Exam 3 Content Materials

1. Exam 3 Content Materials New Venture Development Spring 2013

2. Major content areas • How venture capital works • How venture capitalists evaluate opportunities • The four pillars of growth • Business model generation • Business planning

3. How venture capital works Zider, R. 1998. How venture capital works, Harvard Business Review, November-December, 131-139

4. VCs invest in high potential growth companies that will be game changers in their industries.

5. If you work in an industry that is attracting attention from VCs, be ready for radical change

6. VC system works for • Entrepreneurs • Institutional investors • Investment bankers • Venture capitalists

7. Zider, 1998

8. Filling the void • Venture capital plays an important role in the stage of the company’s innovation life cycle when it begins to commercialize its innovation • > 80% of VC $ goes into building infrastructure needed to grow the business – in expense investments (mfrg capacity, marketing, sales) and the balance sheet (working capital and fixed assets) Zider, 1998

9. Timing is everything • > 80% $ invested by VCs goes into adolescent phase of a company’s life cycle • During this phase the financials of eventual winners and losers look highly similar Zider, 1998

10. The “adolescence” stage

11. Zider, 1998

12. Several moving parts in execution: Assume 80% probability of success each Failure on any single step is NOT an option Zider, 1998

13. Logic of the deal • Term sheets offer downside and upside protections • Downside • Preferred stock gives VCs liquidation preference • Ratchets protect VCs from dilution if more $ needs to be raised at lower valuation – they keep their same % ownership position • Upside – can put additional $ into firm at predetermined prices – they can increase the stakes in successful firms below market prices

14. Typical portfolio payout per $1,000 invested Zider, 1998

15. Zider, 1998

16. Profile of the ideal entrepreneur • Is qualified in a “hot” area of interest • Delivers sales or technical advances such as FDA approval with reasonable probability • Tells a compelling story and is presentable to outside investors • Recognizes the need for speed to an IPO for liquidity • Has a good reputation and can provide references that show competence and skill • Understands the need for a team with a variety of skills and therefore sees why equity has to be allocated to other people Zider, 1998

17. Profile of the ideal entrepreneur • Works diligently toward a goal but maintains flexibility • Gets along with the investor group • Understands the cost of capital and typical deal structures and is not offended by them • Is sought after by many VCs • Has realistic expectations about process and outcome Zider, 1998

18. Value of an individual to a VC • Is a function of these conditions: • # of people within the high-growth industry who are qualified for the position • The position itself (CEO, CFO, CTO, technician) • Match of person’s skills, reputation, and incentives to the VC firm • Willingness to take risks • Ability to sell oneself • Entrepreneurs who satisfy these conditions have strong negotiating position with VCs Zider, 1998

19. Entrepreneurs sought by multiple VCs should ask: • Who will serve on board and what is that person’s position in the firm? • How many other boards does the VC serve on? • Has the VC ever written and funded his or her own business plan successfully? • What, if any, is the VC’s direct operating or technical experience in this industry? • What is the firm’s reputation with entrepreneurs who have been fired or involved in unsuccessful ventures? Zider, 1998

20. Considerations for entrepreneurs • Understand what VCs want and reduce the uncertainty in their decision making • Understand how VCs will structure capitalization – you want 20% of a $500M company, not 100% of a $100,000 one • Innovate and sell into a new, high-growth market

21. How venture capitalists evaluate potential venture opportunities New Venture Development

22. Key questions • How do you evaluate potential venture opportunities? • How do you evaluate the venture’s prospective business model? • What due diligence do you conduct? • What is the process through which funding decisions are made? • What financial analyses do you perform? • What role does risk play in your evaluation?How do you think about potential exit routes?

23. Evaluating potential venture opportunities • Large market opportunity in fast-growing sector • Explosive growth – difficult for others to catch up and for incumbents to respond • $100 to $300 M revenue stream within five years • Market potential needs to be > $500M to get 25% market share

24. Evaluating potential venture opportunities • Competitive advantage – as unfair as possible • Network effect like eBay or operating system lock-in like Microsoft • Usually based on difficult engineering problem that takes years to solve • Patents OK, but competitors work around them

25. Evaluating potential venture opportunities • Team • Strong technical founder for technical problem + a sales-oriented entrepreneur • Founder understands thrusts of technology and industry dynamics around it • Entrepreneur drives other parts of the business and sells the vision to investors • Vision, execution, sales, and entrepreneurship

26. Evaluating potential venture opportunities • Other factors • How much pain does the customer feel, and how much will he pay to solve it? • Market opportunities (2 types) • Replacement for existing product: better, faster, cheaper • New-to-the-world product with less market certainty and greater risk

27. Evaluating the business model • Two kinds of investments opportunities • First is a company capable of executing better or offering a better version of an existing product or service – market is proven • Second, completely new markets or business models where they think they understand their bets: e.g., Friendster or Webvan

28. Due diligence • VCs hire professors and technical experts to meticulously study a new technology. Too hard to be done? Or are they asking the right questions? • Determine customers’ real needs and their willingness to pay • Industry experts about the idea, team , market, and market need • Entrepreneur and team – call references and blind references • Some firms require 2 general partner sponsors and a devil’s advocate to raise objective questions

29. Financial analysis? • Revenue and expense models • VCs look at expense model first to determine break-even point [FC/(VR-VC)] • Create their own revenues models – not top-down, but bottoms-up, which becomes a fraction of the top-down estimate in the business plan

30. Role of risk • Consider technical, competitive, and market risks before investing in a company • Track milestones around product, first beta customers, first revenue customers

31. Potential exit routes • Market cap > $200 M, • + Revenues > $60 - $80 M • = large enough market for an exit • Plus consideration of likely acquirers • IPO always most profitable exit

32. The four pillars of organic growth Summary of Joel Spolsky (CEO of Fog Creek Software) article in Inc. Magazine http://www.inc.com/magazine/20080101/how-hard-could-it-be-the-four-pillars-of-organic-growth.html

33. The four pillars • Revenue • Head count (i.e., employees) • PR (i.e., advertising and market growth) • Quality Each of these pillars must grow in tandem with the other

34. Revenue • Scenario 1: Revenues grow faster than the rate at which you can hire. • The result: poor customer service. • Staff members will probably become overworked and demoralized. They will take days to get back to prospective customers, by which time those prospective customers will have gone to one of your competitors. 

35. Employees • Scenario 2: Hire employees faster than you can reasonably expect the quality of your product to improve • The result: New hires don't have a chance to learn the company culture and the founder's values from experienced hands – the quality of work they do and the quality of service they provide are inferior • The fastest you should hire employees is the rate at which they can learn to do their jobs

36. Advertising / market awareness • Scenario 3: PR grows faster than the quality of your product • If you haven't worked out the kinks, a lot of people who are interested in your business become tire kickers rather than paying customers • Many of these customers will be permanently convinced that your product is simple and inadequate, even if you improve it drastically later on

37. Quality • Scenario 4: You have a lot of money to promote your products and hire employees • It is hard to improve product quality at the same pace, because that takes time – especially with high-tech products. • It takes time for any new employee time to learn the business and how to play his or her role correctly. • It takes years for a business to create sustainable and predictable market demand (e.g., repeat customers) so $ and people do not translate into a sustainable market

38. Take-aways • A company that lands a big investment too early is often worse off, not better – it often finds itself in a situation where it is much harder to make that investment pay off • Saying “no” to opportunities that promise your company a great leap forward is contradictory to what we’ve been taught – but if the result is that your business is easier to manage and more likely to please its customers, how can you afford not to?

39. Four pillars in action Quality Employees Revenues Advertising / market awareness

40. Business Models Using the “business model canvas”

41. The business model canvas

42. 1 Customer Segments The Customer Segments Building Block defines the different groups of people or organizations an enterprise aims to reach and serve

43. Customer Segments Customer groups represent separate segments if: • Their needs require and justify a distinct offer • They are reached through different distribution channels • They require different types of relationships • They have substantially different profitabilities • They are willing to pay for different aspects of the offer

44. Examples of Customer Segments • Mass market • Niche market • Segmented • Diversified • Multi-sided platforms (or multi-sided markets)

45. 2 Value Propositions The Value Propositions Building Block describes the bundle of products and services that create value for a specific Customer Segment The Value Proposition is the reason why customers turn to one company over another.

46. Examples of Value Propositions • Newness • Performance • Customization • “Getting the job done” • Design • Brand/status • Price

47. 3 Channels The Channels Building Block describes how a company communicates with and reaches its Customer Segments to deliver a Value Proposition

48. Channels • Communication, distribution, and sales Channels comprise a company's interface with customers. • Channels are customer touch points that play an important role in the customer experience.

49. Channels • Channels serve several functions, including: • Raising awareness among customers about a company’s products and services • Helping customers evaluate a company’s value Proposition • Allowing customers to purchase specific products and services • Delivering a Value Proposition to customers • Providing post-purchase customer support

50. Channels – Key Questions • Through which Channels do our Customer want to be reached? • How are we reaching them now? • How are our Channels integrated? • Which ones work best? • Which ones are most cost-efficient? • How are we integrating them with customer routines?