Venture Capital 101

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Financing: Stops Alongthe Investment Food Chain

Venture Capital 101

Mass. Software and Internet CouncilMarch 21, 2002

Financing: Stops Alongthe Investment Food Chain

Venture Capital 101

Mass. Software and Internet CouncilMarch 21, 2002

Mark B. SteinMark B. Stein

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Venture Capital 101Venture Capital 101

Agenda1. Venture Capital Overview

2. What VCs Are Looking For

3. Preparing for V.C. Investment

4. Investor Term Sheets

5. Alternatives to VC Financing

Agenda1. Venture Capital Overview

2. What VCs Are Looking For

3. Preparing for V.C. Investment

4. Investor Term Sheets

5. Alternatives to VC Financing

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Venture Capital 101Venture Capital 101

1. Overview of Venture Capital

I. Pooled Investment Vehicle -Partnership

II. Foundations, Universities, Corps,High Net Worth Indivs

III. Asset Allocation: 20-30% RoI

IV. 10-Year Term; 6-7 YearInvestment Period

1. Overview of Venture Capital

I. Pooled Investment Vehicle -Partnership

II. Foundations, Universities, Corps,High Net Worth Indivs

III. Asset Allocation: 20-30% RoI

IV. 10-Year Term; 6-7 YearInvestment Period

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1. Overview of Venture Capital (continued)

V. 2/20 Economics

VI. 3-5 Year Investment

VII. Exit: IPO, Trade Sale, Recap

VIII. 6-10 Portfolio Companies per Investment Manager

1. Overview of Venture Capital (continued)

V. 2/20 Economics

VI. 3-5 Year Investment

VII. Exit: IPO, Trade Sale, Recap

VIII. 6-10 Portfolio Companies per Investment Manager

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$0

$2

$4

$6

$8

$10

Median AmountInvested (Total)

Median AmountInvested (Initial)

Venture Capital 101Venture Capital 101

$0

$20

$40

$60

$80

$100

Total Amount Invested

Source: Venture One

Amounts Invested --Highlights and Lowlights

Millions Millions

1998 19992000 2001

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Venture Capital 101Venture Capital 101

0

1,000

2,000

3,000

4,000

5,000

1999 2000 2001

Number of FinancingsInitial Rounds of Finance

Source: Venture One

Financings --Highlights and Lowlights

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17%

65%

17%17%

65%

17%

Venture Capital Investment Highlights - and LowlightsVenture Capital Investment Highlights - and Lowlights

29%

61%

9%29%

61%

9%

2000

33%

56%

10%

33%

56%

10%

1999

2001

Percentage of Financing Rounds by Industry

Source: Venture One

Information Technology

Healthcare

Products and Services

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Venture Capital 101Venture Capital 101

2. What VCs Look For

I. Unique/Breakthrough Idea

II. Barrier to Entry -- IP, Franchise

III. No Legacy

IV. Relevant Expertise in House

V. Solid Management Team

VI. 4-5x Investment in 3-5 Years

VII. $100 Million Business

2. What VCs Look For

I. Unique/Breakthrough Idea

II. Barrier to Entry -- IP, Franchise

III. No Legacy

IV. Relevant Expertise in House

V. Solid Management Team

VI. 4-5x Investment in 3-5 Years

VII. $100 Million Business

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3. Preparing for V.C. Investment

I. Structure to contemplate futuredilution- Cash investors

- Employees/advisors

* Founders typically end up with 10-12% of company on fully-diluted basis by the time of I.P.O.

3. Preparing for V.C. Investment

I. Structure to contemplate futuredilution- Cash investors

- Employees/advisors

* Founders typically end up with 10-12% of company on fully-diluted basis by the time of I.P.O.

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Venture Capital 101Venture Capital 101

3. Preparing for V.C. Investment

Typical Structure Post-Series A

Founders (+ Angels) = 40%

VCs = 40%

Reserve for Employees = 20%

3. Preparing for V.C. Investment

Typical Structure Post-Series A

Founders (+ Angels) = 40%

VCs = 40%

Reserve for Employees = 20%

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Venture Capital 101Venture Capital 101

3. Preparing for V.C. Investment

II. Organize as “C” Corporation

III. Take Steps to Protect IntellectualProperty- Copyright, Trademark

- Domain Names

- Provisional Patent or Patent

- NDA

3. Preparing for V.C. Investment

II. Organize as “C” Corporation

III. Take Steps to Protect IntellectualProperty- Copyright, Trademark

- Domain Names

- Provisional Patent or Patent

- NDA

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Venture Capital 101Venture Capital 101

3. Preparing for V.C. Investment

IV. Core Management Team- Stock Vesting

- Stockholders Agreement

V. Business Plan Executive Summary

3. Preparing for V.C. Investment

IV. Core Management Team- Stock Vesting

- Stockholders Agreement

V. Business Plan Executive Summary

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4. Investor Term Sheets

Typical Objectives in Investment

I. Upside Return on Investment

- Convertibility

- Participation

- Convertible Redeemable Preferred

- Warrants

4. Investor Term Sheets

Typical Objectives in Investment

I. Upside Return on Investment

- Convertibility

- Participation

- Convertible Redeemable Preferred

- Warrants

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4. Investor Term Sheets (continued)

II. Downside Investment Protection- Liquidation preference

- Fixed dividend

- Anti-dilution ratchet

III. Operational Governance

- Board of Directors composition

- Selection of key management team

- Consent to major actions

4. Investor Term Sheets (continued)

II. Downside Investment Protection- Liquidation preference

- Fixed dividend

- Anti-dilution ratchet

III. Operational Governance

- Board of Directors composition

- Selection of key management team

- Consent to major actions

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4. Investor Term Sheets (continued)

IV. Other Control Features

- Right of First Refusal

- Reports

- Affirmative/negative covenants

* Affiliate transactions

* Presentation to LPs

* Confidentiality

- Key-man insurance

4. Investor Term Sheets (continued)

IV. Other Control Features

- Right of First Refusal

- Reports

- Affirmative/negative covenants

* Affiliate transactions

* Presentation to LPs

* Confidentiality

- Key-man insurance

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4. Investor Term Sheets (continued)

V. Exit From Investment

- Registration rights

- Co-Sale rights

- Drag-along rights

- Redemption right

4. Investor Term Sheets (continued)

V. Exit From Investment

- Registration rights

- Co-Sale rights

- Drag-along rights

- Redemption right

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Venture Capital 101Venture Capital 101

Sample Venture Capital Term Sheet

• Security: Convertible Preferred Stock

• Pre-Money Valuation: $______ (including the Option Pool).

• Capitalization: immediately after the proposed financing :– Common Stock 45%– Series A Preferred 34%– Stock Option Pool 21%– Total 100%

Sample Venture Capital Term Sheet

• Security: Convertible Preferred Stock

• Pre-Money Valuation: $______ (including the Option Pool).

• Capitalization: immediately after the proposed financing :– Common Stock 45%– Series A Preferred 34%– Stock Option Pool 21%– Total 100%

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Rights and Preferences:

• Dividends: Cumulative dividends of __%, payable upon liquidation or dissolution, redemption, (conversion)

• Liquidation preference: 1 1/4x original price, plus all unpaid dividends; participation with Common Stock on “as-converted” basis thereafter. Merger, sale of substantially all assets of Company treated as liquidation.

Rights and Preferences:

• Dividends: Cumulative dividends of __%, payable upon liquidation or dissolution, redemption, (conversion)

• Liquidation preference: 1 1/4x original price, plus all unpaid dividends; participation with Common Stock on “as-converted” basis thereafter. Merger, sale of substantially all assets of Company treated as liquidation.

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Venture Capital 101Venture Capital 101

• Conversion: Elective; Automatic upon vote or QPO

• Anti-dilution: Full/[Weighted Average] ratchet adjustments for subsequent issuances of stock at a lower price, customary exclusions.

• Consent Rights: 2/3 vote required for: liquidation, merger, sale of all assets, increase/decrease in authorized Preferred Stock, change in the terms of the Preferred Stock, amendments to Charter or By-Laws.

• Conversion: Elective; Automatic upon vote or QPO

• Anti-dilution: Full/[Weighted Average] ratchet adjustments for subsequent issuances of stock at a lower price, customary exclusions.

• Consent Rights: 2/3 vote required for: liquidation, merger, sale of all assets, increase/decrease in authorized Preferred Stock, change in the terms of the Preferred Stock, amendments to Charter or By-Laws.

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Venture Capital 101Venture Capital 101

• Optional Redemption: 1/3 of Preferred Stock redeemable on 6th, 7th, and 8th anniversaries of Closing. Price per share = original purchase price plus all unpaid dividends.

• Registration Rights: – 2 S-1 demand registrations on S-1; – Unlimited S-3 demand and piggybacks. – No grants of additional registration rights without

consent of Preferred Stock.

• Optional Redemption: 1/3 of Preferred Stock redeemable on 6th, 7th, and 8th anniversaries of Closing. Price per share = original purchase price plus all unpaid dividends.

• Registration Rights: – 2 S-1 demand registrations on S-1; – Unlimited S-3 demand and piggybacks. – No grants of additional registration rights without

consent of Preferred Stock.

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• Rights of First Refusal, Co-Sale, Drag-Along:– Company option to acquire shares to be sold by

Founders before QPO.

– Preferred Stock may sell proportional share as part of sale by Founder.

– Preferred Investors can purchase their pro rata share in any subsequent offering before QPO.

– Preferred Stock right to cause Founders to vote for sale of Company if (i) no QPO by 6th anniversary; or (iii) 2/3 Preferred vote in favor.

• Rights of First Refusal, Co-Sale, Drag-Along:– Company option to acquire shares to be sold by

Founders before QPO.

– Preferred Stock may sell proportional share as part of sale by Founder.

– Preferred Investors can purchase their pro rata share in any subsequent offering before QPO.

– Preferred Stock right to cause Founders to vote for sale of Company if (i) no QPO by 6th anniversary; or (iii) 2/3 Preferred vote in favor.

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Venture Capital 101Venture Capital 101

• Information Rights:– Audited financials w/in 120 days of FY end;

performed by a “Big Five” accounting firm;

– Unaudited quarterly and monthly financials w/in 30 days of period end;

– Progress reports from the CEO (research, development, sales, marketing, etc.) monthly;

– Annual budget 30 days before each FY.

• Information Rights:– Audited financials w/in 120 days of FY end;

performed by a “Big Five” accounting firm;

– Unaudited quarterly and monthly financials w/in 30 days of period end;

– Progress reports from the CEO (research, development, sales, marketing, etc.) monthly;

– Annual budget 30 days before each FY.

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• Information Rights: (continued) – Non-Competition Agreements: Founders and

Key Employees not to compete with Company for one year after termination of employment.

– Attorneys Fees: Fees not to exceed $[ ] and expenses of such counsel will be borne by Company.

• Information Rights: (continued) – Non-Competition Agreements: Founders and

Key Employees not to compete with Company for one year after termination of employment.

– Attorneys Fees: Fees not to exceed $[ ] and expenses of such counsel will be borne by Company.

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5. Alternatives to VC Financing

I. Friends & Family

II. Angels

III. Corporate/Strategic

5. Alternatives to VC Financing

I. Friends & Family

II. Angels

III. Corporate/Strategic

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Financing: Stops Alongthe Investment Food Chain

Venture Capital 101

Mass. Software and Internet CouncilMarch 21, 2002

Financing: Stops Alongthe Investment Food Chain

Venture Capital 101

Mass. Software and Internet CouncilMarch 21, 2002

Mark B. SteinMark B. Stein