Early Stage Venture Capital Due Diligence and Valuations

1. Early Stage Venture CapitalDue Diligence and Valuations David M. Lee 2/12/2003

2. Agenda • Due Diligence • Inside a Venture Fund • Valuations

3. Dual Mission • DELETED

4. Investment Criteria • Key Criteria: • Fits within market focus and portfolio • Significant market size • Headquarters in Texas • National or international in scope • Manageable competition • Fundamental sustainable differentiator • Top-tier management team • Good chemistry • Priority: • Insiders are willing to participate • Includes a syndication with value-added outside investors

5. Investment Process

6. Process Documentation • Investment Overview • 1-2 page document that provides a high-level summary • Enables the General Partner to relay first opinions back to sponsor • Investment Due Diligence Document • 10-15 page document that answers questions in depth about the deal • Detailed summary about multiple aspects of the business and management team including risks and issues • Investment Decision Document • 2-3 page document that contains a summary of the due diligence • Leads to the recommendation by the sponsor and records the final vote on whether or not to invest

7. Portfolio Management • Increase funding potential • Assist in refining business plans and financial projections • Recruit management team and board members • Facilitate follow-on funding • Provide introductions to other VCs, funds, banks, and angels • Aid development of investor pitch and offering materials • Validate market and technical strategies • New product, business feasibility, and market research studies • Strategic market planning, periodic technical/marketing reviews • Provide access to service provider network • Referrals to legal, accounting, PR, and marketing firms • Contacts for executive consultants, industry experts, and analysts

8. Time Management • GP has 3 full-time and 2 part-time partners • Limit of 6 portfolio companies per full-time partner • Total money placed per full-time partner is < $25,000,000 • Each full-time partner reviews 400 deals w/in commitment period • Target fund size of up to $90,000,000

9. Portfolio Allocation • Target is 18 to 23 portfolio companies • $1.5 million average initial investment • Active management of 70% of the portfolio companies • Lead investor for 40% of the investments • Over 50% of the fund reserved for follow-on investments • Establish up front funding milestones/trigger based budgets

10. Investment Returns • DELETED

11. Fund Management • Fund managers bring over 100 years of operating experience: • 3 Full-time Partners - Managing Partner and 2 General Partners • 2 Part-time Partners - Venture Partner and Fund Administrator • Each principal was strategically selected: • Supporting Staff • Venture Consultants, Contractors, Associates, and Interns

12. Fundamentals • Block-n-Tackle Business Planning • Revenue Growth, Expense Controls, and Profit Focus • Solution for a significant pain that a large group of people with money are willing to pay for • Experienced management team that knows how to make payroll • Sustainable differentiation with an emphasis on unique best-of-breed IP • Venture acceleration, not venture support

13. Current Focus • High Technology (3-4 Month ROI): • Enterprise Software • Telecommunications Utilization Software • Semiconductors and MEMs/Nanotechnology • Bioinformatics and Life Sciences/IT convergence • Life Sciences: • Diagnostic Tests • Pharmaceuticals • Genomics/Proteomics • Medical Devices

14. Valuation’s Role in Financing • Sets economic interests going forward. • Establishes an intrinsic value for the company • Valuation is not transaction independent • One of many terms under negotiation …

15. From the Term Sheet • Terms • Capitalization • Type of Security/Securities • Characteristics of the Security/Securities • Anti-dilution • Liquidation preference • Representations and Warranties of the Company • Other Conditions to the Deal • Governance Requirements • Reporting Requirements • Expenses • Non-solicitation • Changes to Management • Key-man Insurance

16. The Technologist The Technology Personnel (Technical) The Market Personnel (Business) The VC Personnel (Business) Personnel (Technical) The Market The Technology – Must have IP! Initial Valuation Views

17. Methods of Valuation • Methods: • Discounted Cash Flows (DCF) • Comparables • Target Ownership • Reality for Early Stage Companies • Use the first two to justify the third

18. Pros and Cons of DCF • Pros • Highly quantitative • Provides specific, objective (?) numbers as a basis for negotiation • Speaks to “Intrinsic Value” of company • Cons • Too many variables • Depends upon accurate forecasting • Difficult to discount for risk and lack of liquidity

19. Comparables • Most closely resembles Real Estate valuations • Look at prices of similar deals • Stage of business • Location of business • Industry • Adjust up or down for specific circumstances

20. Comparables Adjustments • Current capitalization • Cap table • Past investment rounds • Product development • In Beta • General Availability • Management • Good or bad management • Business Development • Sales booked • Quality of sales pipeline • Profitability

21. Pros and Cons of Comparables • Pros • No need to adjust for risk or liquidity • A common method that is fairly well understood within early stage companies • Fast • Cons • Highly subjective • Imperfect distribution of information

22. Reality of Valuation • First Round company • Some seed money in (Friends and family – 20%) • Networking Software space • Excites one of the Partners • Product in Beta • Missing management team members • No option pool • Based in New Mexico • $3M raise • Syndicate has target ownership of 33%

23. Reality of Valuation • In year of comparison – Average Post-money valuations: • Communications SW, Series A: $7.78M • SW & Rocky Mtn., Series A: $8.66M • Average post-money valuation of $8.25M • Pre-money valuation of $5.25M • $3M raise • Resulting Ownership • 36% - New Investor ownership (Series A Preferred) • 20% - Option pool forced before round • 11% - Friends and Family Ownership • 33% - Founder Ownership

24. Further Justification • Adjustments to the valuation • Large Stock Option plan needs to be created • Management team is incomplete • Hot space • Don’t forget the Run with the Pack mentality • We’ll be the lead investor • > 1 additional financing round expected • New investors will also be diluted • Product in Beta • Technology risk still exists • Not proven in the field (lack of customers) • Claim to go from $0 to $250M in 4 years • Several companies will put this in the plan, but very few can defend it

25. Q&A