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Copyright ©2010 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be

reproduced for educational purposes only.

Chuck Eesley and Ravi Belani

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 Wrap-up Lew Cirne, Wily  Data on Founding Teams   Intro to Venture Finance  Ravi Belani

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 Team effectiveness  Which OAP team(s) you’d invest your $1m

in?  Mentor presentations – before session 16

(5/18)  Ann Miura-Ko and Dan Dorosin will lead

5/18 class (I’ll be in London.)  OEP – 15 mins, 8 slides, due before

session 17 (presentations session 17-18)  Session 20 – OEP written analysis, 1500

words

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 Founder and CEO of New Relic, Inc.  Founder and CEO/CTO of Wily Technologies  Board Member Pano Logic  Entrepreneur-in-Residence, Benchmark

Capital  Senior Software Engineer at Apple  Coding since the Commodore Vic 20 (3583

bytes of RAM)

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 Events, conditions and founder characteristics precipitating a replacement

 Search process involved  Founder’s negotiations with the Board over

candidate characteristics   Importance of culture  Whether the founder should remain with

the company and in what role after succession

 How involved the founder (and top management) should be in the search process

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Employees (%) M&A or IPO (%)

Idea assets (outside of Biotech/chem)

4.5 16.6

Contracting Exp. w/o VC 11.9 159

Contr. Exp. present, adding idea assets

8.2 87.8%

Idea assets present, adding contracting

14.9 20x

Interaction effects for idea assets in weak appropriation environments are strongest for firms with the highest likelihood of having an exit (Hoetker 2007; Norton et al., 2004). It is weakest for those at very low or very high probabilities.

The interaction effect for idea assets and contracting experience is strongest for those at a moderate likelihood for an exit event.

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#15: Chi-Hua Chien Kleiner Perkins www.kpcb.com

#14: Ravi Belani DFJ

www.dfj.com

#16: Ann Miura-Ko Floodgate

www.floodgate.com

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  Associate at Draper Fisher Jurvetson   on the boards of DesiHits, Redux, LiveMedia, Yield Software, and

Vizu.   investments in Komli and Pubmatic. Prior board directorships

include TinyPictures (acquired by Shutterfly, NASDAQ: SFLY) and Personiva (acquired by Glam Media).

  product management at software startup Zaplet (acquired by MetricStream).

  Extensity (IPO’d then acquired by GEAC) as a Mayfield Fellow.   McKinsey and Company's San Francisco office   Medtronic on wireless communication technologies for remote

patient monitoring   equity research at Bridgewater Associates.   Stanford University, holding a BS with Distinction and MS in

Industrial Engineering and Engineering Management. MBA from Harvard Business School.

  Board Fellow at Harvard, Ravi served the Global Board of TiE (The Indus Entrepreneurs). Ravi is also a graduate of the Kauffman Fellows Program.

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Part II. Given the nature of the business and the objectives of the founders, what capital resources are needed to build the venture?

Part I. What is the purpose of a business plan?

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•  Executive Summary

•  Market Analysis

•  Vision and Concept (including Technology)

•  Competitive Positioning and Marketing

•  Business Model

•  Organization

•  Financial Projections

•  Ownership

Focus of these 2+

weeks

A. Amount of Cash Needed and Purpose

B. Sources of Capital

C. Deal Structure

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#1 How much money is needed for this “round” or “stage” of financing?

Typical Financing Stages (or Rounds):

Seed Early Mezzanine Late (e.g., IPO)

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Team Risk

Technology Risk Capital Risk

Market Risk

Idea Business Plan

Prototype Beta

Sales Profitability

Decreasing Risk

$ 100K

$ 1M

$ 10M

Dec

reas

ing

Ret

urn

Venture Capital Banks

Angels FFF Gov’t

IPO Strategic Partners

Reference: Tom Stephenson, Verge

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TABLE 18.4 Comparison of major selected sources of growth capital.

Source of Capital Amounts Advantages Disadvantages 1. Individuals (Angels)

$10,000 to $1 million with low to medium levels of patience and expertise

Create little dilution for the venture; can move fast because of minimal negotiation and due diligence requirements

Lack sufficient funds for capital-intensive opportunities; can lack long-term perspective; may not provide good advice

2. Venture Capital Firms

$1-$20 million with high levels of patience and expertise

Possess large sums of money to deploy; provide recruiting assistance and other services; enhance venture’s reputation and credibility immediately

Require larger percentage ownership of the venture; expect significant role in making major decisions; play active role in building executive leadership team

3. Corporations $5-$50 million with medium to high levels of patience and expertise

Generate moderate dilution for the venture; provide opportunity for distribution and product development assistance and advice

Create problems with other potential relationships (e.g., corporation’s competitors); can put the venture’s intellectual property at risk

VENTURE CAPITALISTS (Finding and Funding

Entrepreneurial Companies)

ENTREPRENEURS (Starting and Building

Companies)

INSTITUTIONAL INVESTORS (Limited Partners – e.g.

University Endowments, Pension Funds)

Source: Andy Rachleff

“Liquid” stock Preferred stock

$ $

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•  GDP: about $12.5 trillion annually

•  Hedge funds: $1 trillion over 3 years

•  Mutual funds: $136 billion in 2005

•  Buyout funds: $86 billion in 2005

•  Venture capital? $25 billion in 2005… just 0.2% of GDP.

Source: BLS website, Investment Company Institute, Thomson Financial, NVCA

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  2006 US Deal Stats –  $25.8bn invested –  2,454 deals –  $10.5m per deal

  By Sector –  57% IT –  26% HC

  By Geography –  Bay Area 33% –  CA 47% –  New England 11%

  Players –  600 Active Firms –  8,000 professionals

  Huge Growth in Asset Class (LP commitments)

–  1980 $2.1 bn –  1990 $3.4 bn –  1999 $106 bn –  2005 ~$20 bn

  Internationalization Ongoing

–  India, China, EU, Israel

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“I call my invention ‘The Wheel,’ but so far I’ve been unable to attract any venture capital.” • Source: Forbes Magazine, June 2004

US Model International Model (e.g., Europe)

People company founders and builders consultants and bankers

Stage seed early (A Round), but not seed

Provide “value added” “just money”

Style hands on hands off

Objective create very large companies

create medium sized companies

Philosophy maximize upside minimize downside

Returns target a small number of

big winners – home run investing

believe returns can be earned across a portfolio

Reference: Mowbray Capital, London

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1. What percentage of the company do the investors receive for their cash?

2. What special terms and conditions are necessary to compensate them for the risk?

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•  Roma’s hot startup requires $10 million in order to form its business. She expects to earn $5 million in its fifth year.

•  Randy’s VC firm has reviewed the company's business plan and believes that he is entitled to a 50% annual return on his investment. Hint: how many “times” must his firm’s money grow in 5 years?

•  Publicly traded companies in this category and industry trade at an average of 30 times earnings (PE ratio). There is no material difference between these companies and Roma’s startup.

•  What portion of the company should Randy’s VC firm receive today? Hint: what is future value of that investment?

1. Value of VC Investment in Year 5 = $10 m*(1+50%)^5 = $76m

2. StartUp’s Value in Year 5 = $5 m*(P/E of 30) = $150m

3. VC Firm’s Share Today = Step 1/Step 2 = $76 m/$150m = ~ 50%

4. “Post-Money” Value Today = $10 m / 50% = $ 20 m

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Time I II III IV V

33 1/3 %

33 1/3 %

33 1/3 %

1mm shares for each founder

Σ=3mm shares @ $0.001 ea.

Value=$3k

Note: not to scale

20 %

20 %

20 %20 %

20 %

+1mm shares each for CEO & employees

Σ= 5mm shares @ $0.01

each

Value=$50k

10 %10 %

10 %

10 %10 %

50 %

+5mm shares for first VC

firm

Σ=10mm shares @ $1.00

each

Value=$10mm

Use of $: R&D

Post-money value = $10mm

Pre-money value = ?

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33 1/3 %

33 1/3 %

33 1/3 %

20 %

20 %

20 %20 %

20 %

10 %10 %

10 %

10 %10 %

50 %

Time I II III IV V

1mm shares for each founder

Σ=3mm shares @ $0.001 ea.

Value=$3k

1mm shares each for CEO & employees

Σ= 5mm shares @ $0.01

each

Value=$50k

5mm shares for first VC

firm

Σ=10mm shares @ $1.00

each

Value=$10mm

Use of $: R&D

5 %5 %

5 %

5 %

5 %

25 %

25 % 25 %

+5mm shares for sale to public in

IPO

Σ = 20mm shares @ $15.00

each

Value=$300mm

Use of $: Operations

6 2/3 %6 2/3 %

6 2/3 %

6 2/3 %

6 2/3 %

33 1/3 %

33 1/3 %

+5mm shares for second round VCs

Σ=15mm shares @ $5

each

Value=$75mm

Use of $: Mktg. Note: not to scale

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Market Capitalization

Net Income: $10 M

P/E 30

$300 M

Share Price: $15

# Shares: 20 M

$300 M

Sales: $100 M

PPS: 3

$300 M

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  Management Fees (typically 2-2.5% of AUM) –  Charge a management fee to cover the costs of

managing the committed capital.

  Carried Interest (typically 20-25%) –  "Carried interest" is the term used to denote the profit

split of proceeds to the general partner.

  Example $100m fund –  4x return and 2 and 20% –  $2m per year in management fee –  (($100m x 4) - $100m) * 20% = $60m in carried

interest

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 VC’s segment in a number of ways – Sector

» Healthcare versus IT versus clean energy

– Size » Small fund (<$100M) to large fund (>$1B+)

– Geography » US, EU, India, Israel

– Stage » Seed/early – two guys and an idea/demo » Mid-Stage – initial revenue traction » Late-Stage – near breakeven – expansion/

mezzanine capital

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 General Partners – 6-8 active deals at a

time

 Principals/Associate – Drive deal flow, deal

process, and portfolio company development

 Finance, Marketing, and HR Staff

 Decision Making – Typically unanimous – Individual partners

champion deals to group

– Deal team diligences prospect and builds investment case

– Partnership acts as a check and balance to ensure careful decision making

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 This depends on stage – let’s focus on early stage since that is what we do. – Team

» Domain expertise with core technical strength and knowledge of given market opportunity

» History of collaboration and success »  A willingness to allow VC’s to help build the team

– Market »  Emerging and fast growing market »  Bad markets make for bad companies

– Business model » How will you make money, how will you sell

– Technology » Defensible technology/IP that can be protected to form

competitive barriers over time

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  Be committed….   Hire a great Valley lawyer   Figure out what stage and sector you are   Identify 4-5 firms that focus on this stage   Identify which partner you think is most relevant   Get an introduction to that partner   Prepare a 1-2 page overview to send him/her   Prepare a 10-15 slide presentation to give in a

30-45 minute timeframe if they ask you to present   Only goal of the first meeting is to get a second

meeting.

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  What we do   Who we are   How we plan to make money   What we are asking for (how much money)   Demo   Secret Sauce/Technology   Market Analysis   Competitive Assessment   Go to Market   Business Model/Financials/Targeted

Milestones

Your Pitch: 10 Slides

The audience most know in first minute what you do or they will tune out

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 Pat your head –  Spec out 1.0 and focus on a customer need –  Narrow the focus to broaden the appeal

 Rub your tummy –  Paint a picture and product roadmap that is a

company not a feature

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  12-16 week process –  First meeting to close –  1st mtg diligence

partner meeting TS negotiation close

  Prepare Investor Package –  Presentation –  Financial Plan –  Personal references –  Customer references –  Market references –  Cap Table –  Market research –  Product documentation –  Competitive Analysis

  Investors will seek: –  20-50% of the company –  Valuation function of

targeted raise, ownership, and stage,

–  Preferred Equity securities, with key terms:

»  BoD seat »  Liquidation Preference »  Anti-dilution Protection »  Participation »  Pro Rata rights »  Protective Provisions »  Vesting terms for

founders and employees

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  Is the idea sufficiently baked? – Optimal time is 6 months of iteration

 Pick your co-founders very carefully  Test fit with VC

– Personality, values, knowledge of market

 Optimize for best deal not best price  Consider the downstream effects of the

financing – High-post moneys can by Pyrrhic victories if

company misfires – Angel financing can be a mixed blessing – be

careful

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 Investing is a people business, and getting a meeting is all about “who you know”

 Best way to approach a VC is some form of introduction – If you don’t know a VC, find someone

who knows you who does and get them to introduce you

– Entrepreneur, professor, attorney… – Sending a plan to info@vcfirmname.com

is a waste of time

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 Don’t take rejection personally, the odds are against you.

 Every VC is “interested” – force them to do work to test their level of interest.

 Don’t waste time trying to change the mind of someone who says “no”.

 Don’t shop to multiple partners in a firm if the first rejects you.

 Don’t ignore the junior partners – they can really help.

 There are lots of VC firms, focus on a firm that has some connection to you.

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Source: Venture Economics/NVCA

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*Source: Venture Source

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% o

f To

tal V

C Ro

unds

27%

58%

11%

23%

13%

26%

57%

13%

61%

3%

10%

4%

Source: Dow Jones VentureOne/Ernst &Young

5%

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1.   Brief  Historical  background  

2.   Economics  of  VC  

3.   Drivers  of  VC  investment  (from  entrepreneur’s  POV)  

4.   Concluding  remarks  

Proposed  Outline  

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In 1946, MIT President Karl Taylor Compton conceived of the idea of high tech venture capital with Georges Doriot from HBS founded the first venture capital firm – American Research and Development (ARD).

Most successful investment Digital Equipment Corporation - invested $70k in 1959 which by 1968 was worth $37 mn!

The 1979 ERISA act allowed pension funds to invest in PE.

VC is 3% of R&D but accounts for about 8% of industrial innovations between 1983-1992 (Kortum and Lerner 2000)

History  

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1.   Historical  background  

2.   Economics  of  VC  

3.   Drivers  of  VC  investment  (from  entrepreneur’s  POV)  

4.   Concluding  remarks  

Proposed  Outline  

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VC revenue averages $5 million per VC-backed company

Founding team averages $9 million per VC-backed company (most from small probability of great success)

Economically rational founding team would sell at time of VC funding for $900,000 to avoid the undiversified risk.

Entrep.  Exit  value  (millions)  

0  to  1   1  to  10  

10  to  50  

50  to  100  

100  to  200  

200  to  500  

500  to  1000  

1000  and  up  

Percent  of  Co’s.  

67   20   9   2.4   1.3   0.5   0.1   0.03  

Splitting  the  Pie  

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  1.)  Human  Capital    

  Sequence  #  of  fund    Start-­‐up  experience  (early  stage)  (Zarutskie)  

  2.)  Focus  (Lerner  et  al.  )    Industry  /  stage  

  3.)  Organization  (Wasserman  2007;  Schoar  and  Lerner)  

  Partner  to  $$  ratio    Partner  to  non-­‐partner  ratio  

  4.)  Less  growth  across  funds  

  5.)  Public  market  (experienced  VCs  react  quicker)  

Drivers  of  VC  Returns  

Overall (VC, not PE): Returns are highly skewed (a few rock stars make $$$)

Returns are highly correlated with general stock market

Risk-adjusted returns are not different from Dow Jones 5000

(Hall and Woodward 2007)

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The  Micro-­‐economics  of  VC    Information asymmetry drives VC industry choice and stagings: Time between rounds gets shorter when:

• Assets are more specific and intangible • Greater growth opportunities (Gompers, 1995)

Principal-agent theory describes VC contracts, but more complex than theory predicts: • Contracts allow VCs to separately allocate cash flow rights, board rights, voting rights, liquidation rights, and other control rights • Dependent on stage and size of investment, uncertainty, performance, contingencies, etc. (Kaplan and Strömberg, 2000)

VC characteristics: • Prior VC experience improves the # of IPO/Acquisitons. • Performance doubles when the VC has prior VC experience and experience managing a start-up • For seed stage: MBA hurts performance (unless it’s an Ivy MBA then no difference) Overall an Ivy degree doesn’t help • Science & Engineering degrees help performance

Individual VC characteristics matter more in seed stage funds than for later stage funds. (Zarutskie 2007)

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1.   Historical  background  

2.   Economics  of  VC  

3.   Drivers  of  VC  investment  (from  entrepreneur’s  POV)  

4.   Concluding  remarks  

Proposed  Outline  

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  1.)  Work  history  (Burton,  et  al.  2002;  Higgins  and  Gulati  1996)  

  2.)  Social  network  (Shane  and  Stuart  2002  –  134  MIT  spin-­‐offs)  

  3.)  Timing    

  Public  markets  

  Persistence  (~9-­‐12  months  to  raise  VC)  

  4.)  Partnerships/Endorsements    -­‐  (Shane  and  Cable  2002  –  50  MIT  spin-­‐offs,  202  seed-­‐stage  investors  

  5.)  Firm  strategy  –  innovation,  time  frame  to  exit  

  6.)  No.  of  cofounders,  Prior  IPO,  same  industry  start-­‐up,  US  citizen  (Eesley,  2,100  MIT  alumni  start-­‐ups)  

  Assuming  geography  and  industry  sector  that  VCs  invest  in  (Sorenson  and  Stuart  2001)  

  Assuming  fit  with  VC  growth  model  (Fluck,  Zsuzsanna,  Douglas  Holtz-­‐Eakin,  and  Harvey  S.  Rosen,  1998)  

Drivers  of  Obtaining  VC  

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Message  to  Entrepreneurs:    –  Selecting  Your  Financial  Partners  

 Seek  True  Value  Added         Operating  Experience       Rolodex/Network       Awesome  Portfolio  (in  your  space)       Cool  Limiteds  (in  your  space)     Entrepreneurs  “pay”  in  terms  of  lower  valuations  for  affiliating  with  higher  status  VC  firms  (Hsu,  2004)  

 Keep  Realistic  Expectations     Time  to  Market       Revenue  growth       Valuations  

Ravi Belani DFJ

www.dfj.com