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Early Stage Venture Capital Due Diligence and Valuations. David M. Lee 2/12/2003. Agenda. Due Diligence Inside a Venture Fund Valuations. Dual Mission. DELETED. Investment Criteria. Key Criteria: Fits within market focus and portfolio Significant market size Headquarters in Texas

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agenda
Agenda
  • Due Diligence
  • Inside a Venture Fund
  • Valuations
investment criteria
Investment Criteria
  • Key Criteria:
    • Fits within market focus and portfolio
    • Significant market size
    • Headquarters in Texas
    • National or international in scope
    • Manageable competition
    • Fundamental sustainable differentiator
    • Top-tier management team
    • Good chemistry
  • Priority:
    • Insiders are willing to participate
    • Includes a syndication with value-added outside investors
process documentation
Process Documentation
  • Investment Overview
    • 1-2 page document that provides a high-level summary
    • Enables the General Partner to relay first opinions back to sponsor
  • Investment Due Diligence Document
    • 10-15 page document that answers questions in depth about the deal
    • Detailed summary about multiple aspects of the business and management team including risks and issues
  • Investment Decision Document
    • 2-3 page document that contains a summary of the due diligence
    • Leads to the recommendation by the sponsor and records the final vote on whether or not to invest
portfolio management
Portfolio Management
  • Increase funding potential
    • Assist in refining business plans and financial projections
    • Recruit management team and board members
  • Facilitate follow-on funding
    • Provide introductions to other VCs, funds, banks, and angels
    • Aid development of investor pitch and offering materials
  • Validate market and technical strategies
    • New product, business feasibility, and market research studies
    • Strategic market planning, periodic technical/marketing reviews
  • Provide access to service provider network
    • Referrals to legal, accounting, PR, and marketing firms
    • Contacts for executive consultants, industry experts, and analysts
time management
Time Management
  • GP has 3 full-time and 2 part-time partners
  • Limit of 6 portfolio companies per full-time partner
  • Total money placed per full-time partner is < $25,000,000
  • Each full-time partner reviews 400 deals w/in commitment period
  • Target fund size of up to $90,000,000
portfolio allocation
Portfolio Allocation
  • Target is 18 to 23 portfolio companies
  • $1.5 million average initial investment
  • Active management of 70% of the portfolio companies
  • Lead investor for 40% of the investments
  • Over 50% of the fund reserved for follow-on investments
  • Establish up front funding milestones/trigger based budgets
fund management
Fund Management
  • Fund managers bring over 100 years of operating experience:
    • 3 Full-time Partners - Managing Partner and 2 General Partners
    • 2 Part-time Partners - Venture Partner and Fund Administrator
  • Each principal was strategically selected:
  • Supporting Staff
    • Venture Consultants, Contractors, Associates, and Interns
fundamentals
Fundamentals
  • Block-n-Tackle Business Planning
    • Revenue Growth, Expense Controls, and Profit Focus
  • Solution for a significant pain that a large group of people with money are willing to pay for
  • Experienced management team that knows how to make payroll
  • Sustainable differentiation with an emphasis on unique best-of-breed IP
  • Venture acceleration, not venture support
current focus
Current Focus
  • High Technology (3-4 Month ROI):
    • Enterprise Software
    • Telecommunications Utilization Software
    • Semiconductors and MEMs/Nanotechnology
    • Bioinformatics and Life Sciences/IT convergence
  • Life Sciences:
    • Diagnostic Tests
    • Pharmaceuticals
    • Genomics/Proteomics
    • Medical Devices
valuation s role in financing
Valuation’s Role in Financing
  • Sets economic interests going forward.
    • Establishes an intrinsic value for the company
    • Valuation is not transaction independent
  • One of many terms under negotiation …
from the term sheet
From the Term Sheet
  • Terms
    • Capitalization
    • Type of Security/Securities
    • Characteristics of the Security/Securities
      • Anti-dilution
      • Liquidation preference
    • Representations and Warranties of the Company
  • Other Conditions to the Deal
    • Governance Requirements
    • Reporting Requirements
    • Expenses
    • Non-solicitation
    • Changes to Management
    • Key-man Insurance
initial valuation views
The Technologist

The Technology

Personnel (Technical)

The Market

Personnel (Business)

The VC

Personnel (Business)

Personnel (Technical)

The Market

The Technology – Must have IP!

Initial Valuation Views
methods of valuation
Methods of Valuation
  • Methods:
    • Discounted Cash Flows (DCF)
    • Comparables
    • Target Ownership
  • Reality for Early Stage Companies
    • Use the first two to justify the third
pros and cons of dcf
Pros and Cons of DCF
  • Pros
    • Highly quantitative
    • Provides specific, objective (?) numbers as a basis for negotiation
    • Speaks to “Intrinsic Value” of company
  • Cons
    • Too many variables
    • Depends upon accurate forecasting
    • Difficult to discount for risk and lack of liquidity
comparables
Comparables
  • Most closely resembles Real Estate valuations
  • Look at prices of similar deals
    • Stage of business
    • Location of business
    • Industry
  • Adjust up or down for specific circumstances
comparables adjustments
Comparables Adjustments
  • Current capitalization
    • Cap table
    • Past investment rounds
  • Product development
    • In Beta
    • General Availability
  • Management
    • Good or bad management
  • Business Development
    • Sales booked
    • Quality of sales pipeline
    • Profitability
pros and cons of comparables
Pros and Cons of Comparables
  • Pros
    • No need to adjust for risk or liquidity
    • A common method that is fairly well understood within early stage companies
    • Fast
  • Cons
    • Highly subjective
    • Imperfect distribution of information
reality of valuation
Reality of Valuation
  • First Round company
  • Some seed money in (Friends and family – 20%)
  • Networking Software space
  • Excites one of the Partners
  • Product in Beta
  • Missing management team members
  • No option pool
  • Based in New Mexico
  • $3M raise
  • Syndicate has target ownership of 33%
reality of valuation23
Reality of Valuation
  • In year of comparison – Average Post-money valuations:
    • Communications SW, Series A: $7.78M
    • SW & Rocky Mtn., Series A: $8.66M
  • Average post-money valuation of $8.25M
    • Pre-money valuation of $5.25M
    • $3M raise
  • Resulting Ownership
    • 36% - New Investor ownership (Series A Preferred)
    • 20% - Option pool forced before round
    • 11% - Friends and Family Ownership
    • 33% - Founder Ownership
further justification
Further Justification
  • Adjustments to the valuation
    • Large Stock Option plan needs to be created
      • Management team is incomplete
    • Hot space
      • Don’t forget the Run with the Pack mentality
      • We’ll be the lead investor
    • > 1 additional financing round expected
      • New investors will also be diluted
    • Product in Beta
      • Technology risk still exists
      • Not proven in the field (lack of customers)
    • Claim to go from $0 to $250M in 4 years
      • Several companies will put this in the plan, but very few can defend it
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