1. PROFESSIONAL VENTURE CAPITAL
ENTREPRENEURIAL FINANCE
Leach & Melicher
Chapter 12
PROFESSIONAL VENTURE CAPITAL
© 2003 South-Western College Publishing

2. Chapter 12: Learning Objectives
Discuss the history & current status of venture investing in the U.S.
Explain the professional venture investing cycle and its relevance to entrepreneurs seeking professional venture capital
List major elements in the design & structure of a venture capital fund

3. Chapter 12: Learning Objectives
Describe the venture capital screening process & list characteristics that will determine whether a VC will invest
Discuss the various roles a venture capitalist can take in providing financing and services to an emerging venture
Enumerate several terms or conditions to be negotiated with structuring venture capital financing

4. Historical Development of Professional Venture Capital
Professional Venture Capitalists (VCs) >Raise capital from investors, in addition to their personal funds, to invest in a portfolio of risky ventures
Pre-World War II Era >Most venture investing came from wealthy individuals and families
1946: Beginning of Professional VCs >Formation of American Research & Development (ARD)

5. 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 if 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)

6. 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 taxs and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital

7. 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%

8. 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

9. DETERMINING (NEXT) FUND OBJECTIVES & POLICIES
Professional Venture Investing Cycle

10. ORGANIZING THE NEW FUND
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

11. ELEMENTS of VC FUND PLACEMENT MEMORANDUM
Frontmatter Declarations
State Securities Disclosures
Offering Summary
Fund Overview
Executive Summary
Summary of Terms

12. SUPPLIERS OF VENTURE CAPITAL: 15 Year Average
40% Pension Funds
13% Individuals
12% Corporations
12% Insurance Companies
12%Endowments
12% Foreign

13. CAPITAL CALL
Capital call: when the venture fund calls upon the investors to deliver their investment funds
Subsequent investments consistent with the levels of investors contributions

14. CONDUCTING DUE DILIGENCE AND ACTIVELY INVESTING
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

15. VC SCREENING CRITERIA 1. Venture Capital Firm Requirements
2. Characteristics of the Proposal
3. Characteristics of the Entrepreneur/Team
4. Nature of the Proposed Industry
5. Strategy of the Proposed Business

16. VC SCREENING CRITERIA 1. Venture Capital Firm Requirements
a. Cash out potential
b. Equity share
c. Familiarity with technology, product, market
d. Financial provisions for investors
e. Geographic location
f. Investor control

17. VC SCREENING CRITERIA 1. Venture Capital Firm Requirements
g. Investor control
h. Investor group
i. Rate of return
j. Size of investment
k. Stage of development

18. VC SCREENING CRITERIA 2. Characteristics of the Proposal
a. Requirement for additional material
b. Stage of plan

19. VC SCREENING CRITERIA 3. Characteristics of the Entrepreneur/Team
a. Ability to evaluate risk
b. Articulate regarding the venture
c. Background/experience
d. Capable of sustained effort
e. Managerial capabilities
f. Management commitment
g. References
h. Stake in firm

20. VC SCREENING CRITERIA 4. Nature of the Proposed Industry
a. Market attractiveness
b. Potential size
c. Technology
d. Threat resistance

21. VC SCREENING CRITERIA 5. Strategy of the Proposed Business
a. Product differentiation
b. Proprietary product

22. OUTCOMES OF THE SCREENING PROCESS
1. Seek lead investor position
2. Seek a non-lead investor position
3. Refer venture to more appropriate financial market participants
4. SLOR (standard letter of rejection) the venture

23. ARRANGING HARVEST OR LIQUIDATION
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

24. ARRANGING HARVEST OR LIQUIDATION
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

25. ARRANGING HARVEST OR LIQUIDATION
Typical Issues Addressed in a Term Sheet
Employment contracts
Incentive options
Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock o termination, term of agreement, post-employment activities and competition
Founder stock vesting
Confidentiality agreements and protection for intellectual property