Topic 2: Venture Capital Fundraising Investment Strategy and Deal Sourcing

Learning objectives
• 2.1 To develop an understanding of Venture Capital finance from the viewpoint of the investors
– how investment opportunities are sourced, financed and serviced.
• 2.2 To advance your understanding of fundamental concepts of Venture Capital funds and
working knowledge of portfolio management.
• 2.3 To explain how Venture Capitalists formulate investment strategies that will optimize the
investor’s expected investment outcome.
Structure of the presentation

• How does it work?

• Fundraising
• Pipeline
• Due diligence (DD)
• Valuation
• Partnership
• Negotiation
• Deal structure
• Post investment support
• Exit
• Fundraising

How can I join GP without track record?

Personal contacts, knowledge (GP are not specialised in Business studies, so they offered partnership to
young people who know the specific sector of interest. Otherwise, you have studies and have knowledge
of the investment field so you’ve studied methodologies of investment).
GPs → LPs and ask for $100 mln
Pension fund 1 gives me $10 mln → 10%
Investment companies gives me $20 mln → 20%
… until I reach $100 mln
Fund commitment: i.e. Pension fund doesn’t give literally the money, they committee money.
Assume you have commitment of $100 mln from LPs and you start search for companies.
Assume you choose Google and it needs 10 million. You’ll ask to Pension fund 1 the proportion, so 10%
of $10 mln and not the all $10 mln. You will ask a proportion to all LPs.
Rule: every time we go to LPs we ask the proportion of money they committed.
Let’s say we sell google. When you invest all the money and you sell all the companies, assume to
duplicate at $200 mln. The investment is splatted between LPs and GPs. The earn of GPs is called current
interest.
Raising a VC fund
• Professional Venture Capital Firms raise money from Insurance Companies, Educational
Endowments, Pension Funds and Wealthy Individuals.
• These organizations have an investment portfolio which they allocate to various asset classes
such as stocks (equities), bonds, real estate etc.
• One of the assets classes is called “Alternative Investments”- venture capital is such an
investment. Perhaps 5% to 10% of the portfolio might be allocated to Alternative Investments.
Raising a VC fund
• The portfolio owners seek to obtain high returns from these more risky Alternative Investments.
• A GP must have at least 2 partners
Because decisions need more than 1 person.
• Partners should:
• have excellent track record
• very good network
• put a very small proportion of their own money i.e. 1%
to show commitment, to show they believe in the investment
• In some countries GPs raise publicly backed funds (fondi pubblici) which do not necessary
require the above criteria
Raising a VC fund
• Capital Commitments
• The Limited Partners do not actually invest money in the Fund at the closing. They
legally commit to provide a certain amount of capital when they are called upon. This is
called a Limited Partner’s Capital Commitment.
• Capital Calls
 • When the General Partners find what they think is a good investment opportunity they
make a “Capital Call” on the Limited Partners.
• Example: a Fund has $500M of capital and the GP/VCs want to make an investment of
$10M. A Limited Partner with a Capital Commitment of $50M will be required to send
$1M to the General Partners: 50M/500M = 10% times 10M = $1M
Let’s assume we ask to LPs money and they will accept.
Commitment means that they promise, so they do not literally give money.
LPs will refuse to invest in weapons, gambling, ecc.
Economics of VC Firm
• Management Fees (typically 2-2.5% of AUM)
Charge a management fee to cover the costs of managing the committed capital.
• Carried Interest (typically 20-25%)
"Carried interest" is the term used to denote the profit split of proceeds to the general partner.
in order to receive carried interest, the manager must first return all capital contributed by the
investors, and, in certain cases, a previously agreed-upon rate of return (the "hurdle rate" or "preferred
return")
100 $ raised from LPs. GPs made 200$ from investments. 100$ are back to LPs. The remaining $100 are
split: at first current interest 20-25$ to GPs and then to companies.
Is it possible to contract and increase the current interest? Yes, it depends on your ability as GPs.
• Example $100m fund
4x return and 2% management fee and 20% carried interest
$2m per year in management fee (($100m x 4) - $100m) * 20% = $60m in carried interest
How GPs make money? Current interest. Since we do not pay dividend (we divide the earn) to invest and
expand money, …
Who pay for lawyers, peoples needed in the contract? The start-up. The contract establishes that deals
are paid by the start-up.
Raising a VC fund
• Splitting the Returns
• The returns from the investment are split between the Limited Partners and the General
Partners. A typical arrangement is as follows:
• The Limited Partners receive 99% of all the returns and the GP/VCs receive 1% of
all returns until the Limited Partners receive back 100% of their Capital (plus in
some cases “interest” on that Capital).
• Thereafter the splits go 80% to the Limited Partners and 20% to the GP/VCs. This
20% part is called the GP’s “Carried Interest”
 • Venture Capitalists with a great track record will receive a higher Carried Interest- e.g.
30%

Raising a VC fund: example

• Assume the Fund has invested $400M in 20 companies ($20M per company on average).
• Assume that each of the Fund’s investment provides it with a 50% ownership interest in
a portfolio company.
• Assume that 25% of the companies are successful and the Fund can harvest (raccogliere)
those investments
• Assume the average “win” returns to the Fund 5 times the amount invested. In our
example, the $20M becomes $100M.
• Note: If the Fund owns 50% of a company then the value of the company at
harvest has to be $200M in order for the Fund to receive 5 times its investment
(5x)
• What if the return was $380m or $340m?
Only 5 of 20 generated money. How can we split this money?

Do you think 23 $ is fair? Yes, because GPs work. However LP could argue that it isn’t like that because
GP doesn’t take risk. But GP risks his reputation.
GP lost a lot of money.
Liquidation preference: LP takes money first.

GP will only make money if companies are sell for million: it is important to find the next Google!
Structuring a VC fund
• General Partners few
• 6-8 active deals at a time
• Principals/Associate
• Drive deal flow, deal process, and portfolio company development
they have to go out and find these companies
• Finance, Marketing, and HR Staff
Assume you work for GP. As a graduate you will join as analyst. Your boss will be the director, or anyway
? from GP. You must find good companies. Where? Incubators, universities, competitions, etc. Assume
you find a company. Firstly, You will ask funding proposal and you like it. You talk to your boss then: you
go to GP and talk about it. You set a meeting between GP and the company that should present the idea
(pitch). Know them personally (feel free to ask for a drink). GP presents the idea to all the partners and
all of them have to like the idea to accept it. The decision should be unanimous of all GPs because it is
about their reputation.

• Decision Making
• Typically unanimous
GPs need to all agree to decisions
• Individual partners champion deals to group

• Deal team diligences prospect and builds investment case

• Partnership acts as a check and balance to ensure careful decision making
The negotiation could be about:
- equity
i.e. $ 1000 000 correspond to 10% : evaluation of company $10 million
$ 1000 000 correspond to 40% → evaluation of company $ 2.5 m
How GPs split the return from the exit of the start-up?
The investment goes back to GPs.
2 liquidations preference: one from Start-up to GPs and one from GPs to LPs.

Identifying the fund’s strategy

• Stage
Clearly identify the stages of investments. Pre-seed, seed, etc. W should invest in the earlier
stager
• Industry sector
 • Geography i.e. Europe, US, etc.
• Specialized by sector: ex. only in pharmaceutical.
• Generalist invests in every sector
Which is better? Specialised (required fully knowledge of sector) or generalist (can be in
different)?
• Lead has the power/passive the others
What is the risk if you raise much money than required? You could not be able to invest it. And if you
will not good to invest, it will damage your reputation.
Buy outs? buy the majority of the company.
Running a VC fund your job if you are a GP
1. Assess applications
2. Meets the entrepreneur
3. Internal peer review meeting
4. Agree to conduct DD
5. Valuation of the company how to decide the company is good?
The idea is right
you like the management team (you have to work together)
business model
the market (the company is profitable) i.e machine learning market is booming but it’s not new,
it’s at right time
track record of entrepreneur important because VC need to know the person in which is
investing. What of investing in someone that failed in the past? Have failed a start-up is good or
not? You have learned how to mange money from the past. In US mentality is accepted. In
Europe the mentality is different.
6. Searchers for co-investors
Let’s say you are a GP and you would like to find a co-investor. You should approach a GP of the
same sector, but above all someone who has very good track record.
The best GP will always take the best opportunities in the market. Therefore could not due to his
effort, but because approach the best start-up. → past performance must be considerated
7. Identify lead investor
8. Starts negotiations
9. Structures the deal
10. Agrees to fund the company
11. Shareholder agreement (preferred shares that have liquidation preference (they take the money
first), board, clauses)
12. Aims to liquidate the shareholding after 4-8 years or with follow up funding much earlier
13. Provide hands on support and assistance ‘smart money’
Re-investment of proceeds
• The partnership may also be allowed to reinvest part of the proceeds of realisation of
investments in specified circumstances and amounts. For example, the partnership might be
able to reinvest the proceeds of realisation of an investment where an exit is achieved shortly
after making the investment, or the partnership might be entitled to reinvest proceeds up to an
agreed percentage of the total funds raised, or might be entitled to reinvest up to an amount
equal to management fees and expenses so that the partnership ends up investing the full
commitment (rather than the full commitment less management fees and expenses).
You need to invest 100M and could invest 90M because you have to pay 10M to management. If
you have an imminent exit, you can invest it to reach the amount needed.
Bridge financing
• The partnership may also be free to reinvest amounts drawn down from partners to provide
bridge financing. Bridge financing occurs, for example, where the manager does not have time
to syndicate or put together a leveraged finance package before completing an investment. The
partnership will provide “bridge finance” to complete the deal and be repaid this amount when
a permanent finance structure is put in place

Setting up a new fund

• In order to prevent the manager setting up a new fund while money in the existing fund
remains uninvested, a restriction may be placed on the manager’s ability to set up a new fund
until an agreed percentage of the existing fund’s money has been spent. In order to give
continuity between funds, some leeway is necessary so that the existing fund does not have to
spend all its money before the manager can start the sometimes lengthy process of raising a
new fund. Overlap arrangements might also be included, for example, to govern the proportions
in which an existing and a new fund may participate in an investment opportunity which arises
while both funds are in existence.
Can I raise the identical fund? There are restrictions
Transaction costs
• The LPA will deal with costs incurred by the manager in connection with proposed investments,
such as legal and accounting advisers’ fees. Usually, the costs of a successfully completed
investment will be borne by the target company. The start-up pays for deals. Where costs are
incurred in trying to make an investment which is not successfully completed, the manager will,
where possible, generally seek to charge such costs to the target company by agreeing a break-
up fee for the transaction. Where costs are not met by the target company, they will either be
borne by the manager or by the partnership or split between them.

Identifying the right companies

• Team
• Domain expertise with core technical strength and knowledge of given market
opportunity
 • History of collaboration and success
• A willingness to allow VC’s to help build the team
• Market
• Emerging and fast growing market
• Bad markets make for bad companies
• Business model
• How will you make money, how will you sell
• Technology
• Defensible technology/IP that can be protected to form competitive barriers over
time
• Funds investment strategy maybe is not in the area/sector of your investment strategies
i.e. Assume the governemnt invest as GP
$100 Barcelona
$ 100 Extramedura
geographical restriction: they can invest only in their area
Barcelona will have advantage from institution, connection etc.
Extramedura will not have companies in which invest. They will put down their investment
Identifying the right companies
• Questions to ask:
- Is the company able to conduct profitable and growing business operations?
- Do the company executives have the necessary qualities to manage the business in the various
development stages?
- Will the investor be able to obtain the desired return through an increase in the company's net worth?

GPs need to be physically near the start up, because face to face meetings are needed. If I want to invest
in a foreign country I need someone who knows very better the market. Therefore I can do a partnership
with local VCs.
Calculating the company’s value
• Pre-money valuation V: agreed value of company prior to this round’s investment (I)
• Post-money valuation V’ = V + I
• VC equity in company: I/V’ = I/(V+I), not I/V
Example: $5M invested on $10M pre-money gives VC 1/3 of the shares,
V’ = V + I  $15M=$10M+$5M
I/V’=I/(V+I)  $5M/$15M=$5/($10M+$5M)

 I and V are items of negotiation

• Generally company wants large V, VC small V, but there are many subtleties…
• This round’s V will have an impact on future rounds
• Possible elements of valuation:
• Multiple of revenue or earnings
• Projected percentage of market share
Structuring the deal
• Investment for a portion of the company
• Liquidation preference
• Interest rate
• Management stock option pool
Dealing with the company
 • Corporate boards:
– Not involved in day-to-day operations
– Hold extreme control in major corporate events (sale, mergers, acquisitions, IPOs, bankruptcy)
• Lead VC in each round takes seat(s)
• Reserved matters (veto or approval):
– Any sale, acquisition, merger, liquidation
– Budget approval
– Executive removal/appointment
– Strategic or business plan changes
• During difficult times, companies are often controlled by their VCs

Methods of evaluation
• Cost
• Earnings
• Net asset value
• Market value
• Comparables
• Estimated terminal value (price-earning ratio applied to the projected net income)
(BVCA Guidelines)
Structuring the deal
• Investment for a portion of the company
• Liquidation preference
• Interest rate
• Management stock option pool
Supporting the company
• Through the VC’s expertise and network the portfolio companies could gain access to:
• follow-on capital through venture capital ties
• knowledge of partnership opportunities in multiple markets
• in-depth operational and management experience’
 • access to high-quality management teams
• ties to the investment banking community

Dealing with the company

• Corporate boards:
– Not involved in day-to-day operations
– Hold extreme control in major corporate events (sale, mergers, acquisitions, IPOs, bankruptcy)
• Lead VC in each round takes seat(s)
• Reserved matters (veto or approval):
– Any sale, acquisition, merger, liquidation
– Budget approval
– Executive removal/appointment
– Strategic or business plan changes
• During difficult times, companies are often controlled by their VCs

Supporting the company

• Through the VC’s expertise and network the portfolio companies could gain access to:
follow-on capital through venture capital ties
knowledge of partnership opportunities in multiple markets
in-depth operational and management experience’
access to high-quality management teams
ties to the investment banking community
Relation GP and company

Point 2
300 000 → 40%
750 000 → 100% Post- money evaluation value of the company after the investment
Primary evaluation: value before the investment
Point 3
What is the value of John’s share? 243.75 → dilution
Somebody wants to buy the company for 2 million → Point 4 (positive exit)
We sell the company. How do we split money? Liquidation preference: they take back the original
investment ($300 000) and then they will divide according to percentage.
To GP $300 000 + 40% * 1.7 mln = $ 980 000
GP has liquidation preference because he needs to give back to LPs.

And if there is a negative exit ($ 500k)

FAremo esercizi su questo la prossima volta

Targeting the most promising funds

• More experienced managers perform better
• No. of previous funds raised is significantly associated with performance
• Past success predicts future success
• Investing in earlier rounds is a good thing
• Investing in ICT generated the highest historical returns
• Funds £50M - £250M performed better (neither too small or too big)
Investment strategy
 • The investment strategy of each fund will provide significant signals whether a company is a
good fit for this particular fund. For example, if a company is at the very early stage of
development and operates in the ICT sector then it should approach funds that their investment
strategy is to invest in such companies (and not lets say in Biotech companies).
• Key characteristics of the fund investment strategy may include, stage and industry focus,
amounts invested, some funds often want to be the first institutional investor, co-investors
strategy etc. etc. Venture capital funds can target a specific industry or segment of the market.
They may also have a specific amount of money to invest per deal.
• Venture capital funds look for investment opportunities in sectors that fit their expertise and
their investments strategy which has been already agreed with their LPs, in the LPAs as we saw
in the previous topic. This is to ensure that the LPAs have some reassurance that the fund will
follow a certain strategy that LPs believed that it would be profitable
• The strategy of the fund also depends on the nature of their LPs. For example, Corporate
Venture Capital funds are more likely to invest in companies that ultimately will add value to the
main corporation. In contrast, publicly backed venture capital funds, may have much broader
objectives and invest in companies with a social goal.
Deal sourcing
• Once a VC fund has decided its general investment strategy it has to identify and evaluate
investment opportunities. There are two ways of identifying deals:
• attracting them and
• finding them
Good GPs attract good companies because they have good records, but some start-up don’t even know
which GP is good or don’t know how to approach them.
• A reputable and well established fund is likely to attract not only ambitious entrepreneurs that
seek finance, but also other venture capital funds that are looking for co-investors.
• For example, top performing venture capital firms such as Sequoia, Accel, Kleiner
Perkings in the US and Index, Amadeus and Eden in the UK, attract top entrepreneurs.
Banks cannot invest, so they
• When the entrepreneur comes directly to the GP the deal is called a ‘proprietary deal’.

• However, venture capitalists also do proactive deal sourcing. This requires that the GPs develop
an in-depth knowledge of their sector of interest and are very well connected with the industry.
A widely used approach in finding deals is through intermediaries such as friends, banks,
consultancies, lawyers etc.
• Most venture capital funds also offer an on line application form. Entrepreneurs can fill this
form and wait to hear from the venture capitalists. It is however a common knowledge among
the industry practitioners that on line application forms are not the most effective way of
 approaching a fund. In most cases, an introduction or a face to face meeting may be more
effective.

• Case study: Adara Ventures (see intranet for details)

We always issue new shares

• Exercise on dilution (see intranet for details)