BUSI 5908 and 5900 Effects of Terms and Conditions of Venture Capital Financing on Firm Strategy Submitted by: Ryan J. Riordan Student ID: 100234855 In Partial Fulfillment of the Degree of Master of Business Administration Supervised by: Dr. John Callahan July 08, 2005
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BUSI 5908 and 5900 Effects of Terms and Conditions of Venture Capital Financing
on Firm Strategy
Submitted by: Ryan J. Riordan Student ID: 100234855
In Partial Fulfillment of the Degree of
Master of Business Administration
Supervised by: Dr. John Callahan July 08, 2005
Table of Contents
TABLE OF CONTENTS........................................................................................................................2 LIST OF FIGURES & TABLES............................................................................................................4 SECTION 1 - INTRODUCTION ...........................................................................................................5 SECTION 1 - INTRODUCTION ...........................................................................................................5
RESEARCH PROBLEM ............................................................................................................................5 RATIONALE ..........................................................................................................................................5 CONTRIBUTION .....................................................................................................................................5
SECTION 2 - LITERATURE REVIEW................................................................................................6 METHODOLOGY ....................................................................................................................................6
SECTION 3 - RESEARCH DESIGN .....................................................................................................7 CASE SELECTION AND DEVELOPMENT ...................................................................................................8
SECTION 4 - CASES ........................................................................................................................... 11 OVERVIEW OF CASES .......................................................................................................................... 11 CASE 1 (C1)........................................................................................................................................ 13
Data Collected............................................................................................................................... 13 Business/History ............................................................................................................................ 13 Management Team......................................................................................................................... 14 Funding......................................................................................................................................... 14 Left Hand Side............................................................................................................................... 15
CASE 2 (C2)........................................................................................................................................ 16 Data Collected............................................................................................................................... 16 Business/History ............................................................................................................................ 16 Management Team......................................................................................................................... 16 Funding......................................................................................................................................... 17 Left Hand Side............................................................................................................................... 18
ENDECA ............................................................................................................................................. 18 Data Collected............................................................................................................................... 18 Business/History ............................................................................................................................ 18 Management Team......................................................................................................................... 19 Funding......................................................................................................................................... 20 Left Hand Side............................................................................................................................... 20
EXP SYSTEMS .................................................................................................................................... 20 Data Collected............................................................................................................................... 20 Business/History ............................................................................................................................ 21 Management Team......................................................................................................................... 21 Funding......................................................................................................................................... 21 Left Hand Side............................................................................................................................... 22
CASE 5 (C5)........................................................................................................................................ 22 Data Collected............................................................................................................................... 22 Business/History ............................................................................................................................ 23 Management Team......................................................................................................................... 23 Funding......................................................................................................................................... 23 Left Hand Side............................................................................................................................... 24
COMPANY 6 (C6) ................................................................................................................................ 24 Data Collected............................................................................................................................... 24 Business Overview......................................................................................................................... 24
Management Team......................................................................................................................... 25 Funding......................................................................................................................................... 25 Left Hand Side............................................................................................................................... 26
COMPANY 7 (C7) ................................................................................................................................ 26 Data Collected............................................................................................................................... 26 Business Overview......................................................................................................................... 26 Management Team......................................................................................................................... 27 Funding......................................................................................................................................... 27 Left Hand Side............................................................................................................................... 27
COMPANY 8 (C8) ................................................................................................................................ 28 Data Collected............................................................................................................................... 28 Business Overview......................................................................................................................... 28 Management Team......................................................................................................................... 28 Funding......................................................................................................................................... 29 Left Hand Side............................................................................................................................... 29
CONFIRMING FINDINGS ....................................................................................................................... 29 SECTION 5 – ANALYSIS, PROPOSITIONS AND MODEL DEVELOPMENT .............................. 30
STAKEHOLDER ANALYSIS ................................................................................................................... 31 PROPOSITION DEVELOPMENT .............................................................................................................. 35 PEOPLE............................................................................................................................................... 36 FINANCE............................................................................................................................................. 37 BUSINESS ........................................................................................................................................... 37
Product Strategy............................................................................................................................ 38 Comparison to Literature....................................................................................................................... 38 Effects observed .................................................................................................................................... 38
Market Strategy ............................................................................................................................. 39 Comparison to Literature....................................................................................................................... 39 Effects observed .................................................................................................................................... 39 Circumstances ....................................................................................................................................... 40 Bargaining Power .................................................................................................................................. 40 Product ................................................................................................................................................... 41 Market .................................................................................................................................................... 41 Investor Alignment and Orientation ...................................................................................................... 41
Model Development ....................................................................................................................... 42 Stipulation of Terms and Conditions............................................................................................... 43
Security Design...................................................................................................................................... 44 Staging of Investments.......................................................................................................................... 45 Shareholder agreements....................................................................................................................... 45 Equity allotment ..................................................................................................................................... 46 Board rights............................................................................................................................................ 46 Liquidation rights.................................................................................................................................... 47 Sale of share restrictions....................................................................................................................... 48 Stock option pools, warrants................................................................................................................. 48 Employment Contracts .......................................................................................................................... 48
PROPOSITION DEVELOPMENT .............................................................................................................. 49 General Propositions..................................................................................................................... 49 Product Strategy Propositions........................................................................................................ 50 Market Strategy Proposition .......................................................................................................... 51
SECTION 6 – ANALYSIS, PROPOSITIONS AND MODEL DEVELOPMENT .............................. 55 KEY FINDINGS AND CONTRIBUTIONS ................................................................................................... 55 LIMITATIONS AND FUTURE STEPS ........................................................................................................ 55
REFERENCES ..................................................................................................................................... 57 COMPANY WEBSITES .......................................................................................................................... 58 RESEARCH WEBSITES.......................................................................................................................... 59
APPENDIX A – SAMPLE TERM SHEET .......................................................................................... 60 APPENDIX B - INTERVIEW OUTLINE............................................................................................ 65
List of Figures & Tables
FIGURE 1 - CARLILE & CHRISTENSEN (2005) THEORY BUILDING PROCESS...................................................7 FIGURE 2 - STAKEHOLDER MAP ............................................................................................................... 32 FIGURE 3 - RELATIONSHIPS BETWEEN THE TERMS AND CONDITIONS ......................................................... 42
TABLE 1 - ALL THE DATA SOURCES USED ..................................................................................................9 TABLE 2 - CASES SUMMARY .................................................................................................................... 12 TABLE 3 - TYPE OF INFORMATION USED TO DEVELOP EACH CASE ............................................................. 12 TABLE 4 - SPECIFIC STAKEHOLDERS ......................................................................................................... 33 TABLE 5 - STAKEHOLDER GRID FOR SELECTED STAKEHOLDERS ................................................................ 34 TABLE 6 - POWER VERSUS STAKES ........................................................................................................... 35
Section 1 - Introduction
Research Problem
The purpose of this study is to determine how the terms and conditions of
venture capital funding deals affect the strategy of the receiving firm. Specifically,
the study seeks to identify effects in areas that have not been extensively
explored, or in areas where previous exploration has identified anomalies.
Rationale
No similar studies have been found linking the terms and conditions of
financing to firm strategy. The terms and conditions can have a significant effect
on the strategy and operations of a firm. Studying and documenting these effects
will afford future researchers the ability to develop theory surrounding these
phenomena. The theories developed can subsequently help to guide
entrepreneurs and VCs when formulating the terms and conditions of venture
capital financing.
Contribution
This study has contributed several items of importance. The study has
identified fruitful areas of future research in venture capital. The study has
identified, developed and presented several plausible propositions to be tested in
later studies. The final contribution of this study is the identification of the
circumstances that effect the terms and conditions of venture capital financing.
Section 2 - Literature Review
The literature review for this research project is presented in an
unconventional manner. The front-end literature review covers the methodology
used to develop the cases. The remaining literature is presented in context when
the findings of the study are compared to extant literature regarding those
subjects.
Methodology
To this researchers knowledge there are no case studies of the effects of
venture capital financing terms and conditions on firm strategy. Case studies
research is specifically useful in developing theory around phenomena that are
not well understood (Eisenhardt, 1989). The design of the current research is
multiple case study (Yin, 1989) with some qualitative cross-case analysis (Miles
& Huberman, 1994). The theory building methods are similar to Eisenhardt’s
(1989) recommendations and Carlile and Christensen’s (2005) inductive
research design. Normative, case-based, inductive research was selected over
deductive research to help identify phenomena not previously discovered in other
deductive studies. Carlile and Christensen (2005) make the distinction between
descriptive theory (finding correlations) and normative theory (finding causes)
with an emphasis on anomaly discovery. This study is geared towards the third
stage of the descriptive theory building process. The third stage is commonly
called the models step. This stage seeks to make associations between category
defining attributes and probable outcomes. Figure 1, depicts, the Carlile and
Christensen (2005) Theory Building Process.
Figure 1 - Carlile & Christensen (2005) Theory Building Process
To facilitate cross case comparison and subsequent theory development,
the same template is used to develop each case (Miles and Huberman, 1984;
Eisenhardt, 1989; Brown & Eisenhardt, 1997). This approach helps to identify
similarities as well as differences amongst several cases.
Section 3 - Research Design
The goal of the study is to observe, describe and measure venture capital
related financing phenomena and to categorize and develop a model based upon
the observed phenomena and anomalies. Observations simply confirming extant
literature will not be further pursued. New phenomena and anomalies will be
compared to extant literature and used to develop several propositions and a
preliminary model.
The study of venture capital in literature is, in the researcher’s opinion, in
the normative theory development stage. Normative theory, as opposed to
descriptive theory, seeks to answer the question of what causes something.
Descriptive theory seeks to determine correlations. Carlile and Christensen
(2005, p. 7) state that “…normative theory has much greater predictive power
than descriptive theory does…” because it allows researchers to assert which
actions managers should take given the current circumstance.
The unit of analysis in this study is the venture capital financing deal. Eight
cases are developed and examined. Each case is treated as an independent
experiment from which factors affecting the venture are identified based on the
evidence discovered during case study development, follow-up interviews and
stakeholder analysis.
Case Selection and Development
Cases were selected using theoretical sampling (Glaser, 1978), the goal
being to reach theoretical saturation and completeness. The eight cases develop
fall within the guidelines set by Eisenhardt (1989) of between four and 10 cases.
Table 1 lists all the data sources used in this study.
The nature of the research requires divulgence of highly sensitive financial
and legal information to the researcher. In practice, this often meant that the
researcher had to be satisfied with only one piece of primary data. The
information hurdle for case inclusion was one of the following:
i) an interview with a VCF or principal;
ii) a complete term sheet or;
iii) a summarized term sheet and a pre-existing case write-up.
Five cases were developed using interviews as the primary data source,
one case was developed using a complete term sheet, and two cases were
developed using summarized term sheets and pre-existing case data. Other
secondary data was used to augment the available primary data. Secondary data
included company press releases, VC press releases, articles in the press and
proprietary databases, specifically the Mary Macdonald Canada VC database.
Table 1 - All the Data Sources Used Source of Evidence Type Code Description Interviews I1 Informal interviews with VCs or entrepreneurs I2 Specific follow-up interviews with VCs or entrepreneurs Documents D1 Correspondence with VCs or entrepreneurs D2 Term Sheet D3 Summarized Term Sheet D4 Articles in press D5 Internet search results D6 Firm or VC press releases D7 Case Data D8 CanadaVC Database D9* Management Plan (never saw document incl. In TS)
Each case involved the receipt of seed, start-up, early stage or expansion
venture capital funding, as listed in the Mary Macdonald VC database. Five of the
cases were in the National Capital region, two were from the U.S. and one was
based in British Columbia. All but one of the cases were in the field of high-
technology. An effort was made to restrict the cases to high-technology firms in
the National Capital region. The researcher was opportunistic however, and
cases were not excluded provided they contained rich data.
The cases involved funding between 1999 and April 2005. Although the
April 2005 funding is quite recent, a case was deemed acceptable if enough data
were present and enough time had elapsed in order for an effect to be observed.
The time frame of the study comprises one entire cycle in the venture capital
industry. Therefore, observed effects will likely not be attributable solely to
industry fluctuations.
The VC and founder interviews were conducted via telephone and notes
were made and confirmed throughout the interview. Careful attention was paid to
the amount of time between the VC deal under analysis and the case
preparation. Specifically, enough time had to have elapsed in order to observe
any influences the deal may have had on strategy. In addition, the elapsed time
needed to be sufficiently short such that a significant retrospective bias was not
introduced into the study. Initially, the study time frame was set between the
beginning of the year 2000 and the end of 2004. The pre-2000 cases were
developed from existing case studies around the same period of time, thereby
eliminating retrospective bias. The case in which a deal was included post 2004
also contained a deal in 2004, for which an interview was provided, and was
therefore included.
Prior to the initial interview, an email was sent outlining the goals of the
study and the initial lines of questioning. Interview duration ranged from 15 to
thirty minutes; one interview was conducted over two separate days. Several
follow-up interviews were conducted to clarify points and issues that presented
themselves during case preparation. After each interview, subjective comments
were added to the key points while the conversation was still fresh.
A ninth deal was under consideration, but could not be included in the final
project. The insights gained from the two founders of this deal, however, were
included in the hypothesis development and validation of information phases
along with the initial eight cases.
Each case was developed using the same template: company portrait,
historical timeline, funding information, strategy effects and other interesting
points. Appendix B contains an interview outline that was used to guide each
interview. Questions were also included regarding board composition,
management changes, business model churn, product, market and research and
development strategies. Every effort was made to triangulate (Eisenhardt 1989)
data to ensure that there were no discrepancies. No discrepancies were
observed.
Section 4 - Cases
Overview of Cases
Six of the cases were written such that companies and personalities
remain anonymous, as this was a requirement of the participants given the
nature of the information being divulged. Two of the cases under analysis here
use Harvard Cases as the basis for the analysis.
Table 2 below details some summary information regarding the cases
developed.
Table 2 - Case Summary Case Name Code Description Artefacts
Company 1 C1 Industrial I1, I2, D1, D4, D5, D8
Company 2 C2 Network Infrastructure I1, I2, D1, D4, D5, D6,
D8 Endeca C3 Enterprise Internet Software D3, D4, D5, D6, D7
EXP Systems C4 Internet Service D3, D4, D5, D6, D7 Company 5 C5 Server Infrastructure D2, D4, D5, D6, D8 Company 6 C6 Network Infrastructure I1, D4, D5, D6, D8 Company 7 C7 Mobile Data Software I1, I2, D4, D5, D6, D8 Company 8 C8 Network Infrastructure I1, D4, D5, D6, D8 In Table 3, the artefact codes correspond to the type of information used
to develop each case.
Table 3 - Type of Information Used to Develop each Case Source of Evidence Type Code Description Interviews I1 Informal interviews with VCs or entrepreneurs I2 Specific follow-up interviews with VCs or entrepreneurs Documents D1 Correspondence with VCs or entrepreneurs D2 Term Sheet D3 Summarized Term Sheet D4 Articles in press D5 Internet search results D6 Firm or VC press releases D7 Case Data D8 CanadaVC Database
Case 1 (C1)
Data Collected
This case was developed with a VC interview, a follow-up interview, an
email with the VC, some articles that were available in the press, some Internet
search results and data contained in the Mary Macdonald database.
Business/History
The company was very interesting in terms of strategy. They developed a
novel technology with applications in many fields. The technology also has
applications in industries that have previously not been able to afford it. The
company was founded in 1995 and remains a private company. They received
three rounds of funding, including the one under analysis, with the same VCs
each time.
They had initial success in their first target market, but fell short of
expectations in terms of new business development. Even though the company
had an excellent value proposition, their sales seemed to stagnate and remain
dependent on their initial market.
The board was comprised of seven members. Five of the board members
were VCs, one was from the management team and the remaining member was
a mutually agreed upon independent member.
Over the past two years, the company has had major problems.
Management began to miss agreed revenue milestones and new market
development targets. There were few signs that this would change in the near
future. The company was finally petitioned into receivership and their assets
were sold.
Management Team
The management team was weak in terms of marketing and business
development. According to the VC, the management team had trouble remaining
objective. At the end, they “…seemed to focus on saving themselves, rather than
the company.” They did a good job of dividing the investor base in order to
promote a stasis at the board level.
Funding
The first two rounds of funding were secured in years six and eight.
Subordinated debt and warrants were used in the first deal, while preferred
shares were used in the second round. The final round occurred exactly one year
after the round two funding.
The company needed new money, and no one was interested in providing
it. Some investors wanted to switch the management team but could not get 75%
board approval. One VC came in with what our contact described as a ‘cram-
down1’ term sheet, which was rejected. The problem was at the board level,
where our VC had a seat. Management was doing a good job of splitting the
investor base. The result was that the company wasn’t moving forward on its own
1 Cram down round – a financing event upon which new investors with substantial capital are able to demand and receive contractual terms that effectively cause the issuance of sufficient new shares by the startup company to significantly reduce (“dilute”) the ownership percentage of previous investors. (http://mba.tuck.dartmouth.edu/pdf/2002-5-0007.pdf)
terms and the investors could not come to a consensus regarding a course of
action.
The solution was that all of the investors put together a ‘debt piece’ to fund
the company for six months. After the six-month period, any creditor could
petition C1 into receivership for failure to pay. This did happen at exactly the six-
month mark.
Two very interesting points presented themselves in this case. The first
interesting point was the lack of consensus and the split in the board of directors.
Although the board was dominated by term sheet stipulated investor board
members, they could not reach a consensus and make a decision. The
management team was also restricted from finding new investors or seeking debt
from other sources. The addition of the debt piece is quite common, according to
our VC. In the end, a company that was a heavy user of C1’s product purchased
its assets.
Left Hand Side
This funding round was designed to allow C1 to accelerate market
penetration. The release of funds was multi-stage and dependent upon meeting
certain market penetration milestones. Post receipt of financing, C1 introduced
derivations of their original product to new market segments. They presented
their adapted technologies at two distinct and separate market tradeshows. C1
had not done this prior to receiving this round of funding.
Case 2 (C2)
Data Collected
This case was developed with a VC interview, a follow-up interview, an
email with the VC, firm and VC press releases, some articles that were available
in the press, some Internet search results and data contained in the Mary
Macdonald database.
Business/History
C2 operates in the semiconductor industry. They managed to develop two
break through networking chips as well as network management software that
drives the operations of the chips. They have solved a problem in the industry
that, according to one expert, “…a lot of people have been trying to solve.” Their
chips are now integrated with products in the consumer electronics market and
the network provider market. C2 has been in operation for four years and is
currently a private company.
The company had very good patent and IP protection. The VC
commented that the IP protection the company had was overkill and certainly
was not a requirement to invest. IP protection rarely is, and was certainly not
required for this company. According to our VC contact, this company could IPO
in 2006 or 2007 at the latest.
Management Team
Former employees of a leading high tech firm formed the company. The
company has good connections in the venture capital market as well as within
their own industry. The founding team is very strong, according to our VC
contact, but lacks financial experience. The VC team augments this very well
with their inclusion on the board and by providing periodic advice to company
management.
Funding
The deal under analysis for C2 is a third round VC financing deal. The
deal occurred three years after company inception. All of the original venture
capital companies that funded C2 in the first two rounds also participated in the
round three funding. The amount infused was roughly equal to the total amount
previously invested in C2 in the first two rounds.
The VC that spoke to the researchers regarding C2 was brought into the
over-subscribed third round for strategic reasons. The previous partners all had
“powder still in the keg,” but thought that the VC could add something extra to the
company. The terms and conditions of the round were laid out to our VC contact
in a take-it-or-leave-it fashion, and no new board seat was offered to our contact.
The investor-management relation was described as very amicable.
According to our contact, there have been no contentious issues raised at, or by,
the board. The board consists of three members. VCs hold two of the seats,
while C2 management appointed the third.
Although there have been no overt displays of power, two very key
management and board changes happened directly after the third round funding.
The change in management happened in the same week as the board change
and involved the CFO of the organization. The CFO was, according to our VC
contact, a ‘virtual CFO’, and needed to be replaced by someone permanent. This
was a condition of the financing. The new board member is a very well
connected industry representative, is the only independent on the board and has
had experience as a board member with one of the VCs portfolio companies.
Our VC contact had some interesting comments regarding restrictive
clauses in term sheets.
“There are no restrictive clauses in the deal. You have to be careful because there are usually other VCs involved in the same term sheet and the restrictions set can back-fire.”
Left Hand Side
The funding for this round was to “… allow the company to take its
technology to the next stage in preparation for releasing products next year.”
Directly after receipt of funding, C2 released a new wireless chip. The release of
funds was made contingent upon the completion and release of the wireless chip
that was under development.
Endeca
Data Collected
This case was developed using primarily the Harvard case data and the
summarized term sheet included in the cases, but also made use of articles in
the press, internet search results and firm and VC press releases.
Business/History
Endeca was founded in the summer of 1999, with headquarters in
Cambridge, MA. Their product is an information discovery tool that helps
companies solve their ‘information overload’ problems. The company has gone
through two prior funding rounds.
The first trial of the product was a success and the company managed to
demonstrate that it could be implemented without excessive customer
implementation costs. Subsequent to their initial success, they have implemented
their products at many large multinational corporations, including, Wal-Mart, IBM
and Bank of America.
At the time of the new deal, C3 required funds to continue their
‘aggressive product development, and to expand marketing and sales’ of its
product line.
The previous investors dominated the board. The investors controlled
three of the five board members while management controlled two. One of the
management controlled board seats was required to be occupied by an
independent board member presented by management and accepted by the
investors.
Management Team
The company was co-founded by Steve Papa, a respected and successful
Internet industry professional. Papa had worked for Inktomi, where he was
responsible for creating the information caching business which generated 60%
of their revenue. Papa holds an MBA from Harvard and was part of the original
Akamai business team, another successful Internet company. Steve also has
experience working as a VC for Venrock, and managed AT&T’s $500 million
high-end enterprise computing line. Endeca’s co-founder, David Gourley, is also
Endeca’s current CTO. Gourley was also part of the founding team at Inktomi
and helped to build their caching product. Gourley has a B.A. in Computer
Science from the University of California at Berkeley. The founding team of
Endeca was the strongest of all of the cases. They possess excellent industry,
financial and VC knowledge.
Funding
This Series C funding round took longer than anticipated. Two VC groups
were bidding for the term sheet. The term sheet that offered the highest pre-
money valuation was accepted, even though it was with a different group of
investors.
Left Hand Side
After the receipt of Series C funding, C3 opened its first international
office. The company also released a new version of their software within three
months of receipt of funding. Later in the following year, but less than one
calendar year later, the research and development department of C3 released
software that addressed an entirely new market.
EXP Systems
Data Collected
This case was developed using primarily the Harvard case data and the
summarized term sheet included in the cases, but also made use of articles in
the press, internet search results and firm and VC press releases.
Business/History
Founded in 1998 during the dot-com boom, the business model of EXP
Systems was based on a novel derivation of an existing Internet sales model.
The company offers online access to professionals for individuals seeking
advice. The company is located in Menlo Park, California, and is now defunct.
The company released the first beta version of their product in 1999. The
company was 50% owned by the investors, 26% by management and advisers.
The remaining 24% of equity was set-aside for employees, at the instruction of
the investors. The board consisted of five members; three were appointment by
the investors and two by management.
Management Team
The CEO of EXP Systems was a well-respected industry figure who had
had success in previous ventures. It was through that success that he was
introduced to the VCs that ultimately funded EXP Systems.
Funding
The initial round of funding was specifically to fund the development of the
prototype. The receipt of series B funding was made contingent upon meeting
the prototype release milestone.
Series B funding came from some new investors, including the corporate
venture capital arms in the high tech industry. The new VCs also had portfolio
company experience in the consumer market, which EXP Systems was targeting.
The funds were earmarked for operating expenses, to fund a product launch and
to support a major advertising campaign.
A subsequent funding round three years after company inception added
more corporate venture capital funding arms. Some of the new partners were
included for their financial strength while others were included for strategic
reasons.
Left Hand Side
Each of the funding rounds had an interesting interaction with the product,
market and partner selection. The first round of funding was directed at prototype
development. Receipt of the second round of funding seemed to be contingent
upon the successful release of the beta site, which occurred. The second round
funds were earmarked to fund a full product launch, which occurred within three
months, and for marketing and operating expenses.
The third round was the most interesting in terms of the partners EXP
Systems selected. Directly after receiving third round funding, EXP Systems
announced partnerships with the parent companies of the corporate VCs that
were involved in the deal.
Case 5 (C5)
Data Collected
Case 5 was developed with complete term sheet, articles in the press,
Internet search results, firm press releases and information contained in the
Canada VC database.
Business/History
This company, founded in 2001, is a specialized network infrastructure
provider. Its board consists of seven members, with four seats controlled by
investors. Two seats are held by the management team and there is one
independent board member.
Company 5 has gone through four financing rounds to date. The financing
deal in question is the third round, early stage funding.
The company has their product installed worldwide and continues to be
successful in their target market penetration.
Management Team
The co-founder, President and CEO is an industry expert with many years
of experience in the sector. The CTO, and co-founder, has over 20 years of
industry experience and designed C5’s initial product. The CFO has spent the
past several years of his career, prior to C5, with venture funded start-ups in the
National Capital Region.
Funding
The first two funding rounds were designed to bring C5’s product through
beta testing and customer trials, which occurred. This third round funding deal
was designed to ‘ramp-up’ production of its flagship product.
Left Hand Side
Less than three months after receiving the third round funds, the company
announced a large-scale customer trial of their products. Two months after the
trials, an announcement was made that the product was ‘generally available.’
One day prior to announcing a new financing deal with new strategic
investors, C5 announced the expansion of their product line. The strategic
investors announced that they were pleased with the milestones the company
had met and were also interested in integrating the product into their own
infrastructure.
Company 6 (C6)
Data Collected
This case was developed using information from an interview with the VC,
a founder interview, Internet search results, press releases and Canada VC deal
information.
Business Overview
Company 6’s business revolves around software solutions for network and
service providers. Company 6 has very good IP protection for their software. The
company managed to release the first version of their software, and have it
implemented, with a tier one service provider in the United States. The software
is slated for customer trials with two other tier one U.S. service providers. Our
founder contact indicated that the company is in very good shape. Company 6
has $5 million dollars in the bank from customers and intends to increase this to
$10 million by year-end. This is a tier one customer requirement in order to
ensure the continued viability of the companies they deal with.
Company 6 has undergone three rounds of funding. The initial lead
investor has participated in every round and led the round in question. The
company has five board seats, of which investors hold two, management holds
one and independent board members hold the remaining two seats.
Management Team
The founder of the company has many years of experience in the local
area. He has experience with other start-ups as well as experience with an
optical networking company. The CFO of the company has extensive experience
with venture-backed start-ups.
Funding
The initial funding rounds were relatively close together, indicating a
strong desire to stage investments with C6. The first funding round was
dispersed in two tranches each with distinct milestones. The first tranche was
released with the stipulation that management provide an “...acceptable business
and operating plan.” The second tranche was dependent upon successful
customer lab trials. An interesting point regarding this funding round is the
inclusion of a U.S. based VC, which caused some difficult company legal
manoeuvring in order to accommodate the new partner.
The second series, third round of funding, was made virtually condition
free, due to the success of the company and a good understanding between
investors and company regarding product and market direction.
Left Hand Side
Company 6 is very interesting in that it confirms some previous findings
about the success of a company influencing the terms and conditions, as well as
confirming findings about the stage of product development influencing terms
and conditions. The first two rounds were made contingent upon terms and
conditions that stipulated product and market goals, in the form of an ‘acceptable’
business plan. Acceptable was defined as in line with the strategies presented
and negotiated at prior investor/entrepreneur meetings and presentations. The
second tranche was dependent on market acceptance of the product in the form
of a successful customer trial. Successful was determined to be a commitment
from the customer to purchase the product.
Company 7 (C7)
Data Collected
Case 7 was developed with the help of a VC interview, a follow-up VC
interview, Internet search results, articles in the press, and firm and VC press
releases.
Business Overview
The company has developed a novel piece of integrated infrastructure
management software. The software offers a single point of contact for various
network service providers. The software also facilitates the delivery of mobile
content to a wide array of mobile devices.
The company was founded in 2001, and has received five injections of
capital since inception. The board consists of five members and is investor
dominated with four seats controlled by the investors and one seat controlled and
filled by management.
The company has successfully launched new versions of their product and
has recently won several industry awards. The company’s headquarters are in
Toronto and they have offices in London and a new office in Asia.
Management Team
The founder, and current president and CEO of company 7, has had
extensive experience in the U.S., Europe and Canada over his career. The CFO
of the company has worked for numerous venture and non-venture backed
companies both in Canada and the U.S.
Funding
The deals in questions are both the 4th and 5th rounds of funding. The 4th
round came early in 2004 and the most recent round came exactly 12 months
later. The deals were both dependent upon C7 attaining certain milestones in
market penetration and new product releases.
Left Hand Side
The new cash is to promote sales, operations and development of their
flagship product. Some of the new strategic investors stipulated that they would
invest on the condition that their flagship product would be ready for
implementation within a certain timeframe.
The second round of funding was disbursed on the condition that C7
execute their business plan and achieve their financial goals.
Company 8 (C8)
Data Collected
The final case was developed with a VC and founder interview, Internet
search results, firm and VC press releases and Canada VC database deal
information.
Business Overview
Established in 2002, Company 8 has set out to solve one of the most
vexing computing problems for users of large-scale computing. The goal is to
provide a scalable and robust environment to the industry.
To date, company 8 has undergone two rounds of venture financing. The
company has its headquarters in the National Capital Region. The board has
seven seats, four of which are VC controlled, while two are held by the founders.
An independent board member holds the final seat.
Management Team
The founder, and CEO of company 8, has an excellent record developing
systems for a well-known National Capital Area telecommunications supplier. He
has considerable experience developing products as well as businesses, and
has hands-on knowledge in various business areas. The co-founder of C8 has
almost 24 years of industry experience and has worked extensively with his
founding partner in a previous organization. The SVP of business development
was selected for his in-depth knowledge of the requirements of C8’s customers.
Funding
The first round of funding was to develop a prototype of the company’s
product. The same investors from the first round were involved in the second
round, and one additional investor was been added for strategic reasons. The
second round of funding came one year after C8’s first round, and three years
after company inception. The funds were to be used to complete development of
their breakthrough product.
Left Hand Side
The first round of funding was classified as onerous in terms of the
restrictions placed upon strategy. The first round contained stipulations on
spending limits, hiring and product development. The second round was
regarded as “generous” by our founder contact. The strategy proposed by the
company was in line with what the investors wanted. The terms and conditions
regarding product and market are almost non-existent. The investors wanted to
structure the round such that the company had enough latitude to pursue
opportunities wherever they presented themselves.
Confirming Findings
The results and findings from the case studies were further confirmed via
follow-up interviews and interviews with industry experts with insight into the
venture capital funding process. Specifically a VC industry consultant
experienced as a VC and a CFO with a venture capital backed firm and two
founders were interviewed post-case and pre-proposition development to confirm
findings, provide insight and validate the findings of the study. The industry
contacts confirmed the findings and provided examples of these findings in other
firms in the National Capital Region.
The founder of Company 6 provided an interesting confirmation in the
form of an example from another company in which he is an insider. The
company, after receiving an investment from a single investor (he called this
‘scared money’), required bridge financing. The terms and conditions of the
bridge financing were so onerous that they caused the company to fail. The
requirements were that the company produce three sales of their product to tier
two customers. The problem was that the product was geared towards tier one
customers. The company had to subsequently change their entire strategy and
ultimately failed because of the confusion caused in the market, and the lack of
suitability of the product to its new target market. This is interesting in that it
confirms the previous findings that the bargaining power of a firm can have a
substantial effect on the terms and conditions and how these affect strategy.
Section 5 – Analysis, Propositions and Model Development
This chapter is divided into two sections. The first section, stakeholder
analysis, is used to analyze the information contained in the eight case studies.
The stakeholder analysis highlights areas where stakes and power are in conflict
and where possible disconnect between the goals, power and stakes of specific
stakeholder groups exist. From the stakeholder analysis, cases and follow-up
interviews, several propositions have been developed. The model development
is found in section 2 of this chapter.
Stakeholder Analysis
The venture funding process is a competitive, free-market process that
includes and affects various stakeholders in competition for scarce financial
resources. There are varying degrees of power between numerous internal and
external stakeholders.
Stakeholders are defined as ‘those groups without whose support the
organization would cease to exist’ (Freeman 1984). The analysis was performed
according to Freeman’s model presented in his landmark book, Strategic
Management: A Stakeholder Approach (1984). The steps performed include:
i) Developing a stakeholder map
ii) Preparing a chart of stakeholders
iii) Identifying stakes of stakeholders
iv) Preparing a power versus stake grid
In order to identify the impact on a new venture that is attributable to
receipt and structure of venture capital financing, it is necessary to determine the
stakeholders, their stakes and their power. See figure 1 for stakeholder map.
Venture Capital Funding Deal
Entrepreneur
Venture Capitalist Employees
Other Investors/Creditors
Board MembersSuppliers
CustomersSubsequent Providers of
Capital
Figure 2 - Stakeholder Map
The stakeholders identified are identical to those venture capital
stakeholders listed in Muegge (2004). While not comprehensive, these
stakeholders represent those relevant in the context of this study. Subsequently,
each of these relationships was articulated in a stakeholder chart of specific
venture capital deal stakeholders. See table 4 for a list of the specific
stakeholders.
Table 4 - Specific Stakeholders Venture Capitalist Entrepreneur Partner Founder/Co-founder Investment Analyst Fund Investors Board Members Current Employees Past Management Operational Suppliers Current Other Investors/Creditors Potential Angels Previous VC Customers Friends and Family Existing Banks Prospective Other Creditors
The above stakeholders represent the specific and relevant actors
included in each group. Other specific actors may exist depending on the
Venture Capital Deal. Such specific stakeholders were explicitly present in at
least one of the venture capital deals under analysis.
The stakes, defined as ‘an interest for which a normative claim can be
advanced’ (Reed 1999), are listed for each stakeholder in table 5.
Table 5 - Stakeholder Grid for Selected Stakeholders Stakeholder Grid for selected stakeholders
Stakeholder Group Venture Capital Firm (VCF) Employees
Stakeholder Partner Management
Stakes Value of investment/equity held, reputation, employment
Reputation, monetary reward, employment
Stakeholder Fund Investors Operational
Stakes Value of fund Employment, monetary reward
Stakeholder Group Suppliers Customers
Stakeholder Current Existing
Stakes Payment, continued business Product support, warranty, upgrades, continued usage
Stakeholder Potential Prospective
Stakes Future business, terms and conditions Terms and conditions, availability
Stakeholder Group Other Investors/Creditors Other Investors/Creditors
Stakeholder Angels Banks
Stakes Value of equity held Loan
Stakeholder Other equity investors Other Creditors
Stakes Value of equity held Loan
Stakeholder Friends and Family
Stakes Value of equity held
Stakeholder Group Entrepreneur Board
Stakeholder Founder/Co-founder Current Members
Stakes Employment, monetary reward, value of equity, reputation Reputation, compensation
Stakeholder Former
Stakes Reputation
The value in understanding the stakes by stakeholders is found by
articulating the stakes held by each stakeholder for which we can surmise, or at
least begin to understand, the motive thereof.
The power vs. stake grid below plots stakeholder power (formal, economic
or other) against their respective stakes (power, economic or other). Formal
power is defined as power supported by contract. Relevant contracts include
shareholder agreements, term sheets and other contracts. Economic power is
defined as the power to withhold or provide something of economic value to the
organisation. Economic power could be the power to provide new capital, the
power to provide specialized skills or to withhold payment. Other power
encapsulates power that is neither formal nor directly economic, such as the
power to advise or promote a new venture. The power versus stakes table 6 is
presented below.
Table 6 - Power versus Stakes Power versus Stake grid
Power
Stake
Formal (contract, shareholders agreement,
term sheet) Economic Other
Equity
VCF, other equity investors (angels, friends and family),
entrepreneurs, management, current board
members VCF, other equity investors Operational employees
Economic Bank, other creditors,
current board members Existing customers, bank,
other creditors Suppliers, operational
employees Other Current board members Prospective customers Former board members
Much research has been directed at understanding the venture capital
funding process (Gompers and Lerner 2001) but very little has been directed
towards understanding how VC financing terms and conditions affect the strategy
of a firm.
Proposition Development
The purpose of this study is to identify potential influences that the terms
and conditions of venture capital financing deals have upon the strategy a firm
employs. Three general areas of influence were identified:
1.) People
2.) Finance
3.) Business
People
The first area of influence, people, is comprised of:
1.) Employees
2.) Management
3.) Board Members
Specifically, the ability to attract, retain and motivate these groups of
people is critical to the success of a firm. The cases developed above
demonstrated that this area can be affected by the terms and conditions of
venture capital financing.
The affect of venture capital financing on the ‘people’ strategy of a firm
has been well documented and studied. Byers (1997), Bygrave and Timmons,
(1992), Gorman and Sahlman (1989) and Hellman (1998) all detail how venture
capitalists help to attract key personnel. Two of the cases described how the VCs
imposed an equity compensation scheme for employees through Employee
Stock Option Programs (ESOP). Bygrave and Timmons noted that ESOPs are
used extensively by VCs in their portfolio companies (1992).
Venture capitalists often exert control over management composition. The
cases developed in this study demonstrated several examples of this VC role in
appointing members of the management team. In Case 1, the entire
management team was replaced. In several other cases, key chief level
(although not CEO level) positions were driven by VC demands. Hellman (1998)
found that VCs typically play a large role in corporate governance, often
replacing the CEO. Gorman and Sahlman (1989) found that VCs typically use
board control to replace CEOs. In only one of the cases developed here (C1)
was the CEO replaced. This represents somewhat of an anomaly when
compared to the literature.
The role of VCs on the boards is well researched in the literature. Clark
(1987), Fenn, Liang and Prowse (1995), Fried and Hisrich (1995), Gompers
(1995), Lerner (1995), and Sahlman (1991) all confirmed the findings regarding
board composition and role found in the cases developed herein. Specifically, the
fact that VCs effectively dictated board composition and that VCs used their
control of the board to control a firm was demonstrated.
Finance
The cases demonstrated two specific effects in the area of finance. The
first was the increase in financial oversight and reporting a VC requires and,
therefore, imposes. The second was the VC role in raising new funds. The
affects venture capitalists have upon the financial strategy of a firm are well
understood. Gorman and Sahlman (1989) found that after making the initial
investment, VCs tend to be very active in raising additional funds. Little research
exists regarding the imposition of financial reporting and oversight required by
VCs, and there is little evidence in the cases that the affects in this area were
great.
Business
The following two categories were developed from evidence of affects
found in the cases.
1.) Product Strategy
2.) Market Strategy
These two categories are further expanded below. Following the
description of these categories, propositions are developed regarding the affect
of the terms and conditions of venture capital financing upon the two strategies.
Product Strategy
Comparison to Literature
The product strategy of a firm includes the release of the product, the
decision to develop new products, revenue from new products and the feature
set of a product. Other product related strategies include time to market, generic
versus specific strategies, whether to develop modular or integrating products
and whether or not to develop and release derivative products. The literature
surrounding the role of venture capital in the product strategies of a firm is
sparse. Hellman and Puri (2000) published a paper outlining the effects of
product market and the financing of a firm. The article specifically found that the
receipt of venture capital funds is correlated with a significant reduction in time to
market. What the article does not do is outline the circumstances under which
this is true and what other affects the receipt of VC funding may have on product
strategies.
Effects observed
Product strategy effects and potential effects were observed in several
cases. The most common affect was upon the timing of release of certain
products. Specifically, it was found that products in prototype, beta or release 1.0
stages had to be released and tested before the next round of funding would be
released. Other effects observed included the creation of derivative products for
application in related markets. The features of a product were stipulated in
several cases; in one case, a strategic investor made the stipulation that the
product had to include features that were specific to the parent company of the
corporate VC arm.
Market Strategy
Comparison to Literature
The market strategy of a firm includes the product mix in a market, target
markets, revenue, customers, sales leads, implementations at key customers,
number of customers in a certain tier, revenue from a target market and market
penetration. Other more generic market strategies revolve around market
leadership and market penetration and product releases in new markets. Studies
have been conducted (Jaworski & Kohli, 1993; Slater & Narver, 1994) relating
market orientation and firm performance, but very few studies exist that detail the
affects of venture capital on a firm’s market orientation.
Effects observed
The most common stipulations and effects seen were in the area of
market strategies. Industry experts further confirmed this as common in venture
capital deals. Effects observed included number of reference customers from
certain vertical markets, the amount of revenue generated from specific markets,
tier one customers, release of products in new markets and acceptance of
product standards in a new market.
Circumstances
The circumstances of a deal have a direct affect on the terms and
conditions of venture capital financing. The following categories of circumstances
were identified:
1.) Bargaining Power
2.) Stage of Product Development
3.) Market Orientation
4.) Investor Alignment and Orientation
All of these circumstances affected the types and nature of the terms of
conditions as well as their restrictiveness.
Bargaining Power
Bargaining power can be distilled into the weak and strong extremes on a
continuum. Bargaining power is determined by several factors, according to the
VCs, entrepreneurs and industry experts consulted. The factors observed were:
1.) Supply
2.) Demand
3.) Quality
The supply describes the amount of VC money available to be invested.
Demand describes the number of firms seeking funding at a given time. The
quality of a firm is determined by the strength of a management team, the track
record of a firm, as determined by their ability to meet previous milestones, the
quality of a product or idea and the size of the potential market.
Product
The stage of product development directly affected the type and nature of
terms and conditions. A firm with a product in prototype development stage will
have different terms and conditions than one that has product ready for release
1.0.
Market
The market orientation of a firm will also have an affect on the terms and
conditions, and therefore the strategies, of a firm. A firm that is targeting a new
market will have different circumstances, and therefore terms and conditions,
when compared to firms targeting existing markets.
Investor Alignment and Orientation
The alignment of investors, both within their ranks and with the
entrepreneurs, was seen to be important in the cases. A firm that has a split
investor base will find its terms and conditions to be more onerous. Similarly, a
firm whose goals are not aligned with those of the investors will also find that the
terms and conditions of financing are more onerous.
The researcher identified all of these as circumstances that may have an
affect on a deal. They are presented in a model below.
Model Development
The following figure 2 depicts the relationships between the terms and
conditions of a specific venture capital financing deal and the strategy affects of
the deal.
Figure 3 - Relationships Between the Terms and Conditions
The model depicts the venture capital financing deal as the central
component. The venture capital financing deal is affected by the relative
bargaining power of the firm. A firm in a strong position to bargain will be able to
negotiate less onerous or restrictive terms and conditions; this will likely reduce
the strategic effects of the deal.
The market orientation affects the deal in that firms pursuing new markets
will have different contract stipulations than would firms targeting existing
markets. Similarly, deals exhibiting disruptive characteristics as opposed to
sustaining characteristics will be structured differently; this also affects the
strategy effects of the deal. Investor alignment is important in that it will affect
how the investors view the deal and hence structure it. The product development
stage is important in that products in different stages of development have
different funding requirements and the stipulations should reflect the reality of the
product development cycle. All of these factors affect the deal, which
subsequently affects the product and market strategies of a firm, which ultimately
affects the full strategy of a firm.
The manner in which investors stipulate the terms and conditions of deals
is detailed below.
Stipulation of Terms and Conditions
The terms and conditions of receiving venture capital are typically
stipulated in the form of a term sheet. A term sheet is essentially an offer to
purchase equity in a venture under certain terms and conditions. An accepted
term sheet has the same legal status of any other form of written contract. A
venture can accept extremely onerous terms and conditions or it can negotiate
terms and conditions that are more favourable. Appendix A shows a sample term
sheet.
The following list outlines several ways in which venture capital firms
stipulate the terms and conditions of a deal. Any one of these can be used to
influence the strategic decisions of a firm. An example of each will be presented
below from the cases developed previously. The examples of terms and
conditions provided below are not from the cases developed above, however
they are similar enough to represent the types of terms and conditions found in
the eight cases.
i) Security design
ii) Staging of investments
iii) Shareholder agreements
iv) Equity allotment
v) Board rights
vi) Liquidation rights
vii) Sale of share restrictions
viii) Stock option pools, warrants
ix) Employment contracts
Security Design
Several types of securities can be used in a venture capital deal. Preferred
shares are the most common type of security used (Kaplan and Stromberg 2003)
A preferred share is a share that can have many assigned restrictions and rights.
The conversion of the shares can be made contingent upon liquidation events
(described below), revenue milestones or other events.
The example used is from Company 2 and the security used is a
convertible preferred share. The preferred shares have different conversion
factors depending upon the attainment of certain revenue goals. If C2 meet its
revenue goals, the conversion factor is lower -- that is, the VC receives less
common shares for each preferred share. Conversely, if C2 meets its revenue
goal, the VC will receive more common share for each preferred share held.
According to industry sources, this is a common practice but is not
universal. This phenomenon was observed in only two of the cases under
analysis.
Staging of Investments
The most common manner identified in which a VC attempts to influence a
firm is through the staging of investments. Staging, in the form of funding rounds,
was found in all of the previously developed cases. Other industry contacts
confirmed that the release of subsequent funds was almost universally
contingent upon meeting certain milestones. Cornelli and Yosha (2003)
Gompers (1995) and Repullo and Suarez 1999 confirm this in the literature).
Company 6 provides an example of this. C6 received three injections of
capital in 10 months; each investment was exactly five months apart. At each
funding round, only enough funds were dispersed to reach the goals set in the
business during the next five months. If the goals were met, the next injection
would occur. The company attained the goals set out in its business plan.
Shareholder agreements
Shareholder agreements are made between the holders of equity in a firm
and the firm itself. Often conditions that are not present in a term sheet are
included in such agreements. Usually the restrictions and rights set forth in a
shareholder agreement revolve primarily around the transfer of shares and voting
rights. There can, however, be other factors.
Company five had a good example of the term sheet referring to the
contents of a shareholders agreement. In this case, the shareholder agreement
was not seen and was not a factor in our study. See Chemla, Habib, M.
Ljungqvist (2003) for an excellent analysis of shareholder agreements and the
clauses contained therein.
Equity allotment
Venture Capital firms can also influence firms via an equity allotment. The
equity allotment is simply another way to align VC goals with incentives for the
entrepreneurs. The equity allotment functions in much the same way as does the
security design. The equity allotment is made dependent upon a firm meeting
certain milestones. If the milestones or stipulations are met, then the equity
allotment is more favourable for the entrepreneurs. If they are not met, it is more
favourable for the VC. This is essentially the same as free call options for the VC
in the case that the company is not as successful as originally planned. This
reduces VC risk and increases entrepreneur incentives.
They was no specific case where this occurred, however the post-case
interview subjects indicated that this is a quite common practice, and provided
examples of this happening in the industry.
Board rights
The relevancy of board rights are that in the case where investors, VCs,
angels, or others control the board, conditions can be placed upon financing and
restrictions from receiving further financing can be made contingent upon
executing a business plan or achieving milestones. Although the terms and
conditions are stipulated in advance they can be altered, added and enforced
through the board.
Every case under analysis had a board of directors where the investors
controlled the majority of seats; in every case except one, the investors were
VCs. The other seat was for an angel investor.
Liquidation rights
The liquidation rights are the rights that holders of certain groups of
securities have upon a liquidation event. The typical term sheet definition of a
liquidation event is as follows:
“A merger, acquisition, sale of voting control or sale of substantially all of
the assets of the Company in which the shareholders of the Company do
not own a majority of the outstanding shares of the surviving corporation
shall be deemed to be a liquidation.” 2
In the event of liquidation, several terms and conditions can be stipulated
in the term sheet that have an affect on the product, market and R&D strategies
of a firm. The following is a sample liquidation preference term:
“Liquidation Preference: In the event of any liquidation or winding up of the
Company, the holders of the Series A Preferred shall be entitled to receive
in preference to the holders of the Common Stock a per share amount
equal to [x] the Original Purchase Price plus any declared but unpaid
dividends (the Liquidation Preference).”3
2������������� ������������������������������� 3 Source: http://www.feld.com/blog/archives/term_sheet/
The term sheets collected for cases all contained liquidation rights,
however none seem to have affected the firm strategy.
Sale of share restrictions
Another way in which VCs influence strategy is via the use of sale of share
restrictions. These restrictions usually apply to the sale of shares by the firm’s
founders or entrepreneurs. This clause essentially locks the founders into the
firm by tying their personal wealth to staying with the company.
This is a very common stipulation and was seen in each of the three term
sheets used to develop cases, as well as in one sample term sheet.
Stock option pools, warrants
Stock option pools and warrants are securities that, given certain criteria,
can be converted into common shares in a firm. The size of a pool, and the
numbers of warrants, are usually made contingent upon the company achieving
certain goals.
Company 6 used founder’s options to provide incentives to the founders to
adhere to the content of a business plan and presentation made to the investors.
The option pool would increase depending on the number of goals met and the
timing of achieving those goals.
Employment Contracts
The founders of a venture are usually required to negotiate employment
contracts, either before (if they are smart) or after the acceptance of a term. The
employment contracts stipulate what happens in the event of a termination, what
constitutes grounds for termination and, finally, what compensation is paid in the
event of termination. The incentives for founders are therefore tied directly to the
terms and conditions of their employment contract.
Proposition Development
This section develops 9 propositions from the cases developed in the
previous sections. No propositions have been developed for People and Finance
strategies as there was only one minor anomaly found in these areas and the
areas themselves have been well researched. Propositions have been developed
around:
1.) Product Strategies; and
2.) Market Strategies.
The propositions presented here relate to observations made in the cases
regarding effects and the circumstances surrounding a deal. The propositions
have been confirmed as likely to occur through using cross-case analysis and
post-case development interviews.
General Propositions
One general proposition affects neither product nor market strategy
directly. The proposition relates to the existence of milestones, budgets and other
stipulations included in venture capital contracts and forms the basis for the
subsequent propositions. Every case demonstrated that the greater the number
of stipulations in the financing deal, the less flexibility management had in the
operations of the firm. Both Harvard cases specified that a deal was structured
with fewer stipulations in order to increase the likelihood of firm success. Our VC
contact on several of the other deals noted that they (the VC) prefer to structure
deals where the firm has the latitude to make decisions without having to consult
legal documents on a daily basis. Only as deals become less likely to succeed do
VCs prefer to include more stipulations in a deal. The following proposition was
developed from this observation.
Proposition 0: Ceteris Paribus – The greater the number of stipulations in
the terms and conditions of a venture capital financing deal, the lesser the
degree of firm decision making latitude and therefore the greater the strategy
effects of those stipulations.
Product Strategy Propositions
The following proposition stems from the observation that the terms and
conditions of certain deals were significantly different in their effects, both
potential and observed, upon strategy given the stage of product development a
firm’s product is in. A firm with a product in the prototype development stage was
observed to have very onerous and restrictive terms and conditions stipulated in
the deal. These conditions stipulated exactly what funds were to be used for, how
much could be used and technical requirements a product was required to meet.
In the same case in the second funding round, after having completed prototype
development, the terms and conditions were different and considerably less
onerous. Only the time frame for beta release was stipulated. The following
proposition is the result of these observations:
Proposition 1: Ceteris Paribus - The product development stage of a firm’s
product affect the terms and conditions of a financing deal and the resulting
product strategies driven by them.
The next proposition revolves around the alignment of investor and
entrepreneur goals. Regardless of the past and current success of a firm, the
alignment of investor goals with entrepreneur goals has an affect on the
development of a product. In one of the cases developed herein, an obvious
misalignment of goals was observed. As a result, the investors wished to have a
product line discontinued whereas the entrepreneurs wished to continue
development. The ultimate result was bankruptcy. The following proposition is
based upon these observations:
Proposition 2: Ceteris Paribus – The alignment of investor and
entrepreneur goals reduces the product restrictions in the terms and conditions of
financing.
The implication is that if investors are not aligned, terms and stipulations
will be required in order to cover eventual splits in the investor base. The result of
this is likely a reduction in firm flexibility.
Market Strategy Proposition
The effects of the terms and conditions of financing were more
pronounced for market strategy than they were for product strategy. The
following proposition relates to bargaining power and its affects on market
strategy.
A firm with good bargaining power, Company 6, demonstrated that by
meeting previous milestones and by strengthening their management team, they
could significantly limit the affect of financing terms and conditions on market
strategy. Company 6 was able to negotiate much less onerous terms and
conditions and thereby limit the effects on the company’s market flexibility. Firms
with less bargaining power, like Company 1, had much more onerous market
restrictions than did other companies. The following proposition was developed
based upon this observation:
Proposition 3: Ceteris Paribus – The degree of bargaining power a firm
possesses determines the restrictiveness of market terms and conditions and
therefore their effects.
A company that is targeting a new market, like EXP Systems, will have
different terms and conditions than a company seeking to enter an existing
market with an incumbent, like Company 8. Specifically, the terms and conditions
observed at C8 were directed at getting enough reference customers to talk to
the investors about the product. The requirements for EXP Systems were related
to technical quality and were unrelated to the market. The following proposition
was developed based upon these observations:
Proposition 4: Ceteris Paribus – The characteristics of the market targeted
by a firm will determine the types of terms and conditions and their affect on the
market strategies of a firm.
A more precise proposition, based upon the above proposition, is that
market characteristics will determine investment terms and conditions; this
relates to the two market extremes. The concept of sustaining versus disruptive
innovations, is presented in The Innovator’s Solution (Christensen, 2003), where
sustaining innovations target existing markets and disruptive innovations target
new markets. The following proposition was developed based upon the
sustaining versus disruptive innovations, or products:
Proposition 4a: Ceteris Paribus – Firms with sustaining innovations will
have more restrictive market related terms and conditions in their deal than will
firms with a disruptive innovation.
This phenomenon was observed in comparing Company 6 with Company
2. Company 6’s product could be classified as a sustaining innovation. The
investors required that C6 prove that they could penetrate an existing market with
their product. C2, with a disruptive innovation, were required by investors to
prove the technology, but no market related restrictions were made.
The following propositions relates to investor type. Strategic investors, or
the venture capital arms of corporations, have different goals for their portfolio
companies than do typical venture capitalists. Company 8 provides an example
where one of the investors attempts to push the development of a market in the
direction of the parent company’s target market. This meant that both the
investors, between themselves, and management, were not aligned in their
goals. The result was very restrictive terms and conditions of financing for
Company 8. This proposition also relates to the type of investor investing in a
firm, as well as investor homogeneity. The following proposition was developed
based on these observations:
Proposition 5: Ceteris Paribus – The more homogenous and aligned an
investor base is, the less restrictive the market related terms and conditions of
financing.
This proposition can be separated into two more specific propositions. The
more homogenous the investor base in terms of market orientation and
specialization and in terms of investor type i.e. corporate versus institutional, the
less likely was a split in the base that required additional deal terms and
conditions to control for the split. The following proposition was developed to
capture this observation.
Proposition 5a: Ceteris Paribus – The more homogenous an investor
base, the less restrictive the market related terms and conditions of financing to
control for investor split.
The second proposition is built upon the previous observation but
introduces the idea of investor/entrepreneur alignment. The case demonstrated
that if the investor base was homogeneous in goals and type, their was little
chance for a split in their ranks. This affected the alignment with the
entrepreneurs as well. An unaligned investor base also caused a misalignment
with the entrepreneurs.
Proposition 5b: Ceteris Paribus – The more aligned the investors are with
the entrepreneurs, the less likely are onerous and numerous market related
terms and conditions.
The preceding propositions and model represent the end product of this
research project. The propositions are meant to provide the basis for more
extensive research into the phenomena discussed here in future studies.
Section 6 – Analysis, Propositions and Model Development
Key Findings and Contributions
This study identified several issues not previously researched in the field
of venture capital investing. The affects of the terms and conditions on product
and market strategies have been identified. Specifically, the affects of deal terms
and conditions on product development, market goals and company product and
market milestones have been identified. The circumstances that can occur and
how they influence a deal have been identified as well. Issues surrounding
product development stage, market type, investor entrepreneur alignment and
bargaining power and their effects upon a venture capital financing deal have
been identified. Specific terms and conditions found in venture capital financing
deals have been identified and their use analyzed is the cases developed. The
study may not have proven that an effect exists, but it does highlight areas of
probable influence and areas for fruitful future research, as outlined below.
Limitations and Future Steps
This study is limited in several ways. The most obvious limitation of this
study is the lack of investor and entrepreneur involvement in each case. Only two
of the cases were developed with the benefit of the involvement of both. By
involving both parties, a more accurate picture could be developed regarding the
phenomena observed here. Another limitation is the lack of term sheet,
shareholder agreements and business plans available to the researcher to
corroborate investor and entrepreneur depictions of events. Another limitation is
the heterogeneity of participant industry and geography. The issue lies in that not
enough heterogeneity exists to make the result generalisable, nor is their enough
industry and region concentration to make generalisations in either of those
areas.
The study does provide a very good basis for future work in this area.
Fruitful areas of inquiry have been identified. The potential pitfalls have also been
identified. Interesting next steps include undertaking a research project with the
intention of researching the previously less-researched phenomena identified
above. The time should be taken to select participant where both the investors
and entrepreneurs are willing and able to talk about the deal and where relevant
legal documentation is being provided. This study outlines the relevant
documents and clauses that can be used to determine the actual terms and
conditions of a venture capital financing deal. This is important given that venture
capital deals often have different legal documentation and the terms and
conditions may be in different documents depending on the deal under analysis.
The most important contribution of the study is to confirm this area of research as
a potential fruitful and viable avenue to pursue for future researchers.
References Brown, S.L., & Eisenhardt, K.L., (1995). Product development: past research,
present findings, and future directions. The Academy of Management Review 20 (2), 343–379.
Byers, B., (1997). Relationship between Venture Capitalist and Entrepreneur.
Pratt’s Guide to Venture Capital Sources, Venture Economics, Wellesly Hills, MA, 1997.
Bygrave, W. & Timmons, J., (1992). Venture Capital at the Crossroads, Harvard
Business School Press. Chemla, G., Habib, M. & Ljungqvist, A., (2003). An Analysis of Shareholder
Agreements. UBC Working Paper. Retrieved June 14 2004, from http://www.haas.berkeley.edu/finance/Shareholderagreements1.pdf
Christensen, C. M. & Carlile, P., (2005). The Cycles of Theory Building in
Management Research. Working Paper. Christensen, C. M., & Raynor, M. E., (2003). The Innovator’s Solution. Harvard
Business School Press: Boston. Retrieved June 15, 2005, from http://www.innosight.com/documents/Theory%20Building.pdf
Clark, R., (1987). Venture Capital in Britain, America and Japan. Croom Helm,
London and Sydney. Cornelli, F., and Oved, Y., (2003). Stage Financing and the role of convertible
debt. Review of Economic Studies, 70, 1-32. Eisenhardt, K. M., (1989). Building theories from case study research. Academy
of Management Review, 14 (4), 532-550. Fenn, G., Liang N., & Prowse, S. (1995) The Economics of Private Equity
Markets," Staff Study #168, Board of Governors of the Federal Reserve System.
Freeman, R. E., (1984). Strategic Management: A Stakeholder Approach.
Pitman, Boston. Fried, V., & Hisrich, R., (1995). The Venture Capitalist: A Relationship Investor.
California Management Review, vol. 37, pp. 101-113. Gompers, P., & Lerner, J., (2001). The Venture Capital Revolution. Journal of
Economics Perspectives, Vol. 15 No. 2. p.145-168.
Gompers, P., (1995). Optimal Investment, Monitoring, and the Staging of Venture Capital. Journal of Finance, vol. 50 , pp. 1461-1489.
Gorman, M. & Sahlman, W., (1989) What do venture capitalist do? Journal of
Business Venturing, vol. 4, pp. 231-248. Hellman, T., (1998). The allocation of control rights in venture capital contracts.
Rand Journal of Economics, vol. 29, no. 1, p 57-76. Hellman, T., & Puri, M., (2000). The Interaction Between Product Market and
Financial Strategy: The Role of Venture Capital. Review of Financial Studies, vol. 13, no. 4, pp. 959–84.
Jaworski, B. J., & Kohli, A. K., (1996). Market Orientation: Review, refinement,
and roadmap. Journal of Market Focused Management, vol. 1, 119-35. Kaplan, S., & Strömberg, P., (2003). Financial Contracting Theory Meets the
Real World: An Empirical Analysis of Venture Capital Contracts. Review of Economic Studies, vol. 70, pp. 281-316.
Lerner, J., (1995). Venture Capital and the Oversight of Private Firms. Journal of
Finance, vol. 50, pp. 301-318 Miles, M. B., & Huberman, A. M., 1994. Qualitative Data Analysis 2nd edition.
Sage Publications, Thousand Oaks, CA. Repullo, R., & Suarez, J., (1999). Venture capital finance: A security design
approach, CEPR Discussion Paper No. 2097. Sahlman, W., (1991). Insights from the American Venture Capital Organization.
Working Paper 92-047, Harvard Business School, 1991. Slater, S. F., & Narver, J. C., (1994) Market Orientation, Customer Value, and
Superior Performance. Business Horizons, vol. 37, pp. 22-28. Yin, R., (1989). Case Study Research: Design and Methods. Sage, Newbury
Park, CA.
Company Websites http://www.endeca.com
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Research Websites http://www.canadavc.com http://www.convergedigest.com http://www.factiva.com http://www.google.com
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Appendix A – Sample Term Sheet Source (www.drm.com/newstand/presentations/VC.Model_TS.pdf)
[Company Name]
Series A Convertible Preferred Stock Summary of Terms and Conditions
_________, 2000 Amount of Investment: $_________ (subject to the Company obtaining commitments from additional Purchasers which commitments will be for a minimum of $_________) Purchasers: VC Capital, LC (“VC”) and other investors acceptable to VC Company: [Company Name], a [Delaware] corporation Security: Series A Convertible Preferred Stock (the “Series A”) Purchase Price: To be determined. The share price will be set at a level that results from a preinvestment valuation for the Company of $___ million and will take into account the option pool and all common stock and securities convertible into common stock on a fully diluted, common stock equivalent basis). Closing: The closing of the Purchaser’s purchase of the Series A stock (the “Closing”) is expected to occur on or about __________, 2001. The Closing will be contingent upon the satisfactory completion of due diligence and completion of documentation acceptable to VC and the Company. Pre-Closing The capital structure of the Company immediately prior to the Closing shall Capital Structure: consist solely of Common Stock. Option Pool Provision: As of the Closing, an allocation of Common Stock will be made to an option pool for the purpose of attracting a senior executive and other personnel which allocation will be equal to ___% of the fully diluted Common Stock (after giving effect to the issuance and conversion of the Series A). Post Closing Capitalization: Class Number of Shares Percent
Common Stock/Founders ______________ __%
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Series A Convertible ______________ __% Preferred Stock
Option Pool ______________ __% (Common Stock)
Total ______________ 100% Principal Terms of Series A: Dividend Rights: When and if dividends are declared by the board of directors of the Company (“Board”), the holders of the Series A shall be entitled to receive noncumulative dividends in preference to the holders of Common Stock of the Company of 8% per share per annum. Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A shall be entitled to receive in full, prior to any other distribution made to any other class of the Company’s capital stock, cash consideration in an amount per share equal to the per share purchase price for the Series A (as adjusted for any stock dividends, combinations or splits with respect to such shares), plus all amounts of accrued but unpaid dividends thereon (the “Series A Preference Amount”). After the Series A Preference Amount has been paid in full, any remaining funds and assets of the Company legally available for distribution to shareholders will be distributed among the holders of the Series A and the holders of Common Stock on an as-converted basis until the holders of the Series A have received liquidating distributions equal to an additional two times the amount of their investment in the Series A. Any remaining amounts available will be distributed to the holders of Common Stock. A merger or consolidation of the Company in which its shareholders do not retain a majority of the voting power in the surviving corporation (other than a merger with a publicly traded company in which the shareholders of the Company receive stock of the surviving company which is publicly traded at the time of such merger), or a sale of all or substantially all of the Company’s assets, will each be deemed to be a liquidation, dissolution or winding up of the Company for purposes of the liquidation preference. Conversion Rights/Rate: The holders of the Series A shall have the right to convert the Series A into shares of Common Stock at any time. The initial “Conversion Rate” for the Series A shall be 1-for-1. All rights incident to a share of Series A will terminate automatically upon any conversion of such shares into Common Stock. The Conversion Rate will be subject to appropriate adjustment upon any stock split, reverse stock split or stock dividend or similar transaction. Automatic Conversion: All shares of Series A shall automatically be converted into Common Stock, at the then applicable Conversion Rate in the event of (a) the closing of an underwritten public offering of shares of Common Stock at an aggregate offering price of not less than $15,000,000 and a price per share of not less than three times the purchase price per share of the Series A (appropriately adjusted for stock-splits, reverse stock-splits, stock dividends and similar events), or (b) the election of at least a majority of the then outstanding Series A, voting together as a single class. Anti-dilution Provisions: The Company will provide (a) proportional adjustments to the Conversion Rate for the Series A for stock splits, dividends, recapitalizations and similar
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transactions, and (b) a broad based weighted average adjustment to the Conversion Rate for issuance of all securities below the then effective Conversion Price (determined by dividing the Purchase Price by the then-effective Conversion Rate). No adjustments shall occur upon the issuance of shares of Common Stock upon the exercise of employee stock options provided that the exercise price of such options are at or above the fair market value of such securities at the time of issuance as determined by the Board. Further, there shall be no anti-dilution adjustment with respect to Common Stock issued by the Company in connection with bank loans and similar transactions if such issuance is authorized by the Board. Voting Rights: Holders of Series A will be entitled to vote on all matters submitted to shareholders for a vote or consent. The shares of the Series A will have voting rights equal to the shares of Common Stock on an as-converted basis. Except when a separate class vote is required, the Series A will vote with the Common Stock as a single class. Registration Rights: Registration Rights. The holders of Series A will have (a) unlimited S-3 registration rights (subject to minimum offering amount of $1,000,000), (b) unlimited “piggyback” registration rights, and (c) one annual demand registration at the Company’s expense to a maximum of two demands; provided, however that such demand rights shall not be exercisable until the earlier of the second anniversary of the Closing and 6 months following the Company’s initial public offering, and, provided further, that such demand registration cannot involve the initial public offering unless such offering meets the standards for Automatic Conversion as set forth above. Registration rights shall be allocated among all holders of registration rights on a pro rata basis, subject to a minimum cut-back agreed upon by the parties. Preemptive Rights: Holders of Series A will have rights to purchase its pro-rata portion of any new securities issued by the Company in future financings (subject to standard exceptions) on the same terms and conditions as in such financing. Stock Purchase Agreement: The purchase of Series A shall be made pursuant to a Stock Purchase Agreement reasonably acceptable to the Company and the Purchaser and containing representations and warranties typical of transactions of this type. Investors Rights Agreement: An Investors Rights Agreement shall be entered into among the purchasers of the Series A and the Company covering registration rights, preemptive rights and other matters of corporate governance. Shareholders Agreement: A Shareholders Agreement shall be entered into among the purchasers of the Series A and shareholders who now or in the future holds 5% or more of the voting securities of
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the Company granting the holders of Series A co-sale rights and a right of first refusal, subject to standard exceptions. Protective Provisions: The Amended Certificate of Incorporation shall provide that, without the approval of the holders of at least a majority of the Series A voting as a separate class, the Company will not:
(i) disburse funds in excess of $250,000 outside of the ordinary course of the Company’s business;
(ii) select a Chief Executive Officer, President and Chief Financial Officer; (iii) merge with or acquire another company, liquidate or dissolve of the Company
or sell all or substantially all of the assets of the Company, including any material license granting others exclusive rights to intellectual property of the Company;
(iv) engage in any business that is substantially different than that engaged in on the closing date of the purchase of the Series A;
(v) increase or decrease the authorized number of members constituting the Board;
(vi) become obligated under any loan or guaranty of indebtedness in excess of $1,000,000;
(vii) repurchase or redeem any securities, except for repurchase under stock option or restricted stock agreements with employees previously approved by the Board;
(viii) sell any subsidiary or shares held in any subsidiary; (ix) declare or pay any dividend on the Common Stock; (x) amend or change the rights preference, privileges or powers of, or the
restrictions provided for the benefit of, the Series A; (xi) take any action that authorizes, creates or issues shares of any class of stock
having preferences senior to or on parity with the Series A;
(xii) take any action that reclassifies any outstanding shares into shares having preferences or priority as to dividends or assets senior to or on parity with the preferences of the Series A; and
(xiii) amend the Company’s Certificate of Incorporation or Bylaws in any manner that materially and adversely affects the rights of the Series A.
Financial Statements: The Company will prepare and submit to the holders of Series A whose stock represents 5% or more of the outstanding voting securities of the Company (on an as-converted basis): (a) on an annual basis, audited financial statements, including comparatives, and a budget and financial plan approved by the Board for the coming fiscal year, including projected financial statements; (b) on a quarterly basis, quarterly financial statements, budgets and cash flow projections used in the normal management of the Company’s affairs; (c) upon transmission, copies of all reports and communications with any other class or series of the Company’s securities, or any communication to or from the Securities and Exchange Commission (other than Regulation D and similar routine exemption filings), and; (d) upon request, such other management and financial information as such holders may reasonably request.
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Employment and Non-Compete: The management team of the Company shall enter into employment and non competition agreements and employee proprietary information and invention assignment agreements with the Company, in each case, in a form acceptable to VC. “Key Man” Life Insurance: The Company will purchase life insurance policies with terms reasonably acceptable to the Purchaser on certain of the key members of the management of the Company. Board of Directors: [Until the initial public offering of the Company’s Common Stock, the Board will consist of not more than 5 members who shall be elected as follows: (a) two (2) members of the Board shall be elected by the holders of Series A; (b) two (2) members of the Board shall be elected by the holders of Common Stock, and (c) the fifth member of the Board shall be elected by the holders of Common Stock and Series A voting as a single class.] Board members appointed by the holders of the Series A that are outside directors will be compensated on terms typical of such arrangements. It is contemplated that such an outside director will not receive salary, but will receive reimbursement of expenses. At least one Board member appointed by the holders of Series A shall serve on each of the audit committee and the compensation committee of the Company. If no such committees currently exist, this provision will apply to such committees when, and if they are formed or established. Employee and Founder Stock: All securities granted under the Company’s stock option plan shall vest over a period of four years from the date of issuance. All securities issued to founders and employees of the Company prior to the Closing shall be subject to repurchase by the Company at a price equal to the consideration paid if the founder or employee ceases to be employed or engaged by the Company for any reason during the four-year period commencing on the Closing date; provided that such securities shall vest (and shall not be subject to repurchase) at a rate of ¼ of the securities held by such founder or employee at the end of the first year commencing on the Closing date and 1/36 of the remaining securities each following month. Such vesting shall be accelerated in the event of death, disability or termination without cause. Fees and Expenses: At the Closing, the Company will pay $______ to VC to compensate it for transaction-related expenses. VC will prepare the initial drafts of the operative agreements.
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Appendix B - Interview Outline Introduction of Researcher and Project
- Sprott School of Business MBA Student - Final Project - Study Effects of Terms and Conditions of Venture Capital Financing on
Firm Strategy VC Questions
- VC firm History, size, number of investments, focus - VC Partner industry experience - Founder relationship questions
Founder Questions
- Company history, market, product - Founder industry experience, previous VC backed company
experience - VC relationship questions
Deal Questions
- Size of deal - Stage of deal - Stage of product development - How was firm introduced to investors (solicited, relationship) - Terms and Conditions (Onerous, generous…) - Strategy questions
o Board (Composition, control) o Employee (Compensation, attraction and retention) o Financial (Subsequent VC funding, debt, IPO) o Product (Features, release, quality) o Market (Revenue targets, orientation, customer focus,
acquisition) Wrap-up
- Final comments - Confirm preferred follow-up questions method (phone, email) - Thank participants
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