Download Some Basics of Venture Capital

Some Basics of Venture Capital
Outline
• The basics: how VC works
• Case study: DDoS defense companies
What is Venture Capital?
• Private or institutional investment (capital) in relatively
early-stage companies (ventures)
• Recently focused on technology-heavy companies:
– Computer and network technology
– Telecommunications technology
– Biotechnology
• Types of VCs:
– Angel investors
– Financial VCs
– Strategic VCs
Angel Investors
• Typically a wealthy individual
• Often with a tech industry background, in position
to judge high-risk investments
• Usually a small investment (< $1M) in a very earlystage company (demo, 2-3 employees)
• Motivation:
– Dramatic return on investment via exit or liquidity event:
• Initial Public Offering (IPO) of company
• Subsequent financing rounds
– Interest in technology and industry
Financial VCs
• Most common type of VC
• An investment firm, capital raised from
institutions and individuals
• Often organized as formal VC funds, with
limits on size, lifetime and exits
• Sometimes organized as a holding company
• Fund compensation: carried interest
• Holding company compensation: IPO
• Fund sizes: ~$25M to 10’s of billions
• Motivation:
– Purely financial: maximize return on investment
– IPOs, Mergers and Acquisitions (M&A)
Strategic VCs
• Typically a (small) division of a large
technology company
• Examples: Intel, Cisco, Siemens, AT&T
• Corporate funding for strategic investment
• Help companies whose success may spur
revenue growth of VC corporation
• Not exclusively or primarily concerned with
return on investment
• May provide investees with valuable
connections and partnerships
• Typically take a “back seat” role in funding
The Funding Process: Single Round
• Company and interested VCs find each other
• Company makes it pitch to multiple VCs:
– Business plan, executive summary, financial projections with
assumptions, competitive analysis
• Interested VCs engage in due diligence:
– Technological, market, competitive, business development
– Legal and accounting
• A lead investor is identified, rest are follow-on
• The following are negotiated:
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Company valuation
Size of round
Lead investor share of round
Terms of investment
• Process repeats several times, builds on previous rounds
Due Diligence: Tools and Hurdles
• Tools:
– Tech or industry
background (in-house
rare among financials)
– Industry and analyst
reports (e.g. Gartner)
– Reference calls (e.g.
beta’s) and clients
– Visits to company
– DD from previous rounds
– Gut instinct
• Hurdles:
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Lack of company history
Lack of market history
Lack of market!
Company hyperbole
Inflated projections
Changing economy
Terms of Investment
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Initially laid out in a term sheet (not binding!)
Typically comes after a fair amount of DD
Valuation + investment  VC equity (share)
Other important elements:
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Board seats and reserved matters
Drag-along and tag-along rights
Liquidation and dividend preferences
Non-competition
Full and weighted ratchet
• Moral: These days, VCs extract a huge amount
of control over their portfolio companies.
Basics of Valuation
• Pre-money valuation V: agreed value of company prior to this
round’s investment (I)
• Post-money valuation V’ = V + I
• VC equity in company: I/V’ = I/(V+I), not I/V
• Example: $5M invested on $10M pre-money gives VC 1/3 of
the shares, not ½
• Partners in a venture vs. outright purchase
• I and V are items of negotiation
• Generally company wants large V, VC small V, but there are
many subtleties…
• This round’s V will have an impact on future rounds
• Possible elements of valuation:
– Multiple of revenue or earnings
– Projected percentage of market share
Board Seats and Reserved Matters
• Corporate boards:
– Not involved in day-to-day operations
– Hold extreme control in major corporate events
(sale, mergers, acquisitions, IPOs, bankruptcy)
• Lead VC in each round takes seat(s)
• Reserved matters (veto or approval):
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Any sale, acquisition, merger, liquidation
Budget approval
Executive removal/appointment
Strategic or business plan changes
• During difficult times, companies are often
controlled by their VCs
Other Typical VC Rights
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Right of first refusal on sale of shares
Tag-along rights: follow founder sale on pro rata basis
Drag-along rights: force sale of company
Liquidation preference: multiple of investment
No-compete conditions on founders
Anti-dilution protection:
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Recompute VC shares based on subsequent “down round”
Weighted ratchet: use average (weighted) share price so far
Full ratchet: use down round share price
Example:
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Founders 10 shares, VC 10 shares at $1 per share
Founder issues 1 additional share at $0.10 per share
Weighted ratchet: avg. price 10.10/11, VC now owns ~10.89 shares (21.89 total)
Full ratchet: VC now owns 10/0.10 = 100 shares (out of 111)
– Matters in bridge rounds and other dire circumstances
• Right to participate in subsequent rounds (usually follow-on)
• Later VC rights often supercede earlier
Why Multiple Rounds and VCs?
• Multiple rounds:
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Many points of valuation
Company: money gets cheaper if successful
VCs: allows specialization in stage/risk
Single round wasteful of capital
• Multiple VCs:
– Company: Amortization of control!
– VCs:
• Share risk
• Share DD
– Both: different VC strengths (financial vs. strategic)
So What Do VCs Look For?
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Committed, experienced management
Defensible technology
Growth market (not consultancy)
Significant revenues
Realistic sales and marketing plan (VARs
and OEMs vs. direct sales force)
Case Study: DDoS Defense Technology
• DDoS: Distributed Denial of Service
• Web server, router, DNS server, etc. flooded with automated, spurious
requests for service at a high rate
• Outcomes:
– Resource crashes
– Legitimate requests denied service
– Bandwidth usage and expense increase
• Attack types:
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SYN flood
ICMP echo reply attack
Zombie attacks
IP spoofing
Continually evolving!
• Attack characteristics:
– Distributed
– Statistical
– Highly adaptive
• Not defendable via cryptography, firewalls, intrusion detection,…
• An arms race
Market Landscape
• Victims include CNN, eBay, Microsoft, Amazon
• > 4000 attacks per week (UCSD study)
• Recent “Code Red” attack on White House foiled,
but > 300K client zombies infected
• Costs:
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Downtime, lost productivity
Recovery costs (personnel)
Lost revenue
Brand damage
• Attack costs $1.2B in Feb. ’00; 2005 market
estimate $800M (Yankee Group)
Who Can and Will Pay?
• Internet composed of many independently owned and operated
autonomous networks
• Many subnets embedded in larger networks
• Detecting/defending DDoS requires a minimum network footprint
• Must solve problem “upstream” at routers with sufficient bandwidth
to withstand attack traffic!
• May simply trace attack source to network edge
• Target customers:
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Large and medium ISPs, MSPs, NSPs
Large and medium data centers
Backbone network providers
Future: wireless operators; semi-private networks (FAA, utilities)
Making target customers care; cannibalization
• Key points:
– Problem did not exist until recently on large scale
– No product available for its defense
– No historical analysis of market possible (firewall and IDS)
The Companies
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Four early-stage companies focused specifically on DDoS
All with strong roots in academia
Headcounts in 10’s; varied stages of funding and BD
Larger set of potential competitors/confusers:
– Router manufacturers (e.g. Cisco)
– IDS and firewall companies
– Virus detection companies (e.g. McAfee)
• Technology:
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All four solutions involve placing boxes & SW “near” routers
Differing notions of “near”
Boxes monitor (some or all) network traffic
Boxes communicate with a Network Operations Center (NOC)
Key issues:
• Detection or Defense?
• Intrusiveness of solution?
Some Specifics
• Company Detect:
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Emphasis on detection tools provided to NW engineer
Claim more intrusive/automated solutions unpalatable
Emphasis on GUI and multiple views of DDoS data
More advanced in BD (betas), PR, partnerships
More advanced in funding (>>$10M capital taken)
• Company Defend-Side:
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Emphasize prevention of attacks by filtering victim traffic
Box sits to the side of router over fast interface
Claim there is a “sweet spot” of intrusiveness
Box only needs to be fast enough for victim traffic, not all
Don’t need perfect filtering to be effective
No GUI emphasis; behind in BD; less advanced in funding
• Company Defend-Path:
– Also emphasizing prevention, but box sits on “data path”
– Need faster boxes and more boxes (scalability)
– Concerns over router integration
Due Diligence
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No company has any revenue yet
Some have first-generation product available
All have arranged beta trials with some ISPs
Have roughly similar per-box pricing model and ROI argument
Due diligence steps:
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Repeated visits/conversations with companies: technical, sales strategy
Multiple conversations with beta NW engineers
Development of financial model for revenue projections & scenarios
Compare with firewall and IDS market history: winners & losers, mergers
Conversations with previous round VCs: DD and commitment
• In the end, a decision between:
– More conservative technology with a slight lead in BD and R&D
– More ambitious technology with less visibility, but a better deal
• Contemplating both investments…
• …then came September 11.
Venture Capitalists
• Venture capital firms specialize in providing equity financing
for firms that are in an early stage of development (start-ups).
• Examples of companies that received venture capital funding
in their early development include Apple, Federal Express,
Microsoft, Genentech, and Google.
• Venture capital (a.k.a. private equity) is a pool of capital most
commonly organized as a limited partnership. The venture
capital firm serves as the general partner and investors are the
limited partners. Limited partners can include pension funds,
university endowment funds, wealthy individuals, and other
financial institutions and corporations.
• Managers of venture capital firms (venture capitalists) closely
follow the technology and market developments in their area
of expertise (e.g., computer software, communications,
computer hardware, medical/health, industrial/energy,
biotechnology, retailing, restaurants, etc.)
• They screen entrepreneurs and their business concepts prior to
making an investment. To diversify risk, they create a venture
fund that is a portfolio of investments in young companies.
• Venture capitalists are not passive equity investors. They
structure a financing deal with great attention to creating the
right incentives and compensation for the start-up firm’s
owners. They are also instrumental in raising additional
financing during future stages of the firm’s lifecycle.
• Types of venture capital financing provided to companies:
» Seed: prior to a product being developed or to the start-up
being organized.
» Early Stage: after a company has expended initial capital
in development and market testing and is now ready to
begin full-scale operations and sales.
» Expansion Stage: the company is producing and shipping
and has growing inventories and accounts receivable.
» Later Stage: company is now breaking-even or profitable
and requires funds for plant expansion, full-scale
marketing, and working capital.
» MBO/Acquisition: This situation occurs when managers
wish to purchase an independent company or a division or
product line of their employer, thus creating a new
independent firm.
• Venture capitalists (VCs) continuously monitor their companies.
» VCs typically serve on the company’s Board of Directors.
» VCs provide mentoring and strategic advice to the
company’s managers.
» VCs often provide business contacts to company managers.
» VCs help recruit additional managers for the company.
» VCs set company performance targets. If these targets are
not met, VCs may have the option of replacing the company
founder as the CEO.
• Empirical evidence finds that
» Companies with innovative, rather than imitator, business
plans are more likely to receive VC financing.
» Ceteris paribus, companies obtaining VC financing bring
their products to market more quickly.
• A venture capital firm typically raises money for a venture
capital fund by obtaining commitments from limited partner
investors. Based on the fund’s prospectus, limited partners
agree to make investments for a period that is often 10 years.
• After commitments are obtain, the VC begins making
investments in young companies. VCs make “capital calls” to
the limited partners as funds are dispersed to the start-up
companies.
• The most common way that the VC obtains a return from its
investment in a start-up company is by the company being
acquired by a mature corporation. In other cases, the VC
obtains a return when the company issues an IPO. After the
IPO, the stock held by the VC is given to the partners who can
continue to hold it or liquidate it.
• Most commonly VCs are private independent firms. However,
sometimes a VC firm is a
» Subsidiary of a commercial bank holding company (BHC).
This allows the BHC to provide (high-risk) equity
financing that could not be made by BHC’s commercial
bank subsidiary.
» Subsidiary of an investment bank. Investment banks see
VC investing as a way to groom companies for an IPO.
» Subsidiary of a non-financial corporation (a.k.a. direct
investing). The parent company’s capital is used to invest
in young companies that may produce synergies or cost
savings for the parent.
• The major alternatives to venture capital financing are
» Angels: These are wealthy individuals (often former
corporate executives) who mentor a company and provide
financing and expertise to start-ups.
» Commercial banks: often in the form of lines of credit.
» Government: Through grants or Small Business
Administration financing and loan guarantees.
» Self-financing: including family members and friends.
• VC financing grew tremendously during the 1990s. The
recession and decline in technology firms (a major source of
VC investment), led VCs to reduce their investments because
prospects for making profits in start-ups was greatly reduced.
Total Venture Capital Disbursements $M
120000
100000
80000
60000
40000
20000
03
20
02
20
01
20
00
20
99
19
98
19
97
19
96
19
95
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94
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93
19
92
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91
19
19
90
0
Number of Venture Capital Deals
9000
8000
7000
6000
5000
4000
3000
2000
1000
03
20
02
20
01
20
00
20
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
19
90
0
• While it may be some time before VC activity returns to the
level of the “bubble” years of 1999-2000, VC financing will
remain an important source of funding for entrepreneurs with
innovative business strategies.
Questions?