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Venture Capital Financing
Thomas Chemmanur
VENTURE CAPITAL FINANCING

MANY FIRMS GO THROUGH A LIFE-CYCLE:
1. START OUT AS SMALL PRIVATE FIRMS
2. EXPAND THROUGH VARIOUS STAGES OF
V.C/PRIVATE EQUITY FINANCING (ALSO: BANKDEBT).
3. GO PUBLIC (HAVE AN INITIAL PUBLIC OFFERINGIPO).
4. FURTHER EXPAND THROUGH ADDITIONAL ROUNDS
OF PUBLIC EQUITY/DEBT FINANCING.
 FOCUS ON STAGE (2), VENTURE CAPITAL FINANCING
HERE.
2
SOURCES OF V.C FINANCING
1. PRIVATE PARTNERSHIPS AND CORPORATIONS SET UP
TO PROVIDE FUNDS.
 ORGANIZER BEHIND THE PARTNERSHIP MAY
OBTAIN FUNDING FROM INSTITUTIONS (INSURANCE
COMPANIES AND PENSION FUNDS) OR INDIVIDUALS.
 PRATT’S GUIDE TO VENTURE CAPITAL LISTS 2000
SUCH FIRMS.
 AVERAGE AMOUNT INVESTED BY THESE PER FIRM:
$1 TO 2 MILLION
 E.g: ARTUR ROCK & COMPANY OF SAN FRANCISCO
PROVIDED VENTURE FUNDS TO APPLE COMPUTERS
 ONLY 2% OF REQUESTS RECEIVE FINANCING.
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SOURCES OF V.C FINANCING
2. VENTURE CAPITAL SUBSIDIARIES OF LARGE
INDUSTRIAL OR FINANCIAL CORPORATIONS.
 E.g: CITICORP VENTURE CAPITAL, CHEMICAL
VENTURE CAPITAL CORP.
 ONLY SMALL PORTION OF V. C. MARKET.
3. HIGH NET-WORTH INDIVIDUALS AND FAMILIES
(“ANGELS”), WITH EXPERIENCE AND KNOWLEDGE IN
THAT INDUSTRY. (TYPICAL ANGEL NET WORTH OVER
$1 MILLION).
 ANGELS TEND TO INVEST ONLY SMALLER AMOUNTS
ON AVERAGE ($250,000) THAN V.C. FIRMS.
 HOWEVER, THE AGGREGATE INVESTMENTS FROM
THIS SOURCE IS MUCH LARGER (AT LEAST TWICE AS
MUCH) AS FROM VENTURE CAPITAL FIRMS.
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WHAT DO VENTURE CAPITALISTS DO?
1. PROVIDE FINANCING
2. MONITOR THE ENTREPRENEUR: MANY VENTURE
CAPITALISTS SPEND SEVERAL HOURS A WEEK WITH
THE FIRM THEY HAVE INVESTED IN.
3. PROVIDE EXPERTISE TO FIRM MANAGEMENT (AND
CONTACTS, OBTAINED FROM BEING INVOLVED IN
SIMILAR FIRMS BEFORE).
4. HELP THEM WITH ADDITIONAL FINANCING FROM
OTHER SOURCES, INCLUDING INITIAL PUBLIC
OFFERINGS (IPOs).
5
WHAT DO VENTURE CAPITALISTS DO?
 IPO’S WITH VENTURE BACKED FINANCING:
 EVIDENCE INDICATES THAT VENTURE-BACKED
DEALS TEND TO BE LESS “UNDERPRICED” THAN
NON-VENTURE BACKED DEALS.
 ALSO, VENTURE CAPITALISTS (MANY) SEEM TO
HAVE EXCELLENT “TIMING” ABILITY (i.e., THE
TIMING OF THE GOING-PUBLIC DECISION).
 EXAMPLE: KAPOR STARTED LOTUS IN 1981 WITH
FINANCING FROM SEVIN-ROSEN
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LOTUS EXAMPLE
 WHAT EACH PARTY BROUGHT TO THE DEAL:
 KAPOR (ENTREPRENEUR)
 (I) RECOGNIZED A MARKET NEED
 (II) TECHNICAL ABILITIES AND TEAM
 (III) HAD A REASONABLE BUSINESS PLAN
 SEVIN-ROSEN (V.C)
 (I) CAPITAL
 (II) EXPERIENCE
 (III) INDUSTRY CREDIBILITY
 SOMETIMES, THE V.C’S CONTACTS CAN BE SO CRUCIAL
THAT FROM WHOM CAPITAL IS RAISED CAN BE MORE
IMPORTANT THAN TERMS ON WHICH RAISED.
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POTENTIAL ISSUES WITH V.C. FINANCING
1. POTENTIAL FOR EXCESSIVE DILUTION OF EQUITY
(OBVIOUS).
2. POTENTIAL INTERFERENCE IN THE DAY-TO-DAY
RUNNING OF THE FIRM.
3. MAY FORCE PRE-MATURE ABANDONMENT OF
PROJECT(S) IF V.C IS SOLE SUPPLIER.
4. FIRM MAY HAVE TO TRY TO GO PUBLIC TOO EARLY.
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EXIT STRATEGIES ADOPTED BY V. C.’S
1. GOING PUBLIC TYPICALLY THE MOST DESIRABLE
ROUTE - SO THE ONE THE V.C. AIMS AT; MOST
COMMON
2. SALE TO ANOTHER COMPANY
3. SALE OF OWNERSHIP STAKE TO ANOTHER INVESTOR: OFTEN TO A “WORKING PARTNER”.
4. SALE BACK TO ENTREPRENEUR.- RARE, BUT USED IF
ENTREPRENEUR CAN BORROW FROM BANK OR HAS
CASH.
5. REORGANIZING THE COMPANY (CHAPTER 11)
6. LIQUIDATION OF ASSETS.
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FINANCIAL CONTRACTING WITH V. C.’S
 A V.C DEAL IS ANY AGREEMENT BETWEEN PARTIES
FOR THE ALLOCATION OF ECONOMIC VALUE.
 A DEAL ALLOCATES CASH FLOWS BY AMOUNT AND
TIMING, AS WELL AS RISK.
 THE STRUCTURE OF A V.C. DEAL CAN RESULT IN
THE SUCCESS OR FAILURE OF THE FIRM/PROJECT.
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FINANCIAL CONTRACTING WITH V. C.’S
 A VENTURE-CAPITAL CONTRACT OR DEAL SHOULD:
 (I) ALLOCATE CASH FLOWS APPROPRIATELY.
 (II) ALLOCATE THE RISKS INVOLVED IN THE FIRM
 (III) GIVE RISE TO THE “RIGHT” INCENTIVE EFFECTS
BETWEEN THE ENTREPRENEUR AND VENTURE
CAPITALIST.
(i.e., IT SHOULD MOTIVATE THE ENTREPRENEUR
TO PUT FORTH OPTIMAL EFFORT AND PUT-FORTH
REALISTIC CASH FLOW PROJECTIONS)
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DESIGNING DEALS
 DESIGNING DEALS INVOLVES CHALLENGES AND
OPPORTUNITIES:
(1) UNCERTAINTY ABOUT CASH FLOWS
(2) DISCOUNT RATES DIFFICULT TO DETERMINE.
(3) PARTIES MAY DISAGREE ABOUT EXPECTED CASH
FLOWS, THEIR RISKS AND THE APPROPRIATE RATES.
(4) PARTIES AFFECTED DIFFERENTLY BY
TRANSACTION (TAX EFFECTS, FOR EXAMPLE).
(5) ASYMMETRIC INFORMATION
(6) CONFLICTS OF INTERESTS
(7) INCENTIVE EFFECTS OF DEAL ITSELF.
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ADDRESSING DIFFICULTIES
 DIFFICULTIES ARE DEALT WITH BY:
(A) STAGE FINANCING  FINANCING THE PROJECT
(INVESTING IN THE FIRM) IN STAGES.
(B) USE OF APPROPRIATE FINANCIAL CONTRACTS:
(I) DEBT WITH WARRANTS
(II) CONVERTIBLE DEBT
(III) PREFERRED EQUITY, ESPECIALLY
CONVERTIBLE PREFERRED EQUITY.
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VENTURE CAPITAL VALUATION
 PRE-MONEY VALUATION
 PRODUCT OF PRICE PAID BY V.C PER SHARE AND
THE NUMBER OF SHARES OUTSTANDING PRIOR TO
V.C’S INVESTMENT.
 POST-MONEY VALUATION:
 PRODUCT OF PRICE PAID PER SHARE BY V.C AND
THE TOTAL NUMBER OF SHARES (INCLUDING NEW
SHARES ISSUED TO V.C) OUTSTANDING AFTER V.C’S
INVESTMENT.
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EXAMPLE OF A V.C VALUATION
 POST-MONEY VALUATION EXAMPLE:
 ASSUME:
 INVESTMENT FROM V.C = $300,000 EQUITY
PARTICIPATION OF V.C = 15%
 IMPLIED EQUITY OF FIRM = 300,000/0.15 = 2 MILLION
 POST-MONEY BALANCE SHEET
ASSETS
CASH
OTHER
LIABILITIES
$300,000
EQUITY
$2,000,000
100,000
INTANGIBLES 1,600,000
$2,000,000
$2,000,000
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EXAMPLE OF A V.C VALUATION
 VC EXPECTED RETURN:
 RISKLESS RATE (LTG)
 MARKET PREMIUM
 SMALL CAPITAL PREMIUM
 LIQUIDITY PREMIUM + VALUE
ADDED PREMIUM+ CASH FLOW
ADJUSTMENT
=
 V.C EXPECTED RETURN  40 TO 50%
6.0%
5.0%
11%
2%
13%
30%
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EXAMPLE OF A V.C VALUATION
 ASSUME THAT THE V.C EXPECTS A RETURN OF 50%.
THEN, IN FIVE YEARS:
 VALUE OF V.C’S INVESTMENT
= $300,000 * (1.50)5 = $2.3 MILLION
(1+r)5
  EQUITY VALUE OF ENTIRE FIRM = 2.3/0.15 = $15.3
MILLION.
17
EXAMPLE OF A V.C VALUATION
 IS THIS REALISTIC?
 ASSUME (BUSINESS PLAN PROJECTS): (FOR YEAR FIVE)
 SALES $37.4 MILLION
 EBIT (10% OF SALES) = 3.7 MILLION
 PROFITS (NO DEBT ASSUMED) = 1.8 (AFTER Tc = 0.5)
 HENCE, REQUIRED PRICE/EBIT MULTIPLE = 15.3/3.7 = 4.2
 AND PRICE/EARNINGS MULTIPLE = 15.3/1.8 = 8.5
 BOTH OF WHICH ARE REASONABLE.
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FLOW OF MONEY & VALUATIONS
 FLOW OF MONEY INTO V.C FUNDS SEEMS TO
FOLLOW A BOOM-BUST PATTERN; ALSO PREMONEY VALUATIONS SEEM TO FOLLOW SUCH
VARIATIONS IN INFLOWS
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STAGES OF PRIVATE FINANCING
 A. FIRST ROUND: START-UP; R&D, TESTS, MARKET
RESEARCH.
 B. SECOND ROUND: PROTOTYPES. FURTHER TESTING;
EARLY EXPANSION.
 C. THIRD ROUND: FULL SCALE MANUFACTURING &
MARKETING
 D. FOURTH ROUND: CONVENTIONAL FINANCING
(PRIVATE PLACEMENT, MEZZANING FINANCING, AND
IPO).
 (V.Cs TYPICALLY INVOLVED IN 2nd AND 3rd ROUNDS).
 ANOTHER CLASSIFICATION OF INVESTMENT STAGES
 BENEFIT OF STAGE FINANCING: INCREASED NPV
20
STAGED FINANCING: OPTION TO ABANDON
 ONE ADVANTAGE OF STAGED FINANCING IS THAT THE
V.C HAS THE OPTION NOT TO PROVIDE FUNDING AS
MORE INFORMATION BECOMES AVAILABLE.
 CASE-I (SINGLE-ROUND FINANCING)
PV = 500 (NEWS = GOOD)
INVEST
0.5
UPFRONT
-200
0.5
PV = 10 (NEWS = BAD)
 E[NPV] = -200 + 0.5(500) + 0.5(10) = $55
21
STAGED FINANCING: OPTION TO ABANDON
 CASE-II: STAGED FINANCING
INVEST $100, PV = 500
INVEST
UPFRONT
$100
GOOD NEWS
0.5
0.5
BAD NEWS
DON’T INVEST, PV = 0
INVEST $100, PV = 10
DON’T INVEST, PV = 0
 E[NPV] = -100 + 0.5[500 - 100] + 0.5(0) = $100
 NPV HAS GONE UP IN STAGED FINANCING!
22
VALUATION & V.C. OWNERSHIP STAKE
 EXAMPLE: PRE-AND POST-MONEY VALUATION AND V.C
OWNERSHIP STAKE
 $5 MILLION INVESTMENT REQUIRED IN BIO-TECH
VENTURE
 PROJECTED NET-INCOME IN YEAR 7 = 20 MILLION.
 AVERAGE P/E OF PROFITABLE BIO-TECH FIRMS
(COMPARABLES) = 15
 CURRENT NO. OF SHARES OUTSTANDING = 500,000
 ASSUME EXPECTED RETURN 50%
 CASE-I: NO FURTHER FINANCING NEEDED UNTILL FIRM
GOES PUBLIC (IN YEAR 7)  NO NEW SHARES ISSUED
BEFORE V.C EXITS
23
VALUATION & V.C. OWNERSHIP STAKE
 CASE-I
 DISCOUNTED TERMINAL VALUE
= TERM. VAL./(1 + r)7 = 20 * 15/1.57 = $17.5 M
 REQUIRED EQUITY OWNERSHIP
= INVESTMENT/DISCOUNTED TERMINAL VALUE
= 5/17.5 = 0.285 OR 28.5%
  TOTAL SHARES AFTER VALUATION
= 500,000/(1 - 0.285) = 700,000
 NO. OF NEW SHARES ISSUED TO V.C = 200,000
 PRICE PER NEW SHARE = $5 M /200,000 = $25 /SHARE
 IMPLIED PRE-MONEY VALUATION = (25)500,000 = $12.5 M
 IMPLIED POST-MONEY VALUATION = (25)700,000 = $17.5 M
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VALUATION & V.C. OWNERSHIP STAKE
 CASE-II: TWO ROUNDS OF FINANCING BEFORE V.C
EXITS; THREE MORE SENIOR EXECUTIVES NEED TO BE
HIRED (10% OF EQUITY GIVEN AS STOCK OPTIONS TO
THEM); ALSO, 30% OF EQUITY SOLD IN A SUBSEQUENT
FINANCING ROUND.
 CASE-II: CALCULATIONS NEED TO BE AMENDED AS
FOLLOWS
 RETENTION RATIO:
AFTER FIRST ROUND  1/1.1 = 90.9%
AFTER SECOND ROUND = (1/1.1)/1.3 = 70% OF EQUITY
 REQUIRED CURRENT OWNERSHIP = REQUIRED FINAL
OWNERSHIP/RETENTION RATIO = 0.285/0.7 = 40.7%.
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VALUATION & V.C. OWNERSHIP STAKE
 NO. OF NEW SHARES = 500,000/(1 - 0.407) - 500,000
= 343,373 SHARES
 PRICE PER NEW SHARE = $5 MILLION/343,373
= $14.56/SHARE
 IMPLIED PRE-MONEY VALUATION
= 14.56 * 500,000 = 7.28 MILLION
 IMPLIED POST-MONEY VALUATION
= $7.28 + $5 = 12.28 MILLION
 CURRENT VALUATION HAS FALLEN (WHY?)
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RISK ALLOCATION - DEBT WITH WARRANTS
 EXAMPLE OF RISK-ALLOCATION, USING DEBT WITH
WARRANTS.
 ASSUME INVESTMENT BY V.C = $1000
0.5
MEDIOCRE (I)
0.5
VERY SUCCESSFUL (II)
YEAR
0
1
2
3
CASH FLOW
-1000
CASE-I
250
300
1000
CASE-II
350 700 5000
EXPECTED
-1000 300
500
3000
 SAMPLE CALCULATION OF CASH FLOW IN YEAR 0:
= 0.5(250) + 0.5(350) = 300
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RISK ALLOCATION - DEBT WITH WARRANTS
 ASSUME EXPECTED RETURN OF V.C IS 40%
 IN ORDER TO INVEST, THE V.C IS GOING TO DEMAND
AN EQUITY PARTICIPATION WHICH WILL GIVE HIM A
PV OF $1000 (AMOUNT INVESTED) AT AN EXPECTED
RETURN OF 40%.
 PV OF PROJECT EXPECTED CASH FLOW (AT 40%
RETURN) = $1562.6 (CHECK!)
 EQUITY PARTICIPATION IF V.C TAKES STRAIGHT
EQUITY = 1000/1562.5 = 0.64 OR 64%
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RISK ALLOCATION - DEBT WITH WARRANTS
 ALTERNATIVE TO EQUITY FINANCING: DEBT WITH
WARRANTS
 TWO PARTS IN SECURITY PACKAGE:
 BOND: GIVES V.C A CASH FLOW OF $250 AT t = 1, $300 AT
t = 2, AND $1000 AT t = 3.
 (THUS, THE V.C GETS ALL THE CASH FLOW IN THE LOW
SCENARIO; THE ENTREPRENEUR GETS NONE).
 THE BOND PAYS OFF THE SAME AMOUNT IN EITHER
SCENARIO (IN THE HIGH SCENARIO, THERE WILL BE
SOME MONEY LEFT OVER AT EACH DATE FOR THE
ENTREPRENEUR).
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RISK ALLOCATION - DEBT WITH WARRANTS
 CASH FLOW TO V.C (FROM BOND ALONE)
t=0
1
2
HIGH SC
250
300
LOW SC
250
300
E(CASH FLOW)
250
300
3
1000
1000
1000
 PRESENT VALUE AT 40%
= 250/1.4 + 300/1.42 + 1000/1.43
= 696
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RISK ALLOCATION - DEBT WITH WARRANTS
 REMAINING PRESENT VALUE TO BE PROVIDED TO V.C
= 1000 - 696 = 304
 THIS CAN BE PROVIDED TO THE V.C IN THE FORM OF A
WARRANT, WHICH CAN BE CONVERTED TO 41.8% OF
FIRM’S EQUITY IN HIGH SCENARIO AT t = 3. (THE V.C
GETS ALL THE FIRM’S MONEY IN THE LOW SCENARIO,
ANYWAY, THROUGH THE BOND).
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RISK ALLOCATION - DEBT WITH WARRANTS
 CALCULATING THE FRACTION OF EQUITY TO BE
PROVIDED TO V.C THROUGH WARRANT IN HIGH
SCENARIO
 PRESENT VALUE TO BE PROVIDED (CALCULATED
BEFORE) = 304.
  t = 3 EXPECTED CASH FLOW TO BE PROVIDED =
304(1.4)3 = $835 (SINCE DISCOUNT RATE = 40%).
 SINCE WARRANTS ARE WORTHLESS IN LOW
SCENARIO, EXPECTED CASH FLOW TO V.C
= 835 = 0.5 (LOW-SCENARIO CASH FLOW = 0) + 0.5
(HIGH-SCENARIO CASH FLOW).
32
RISK ALLOCATION - DEBT WITH WARRANTS
 SOLVING:
 HIGH-SCENARIO CASH FLOW = 835/0.5 = $1670
 NOW, TOTAL CASH FLOW AVAILABLE TO EQUITY IN
HIGH SCENARIO = $5000 -$1000 = $4000
 PAID TO BOND
  EQUITY TO BE PROVIDED TO V.C WARRANTS =
1670/4000 = 41.8%
33
RISK ALLOCATION - DEBT WITH WARRANTS
 SUMMARY: TOTAL CASH FLOW TO V.C
YEAR
0
1
2
LOW SCEN:
BOND:
250
300
WARR:
HIGH SCEN:
BOND:
250
300
WARR:
EXPECTED CASH FLOW:
BOND:
250 300
WARR:
TOTAL:
250
300
3
1000
1000
1670
1000
835
1835
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RISK ALLOCATION - DEBT WITH WARRANTS
 BOND PLUS WARRANTS: SPLIT-UP OF PRESENT VALUE
V.C
ENTREPRENEUR
TOTAL
CASH %
CASH %
CASH
PV:
696 = 100%
0 = 0%
696
(LOW SCENARIO)
PV:
1305 = 54%
(HIGH SCENARIO)
1125 = 46%
2429
PV (ECF): 1000 = 64%
563 = 36%


SAME AS IN EQUITY CASE
1563
35
RISK ALLOCATION - DEBT WITH WARRANTS
 NOTE:
1. INCENTIVE-EFFECTS: THE ENTREPRENEUR WORKS
HARD (HE GETS NOTHING IN LOW SCENARIO).
2. INFORMATION-EFFECTS: ENTREPRENEUR HAS NO
BENEFIT FROM OVERSTATING PROBABILITY OF HIGH
SCENARIO.
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EARNOUT AGREEMENTS:
 SIMILAR TO STAGED FINANCING IN THAT A PORTION
OF THE PURCHASE PRICE IS PAID IN THE FUTURE
CONTINGENT ON THE TARGET’S FUTURE EARNINGS.
 EXAMPLE:
 WHEN COMPANY A ACQUIRES B, THE SELLER WILL
BE PAID FOUR TIMES TARGET FIRM’S EBIT FOR THAT
YEAR.
 THUS, WHEN GM ACQUIRED EDS AND HUGHES
ELECTRONICS, IT PAID FOR THE ACQUISITIONS WITH
A SEPARATE CLASS OF SHARES, WITH DIVIDENDS
CONTINGENT ON PROFITS.
37
EARNOUT AGREEMENTS:
 ADVANTAGES OF EARN-OUT AGREEMENTS:
 PARTICULARLY USEFUL IN ACQUIRING PRIVATE
FIRMS, DIFFICULT TO VALUE
 SCREENS OUT SELLERS WHO TRY TO MISREPRESENT
THE EARNINGS POTENTIAL OF THEIR BUSINESS
 PROVIDES INCENTIVES TO THE
SELLER/ENTREPRENEUR IF HE STAYS ON AS A
MANAGER (OFTEN THE CASE).
 DIMINISHES UP-FRONT COMMITMENT OF BUYER
 PROTECTS BUYER FROM NEGATIVE SURPRISES
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