Seeking venture funding…what an investor looks for and what to look for in an investor A discussion of considerations from a pre-seed and seed investor perspective… August 25 and October 13, 2005 Teri F. Willey, Managing Partner ARCH Development Partners firstname.lastname@example.org
Planning to cover… • How a VC fund works • Some background on ARCH Development Partners • What investors like to see (and what you might look for in investors) • Risk and Return • Term Sheet Tango • Resources
Structure – how a fund works • The Fund • Fund raises money from institutional investors (LP’s) • University endowments, pension funds, insurance companies, corporate venture funds, wealthy individuals • Fund may range from $30M - 400M, $1-$10M per LP • Fund lasts 10 years. First 3-4 years initial investments, then follow-on investments and exits. • Multiple Funds may be managed concurrently • The Partnership • 20% carry. (For a $100M fund, all gains over $100M get split 80/20 with investors/fund managers) • The Management Company • 2-3% fees per year. (2% fee on $100M is $2M year)
Return - % returns based on age of fund for period ending 2003 (www.nvca.org)
Return – multiples and IRR • Homeruns (10x) • Singles/Doubles/Triples (1x<10x) • Strikeouts (<1x) • Multiple: $exited/on $invested • IRR: timing to exit from the first investment • Note: 2.5X for a 20% IRR, 5X for a 40% IRR
Background…ARCH Development Partners • Currently $32 million under management • LP’s: Universities, Foundations, Banks, Corporations, and Hospitals • Strategy: • Strategically partner with communities to create start-ups • Current partners: Kalamazoo,Peoria,Lafayette, Cincinnati, St. Louis • Make “pre-seed” investments ($50,000 to $1,000,000) • Syndicate deals with other early-stage investors, e.g. angels • Structure deals for optimal early exits • Primary Deal Sources: University and Corporate spin-outs • Investments: Biotechnology, Information Technology • Geographic Focus: Upper Midwest: IN, IL, MI, OH • General Partners: Experienced investors and entrepreneurs
Stage of investments Focus Pre-Seed Seed Early Stage Mid-Stage Exit Description Team $ Needed Keys to Success • IP/Technology • Technologist / founder/business development • <$500K • Identifying technology via relationships • Determining commercial viability • Accessing rights/Recruiting CEO • Product-in-development • Plus first senior mgmt team member • $250K to $1M • Finding development partners • Developing business strategy • Recruiting BOD & SAB • Product at beta clients • Senior mgmt team formation • $1M to $5M • Growing the sales pipeline • BOD and SAB in place • Full customer pipeline • Senior mgmt team in place • $2M to $20M • Managing growth • Becoming profitable • Identifying exits • Business Expansion • Public Markets
The ARCH Model • Apply Time-tested Traditional VC Disciplines to: • Identify Platform Technologies • Create Patent Strategy • Recruit the CEO • Identify and Quantify the Market • Create the Business Model • Recruit BOD and SAB • Raise $$$ • Manage to Milestones
Accelerating New Business Growth Inception Groundwork Interim management Talent Toward independence • Managing Licensor relationship • Technology due diligence • Business plan creation • Patent and IP protection • Finding and closing initial financing • Consultation/ liaison on university policy • Incorporation • Office space • Payroll and benefits • Accounting • IT and telephone • Advisory board and BOD • Marketing/PR • Financial modeland pricing • Business development • Operations processes • Product development • Recruiting and hiring • Organizational structure • Compensation planning • Staffing models • Culture building • Product commercialization • Customers • Revenue • Space to grow • Next roundfunding • Updated Advisory board and BOD
The “squeeze” perspective • At the early stages … it is about squeezing out enough risk so traditional corporate partners and investors can participate. We think about how you can facilitate: • hitting the most critical milestone's) • in the least amount of time • with the least amount of money • light initial capitalization • management compensated w/stock • use non-dilutive funds • outsource • exit strategy flexibility
What we want to see – MANAGEABLE RISK • As we evaluate each of the foregoing we are considering the main types of risk, if they are manageable and if so how they will be managed: • IP • Market • Technical • Financing • Management
Risk con’t PROBABILITY • Sufficient capital 80% • Management is capable and focused 80% • Product development goes as planned 80% • Production and component sourcing goes as planned 80% • Competitors behave as expected 80% • Customers want the product 80% • Pricing is forecast correctly 80% • Patents are issued and are enforceable 80% • Combined probability of success 17% • Harvard Business Review November-December 1998
What we like to see - TYPE • Science/innovation based company. • Prefer university or corporate owned intellectual property as the basis for the spin out (vs independent inventor). • Biomedical, biotechnology, pharmaceutical, bioinformatics, information technology, wireless, internet infrastructure.
What we like to see - STAGE • Pre-business plan and management team is fine. • We prefer to act as founders at this stage, assist with company formation and management and board recruitment and the acquiring the necessary intellectual property rights.
What we like to see - $ REQ • 50k to 1 million needed for the purpose of squeezing risk out of the venture and positioning it for further investment or revenue generation. • 20-50 million total to get to exit. • Realistic expectations regarding valuation, that is what the investment buys in ownership and control
What we like to see - MARKET • The product(s) the company is proposing to develop should have a market of 200 million or more (that is the company’s sales are expected to be 200 million or more annually in a reasonable time after product launch) • Understanding of the commercialization strategy and competitive advantage. • Clear and realistic idea of who and what the competition is and how the idea will reach the market in the form of a product. • Know where the pain is that this product addresses and where a the incentives are to adopt the new product (the value proposition).
What we like to see - IP • The proposed product should be based on an appropriate proprietary position, preferably a strong patent position or the real potential for one. • This includes understanding freedom to operate issues and determining that they are clearly addressed or reasonably manageable.
What we like to see - MGMT • If there are there already or if we need to recruit them: • Product development experience and operating experience (fund raising a plus). • Reasonable compensation expectations. • Chemistry with the founding scientists/innovators. • Early stage company experience • Network
What we like to see - EXIT • The company or proposed company should be one poised for an acquisition exit or in some cases an IPO exit. • Pre-seed and seed stage investors like ARCH may lean toward an acquisition exit as it is consistent with our model (and the only choice when the window is closed) and hence towards deals in industries in which M&A is the favored transaction.
What we like to see - RETURNS • At exit it’s about how… • many shares are we going to own. • much do we invest to get there. • much to others invest to get there. • long will it take us to get there. • much will they be worth at exit.
Sources of these shares…of equity • In addition to acquiring equity as consideration for investing dollars in the company (usually preferred) equity may also be obtained… • As consideration for the technology license (common or preferred) • As consideration for forming the company or providing services (sweat equity – usually common) • As compensation (options for common or restricted stock)
How much equity • Pre-money valuation + dollars invested = post money valuation • Equity ownership equals dollars invested divided by the post money valuation…or does it?! • Equity ownership on a fully-diluted basis
Term Sheet • Financial Terms • Non-financial Terms • Equity Provisions
Terms to address the traditional ‘valuation gap’ • Pre-money valuation • Financial tools • Liquidation preferences • Warrants • Dividends • Incentive based tools • Price controls aka ratchet mechanisms • Preemptive rights • Performance based incentives • Management options • Vesting founders shares • Terms to address managing risk via control • Board representation • Class voting • Voting the option pool • Protective provisions
Liquidation preferences • These preferences allow certain investors, in the case or acquisition or liquidation, to get their initial investment back (or multiples of it in the case of 2x or 3x liquidation preferences) before returns are shared ratably with the other share holders.
Warrants • Another word for an option to purchase a security. The term is generally used for options provided by the company to outside investors (as distinct from officers, employees, etc.) • Contract which covers time frame during which the investor can convert the warrants and the price they can convert/buy stock • Sometimes used with or without interest on convertible bridge loans and can be based on a percent of the bridge • This can be a cashless transaction if the warrants are converted at exit • Taken into consideration when determining a fully diluted share price
Anti-dilution • Price protections…if stock is sold, at a price less what the investor with anti-dilution protection paid for it, the lower price is applied to the conversion formula • Full-ratchet • Weighted average • Preemptive rights…the right of the investor to acquire new securities issued by the company to the extent necessary to maintain its percentage interest on an as converted basis)
Vesting founders shares • Incentive to keep founders with the company • “Earning back” the initial ownership in the company over time or against milestones
Control via business decisions • Protective provisions • May provide significant control of the investors even if they do not own a majority of the company. • Outlines which decisions require approval of the investors (which class of investors, percent, etc.) • Board representation • Investors my require one or more board seats
Resources • Indiana Venture Center • www.indianaventurecenter.org • Indiana Seed Fund I. LLC (ISF) • www.biocrossroads.com/entrepreneur/isf.htm • Model documents and industry overview • www.nvca.org • More course work • www.vcinstitute.org