GUIDE TO ANGEL, VENTURE CAPITAL AND PRIVATE EQUITY

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1 IVCA GUIDE TO ANGEL, VENTURE CAPITAL AND PRIVATE EQUITY INDIAN PRIVATE EQUITY & VENTURE CAPITAL ASSOCIATION

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3 GUIDE TO ANGEL, VENTURE CAPITAL AND PRIVATE EQUITY

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5 CONTENTS Sources of Equity Financing Angels Venture Capital Corporate Venture Capital Private Equity Alignment of Interest Business Plan Stages of a Company Investment Criteria Value Addition Exits & Exit Readiness Terms Sheets

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7 Sources of Equity Financing For Entrepreneurs & Start-ups Angel Investors Angel investors are typically the earliest equity investments made in start-up companies. The chief characteristics of Angel investors are : An Individual investor who provides financial backing for small start-ups or entrepreneurs is called an Angel investor. Angel investors are usually high net worth individuals. Typically they are themselves successful entrepreneurs who provide early mentorship to new entrepreneurs. The capital they provide can be a one-time injection of seed money. A primary purpose of angel investing is to validate the business model. Examples of Angel Investors in India: Sunil Kalra, Rajan Anandan, Sachin Bansal, Zishaan Hayath and others. Examples of Angel Networks in India: Indian Angel Network, Mumbai Angels, Hyderabad Angels, Lead Angels. Venture Capital Venture capital is long-term stable capital provided to early-stage, high-potential, and growth start-up companies. Venture capital fundsgenerally invest in novel and scalable technology or business models in technology industries, such as software engineering, consumer internet, biotechnology and ot her industries.venture capital funds usually 1

8 require proof of concept prior to their investment. Venture capital funds bring domain knowledge and expertise. This is a very important source of funding for start-ups that do not have access to capital markets. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. There are about 100 venture capital funds investing in India. Examples of venture capital Funds in India : Sequoia Capital, Accel Partners, Tiger Global, Kalaari Capital, Blume Ventures, IDG ventures, SAIF Partners and many others. 2

9 Venture Capital Investment Process The process of venture capital follows a typical sequence starting with the identification of potential investment opportunities which is the sourcing of deals. Deals may be sourced through trusted sources of the venture capital fund. This is followed by a process of screening of those opportunities which the fund manager considers merit further analysis. Then a process of investigation is conducted called due diligence, during which a detailed background check and the business plan and model are analysed. If the fund manager considers the deal as investment worthy, then the opportunity is presented to an internal investment committee for approval. This is followed by signing of documents to make the investment. During the investment holding period, the fund manager monitors the investment and appoints a domain expert on the Board of the portfolio company. The aim of such monitoring is to add value to the enterprise. Finally, after a holding period of several years, the fund manager exits the investment. See diagram below which summarises the investment process of a venture capital fund. Private equity funds also follow a similar process. 3

10 Corporate Venture Capital 1 Many large companies in the US and Europe engage in corporate venturing (CV). An example of CV in India is Intel Capital. Corporate venture capital investments are usually minority equity investments stakes in ventures that are managed outside a company's normal operating structures. This means that long-term strategic partnerships, among other things, do not qualify as corporate venturing. For a company engaged in CV, it can be a very valuable growth tool, given the right strategic conditions, which are: 1. Significant uncertainty exists about the "winning" technology, distribution or business model being considered 2. Technology or business models are developing at a pace faster than the company can keep up with alone 3. There is value in being involved early as opposed to simply waiting for uncertainty to disappear 4. Investment will present a win-win situation by adding value for both the investor and the investee (target company) 5. Investment is related to the company's c ore business in the appropriate manner The following 5 key operational guidelines, can help companies minimise the most common organisational difficulties : 1. Find the proper balance between strategi c and financial objectives and ensure that mechanisms are in place to measure both 2. Obtain and maintain full Board c ommitment over the long term Ensure effective co-operation between the investee companies, the CV department and the Business Units of the company Set up a CV team which can collect both the business knowledge and the venture capital (VC) knowledge necessary Recognise and manage the tensions between corporate-based and VC-based compensation schemes. 1http:// 4

11 Intel Corporate Venture Capital -An Example of Corporate Venture Capital Source: BVCA website In the rush to champion independent venture capital, it can be quickly forgotten that one of the biggest and most successful tech investors is actually a corporate. With a track record of more than 20 years and num erous successes to its name, Intel Capital has been patiently working away as a st alwart of the industry. Since 1991 Intel Capital has invested well in excess of US$10bn into over 1,200 portfol io companies worldwide, adding 34 new investments in the first six months of 2013 alone. Intel Capital s strategy has always provided it with a hedge against future uncertainly in an ever-changing business environment, making equity investments of between US$500,000 to over US$100m in high-growth potential businesses depending on opportunity and circumstance. Intel follows no st rict pattern with its investments. It follows general princip les: a single investment team makes decisions; portfolio companies are encouraged to develop independently; remuneration and financial structures follow VC-style disciplines; and Intel Capital does not buy to acquire, preferring to improve the general business eco system (thereby creating demand for its core products). The development and evolution of Intel Capital s model has provided, if not a template, thena useful guide which other CVC pr ogrammes have tended to follow. Private Equity Private Equity funds generally invest at the later and more mature stages of a company. They can make large infusions of capital depending on the needs of an enterprise. Private equity funds generally take a lot of operational interest in the investee companies in order to add value. Capital for private equity funds is raised from institutional investors and high net wo rth individuals, and can be used to fund 5

12 new technologies, expand working capital, make acquisitions, or to strengthen a balance sheet. Private equity funds. There are about 100 private equity funds in India. Examples : TVS Capital, KKR, Carlyle, Warburg Pincus,, India Value Fund Advisors and several others. Alignment of Interest : 'Skin in the Game' 2 The providers of venture capital and private equity capital to funds are known as limited partners. These include pension funds, insurance companies, sovereign wealth funds, university endowments and others. The guardians of these funds owe a duty to their beneficiaries i.e. the limited partners, to earn an appropriate rate of return. One key principle in achieving this rate of return is to ensure that all the parties which have responsibility for managing or using these funds align their interest to those of the beneficiaries i.e the limited partners. This is done in many ways two of the most common ones are described here. Stock Options : All employees of start-ups and other ventures are provided an incentive for running their businesses to achieve good returns by granting them stock options. Usually these options are given on a staggered basis over a 4 to 5 year period to ensure that those who stay with the firm receive the most stock options and the largest incentives. Co-investment by the Fund Manager : The fund manager of the venture capital or a private equity fund, as a steward of LP capital, also needs to be aligned. This is achieved by the method of co-investment as described in the Carlyle website quoted below

13 'The private equity model of value creation has many virtues, but one foundational aspect is fundamental to this industry s long-term success: alignment of interests. The goal is to align the interests of fund investors, Carlyle professionals and portfolio company management so that we all rise or fall together. Since inception through June 30, 2015, Carlyle professionals, Operating Executives and other professionals have committed more than $7 billion of their own money alongside our fund investors. The managers of the companies we invest in also commit personal capital to those investments. When an investment succeeds, all parties benefit. When an investment fails, all parties lose. This is a powerful motivator for Carlyle professionals and portfolio company management to work in tandem to create value for our investors.' Fund Raising By Start-ups : Business Plan Most investors will ask aspiring entrepreneurs to submit a business plan. The plan should introduce the team, including the founders. It should explain the business model which is the method by which the enterprise will make money. The business plan should highlight any disruptive effect the new business model, or the new product, might have on the existing industry. The business plan should be distilled into a crisp and compelling 10 to 12 slide presentation. The founders should rehearse the pitch several times and anticipate questions for which they should have answers ready, backed by a convincing logical analysis. The business plan should contain answers to the following type of questions: What problem does the company s product or service solve? What niche will it fill? What is the company s solution to the problem? Who are the company s customers, and how will the company market and sell its products to them? 7

14 What is the size of the market for this solution? What is the business model for the business (how will it make money)? Who are the competitors and how will the company maintain a competitive advantage? How does the company plan to manage its operations as it scales and grows? Who will run the company and what makes them qualified to do so? What are the risks and threats confronting the business and what can be done to mitigate them? What are the company s capital and resource requirements? What are the company s historical and projected financial statements? Enterpreneurs can present the market potential in concentric circles as shown below. 8

15 The typical components of a business plan are illustrated in the diagram below.

16 Pre-Revenue Stage : Seed Capital savings (e.g. from a severance package from the founder s prior job) or from Pre-Revenue Stage : Angel Investor Funding stock (often it converts to the Series A round of stock). Friends & Family investors Early, Growth & Expansion Stage : Venture capital (VC) funding is typically used by companies that are already distributing / selling their product or service, even though they may not be profitable at the time. If the company is not profitable, the venture capital financing is often used to offset the negative cash flow. There can be multiple rounds of VC funding stretched out over several years and each is typically given a letter of the alphabet (A followed by B followed by C, etc.). For example, Alibaba had about 10 rounds of venture capital funding between 1999 and their IPO in

17 The different VC rounds reflect different valuations (e.g. if the company is prospering, the Series B round will value company stock higher than Series A, and then Series C will have a higher stock price than Series B). If a company is not prospering, it may still get subsequent Series-rounds of financing, but the valuation will be lower than the previous series: this is known as a down round. These rounds may also include strategic investors: investors who participate in the round who also offer value such as marketing or technology assistance. START-UP FINANCING CYCLE Angels, FFF, Seed Capital VCs, Acquisitions/Mergers, Strategic Alliances IPO Revenue Mezzanine Secondary Offerings Public Market BREAK EVEN 1st 2nd 3rd Valley of Death Time This graphic is an example of a start-up financing cycle using traditional funding sources, through an initial public offering (IPO). (Source: Startup Company Wikipedia, The Free Encyclopedia. Wikimedia Foundation, Inc. 11 March Web. June 2012 : <

18 Mature Stage : Mature Stage : an Initial Public Offering or IPO. An IPO generally comes at a stage when the stream, or the number of years it has been in the market. Stage Investor Type 12

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20 Investment Criteria Investment Criteria of Angels Illustrative Investment criteria: The following is an illustrative investment criteria for Angel Networks. (Investment criteria of the Boston Angel Group)

21 4. Sales and Marketing 5. Technology & Product 6. Financial Evaluation

22 7. Exit Strategy

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24 Investment Criteria of a Private Equity Fund Illustrative Investment criteria: The following is an illustrative investment criteria for private equity fund. 4 18

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28 Help with Mergers and Acquisitions Venture Capital funds generally have a clear systems and processes to increase efficiency, lower cost and scale effectively. VALUE CREATION LEVERS EXAMPLES Capital-Efficient Profitable Growth Increase Profits Grow Revenues Reduce Costs Pricing Volume COGS SG&A Pricing realization Product mix Trade promotion New products and R&D New customers, channels and markets Sales force effectiveness Direct procurement Process efficiency Capacity utilization Indirect procurement Overhead and support Outsourcing Shared services Organization streamlining Footprint rationalization Inventory Inventory management Reduce Working Capital Reveivables Receivables terms and timing Improve Capital Efficiency Payables Payment terms and timing Improve Fixed Capital Project Investments Source : Booz & Company 22

29 exit readiness. A venture which achieves performance milestones, has good management practices and organisational systems and procedures is more likely to be exit-ready when the holding period ends. They must exit all their investments before the end of the fund s life. In contrast a sovereign wealth fund, or a strategic investor, may have a much longer holding period in mind. The common alternative exit methods are described below. Mergers and Acquisitions : The portfolio company may decide to sell to a another company in the market. For example the $200 million acquisition of Taxi for Sure by Ola, presented an exit option for its investors like Blume Venture and Orios Ventures. 23

30 Distressed Sale: The portfolio companies may also be sold to another financial institution or other companies. Buybacks : The founders may buyback the investment from the fund. Exit Op ons IPO Distribute Cash Sell Company Founder Buyback Strategic Sale Financial Sale to Another Fund Sale to Employees 24

31 Term Sheet Provisions

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33 Illustrative terms

34 Making Monetary Sense: How To Understand Your VC Term Sheet, Shahram Safai & Ronnie Dabbassi

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36 Indian Private Equity & Venture Capital Association Acknowledgment : Ritu Singh, Mannsi Gupta, Ntasha Berry, Yogesh Arora