E145 Winter 2008 Copyright ©2008 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be reproduced for educational purposes only. E Workshop B Venture Finance Presented by Ann Miura-Ko and Austin Rachlin (with Thanks to Professor Tom Byers) Stanford University Special Thanks to Eric Carr, Scott Bowie and Mike Rosenbluth, Past E145 TAs

E145 Winter 2008 Some fundamentals... What is a V.C.? Why would I want to take their money? and what will I have to give up? Would they want me to take their money?!?

E145 Winter 2008 What is Venture Capital? VENTURE CAPITALISTS (Finding and Funding Entrepreneurial Companies) ENTREPRENEURS (Starting and Building Companies) INSTITUTIONAL INVESTORS (Limited Partners – e.g. Endowments, Pension Funds) High Risk Equity Return (30%+) Diversification Management Fees Share of Profits Management Help Financing Credibility Capital Capital, Time Help “Liquid” StockPreferred Stock Limited partnerships, governed by partnership agreement covenants, of finite life, with substantial profit sharing...

E145 Winter 2008 Typical Asset Allocation for LP Asset allocation for Stanford –Endowment Size: $17.2B

E145 Winter 2008 Typical Asset Allocation for LP Asset allocation for Calpers –Fund size: $239.2B

E145 Winter 2008 How does a VC work Size of VC fund: $500M –Institutional $10-50M –Individuals $0.5-5M Invests over 3-5 years, return within 10 On average delivers 30% per year return 10 partners, companies per fund What size deal would be interesting?

E145 Winter 2008 Which do you like? Suppose you were to invest $10M –Fund 1: 2x return on all 10 $1M investments –Fund 2: Loses all $1M investments in 8 deals Wins 20x on the remaining 2 $1M investments Source: Andy Rachleff

E145 Winter 2008 So, what do I have to give up?

E145 Winter 2008 That’s not the right question It ain’t the angle of the slice - it’s the size of the PIE –Goal: Trade shares to grow the pie –Is worth more than the whole pie that never grows –Is not easy to achieve, even with lots of financing –Requires a good relationship between entrepreneur and investors

E145 Winter 2008 A Real Life Example: Chemdex* How much money do the founders need? How long until significant revenue? How long until profitability? What’s the going rate for 1st round deals? Valuation is an art, not a science. *Chemdex is now called NexPrise (NXPS)

E145 Winter 2008 Chemdex in 1997: Series A 1. How much does the company need to raise?

E145 Winter 2008 Series A 2.Negotiate a pre-money valuation post $ = pre $ + amount raised = $2.7 M + $1.9 M % of company sold = amount raised / post $ valuation = $1.9 M / $4.6 M How much do the founders own at this point?

E145 Winter 2008 Series A 3. Determine share price and total number of shares In Round A, share price is set so total shares = 5-10 million Total Shares = post $ / share price = $4.6 M / $0.54 = 8.5 M shares

E145 Winter 2008 Series B 1. How much does the company need to raise?

E145 Winter 2008 Series B 2. Negotiate a pre-money valuation post $ = pre $ + amount raised = $11 M + $13 M % of company sold = amount raised / post $ valuation = $13 M / $24 M

E145 Winter 2008 Series B 3. Determine new share price Share price = (pre-money valuation) / (total pre-money shares) = $11M / 8.5 M

E145 Winter Determine total number of shares Total Shares = pre $ shares + amount raised / share price = 8.5 M + $13 M / $1.29 Series B

E145 Winter 2008 Chemdex - Series C 3. Determine new share price 4. Calculate total number of shares 1. Decide how much you need to raise 2. Negotiate a valuation

E145 Winter 2008 Chemdex Financing

E145 Winter 2008 Calculating Dilution Percentage owned = owned shares / total shares Founders’ shares = 59% of 8.5M = 5.02M shares Series B Dilution: 5.02M / 18.6M = 27% Series C Dilution: 5.02M / 24.2M = 21% IPO Dilution: 5.02M / 31.8M = 16% Post-$ Valuation $471$24$130$4.6 Could Chemdex founders get to this size on their own?

E145 Winter 2008 What besides cash do they offer? (Picture of Randy) Randy Komisar –Expertise –Contacts (their and the firm’s rolodex) Your due diligence of the VC firms you interact with should be at least as in depth as their due diligence of you

E145 Winter 2008 Chemdex and Dilution

E145 Winter 2008 Andy Rachleff Juniper Networks - First $2,000,000 $4,000,000 Price/Share$1.00 2,000,000 Pre-Money Seed Investor Post-Money AmountSharesPercentage 50.0% Founders Employee Pool Total Employees 1,500, ,000 2,000, % 12.5% 50.0% Total Shares Outstanding 4,000,000

E145 Winter 2008 Andy Rachleff Juniper Networks - Second $32,000,000 $4.80 2,312,500 1,354, % 20.3% 1,500,000 3,000, % 45.0% $24,000,000 $1,500,000 $6,500,000 $2,000,000 $4,000,000 Price/Share$1.00 2,000,000 Pre-Money Seed Investor Venture Investor Post-Money AmountSharesPercentage 50.0% Founders Employee Pool Total Employees 1,500, ,000 2,000, % 12.5% 50.0% AmountSharesPercentage Total Shares Outstanding 4,000,000 6,666,667

E145 Winter 2008 Juniper Final Cap Table

E145 Winter 2008 Valuing Public Companies

E145 Winter 2008 Ratios & Valuing Public Companies Today Market Cap = # shares outstanding x Share price –Answers “What does the market think the company is worth?” –Examples GOOG with 306M outstanding $ / share = $143B market cap YHOO with 1.36B outstanding $28.56 / share = $48.9B market cap

E145 Winter 2008 Ratios & Valuing Public Companies Today Ratios –EPS = Earnings per share An indicator of value created for shareholders –P/E = Market Cap / Annual Earnings = Stock Price / EPS How much does $1 of earnings cost an investor? –P/S = Market Cap / Annual Sales Similar companies facing similar risks should have similar ratios (Comparables / Comps) “Enterprise Value” - Market Cap + Debt

E145 Winter 2008 Metrics in Action Market Cap Net Income: $10 M P/E: 30 $300 M Share Price: $15 # Shares: 20 M $300 M Sales: $100 M P/S: 3 $300 M

E145 Winter 2008 A Sampling of Public Companies Note: Updated Feb 6, 2006 Close

E145 Winter 2008 Metrics Calculation Public Company Info: (must be filed with SEC) We can calculate:

E145 Winter 2008 Metrics Calculation Public Company Info: (must be filed with SEC) We can calculate:

E145 Winter 2008 Valuing Startups

E145 Winter 2008 Capital Risk (ß) Valuation Idea is Feasible Technology Works A Customer Buys Seed Funding R&D Capital Go-to-Market Capital Expansion Capital P(success) = 30% Req’d IRR = 100% P(success) = 40% Req’d IRR = 70% P(success) = 50% Req’d IRR = 50% P(success) = 80% Req’d IRR = 30% Source: Jim White (SHV) VC Discount Rates and Risk Reduction Milestone Funding

E145 Winter 2008 VC Milestone Staged Timeline Seed“A”“B”“C/D”IPO/M&A Size~$1m$3-8m$10-20m~$20m~$50m SourceAngelVCVCMezzIB Runway 6-12 months months months 2+yrs # Empl. <10~30~50~100>100 Milestone Clear plan & Team Beta product & customers Sales, mkt size, competition Strategic, financial execution Growth, profit

E145 Winter “Venture Capital” Method Valuing Cash, Time and Risk This method defines one simple valuation approach: 1.Forecast Future Results (Financial Statements) 2.Determine likely value at that point (P/E Ratio) 3.Determine Dilution (Capital, Stock Options) 4.Determine share of pie demanded given required rates of return 5.Convert future values to present to derive share prices, ownership percentages Source: Prof. Doug Mackenzie (KPCB)

E145 Winter “Venture Capital” Quick Example 1.Forecast Future Results (Financial Statements) Net Income of $10M in Year 5 2.Determine likely value at that point (P/E Ratio) Industry currently demanding P/E ratios of 30, future value of $300M (year 5) 3.Determine Dilution (Capital, Stock Options) See Chemdex example (identify capital needs and shares required for management and employees)

E145 Winter “Venture Capital” Quick Example 4.Determine share of pie demanded given required rates of return Each investor class (VC Round) will require a rate of return, lower over time as risk is mitigated through successful milestones 5.Convert future values to present to derive share prices, ownership percentages Chemdex shows share valuation and issuance of new shares If a VC invests $5M today with expected IRR of 70%, would require ownership stake of $71M (23%) in year 5 at exit / IPO.

E145 Winter 2008 PositionPre-Rev Post- Rev CEO5-10%3-8% VP Engineering3-5%1-3% VP Marketing3-5%1-3% VP Sales1-2%1% CFO2-3%1-2% Other VPs1-2%1% Key Individuals0.5-2%0.3-1% Ranges of Grants