Chapter 11Professional Venture Capital
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ENTREPRENEURIAL FINANCE
Historical Development of Professional Venture Capital
Venture Capitalists (VCs):individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing ventures
Pre-World War II Era:Most venture investing came from wealthy individuals and families
1946: Beginning of Professional VCsFormation of American Research & Development (ARD)
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Historical Development of Professional Venture Capital (cont’d)
ARD’s Early Performance $3.5 million was raised ($2 million
from institutional investors) By end of 1947, ARD had invested in
eight ventures, six of which were startups
By 1951 the performance was still lack-luster (stock price was at $19 down from the initial offering price of $25 in 1946)
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Historical Development of Professional Venture Capital (cont’d)
1953: Small Business Administration (SBA) was formed Legislation permitted the federal government to
actively engage in fostering new business formation
1958: SBA Created Small Business Investment
Companies (SBICs) Due to tax and leverage advantages, the SBIC
became the primary vehicle for professionally managed venture capital
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Historical Development of Professional Venture Capital (cont’d)
ARD’s Later Performance: In 1957, ARD had invested $70,000 in
the startup company Digital Equipment Corporation (DEC)
1972, ARD was sold for $813 Per Share
Original ARD investors received a compound annual return of 14.7% due primarily to DEC
Without the DEC investment, the rate of return would have been only 7.4% 5
Historical Development of Professional Venture Capital (cont’d)
Late 1960s-Early 1970s: Boom-Bust Cycle: Many SBICs began
having operating problems due to the mixing of risky venture investments & high financial leverage (debt service commitments)
1970s: Professional VC organizational
structure changes Movement to private partnerships
from public firms & volatile financial markets 6
Dot.Com Bust and Recent History
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Professional Venture Capital Investing Cycle
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Useful Terms
Carried Interest:portion of profits paid to the professional venture capitalist as incentive compensation
Two and Twenty Shops:investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest
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Soliciting Investments: Suppliers of Venture Capital – 25-Year Average
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Obtaining Commitments:Arrangements with Fund Investors
Capital Call:when the venture fund calls upon the investors to deliver their investment funds
Common to require subsequent investments consistent with the levels of investors’ initial contributions
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Due Diligence and Active Investing:VC Fund Management
Deal flow:flow of business plans and term sheets involved in the venture capital investing process
Due diligence (in venture investing context):process of ascertaining the viability of a business plan
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VC Screening Criteria
1. The Industry2. Stage of the Business3. Size of the Investment4. Geographic Area
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Screening Outcomes
1. Seek lead investor position2. Seek a non-lead investor
position3. Refer venture to more
appropriate financial market participants
4. SLOR (standard letter of rejection) the venture
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Structuring a VC Investment
Term Sheet:summary of the investment terms and conditions accompanying an investment
Typical Issues Addressed in a Term 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 Redemption rights and responsibilities
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Structuring (cont’d)
Typical Issues Addressed in a Term Sheet Dividend structure (Number of VCs and outsiders) Additional management Conversion value protection Registration rights Exit conditions and strategy IPO-dictated events (e.g. conversion) Co-sale rights (with founders) Lock-up provisions
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Structuring (cont’d)
Typical Issues Addressed in a Term Sheet Employment contracts Incentive options Founder employment conditions: compensation,
benefits, duties, firing conditions, repurchase of stock at termination, term of agreement, post-employment activities and competition
Founder stock vesting Confidentiality agreements and protection for
intellectual property
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