Some Basics of Venture Capital

Some Basics of Venture Capital

OutlineThe basics: how VC worksCase study: DDoS defense companies

What is Venture Capital?Private or institutional investment (capital) in relatively early-stage companies (ventures)Recently focused on technology-heavy companies:Computer and network technologyTelecommunications technologyBiotechnologyTypes of VCs:Angel investorsFinancial VCsStrategic VCs

Angel InvestorsTypically a wealthy individualOften with a tech industry background, in position to judge high-risk investmentsUsually a small investment (< $1M) in a very early-stage company (demo, 2-3 employees)Motivation:Dramatic return on investment via exit or liquidity event:Initial Public Offering (IPO) of companySubsequent financing roundsInterest in technology and industry

Financial VCsMost common type of VCAn investment firm, capital raised from institutions and individualsOften organized as formal VC funds, with limits on size, lifetime and exitsSometimes organized as a holding companyFund compensation: carried interestHolding company compensation: IPOFund sizes: ~$25M to 10s of billionsMotivation:Purely financial: maximize return on investmentIPOs, Mergers and Acquisitions (M&A)

Strategic VCsTypically a (small) division of a large technology companyExamples: Intel, Cisco, Siemens, AT&TCorporate funding for strategic investmentHelp companies whose success may spur revenue growth of VC corporationNot exclusively or primarily concerned with return on investmentMay provide investees with valuable connections and partnershipsTypically take a back seat role in funding

The Funding Process: Single RoundCompany and interested VCs find each otherCompany makes it pitch to multiple VCs:Business plan, executive summary, financial projections with assumptions, competitive analysisInterested VCs engage in due diligence:Technological, market, competitive, business developmentLegal and accountingA lead investor is identified, rest are follow-onThe following are negotiated:Company valuationSize of roundLead investor share of roundTerms of investmentProcess repeats several times, builds on previous rounds

Due Diligence: Tools and HurdlesTools:Tech or industry background (in-house rare among financials)Industry and analyst reports (e.g. Gartner)Reference calls (e.g. betas) and clientsVisits to companyDD from previous roundsGut instinct

Hurdles:Lack of company historyLack of market historyLack of market!Company hyperboleInflated projectionsChanging economy

Terms of InvestmentInitially laid out in a term sheet (not binding!)Typically comes after a fair amount of DDValuation + investment VC equity (share)Other important elements:Board seats and reserved mattersDrag-along and tag-along rightsLiquidation and dividend preferencesNon-competitionFull and weighted ratchet Moral: These days, VCs extract a huge amount of control over their portfolio companies.

Basics of ValuationPre-money valuation V: agreed value of company prior to this rounds investment (I)Post-money valuation V = V + IVC equity in company: I/V = I/(V+I), not I/VExample: $5M invested on $10M pre-money gives VC 1/3 of the shares, not Partners in a venture vs. outright purchaseI and V are items of negotiationGenerally company wants large V, VC small V, but there are many subtletiesThis rounds V will have an impact on future roundsPossible elements of valuation:Multiple of revenue or earningsProjected percentage of market share

Board Seats and Reserved MattersCorporate boards:Not involved in day-to-day operationsHold extreme control in major corporate events (sale, mergers, acquisitions, IPOs, bankruptcy)Lead VC in each round takes seat(s)Reserved matters (veto or approval):Any sale, acquisition, merger, liquidationBudget approvalExecutive removal/appointmentStrategic or business plan changesDuring difficult times, companies are often controlled by their VCs

Other Typical VC RightsRight of first refusal on sale of sharesTag-along rights: follow founder sale on pro rata basisDrag-along rights: force sale of companyLiquidation preference: multiple of investmentNo-compete conditions on foundersAnti-dilution protection:Recompute VC shares based on subsequent down roundWeighted ratchet: use average (weighted) share price so farFull ratchet: use down round share priceExample:Founders 10 shares, VC 10 shares at $1 per shareFounder issues 1 additional share at $0.10 per shareWeighted ratchet: avg. price 10.10/11, VC now owns ~10.89 shares (21.89 total)Full ratchet: VC now owns 10/0.10 = 100 shares (out of 111)Matters in bridge rounds and other dire circumstancesRight to participate in subsequent rounds (usually follow-on)Later VC rights often supercede earlier

Why Multiple Rounds and VCs?Multiple rounds:Many points of valuationCompany: money gets cheaper if successfulVCs: allows specialization in stage/riskSingle round wasteful of capitalMultiple VCs:Company: Amortization of control!VCs:Share riskShare DDBoth: different VC strengths (financial vs. strategic)

So What Do VCs Look For?Committed, experienced managementDefensible technologyGrowth market (not consultancy)Significant revenuesRealistic sales and marketing plan (VARs and OEMs vs. direct sales force)

Case Study: DDoS Defense TechnologyDDoS: Distributed Denial of ServiceWeb server, router, DNS server, etc. flooded with automated, spurious requests for service at a high rateOutcomes:Resource crashesLegitimate requests denied serviceBandwidth usage and expense increaseAttack types:SYN floodICMP echo reply attackZombie attacksIP spoofingContinually evolving!Attack characteristics:DistributedStatisticalHighly adaptiveNot defendable via cryptography, firewalls, intrusion detection,An arms race

Market LandscapeVictims include CNN, eBay, Microsoft, Amazon> 4000 attacks per week (UCSD study)Recent Code Red attack on White House foiled, but > 300K client zombies infectedCosts:Downtime, lost productivityRecovery costs (personnel)Lost revenueBrand damageAttack costs $1.2B in Feb. 00; 2005 market estimate $800M (Yankee Group)

Who Can and Will Pay?Internet composed of many independently owned and operated autonomous networksMany subnets embedded in larger networksDetecting/defending DDoS requires a minimum network footprintMust solve problem upstream at routers with sufficient bandwidth to withstand attack traffic!May simply trace attack source to network edgeTarget customers:Large and medium ISPs, MSPs, NSPsLarge and medium data centersBackbone network providersFuture: wireless operators; semi-private networks (FAA, utilities)Making target customers care; cannibalizationKey points:Problem did not exist until recently on large scaleNo product available for its defenseNo historical analysis of market possible (firewall and IDS)

The CompaniesFour early-stage companies focused specifically on DDoSAll with strong roots in academiaHeadcounts in 10s; varied stages of funding and BDLarger set of potential competitors/confusers:Router manufacturers (e.g. Cisco)IDS and firewall companiesVirus detection companies (e.g. McAfee)Technology:All four solutions involve placing boxes & SW near routersDiffering notions of nearBoxes monitor (some or all) network trafficBoxes communicate with a Network Operations Center (NOC)Key issues:Detection or Defense?Intrusiveness of solution?

Some SpecificsCompany Detect:Emphasis on detection tools provided to NW engineerClaim more intrusive/automated solutions unpalatableEmphasis on GUI and multiple views of DDoS dataMore advanced in BD (betas), PR, partnershipsMore advanced in funding (>>$10M capital taken)Company Defend-Side:Emphasize prevention of attacks by filtering victim trafficBox sits to the side of router over fast interfaceClaim there is a sweet spot of intrusivenessBox only needs to be fast enough for victim traffic, not allDont need perfect filtering to be effectiveNo GUI emphasis; behind in BD; less advanced in fundingCompany Defend-Path:Also emphasizing prevention, but box sits on data pathNeed faster boxes and more boxes (scalability)Concerns over router integration

Due DiligenceNo company has any revenue yetSome have first-generation product availableAll have arranged beta trials with some ISPsHave roughly similar per-box pricing model and ROI argumentDue diligence steps:Repeated visits/conversations with companies: technical, sales strategyMultiple conversations with beta NW engineersDevelopment of financial model for revenue projections & scenariosCompare with firewall and IDS market history: winners & losers, mergersConversations with previous round VCs: DD and commitmentIn the end, a decision between:More conservative technology with a slight lead in BD and R&DMore ambitious technology with less visibility, but a better dealContemplating both investmentsthen came September 11.

Venture capital firms specialize in providing equity financing for firms that are in an early stage of development (start-ups).

Examples of companies that received venture capital funding in their early development include Apple, Federal Express, Microsoft, Genentech, and Google.

Venture capital (a.k.a. private equity) is a pool of capital most commonly organized as a limited partnership. The venture capital firm serves as the general partner and investors are the limited partners. Limited partners can include pension funds, university endowment funds, wealthy individuals, and other financial institutions and corporations.

Venture Capitalists

Managers of venture capital firms (venture capitalists) closely follow the technology and market developments in their area of expertise (e.g., computer software, communications, computer hardware, medical/health, industrial/energy, biotechnology, retailing, restaurants, etc.)

They screen entrepreneurs and their business concepts prior to making an investment. To diversify risk, they create a venture fund that is a portfolio of investments in young companies.

Venture capitalists are not passive equity investors. They structure a financing deal with great attention to creating the right incentives and compensation for the start-up firms owners. They are also instrumental in raising additional financing during future stages of the firms lifecycle.

Types of venture capital financing provided to companies:Seed: prior to a product being developed or to the start-up being organized.Early Stage: after a company has expended initial capital in development and market testing and is now ready to begin full-scale operations and sales.Expansion Stage: the company is producing and shipping and has growing inventories and accounts receivable.Later Stage: company is now breaking-even or profitable and requires funds for plant expansion, full-scale marketing, and working capital.MBO/Acquisition: This situation occurs when managers wish to purchase an independent company or a division or product line of their employer, thus creating a new independent firm.

Venture capitalists (VCs) continuously monitor their companies.VCs typically serve on the companys Board of Directors.VCs provide mentoring and strategic advice to the companys managers.VCs often provide business contacts to company managers.VCs help recruit additional managers for the company.VCs set company performance targets. If these targets are not met, VCs may have the option of replacing the company founder as the CEO.

Empirical evidence finds thatCompanies with innovative, rather than imitator, business plans are more likely to receive VC financing.Ceteris paribus, companies obtaining VC financing bring their products to market more quickly.

A venture capital firm typically raises money for a venture capital fund by obtaining commitments from limited partner investors. Based on the funds prospectus, limited partners agree to make investments for a period that is often 10 years.

After commitments are obtain, the VC begins making investments in young companies. VCs make capital calls to the limited partners as funds are dispersed to the start-up companies.

The most common way that the VC obtains a return from its investment in a start-up company is by the company being acquired by a mature corporation. In other cases, the VC obtains a return when the company issues an IPO. After the IPO, the stock held by the VC is given to the partners who can continue to hold it or liquidate it.

Most commonly VCs are private independent firms. However, sometimes a VC firm is aSubsidiary of a commercial bank holding company (BHC). This allows the BHC to provide (high-risk) equity financing that could not be made by BHCs commercial bank subsidiary.Subsidiary of an investment bank. Investment banks see VC investing as a way to groom companies for an IPO.Subsidiary of a non-financial corporation (a.k.a. direct investing). The parent companys capital is used to invest in young companies that may produce synergies or cost savings for the parent.

The major alternatives to venture capital financing areAngels: These are wealthy individuals (often former corporate executives) who mentor a company and provide financing and expertise to start-ups.Commercial banks: often in the form of lines of credit.Government: Through grants or Small Business Administration financing and loan guarantees.Self-financing: including family members and friends.

Total Venture Capital Disbursements $MVC financing grew tremendously during the 1990s. The recession and decline in technology firms (a major source of VC investment), led VCs to reduce their investments because prospects for making profits in start-ups was greatly reduced.

Chart1

2788.92

2261.98

3539.44

3734.3

4152.79

7667.77

11580.26

14932.46

21511.66

54958.59

106202.91

40721.48

21412.91

18043.16

Sheet1

199014542788.92

199112562261.98

199213903539.44

199311873734.3

199412224152.79

199518847667.77

1996263511580.26

1997321114932.46

1998411421511.66

1999563654958.59

20008124106202.91

2001463140721.48

2002304221412.91

2003204018043.16

Sheet1

Sheet2

19901454

19911256

19921390

19931187

19941222

19951884

19962635

19973211

19984114

19995636

20008124

20014631

20023042

20032040

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Number of Venture Capital DealsWhile it may be some time before VC activity returns to the level of the bubble years of 1999-2000, VC financing will remain an important source of funding for entrepreneurs with innovative business strategies.

Chart2

1454

1256

1390

1187

1222

1884

2635

3211

4114

5636

8124

4631

3042

2040

Sheet1

199014542788.92

199112562261.98

199213903539.44

199311873734.3

199412224152.79

199518847667.77

1996263511580.26

1997321114932.46

1998411421511.66

1999563654958.59

20008124106202.91

2001463140721.48

2002304221412.91

2003204018043.16

Sheet1

Sheet2

19901454

19911256

19921390

19931187

19941222

19951884

19962635

19973211

19984114

19995636

20008124

20014631

20023042

20032040

Sheet2

Sheet3

Questions?