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Chapter 11

ENTREPRENEURIAL FINANCE. Professional Venture Capital. Chapter 11. Historical Development of Professional Venture Capital. Venture Capitalists (VCs): individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing ventures

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Chapter 11

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  1. ENTREPRENEURIAL FINANCE Professional Venture Capital Chapter 11

  2. Historical Development of Professional Venture Capital • Venture Capitalists (VCs): individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing 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)

  3. 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 of 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)

  4. 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 tax and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital

  5. 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%

  6. 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

  7. Dot.Com Bust and Recent History

  8. Professional Venture Capital Investing Cycle

  9. Useful Terms • 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

  10. Soliciting Investments: Suppliers of Venture Capital – 25-Year Average

  11. Obtaining Commitments:Arrangements with Fund Investors • Capital Call: when the venture fund calls upon the investors to deliver their investment funds • Common to require subsequent investments consistent with the levels of investors’ initial contributions

  12. Due Diligence and Active Investing:VC Fund Management • 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

  13. VC Screening Criteria • 1. The Industry • 2. Stage of the Business • 3. Size of the Investment • 4. Geographic Area

  14. Screening Outcomes • 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

  15. Structuring a VC Investment • Term Sheet: summary of the investment terms and conditions accompanying an investment • 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

  16. Structuring (cont’d) 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

  17. Structuring (cont’d) Typical Issues Addressed in a Term Sheet • Employment contracts • Incentive options • Founder employment conditions: compensation, benefits, duties, firing conditions, repurchase of stock at termination, term of agreement, post-employment activities and competition • Founder stock vesting • Confidentiality agreements and protection for intellectual property

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