Introduction to Venture Capital Week 3 About Due Diligence, Valuation, Negotiation, and Mistakes you shouldn t make in the process School of Business and Economics TIME Research Area Innovation & Entrepreneurship Group (WIN)
If you make the cut, the VC will get in contact with you and enter a detailed analysis Nondisclosure agreement Letter of intent Term sheet (investment proposal) Contract 1 month 2 weeks - 2 months 1-3 months 1-3 months Contact phase Rough analysis phase Detailed analysis phase Negotiation phase Contacting a Venture Capitalist directly or via a mediator regarding an investment Contact is best made using a short paper describing the venture Venture Capitalist makes a preliminary decision on whether to follow up on the contact or not This week we will focus on: The Valuation, Due Diligence and Negotiation Up to 90% of investment proposals fail at this stage Business plan is checked in detail (due diligence) Several meetings between the Venture Capitalist and the entrepreneurs usually take place in this phase Final negotiations about all details of the contract Negotiations may take place over a period of several months Source: Boersch (1998), Icons by Freepik 2
In doing so, keep in mind more tips on potential mistakes throughout the process when talking to a VC: Patents make our product defensible We have a proven management team Oracle is too big/dumb/ slow to be a threat Hurry because several other VC firms are interested ç All we have to do is get 1% of the market Our projections are conservative (Big'name'research'firm)'says' our'market'will' be'50bn'in'2020 (Big name company) is going to sign our purchase order next week Key employees are set to join us as soon as we get fund No one can do what we are doing No one is doing what we are doing Source: Guy Kawasaki Blog 3
Introduction to Venture Capital Week 3 Due Diligence School of Business and Economics TIME Research Area Innovation & Entrepreneurship Group (WIN)
Entering the Due Diligence process is generally a good sign, as the VC is ready to dedicate a lot of work to you, however 2
the downside is that the VC might and will ask for every piece of information related to your business. TECHNICAL Working our the strength, weakness, opportunities, threat (SWOT) profile FINANCIAL Checking the assumptions for valuation and securing ç THE DUE DILIGENCE ECONOMIC Investigation and analysis business model and team LEGAL Importance for guarantee, product and competition claims TAX Prevention of tax liabilities ENVIRONMENTAL Stock market admission and sales brochure Source: Schanz (2000) 3
You should be ready to present all necessary documents during the DD process, especially: Contracts between you and your co-founders and previous investors Contracts between you and your customers and suppliers Financial statements, account receipts, insurance documents, etc. Technical documentations, environmental standards, etc. Remember: You should not try to hide anything sooner or later it will be discovered anyways and good VCs appreciate full disclosure early on! Source: Feld & Mendelson (2013), Icons by Freepik 4
Introduction to Venture Capital Week 3 Valuation School of Business and Economics TIME Research Area Innovation & Entrepreneurship Group (WIN)
Valuation: Art, Science, or in the case of Whatsapp Magic?? After all, it s about building an equity story (more on this in week 6) WhatsApp went from a USD 250k seed round in 2009 to an USD 8mn round at an approximately USD 80mn valuation in 2011 Final round was a USD 50mn round back in 2013, at a USD 1.5bn valuation USD 19bn valuation in 2014 (largest purchase of venturebacked company in history) Source: TechCrunch 2
How can you actually come up with the right valuation for your company? Fact is: There is no right valuation ART SCIENCE AGE OF THE COMPANY Stage of the company Competition with other funding sources Experience of Entrepreneurial Team ASPECTS THAT ARE CONSIDERED VC s natural entry point Numbers Current economic climate 3
There are some techniques close to Art Like the Berkus Method or the Rule of Thirds The Berkus Method Superangel Dave Berkus values the deal based on a simple formula:! Sound idea (USD 1mn) + prototype (USD 1mn) + mgmt. team (USD 1-2mn) + board quality (USD 1mn) + sales (USD 1mn) " Rule of thumb based on individual experience The Rule of Thirds Many Business Angel investors rely on this heuristic! The rationale behind the Rule of Thirds is: 1/3 of the investment goes to the founders, 1/3 to the capital provider and 1/3 to the management " Differentiation between founders and management! Simple and reflects a reasonable start-up valuation! Simple and quick! Definition of items slightly unclear and will lead to discussions with the entrepreneur! Differentiation between founders and management not always entirely clear Source:(Amis(et(al.((2002) Icons by Freepik 4
And there are more scientific models that actually require at least some basic math skills, like the DCF and Multiple Methods Discounted cash flow (DCF) Multiples EV FCF TV EV Target EBIT Target EV/ EBIT Cash flows are calculated over a detailed forecast period and discounted to the present day A terminal value is determined which is also discounted " More complex method " Detailed information necessary Relative market value measures are calculated for comparable companies Derived multiples are applied to the own company " Simplified approach " Most common technique " There is no single correct valuation method " Each approach has strengths and weaknesses " Generally, several valuation methods are used to determine a value range Icons by Freepik 5
However, also those have their limitations, especially in uncertain and closed-off startup environments Discounted cash flow (DCF) Theoretically the best valuation approach Dynamic approach based on future firm performance Scenario simulation possible Less dependent on stock market movements Valuation of synergies possible In-depth understanding of the firm and its value drivers Multiples Easy to communicate Based on public data Very important valuation technique for investors and analysts Transaction multiples: Purchase price often available even for transactions where the target is not listed Transaction multiples: Additional information on takeover premium Detailed planning necessary Results highly sensitive to assumptions Terminal value often represents significant portion of total value Sometimes disconnect between market expectations of value and DCF result Very complex compared to multiples Lack of comparable companies Static approach, no consideration of future development Trading multiples: Highly dependent on stock market movements Transaction multiples: Low level of transparency (e.g. purchase price) Icons(by Freepik 6
So if there s no correct valuation for your startup how will you ever come up with a valuation that makes sense? Or is it really about valuation in the first place? Build a relationship based on mutual trust Reach a level of understanding that ensures that each party will be adequately rewarded for future success ç HOW TO GET A FAIR DEAL Draft a contract that optimizes value not just valuation Take into account the venture capitalists value-add, such as mentoring, strategic advice, network resources and political capital and do not only focus on the money Source:(Harvard(Business(Review 7
Introduction to Venture Capital Week 3 Negotiation School of Business and Economics TIME Research Area Innovation & Entrepreneurship Group (WIN)
Coming up with a price for your startup is probably the most difficult task or is it? Icons by Freepik 2
When you negotiate a deal, best know who you re dealing with THE BULLY Yells and screams at you, tries to win by force. If you can, outbully the bully. Otherwise chill out and wait! THE NICE GUY Rather hard to pin down on anything and get a clear commitment. Be clear and direct, don t get worn down! THE WIMP Often let s you negotiate both sides of the deal. But: if the result seems too good to be true, the deal will haunt you with the wimp sitting on your board. THE CURMUDGEON Like a visit to the dentist. Every step is a pain. Never happy. Be patient, upbeat and tolerant (just like with your old, grumpy grandfather...) THE TECHNOCRAT Get s caught up in detail and has a hard time deciding. Don t lose focus, cover all your points together! The old cliché... There s a reason you re born with two ears and one mouth! Icons by Freepik 3
Introduction to Venture Capital Week 3 The 3P Framework of how to get Venture Capital School of Business and Economics TIME Research Area Innovation & Entrepreneurship Group (WIN)
The 3P Framework on how to get financed summarizes the last three weeks and can be used as a checklist tool! Papers People Process Icons by Freepik 2
Papers do your homework, understand the paperwork, and you will move through the process much faster Pitchdeck Papers Term Sheet Business Plan Contract Due Diligence Material People Process Icons by Freepik 3
Process check the most basic questions and then be ready to move through the 4 main steps, one by one Are YOU ready for VC? Is the VC ready to talk to you? Papers Contact Rough Analysis Detailed Analysis Negotiations People Process Icons by Freepik 4
People maybe most important: Who does what? Be clear about it and have one go-to-guy driving the process! Is YOUR CFO driving the process? Is YOUR CEO ready to present in front of the VC? Papers Who is on the other side? Can your contact person take a decsion? Do you want to talk to the Partner or Analyst? People Process Icons by Freepik 5
Remember the framework, check the 3P s lists and be ready to get financed! Next comes the Term Sheet! Papers People Process Icons by Freepik 6