Early Stage Venture Capital Investments

1

Early Stage Venture CapitalInvestments

Stephen FlemingChief Commercialization Officer

<[email protected]>

29/18/07 Early Stage Venture Capital Investments

Stephen Fleming

• 10+ years investment experience.– General Partner, Alliance

Technology Ventures.

– 18 investments as leadinvestor, 15 exits to date.

• BS, Physics, Ga. Tech (Highest Honors).

• 15 years operational experience at AT&T Bell Labs,Nortel, LICOM (venture-backed startup).– Supervised startups developing first ADSL modem and one of

the first cablemodems in early 1990s.

• Multiple advisory boards at Georgia Tech; endowedchair in telecomm; occasional instructor in MBAentrepreneurship program.

• Strong regional technology leader.


Overview

• Financing a startup

• Finding early-stage deals

• Series A term sheets

• Venture capital in the Southeast

• Lessons from experience


Financing a Startup

• Options:

• The hard way.

• The other hard way.

• The very narrow way.

• The really hard way.


Financing a Startup

• Options:

• The hard way. Debt

• The other hard way. Equity

• The very narrow… Grants

• The really hard way. Bootstrapping

Venture capital consists ofpurchasing equity in startupbusinesses.


The Venture Equity Cycle

InstitutionalInvestor

VentureCapital Firm Entrepreneur

Liquidity Event(Sale or IPO)

Carried Interest

Equity

Capital

Gains


$1x $ Amount Mechanism Type

104 10,000 Visa card Debt

30,000 Second mortgage Debt

105 100,000 Angel investor Debt/Equity

300,000 Angels and seed funds Equity

106 1,000,000 Seed-stage venture capital Equity

3,000,000 Early-stage venture capital Equity

107 10,000,000 Later-stage venture capital Equity

30,000,000 Public markets (IPO) Equity

108 100,000,000 Corporate bonds Debt+

Logarithmic Financing

Different stages of development means usingdifferent kinds of funds.

SARBANES

SARBANES

OXLEY

OXLEY


$1x $ Amount Mechanism Type

104 10,000 Visa card Debt

30,000 Second mortgage Debt

105 100,000 Angel investor Debt/Equity

300,000 Angels and seed funds Equity

106 1,000,000 Seed-stage venture capital Equity

3,000,000 Early-stage venture capital Equity

107 10,000,000 Later-stage venture capital Equity

30,000,000 Public markets (IPO) Equity

108 100,000,000 Corporate bonds Debt

Logarithmic Financing

Focus on seed- and early-stage venture capital.

+


After the “Bubble”

1995 1996 1997 1998 1999 2000 2001 2002 2003

Source:Source: PWC MoneyTreePWC MoneyTree

Quart

erly V

C I

nvestm

ent

($Billions)

Venture capital investments in the U.S., by quarter

2004 2005 2006 2007

5

10

15

20

25

30

Total Venture Capital Investment

Seed and Early-Stage Investment


Lessons from Silicon Valley

What are the key value drivers of asuccessful startup?

• Large, fast-growing market segment

• Unique technology advantage

• Experienced management team

• Reasonable financial terms

• Measurable milestones for success


Overview

✓Financing a startup

• Finding early-stage deals





Finding Early-Stage Deals

• Universities

• Local mature technology companies

– Especially those in transition (Cisco acquiringScientific-Atlanta, etc.)

• Local technology groups

• Standard network: lawyers, accountants,recruiters, etc.

• Dealflow can be overwhelming—so filteraggressively!


Universities

• Now the wellspring of innovation for U.S.– Industrial research partnerships

– Technology transfer

– Entrepreneurial development

• Led by Federal R&D dollars– NSF, NIH, DoD, DoE, NASA, etc.

– $29.2B in FY2005

– Approx. half of all Federal R&D dollars aredevoted to healthcare and life sciences

– 70% of Federal R&D is directed to approx.80 universities


Federal Dollars Dominate

Source: http://www.nsf.Source: http://www.nsf.gov/gov/

statistics/seind06statistics/seind06


Distribution by Agency

Healthcaredominates




Distribution by Specialty



Healthcaredominates


Dealing with Universities



• Teaching a professor how to be anentrepreneur is like teaching a cat to swim:

– It can be done.

– You will lose blood.

– You’ll never be satisfied with the results.

– You will annoy the cat.

• Different motivations, different priorities,different views of “proper procedure”

• Best bet: Recruit an entrepreneur to workwith the professor. 1+1=3.



• Complex processes.

• Sometimes-absurd rules.

• Inexplicable delays.

• Petty rivalries.

• Just pretend it’s a Soviet pre-school and itwill all make sense!


IP Mgmt./Evaluation

InventionDisclosures

Dept. Chairs /Deans / GTRI

TechnologyEvaluation

Path?

Rights toFaculty?

Initiate IP Prot.

Need more information / development

MarketEvaluation

TechnologyAnalysis

ProtectIP?

MarketAnalysis

PatentApplication

ExternalCounsel

$

...continued

Export Control

Industrial Contracts

Screens

Responsibility

GTRC

EI2 / CS

$ $


IP Business Development

Rights toFaculty?

VentureLab Tech. Marketing

Path?

Startup / Spinout Industrial License

Consulting

GeorgiaResearchAlliance

$

Licensee?Rights toFaculty?

Funding& CEO?

Term Sheet Negotiation

Rights toFaculty?

LicenseNegotiation

ComplianceReview

StandardTemplates

...continued

Responsibility

GTRC

EI2 / CS

MarketingWhite Paper

External Counsel

BusinessPlan

Conflict ofInterest Plan

StandardTemplates

COI Review


Royalty Collection Monitoring

Compliance / LitigationPatent Maint. & Defense

IP Licensing/Compliance

License

LicenseNegotiation

Startup / Spinout Industrial License

Startup Formed

Incubator?

SuccessfulStartup

ATDC orEmTech Bio

IndustrialPartner

Responsibility

GTRC

EI2 / CS

Distributionof Payments

Inventor(s)

Academic Department(s)

GTRC

PortfolioLIquidation

$

Royalties & etc.Equity


Intellectual Property

• Permitted:

• Educational– Instruction or training of individuals and community

• Scientific– Research to be carried in the public interest.

– Results of research available to the public in a non-discriminatorybasis.

• Forbidden:

• Activities ordinary to commercial or industrialoperations.

• Inspection or testing of materials or products

• Designing or construction of equipment, building, etc.

• No “work for hire” — would affect tax exempt status


Publication Policy

• Contract must outline the expectations ofsponsor and institution with respect todissemination of research results

– Right to publish results is important to facultyand students.

– Also important to help maintain non-profitstatus and overcome most export issues

– Should provide industrial sponsor the right toreview 30 days prior to publication, not toapprove.


Export/ITAR Restrictions

• Every university campus depends onforeign national graduate students andpost-docs to function.

• Interaction with foreign companies isgrowing (“the world is flat”).

• National security implications mean thatuniversities are under closer scrutiny.

• “Deemed export” rule (Dept. of Commerce)

• ITAR (Department of State)

• Since 9/11: Arrest first, explain later!


Export Control List

• Nuclear Materials, Facilities & Equipment

• Materials, Chemicals, Microorganisms, and Toxins

• Materials Processing

• Electronics

• Computers

• Telecommunications

• Information Security

• Sensors and Lasers

• Navigation and Avionics

• Marine

• Propulsion Systems, Space Vehicles and RelatedEquipment


Implications for Startups

• You need to verify the nationality ofeveryone working on your technology:– Employees

– Contractors

– Consultants

– Graduate students

• This may violate EEOC regulations. Tough.

• If you have non-US nationals who do nothave permanent residency (green card),you need to talk to an export lawyer soon!

• Criminal penalties apply — jail time!


Finding Early-Stage Deals

✓Universities

• Local mature technology companies

– Especially those in transition (Cisco acquiringScientific-Atlanta, etc.)

• Local technology groups

• Standard network: lawyers, accountants,recruiters, etc.

• Dealflow can be overwhelming—so filteraggressively!

– Does each deal pass the “LP Test”?


The “LP Test”

• If you feel uncertain about a deal, imaginethat:

– It has completely imploded, and

– You are explaining it to your toughest, mostcynical LP.

• Do you feel embarrassed? Defensive?Stupid?

• Do you really want to do this?


Overview


✓Finding early-stage deals





Series A Term Sheets

• If the entrepreneur hasn’t done this before,he or she will not understand the process

– Don’t take advantage of your greaterexperience to slip something past... it willcome back to bite you!

• Key issues:

– Valuation

– Board seats

– Liquidation preferences


Valuation

• Early-stage valuation is an art, not ascience.

• Needs to be high enough to rewardentrepreneurs for risk (quitting job, etc.)

• Needs to be low enough to allow step-up atSeries B round.

• Irrational but true: Valuation depends onthe amount of money being raised!


Valuation

• Ask Monro Lanier about “MMM” and“COMBAT” valuations.

• Any rule will have error bars so large as tobe meaningless... but:

• If you wind up with

– Investors 40%

– Founders 40%

– Employee Option Pool 20%

• ...you probably won’t be wrong.


Board Seats

• After Series A, an early stage board shouldhave at least three members:

– One founder

– One investor

– One outsider with relevant experience

• More is okay, if they are truly committedto participate:

– Confiscate BlackBerries; ban speakerphones– Scheduling difficulty rises as N2-N

• Don’t worry about an odd or even number!


Liquidation Preferences

• Entrepreneurs assume they are goingpublic, so they ignore these terms.

• You know that you’re going to sell thecompany, so you insist on a preference.

• Very entrepreneur-hostile.

– Can dilute founder’s equity down to point ofmeaninglessness

• Can’t “un-ring the bell”... if you havepreferences in Series A, you will see themin all future rounds.


Liquidation Preferences

• At Series A time:– 1x is probably okay.

– 2x is painful.

– 3x and above are “vulture capitalism.”

• Exception: If the entrepreneur is stuck ona high valuation...– You accept his/her valuation...

...but insist on a high liquidation preference.

– If it’s a skyrocket, entrepreneur maintainsmore ownership.

– Protects you in case of a mediocre buyout.


Overview



✓Series A term sheets




VC in the Southeast

1995 1996 1997 1998 1999 2000 2001 2002 2003


Quart

erly V

C I

nvestm

ent

($Billions)

Venture capital investments in the U.S., by quarter

2004 2005 2006 2007

5

10

15

20

25

30

Total Venture Capital Investment

Investment in the Southeast U.S.


VC in the Southeast

1995 1996 1997 1998 1999 2000 2001 2002 2003


Quart

erly V

C I

nvestm

ent

($Billions)

Southeast: steady state of less than $500M/quarter

2004 2005 2006 2007

5

10

— off scale —Total Venture Capital Investment

Investment in the Southeast U.S.


Technology in Southeast

Multiple technologyMultiple technology

centers.centers.

Anchored by:Anchored by:

Atlanta, Atlanta,

Research Research

Triangle, Triangle,

Florida.Florida.

Pockets ofPockets of

innovation:innovation:

Universities,Universities,

FederalFederal

R&D centers.R&D centers.

Biggest challenge:Biggest challenge:

Lack of local venture capital.Lack of local venture capital.


Attractive Targets in SE

Silicon ValleySilicon Valley

NewNew

EnglandEngland

NY MetroNY Metro

SoutheastSoutheast8%8%

TexasTexas

SoCalSoCal

MidwestMidwest

OtherOther

Source:Source: MoneyTree MoneyTree

Survey, 1998-2003Survey, 1998-2003

• Local startups have demonstrated consistentpotential to attract investment dollars.


Regional Capitalization

• Local venture firms do not offer adequateleverage for local R&D.

0

5

10

15

20

25

30

35

40

45

Bay Area Northeast Southeast

University R&D ($B)

Venture Investment ($B)

1.61.6 xx

99 xx

2121 xx

SubstantialSubstantial

room forroom for

improvement!improvement!

Source:Source: Venture Economics and Venture Economics and

the Center for R&Dthe Center for R&D


Overview




✓Venture capital in the Southeast



Maalox Systems, Inc.

• Raised multiple rounds of professionalventure capital (over $20M invested).

• Ran into a market buzzsaw.

– Staffed up to meet customer demand.

– Customer turmoil meant zero sales.

– Burn rate killed them.

• Sold to a competitor for pennies on thedollar.


Maalox Systems, Inc.

• Raised multiple rounds of professionalventure capital (over $20M invested).

• Ran into a market buzzsaw.

– Staffed up to meet customer demand.

– Customer turmoil meant zero sales.

– Burn rate killed them.

• Sold to a competitor for pennies on thedollar. x3


TulipsOnline.com

• Initial business model based on Internetsubscription revenue.

• Switched to advertising-based model,brought in new management.

• Went public at height of Internet hysteria.

– Sustained a market cap in excess of $1 billionfor several months.

– Now trading 90% off its high.

– Layoffs, underwater options, etc., etc.


LP Exit

IPO

TulipsOnline.com

• Timing is everything!


Whistling Dixie Corp.

• Concentrated on proprietary technology.

• Got an initial customer commitment.– Demonstration led to field trial.

• Management realistically assessed capitalrequirements to take product throughdevelopment.– When an acquiror called, they listened.

• Sold for 30x return on investment.– Founder is now living on a sailboat in the

British Virgin Islands!


Tortoise Technologies, Inc.

• Technology transfer from university.

• Very tight focus on one particular piece ofintellectual property.

– Almost all employees were Masters/PhD levelwith industry experience.

– Relied on corporate partnerships to handlemanufacturing, sales, and marketing.

• Went public with top-notch bankers basedon expected royalty streams.

• “Slow and steady wins the race.”


Overview




✓Venture capital in the Southeast

✓Lessons from experience


For Further Information

Stephen Fleming

Chief Commercialization Officer

Georgia Institute of Technology

<[email protected]>

<http://innovate.gatech.edu/commercial/>

<http://academicvc.blogspot.com>

(404) 385-2360

Early Stage Venture Capital Investments

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