Venture Capital Financing: Venture Capital Financing MBA 6314/TME 3413 October, 2003 Overview: Overview VC and corporate finance Overview of VC industry The VC life cycle The VC investment process Negotiations Valuation and pricing Deal structure The “Venture Capital Method” The Shareholder’s Agreement Growing the business The exit Conventional Financing: Conventional Financing Assets Inventory & receivables Land & buildings Equipment & vehicles Other Liabilities & Equities Operating line of credit Mortgage Term loan Share capital & retained earnings VC Financing: VC Financing Fills the cash gap between cash needs to finance high growth and cash available from earnings and conventional financing Giving up a piece of the pie to grow a bigger pie Overview of VC Industry: Overview of VC Industry Angel investors Private equity funds Labor sponsored funds Institutional investors Diversified versus focused Venture Capital Trends PowerPoint Presentation: Gap With U.S. Has Closed Disbursements 1995-2001; Canada & U.S. $ Invested by Canadian VCs - $ Billions $ Invested by US VCs - $ CDN Billion PowerPoint Presentation: Less $ to Big Deals Drives Decline $ Invested by Transaction Size; Atlantic Region $33M $23M $48M $53M $75M $53M Technology Almost Exclusive Focus Disbursements in Canada: Technology Almost Exclusive Focus Disbursements in Canada $1,089M $1,774M $1,751M $2,986M $6,629M $4,874M Capital Markets Playing Field: 9 Capital Markets Playing Field Concept Investigation Basic Design Prototype Building Market Entry Manufacturing Ramp-up Knowledge Acquisition Government Programs Public Issues Commercial Banks Non-Financial Corporations Venture Capital Funds Seed Funds Wealthy Family Funds Private Investors Faminly and Friends Personal Savings Phase I Phase II Phase III The VC Life Cycle: The VC Life Cycle Submit business plan Preliminary assessment Meet the people Light due diligence Term sheet Heavy due diligence Investment memorandum Commitment letter Shareholder’s agreement Grow the company Exit The Business Life Cycle: The Business Life Cycle Typical SME Growth Profiles : Typical SME Growth Profiles High-Growth Firm Moderate-Growth Firm Low-Growth Firm VC Prospects VC Investment Criteria: VC Investment Criteria Exponential growth potential Attractive industry Sustainable advantage platform Excellent team “execution” Owners receptive to involvement of outsiders Owners willing to share the wealth creation Credible exit alternatives (4-7 years out) The Ingredients- Good CEO: The Ingredients- Good CEO Good CEO is the most critical element Best is “been there and done that” Has specific domain experience/expertise “Knows what he/she doesn’t know & locates resources to fill gaps. Shows “fire in the belly” Recognizes urgency-revenue generation/ burn rate Knows the difference between being an employee and being a shareholder The Ingredients-Strong Management Team: The Ingredients-Strong Management Team Characteristics Include: Honesty/Integrity/Competence/Discipline Have specific domain experience Ability to self-assess Motivated “Fire in the belly” Plans and communicates effectively Develops appropriate MIS Caveat-beware the “family ties” The Ingredients-Technology/Core Competence: The Ingredients-Technology/Core Competence Ability to define and enunciate what it is Ability to relate core technology-/competence to a variety of significant market applications-(must be balanced by focus) Strong “in house” R&D capability with the mechanisms to fund it. Equity/loans Customer Pays (direct or through margins) The Ingredients-The Business Model: The Ingredients-The Business Model Implies having a well defined business model that says, “I know who my customers are, what they need, how I will meet their needs, how I will reach them, how I will service them, how I will continue to best my competition and how I will make money. Avoid “if we build it they will come!” Ingredients-The Value Proposition: Ingredients-The Value Proposition Why will/do our customers buy or product? Ease the Pain Improve Revenue/ Productivity/Profitability The Ingredients-The Strategic Alliance: The Ingredients-The Strategic Alliance A “must” for most emerging companies distribution product development (perhaps) Can accelerate success or hasten demise Venture Capital Valuation & Pricing Internal Rate of Return (IRR): Venture Capital Valuation & Pricing Internal Rate of Return (IRR) VC Investments and IRR: VC Investments and IRR VC Target IRR: VC Target IRR Seed Startup First stage Second stage Bridge Restart IRR>80% 50-70% 40-60% 30-50% 20-35% ?? What are they prepared to pay for?: 23 What are they prepared to pay for? In later stage companies VC’s can value the “cake” as well as the “ingredients”. This is a luxury they do not have in funding emerging technology companies. The “cake” represents companies with demonstrable and sustained patterns of growth in revenue (30%+/annum compounded) and profitability (commensurate) In early stage companies VC’s have to value the ingredients and estimate what the “cake” might look like in 3 to 5 years! sGood CEO is the most critical element “Knowing what you don’t know” and locating the resources to fill the gaps Having a strong board of directors with good mix of skillsets/properly motivated, i.e. financial Having a strong & motivated management team Having a strong core technology/competence applicable to variety of market applications Building the right strategic alliances in the right way Why so High?: Why so High? Base IRR =risk free rate Plus premiums Why so High?: Why so High? Systematic risk in capital markets Unsystematic (unique) risk diversified away VC firms more vulnerable to market swings Why so High?: Why so High? Liquidity premium 4-7 year investment time horizon Not easy to liquidate investment Why so High?: Why so High? Value added premium Recruitment of key personnel Strategy Board of Directors Network Deep pockets Why so High?: Why so High? Portfolio average return 2-6-2 rule Valuation and Pricing: Valuation and Pricing Magnitude of investment Staging of investment Syndication Target IRR Investment time horizon Terminal value of firm % ownership required Deal structure Future financing and dilution – “The Venture Capital Method” Magnitude of Investment: Magnitude of Investment Typically >$1.0 million for institutional Small deals too costly Typically less than $10 million in Canada Based on business plan pro forma Staging of Investment: Staging of Investment All up front Two or three tranches Contingent on meeting milestones/targest Option to abandon Syndication: Syndication Sharing the deal with other VC firms Diversify the risk Broaden the network Increase size of portfolio Target IRR: Target IRR 25-80 % Stage of company Use of funds Deal structure Investment Time Horizon: Investment Time Horizon 4-7 years How long will it take to create value? Years to cash flow breakeven Terminal Value of Firm: Terminal Value of Firm Projected earnings at exit Price/earnings ratio (PER) Projected TV=Projected Earnings x PER % Ownership Required: % Ownership Required Magnitude of investment Duration of investment Target IRR Terminal value of firm Room for future investment? VC Investments and IRR: VC Investments and IRR % Ownership Required: % Ownership Required Deal Structure: Deal Structure Shares Shares and subordinated debt Shares and convertible subordinated debt What is the upside? What is the downside? Does the structure affect the risk to the VC? Typical Investment Structures: 40 Typical Investment Structures Early Stage Common Shares- Maybe “Put” requirement or “Forced Sale” provision on commons if no exit within 5 to 7 years Preferred Shares-convertible into common or with warrants attached, frequently with cumulative dividend- 5 yr. term %tage of equity required tied directly to valuation and amount of capital being sought Typical Investment Structures: 41 Typical Investment Structures Later Stage Investments (Mezzanine) Convertible Debentures/Debentures with Warrants Debentures with nominal cost equity Debentures may be unsecured or secured (back of the bus) and usually carry an interest coupon Straight debentures may or may not be sinking fund ” Deal Structure Spreadsheets Three Scenarios: Deal Structure Spreadsheets Three Scenarios $1.0 m VC investment 5 year time horizon Target IRR 40% Terminal value $11.25 m Three different deal structures Varying % ownership Scenario A: Scenario A Scenario B: Scenario B Scenario C: Scenario C The Venture Capital Method Step 1: The Venture Capital Method Step 1 Given the VC investment, the target IRR and the investment time horizon, determine the future value of the VC investment FV = PV(1+i)^n i = target IRR N = time horizon to exit Eg. FV = $1.0m(1+0.35)^5 = $4.5m The Venture Capital Method Step 2: The Venture Capital Method Step 2 Given the projected earnings at exit and an appropriate Price Earnings ratio (PER) for the company, calculate the projected terminal value of the company at exit Eg. TV = $1.0m(15) = $15m The Venture Capital Method Step 3: The Venture Capital Method Step 3 Determine the % ownership required by dividing the required future value of the investment at exit by the projected terminal value of the company at exit Eg. FV= $4.5m/TV$15m = 30% Or divide the VC investment by the present value of the projected terminal value of the company at exit Eg. PV=$15m/(1+0.45)^5=$3.33m ; $1.0m/$3.33m=30% The Venture Capital Method Step 4: The Venture Capital Method Step 4 Determine number of new shares (NS) to be issued to VC. Find number of shares outstanding before investment (old shares (OS) eg. 1.0m) VC % Ownership = NS/(NS +OS) Eg. 30% = NS/(NS + 1.0m) NS= 430,000 Price per share = $1.0m/430,000 = $2.33 The Venture Capital Method Step 5: The Venture Capital Method Step 5 Determine pre and post-money valuation If 30% of the company is acquired for a $1.0 VC investment, this implies a post-money valuation of $1.0/0.30 = $3.33m Give a post-money valuation of $3.33m and an investment of $1.0m, the pre-money valuation is $2.33m Does this valuation make sense? Is it realistic? The Venture Capital Method Step 6: The Venture Capital Method Step 6 Assess future dilution due to issuance of additional shares prior to exit. Shares to management, future investors Estimate retention ratio = 100% - % of ownership issued to others in future Eg. If a future investor negotiates a 10% ownership, the retention ratio is 100%-10%=90% The Venture Capital Method Step 7: The Venture Capital Method Step 7 Calculate adjustment to required ownership % due to expected future dilution Adjusted ownership % = % ownership without dilution divided by retention ratio Eg. Adjusted % = 30%/90% = 33.3% If VC owns 33% after investment and gets diluted by 10% before exit, the final ownership % will be 30%, ie. the required ownership % to realize target IRR given projected terminal value Venture Capital Method Spreadsheet: Venture Capital Method Spreadsheet The Venture Capital Method Multiple Rounds of Financing: The Venture Capital Method Multiple Rounds of Financing Often subsequent rounds of financing are anticipated before the round 1 VC investor plans to exit Each subsequent round will negotiate an ownership position based on their own magnitude of investment, target IRR and investment time horizon The round 1 VC investor has to anticipate these future investments and adjust required ownership % for expected future dilution Typically future investments have a lower target IRR The round 1 investor retention ratio is 100% minus the % owned by future round investors at exit Sensitivity Analysis: Sensitivity Analysis Terminal Value Future Earnings (Sales, Expenses, Profits) PER Target IRR Risk Deal Structure Liquidity Dilution Future Rounds (Amounts, IRR, Horizon) Management incentives The VC-Company Relationship: The VC-Company Relationship VC Fees The Shareholder’s Agreement Corporate Governance Exit VC Fees: VC Fees Commitment fee Termination fee Due diligence expenses Legal expenses All paid by company Shareholder’s Agreement: Shareholder’s Agreement Defacto control over critical decisions Hiring/firing key management personnel Budgets and capital expenditures Financing Strategic changes Veto rights Dispute resolution Shareholder’s Agreement: Shareholder’s Agreement Exit Provisions “Put”/ “Call” Rights “Drag Along” Rights “Tag Along” Rights “Right of First Refusal” Rights Valuation formula/process Shareholder’s Agreement: Shareholder’s Agreement Corporate Governance Board of Directors Independent members Swing vote to independents Help create value Corporate Governance: Corporate Governance No interference in day-today operations Regular reporting (monthly) Regular Board meetings Annual audits Performance assessment Help out when needed Exit Alternatives: Exit Alternatives Sale to company treasury Sale to equity partners Sale to owners/management/employees Sale to third party (VC shares or all) IPO Hold and “milk” Liquidate The Initial Public Offering (IPO): The Initial Public Offering (IPO) Address capital needs beyond limits of VC’s Liquidity for VC’s “Quiet period” “Lock up” period Legal, accounting and investment banking fees Prospectus and road show Public scrutiny Focus on stock price, short term results What Should You Expect From Your V.C?: What Should You Expect From Your V.C? An investment in size, scope and structure consistent with the execution requirements of your business plan Ability to bring other V.C.’s and financiers to the table Active, value adding board of directors involvement Access to network and other resources A fair deal that creates a win/win for everybody and recognizes the value of monetary and non monetary contributions of key stakeholders Ongoing financial support where business case warrants Do your homework, v.c. money is not homogeneous Realities of the Current Market: Realities of the Current Market Financing based on “Napkin” business plans is “out” Fundamentals are back “in” Companies must show more evidence of market acceptance of product, value proposition and business model before funding Tough with no sales Valuations are down 50-75% V.C.’s are staying closer to home PowerPoint Presentation: Investors Active in Atlantic Canada ACF Equity Atlantic Inc. BMO Capital BDC Venture Capital Group Canadian Science and Technology Group Roynat Manulife EDC CDP – Accés Capital CDP - Sofinov Genesys Capital Partners Latitude Partners Ventures West Management Inc ETSIF Skypoint RBCP.