Crowdfunding - explicacoesdogastao.pt  · Web viewAll reports should start with a firstpage "executive summary" that identifies main issues and summarises fundamental recommendations.

0.• Group written reports on the case-studies: 35% (Each group is required to make 4 reports)• Group participation in the simulation 15% • Individual participation on class discussions and presentations 15%• Final Exam: 35%

COURSE CONTENT

1. (9/2) Introduction to Entrepreneurial Finance 1.1 Differences between entrepreneurial finance and corporate finance 1.2 Types of new ventures: Self-employment, lifestyle and high-growth 1.3 Evolution stages of high-tech ventures

Readings: Smith et al, chpts 1, 2.

2. (23/2) Evaluation of Business Opportunities and Business Plans 2.1 Analysing the opportunity, the context and the team 2.2 Venture strategy and financing strategy 2.3 Bootstrapping 2.4 Crowdfunding 2.5 Angel Financing 2.6 Business Plans

Readings: Sahlman, William Some Thoughts on Business Plans, Harvard (9-897- 101).

3. (2/3) Methodologies for Early Stage Valuation 3.1Valuation principles 3.2 Cost of capital determination3.3 The venture capital method 3.4 Real-options methods 3.5 Decision-tree valuations and real options

Case-study: Diabetogen, Ivey (900N07). Readings: Smith et al, chpts 5, 10 and 11

4. (9/3) Early Stage Financing and Building the Team 4.1 Building the entrepreneurial team 4.2 Splitting equity between the founders 4.3 Early-stage financing 4.4 Crowdfunding new products

Student Presentations: Milkmade Ice Cream: Running a Sucessful Crowdfunding Campaign, Darden (UV 6995); NanoGene Technologies, Inc, Harvard (9-803- 117). Readings: Raising Startup Capital, Harvard (9-814-089)

5. (15/3) Scaling-up Funding Dilemmas 5.1 Introduction to the entrepSim simulation 5.2 Scaling-up financing dilemmas

Student Presentations: Punchtab, Inc, Harvard (9-812-033); Qualtrics: Bootsrapping Growth, Stanford (SM-224); Readings: Angel Investments in Europe and Recent Developments in Crowdfunding, Harvard (9-814-047); Convertible Notes in Seed Financings, Harvard (9-813-017)

6. (6/4) Venture Capital 6.1 Introduction to venture capital 6.2 Organisation of venture capital partnerships 6.3 Trends in European venture capital 6.4 Fintech ventures

Readings: Smith et al, chpt 3

7. (13/4) Venture Capital Deal Structure and Terms 7.1.The design of VC deals 7.2. Aligning interests 7.3Venture Capital term sheets

Case-study: Term Sheet Negotiations for Trendsetter, Harvard (9-801-358). Readings: Smith et al, chpts 4

8. (20/4) Building and Growing the Venture Capital Firm 8.1 Building VC firms 8.2 Strategy and organisation of VC firms 8.3 Growing the VC firm 8.4 VC investment selection and value added

Student Presentations: Adara Venture Partners: Building a Venture Capital Firm, INSEAD (815-086-1); Andreessen Horowitz, Harvard (9-814-060).

9. (27/4) Later Stage Financing 9.1 Venture debt financing 9.2 Later stage financing under a difficult environment

Student Presentations: Avid Radiopharmaceuticals and Lighthouse Capital Partners, Harvard (9-810-054); Bladelogic (A), Babson (BAB153)

10. (4/5) Exiting VC Investments 10.1 Exit by trade sale 10.2 Exit by IPO

Case-study: Chipidea, NovaSBE (NSBE 16-14002).

11. (11/5) Especial Topics 11.1 Venture Capital investments and associated returns 11.2 Startups in financial distress

Student Presentations: StreetShares Inc, Fintech Platform Lending Business, Darden (UV7935); Bloomthat: Navigating the Ups and Downs of a Silicon Valley Satrtup, Stanford (E-685)

12. (4/5) Presentations and course wrap up 12.1 Simulation wrap-up 12.2 Presentation by an entrepreneur

12.3 Presentation by a Venture Capitalist

Reports- All reports should start with a firstpage "executive summary" that identifies main

issues and summarises fundamental recommendations.- Then, the report should address the issues raised by the instructor.

1. ENTREPRENEURIAL FINANCE

Financing New VenturesVenture Types

• Self-employment– Very small business, up to 3 employees; minimum investment– Financing: Founders; Microcredit; Leasing; Factoring– Exit: None or sale to other entrepreneur

• Lifestyle– Low-growth opportunity with sufficiently high cash-flow potential to provide founder with“comfortable life”; Up to 1M€ investment– Financing: Founders; leasing; Factoring; bank loans at later stages or if collateral can be posted– Exit: none planned; sale to small firm or other entrepreneur

• High-Tech / Med-tech - High growth– Long “death valley” and high (usually > 1M€) initial investment– Financing: Bootstrapping followed by Business Angels, VC and/or strategic investor– Exit: Trade sale or IPO

Most critical thing in the valley of death >> building credibility around the product/firm >> keep up with the promises you´ve made

Harvest >> venture capitalist sells and recollects profit, when CFs are already positive

Early Stage >> Seed● Idea requires some R&D, marketing study, or other pre-launch studies demanding

some moderate funding needs >> time for a first business plan ● Issues:

– Technological proof of concept; market proof of concept – What is the time to market?– What team has been assembled so far?

● Sources of finance:– Personal/founders– early sales (Clients – build a clever revenue model (subscription?))>> bootstraping (building a company from the ground up with nothing but personal savings, and with luck, the cash coming in from the first sales; financing the growth of the company from the available cash flows produced by a viable business model) >> the best money is the money you don´t raise >> at this stage you should avoid equity deals >> you should be worried about keeping equity, because it will be worth more further down the road and then you can sell it for more >> Use your own assets (garage companies); Cash: Accumulated savings, credit card; Take a second mortgage on your home– family, friends and fools

– Can they provide collateral for a loan? – Can they open any doors - business contacts - banks, VC’s; customers;

suppliers? – Angel financing – Government R&D support – VC is highly unlikely

Using Customer Cash to Finance Your Start-Up >> negative net working capital >> receiving money from customers first before paying costs >> it allows not to request funding so yearly from investors, and thus receive a higher valuation later >> adopting business models that give them advance access to customers’ cash as a means of funding early growth >> do not spend too much time looking for financing—and invest too much money in prototypes or inventory >> allows company founders to launch with little or no external financing and to use the time not spent seeking potential investors to fine-tune their businesses.

1.The Matchmaker Model:-Some companies’ entire business models consist of connecting buyers and sellers. This strategy can dramatically reduce the need for capital, because the companies have no inventory and the cost of goods sold is extremely low. Consignment stores and real estate brokers have operated on this basis for centuries. More-recent examples include eBay and Expedia.

2. The Deposit Model: by asking for deposits up front, it gained crucial early funding without having to look to outside sources.

3.The Subscription Model:Because customers pay a predictable monthly fee in advance, the business is highly capital-efficient, and it enjoys smoother revenue growth than most start-ups do

4. The Standardize-andResell Model: strategy of winning a contract to create something for one customer and then reselling a variant of that product on a wider scale can work well for small firms.

5.The Scarcity Model: other companies use scarcity to motivate customers to buy (and pay) early on. Zara, the Spanish pioneer of the fast fashion concept, creates more than 10,000 styles a year, with limited-edition designs moving from its studios to its stores in as little as two weeks. Because customers know that the next week’s assortment won’t be the same, they tend to quickly buy items they like. Zara pays its vendors on extended terms, creating negative net working capital that has helped fuel the company’s fast growth

Attention: Customer-funded models don’t suit every venture. Capital-intensive projects that require manufacturing plants or other infrastructure must almost always rely on traditional financing.

Crowdfunding4 crowdfunding models:

Perverse incentives in equity Crowdfunding:1. Raise equity from a pool of un-informed investorsIn a hands-off equity crowdfunding entrepreneurs may have incentive to fail. Spend investors’ money on yourself: not the business. In the event of failure there are no appropriate monitoring mechanisms • Entrepreneurs may seek own personal objectives and deviate cash-flow to self-interest objectives

Operational Funding

• Suppliers – Negotiate credit terms (pay at the last allowed date) • What if they demand letters of credit?– Make them see you as a strategic partner – Do you want them as an investor? • Under which terms? • How will potential future investors (VC?s?) react?

• Customers

– Make them see you as a strategic partner • In other words, convince them to pay fast or to finance your purchases – Do you want them as an investor? • Their involvement brings credibility to the venture • What do they want in return … besides money? – Use them as a source of credibility • To VC’s and other clients nothing beats a landmark customer

• Internally-generated cash-flow: At initial stages do not concentrate exclusively on R&D, etc >> Try to generate cash-flow from sales

• Cash-management:-Limit your costs to the absolute minimum – Garage company? – Starting with your

own salary-Minimise your inventory; be as “just in time as possible”– One day you’ll have to decide which bills not to pay • Be careful to avoid harming

strategic relationships or/and bankruptcy or even personal liability

Debt

Don´t get back Bank financing at early stages• Companies lacking track-record may fail to attract traditional unsecured bank loans due to their high-risk • Some bank lending possible, but:– Increases your firm’s (and yourself’s) bankruptcy risk– Imposes an extra cash-outflow: interest payments– May hinder future growth prospects• Debt should be avoided by firms facing: – High risk; High growth prospects; high “burn rate”

Get Asset-based lending:– Leasing vs buy

• Flexibility: if you lease is easier to abandon the (bad) investment– Inventory financing

• Typically via short-term credit lines secured by inventory• Better keep inventory under strict control and make sure you’re not selling on credit…

– Factoring• Usually expensive but can provide partial working capital requirement financing

– Other credit lines• Typically they are short-term and with covenants attached• You may be required to pledge your own assets and other forms of personalguarantees.Are you willing to take that risk? Do you fully understand the consequences?

Angel financingHigh net worth individual who invests a portion of his wealth in startup companies aiming at profiting at exit.– Typically invest on industries they understand – Tend to invest in very early-stages– Use terms and conditions much more “informal” than those of venture capital firms >>Typically invest in straight equity– May contribute with connections and advice • Being shareholders they have incentive to promote company value • May even source for later rounds (VC, banks, etc)– Some are successful entrepreneurs themselves

Common screening criteria:• Industry attractiveness / knowledge • Geography • Market growth potential • Personal integrity and attributes • Management track-record • Referral source • Due-diligence: business plan, Archangels, etc

– Angel circles – Elevator-pitch sessions

Angels vs VCs • Advantages of Angel financing

– Simpler investment structures (equity) – More available for small amounts of funding – Minimal due-diligence and deal negotiation

• Disadvantages – Inadequate when large amounts of capital are required

– VC-backed firms seem to outperform angel-backed >> Size and/or more professional/”hands-on” VC approach

– Handling information to a large group of individuals

Later-stage Financing • Cash is required to support growth of a company that is still on a negative cash-flow position • As the business grows other sources of finance may become available: – Equity: Venture Capital; strategic partners; M&A – Venture Debt; mezzanine financing – Leasing and other asset-based lending – Fintech platforms – IPO as a financing tool

Case study - Milkmade Ice cream(Early stage financing)

Analysing New Ventures(How do VC’s analyse business plans)

Key Elements:1st:1.The Opportunity2.The Context3.The Team

4.After deciding to go further they may have a look at your financial projections

5.The Deal (kind of financial deal that can be designed for this venture)

6. How can such a venture be harvested?

1. The Opportunity(• What is the size and nature of the opportunity? • How strong is the value proposition and)

key issues a) the disruptive character of the innovationb) the marketc) the competitiond) the costumere) the Intelectual Property issuesf) The business model

a) How Disruptive is your Innovation ?– Will significantly change an industry / market– Does create substantial value for customers

– Quantify that value – Have a clearly-stated value-proposition

– It is not easy to replicate

b)Market: how attractive is the target market? - clearly identified target market:

– What is the relevant target market? – How large is it? – How attractive is it?

• Margins (and ability to protect them); costs; technological stability; • Market growth; margins; threats, etc

– What share of the market can be captured? – What are the growth prospects? Can we ride on its growth? – How easy it is to enter and capture a share of it?– It is not just a scientific project – Market size is relevant, quantified, and growing – May have more than one use

- How attractive is the target market ?• Potential uses for the innovation are clearly identified • Most valuable uses are targeted first

– Value for innovator is generated from the ability to create customer value in a large growing market

– Only expand to a new use after well established on the first • Market is segmented to identify user groups with common needs • Relevant users and uses are identified – Appropriate market strategy for each use

– Is in a “hot sector”?

c) Competition is years away from it, – Who is the competition? What are their strengths? Any soft-spots?

• Competitors, for each use, are dormant or unable to react

d) The costumer: – Who is he/she? – How does he (or who does) make decisions? Or who actually makes the decision to buy the product.

-What is the Decision Making Process for that Product? – What needs can we serve? and how? – How to market/position the product (4 p’s…) – How to attract customers? (at which cost?) – customer acquisition costs – How to retain, cross-sell and evaluate (CRM)? – How much does it costs to support? – How to monitor customer satisfaction and anticipate future needs?

e) Intellectual Property• Who owns the IP? – Yourselves? A University? – Is it transferable? How? – Who owns the IP in case your firm becomes insolvent? • Is (are) there any patent (s)? – How strong are they?

– Do we have to invest to get stronger IP protection? – Do you own the patents or just the rights to use it via a royalty?– Can we buy the patents?

Weak IP >> legal battles and expenses

f) The Business Model • How does the company intend to generate cash-flow?

• How does it appropriate value for its shareholders? • Examples:

– Price per unit sold – Price (to implemente) + maintenance fees – Subscription – Give away (for little price) main product + sell consumables – Freemium -> premium– Price base product + High margin add-ons

2. The ContextStart when the external context is right• Macroeconomic level – And its impact on the opportunity • Regulation + Legislation • Financing environment – bubbles; crashes; high rates; expectations; “fashions” • Infrastructure• How is it going to change?

3. The people • Who are the people involved and do they have these capabilities? • How well are the team members able to adapt to change?

• Who are the founders? – What have they accomplished in the past? – Have they worked together as a team in the past? – Are they friends / relatives? How many are they? (too many/few)? – Who else (what skills) should join the team?

• Do they possess the right skills for this Opportunity? – Technological; Marketing; Managerial

• Whom do they know? (what is their reputation?)– What doors may be open by these contacts? • How committed are they? – Their own initial investment (cash, time, opportunity costs) – What alternatives do they have?

• How adaptable are they? • How will they respond to adversity?

• Do they understand the sequences of options involved?

• Are they realistic?

• What are their (real) motivations?

• What role is played by each member? – What happens if (each) one of them leaves? – Cronyism? What if we are forced to make one of them leave?

• Who is helping them? – Consultants, lawyers, venture capitalists, angels – Technology providers

• What capabilities are required to explore this opportunity? Do they have the right combination of skills ?1.Strong Management Experience – Preferably on the target market2.Strong Marketing & Sales Experience – Preferably on the target market3. Clear ability to “manage for cash”4. Have strong technological knowledge in the relevant innovation • Have the relevant “contacts”5. Are ready to establish the right partnerships in order to get access to relevant strategic resources – And give away value percentage for that

4. The deal • Financial Deal – Valuation; Value and risk sharing – How much money is really needed (now)?

• Staging: How much is needed in this round and how you measure success? – Whom you get money from? From whom you raise capital is often more important than the terms

• At which terms? • Are you (and them) protected/prepared for future rounds? • How will they exit? • How are incentives aligned (or not) ?

• What else can they provide besides cash? – What is their expertise? How helpful and involved will they be?

• Other deals – Suppliers; customers; employees

Case study Nanogene(building the team)

Valuation of New Venturesvalue of a firm is determined by it’s ability to generate cash-flow for the people who financed (shareholders and lenders) it

Techniques of valuation:

1. Discounted cash-flow techniques (NPV) – Hardly appropriate to value new ventures due to the fact that most future investments are not pre-determined and are contingent on the verification of future events– Hard to apply considering the high uncertainty surrounding even the nearest cash-flows – Issues surrounding risk, diversification and other issues make cost of capital determination extremely difficult to determine – The role of intangible factors (Human capital; VC value added, etc) played in the valuation is not taken into account in this type of valuation

2. Real options techniques – More appropriate in the context of an uncertain investment plan – May better incorporate flexibility issues in new venture management

3. The Venture Capital Method● determine the Terminal Value - under a success (not necessarily optimistic) scenario

>> May be computed by applying multiples to last year projections● compute PV by applying a very high discount rate (VC´s IRR)● Determine the fraction of ownership that is required in exchange for VC’s capital

outlay

● However, that percentage may change with time due:- To the entry of new investors and prices paid by them leading to possible

dilution of initial investors;

- The exercise of stock options or warrants by founders or some investors (more dilution);

● That percentage may also be affected by factors such as:- The firm’s performance (ratchets);- the special characteristics of the securities used by VC’s.

How to challenge this valuation

Cost of capital: What determines VC’s risk-premium?

• CAPM not applicable because entrepreneurs concentrate their wealth on the new venture– Thus, relevant concept is “total risk” (not “systematic” -part of the total risk that is caused by factors beyond the control of a specific company or individual- only)- Entrepreneurs may be risk-prone, and have no opportunity to take advantage of leverage (as assumed on SML), thus being willing to accept below SML returns

1. Market risk premium – Exposure to market fluctuations2. Liquidity risk – Impossibility to dispose of the company’s securities3. Value-added by VC – VC spends time (and money) trying to help steering the

company towards a successful “exit”4. Cash-flow adjustment because Typically, entrepreneur’s expectations about

outcomes are high and their risk estimation is low >> entrepreneurs overstate (or have higher expectations about future cash-flows, which, paradoxically, may lead them to perceive higher valuations than investors’

• Commitment >> also affects cost of capital – What are the entrepreneur’s alternatives? – What are hers/his other sources of income? – What percentage of his wealth is invested in the venture?

E.g.: Required Rate of Return – Biotech ventures

Seed stage 70% - 100%

Startup stage (pre-clinical) 50% - 70%

First Stage (phase 1) 40% - 60%

Second Stage (phase 2) 35% - 50%

Third Stage (phase 3) 25% - 40%

• In situations with many interim cash-flows, positive and negative, it is not preferable to use simplified VC methold, but instead a full DCF valuation from the VC’s perspective should be used = (PV of VC’s exit) - (PV of expected VC cash infusions on the firm)

• There are many circumstances under which NPV is not appropriate to value new projects

a) When there is the possibility to postpone the decision, making it contingent to the actual observation of future relevant facts

i) Option to expandii) Option to postpone

b) When there is the possibility to abandon the project before the end of its expected life: Option to abandon

c) When the project may follow multiple paths depending on the progress of technology and its applications

>> in these cases we use: REAL OPTIONS

Case study - Diabetogen(Valuing new ventures)

Scaling-up Funding Dilemmas

Case study Punch-tab•Too early?

– low valuation and dilution

–Lacking any form of proof of concept

•No milestones met

–Very small team

•Funding gap: can Punchtab find value-added investors?

–Lack of diverse pool of early-stage VC’s

•Previous track record is a plus

•Wants to raise $50M and get a venture-type return

•What about an incubator?

Early stage alternatives

•Early Stage VC’s

–Better for the long-run; more value added ?

–Riskier: if they don’t follow on nobody will

•Angels

–Small amounts of Money; Need to raise $ from many diferente people

–Shorter-term focus; simpler investment terms

–Lower value-added? (remember these 40+ blind investments?)

•Super Angels / Archangels

–Larger amounts of Money; Prominent individuals

–Hyper-egos? May demand a lower cap

–Will try to force an early exit?

•A mixture of the above? Angels + VC will work?

Convertible notes

Avoids setting a valuation at such early stage

–High uncertainty and asymmetries of information

–Investors avoid getting trapped on a high valuation- buy at discount of VC round

•Cap sets maximum price (through implied valuation) they will pay even in case of exceptional performance (in this case $6M valuation )

–Founders avoid excessive dilution too early

Case study Qualtrics

2. Venture CapitalVenture Capital Investment:

- Investment in non-listed securities via dedicated VC/ PE funds managed by professional general partners who raised funds from institutional limited partners

Main investments: – Startups (venture capital) – Buyouts – Infrastructures – Energy / renewables – Distressed securities

Stages of financing:

VC funds are funded by investors (limited partners) >> Investments are made through VC Funds / not directly >> General partners create, manage and liquidate funds (they´re experienced on the type of investment they will be responsible for: Sector, regional or corporate finance experts) >> General partners set the terms and regulations (LPA-limited partnership agreement) governing the fund:

- Funds’ objectives and target investments (Sector; stage; regional, etc)- Commissions; investment criteria; governance

>>General partners search for potential investors: Institutional investors; banks; Govt agencies; wealthy individuals (limited partners)

Typical fee structure

1. Management fee: 2.5% per annum of total funds raised (or maximum fund size) from limited partners (With a minimum of €xxx)

2. Carried interest: 20% of capital gains exceeding the compounded annual return of 6%

Pros and cons of investing in PE/VC fundsPros – High expected returns – Diversification – Since VC investments are non-listed their book values (although not economic values) are less sensitive to stock market fluctuationsCons– Fee structure makes sure that general partners always do well (even if limited partners don’t) – call option like– General partners may fail to generate good deals– Are returns compatible with effective risk level?

Performance metrics

Key concepts used to measure performance are:- Funds committed by the LP’s - Actual paid in capital by the LP’s- Actual distributions made by the fund back to LP’s- Net Asset Value (NAV) of all assets still in the fund (problem: its calculation, although

regulated, is controlled by GP’s)

key performance metric: internal rate of return (IRR) earned by the LP’s (although can be computed on a deal by deal basis after each exit, can only be appropriately performed for the fund after the last exit)

Performance metrics used during the life of the fund:

1. PIC (Paid-in capital / also called capital ratio) = Paid-in capital / Total commited capital(% of committed capital that has been called)

2. DPI (Distribution to Paid-IN) = Capital Distributed to LP’s / Capital Paid-In by LP’s(% of paid-in capital that has been returned to LP’s)

3. RVPI (residual Value to Paid-IN) = Net Asset Value of the Fund / Paid In capital(value still hold by the fund as % of paid-in)

4. TVPI (Total Value to Paid-IN) = DPI + RVPI

Investment process:Evaluate proposal and business plan >> Conduct due-diligence >> negotiate deal (or reject) >> invest >> monitor/manage/advise >> harvest

Critical Factors for VC’s: – Team: 95% – Business Model: 74% – Market: 68% – Industry: 31%

Metrics used: – Cash on cash return – Annualized IRR

Value added by VC / PE investing

1. Focus: Selecting investments based on the general partners’ field of expertise (industry; stage; regional; etc)– Supporting opportunities that otherwise would not get funding – Screening for high-growth potential opportunities

2. Deal structuring:– Structuring deals in such a way to make sure all parties have the right incentives (contracts) – Making sure that VC’s position is protected: paid the “right price”; anti-dilution provisions; shareholder’s agreement; invested on the right type of securities (convertible, etc)

3. Effort allocation – General partners team has to dedicate to several activities: fund-raising, screening for opportunities, selection, due-diligence, deal-structuring, monitoring investments, etc – However, monitoring and associated activities seem to play a crucial role on PE fund performance, thus recommending that an important fraction of effort is allocated to this activity

4. Monitoring investments (portfolio companies) – (Active) Participation (non-exec) in boards (“hands-on” approach)– Providing advice (managerial, financial, etc) – Active monitoring of managerial performance (Active involvement in the management control process, including budgeting, budget analysis, monitoring key performance indicators)

Venture capital Financing(VC deal structure and term sheets)

Financial contracting - complex process aiming not just at providing the required amounts of funds, but also to clearly stipulate the terms under which the two sides will cooperate

Problems:1. Asymmetric information:

– Entrepreneurs know more about the venture than the investor – If there is un-proportional sharing, entrepreneurs receive a call option (paid by investor) on their own venture – nothing to loose – Information risk leads investor to require high cost of capital

2. Differences in expectations- Typically, entrepreneurs’ is higher

3. Investors’ under-pricing (or high cost of capital): Some investors, including VC’s, offer low prices at initial finance rounds to compensate for low liquidity and asymmetric information

4. Entrepreneurs’ key-role on venture >> Demanding special incentive mechanism to tie them to venture

Once the financing has been agreed moral hazard may occur:– Entrepreneur acts according with his own interest >> This demands contracts to limit such behaviour– Moral hazard problems arise from:

• Incentive conflicts; “lifestyle companies” • Seeking opportunities outside the venture (other venture; job) • Selling the majority stake of the firm at premium • Specific investments (non-recoverable) sunk costs leading the company to pursue

low-price lines of business– If outside finance is primarily debt >> Opportunistic strategies by entrepreneurs (risk-seeking)

Solving asymmetric information:

1.Signalling: Give credible demonstration about your statements(success-fees; tie your performance to landmarks; warrants; Accept investors protection clauses; Earnouts: price is determined by future performance (in entrepreneurial finance that can be implemented through warrants that may be exercised by investor, at low prices, if performance targets are not met) or ratchets and anti-dilution provisions)

2. Screening: The party with low information (VC) offers a choice of alternative terms to the informed one (entrepreneur)(Ex: Low salary vs high success benefit (avoids “lifestyle” behaviour))

Financing structure of VC deals- In Venture Capital transactions the capital structure choice is more than a mere debt/equity optimisation >> Most securities have hybrid characteristics- The financing package is structured in order to:

– Split value between the parties at different states of nature – Shift and split risk between the parties – Efficiently allocate risk and return in the presence of asymmetric expectations – Create the right incentives for the parties – Secure investors’ position at special events (sale, liquidation, IPO, etc)

• A critical part of the structuring of VC deals involves the alignment of incentives between the parties and solving asymmetric expectations about the venture.

Securities used in venture capital transactions

Usually VC’s will design financing structure using securities which enable them to: – Give the right incentives to entrepreneurs; – Give VC the downside protection typical of debt securities but with the upside of equity, while giving it all the (voting, etc) rights associated with the latter

1. Preferred stock:- typical security used by VC’s- liquidation preference over common stock: at critical (defined as “liquidation”) events

such as sale of the company, IPO, bankruptcy, etc the preferred stockholders may demand the company to redeem their shares at par or multiple of par

- May have right to preferred dividends >> Works as downside protection because cumulative unpaid dividends become a company’s liability in a liquidation event

- Typically votes as ordinary shares- Preferred shareholders subscribe a shareholders agreement with ordinary

shareholders, giving the former special rights

a) Redeemable Preferred (or straight preferred)-never converted into equity: acts as junior debt-If firm is sold or liquidated it must be fully redeemed before any payments are made to common stock holders; may be redeemed at multiples of par (2x)-Is entitled to (cumulative?) preferential dividends-Redemption is mandatory after certain amount of time-It is usually used in conjunction to warrants (derivative that give the right, but not the obligation, to buy or sell a security—most commonly an equity—at a certain price before expiration), who provide the “upside” or “equity kicker” >> VC’s investment is fully covered by redemption rights plus a % of firm’s equity

b) Convertible Preferred:- has the option to be redeemed or converted into ordinary shares-Redemption gives downside protection while conversion provides the upside benefits-Conversion may be mandatory at certain events (ex: IPO or trade sale) if the value of firm is sufficiently high (thus making that option “in the money”)- May have “anti-dilution” clauses to protect investors in future financing rounds

c) Participation Convertible Preferred-less common form of convertible preferred-works as the conventional security except that in the event of a sale or liquidation of the firm the security-holders are entitled to receive: redemption of the face value of the security + Their share of company’s equity as if it has been converted into common stock .-It is usually issued at later-stage rounds as a way to compensate investors for the high valuations

Stage financing- Venture capitalists prefer to make their investments in stages rather then giving a large

amount upfrontWhy?

1. VC has the option to re-evaluate the venture and if necessary exit2. Increases the incentive to founders to work right from the beginning – a necessary condition

to attract money at further rounds3. Reduces founders incentives to over-expand via higher control from investors

Anti-dilution (ratchet) provisions- VCs protecting themselves from later financing rounds at lower prices- Under anti-dilution rules, the preference shares’ conversion ratio into ordinary shares is

adjusted to reflect this “new additional shares

1. Strongest form >> Full ratchet: VC is entitled to receive free additional shares to make sure that its average price equals that of the new financing round

2. Weighted average: VC receives new shares in order to keep its average price equal to the weighted average price of new round

3. Preemption Rights on new Issues: investors may demand the right to participate pro rata (proporcionalmente) on future issues of stock by the venture

● In practice, the new VC shares are not issued immediately. However, their conversion ratio changes to reflect the above calculations

Warrants, stock options and ESOPS(positive incentive mechanisms to reward employees that are relevant to the value-creation process)

1. Warrants and SO are designed to provide incentive-If combined with straight debt is equivalent to holding convertible stock-If combined with straight equity leverages the equity position (asymmetric gains and losses)

2. ESOPS: combinations of stocks and options-The major problem with this systems is the dilution of external equity providers >> VC’s may demand protection against them

Vesting provisionsentrepreneur’s stock is not appropriated by him/her: –For a given period of time –Until some landmarks are met>> used to give incentive and prevent entrepreneurs to sell their shares “too soon” and thus tie them to the company

E.g.:•Founders’ shares vest 25% on closing with remainder vesting linearly on a monthly basis during 36 months •Employees’ shares vest in 48 months with a 12 month cliff

Covenants: Contractual provisions to protect VC’s investment

- main objective is to limit investors’ risk through information, conversion rules and their veto right on relevant issues

- Such terms are usually the subject of a shareholders agreement between the entrepreneur and the VC

a) Positive covenants: concern actions that the firm agrees to perform

E.g.s:

1.Appoint x people designated by the VC firm as members of the Board

–VC may have majority or impose that majority lies with external non-executive directors

2.Annual accounts are subject to an external audit

3.Company agrees to fulfil all social security and tax obligations

4.Company agrees to keep the other party informed about relevant corporate facts

b) Negative covenants: impose restrictions on the companies actions

1.Restrictions on new investments and asset sales without VC’s approval (Including setting up subsidiaries, participating in mergers and/or acquisitions)

2.Restrictions on the contracting of new external finance:

- Debt: to prevent more risk or dilution via new convertibles- Equity: right to refuse and anti-dilution provisions

3.VC may demand preference to purchase founder’s shares in event they are put for sale >> May stipulate put and call provisions for the VC

- Most of these restrictions are associated to a “supermajority rule) ex: 2/3 of the vote (common + preferred)

c) Exit route covenants:c.1) Founders may have the right to purchase VC’s investment at a price determined by a third-party (right of first refusal) and vice versa

- Acquisition may imply conversion of VC’s investment (debt) into redeemable preferred stock prior to purchase >> This way founders may later force the company to redeem

- If founders fail to exercise their right, then VC has the right to sell 100% of the company >> Thus, Founders give VC a selling mandate for their shares, who are deposited at VC’s

- VC’s may demand founders to give them a ROFR on their (Founders’) sharesc.2) Liquidation clauses: Defines liquidation event (bankruptcy, sale, IPO, etc) and the compensation given in such event (usually a multiple of VC’s investment)c.3) Drag along: VC may force founders to sell their shares in a liquidity event initiated by themc.4) Tag along: Founders may want right to force VC’s to sell their shares in a liquidity event initiated by VC’s; VC’s may want right to be tagged along on a Founders’ sale

Governance● Board of directors: –“Insiders” or executives; – Investors’ (non-executive) representatives; –

Independents

● Investors’ veto power on all fundamental matters that may affect: Changes in company’s statutes, etc; Decision to liquidate or sell; Business activity or risk; Board, composition, etc; New finance rounds

Building and Growing the VC firmAda Ventures Case study

Horowitz Case study

Later stage financing

Case study Bladelogic

Case study Radiopharma

Harvesting / exits• Starts being developed at VC due – diligence phase• Potential buyers are monitored in regard of their acquisition strategy and shifts in overall corporate strategy• Venture’s strategy “aligned” with potential buyers’ strategies as well as the overall market’s perceived trends • IPO strategy discussed from early phases•Viability, interest and risk of following an IPO strategy

– Is IPO plan A or Plan B? – An IPO Plan A involves a complete focus on this exit type with important

implications in terms of the company’s organisation and strategy – Having IPO as Plan B also has implications at later phases

When to harvest?• The ideal timing would happen when the company has reached the “right-size” to be an IPO and/or acquisition candidate and the stock market is particularly “hot”• after 4/5 years the VC should evaluate whether or not the IPO route makes sense and/or start looking for potential private buyers

• Sometimes, “harvesting” either by IPO or trade sale is a combination of: – VC’s selling their position – Company raising funds to finance further growth

Maximising IRR

1. Harvesting via IPO– Many Founders & VC’s dream: because the majority of small-firm IPO’s occur during inflated stock market phases (bubbles) >> Thus being an appropriate mean to explore market inefficiencies

– However, finance literature finds a phenomena called “IPO underpricing– Extremely successful ventures can only be exited this way – IPO’s may be better for entrepreneurs then for VC’s, since the former partially liquidates (cashes) its position without abdicating control– VC may prefer trade-sale, especially if it has control >> No control premium is achieved via this type of exit

IPO Advantages

1. Gives the company visibility and prestige2. Use own shares as currency for acquisitions3. Explore market anomalies4. Raising capital from the general public: – Diluting initial investors – Allows VC’s to

exit5. Gain liquidity for initial investment: – Although initial investors subject to lock-up

provisions – Management may be subject to extended lock-up

Disadvantages1. Costs of Going Public:

– Initial cost may go up to 10% of offer-Reputational costs associated with potential failure– Price and execution uncertainty – execution risk – IPO may underprice the firm

2. Costs of remaining public:– Compliance with public company rules (Disclosure)– Management distraction by stock market performance– Too much focus on short-term performance– Increased scrutiny from outsiders – Complex corporate governance structure

2. Harvesting via Trade SaleAdvantages:– Company may be put to auction – Number of potential buyers limited and known much beforehand – Highest price paid by company who can extract the highest synergies – Much simpler and cheaper than IPO – Price is set; may be subject to adjustments via Earn-Outs and escrow accounts

• Sale to another PE (Excess money in PE may drive prices further up)

The process:• Assemble the Exit task – force (includes CFO + VC’s) • Acquiring the right help – Investment bankers; lawyers; accountants • Prepare the business plan • Identify potential buyers

– Same industry players – competitors – Upstream / downstream – Conglomerates

• Valuation exercise – Determining possible valuations under potential alternative exits • Data Room – Select data to display – Selecting (carefully) access to the data room • Negotiation / Auction • Closing

3. Reverse merger with a SPAC (Special Purpose Acquisition Companies)– Go public with intention to buy a privately listed company– Investors pay stock issue price and get warrants to buy more shares on the SPAC once it announces na acquisition deal– Sponsors (financiers & celebrities) buy shares at deep discounted price– SPAC searches for potential acquisition targets– If within 2 years (?) SPAC fails to merge, SPAC is liquidated and investors will get their money back – If target is found, then it mergers with SPAC, new shares are sold to pay for the acquisition and target becomes publicly listed

Advantages for the target – Take advantage of the SPAC boom (bubble)? – Much easier, from a regulatory standpoint, and cheaper than an ordinary IPO

4. Redemption of VC securities– Usually regarded as a sign of poor performance

5. Sale to Founders / Key employees– Via a RFR? – Contractually-set? Equity Loan? – Viable in the context of excellent performance? – Conflicts of interest? – Via an MBO? • Thus, sale to another private equity?

Case study shipidea

Case study Bloom that

Case study Street shares

Case study - Envia Systems● VC: Atul Kapadia (me)● Founders: Kumar e Sinkula● Founded in July 2007● Lithium-ion (Li-ion) battery company● Board of directors formed after serie A: Kumar, Kapadia and Redpoint partner John

Walecka; one spot reserved for a future CEO and another for an outside board member

1.1. Analyse the opportunity and the team. Is Envia Systems a good investment candidate?

Team

Kumar Sinkula Atul Kapadia

co-founder, president & CTO

co-founder and director of business development

chairman and CEO

● PhD in materials science from the University of Rochester

● after that, made Li-ion battery development his life´s work

● well know within the battery industry and well versed in cutting-edge battery research:

- lead scientist at several battery and nanotechnology companies: senior scientist for Greatbatch (nanotechnology) and at NanoeXa (batteries); principal scientist at Nanogram Devices Corporation

● MSc from university of newcastle in biomedical engineering and BS in Finance from Santa Clara University

● 10 years in nanotechnology, batteries and finance

● founded Molecular ID Systems

● held several finance positions at Hewlett Packard

● director of business development at NanoeXa

● serves on the board of directors of the national alliance for advanced technology batteries

● founding (seed) investor and founding board member of envia systems, afara web systems and auroranetics

● serves on the board of directors of tealeaf technologies, lumension technologies, akros silicon and zenprise

● led investments in cornerstone-on-demand, oncomed, amec and sonoa systems

● prior to investing career, atul served as the chairman and ceo of maple optical systems and worked in sales and general management roles at cadence design systems and arcsys

● top ranked biomedical engineering student at university of bombay and at case western reserve university, where he earned a master´s degree

● had been an engineer in the

and project manager at Nanogram Corp

- inventor of over 40 patents

● published widely in the fields of nanotechnology and lithium batteries

sillicon valley prior to earning an mba at the standford graduate school of business where he was a Dean Arjay miller school

Opportunity

● by mid-2007, Suitable car battery did not exist >> battery technology lagged behind

the intentions of eletric carmakers >> Cost of eletric battery has always been the

biggest impediment to the growth of electric cars >> Li-ion batteries could be the

solution: they were the best batteries in the market due to lower cost while increasing

the energy density (smallest, lightest and most powerful batteries in the market) >>

but still li-ion batteries fell short of what the EV needed >> EV car industry was

waiting for Li-ion batteries to be roadworthy >> opportunity for Envia systems as it

intended to commercialize existing Li-ion research

● Good prospects for eletric car market:

1. retail gas prices were continuously increasing (California had broken the

three-dollar mark in March 2007) >> eletric car market rising as alternative

2. Batteries´ US demand projected to grow 5.4 percent year-over-year until 2014

due to advent of portable eletronic devices and growth of eletronic vehicles

- Li-ion batteries´demand projected to grow 9.9 percent year-over-year

until 2014

● Closest known competitor was a company based in Boston, Massachusetts called

A123 systems that made a lithium iron phospate cathode which only stored about

half as much energy as Envia hoped to achieve >> so competition weak

Risks:

Cavehat: concerns about Li-ion battery safety >> they could overheat and catch fire during

use

● Commercialization path for a new chemistry for batteries takes about 10 years and

especially for the automotive application, heavily relies on partnerships

- kumar thought he could commercialize Li-ion battery in years: 2 years to⅚

develop the process; 2 years to turn it into a product; ½ years for testing

1.2. Suppose you are to conduct due diligence on this venture for a VC firm. What would be the top priority items in your agenda?

● process of creating ten tons of cathode material would yield 20 patents for envia,

serving as the bulk of value creation at this stage, after series-a funding

1.3. Should Envia Systems raise venture capital funding at this stage? How would VC funding affect its strategy and evolution when compared against a purely angel round?

Seed funding

VC Kapadia / Bay partners >> seed money = 250000

Series A

● needed millions of dollars to set up a lab

● had an endorsment from Tesla, who vouched for us as an investment opportunity

● Series A investors: Redpoint ventures and Bay partners >> 3,2 million for 50% of

Envia (25% each = 1,6million)

>> so firm valued at Post-money valuation = 3.2x1/0,5 = 6,4 (pre-money valuation

= 6,4 - 3,2 (vc´s investment) = 3,2 )

redpoint = 25%

bay partners = 25% + 0,25

founders = 50%

- redpoint had a presence in china, where envia would likely need to build a

manufacturing facility later on.

- two VCs more desirable than one >> more support and in a capital intensive

business you want more pockets to ride you through rough patches

● Kumar hired of scientists to reproduce and scale up tacheray´s result >> process of

creating ten tons of cathode material would yield 20 patents for envia, serving as the

bulk of value creation at this stage, after series-a funding

Once Series A funded, two priorities for firm:

1. Strike a licensing deal with Argone National Laboratory to commercialize thackeray´s

patented manganese structure >> formal licensing deal stalled as lawyers kept

reseting the agreement

2. set up a lab in the Bay area in which the development testing could take place

May 2008, Envia successfully reproduced Thackeray´s results:

- Li-ion battery achieved a world leading energy density

January 2009 licensing deal finally closed >> non.exclusive licensing agreement with:

- a fee of $800000;

- 1 percent royalty that scaled down with greater revenues

- maximum payout of $5 million over the life of the original patent

1.4. Compute the fully diluted pre and post money valuations in the term sheet assuming that the loans are converted and the investors invest the full amount. Is this a fair value for Envia Systems? What other terms in the term sheet should founders be worried about?

Clients

● Cell manufacturers didn´t want to buy >> Envia didn´t have a track record or a product that was ready to ship, and battery manufacturers are used to work with large, established companies with six sigma certification and high, reliable output

● while envia´s cathode promised significant savings in total production cost against the prevailing lithium cobalt oxide cathode, it was unclear who would ultimately capture the benefits of a cheaper cathod

- Specific to eletric vehicles application, the new cathode would provide disproportionate cost savings to end users like GM versus direct costumers like LG and NE >> thus Envia addressed them and they in turn could instruct the battery manufacturers to use Envia´s cathode material; otherwise, there was no real incentive for the battery manufacturer to switch

Marketing● in July 2009, Envia won R&D magazine´s R&D 100 award >> boost to marketing● Kumar agressively hit the conference circuit, spreading the word about Envia´s work,

making contacts among the department of energy officials and potential partners

● distribution of small sample battery cells to potential end users, who could test them to verify envia´s claims

Working with GM● GM was struggling to bring to market a cost-effective secong-generation chevrolet

volt >> prospect of dramatically reducing cost of volt battery while increasing its range vs. first-generation volt was tremendously attractive to GM

● samples proved to be popular at GM >> GM gave a development fee of $1.5 million to build prototypes that they were interested in >> Envia made them a flat volt.sized battery as a prototype so they could compare it with first-generation battery. after each round of development they would come back and ask us to do this or that differently >> if development agreement successfull >> production order from the cell manufacturer that supplied GM could be expected within just two to three years

Series B

● spring 2009● licensing deal was done● kumar and his team had already produced one kilogram of cathode material● needed $5 to $10 million more to create an early product

- product would need a high degree of stability so that it would not be prone to spontaneous combustion

- it would also need to be disguised so that it could not easily be copied

● aftermath of 2008 market crash >> investment community wasn´t eager to support a technology company that most venture capital firms still considered “fringe” or “experimental” >> no firm invested

● board prepared for an “inside” round - funding round of existing investors● Also, after inside round´s terms were finalized, firm Pangea Ventures made a small

investment● Closed in october 2009: 7.5 million raised

- original investors bay and redpoint each contributed $3.5 million- pangea invested $0.5 million

post-money valuation = 13,9 (pre-money valuation) + 7.5 = 21,4

bay = (1,6+3,5)/13,9=37%redpoint = (1,6+3,5)/13,9=37%pangea = 0,5/13,9=3,6%founders = 22,4%

Hiring a CEO● main job would be to raise a series C round (given firm´s difficulty to find investor in

series B)● CEO: past decade managed battery production businesses; impressed Envia´s

board with his ear for politics, and his deep understanding of outsourced cell

manufacturing; highly energetic contributor who was well informed about the car battery industry

- agreed to a yearlong half-time appointment in exchange for a salary and 8% equity grant (envia´s equity granted) - this was in addition to the one percent he had been awarded as a board member

- contract would automatically renew 30 days prior to the end of the first term

bay = 37%redpoint = 37%pangea = 3,6%founders = 14,4%ceo = 8%

Competitors1. As Envia was closing its B round, US subsidiary of Japanese cathode manufacturing

giant Toda Kogyo announced plans to open a US facility. Toda had also licensed thackeray´s compound from argonne, and would be a direct competitor to envia

2. Amprius, another startup and competitor to Envia, was investing heavily into advancements in the anode, a long-commoditized part of the battery

Grant- Envia received a $4million ARPA-E grant- the california energy commission announced a concurrent $1 million grant

Needed new CEO (firm was insolvent and CEO wasn´t much around has its focus wasn´t on Envia and had other interests) >> Kapadia (despite conflict of interest of him being VC investor)>> interim CEO >> Kapadi immediate priority would be to raise series C funding:$15 to $25 million >> found several term sheets:

1. GM Ventures: $5M cash and $5M in-kind resources in exchange for a 10x liquidity preference (VC gets to take 10x their original investment out of the company before any other shareholders get their first dollar), board preference, and no royalties for the use of Envia´s technologyPangea´s limited partners:

2. Asahi kasei offered $3million in exchange for exclusive distribution of envia´s product3. asahi glass offered $4million in exchange for 15 percent of envia´s future revenues

and exclusive manufacturing of envia´s product4. one from china offered $15 million at a $90 million valuation provided that the

cathode material was exclusively manufactured in a particular province in china- all were unfavorable