING HERE.

3. 3 3 SOURCES OF V.C FINANCING 1. PRIVATE PARTNERSHIPS AND CORPORATIONS SET UP TO PROVIDE FUNDS.  ORGANIZER BEHIND THE PARTNERSHIP MAY OBTAIN FUNDING FROM INSTITUTIONS (INSURANCE COMPANIES AND PENSION FUNDS) OR INDIVIDUALS.  PRATT’S GUIDE TO VENTURE CAPITAL LISTS 2000 SUCH FIRMS.  AVERAGE AMOUNT INVESTED BY THESE PER FIRM: $1 TO 2 MILLION  E.g: ARTUR ROCK & COMPANY OF SAN FRANCISCO PROVIDED VENTURE FUNDS TO APPLE COMPUTERS  ONLY 2% OF REQUESTS RECEIVE FINANCING.

4. 4 4 SOURCES OF V.C FINANCING 2. VENTURE CAPITAL SUBSIDIARIES OF LARGE INDUSTRIAL OR FINANCIAL CORPORATIONS.  E.g: CITICORP VENTURE CAPITAL, CHEMICAL VENTURE CAPITAL CORP.  ONLY SMALL PORTION OF V. C. MARKET. 3. HIGH NET-WORTH INDIVIDUALS AND FAMILIES (“ANGELS”), WITH EXPERIENCE AND KNOWLEDGE IN THAT INDUSTRY. (TYPICAL ANGEL NET WORTH OVER $1 MILLION).  ANGELS TEND TO INVEST ONLY SMALLER AMOUNTS ON AVERAGE ($250,000) THAN V.C. FIRMS.  HOWEVER, THE AGGREGATE INVESTMENTS FROM THIS SOURCE IS MUCH LARGER (AT LEAST TWICE AS MUCH) AS FROM VENTURE CAPITAL FIRMS.

5. 5 5 WHAT DO VENTURE CAPITALISTS DO? 1. PROVIDE FINANCING 2. MONITOR THE ENTREPRENEUR: MANY VENTURE CAPITALISTS SPEND SEVERAL HOURS A WEEK WITH THE FIRM THEY HAVE INVESTED IN. 3. PROVIDE EXPERTISE TO FIRM MANAGEMENT (AND CONTACTS, OBTAINED FROM BEING INVOLVED IN SIMILAR FIRMS BEFORE). 4. HELP THEM WITH ADDITIONAL FINANCING FROM OTHER SOURCES, INCLUDING INITIAL PUBLIC OFFERINGS (IPOs).

6. 6 6 WHAT DO VENTURE CAPITALISTS DO? IPO’S WITH VENTURE BACKED FINANCING:  EVIDENCE INDICATES THAT VENTURE-BACKED DEALS TEND TO BE LESS “UNDERPRICED” THAN NON-VENTURE BACKED DEALS.  ALSO, VENTURE CAPITALISTS (MANY) SEEM TO HAVE EXCELLENT “TIMING” ABILITY (i.e., THE TIMING OF THE GOING-PUBLIC DECISION). EXAMPLE: KAPOR STARTED LOTUS IN 1981 WITH FINANCING FROM SEVIN-ROSEN

7. 7 7 LOTUS EXAMPLE WHAT EACH PARTY BROUGHT TO THE DEAL: KAPOR (ENTREPRENEUR)  (I) RECOGNIZED A MARKET NEED  (II) TECHNICAL ABILITIES AND TEAM  (III) HAD A REASONABLE BUSINESS PLAN SEVIN-ROSEN (V.C)  (I) CAPITAL  (II) EXPERIENCE  (III) INDUSTRY CREDIBILITY SOMETIMES, THE V.C’S CONTACTS CAN BE SO CRUCIAL THAT FROM WHOM CAPITAL IS RAISED CAN BE MORE IMPORTANT THAN TERMS ON WHICH RAISED.

8. 8 8 POTENTIAL ISSUES WITH V.C. FINANCING 1. POTENTIAL FOR EXCESSIVE DILUTION OF EQUITY (OBVIOUS). 2. POTENTIAL INTERFERENCE IN THE DAY-TO-DAY RUNNING OF THE FIRM. 3. MAY FORCE PRE-MATURE ABANDONMENT OF PROJECT(S) IF V.C IS SOLE SUPPLIER. 4. FIRM MAY HAVE TO TRY TO GO PUBLIC TOO EARLY.

9. 9 9 EXIT STRATEGIES ADOPTED BY V. C.’S 1. GOING PUBLIC TYPICALLY THE MOST DESIRABLE ROUTE - SO THE ONE THE V.C. AIMS AT; MOST COMMON 2. SALE TO ANOTHER COMPANY 3. SALE OF OWNERSHIP STAKE TO ANOTHER INVESTOR: - OFTEN TO A “WORKING PARTNER”. 4. SALE BACK TO ENTREPRENEUR.- RARE, BUT USED IF ENTREPRENEUR CAN BORROW FROM BANK OR HAS CASH. 5. REORGANIZING THE COMPANY (CHAPTER 11) 6. LIQUIDATION OF ASSETS.

10. 10 FINANCIAL CONTRACTING WITH V. C.’S A V.C DEAL IS ANY AGREEMENT BETWEEN PARTIES FOR THE ALLOCATION OF ECONOMIC VALUE.  A DEAL ALLOCATES CASH FLOWS BY AMOUNT AND TIMING, AS WELL AS RISK.  THE STRUCTURE OF A V.C. DEAL CAN RESULT IN THE SUCCESS OR FAILURE OF THE FIRM/PROJECT.

11. 11 FINANCIAL CONTRACTING WITH V. C.’S A VENTURE-CAPITAL CONTRACT OR DEAL SHOULD:  (I) ALLOCATE CASH FLOWS APPROPRIATELY.  (II) ALLOCATE THE RISKS INVOLVED IN THE FIRM  (III) GIVE RISE TO THE “RIGHT” INCENTIVE EFFECTS BETWEEN THE ENTREPRENEUR AND VENTURE CAPITALIST.  (i.e., IT SHOULD MOTIVATE THE ENTREPRENEUR TO PUT FORTH OPTIMAL EFFORT AND PUT-FORTH REALISTIC CASH FLOW PROJECTIONS)

12. 12 DESIGNING DEALS DESIGNING DEALS INVOLVES CHALLENGES AND OPPORTUNITIES: (1) UNCERTAINTY ABOUT CASH FLOWS (2) DISCOUNT RATES DIFFICULT TO DETERMINE. (3) PARTIES MAY DISAGREE ABOUT EXPECTED CASH FLOWS, THEIR RISKS AND THE APPROPRIATE RATES. (4) PARTIES AFFECTED DIFFERENTLY BY TRANSACTION (TAX EFFECTS, FOR EXAMPLE). (5) ASYMMETRIC INFORMATION (6) CONFLICTS OF INTERESTS (7) INCENTIVE EFFECTS OF DEAL ITSELF.

13. 13 ADDRESSING DIFFICULTIES DIFFICULTIES ARE DEALT WITH BY: (A) STAGE FINANCING  FINANCING THE PROJECT (INVESTING IN THE FIRM) IN STAGES. (B) USE OF APPROPRIATE FINANCIAL CONTRACTS: (I) DEBT WITH WARRANTS (II) CONVERTIBLE DEBT (III) PREFERRED EQUITY, ESPECIALLY CONVERTIBLE PREFERRED EQUITY.

14. 14 VENTURE CAPITAL VALUATION PRE-MONEY VALUATION  PRODUCT OF PRICE PAID BY V.C PER SHARE AND THE NUMBER OF SHARES OUTSTANDING PRIOR TO V.C’S INVESTMENT. POST-MONEY VALUATION:  PRODUCT OF PRICE PAID PER SHARE BY V.C AND THE TOTAL NUMBER OF SHARES (INCLUDING NEW SHARES ISSUED TO V.C) OUTSTANDING AFTER V.C’S INVESTMENT.

15. 15 EXAMPLE OF A V.C VALUATION POST-MONEY VALUATION EXAMPLE: ASSUME:  INVESTMENT FROM V.C = $300,000 EQUITY PARTICIPATION OF V.C = 15%  IMPLIED EQUITY OF FIRM = 300,000/0.15 = 2 MILLION POST-MONEY BALANCE SHEET ASSETSLIABILITIES CASH $300,000EQUITY $2,000,000 OTHER 100,000 INTANGIBLES 1,600,000 $2,000,000

16. 16 EXAMPLE OF A V.C VALUATION VC EXPECTED RETURN:  RISKLESS RATE (LTG)6.0%  MARKET PREMIUM5.0% 11%  SMALL CAPITAL PREMIUM2% 13%  LIQUIDITY PREMIUM + VALUE ADDED PREMIUM+ CASH FLOW ADJUSTMENT =30% V.C EXPECTED RETURN  40 TO 50%

17. 17 EXAMPLE OF A V.C VALUATION ASSUME THAT THE V.C EXPECTS A RETURN OF 50%. THEN, IN FIVE YEARS:  VALUE OF V.C’S INVESTMENT = $300,000 * (1.50) 5 = $2.3 MILLION  (1+r) 5  EQUITY VALUE OF ENTIRE FIRM = 2.3/0.15 = $15.3 MILLION.

18. 18 EXAMPLE OF A V.C VALUATION IS THIS REALISTIC? ASSUME (BUSINESS PLAN PROJECTS): (FOR YEAR FIVE)  SALES $37.4 MILLION  EBIT (10% OF SALES) = 3.7 MILLION  PROFITS (NO DEBT ASSUMED) = 1.8 (AFTER Tc = 0.5) HENCE, REQUIRED PRICE/EBIT MULTIPLE = 15.3/3.7 = 4.2 AND PRICE/EARNINGS MULTIPLE = 15.3/1.8 = 8.5 BOTH OF WHICH ARE REASONABLE.

19. 19 FLOW OF MONEY & VALUATIONS FLOW OF MONEY INTO V.C FUNDS SEEMS TO FOLLOW A BOOM-BUST PATTERN; ALSO PRE- MONEY VALUATIONS SEEM TO FOLLOW SUCH VARIATIONS IN INFLOWS

20. 20 STAGES OF PRIVATE FINANCING A. FIRST ROUND: START-UP; R&D, TESTS, MARKET RESEARCH. B. SECOND ROUND: PROTOTYPES. FURTHER TESTING; EARLY EXPANSION. C. THIRD ROUND: FULL SCALE MANUFACTURING & MARKETING D. FOURTH ROUND: CONVENTIONAL FINANCING (PRIVATE PLACEMENT, MEZZANING FINANCING, AND IPO). (V.Cs TYPICALLY INVOLVED IN 2 nd AND 3 rd ROUNDS). ANOTHER CLASSIFICATION OF INVESTMENT STAGES BENEFIT OF STAGE FINANCING: INCREASED NPV

21. 21 STAGED FINANCING: OPTION TO ABANDON ONE ADVANTAGE OF STAGED FINANCING IS THAT THE V.C HAS THE OPTION NOT TO PROVIDE FUNDING AS MORE INFORMATION BECOMES AVAILABLE. CASE-I (SINGLE-ROUND FINANCING) PV = 500 (NEWS = GOOD) INVEST 0.5 UPFRONT -200 0.5 PV = 10 (NEWS = BAD) E[NPV] = -200 + 0.5(500) + 0.5(10) = $55

22. 22 STAGED FINANCING: OPTION TO ABANDON CASE-II: STAGED FINANCING INVEST $100, PV = 500 GOOD NEWS INVEST 0.5DON’T INVEST, PV = 0 UPFRONT $100 0.5INVEST $100, PV = 10 BAD NEWS DON’T INVEST, PV = 0 E[NPV] = -100 + 0.5[500 - 100] + 0.5(0) = $100 NPV HAS GONE UP IN STAGED FINANCING!

23. 23 VALUATION & V.C. OWNERSHIP STAKE EXAMPLE: PRE-AND POST-MONEY VALUATION AND V.C OWNERSHIP STAKE  $5 MILLION INVESTMENT REQUIRED IN BIO-TECH VENTURE  PROJECTED NET-INCOME IN YEAR 7 = 20 MILLION.  AVERAGE P/E OF PROFITABLE BIO-TECH FIRMS (COMPARABLES) = 15  CURRENT NO. OF SHARES OUTSTANDING = 500,000  ASSUME EXPECTED RETURN 50% CASE-I: NO FURTHER FINANCING NEEDED UNTILL FIRM GOES PUBLIC (IN YEAR 7)  NO NEW SHARES ISSUED BEFORE V.C EXITS

24. 24 VALUATION & V.C. OWNERSHIP STAKE CASE-I  DISCOUNTED TERMINAL VALUE = TERM. VAL./(1 + r) 7 = 20 * 15/1.5 7 = $17.5 M  REQUIRED EQUITY OWNERSHIP = INVESTMENT/DISCOUNTED TERMINAL VALUE = 5/17.5 = 0.285 OR 28.5%   TOTAL SHARES AFTER VALUATION = 500,000/(1 - 0.285) = 700,000  NO. OF NEW SHARES ISSUED TO V.C = 200,000  PRICE PER NEW SHARE = $5 M /200,000 = $25 /SHARE IMPLIED PRE-MONEY VALUATION = (25)500,000 = $12.5 M IMPLIED POST-MONEY VALUATION = (25)700,000 = $17.5 M

25. 25 VALUATION & V.C. OWNERSHIP STAKE CASE-II: TWO ROUNDS OF FINANCING BEFORE V.C EXITS; THREE MORE SENIOR EXECUTIVES NEED TO BE HIRED (10% OF EQUITY GIVEN AS STOCK OPTIONS TO THEM); ALSO, 30% OF EQUITY SOLD IN A SUBSEQUENT FINANCING ROUND. CASE-II: CALCULATIONS NEED TO BE AMENDED AS FOLLOWS RETENTION RATIO: AFTER FIRST ROUND  1/1.1 = 90.9% AFTER SECOND ROUND = (1/1.1)/1.3 = 70% OF EQUITY REQUIRED CURRENT OWNERSHIP = REQUIRED FINAL OWNERSHIP/RETENTION RATIO = 0.285/0.7 = 40.7%.

26. 26 VALUATION & V.C. OWNERSHIP STAKE NO. OF NEW SHARES = 500,000/(1 - 0.407) - 500,000 = 343,373 SHARES PRICE PER NEW SHARE = $5 MILLION/343,373 = $14.56/SHARE IMPLIED PRE-MONEY VALUATION = 14.56 * 500,000 = 7.28 MILLION IMPLIED POST-MONEY VALUATION = $7.28 + $5 = 12.28 MILLION CURRENT VALUATION HAS FALLEN (WHY?)

27. 27 RISK ALLOCATION - DEBT WITH WARRANTS EXAMPLE OF RISK-ALLOCATION, USING DEBT WITH WARRANTS. ASSUME INVESTMENT BY V.C = $1000 0.5MEDIOCRE (I) 0.5 VERY SUCCESSFUL (II) YEAR0123 CASH FLOW -1000 CASE-I2503001000 CASE-II3507005000 EXPECTED -10003005003000 SAMPLE CALCULATION OF CASH FLOW IN YEAR 0: = 0.5(250) + 0.5(350) = 300

28. 28 RISK ALLOCATION - DEBT WITH WARRANTS ASSUME EXPECTED RETURN OF V.C IS 40% IN ORDER TO INVEST, THE V.C IS GOING TO DEMAND AN EQUITY PARTICIPATION WHICH WILL GIVE HIM A PV OF $1000 (AMOUNT INVESTED) AT AN EXPECTED RETURN OF 40%. PV OF PROJECT EXPECTED CASH FLOW (AT 40% RETURN) = $1562.6 (CHECK!) EQUITY PARTICIPATION IF V.C TAKES STRAIGHT EQUITY = 1000/1562.5 = 0.64 OR 64%

29. 29 RISK ALLOCATION - DEBT WITH WARRANTS ALTERNATIVE TO EQUITY FINANCING: DEBT WITH WARRANTS TWO PARTS IN SECURITY PACKAGE: BOND: GIVES V.C A CASH FLOW OF $250 AT t = 1, $300 AT t = 2, AND $1000 AT t = 3. (THUS, THE V.C GETS ALL THE CASH FLOW IN THE LOW SCENARIO; THE ENTREPRENEUR GETS NONE). THE BOND PAYS OFF THE SAME AMOUNT IN EITHER SCENARIO (IN THE HIGH SCENARIO, THERE WILL BE SOME MONEY LEFT OVER AT EACH DATE FOR THE ENTREPRENEUR).

30. 30 RISK ALLOCATION - DEBT WITH WARRANTS CASH FLOW TO V.C (FROM BOND ALONE) t = 0123 HIGH SC2503001000 LOW SC2503001000 E(CASH FLOW)2503001000 PRESENT VALUE AT 40% = 250/1.4 + 300/1.4 2 + 1000/1.4 3 = 696

31. 31 RISK ALLOCATION - DEBT WITH WARRANTS REMAINING PRESENT VALUE TO BE PROVIDED TO V.C = 1000 - 696 = 304 THIS CAN BE PROVIDED TO THE V.C IN THE FORM OF A WARRANT, WHICH CAN BE CONVERTED TO 41.8% OF FIRM’S EQUITY IN HIGH SCENARIO AT t = 3. (THE V.C GETS ALL THE FIRM’S MONEY IN THE LOW SCENARIO, ANYWAY, THROUGH THE BOND).

32. 32 RISK ALLOCATION - DEBT WITH WARRANTS CALCULATING THE FRACTION OF EQUITY TO BE PROVIDED TO V.C THROUGH WARRANT IN HIGH SCENARIO  PRESENT VALUE TO BE PROVIDED (CALCULATED BEFORE) = 304.   t = 3 EXPECTED CASH FLOW TO BE PROVIDED = 304(1.4) 3 = $835 (SINCE DISCOUNT RATE = 40%).  SINCE WARRANTS ARE WORTHLESS IN LOW SCENARIO, EXPECTED CASH FLOW TO V.C = 835 = 0.5 (LOW-SCENARIO CASH FLOW = 0) + 0.5 (HIGH-SCENARIO CASH FLOW).

33. 33 RISK ALLOCATION - DEBT WITH WARRANTS SOLVING: HIGH-SCENARIO CASH FLOW = 835/0.5 = $1670 NOW, TOTAL CASH FLOW AVAILABLE TO EQUITY IN HIGH SCENARIO = $5000 -$1000 = $4000  PAID TO BOND  EQUITY TO BE PROVIDED TO V.C WARRANTS = 1670/4000 = 41.8%

34. 34 RISK ALLOCATION - DEBT WITH WARRANTS SUMMARY: TOTAL CASH FLOW TO V.C YEAR0123 LOW SCEN: BOND:-2503001000 WARR:---- HIGH SCEN: BOND:-2503001000 WARR:---1670 EXPECTED CASH FLOW: BOND: -2503001000 WARR:---835 TOTAL:-2503001835

35. 35 RISK ALLOCATION - DEBT WITH WARRANTS BOND PLUS WARRANTS: SPLIT-UP OF PRESENT VALUE V.CENTREPRENEURTOTAL CASH %CASH %CASH PV: 696 = 100% 0 = 0% 696 (LOW SCENARIO) PV: 1305 = 54% 1125 = 46%2429 (HIGH SCENARIO) PV (ECF): 1000 = 64% 563 = 36% 1563 SAME AS IN EQUITY CASE

36. 36 RISK ALLOCATION - DEBT WITH WARRANTS NOTE: 1. INCENTIVE-EFFECTS: THE ENTREPRENEUR WORKS HARD (HE GETS NOTHING IN LOW SCENARIO). 2. INFORMATION-EFFECTS: ENTREPRENEUR HAS NO BENEFIT FROM OVERSTATING PROBABILITY OF HIGH SCENARIO.

37. 37 EARNOUT AGREEMENTS: SIMILAR TO STAGED FINANCING IN THAT A PORTION OF THE PURCHASE PRICE IS PAID IN THE FUTURE CONTINGENT ON THE TARGET’S FUTURE EARNINGS. EXAMPLE:  WHEN COMPANY A ACQUIRES B, THE SELLER WILL BE PAID FOUR TIMES TARGET FIRM’S EBIT FOR THAT YEAR.  THUS, WHEN GM ACQUIRED EDS AND HUGHES ELECTRONICS, IT PAID FOR THE ACQUISITIONS WITH A SEPARATE CLASS OF SHARES, WITH DIVIDENDS CONTINGENT ON PROFITS.

38. 38 EARNOUT AGREEMENTS: ADVANTAGES OF EARN-OUT AGREEMENTS:  PARTICULARLY USEFUL IN ACQUIRING PRIVATE FIRMS, DIFFICULT TO VALUE  SCREENS OUT SELLERS WHO TRY TO MISREPRESENT THE EARNINGS POTENTIAL OF THEIR BUSINESS  PROVIDES INCENTIVES TO THE SELLER/ENTREPRENEUR IF HE STAYS ON AS A MANAGER (OFTEN THE CASE).  DIMINISHES UP-FRONT COMMITMENT OF BUYER  PROTECTS BUYER FROM NEGATIVE SURPRISES