EPSE Module 3—Session 2

Ken LiuMarch 19, 2012

Business PlanCompetition

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There is no such thing as no competition!

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Competition

Direct, indirect, substitute, complementary Customer DIY/NIH Fragmented vs. concentrated

◦ Top 3 >50% market share vs.◦ Hundreds w/no clear leader

Coopetition ◦ Google vs. everybody◦ HP vs. IBM◦ Apple vs. everybody

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Competition

Substitute Indirect Solar Wind Geothermal Hydro Oil Gas Coal Nuclear

Concerts Baseball game Eating out Piano lessons Vacation NetFlix Pets

5BTU

Discretionary/time & $$

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Complementary Products

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Direct Indirect Substitute Complement

Very few technologies are patentable or truly protectable◦ ICs◦ Life sciences◦ Materials

Software patents are rare with doubtful value Need to measure benefits vs. very high costs

of patent prosecution Best protection: high market share +

continuous innovation New test: Can China break it in a month?

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IP & Entry Barriers

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Avoid the Frontal AssaultGo around

Go elsewhere

Feed the beast

Change rules of fight

Technology Holographic discs (patented)

Advantage Higher resolution (600 dpi) & cheaper (10-30%) than conventional lens

Target Product 4-in-1 peripheral (printer, fax, copier, scanner)

Market SOHO + SME

Partner Targets HP, Canon, Xerox, Ricoh, Samsung, LG…

Status Out of $$Poor capital market (’87 crash)Unfinished prototypeTechnical issues

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Holographix Story—1986-90

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Holographix—What’s broken?

Technology overreach◦ Optical component >> systems integration

10 yrs. ahead of market◦ Market leaders controlled product cycle &

cannibalization

Direct competition with entrenched leaders

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Holographix Mistakes

Change plan to optical components licensing for printers

LG 1st licensee for laser printers In & out of Chp. 11 Got new VC funding Evolved to manufacturing optical discs for

various markets Sold to Avanex for $90M in 2000 to supply

their optical needs Bought back from Avanex in 2003

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Somewhat Happy Ending—2000

Business PlanBusiness Model

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How you make $$? How much? When? How to scale? How much $$ you need? How company structured? Who to hire? Valuation model & potential Risk & return

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What is Business Model?

“Let me get this straight on how this works: people pay you money at the beginning of the year, and at the end of the year you may or may not pay some of them back?”

Investment banker: Yes.

“That’s a good business.”--Warren Buffetton why he bought Geico

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Business Model—the Essence

$ to Market

Ramp S to Profit

Comments

Adverts <$250K

3 yrs $5M Crowded, $$ sliced thin among partners, eyeballs again?

Freemium <$250K

3 yrs $3M Who uses or cares?

Phone apps

<$50K 1 yr. $50K Great lifestyle biz. Need portfolio for company.

SaaS $3M >3 yrs. >$5M Valuable biz if done right. Salesforce.com

E-tail $1-3M 3 yrs. >$5M Valuable biz if done right. Commerce Platform

$5M 5 yrs. $10M Any appetite left by VCs?

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Internet Business Model

$ to Market

Ramp S to Profit

Comments

Open Source

$3M >3 yrs.

>$5M Similar to enterprise app model but different cost ratios & revenue sources.

Enterprise Apps

$3M 5 yrs >$10M Hard. Industry consolidation

License $2M 1 yr. $2M 99% are small deals. 1% is QCOM of the world.

Big bucks• therapeutics• energy• ASICs

>$20M >7 yrs.

>$50M Land of the disappearing brave.

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Enterprise Business Model

Founded in 1986 as spin-off from TRW Leader in bleeding-edge neural network

technology (son of AI) $6M sales, 60 people 4 BUs:

◦ R & D◦ Tools◦ OCR◦ Financial decisions

Almost breakeven, ready for hockey stick Just raised Series C in Dec. 1990

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HNC—Spring1991

Tools sales dead due to recession Big cost overrun on image processing chip

development project w/Japanese partner Bleeding $300,000/month Management salary cut by 20% Out of money by Spring 1992 State of BUs

◦ R & D—ongoing $2M projects ◦ Tools—$1M business basically dead◦ OCR--$1.5M business, profitable◦ Financial decisions—initial successes with Equifax, Amex

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HNC—Fall1991

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HNC—What to do?

One of largest software company in SD 1995--$44M sales. 2nd best IPO behind

Netscape. Multiple financial markets

◦ Credit card◦ Workers comp◦ Insurance claims◦ Retail

Bought by FICO in 2002 for ~$600M Spawned analytics cluster in SD

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HNC since 1991

Technology in search of a problem is tough Focus, focus, focus! Disaster or fortune can change drastically

very quickly Many successes have near-death moments

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HNC Lessons

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Business PlanFinancing

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Cash is King! Control Burn!

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By month for the first year By quarter for subsequent years Profit and Lost (P&L) statement Balance Sheet Cash Flow Burn rate Breakeven analysis Funding required & Use of funds

Financials—3 Years

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Total cumulative cash required before you generate cash sustainably◦ Operating losses◦ Working capital ◦ Inventory/Receivables◦ Capital cost

For 18 months if possible

Add 50%+ for contingencies

Funding Required

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Full-time job (3 months+) Lots of rejections Lots of frustrations

◦ How come they are not getting it?◦ “And they invested in that crap?”

Target, learn, adapt & repeat Persist All you need is 1! It’s not done until $$$ clears bank

Fundraising

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How much? Valuation/dilution T & Cs Value-add of investor Mindshare with

investor◦ Vision for business, value

& exit◦ Degree of involvement◦ Control

Financing Considerations

Love is grand…

Divorce is 100 grand

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Financing Sources

3Fs StrategicsVCsAngels

Co. Stage

$$$

Effort

Vendor/License/Grants

PE

200,000

35-50,000

2000

IncubatorsCrowd Source

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Stage IdeaPurpose Build proof of concept/prototypeAmount $25-250KValuation <$500KForm Common stock, loanDuration 3-6 mo.Their Goal Help you (emotional bondage)

A return is nice but assume it’s lost—it’s play money

Freedom High

3Fs: Friends, Family & Fools

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Incubators/Accelerators

Y Combinator Graduates

Y Combinator, EvoNexus…

Free or investmentOffice ITMentoringService providers Intro to $$6-12 months to graduate

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Stage Prototype onwardsAmount $50K+Duration VariesForm Cash for license, maybe warrants

Grants w/o equity hitVendor float, maybe warrantsSBA loans

Valuation N.A.Purpose Minimize dilutionTheir Goal Help you, spur innovationFreedom High

Grants, Vendor & Licensing

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Stage PrototypePurpose 1st customer; market validationAmount $50-3,000KValuation <$500-5,000K, want 30%+ Duration <6-18 mo.Form Common or preferred stock,

warrants, convertible noteTheir Goal Help you, giving back

3-5X return in 3-5 yrs.Freedom High

AngelsSV Angels, 500 Startups, TCA…

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Stage RevenueAmount $1 million+Valuation $5M+Duration N.A. (often part of licensing, joint

development/marketing program)Form Stock, warrants, licensePurpose SynergyTheir Goal Technology, customers

Competitive lock-upPrelude to buyout

Freedom Medium

Strategics

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Stage Prototype onwards Revenue & breakeven w/in 18 mo. if enterprise Eyeball deals all about uniques & traffic

Amount $2 million+Valuation $3M+Form Preferred stock + covenants Duration Initial rounds 12-18 mo. After that, up to

exitPurpose Growth, solid financial baseTheir Goal 10X in 5 yearsFreedom Medium when meeting plan; can fire

you if not

VCs

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$$ from pension funds & endowments 10-yr. funds with target investment areas

Done investing by 4th year, raise another round (if doing well) Pressure to exit deals by 7th year. Potential conflict with

company goals Economics

2% mgmt fees on funds managed—in tranches Common to have 8% base return before profit split 20-25% profit split (“carried interest”) Example: $100M fund needs ~$150M before profit share 1 partner per ~$40-50M to invest Partners split “carry”, rest gets bonuses

Only partners count

Fund Structure

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Looking for specific profile◦ Market◦ Technology◦ Business model◦ Size of deal◦ Stage of development◦ Fund timing◦ Firm strategy/targets

VC Mindset

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Amt. invested, valuation Tranches, milestones 1x preference, fully participating Dilution terms Preference over other classes Veto power Board seats & rights Syndicate

Term Sheet

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Liquidity squeeze IPO way downStrategic buyers consolidating

Companies need less $$Most Internet consumer plays need <$0.5M to startBig plays too risky: cleantech, biotech, ICs

CompetitionAngels & incubators on low endSuper angels can do $3-5M

Industry consolidation50% of firms going/gone. Top-tiers gaining.Fund sizes down

VC Viability Debate

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-10%

2000-2010 VC ROI

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Disappearing Money

# IPOs1990-2000 4,467

2001-2011 1,096

Source: Jay Ritter, Univ. of Florida

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VC Shrinkage

2000 1 2 3 4 5 6 7 8 9 100

100

200

300

400

500

600

2000

1 2 3 4 5 6 7 8 9 100

102030405060708090

Amt. Raised ($ Bil.)

New Funds

Source: VentureSource

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$1.3 million Bridge Note50% Warrant Coverage

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$3.7 million Preferred Stock$6 million Pre-$ Valuation

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“We are bad at picking out the winners a priori. Despite doing extensive diligence…for every 10 deals we do, we lose all of our money on 5 to 6, we make a modest multiple on 2 or 3, but we make a lot of money on 1 or 2.”

--Bill BryantDraper Fisher Jurvetson

It’s a Crap Shoot

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Business PlanExit StrategyValuations

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IPOs are rare now

Buyouts most likely

It’s a buyer’s market◦ IT industry consolidating◦ Buying niche technologies◦ Many to chose from

65% of buyouts written off in 3 years

Exit Scenario

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Bird in hand vs. 2, 6 in bush? How much more in for what return? And

risk? Industry vs. market cycle Business synergy Cultural fit Musical chairs Earnout formula

Buyout Considerations

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IP◦ Assignments◦ strategy

Technology-code review/escrow Contracts

◦ Contingency liabilities◦ What’s given away vs. deal values

Employment agreements Capital structure Sales metrics, process, channels Accounting

Due Diligence Items

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Valuation Methods P/E ratio Free cashflow multiple Sales multiple

Eyeballs multiple

Book value

Liquidation/replace-ment value

Public firms Private, profitable Private, unprofitable but

high potential

Consumer internet deals

20-50%

Asset-based, low-growth

Fire sale

+ control premium

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Profit % Growth Market share Revenue profile

◦ Customer/product mix◦ 1-trick pony?◦ Lumpy vs. annuity/subscription

Future risk◦ Technology◦ Competition◦ Demand shift◦ Regulation?

Valuation Determinants

Rational Market?

Source: Yahoo Finance, 2/5/1257

HP DELL MSFT AAPL EBAY ORCL CSCO YHOO GOOG QCOM VRZN0

5

10

15

20

25

30

35

40

45

50

P/E

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Concluding Thoughts

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So, What’s the Secret?

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Controllable

Business logic Hard work

Decisions

Uncontrollable

Serendipity

Timing

Competition

What’s It All About?

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"Everything that can be invented has already been invented.“ Charles Duell, commissioner USPTO, 1899.

"The Americans have need of the telephone, but we do not. We have plenty of messenger boys,“ Sir William Preece, chief engineer at the British Post Office, 1878.

"Who the hell wants to hear actors talk?" H.M. Warner, Warner Bros., 1927.

"I think there is a world market for maybe five computers," Thomas Watson, chairman of IBM, 1943.

Predictions-1

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"The world potential market for copying machines is 5,000 at most." IBM executives to the founders of Xerox, 1959.

"There is no reason anyone would want a computer in their home." Ken Olsen, founder of Digital Equipment Corp., 1977.

"No one will need more than 637 kb of memory for a personal computer—640K ought to be enough for anybody." Bill Gates, Microsoft, 1981.

"Next Christmas the iPod will be dead, finished, gone, kaput." Sir Alan Sugar, British entrepreneur, 2005.

Predictions-2

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Entrepreneur’s Credo"I do not choose to be a common man, it is my right to be uncommon … if I can. I seek opportunity … not security.I do not wish to be a kept citizen, humbled and dulled by having the state look after me.I want to take the calculated risk; to dream and to build,to fail and to succeed.I refuse to barter incentive for a dole;I prefer the challenges of lifeto the guaranteed existence;the thrill of fulfillmentto the stale calm of Utopia.

I will not trade freedom for beneficence nor my dignity for a handout.I will never cower before any master nor bend to any threat.It is my heritage to stand erect,proud and unafraid;to think and act for myself,to enjoy the benefit of my creations and to face the world boldly and say: This, with God’s help, I have done. All this is what it meansto be an Entrepreneur.

"Common Sense" (1776) Thomas Paine