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Venture Capital Investing A Primer William Quigley Managing Director Clearstone Venture Partners william@clearstone.com

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  1. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Investing A Primer William Quigley Managing Director Clearstone Venture Partners william@clearstone.com

  2. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital “I was seldom able to see an opportunity until it had ceased to be one” Mark Twain

  3. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  4. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  5. C L E A R S T O N E V E N T U R E P A R T N E R S Industry Snapshot • 400+ institutional VC firms in the U.S. • Geographically concentrated • Stage/Industry focused • General partners/Limited partners • 10 year investment horizon • Co-investment with other VC’s common

  6. C L E A R S T O N E V E N T U R E P A R T N E R S Typical Firm Profile • 3 to 4 investment professionals • Review 1000+ business plans a year • Manage $50 to $200 million in capital • Buy equity (preferred stock) - rarely make loans • Investment horizon - 3 to 6 years • Sources of capital: - Pension funds - Corporations - College endowments - Wealthy individuals

  7. C L E A R S T O N E V E N T U R E P A R T N E R S Investment Stages Most VC’s have a preference for a particular investment stage. Five Stages: • Seed • Start-up • Early • Expansion • Mezzanine/Bridge

  8. C L E A R S T O N E V E N T U R E P A R T N E R S Stage/Characteristic Stage Investment Characteristics Seed $50-500K - Founder(s) only - No product - No customers - Primary risk: R&D Start-Up $500K to $1MM- Mgmt. team incomplete - Prototype or beta product - No revenues - Limited customer interest - Some capital invested - Primary risk: market accept.

  9. C L E A R S T O N E V E N T U R E P A R T N E R S Stage/Characteristic Stage Investment Characteristics Early $1MM - $3MM- Most of team in place - Limited revenues - Not profitable - Primary risk:execution Expansion $3MM - $10MM- Meaningful revenues - Achieving profitability - Growing customer base - Primary risk: competition

  10. C L E A R S T O N E V E N T U R E P A R T N E R S Stage/Characteristic Stage Investment Characteristics Mezzanine/ $10MM - $20MM- Significant revenues Bridge - Profitable - Industry player - IPO in 6-12 months - Risk much lower

  11. C L E A R S T O N E V E N T U R E P A R T N E R S The Role of the VC • Board involvement • Management recruitment • Future capital raising • Access to business network • Strategy development • Patience!

  12. Information Technology Medical Services/Devices Communications Biotechnology Some Retail C L E A R S T O N E V E N T U R E P A R T N E R S Targeted Industries Most of the $10 billion invested by VC’s in 1997 was concentrated in five industries.Why these?

  13. C L E A R S T O N E V E N T U R E P A R T N E R S How Do VC’s Make Money? • Collect management fees from L.P.’s - 2 1/2% annually • Share profits with L.P.’s - 20/80 split on investment gains Source of VC Income: How do VC’s earn their income?

  14. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  15. C L E A R S T O N E V E N T U R E P A R T N E R S What Do VC’s Want to See? Venture capitalists tend to focus on five specific areas when evaluating a company: Areas of Focus: • Management • Marketplace • Competition • Business Economics • Risks

  16. C L E A R S T O N E V E N T U R E P A R T N E R S Management The most important question: Has the team had experience and success in the same industry? VC Focus: • DIRECT sales experience? • Prior P/L responsibility? • Personal financial stake? • Willingness to share equity • “Fire in the belly”? • Functional areas covered?

  17. C L E A R S T O N E V E N T U R E P A R T N E R S Market Can management demonstrate a thorough understanding of the marketplace dynamics? VC Focus: • Market size and growth rate? • Market drivers? • Customer involvement in the R&D process? • Number of competitors?

  18. C L E A R S T O N E V E N T U R E P A R T N E R S Competition Does management have a clear understanding of the competitive landscape? VC Focus: • Why are competitors successful? • What is the prevailing business model? • Barriers to entry?

  19. C L E A R S T O N E V E N T U R E P A R T N E R S Business Economics Does management have a deep understanding of the financial dynamics of the business and industry? VC Focus: • Margins comparable to industry norm? • Break-even < 2 years ? • Appropriate sales model? • Moderate capital intensity?

  20. C L E A R S T O N E V E N T U R E P A R T N E R S Risk Does management recognize, accept, and have strategies to deal with key risks? VC Focus: • Reasonable financial projections? • New technology adoption rate? • Length of sales cycle? • Best and worst case scenarios explored? • Regulatory hurdles?

  21. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  22. C L E A R S T O N E V E N T U R E P A R T N E R S The Venture Capital Process • Business Plan • First Meeting • Second Meeting • Term Sheet • Due Diligence • Negotiations

  23. C L E A R S T O N E V E N T U R E P A R T N E R S Business Plan “Madam, enclosed please find the novel you commissioned. It is in two volumes. If I had had more time I could have written it in one.” Voltaire

  24. C L E A R S T O N E V E N T U R E P A R T N E R S Business Plan #1 objective of the the business plan: Get the VC interested in hearing more about the opportunity. Business Plan Basics: • Written by the entrepreneur • Keep it short • Financials (3-5 year proj.) • Income statement • Balance sheet • Cash flow • “What-ifs” helpful

  25. C L E A R S T O N E V E N T U R E P A R T N E R S Business Plan • 50 • 5 • 10 Magic Numbers?

  26. C L E A R S T O N E V E N T U R E P A R T N E R S Business Plan Business plan phrases that ‘spook’ VC’s... • We have no competition…. • We conservatively project….. • We only need a 10% market share…. • We will offer the most features at the lowest price…. • We valued our Internet start-up using multiples of comparable companies…like Netscape, Cisco, Microsoft.…

  27. C L E A R S T O N E V E N T U R E P A R T N E R S First Meeting ‘Skepticism’ might best describe the venture firm’s attitude in the first meeting. Don’t be alarmed by this. The Details: • Location: VC’s office • Duration: 2-3 hours • Attendees: 1 to 2 VC’s • Format: Formal presentation with Q/A

  28. C L E A R S T O N E V E N T U R E P A R T N E R S Second Meeting Getting to the second meeting is an important milestone. The team will now make its case to the entire partnership. Focus On : • Business opportunity - not the technology • Addressing concerns of the skeptics - THIS IS CRITICAL! • Next steps

  29. C L E A R S T O N E V E N T U R E P A R T N E R S What Went Wrong? - A Few Tips Dont’s • Make vague, ambiguous, or unsubstantiated statements • Make reference to unnamed/ mysterious people on the management team • Use statistical arguments for market penetration assumptions • Use technical jargon • Assume you have a deal if there is no term sheet

  30. C L E A R S T O N E V E N T U R E P A R T N E R S What Went Wrong? - A Few Tips Dos • Involve the entire team • Discuss/disclose potential problems • Demonstrate financial commitment to the venture • Prepare realistic market and sales projections • Know your target investor (angel, bank, VC)

  31. Some Guidelines: Needs to be solicited! From knowledgeable sources Develop a dialogue first Avoid answering, debating Have a market-researcher mindset “The greatest gift that God hath given us is to see ourselves as others see us.” Scottish Proverb C L E A R S T O N E V E N T U R E P A R T N E R S What Went Wrong? - Getting Feedback Getting honest feedback can be challenging…

  32. C L E A R S T O N E V E N T U R E P A R T N E R S Term Sheet After the second meeting, the VC typically provides a term sheet to the entrepreneur. Term Sheet - Common questions: • Is it a legally binding document? • What’s covered? • What is it designed to do? • Why participating preferred stock?

  33. Post-money valuation $ amount of the financing Investors identified Size of employee option pool Vesting periods Key-person insurance Board representation Additions to management team, if any Monitoring covenants, Restrictive covenants Other deal specific issues C L E A R S T O N E V E N T U R E P A R T N E R S Term Sheet Conditions The term sheet is intended to embody the overall conditions of a business agreement. What’s covered?

  34. C L E A R S T O N E V E N T U R E P A R T N E R S Due Diligence The “heavy lifting” for the venture capitalist starts with the due diligence process. Due Diligence Overview: • Length: 6-12 weeks • Will perform up to 100 reference calls • Interview customers, former employees, competitors, industry experts • Intense legal, financial work

  35. Some flexibility in: Valuation Total investment Vesting periods Size of option pool Less flexibility in: Equity instrument type Board make-up Anti-dilution rights Restrictive covenants C L E A R S T O N E V E N T U R E P A R T N E R S Negotiations Negotiations take place throughout the due diligence process. What is negotiable?

  36. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  37. C L E A R S T O N E V E N T U R E P A R T N E R S The Business Plan • Executive Summary • Main Body • Appendix

  38. Mission statement Brief company history Description of investment opportunity Market overview Management team Product & technology Customers Strategy Competition Capital requirements C L E A R S T O N E V E N T U R E P A R T N E R S Executive Summary What should the executive summary address?

  39. C L E A R S T O N E V E N T U R E P A R T N E R S Main Body Management Key Questions to Address: • Who are the key people in the company? • Where did they come from, and why are they the right people to run the company? • Have they had previous experience and success in growth companies?

  40. C L E A R S T O N E V E N T U R E P A R T N E R S Main Body Product/Technology/Service Key Questions to Address: • What does the customer have access to today? • How does it differ from competing offerings • What is the superior value proposition to the customer?

  41. C L E A R S T O N E V E N T U R E P A R T N E R S Main Body Marketplace Key Questions to Address: • What is happening in the marketplace? Is it growing, if so, why and at what rate? • What is lacking from the market leaders that this product/tech/service will provide? • Which customers have been involved in the development of the product and are likely to purchase it?

  42. C L E A R S T O N E V E N T U R E P A R T N E R S Main Body Strategy Key Questions to Address: • Why will the customer be compelled to purchase the product? • How will the company maintain its competitive differentiation? • What barriers exist/will be created to curtail new entrants?

  43. C L E A R S T O N E V E N T U R E P A R T N E R S Appendix Not all business plans require an Appendix section, but it can be useful.What to include? • Relevant industry articles to bolster management claims • Major customer testimonials • Other information likely to impress those not familiar with the market

  44. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  45. C L E A R S T O N E V E N T U R E P A R T N E R S Valuation StageCriteriaMethodology Range Seed - Mgmt. track record Comparables, $400K to $1.5MM - Market size/growth Whats the “going - Competition rate” in the region - Investment to date Start-up - Market size/growth Comparables $750K to $2.0MM - Working prototype? - Team complete?

  46. C L E A R S T O N E V E N T U R E P A R T N E R S Valuation StageCriteriaMethodology Range Early - Market size/growth Comparables $1.5 to $5.0MM - Revenue run rate - Gross margin % - Performance to date Expansion - Revenue run rate - 1X sales Varies - Profitability ratios - EBIT multiple - Performance vs. plan

  47. C L E A R S T O N E V E N T U R E P A R T N E R S Valuation StageCriteriaMethodology Range Mezzanine/ - Market share/size Multiples of Varies Bridge - IPO environment proxy companies - Performance Relative to plan

  48. C L E A R S T O N E V E N T U R E P A R T N E R S Venture Capital Industry Overview Screening Venture Opportunities The Venture Capital Process The Business Plan Valuation Exit Getting in Touch

  49. C L E A R S T O N E V E N T U R E P A R T N E R S Exit Strategies • Sale or Merger • Most likely exit • Initial Public Offering • Small fraction go this way • Redemption • Least attractive • Management buy-out • Generally not possible

  50. C L E A R S T O N E V E N T U R E P A R T N E R S Secrets of Success? • CEO carried a bag • Called on same customer base • Gross margin > 50% • Some degree of technology • Cash flow break-even < $5M • Sourced the deal • 25% ownership or greater • First institutional investor The Eight Commandments