Seeking venture funding…what an investor looks for and

what to look for in an investor A discussion of considerations from a pre-seed and seed investor perspective…

August 25 and October 13, 2005Teri F. Willey, Managing PartnerARCH Development Partnerstfw@archdp.com

Planning to cover… How a VC fund works Some background on ARCH Development Partners What investors like to see (and what you might look

for in investors) Risk and Return Term Sheet Tango Resources

Structure – how a fund works The Fund

Fund raises money from institutional investors (LP’s) University endowments, pension funds, insurance companies, corporate

venture funds, wealthy individuals Fund may range from $30M - 400M, $1-$10M per LP Fund lasts 10 years. First 3-4 years initial investments, then follow-on

investments and exits. Multiple Funds may be managed concurrently

The Partnership 20% carry. (For a $100M fund, all gains over $100M get split 80/20 with

investors/fund managers) The Management Company

2-3% fees per year. (2% fee on $100M is $2M year)

Return - % returns based on age of fund for period ending 2003 (www.nvca.org)

-30-20-10

0102030405060

3 yr5 yr10 yr,

Returns - by Stage of BusinessSeed stage – developing product

250K-$1M IRR 70+% Need 10X in 5 years

Venture Series A – Revenue - paying Customers

$1- $3M IRR 50% Need 5 X in 3-4 years

Venture Series B – Sales Expansion

$3- 10M IRR 40% Need 3X in 2-3 years

Late stage – mature business

$15-50M IRR 25% Need 1.25X in 12 mos

Return – multiples and IRR Homeruns (10x) Singles/Doubles/Triples (1x<10x) Strikeouts (<1x)

Multiple: $exited/on $invested IRR: timing to exit from the first investment Note: 2.5X for a 20% IRR, 5X for a 40% IRR

Background…ARCH Development Partners

Currently $32 million under management LP’s: Universities, Foundations, Banks, Corporations, and Hospitals

Strategy: Strategically partner with communities to create start-ups Current partners: Kalamazoo, Peoria, Lafayette, Cincinnati, St. Louis Make “pre-seed” investments ($50,000 to $1,000,000) Syndicate deals with other early-stage investors, e.g. angels Structure deals for optimal early exits

Primary Deal Sources: University and Corporate spin-outs Investments: Biotechnology, Information Technology Geographic Focus: Upper Midwest: IN, IL, MI, OH General Partners: Experienced investors and entrepreneurs

Stage of investments

Pre-Seed

IP/Technology

Technologist /founder/business development

<$500K

Identifying technology via relationships

Determining commercial viability

Accessing rights/Recruiting CEO

Seed Early Stage Mid-Stage Exit

Description

Team

$ Needed

Keys to Success

Product-in-development

Plus first senior mgmt team member

$250K to $1M

Finding development partners

Developing business strategy

Recruiting BOD & SAB

Product at beta clients

Senior mgmt team formation

$1M to $5M

Growing the sales pipeline

BOD and SAB in place

Full customer pipeline

Senior mgmt team in place

$2M to $20M

Managing growth

Becoming profitable

Identifying exits

Focus

Business Expansion

Public Markets

The ARCH Model Apply Time-tested Traditional VC Disciplines to:

Identify Platform Technologies Create Patent Strategy Recruit the CEO Identify and Quantify the Market Create the Business Model Recruit BOD and SAB Raise $$$ Manage to Milestones

Inception

Product commercialization

CustomersRevenueSpace to growNext round

fundingUpdated Advisory

board and BOD

Recruiting and hiring

Organizational structure

Compensation planning

Staffing modelsCulture

building

IncorporationOffice spacePayroll and

benefitsAccountingIT and

telephoneAdvisory board

and BOD

Managing Licensor relationship

Technology due diligence

Business plan creation

Patent and IP protection

Finding and closing initial financing

Consultation/ liaison on university policy

Marketing/PRFinancial

modeland pricing

Business development

Operations processes

Product development

Groundwork Interim management Talent Toward independence

Accelerating New Business Growth

The “squeeze” perspective At the early stages … it is about squeezing out enough risk so

traditional corporate partners and investors can participate. We think about how you can facilitate: hitting the most critical milestone's) in the least amount of time with the least amount of money

light initial capitalization management compensated w/stock use non-dilutive funds outsource exit strategy flexibility

What we want to see – MANAGEABLE RISK As we evaluate each of the foregoing we are

considering the main types of risk, if they are manageable and if so how they will be managed: IP Market Technical Financing Management

Risk con’t PROBABILITY

Sufficient capital 80% Management is capable and focused 80% Product development goes as planned 80% Production and component sourcing goes as planned 80% Competitors behave as expected 80% Customers want the product 80% Pricing is forecast correctly 80% Patents are issued and are enforceable 80%

Combined probability of success 17%

Harvard Business Review November-December 1998

What we like to see - TYPE Science/innovation based company. Prefer university or corporate owned intellectual

property as the basis for the spin out (vs independent inventor).

Biomedical, biotechnology, pharmaceutical, bioinformatics, information technology, wireless, internet infrastructure.

What we like to see - STAGE Pre-business plan and management team is fine. We prefer to act as founders at this stage, assist with

company formation and management and board recruitment and the acquiring the necessary intellectual property rights.

What we like to see - $ REQ 50k to 1 million needed for the purpose of squeezing

risk out of the venture and positioning it for further investment or revenue generation.

20-50 million total to get to exit. Realistic expectations regarding valuation, that is

what the investment buys in ownership and control

What we like to see - MARKET The product(s) the company is proposing to develop should

have a market of 200 million or more (that is the company’s sales are expected to be 200 million or more annually in a reasonable time after product launch)

Understanding of the commercialization strategy and competitive advantage. Clear and realistic idea of who and what the competition is and how

the idea will reach the market in the form of a product. Know where the pain is that this product addresses and where a the

incentives are to adopt the new product (the value proposition).

What we like to see - IP The proposed product should be based on an

appropriate proprietary position, preferably a strong patent position or the real potential for one.

This includes understanding freedom to operate issues and determining that they are clearly addressed or reasonably manageable.

What we like to see - MGMT If there are there already or if we need to recruit

them: Product development experience and operating

experience (fund raising a plus). Reasonable compensation expectations. Chemistry with the founding scientists/innovators. Early stage company experience Network

What we like to see - EXIT The company or proposed company should be one

poised for an acquisition exit or in some cases an IPO exit.

Pre-seed and seed stage investors like ARCH may lean toward an acquisition exit as it is consistent with our model (and the only choice when the window is closed) and hence towards deals in industries in which M&A is the favored transaction.

What we like to see - RETURNS At exit it’s about how…

many shares are we going to own. much do we invest to get there. much to others invest to get there. long will it take us to get there. much will they be worth at exit.

Sources of these shares…of equity In addition to acquiring equity as consideration

for investing dollars in the company (usually preferred) equity may also be obtained… As consideration for the technology license (common

or preferred) As consideration for forming

the company or providing services (sweat equity – usually common)

As compensation (options for common or restricted stock)

How much equity Pre-money valuation + dollars invested = post

money valuation Equity ownership equals dollars invested divided by

the post money valuation…or does it?! Equity ownership on a fully-diluted basis

Term Sheet Financial Terms Non-financial Terms Equity Provisions

Terms to address the traditional ‘valuation gap’ Pre-money valuation Financial tools

Liquidation preferences Warrants Dividends

Incentive based tools Price controls aka ratchet mechanisms Preemptive rights Performance based incentives Management options Vesting founders shares

Terms to address managing risk via control Board representation Class voting Voting the option pool Protective provisions

Liquidation preferences These preferences allow certain investors, in

the case or acquisition or liquidation, to get their initial investment back (or multiples of it in the case of 2x or 3x liquidation preferences) before returns are shared ratably with the other share holders.

Warrants Another word for an option to purchase a security. The term

is generally used for options provided by the company to outside investors (as distinct from officers, employees, etc.)

Contract which covers time frame during which the investor can convert the warrants and the price they can convert/buy stock

Sometimes used with or without interest on convertible bridge loans and can be based on a percent of the bridge

This can be a cashless transaction if the warrants are converted at exit

Taken into consideration when determining a fully diluted share price

Anti-dilution Price protections…if stock is sold, at a price less

what the investor with anti-dilution protection paid for it, the lower price is applied to the conversion formula Full-ratchet Weighted average

Preemptive rights…the right of the investor to acquire new securities issued by the company to the extent necessary to maintain its percentage interest on an as converted basis)

Vesting founders shares Incentive to keep founders with the company “Earning back” the initial ownership in the

company over time or against milestones

Control via business decisions Protective provisions

May provide significant control of the investors even if they do not own a majority of the company.

Outlines which decisions require approval of the investors (which class of investors, percent, etc.)

Board representation Investors my require one or more board seats

Resources

Indiana Venture Center www.indianaventurecenter.org

Indiana Seed Fund I. LLC (ISF) www.biocrossroads.com/entrepreneur/isf.htm

Model documents and industry overview www.nvca.org

More course work www.vcinstitute.org

OPEN CHANNEL SOFTWARE