Venture Capital Financing and Due Diligence

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1 Venture Capital Financing and Due Diligence Sources of Financing to Early Stage Companies 1) Private partnerships and corporations set up to provide funds 2) Venture capital subsidiaries of large industrial or financial corporations (e.g., Intel CVC, Citicorp Venture Capital, Chemical Venture Capital Corp) 3) High net-worth individuals and families ( angels ), with experience and knowledge in that industry 4) Crowd-funding, involving the use of the internet to raise money (with some limits) from even retail investors (e.g., Kickstarter, largest crowd-funding site so far) Sources of Commitments to VC Pension funds (Public and Corporate Pension funds) Foreign Endowments Corporations (including bank and finance companies) Insurance companies Individuals What Do VCs Do? 1) Provide financing 2) Monitor the entrepreneur 3) Provide expertise to firm management 4) Help portfolio companies with additional financing from other sources, including IPOs What each party brings to the deal: Entrepreneur 1) Recognize a market need 2) Technical abilities and team 3) Have a reasonable business plan Venture Capital 1) Capital 2) Experience 3) Industry credibility Sometimes, the VC s contacts can be so crucial that from whom capital is raised can be more important than terms on which raised. 1

2 Potential Problems with Venture-Capital 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) 4) Firm may have to try to go public too early Difficulties and Opportunities in Designing VC Deals 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) Incentive effects of deal itself Typical Exit Strategies Adopted by Venture Capitalists 1) Going public (IPO) 2) Sale to another company (M&A) 3) Sale of ownership stake to another investor 4) Sale back to entrepreneur 5) Reorganizing the company (under Chapter 11 of bankruptcy code in the U.S.) 6) Liquidation of assets Stages of Investment Series A (early or seed stage) Idea to product development Product development to product launch Series B Product launch to real, repeatable revenue model Ramp-up sales and marketing efforts Begin to develop infrastructure to support these efforts Series C/D/E Accelerate business growth Expand sales channels Expand internationally Path to profitability/bridge to IPO 2

3 Benefit of Staged Financing: increased NPV Option to abandon One advantage of staged financing is that the VC has the option not to provide funding as more information becomes available Role of Due Diligence Due diligence is required in order to establish the feasibility and credibility of the business (plan, operations, management team, financial statements) A mini audit of the operations of all aspects of the business involving reviews of legal documents and contracts, interviews of people, and validation of information in the financial statements. Generally conducted by the Potential Investor or Acquirer, or their representatives. 3

4 Series A Investment and Due Diligence Funding the idea/entrepreneur Diligence is focused on the validating the market opportunity, the technology (product), and the founders Serial entrepreneurs have an edge Success breeds success Business Plan/Investor Pitch Generally little, if any, historical financial information Shoebox accounting Financial Projections Too early to tell, but think BIG Most VCs invest in companies that can become multi-b$ companies, not multi- M$ companies Financial statement focus Are all liabilities recorded? Investors want no surprises post financing Post financing Start building the business When does the money run out? Watch cash burn Keep an eye on next fundraising Series A Case Study - YouTube Founded by early employees of PayPal in early 2005 Backed by Sequoia Capital - Roelof Botha, former CFO at PayPal (new partner at Sequoia) Started after experiencing difficulty sharing videos on the web How will they monetize? Sold for $1.65B to Google in October 2006 In 2006, over 100M daily video views Today, over 4B daily views! Series A Case Study - Imgur Imgur (online image hosting service) raises $40 Million from Andreessen Horowitz & Reddit They ve got like 80 other people working for them, and those people are there just to help you, says Schaaf, speaking of the firm s model involving services for entrepreneurs, They ve got a marketing department, a PR department, a department that can help you hire engineers, a department that can help you hire C-level or key hires, Alan Schaaf, founder 4

5 Series B Investment and Due Diligence Still about the team, product and market opportunity Technical diligence Does the product really work? Customer diligence Initial customer traction and references a must Financials take on some importance How did company do w/ the funds they raised in A round? Need for complete, organized financial records Solid 2-3 yr financial projections are important in the process How much runway do the funds provide? What are the key assumptions? Do the projections align with the presented market opportunity? Series B Case Study - MOTISTA Company has developed highly unique product/service around understanding the unspoken, emotional connections which drive consumer behavior Large market opportunity (CMOs call it the holy grail ) Nobody is doing it Hurdles Incomplete management team Lack of customer traction Is it a product or is it a service Diligence Technical Market validation Team Projections do they support high growth business 5

6 Series C (& Beyond) Investment and Due Diligence Companies have likely raised $15M - $30M previously Have strong product and operate in large markets Solid customer acquisition and revenue growth May be thinking about a liquidity event (IPO or Merger) Investor diligence Product, Team, Market, Customers, Revenue growth, HR Want to see GAAP financial statements Continue to rely on projections for view of Company s growth potential Will use historical financials and projections to value company Quality of Earnings audits to ensure credibility of the financial information Customer Contracts Revenue Recognition Series C Case Study Marketo Software as a Service (SaaS) Company in the marketing space sold on a subscription basis similar to Salesforce.com Planning to raise Series C in Q2 of 2010 VC put together term sheet in Q to lead Series C round at significant increase in valuation from previous round Investor did diligence ahead of time, and really wanted in How? Strong product in new and potentially large market, experienced management team, strong customer traction and solid revenue growth Why close the round early? Company got the valuation they thought they d get 9 months later. A bird in hand Round valued Company at $150M, today its value is $1.2B Series C (& Beyond) Observations More private companies valued at $1B or more than ever before Uber $41.2B (and counting) More valuable than Twitter + Hertz 6

7 Venture Capital Valuation Post-money valuation: Product of price paid per share by VC and the total number of shares (including new shares issued to VC) outstanding after VC s investment Pre-money valuation: Product of price paid by VC per share and the number of shares outstanding prior to VC s investment = Post-money valuation New investment Example of a VC Valuation (Post-money) Assume: Investment from VC = $300,000 equity Participation demanded by VC in return for investment = 15% Implied equity of firm = 300,000/0.15 = 2 million How Do VCs Compute Their Expected Return? Riskless rate (long-term) 6.0% Risk (market) premium 5.0% 11% Small capital premium 2.0% 13% Value added premium + Liquidity premium + Cash flow adjustment = 30% VC expected return = 40 to 50% Assume that the V.C expects a return of 50% Then, in five years: Investment x (1+r) 5 = Value of V.C s investments $300,000 * (1.50) 5 = $2.3 million Equity value of entire firm = 2.3/0.15 = $15.3 million 7

8 Pre-and Post-money Valuation and VC Ownership Stake: Example $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 till firm goes public (in year 7) No new shares issued before VC exits Discounted terminal value = Terminal value / (1 + r) 7 = 20 *15 / = $17.5 million Required equity ownership = Investment / discounted terminal value = 5 / 17.5 = or 28.5% Total shares after valuation = 500,000 / ( ) = 700,000 No. of new shares issued to VC = 200,000 Price per new share = $5 million / 200,000 = $25/share Implied pre-money valuation = 25 * 500,000 = $12.5 million Implied post-money valuation = 700,000 * 25 = $17.5 million Case-II: Two more rounds of financing before VC 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 Retention ratio: After second round 1/1.1 = 90.9% After third round (1/1.1)/1.3 = 70% of equity Required current ownership = required final ownership / retention ratio = / 0.7 = or 40.7% No. of new shares = 500,000 / ( ) - 500,000 = 843, ,000 = 343,373 shares Price per new share = $5 million/343,373 = $14.56/share Implied pre-money valuation = * 500,000 = 7.28 million Implied post-money valuation = $ $5 = $12.28 million Current valuation has fallen (why?) Because more money is needed before the firm exits 8

9 Exit Multiples Assume that the first-round investors start the firm with an investment of 10. Then there is a second round where the new investment is 20, with an ex-post valuation of 50. And finally, there is an IPO round at which new money of 30 is invested and the valuation at IPO is 120. The sequence of rounds and exit multiples are depicted in the following table: Das, Jo, and Kim (2011) 9