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A walk through entrepreneurial finance
By Imran Almaleh
Venture Capital 101 - by Imran Almaleh - January 2012
Chapter 1: Introduction
Chapter 2: Financing start-ups
Chapter 3: Venture valuation
Chapter 4: Ownership & Legal issues
Chapter 5: Exiting the venture
Definitions
VC vs. Debt
The VC fund
VC’s business model
VC risk pyramid
Screening ventures
Venture Capital 101 - by Imran Almaleh - January 2012
Venture Capital:
is money provided by an outside investor to finance a new, growing, or troubled business
Venture Capitalists (VCs):
Individuals join in formal, organized Venture capital firms to raise venture capital to new and fast-growing ventures. Leach, Melicher – 2006
Venture Capital 101 - by Imran Almaleh - January 2012
Venture Capital Debt Financing
Holding Period Long term Short/medium term
Instruments Common & preference shares Loans
Collateral No Yes
Impact on B.S Reduce leverage Increase leverage
Exit Mechanism IPO, sale to 3rd parties Loan repayments
Liquidity Low High
Risk/Return High Low
Diversification Low Medium
Venture Capital 101 - by Imran Almaleh - January 2012
Limited Partners(Investors)
•Pension funds•Insurance companies•Private equity funds•Individual investors•Endowment•etc…
Legal Form:Limited Partnership
Company LPC
VC Fund(Closed Fund)
General Partners(VCs)
Provide Work(& some Cap.)
Provide Capital
Venture Capital 101 - by Imran Almaleh - January 2012
InvestorsClosed fund
LP
EntrepreneursVenture
CapitalistsGP
Capital Capital
Capital+Profit fromExit
20% margin
Capital+Restof profit+Fees
2% Fees
6-8 YearsLater
Venture Capital 101 - by Imran Almaleh - January 2012
Management teem
Market Size
Financial
Product/Technical
Economy
Regulations
Venture Capital 101 - by Imran Almaleh - January 2012
Assessment of an idea‟s commercial potential. (finding caterpillars that are likely to turn into butterflies)
1. Qualitative assessment (systematic interview):
◦ Founder
◦ Marketing
◦ Operations
◦ finance
Venture Capital 101 - by Imran Almaleh - January 2012
2. Quantitative assessment (VOS™ indicator):◦ Industry/market
◦ Pricing/profitability
◦ Financial/harvest
◦ Management/team
Scoring:◦ 2.34-3.00: home-run (5X)
◦ 1.67-2.33: average (1-2X)
◦ 1.00-1.66: strike-out (0)
Venture Capital 101 - by Imran Almaleh - January 2012
High = 3Avg. = 2Low = 1
Venture’s life cycle
Financing through the cycle
Example of venture financing
Venture Capital 101 - by Imran Almaleh - January 2012
Idea IPO (5-8y)
1. Development stageIdea, test feasibility, prototype, no market entrance
2. Startup stageRevenue model, first sales
3. Survival stagerevenue<expenses, formal financial statements, growth
4. Rapid growth stageFast growth in revenue & cash-in flows, economies of scale
5. Maturity Slow revenue growth, time to exit
Venture Capital 101 - by Imran Almaleh - January 2012
-1.5 -0.5 0.5 1.5 2.5 3.5 4.5 5.5 6.5
Venture's Life Cycle
Developmentstage
Startupstage
Survivalstage
Rapid-Growthstage
Maturitystage
Revenue
Years
Venture Capital 101 - by Imran Almaleh - January 2012
First 3 stages: NO successful operating history low credit, hard to obtain ordinary financing
Last 2 stages (seasoned firm): Successful op. history new & large sources financial
capital
Venture Capital 101 - by Imran Almaleh - January 2012
Major types of financing:◦ Seed financing
◦ Start-up financing
◦ First-round financing
◦ Second-round financing
◦ Bank loans, Bond issues, Stock issues
Venture Capital 101 - by Imran Almaleh - January 2012
Life Cycle Stage
Type of financing Major providers
Development Seed finance Founders assetsFamily and friends
Startup Startup finance Founders assetsFamily and friendsBusiness angelsVCs
Survival First-Round Business OperationsVCsSuppliers and customersGovernment programsCommercial banks*
Rapid growth Second-RoundLiquidity stage financing
Business OperationsVCsCommercial banksInvestment bankers
Maturity Bank loansBond issueStock issue
Business OperationsCommercial banksInvestment bankers
* Most banks will require 2y of operations
Venture Capital 101 - by Imran Almaleh - January 2012
Stage 1: Seed financing (by an Angel Investor)
Stage 2: Series A round (by VC 1)
Stage 3: Series B round (by VC 2)
Stage 4: Exit (IPO)
Valuation (pre- & post-money)
% ownerships and dilution
IPO issues (7%Commissions, Lockup for 6m)
Overview of valuation
Investor’s rate of return
DCF PV model
VC method
First Chicago Method
Venture Capital 101 - by Imran Almaleh - January 2012
Value = Present Value (all future cash flows)
To make projections better, you need comparables
Main methods:1. Fundamental (DCF PV)
2. VC method (P\E)
3. First Chicago method (probability)
Venture Capital 101 - by Imran Almaleh - January 2012
Stage of venture Financing
Annual ROR %Expected Holding Period
Seed & start-up 50-100% > 10 years
First-round 40-60% 5-10 years
Second-round 30-40% 4-7 years
Bridge 20-30% 1-3 years
Source: Timmons, Spinelli, and Zacharkis – 2005 (Edited)
Holding period: time between Investment and Exit
Venture Capital 101 - by Imran Almaleh - January 2012
To calculate the Required rate of return:
Hurdle rate (RRR) = Re/P
While:
Re: required return on equity
P: probability of success
Venture Capital 101 - by Imran Almaleh - January 2012
The idea:
Value = Σ PV(future cash flows)
Ingredients:◦ Future cash flows
◦ RRR for the early years
◦ ERR for after maturity years
◦ Sustainable G rate at maturity
Terminal value – Reversion value
Venture Capital 101 - by Imran Almaleh - January 2012
0 2 4 6 8 10 12 14
CashFlows
Years
Discount CFs by RRR(variable CFs)
Reversion value (sustainable G rate)
Venture Capital 101 - by Imran Almaleh - January 2012
The formula:
While:CF : Cash flows at end of year
r : Required rate of return
r ͚ : Expected rate of return (at/after maturity)
G : sustainable Growth rate
t : time of maturity
Venture Capital 101 - by Imran Almaleh - January 2012
The idea
Value = Discounted Terminal value
Ingredients:◦ Income or CF at maturity
◦ P\E or P\CF ratio for similar ventures
◦ Required rate of return (Discount factor „r‟)
Venture Capital 101 - by Imran Almaleh - January 2012
0 2 4 6 8 10 12
CashFlows
Years
Terminal Value(value at exit)
Venture Capital 101 - by Imran Almaleh - January 2012
The formula:
While:Et : Earnings(income) at Exit time
P/E ratio : for similar ventures (or Estimated)
r : Required rate of return
t : time of Exit
We can also substitute Earnings for CFs
Venture Capital 101 - by Imran Almaleh - January 2012
Uses a scenario approach to valuation
Example: (#s in millions of $)
Success Sideway survival Failure
Revenue in y 3 8.19$ 3.04$ 2$ (liquidate)
Revenue in y 5 20.97$(IPO) 4.02$
Revenue in y 7 5.32$ (Acquisition)
P/E ratio (at liq.) 17 7
Net income (at liq.) 3.15$ 0.37$
Value of company (at liq.) 53.55$ 2.61$ 0.69$
PV (at rrr=40%) 9.96$ 0.25$ 0.25$
Probability of Scenario 40% 40% 20%
Expected PV of the company 4.13$
The Option pool
Capitalization table
The term-sheet
Venture Capital 101 - by Imran Almaleh - January 2012
Definition:
Shares of stock reserved for employees of a private company
Mostly, it comes out from the Pre-money valuation
Around 20% for startups
Use a hiring plan to justify a small option pool
Example: 10$m Post, 8$m pre (3m Shares), 20% post OP.
Calc: share price(pre&post), % ownership, % pre OP
Venture Capital 101 - by Imran Almaleh - January 2012
Title Range (%)
CEO 5 – 10
COO 2 – 5
VP 1 – 2
Independent Board Member 1
Director 0.4 – 1.25
Lead Engineer 0.5 – 1
5+ years experience Engineer 0.33 – 0.66
Manager or Junior Engineer 0.2 – 0.33
Venture Capital 101 - by Imran Almaleh - January 2012
A table that shows ownership stakes in a startup or early stage venture
Key elements:◦ Founder‟s ownership (% and Shares)◦ Option pool size◦ Investors stake
Main calculations:◦ Pre-money + investment = post-money◦ Share price = pre-money / # of existing shares◦ Investment / share price = # shares to investor
Go to Excel
Venture Capital 101 - by Imran Almaleh - January 2012
A non-binding agreement setting forth the basic terms and conditions under which an investment will be made
Main Terms categories:1. Getting into the deal
2. During the deal
3. Exiting the deal
Venture Capital 101 - by Imran Almaleh - January 2012
Investment amount
Instrument:◦ Convertible preferred stocks
◦ Participating convertible preferred stocks
◦ (angels use Convertible Debt)
Valuation◦ Pre-money value
◦ Post-money value
◦ Option pool
Dividends (cash, shares)
Venture Capital 101 - by Imran Almaleh - January 2012
Board seats ◦ 2 pref. + 2 common + 1 independent
◦ CEO dilemma
Protective provisions (Vito rights)◦ On liquidation, board seats, raising cap, debt, ..
Pro-rata rights◦ % of old ownership
◦ For outside financing
Anti-dilution◦ full ratchet, weighted average (norm)
Venture Capital 101 - by Imran Almaleh - January 2012
Liquidation preference:◦ 1x preference + no participation
◦ 1x preference + full participation
◦ Participation w/Cap
Drag-along right
Redemption right (4-5 years)
Venture Capital 101 - by Imran Almaleh - January 2012
Exclusivity period
Non-competition
IP registration
Vesting & Restricted Stock (4 years)
Exit strategy
IPO
M&A
Buy-outs
Franchising
Venture Capital 101 - by Imran Almaleh - January 2012
"harvest strategy" or "liquidity event“:
The method by which a VC intends to get out of an investment (i.e. "cashing out“)
Common Exit strategies:1. Initial Public Offering (IPO)
2. M&A3. Buy-out4. Franchise
Usually occurs before maturity
To insure market share and expansion
Venture Capital 101 - by Imran Almaleh - January 2012
Sell the shares of the company to the public to be traded on a stock exchange
Investment banking◦ Valuation
◦ Underwriting
◦ Commissions (% of capital raised)
Venture Capital 101 - by Imran Almaleh - January 2012
Acquisition:
Business bought outright by another existing company (larger, strategic partner)◦ Receive cash or stock
◦ Waiting for the IPO
Merger:
Join with and existing company◦ Receive some cash or stock
Venture Capital 101 - by Imran Almaleh - January 2012
One or more stockholders buy out the others
Types:◦ Management Buyout (MBO)
Management buys the shares of the private owners
◦ Leveraged Buyout (LBO)
An external entity takes debt to buy the shares of the company owners
Venture Capital 101 - by Imran Almaleh - January 2012
Sell business concept to others to replicate
Receive cash
Retain current management
Imran Almaleh
Venture Capital 101 - by Imran Almaleh - January 2012
asktheVC.com askventure.com AVC.com Bothsidesofthetable.com Docstoc.com Feld.com Harvard innovation lab Leach & Melicher: “Entrepreneurial finance”, 2nd ed. Macabacus.com National Venture Capital Assosiation (NVCA) Stanford technology venture program Timmons, Spinelli, & Zacharakis: “how to raise capital” Wikipedia.com ThisWeekIn.com