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Douglas Abrams
About the facilitator
• Wharton MBA
• JP Morgan – Vice President - IB Technology, Global
Markets Internet Marketing
• Parallax Capital Management – Co-founder and
MD - Venture Capital
• Extream Ventures – Co-founder and MD - S$20
million VC fund
• Expara – Founder and MD - IDM Ventures
Incubator, fund, advisory, training
• NUS – Adjunct Associate Professor, Business
School, Entrepreneurship
• Sasin – Visiting Professor, Venture Capital
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Douglas Abrams
Expara timeline 2000-2015
3Overview of Expara
2000 20152000 2002 2004 2006 2008 2010 2012 2014
NUS
Expara
EIDMV I
Extream EIDMV II EV III
Parallax
BANSEA
KIMBA
Sasin
Expara Thailand
Expara Malaysia
Expara
Vietnam
Expara
Japan
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Douglas Abrams
Leading venture creation in SEA
Venture capital
• 4 early-stage funds
launched from 2007 to
now
• 40 companies invested
• 3 exits – Fund I
• 5.4x ROI on Fund I
• 1 exit – Fund II
• 1x ROI – Fund II
• 1 exit – Fund III - NSX
Venture Services
• 15 years of experience
• 6000 trained and
mentored
• 500 companies served
• 65 companies advised
• $50 MM raised by these
companies
4Overview of Expara
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Douglas Abrams
EIDMV I
Extream
Ventures
EIDMV II
Expara
Ventures III
2008 to 2013 2012 to present 20152007 to 2011
• Singapore;
• One of the first iJAM
incubators;
• Fund size: S$1M;
• Investment size:
S$55K; and
• Focus: IDM.
• Singapore;
• Fund size:
S$20M;
• Investment size:
S$1M to S$3M;
and
• Focus: IDM,
software, IT.
• Singapore;
• Fund size:
S$4.55M;
• Investment size:
S$255K; and
• Focus: IDM.
Series A Seed Seed - Series A
• South East Asia;
Japan
• Fund size: S$30M;
• Investment size:
S$250K to S$3M;
and
• Focus: ICT,
disruptive
innovation.
Expara’s venture capital funds
Pre-seed
5Venture capital
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Douglas Abrams
Schedule
Day 1
9:00 AM VC Mindset – risk and return I
10:30 AM Break
10:45 AM VC Mindset – risk and return II
12:30 PM Lunch
1:30 PM Evaluating scalability and start-up business models
3:00 PM Break
3:15 PM Forecasting revenue, expenses and cash flow and valuing start-
ups
5:00 PM End day 1
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Douglas Abrams
Idea to Investment – Venture Capital
• Understanding the VC mindset – risk and return
• Evaluating scalability
• Evaluating start-up business models
• Forecasting revenue, expenses and cash flow
• Valuing start-ups
• VC investment process
• Understanding term sheets and deal structures
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Douglas Abrams
Who are entrepreneurs and venture investors?
• Entrepreneurs
– Lifestyle entrepreneurs - limited scope, complication and
risk. Slow growth.
– High-growth entrepreneurs (scalable business)
Significant scope, complication, and risk. Rapid growth.
• Venture investors
– Venture capitalists (VCs)
– Angel investors
– Corporate VCs and investors
– Banks, government
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Douglas Abrams
What roles do they play?
Identify opportunities
Provide funding
Oversee finances
Assist with growth
Generate returns for themselves or
their investors
Venture investors
Create opportunities
Raise funding
Manage finances
Increase value
Generate returns for investors
Entrepreneurs
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Douglas Abrams
Why do companies raise investment?
Lifestyle or scalable?
Paycheck or payout?
A big piece of a small pie?
A small piece of a big pie?
Founder
Investors
Investors
Founder
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Douglas Abrams
VC mindset
Risk and return are highly correlated
You cannot increase return without taking more risk
Return
Risk
Potential outcomes
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Douglas Abrams
Cost, control, growth and risk
Internal
Debt
Equity
Source of funds
Cost Lose Control Growth $ Risk
Impact of funding
Low Somewhat High
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Douglas Abrams
How does a venture capital fund work?
Fund
Investors
VC
8
$ 10 mm
2
$ 10 mm
$ 58 mm
25%
75%
Fund size 10,000,000$
Life of the fund 7
Management fee 2.5%
Investable 8,250,000$
Investment size 1,031,250$
Companies 8
Fail 4 50%
Break even 2 25%
Exit 2 25%
Investor's required ROI 35%
Fund multiple return 5.76
Fund size at exit 57,600,000$
Carry @ 20% 9,520,000
Distribution 48,080,000$
Fund return multiple 4.81
Fund ROI 35%
Required return per exit 28 times
Equity per company F/D 15%
Required value of equity at exit 28,800,000$
Required co value at exit 192,000,000$
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Douglas Abrams
GVMs for all first-round investments
10 years after investment. Data from Sand Hill Road Econometrics. Companies received first financing before 1 January 1999. First non-seed
round investment. Returns are gross - before fees and carry
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Douglas Abrams
How do VCs make money?
Trade sale – sell to
another company
IPO – sell to the
public through listing
on an exchange
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Douglas Abrams
Why invest in venture capital?
As of June 30, 2014. The Cambridge Associates LLC U.S. Venture Capital Index® is an end-to-end calculation based on data compiled from 1,508 U.S. venture capital funds (963
early stage, 165 late & expansion stage, 374 multi-stage and 6 venture debt funds), including fully liquidated partnerships, formed between 1981 and 2014. (1)Pooled end-to-end
return, net of fees, expenses, and carried interest.(2) 2007-2015 Sources: Cambridge Associates LLC, Barclays, Dow Jones Indexes, Frank Russell Company, Standard & Poor's,
Thomson Reuters Datastream, and Wilshire Associates, Inc
Case Shiller Real Estate Index 4.1
Expara IDM Ventures (2) 43.03
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Douglas Abrams
Impact of VC on a diversified portfolio
Private Equity and Strategic Asset Allocation. 2007 Ibbotson Associates
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SEA exit markets at an inflection point
Exit activity in SEA, especially in Singapore, has exploded
• Increased investment in startups since 2007 is beginning to yield results
• Number of exits increased from 5 or less pre-2011 to 60 in last three years
• Singapore alone has had 40 exits since 2007
• Value of exits increased from 51 MM in 2010 to 1.2 B in 2014
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Some recent exits
Company Country Acquiror Price Year
ZopIM Singapore Zendesk US$29.8MM 2014
Non-Stop Games Singapore King US$ 100MM 2014
sgCarMart Singapore SPH S$60 MM 2013
DS3 Singapore Gemalto S$50 MM est. 2013
Asian Food Channel Singapore Scripps Networks Undisclosed 2013
Reebonz Singapore MediaCorp and Existing investors S$250MM 2013
Yfind Singapore Ruckus Wireless Undisclosed 2013
Techsailor Singapore TO THE NEW Undisclosed 2013
travelmob Singapore HomeAway Undisclosed 2013
Catcha Digital Media Singapore Opt Inc Undisclosed 2013
GridBlaze Singapore Undisclosed Silicon Valley Startup Undisclosed 2013
Viki Singapore Rakuten US$200MM 2013
SGE Singapore Tech In Asia Undisclosed 2013
ThoughtBuzz India To The New Undisclosed 2013
AyoPay Indonesia MOL AccessPortal Undisclosed 2013
Tongue in Chic Malaysia PopDigital Undisclosed 2013
Ocision Malaysia Star Publication US$ 4.36MM 2013
Glamybox Vietnam VanityTrove Undisclosed 2013
PaymentLink Singapore Wirecard US$41.2MM 2013
Dealguru Singapore iBuy S$34.28 MM 2013
Buy Together Hong Kong iBuy S$21 MM 2013
Dealmates Malaysia iBuy S$10 MM 2013
PropertyGuru.com Singapore ImmobilienScout24 S$60 MM 2012
HungryGoWhere Singapore Singtel S$12 MM 2012
AdMax Network Singapore Komli Media Undisclosed 2012
TheMobileGamer Singapore Singtel US$1.5 MM 2012
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Douglas Abrams
Why fear risk?
Fear is good when it helps us stay
alive
It is rational to be risk-averse in
life-and-death situations
Most investment decisions are not
life-and-death situations
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Just do it
Everything that is worth doing is
difficult
If it is easy, it is probably not worth
doing
You should never hesitate to do
something difficult
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Risk and return – small versus scalable business
Small business: limited scope,
complication and risk. Slow
growth.
Scalable business: significant
scope, complication, and risk.
Rapid growth.
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Facebook: ROI to 1st round ~5,000x
Feb 2004: Mark Zuckerberg, 19, launches The Facebook from
his Harvard dorm room, with ~10K investment. Half of Harvard
signs up in the first month
June 2004: Facebook receives $500K funding from Peter Thiel
Mid 2005: Accel partners invests $12.7MM and Greylock
$27.5MM
Oct 2007: Microsoft buys 1.6% of Facebook for $246MM
Nov 2007: Li Ka-shing invests $60MM
2009-10: Elevation partners invests $210MM at valuation $12 -
23B
2011: Goldman Sachs buys shares in the secondary market at
an implied valuation of $50B
2012: Valuation after IPO $65B
2014: Valuation $190B
“The youngest
billionaire on
earth” - Forbes
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Instagram: ROI to 1st round ~200x
2010 - Kevin Systrom and Mike Krieger
focus their multi-featured HTML5 check-
in project Burbn on mobile photography
Mar 2010 – Close $500K seed funding
round from Baseline Ventures and
Andreessen Horowitz; est. val. $5 MM
Oct 2010 – Product launches on Apple
App Store
Feb 2012 – Raise $7MM Series A
funding; valuation $25 MM
Apr 2012 – Raise $50 MM at $500 MM
valuation; sold to Facebook, val $1 B
0
5
10
15
20
25
30
35
Millions of Users
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Douglas Abrams
Google: ROI to 1st round ~1000x
1995: Sergey Brin and Larry Page,
two Stanford University graduate
students develop the technology that
will become the Google search engine.
1998: Sergey and Larry raise $1
million in funding from family, friends,
and angel investors to start Google in a
friend's Menlo Park, Calif. garage with
four employees.
1999: Google raises $25MM from VCs
and angel investors
2004: Google goes IPO at a valuation
of US$23.1 billion. Sells 7% to public
for $1.67 billion.
2014: Market cap US$388 billion.
Value of shares at IPO: US$3.8 B each
Value of shares now: US$14 B each
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YouTube: ROI to 1st round ~125x
Feb 2005: Chad Hurley, Steve Chen,
and Jawed Karim found YouTube, Inc.
Nov 2005: YouTube receives funding
from Sequoia Capital
Dec 2005: YouTube service is officially
launched
Nov 2006: Google acquires YouTube
for US$1.65 billion, 20 months after the
company was founded
2013: Youtube revenue 3.5B
Value of shares at exit
US$760 MM
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Douglas Abrams
Product failures – from Apple III to Apple Newton
1980 - Apple III - 75k units sold
1983 – Apple Lisa - 40K units sold in
1984 vs. 80K forecast
1986 – Pixar Image Computer - <
300 units sold
1990 – NeXT workstation – 50K
units sold
1993 – Newton – 100MM spent on
development – 80K units sold
Apple clones, NeXT software
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Douglas Abrams
Steve Jobs career timeline
Success - 1977
• Apple II
Failure – 1980
• Apple III
Failure – 1983
• Lisa
Success – 1984
• Macintosh
Failure – 1985
• Ousted from Apple
Failure – 1988
• Pixar Image
Computer
Failure – 1990
• NeXT Workstation
Failure – 1993
• NeXT discontinues
HW
Success – 1995
• Toy Story; Pixar
IPO
Success – 1996
• Apple buys NeXT
Success – 1997
• Return to Apple
Success – 1998
• Apple profitable
Success 2001
• IPod
Success 2007
• Iphone
Success 2010
• iPad
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Success from failure
Pixar animated films – 1995 (Toy Story)
– 26 Oscars, 7 Golden Globes, 3 Grammies
– Films have earned > $6.3 billion worldwide
iPod - 2001
– 300 MM units sold
– 90% market share
iPhone – 2007
– > 75 MM units sold
– 50% of profits from global mobile phone sales
iPad
– > 15 MM units sold, more than all other tablets combined
– 83% market share
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Douglas Abrams
Idea to Investment – Venture Capital
• Understanding the VC mindset – risk and return
• Evaluating scalability
• Evaluating start-up business models
• Forecasting revenue, expenses and cash flow
• Valuing start-ups
• VC investment process
• Understanding term sheets and deal structures
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Douglas Abrams
Product or service: which scales better?
• Product-based start-ups
• Value proposition is delivered
via product
• Service-based start-ups
• Value proposition is delivered
via people
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Douglas Abrams
Key elements for success
• Solve a problem for customers – Value proposition
• Develop an innovative product – Innovation
• Identify your customers – Market identification and analysis
• Reach your customers – Marketing strategy
• Compete when others enter - Sustainable competitive advantage
• Make money – Business model and financial plan
• Team – A team or B team
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Douglas Abrams
Value proposition – degrees of recognition
• Latent problem – they have a problem but don’t know it
• Passive problem – they know they have a problem but not looking
for a solution yet
• Active or urgent problem – they know they have a problem, are
actively looking for a solution but no serious work done yet to solve
• A vision – they have an idea for solving the problem and a home-
grown solution but are prepared to pay for a better solution
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Douglas Abrams
Value proposition and innovation
1. What is the painful problem they are solving for customers?
2. What is their product and what is innovative about it?
3. What are the shortfalls of the current solutions?
4. How do they solve this problem and can they quantify your
benefit?
5. How does their innovation enable you to accomplish this?
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Douglas Abrams
Market opportunity
1. How big is their market and how fast is it growing?
– Top-down approach
– Bottom-up approach
2. What are trends in the market are favourable for them?
– Technological, social, demographic, regulatory
3. Who are their direct and indirect competitors?
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Competitive strategy
1. How is their product differentiated from competitors’ product?
2. What is their CLV-CAC?
3. How will they create barriers of entry for followers?
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Last-mover advantage
• Reputation
• Preempting positioning
• Switching costs/Lock-in/Network effects
• Unique channel access
• Move down learning curve
• Favorable access to inputs
• Definition of standards
• Institutional barriers – IP protection
Advantages
• Pioneering costs
• Demand uncertainty
• Changes in buyer needs
• Specificity of investments
to early generations
• Technological
discontinuities
• Low-cost imitation
Disadvantages
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Douglas Abrams
Established company strengths and weaknesses
Learning curve
Reputation effect
Cash flow
Economies of scale
Complementary
assets
Advantages
Difficult to innovate
They need to satisfy existing customers,
partners and supply chain
Existing organizational structure is appropriate
to current tasks
Risk aversion
Weaknesses
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Douglas Abrams
Opportunities that favor new firms
Existing firms frozen in the headlights
Disruptive technologies and business models
Uncertainty: existing firms’ advantages in market research are
neutralized; risk propensity
Technologies: Discrete versus systemic technologies, based on
human capital, general purpose rather than specific
Bad customers: Enter market that is unattractive to existing
competitors due to established cost structure
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Douglas Abrams
Idea to Investment – Venture Capital
Understanding the VC mindset – risk and return
Evaluating scalability
Evaluating start-up business models
Forecasting revenue, expenses and cash flow
Valuing start-ups
VC investment process
Understanding term sheets and deal structures
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Douglas Abrams
Key evaluation criteria
Business model
Financial projections
Valuation
Funding required & equity offered
Use of Proceeds
Exit Strategy and ROI
Cap table
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Douglas Abrams
Disruptive business model or disruptive tech
• Diamond is the first mover in
portable MP3 in 1998
• Apple enters in 2003 and
captures 90% of the market
• Business model innovation –
hardware + software + service
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Douglas Abrams
Disruptive models from Gillette to Google
• Gillette – razor and blade
• Southwest Airlines – budget airlines
• Dell Computer – mass customization
• Charles Schwab – on-line broker
• Amazon – ecommerce
• eBay – peer to peer marketplace
• Google – search-based advertising
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Douglas Abrams
Revenue models
• Subscription/membership
• Volume or unit-based sales
• Advertising-based
• Licensing & syndication
• Transaction fee
• Pay-per-use
• Referrals
• Affiliate/revenue sharing
• Selling data
Revenue models
• Single stream
• Multiple streams
• Interdependent
• Loss leader
Revenue streams
• Value pricing
• Competitive
• Volume
• Portfolio
• Razor/blade
• Subscription
• Leasing
• Product based
Pricing models
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Cost structure
• What are the most
important costs
inherent in our
business model?
• Which Key
Resources are most
expensive?
• Which Key Activities
are most expensive?
Key questions
• Cost Driven (leanest cost
structure, low price value
proposition, maximum
automation, extensive
outsourcing)
• Value Driven (focused on
value creation, premium
value proposition)
Is your business more
• Fixed Costs (salaries, rents,
utilities)
• Variable costs
• Economies of scale
• Economies of scope
Sample characteristics
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Idea to Investment – Venture Capital
• Understanding the VC mindset – risk and return
• Evaluating scalability
• Evaluating start-up business models
• Forecasting revenue, expenses and cash flow
• Valuing start-ups
• VC investment process
• Understanding term sheets and deal structures
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Create financial projections
• 3-5 years of projected
balance sheet, income
statement and cash flow
statements.
• Market share and sales
growth are key
• Project cash requirements
using a detailed budget
• Project revenues from top
down and bottom up
Scalability necessary for VC investment - $50MM in annual rev
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Douglas Abrams
Create pro-forma financial statements
• Balance statement - the company’s financial condition
• Income statement (P&L) - the success of the business
• Cash flow statement - cash availability and needs of the business
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Idea to Investment – Venture Capital
• Understanding the VC mindset – risk and return
• Evaluating scalability
• Evaluating start-up business models
• Forecasting revenue, expenses and cash flow
• Valuing start-ups
• VC investment process
• Understanding term sheets and deal structures
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Company valuation methods
• Price to earnings (p/e)
• Dividend yield
• Multiple of book value
• Comparables
• Discounted Cash Flow (DCF)
• VC method
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How much equity does the investor receive?
• Pre-money valuation
• Amount invested by VC ÷ (Agreed pre-money value of business
+ Amount invested by VC)
• $3MM pre + 1 MM VC = 25% VC equity
• Post-money valuation
• Amount invested by VC ÷ post-money valuation
• $4MM post = 25% VC equity
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Comparables
• Use value that has already been established either in public
markets or through a sale for a comparable company
• Difficulties
• How to find comps
• Accounting methods vary
• Public versus private liquidity
• Changing market conditions
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DCF Valuation Model
• Firm value is discounted present value of future cash flows
• Percent of sales forecasting
• Tie income-statement and balance sheet figures to future sales
• Variable costs and most current assets and liabilities tend to vary
directly with sales
• Only future sales require prediction; relationship between items
can be calculated more easily
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Discounted cash flow
• Project cash flow from operations for 3-5 years
• Adjust the cash flow for factors such as non-recurring items of
income and expense, depreciation, amortization, interest and taxes
• Discount the cash flow as adjusted, using alternative assumptions
for time and risk factors.
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VC method of valuation
• What is the required investment today? (I$)
• What is the exit valuation for this company? ($EV)
• What is the target multiple of money on our investment? (M)
• What is the expected retention percentage? (%RP)
• Estimate the total valuation for the company today? TV = ($EV * %RP / M)
• What is the proposed ownership percentage today? (%P)
• Estimate the partial valuation for this investment PV = (%P * TV)
• Investment recommendation: compare partial valuation to required
investment PV > I$ ?
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Idea to Investment – Venture Capital
• Understanding the VC mindset – risk and return
• Evaluating scalability
• Evaluating start-up business models
• Forecasting revenue, expenses and cash flow
• Valuing start-ups
• VC investment process
• Understanding term sheets and deal structures
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Schedule
Day 2
9:00 AM VC investment process
10:30 AM Break
10:45 AM Term sheets and deal structure
12:30 PM Lunch
1:30 PM VC-startup negotiation exercise briefing
2:15 PM VC-startup negotiation team strategizing
3:00 PM Break
3:15 PM VC-startup negotiation exercise
4:30 PM VC startup negotiation game debrief
5:00 PM End day 2
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VC investment process
Approach
Sourcing
Selection
& Due
Diligence
Deal
Structuring
&
Negotiation
Accelerate
to Scale
Portfolio
Management
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Douglas Abrams
Capital and legal structure of firm
• Equity
• Common or preferred stock
• Convertible debt
• Options and warrants
• Debt
• Notes and bonds
• Legal structure
• Corporation
• Limited liability company
• Limited partnership
Due diligence issues
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Equity issued to
• Current management team, including founders
• Management and employees to be hired in future
• Initial investors
• Institutional investors, including VCs
• ESOP – 10 to 15%
• Future CEO may require 5 to 10%
Due diligence issues
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Stages and sources of funds
Founder’s
Capital
Seed/
Angel
Series
A, B, C
Mezzanine Pre-Exit Exit
VC hurdle rates 60-100% 40-60% 20%
OM
F,F&F
Incubators
corporations
government
Customers, suppliers,
strategic partners
VCs, Banks for VC loans
R&D Establishment GTM/Rollout Accelerated Expansion Maturity
Enablement growth
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How does a venture capital fund work?
Fund
Investors
VC
8
$ 10 mm
2
$ 10 mm
$ 58 mm
25%
75%
Fund size 10,000,000$
Life of the fund 7
Management fee 2.5%
Investable 8,250,000$
Investment size 1,031,250$
Companies 8
Fail 4 50%
Break even 2 25%
Exit 2 25%
Investor's required ROI 35%
Fund multiple return 5.76
Fund size at exit 57,600,000$
Carry @ 20% 9,520,000
Distribution 48,080,000$
Fund return multiple 4.81
Fund ROI 35%
Required return per exit 28 times
Equity per company F/D 15%
Required value of equity at exit 28,800,000$
Required co value at exit 192,000,000$
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Key terms of venture capital funds
• Fund size
• Term
• Management fee
• Distribution of returns – return of capital, performance fees, hurdle
rate, catch-up
• Investment period
• Diversification and investment limits
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Example terms of venture capital funds
• Fund size – 20MM
• Term – 8+1+1
• Management fee – 2.5%
• Distribution of returns – return of capital, performance fees, hurdle
rate, catch-up – 100%, 20%, 5%, 100%
• Investment period – 3 years
• Diversification and investment limits – 15% of fund
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VC fund portfolio strategy
• Total investable funds
• Diversification; number of investments
• Expected failure rate
• Gross value multiple
• IRR to LPs
• Distributions of gains
Fund
• Investment stage and risk
• Regional and industry focus
• Timing and size of investments
• Max investment per company
• Follow-on investments
• Min and max return per investment
• Types and timing of exits
Portfolio companies
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Return to investors
• Best case and worst case
• Gross value multiple (GVM)
• Cash flows to investors
• IRR net of fees
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Investment strategy
• How many companies will you invest in?
• How will your investments break down by stage of investment?
• How will you define each stage of investment?
• Within each stage of investment, how will your investments break down by risk
level?
• How much will you invest in each company?
• How many rounds of investments in each company?
• What will the timing be of your investments (e.g. year 1, how many of each type of
investment, how much will each investment be, etc.). Include a capital deployment
schedule that illustrates this.
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How will you generate returns?
• How many of your companies will fail, how many will exit?
• What will the timing be of your exits and failures?
• How will you exit?
• What will be the distribution of returns on your exits?
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Other strategic factors
• What industry verticals will you focus on for your investments?
• In what geographic regions will you invest?
• Any other special features of your fund strategy.
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Idea to Investment – Venture Capital
• Understanding the VC mindset – risk and return
• Evaluating scalability
• Evaluating start-up business models
• Forecasting revenue, expenses and cash flow
• Valuing start-ups
• VC investment process
• Understanding term sheets and deal structures
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VC vs. entrepreneur - interests
• Solve sorting problem
• Minimize agency costs/problems
• Maximize financial returns
• Maintain option to abandon
• Be able to force entrepreneur to
exit and distribute proceeds
• Maintain reputation
VC
• Get outside capital
• Maximize financial gains from
equity stake
• Retain control, minimize
constraints on behavior and
decision making
• Build successful firm
• Build reputation
• Get outside expertise and contacts
Entrepreneur
From Venture Capital Negotiations: VC versus Entrepreneur – HBS Publishing
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VC vs. entrepreneur – sources of power
• Providing capital
• Adding credibility to entrepreneur
• Actions send signal to other VCs
• Adding value through expertise and
contacts
• Entrepreneur's reputational concerns
• Imbalance between supply and demand
• BATNAs: Providing capital/time to other
start-ups or existing portfolio companies;
spending time fund raising
VC
• Deep expertise in hot specialty
• Great track record
• Solid team
• Can keep VC from investing in later
rounds/funds
• VC wants to lay groundwork for
productive working relationship
• VC's reputational concerns
• BATNAs: Other VCs, angels, banks,
corporations
Entrepreneur
From Venture Capital Negotiations: VC versus Entrepreneur – HBS Publishing
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VC versus entrepreneur
• Entrepreneur compensation increases
when value of VC's stake increases
• Vesting of entrepreneur's stake
• Key-person agreements
• Ability to fire managers
Ways to align incentives
• Due diligence
• Repeated relationships
• Monitoring/information rights
Ways to reduce information asymmetries
From Venture Capital Negotiations: VC versus Entrepreneur – HBS Publishing
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VC versus entrepreneur
• Equity stake senior to that of
entrepreneur
• Option to abandon through staging of
investments across financing rounds
• Forcing exit through decision-making
control
• Convertible debt
• Puts rights and anti-dilution provisions
Ways for VC to protect downside
• Seat on board of directors
• Covenants in agreement limiting
entrepreneur's ability to use capital in
undesirable ways
• Involvement in operations
• Super-majority rights
Ways for VC to control decision making
From Venture Capital Negotiations: VC versus Entrepreneur – HBS Publishing
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Chapter 2 – VC players
2.1 Suppose that a $200M VC fund has a management fee of 2.5 percent per year
for the first five years, with a reduction of 0.25 percent (25 basis points) in each
year thereafter. All fees are paid on committed capital, and the fund has a 10-year
life. What are the lifetime fees and investment capital for this fund?
2.2 (This is a little bit tricky.) Suppose that a $1B VC fund has fees of 2.0 percent
per year in all years, with these fees paid on committed capital in the first five years
and on net invested capital for years 6 through 10. You can assume the fund is fully
invested by the beginning of year 6, then realizes 20 percent of its investment
capital in each of the following five years. What are the lifetime fees and investment
capital for this fund? (Make assumptions for any information that you think is still
missing from the problem.)
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Chapter 2 – VC players
2.3 A VC firm is considering two different structures for its new $250M fund. Both
structures would have management fees of 2 percent per year (on committed
capital) for all 10 years. Under Structure I, the fund would receive an X percent
carry with a basis of all committed capital. Under Structure II, the fund would
receive a Y percent carry with a basis of all investment capital. For a given amount
of (total) exit proceeds 5 $Z, solve for the amount of carried interest under both
structures.
2.4 Talltree Ventures has raised their $250M fund, Talltree Ventures IV, with terms
as given in Appendix 2.B of this chapter. Construct an example of fund performance
where the clawback provision would be triggered. In this example, compute the
carried interest paid in each year, and show the total amount that must be paid
back by the GPs upon the liquidation of the fund.
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Chapter 3 – VC returns
3.1 The Bigco pension plan has invested in dozens of VC funds. The director of the
pension plan is preparing his annual report to the Bigco board of directors.
Summary information for Bigco’s VC portfolio is given in Exhibit 3-9. The board has
asked for a five-year report of net returns and gross returns by year, plus the
compound returns and annualized returns for all five years. You can assume that all
new investments and management fees were paid for at the beginning of the year,
and all distributions were paid at the end of the year.
3.2 Consider the case of XYZ Partners from Example 3.3. Now, instead of using a
GVM of 2.5 (as in the example), assume that this GVM is unknown and equal to K.
(a) For any given K, solve for the carried interest, value multiple, and GP%.
(b) How large must K be for the value multiple to be greater than 3?
(c) How would your answer to parts (a) and (b) change if the carry basis were equal
to investment capital? (In the original example, the carry basis is equal to
committed capital.)
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Chapter 3 – VC returns
3.3 True, False, or Uncertain: If both EBV and Owl have the same GVM, then the
value multiple of Owl will be lower than the value multiple of EBV. (See Appendices
2.A and 2.C for more information on EBV and Owl.)
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Chapter 4 – Cost of capital for VC
4.1 The Largeco pension fund aggregates its entire portfolio every month across all
asset classes and computes its net returns, Ri Exhibit 4-7 displays these monthly
returns for one year, along with the market returns and the risk-free treasury bill
rates for those months. Use Equations (4.1) and (4.2) to estimate the beta, alpha,
and cost of capital for the Largeco portfolio. How do you evaluate its investment
performance?
4.2 True, False, or Uncertain: Early stage venture capital should earn a higher
expected return than later-stage venture capital, because early stage ventures have
a higher failure rate than later-stage ventures.
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Chapter 4 – Cost of capital for VC
4.3 Consider the following three companies:
(i) Gasco owns and operates a chain of gas stations in the northeast United States.
(ii) Fuelco is a prerevenue company that is attempting to develop new fuel cell
technologies to replace the internal combustion engine.
(iii) Combco combines the operations of Gasco and Fuelco.
Use qualitative reasoning to order the cost of capital for these three companies
from lowest to highest. (There is more than one reasonable way to answer this
question, but there are also wrong ways to answer.)
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Chapter 8 – Term sheets
8.1 True, False, or Uncertain: After a portfolio company has an IPO, the VCs are
free to sell their stock in this company in the public market.
8.2 EBV is considering a $6M Series A investment for 6M shares of CP at $1 per
share. The proposed capitalization table for Newco is as follows:
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Chapter 8 – Term sheets
(a) What are the OPP and APP for the Series A?
(b) What is the fully diluted share count?
(c) What is the proposed ownership percentage?
(d) What is the post-money valuation?
(e) What is the pre-money valuation?
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Chapter 9 – Preferred stock
9.1 Suppose that it is one year after EBV’s investment in Newco (using the CP
structure from Exercise 8.2), and Talltree makes a Series B investment for 6M
shares of Newco at $0.2 per share. Following the Series B investment, what
percentage of Newco (fully diluted) would be controlled by EBV? Consider the
following cases:
Case I: Series A has no antidilution protection.
Case II: Series A has full-ratchet antidilution protection.
Case III: Series A has broad-base weighted-average antidilution protection.
Case IV: Series A has narrow-base weighted-average antidilution protection.
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Chapter 9 – Preferred stock
9.2 Suppose that EBV decides to consider six possible structures for the Series A stock in
Exercise 8.2:
Structure I: The original structure considered in Exercise 8.2: 6M shares of CP.
Structure II: 6M shares of common.
Structure III: RP + 6M shares of common.
Structure IV: PCP with participation as-if 6M shares of common.
Structure V: PCPC with participation as-if 6M shares of common, with liquidation return capped
at 5 times OPP.
Structure VI: RP ($4M APP) 1 5M shares of CP ($2M APP).
Structures IV and V have mandatory conversion upon a QPO, where a QPO is any offering of at
least $5 per common share and $15M of proceeds. For the purpose of solving this problem,
assume that any exit above $5 per share will qualify as a QPO (i.e., acquisitions for at least $5
per common share would also be considered to be QPOs). Draw an exit diagram for each
structure.
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Chapter 10 – the VC method
10.1 Suppose that the following four funds—all with committed capital of $100M—have combined to form a syndicate to invest in
Newco:
(I) ABC Fund, management fees of 2.5 percent per year of committed capital for all 10 years.
(II) DEF Fund, management fees of 2.5 percent per year for the first 5 years, then decreasing by 25 basis points per year in each year
from 6 to 10. All fees calculated based on committed capital.
(III) UVW fund, management fees of 2.0 percent per year. During the first 5 years of the fund, these fees are charged based on
committed capital. Beginning in year 6, the fees are charged based on net invested capital. UVW expects to be fully invested by the
beginning of year 6, and also to have realized 25 percent of all investment capital by this time. In each of the subsequent 5 years, UVW
expects to realize about 15 percent of all investment capital.
(IV) XYZ fund, management fees of 2.0 percent per year of committed capital for all 10 years. The XYZ fund expects to make all exits
very quickly and to reinvest capital back into new investments. The total amount of investments is limited to $100M.
(a) Suppose that each fund in the syndicate invests $5M in Newco. What is the LP cost for each fund?
(b) It is possible that all four funds could agree on all the assumptions to the VC method, but still disagree about the wisdom of making
this investment. Explain the economic logic behind this possibility.
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Chapter 10 – the VC method
10.2 EBV is considering a $5M Series A investment in Newco. EBV proposes to structure the investment as 6M shares of convertible
preferred stock. The employees of Newco have claims on 10M shares of common stock. Thus, following the Series A investment,
Newco will have 10M common shares outstanding and would have 16M shares outstanding on conversion of the CP. EBV estimates a
25 percent probability for a successful exit, with an expected exit time in 5 years and an exit valuation of $500M. The $100M EBV fund
has annual fees of 2 percent for each of its 10 years of life and earns 20 percent carried interest on all profits.
(a) What is your investment recommendation for EBV? (Show all steps.)
(b) How sensitive is this recommendation to different assumptions about the exit valuation and the probability of success?
(c) Given the evidence described in Chapter 7, do you think that 25 percent is an aggressive assumption about the probability of
success for a first-round investment?
10.3 Assume that EBV invested in Newco at the terms in Exercise 10.2, and it is now one year later. Talltree is considering a $10M
Series B investment in Newco. Talltree proposes to structure the investment as 8M shares of convertible preferred stock. The
employees of Newco have claims on 10M shares of common stock, and the previous venture investors (EBV) hold 6M shares of
Series A convertible preferred. Thus, following the Series B investment, Newco will have 10M common shares outstanding, and would
have 24M shares outstanding on conversion of the CP. Talltree estimates a 40 percent probability for a successful exit, with an
expected exit time in 4 years and an exit valuation of $500M. The $250M Talltree fund has annual fees of 2 percent for each of its 10
years of life and earns 20 percent carried interest on all profits.
(a) What is your investment recommendation for Talltree? (Show all steps.)
(b) How sensitive is this recommendation to different assumptions about the exit valuation and the probability of success?
(c) Given the evidence described in Chapter 7, do you think that 40 percent is an aggressive assumption about the probability of
success for a second-round investment?
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Chapter 10 – the VC method
10.4 Assume that EBV and Talltree invested in Newco at the terms in Exercises 10.2 and 10.3, and it is now
one year later. Owl is considering a $20M Series C investment in Newco. Talltree proposes to structure the
investment as 12M shares of convertible preferred stock. The employees of Newco have claims on 10M shares
of common stock, and the previous venture investors hold 6M shares of Series A convertible preferred (EBV)
and 8M shares of Series B Convertible Preferred (Talltree). Thus, following the Series C investment, Newco will
have 10M common shares outstanding and would have 36M shares outstanding on conversion of the CP. Owl
estimates a 50 percent probability for a successful exit, with an expected exit time in three years, and an exit
valuation of $500M. The $500M Owl fund has fees as given in Appendix 2.C in Chapter 2.
(a) What is your investment recommendation for Owl? (Show all steps.)
(b) How sensitive is this recommendation to different assumptions about the exit valuation and the probability of
success?
(c) Given the evidence described in Chapter 7, do you think that 50 percent is an aggressive assumption about
the probability of success for a third-round investment?
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Chapter 11 – DCF analysis
11.1 EBV is considering an investment in Softco, an early-stage software company. If Softco
can execute on its business plan, then EBV estimates it would be five years until a successful
exit, when Softco would have about $75M in revenue, a 20 percent operating margin, a tax rate
of 40 percent, and approximately $75M in capital. Subsequent to a successful exit, EBV
believes that Softco could enjoy seven more years of rapid growth. To make the transaction
work, EBV believes that the exit value must be at least $400M. How does this compare with the
reality-check DCF? How much must the baseline assumptions change to justify this valuation?
11.2 True, False, or Uncertain: Firm value is maximized when the return on capital is exactly
equal to the cost of capital.
11.3 True, False, or Uncertain: If two firms have exactly the same balance sheet and income
statement on their respective graduation dates, then the firm with the higher growth rate will also
have the higher graduation value.
11.4 Perform a reality-check DCF for a publicly traded company of your choice.
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Chapter 12 – comparables analysis
12.1 Softco, the company valued in Exercise 11.1, is expected to have the following business at exit:
Softco provides business process integration software and services for corporations across a broad range of enterprise
markets. Its main product is the Softco business process integration software platform together with packaged applications and
content, where it expects to derive 75 percent of its revenue. In addition, the company expects to earn the remainder of its
revenue from mainframe outsourcing and midrange systems management.
Use whatever resources you want to identify at least two comparable companies for Softco and to estimate a relative valuation.
12.2 Consider the following “denominators” suggested as part of a comparables analysis:
(a) Number of unique visitors to a website
(b) Number of patents held by the company
(c) Level of dividends paid to common shareholders
(d) Number of demo software programs downloaded per month
For each of these four denominators, choose the numerator that is most appropriate for doing comparables analysis.
12.3 True, False, or Uncertain: The harmonic mean will always provide a lower valuation than the geometric mean, which in
turn will always provide a lower valuation than the median.
12.4 True, False, or Uncertain: The levered beta for a company is always greater than or equal to the unlevered beta for the
same company.