Entrepreneurial Finance Final Exam

The term sheet process begins when...

- Investors express a specific interest

When do entrepreneurs have more power?

During times of an economic boom

What did the later years of ARD performance look like?

- 1957: invested $70,000 in Digital Equipment Corporation - 1971: investment was worth $355,000 - ARD's return was 14.7% per year and without DEC return was only 7.4%

Term sheet should be completed ___________ or ___________ in due diligence.

- Before or Early Avoids wasting time and effort

What are the three types of new ventures? What does each mean?

- Black Holes: Total loss of investment - Living Dead: Wander around breakeven. Minimal return. - Venture Utopias: Phenomenal returns

Basic VCSC approach

- Cash investment today - Cash return at some future exit time - Discount this entire return flow back at the venture investors' target return - Divide today's cash investment by the venture's post-money present value - This will give you the percent ownership to be sold in order to expect to provide the venture investors' target return

Complex term sheets protect investors, but they may also...

- Create an adversarial relationship with the company - Deter interest from follow-on investors - It may also be difficult to maintain the same complex terms over multiple rounds of funding - The Golden Rule - Expect your rights and terms to change

What must be considered when conducting due diligence and actively investing? (step 5 of professional venture cycle)

- Deal Flow: flow of business plans and term sheets involved in the venture capital investing process - Due Diligence: process of ascertaining the viability of a business plan - Pro VCs are constantly on the lookout for new investments and ventures Historical ties to research institutions and new technology (Harvard, MIT, UC Berkley, University of Texas)

What are some of the motives for an equity component in employee compensation?

- Deferred and tax-preferred compensation allows venture to pay lower current compensation - Motivates employees to grow the value of the venture - Helps attract ambitious top talent employees

What are the steps for the professional venture investing cycle?

- Determine (Next) Fund Objectives and Policies - Organize New Fund (usually partnership) - Solicit Investments in New Fund - Obtain Commitments for Series of Capital Calls - Conduct Due Diligence and Actively Invest - Arrange Harvest or Liquidation - Distribute Cash and Securities Proceeds (as available)

Exit values are typically determined using which two methods?

- Discounted Cash Flow (DCF) methods - Relative Valuation Methods

What are the advantages of standardized term sheets?

- Easier to use (over time) - Can facilitate co-investment

What are the three multiples under the Relative Valuation Method?

- Enterprise Value / EBITDA - Enterprise Value / Net Sales - P/E = Equity Value / Net Income

What do VCs focus on when a venture is seeking funding from them?

- Entrepreneurial team - Target market

Who should you consider selling to in an outright sale method?

- Family - Managers - Employees - External buyers

What attributes must one consider when organizing the new fund? (step 2 of professional venture cycle) (**hint: there are six)

- Frontmatter Declarations - State Securities Disclosures - Offering Summary - Fund Overview -Executive Summary - Summary of Terms

What are some of the roles of Professional VC post-investment?

- Funding is a key role - VCs serve on the Board of Ventures - May provide Managerial Expertise and Networking

What is a Term Sheet?

- Gives all parties a relatively short agreement/contract on key points - Outline of the investment transaction - Agreement in principle - Non-binding

What did the early years of ARD performance look like?

- In 1946, ARD raised $3.5 million ($2 million from institutional investors) - By the end of 1947, ARD had invested in 8 ventures, 6 of which were startups - 1951 had lack-luster performance. Price down from $25 to $19

What did the SBA create in 1958?

- In 1958, SBA created Small Business Investment Companies (SBICs) - Tax and debt advantages made SBICs primary vehicle for Professional VC

What are some things to consider when determining fund objectives and policies? (step 1 of professional venture cycle)

- Industry - Venture Stage and Size - Geographic Area

Professional venture capitalists serve as __________________ between investors and entrepreneurs. What other two functions do they serve?

- Intermediaries - Raise funds from investors - Reinvest funds in ventures

What must be considered when obtaining commitments for a series of capital calls? (step 4 of professional venture cycle)

- Outflows to ventures typically happen in stages - VC finds don't always raise all their capital at the beginning. Inflows happen in stages - Capital Call: when venture fund calls upon investors to deliver additional investment funds - Most often additional investments are proportional to initial contribution

When did venture capital funds start? What was the first professional group of intermediaries called? Who founded this organization

- Pre-World War II - No Venture Capitalists funds - 1946: Beginning of Pro VCs - Formation of American Research and Development (ARD) - Harvard Professor - Georges Doriot and Boston Federal Reserve President - Ralph Flanders

VCs primarily spend their time doing what?

- Primarily monitoring and contributing to the ventures in their portfolio - This includes: Solicitation and selection of new ventures, negotiations, monitoring and adding value to portfolio ventures, and implementing an exit strategy

What must be considered when soliciting investments in the new fund? (step 3 of professional venture cycle)

- Prior experience and relationships - Track record of success - Pro VCs spend considerable time fund raising

What is a Leveraged Buyout (LBO)?

- Purchase price of a firm is financed largely with debt financial capital

What are some reasons to use a Term Sheet?

- Reduces pain and confusion - Ensures key issues are resolved upfront - Uses simpler wording to improve understanding - Saves money - Complete negotiations before expensive document drafting - Avoid due diligence costs if terms cannot be settled

What are the possible screening outcomes?

- Seek lead investor position (best case scenario) - Seek a non-lead investor position - Refer venture to more appropriate financial market participants - SLOR (worst case scenario)

What was formed in 1953?

- Small Business Administration (SBA) was formed in 1953 - SBA permitted Federal Government to actively foster new business formation

What is a Management Buyout (MBO)?

- Special type of LBO where the firm's top management continues to run the firm and has substantial equity position in the recognized firm.

What are the three typical harvest methods?

- Systematic Liquidation - Outright Sale - Going Public

What are some typical items included on a Terms Sheet?

- Valuation - Ongoing funding needs - Size and staging of financing - Preemptive rights on new issues - Commitments for future financing rounds and performance conditions - Form of security or investment - Conversion ratio - Additional management - Exit conditions and strategy - IPO-dictated events - Lock-up provisions - Redemption rights and responsibilities - Dividend structure

What are the venture capital screening criteria?

- Venture capital firm requirements - Characteristics of the proposal - Characteristics of the entrepreneur/team - Nature of the proposed industry - Strategy of the proposed business

Do we value equity or total assets when calculating VCSC? What does this mean when we make payments to Debt-holders?

- We value equity - This means there is no need to adjust VCSCs for payments to Debt-holders

What are some of the ingredients of a successful business plan?

- Well written - Overview of business - Amount of funding requested - How funds will be used - How the business will be managed - Summary of Financial Statements and Projections

When should an investor accept a company's term sheet?

- When you are NOT the first investor - When this is NOT the first round of financing

Research by Hustedde and Pulver indicates the most important elements of success in attracting financing is _______________ and _____________.

- Willingness to give up large sums of share of equity - Determination to look for funding in a variety of places

When using only Utopia earnings and cash-flows, what must you do?

- You must discount at Utopia rates of return - If you do enough deals, you receive a diversification benefit - Smooths out bad returns on the total losses (black-holes) and break-even (zombie) projects

What is the equation for finding the issue share price?

= Investment / n n is new shares issued

What is the equation to find the new shares that must be issued when giving up the % ownership?

= m * (Acquired %) / 1 - Acquired %) m is the original number of shares

What is the equation for Acquired % of Final Ownership?

=Investment / ((P/E * Expected income during exit year) / (1 + return required by investor)^exit year # This equation will give the equity ownership percentage that must be given to the investor in order to get the deal done

Venture Capital (VC) Method

A valuation method that estimates a venture's value by projecting only a terminal flow to investors at the exit event

How long does initial screening last? Rejections may be _______ or ________. _____________ is a signal of competence Plan should be __________ but include all relevant information, keeping extraneous information to a ______________.

About six minutes - Rejections may be shallow (not our area) or deep (not proprietary) - Financial information is a signal of competence - Plan should be simple but include all relevant information, keeping extraneous information to a minimum.

Who offers the term sheet?

Active investors typically use their own term sheet

Early term sheets help prevent ____________.

Bad deals

It is best to have a harvest plan strategy from the _____________.

Beginning

_______________ is a type of agreement when investment banks employ only marketing and distribution efforts

Best efforts

Ability to evaluate risk, background/experience, references, management commitment, etc... are part of which venture capital screening criteria?

Characteristics of the Entrepreneur/Team

Requirement for additional material and stage of plan are part of which venture capital screening criteria?

Characteristics of the Proposal

ARD organized as a _____________.

Close-ended mutual fund

What is the equation for the capitalization rate?

Discount rate minus growth rate r - g = cap rate

______________ is the process of ascertaining, to the best extent possible, an issuing firm's financial condition and investment intent.

Due Diligence

When do VCs have more power to dictate their level of financial and managerial participation?

During normal economic times

_____________ is a rough measure of cash flow available to both debt and equity investors.

EBITDA

To determine the exit value of a venture, we can either value the equity or the __________________.

Enterprise

Some venture capitalists may insist on having an ___________ strategy in place before committing funds.

Exit

What is staged financing?

Financing provided in sequences of rounds rather than all at one time

________________ is a type of agreement with investment banks involving the investment bank's underwritten purchase and resale of securities.

Firm Commitment

Having a _____________ plan in place makes it easier to take advantage of windows of opportunity to exit.

Harvest

______________________ is a syndicate's offering price when it is less than the market price immediately following the offering

IPO Underpricing

When was the peak of historical levels of VC Investment?

Late 1990s early 2000s during the technology bubble (before it popped)

Market attractiveness, potential size, technology, and threat resistance are part of which venture capital screening criteria?

Nature of the Proposed Industry

Is a Term Sheet binding?

No; a term sheet is NON-BINDING (except for non-disclosure and no-shop clauses)

Evidence suggests that over ____________ of entrepreneurs either develop formal exit strategies or at least have thought about harvest strategies at the outset of the venture

One-half

What is carried interest?

Portion of profits paid to the professional venture capitalist as incentive compensation

What is the post-money valuation?

Pre-money valuation of a venture plus money injected by new investors = Total new shares * issue share price Total new shares includes (n + m) which is just original shares plus new issued shares

What is the pre-money valuation?

Present value of a venture prior to a new money investment = Original number of shares * issue share price

What is SLOR?

Standard Letter of Rejection

Product differentiation and proprietary product are part of which venture capital screening criteria?

Strategy of Proposed Business

What advantages made SBICs the primary vehicle for Professional VCs?

Tax and debt advantages

What happens to SBICs in the late 1960s and early 1970s? What caused this?

They were failing. In the 1970s a movement to private partnerships and away from public firms caused SBICs to fail.

_________________ is the difference between what the investment back gets from selling securities to public and what they pay to the issuing firm.

Underwriting Spread

What do we need to do to find the pre- and post-money future valuations?

Use the original formulas for pre- and post-money valuations and multiply them by (1 + required rate of return by investor)^exit year Pre-money future valuation = m * issue share price * (1 + r)^exit year Post-money future valuation = (n + m) * issue share price * (1 + r)^exit year

What are two and twenty shops?

VC firms that charge 2% of assets annual management fee and 20% carried interest

What is the direct comparison method?

Valuation by applying a direct comparison ratio to the related venture quantity Basically: (P of a similar venture / E of a similar venture) * E of venture during exit year = P venture during exit year

What is the direct capitalization method?

Valuation by capitalizing earnings using a cap rate implied by a comparable ratio

Cash out potential, equity share, geographic location, investor control, rate of return, risk, etc... are part of which venture capital screening criteria?

Venture Capital Firm Requirements