6. Funding KTT
6.3 Private investors: Business Angels and Venture Capitalists
6.3 Private investors: Business Angels and Venture Capitalists
6.3.4 The structure of a VC Fund
As a rule, VC functions as follows:
• A number of experienced investment professionals, called the General Partners (GPs) start up a Venture Capital Firm (VC Firm).
• These GPs contact organizations and individuals with substantial financial reserves, such as pension funds, insurance companies, banks, family funds, as well as public authorities. The GP’s propose these organizations and individuals to invest an amount of money in a common VC Fund.
• These parties invest a limited percentage of their reserves in these funds as part of their wider investment diversification strategy. Public authorities’ involvement is driven by policy reasons. These organizations and individuals are called Limited Partners (LP):
their commitment is limited to the funds they have provided.
• The GPs manage the VC Fund. They invest in a limited number of carefully selected companies, in exchange for shares of these companies. The VC Fund has a seat on the Boards of Directors of these companies.
Often more than one round of capital injection is needed to bring the company to full fruition; VC Funds are prepared and equipped to participate in a number of investment rounds.
Within its lifespan the VC Fund needs to exit from all its investment, by reselling the shares it has received.
At the end of its lifetime the VC fund is dissolved, and a substantial percentage of the generated profits -if any- is returned to the Limited Partners.
The VC Funds as described above are closed-end: they have a limited life-span, between 12 to 15 years. Other, so-called evergreen VC Funds have an unlimited life span.
Business Angels act on a smaller scale and only invest their own capital, therefore the legal structure is simpler.
6.3.5 The financial logic of VCs
quality of investment
bad alive ok good super total
# projects 2 4 2 1 1 10
amount invested in €
200 400 200 100 100 1000
Multiple after 5 years
0 x1 x5 x10 x20 (x4,4)
Cash from trade sale in €
0 400 1000 1000 2000 4400
Revenue in € -200 0 800 900 1900 3400
Figure 5 Prof. Rudy Aernoudt, guest lecture 2007
The financial logic of a professional VC or BA can best be explained using the table above.
• A VC Fund has 1.000 to invest. It spreads the investments over 10 high potential projects. In each it invests 100, with the objective of reselling the shares in a 5- tot 10-year timeframe.
• Over time some projects succeed, others fail. In this -representative- case:
• 2 projects fail completely; the VC Fund loses all the invested money
• 4 projects barely survive and generate enough to recoup the original investment
• 2 projects are relatively successful and generate 5 times the invested amount
• 1 project is good and generated 10 times the invested amount;
• 1 project is a real success, it generates 20 times the invested amount. This project generates more revenues than all the other combined and covers all the losses incurred on the failed projects.
• As a result, the VC Fund generates a multiple of 4,4: 1.000 has become 4.400. Over a 13-year timespan this results in an Internal Rate of Return (IRR) of 12%.
The example shows the importance of the growth potential of projects in which VC Funds invest: one successful project makes up for several unsuccessful projects. A VC Fund will therefore only invest in projects with a high potential. Nevertheless, still only +/- 2 in 10 will be real successes.
This limits the application area of VC: the overwhelming proportion of starters do not comply to the requirement of high growth potential. In the world of academic entrepreneurship growth-oriented start-ups occur more frequently.
BAs generally invest in earlier stages of the project. They invest smaller amounts and in fewer deals; sometimes they get personally involved in the project.
6.3.6 Dilution, pre and post money valuation
An implication of attracting VC is dilution of the shareholder position of the founder. As the VC Fund receives newly issued shares for the funds it invests in the company, the existing shareholders hold a smaller percentage of outstanding shares after the transaction.
For example
• An entrepreneur starts a company with € 100.000 in capital; he receives 100.000 shares
= 100% of the shares
• After a while, a VC Fund invests €3.000.000 in the company, in exchange of 100.000 new shares.
• After the transaction the entrepreneur still owns 100.000 shares, but now this represents only 50% of all outstanding shares.
• As the VC Fund paid €3 million for 50% of the shares, the company -100% of the shares- is now worth 6 million. The valuation after the transaction is called the ‘post-money valuation’; when subtracting the additional investment, you get the pre-‘post-money valuation. In this example: Post-money valuation €6 million, therefore pre-money valuation = €6 million - €3 million = €3 million. As a result, the initial investment by the entrepreneur of €100.000 is now worth €3 million.
• But on the other hand, the entrepreneur cannot decide the course of the company by himself any more. The VC Fund will have negotiated seats on the Board of Directors of the company and will probably have received veto rights for key decisions. We will see later on that the impact of dilution can be mitigated or increased by clauses added to the shareholder agreement.
How VC’s screen and evaluate projects
Professional VC Funds often receive hundreds of projects per year. They gradually select a limited number, which they screen thoroughly.
A large number of criteria is taken into account when deciding whether or not to invest, and at what conditions. These will always include the quality and maturity of the project and the underlying technology, the market the project serves, and the team that will make the project happen.
Other considerations are the quality of the business model, its scalability, project complexity, the Intellectual Property and Freedom to Operate status of the project, possible exit scenario’s, and the financial expectations of the founders and IP owners.
6.3.7 Negotiating with VC Funds
Investment negotiations with VC Funds can take several months. To succeed, a very different skillset from the average scientist is required. There are a number of potential pitfalls when negotiating with VC Fund.
Valuation
What is the project currently worth? If a VC Fund invests €1 million, and it receives 50%
of the shares for this investment, it implies that the project currently is worth as much: €1 million.
This is a complex and sensitive subject, as both parties have opposing interests.
Putting a value on a project in this stage of development is an act of faith. It is much easier to put a value on an established firm with existing revenue streams and known costs. A VC Fund will insist on the immateriality and immaturity of the academic contribution, compared to their hard cash.
A few approaches that can be used to estimate the current value of the project:
• look for examples of valuation of comparable projects in the past
• try to estimate future revenues streams and costs over a period of 5+ years.
• Study recent investment deals
• take into account sunk costs
There are ways to circumvent the discussion by adding clauses to the term sheet that allow to re-assess the valuation in case certain targets are not met.
Due diligence
VC Funds will perform an in-depth study of the company in all its facets, in order to avoid unpleasant surprises after signing the deal. They will have (confidential) access to all documents related to the company.
Term sheets
At the end of the negotiation all parties will have to agree on a Term Sheet. They will sign a document which contains the conditions under which the parties collaborate. It discusses the invested amounts, the percentage of shares the VC Fund receives, the rights that are attached to these shares (generally different classes of shares are created, each with their own voting and veto rights). The conditions under which these shares may/may not/must be resold are agreed upon.
Clauses that protect minority and majority shareholders can be added. This is a very complex endeavor; it is important that all the negotiating parties have sufficient expertise on board.
6.3.8 Funding Stages
VC Funds and BA’s do not invest all the needed funds in one go: very often this happens in many stages. The most noteworthy funding stages of start-ups (in preparation) are called as follows
Stage Amount raisedraised
Use of ProceedsProceeds Sources of capital Pre-seed € 50k - € 150k technical and/or commercial
Proof of Concept, business plan
angels, FFF, (semi-) public investors, university, crowd funding
Seed € 250k - € 1,5M Develop Minimal Viable Product, initial sales in first target market
angels, early stage VCs Series A € 1M - € 5M International expansion certain angels, VCs Series B € 5M - € 20M Further expansion (scale-up) VCs
Figure 6 Source: QBic, presentation Guy Huylebroeck, October 13 2016 Pre-seed funding
This is the very first, often informal, financing round of a company in preparation. Small amounts of money, often provided by the entrepreneur(s), (university) funding agencies or 3F’s (friends, family and fools) are used, to develop a Minimum Viable Product (MVP), validate a market through market research…
The main objective is to validate the project/product/team/market so that the company is (more) ready for a next investment round
Seed funding
Seed money/funding/capital is a capital investment in exchange for shares in a very young company. It supports the business until it can generate its own cash flow of or until it is ready for further investments. The funds can originate from 3Fs, business angels, crowdfunding and specialized VC Funds.
Series A, B, C, D… Rounds
The first round where VC Funds are fully involved is called Series A Round. The investors
called Series B, C, D… Generally, the invested amounts increase substantially, as the company gets traction in the market and opportunities for (international) expansion are exploited. VC Funds anticipate the fact that follow-up rounds are required and will budget accordingly.
Often this is the moment when BAs hit the limit of their investment abilities. Later on, when the start-up becomes a full scale-up, even the first generation of VCs reach their limits. Some large US VCs are can fund $100M+ investment rounds.
6.3.9 Exits
VC Funds are temporary investors. Within 12 tot 15 years the General Partners needs to return the funds to the Limited Partners; by then must have sold the shares they own. BAs too want a return on their own invested funds.
They can exit through mainly three mechanisms:
• either by selling the entirety of the company to another company, in a so-called Trade Sale. In that case the company loses its independence.
• or by bringing the company to the Stock Exchange in a so-called Initial Public Offer (IPO). In that case the company remains an independent entity. The VC can exit by selling its shares to the wider public.
• a third option is that another private investor buys over the shares of the initial investor in one of the investment rounds. This may happen when the life span of a VC Fund comes to the end, but no exit is planned in the short term. For Business Angels this form of exit is a realistic option.
Questions
What is according to you the current state of VC in your country?
Describe the projects in your university that could have benefitted from VC. Assess initial capital needs. Explain your reasoning.
To which institutions could you possibly turn for the capital required to start a VC Fund?
Develop the pitch towards them.