How Venture Capitalist (VC) Firms Screen Deals

Venture Capital Investing A Primer William Quigley Managing Director Clearstone Venture Partners [email_address] C L E A R S T O N E V E N T U R E P A R T N E R S

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Odds of Getting a Deal Done? Hurdle Likelihood of Occurring 1. Review the plan and - 1 in 15 conclude it makes sense 2. Meet the team and like them - 6 in 10 3. Be attracted to the market - 7 in 10 opportunity and the company strategy 4. Introduce team to the other partners and get their buy-in - 7 in 10 C L E A R S T O N E V E N T U R E P A R T N E R S

Odds of Getting a Deal Done? Hurdle Likelihood of Occurring 5. Complete the due diligence - 7 in 10 process satisfactorily 6. Get a term sheet agreed to - 8 in 10 in principle 7. Find co-investors - if necessary - 9.9 in 10 8. Get legal documentation done - 9 in 10 9. Fund the company EQUATES TO 1% C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions “ Will I have to give up control of my company?” C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions “ Why don’t VC’s sign NDA’s?” C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions “ Raising money - all at once or spread out over time?” C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions “ Its a great invention, so why aren’t they interested?” C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions “ Why do VC’s want to know the other firms that I am talking to?” C L E A R S T O N E V E N T U R E P A R T N E R S

Commonly Asked Questions “ When should I initiate contact with a VC?” C L E A R S T O N E V E N T U R E P A R T N E R S

How do you Contact a VC? Introductions are best: Attorney Accountant Banker Angel Investor Industry Executive C L E A R S T O N E V E N T U R E P A R T N E R S

The Michael Dingman Center at U of MD. The Morino Institute - Netpreneur Program Baltimore/Washington Venture Group NVTC - Emerging Business Network functions Silicon Valley Bank, other community banks Private Investors Network, Grubstakes (networks of angel investors) Pratts Guide to Venture Capital Local Resources C L E A R S T O N E V E N T U R E P A R T N E R S

Venture Capital C L E A R S T O N E V E N T U R E P A R T N E R S

How Venture Capitalist (VC) Firms Screen Deals

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