How Venture Capitalists Evaluate

Potential Venture Opportunities

 How do you Evaluate Potential Venture
Opportunities?
• Large Market Opportunity in a fast growing sector
“We look for a tough problem that hasn’t been solved before. The solution cant
– soExplosive
be growth
straightforward that some makes catch
one can look at theup difficult
blackboard and say, ‘I know
how to do it’. We tend to avoid scientific breakthrough’ we are not great at
– Haveoramanaging
evaluating $100 to $300
science M revenue
projects. stream
years
We know how within five
to make technology,
– Mkt Potential should be at least $500 M or more and the
commercialize it and turn it into a viable business.”

company should have at least 25% of it.

“So overall it’s a funny mix. When we review an investment opportunity,
• Sustained competitive advantage/entry barrier
entrepreneurs have to have a pretty good story to tell about what they want
–tococky,
do. I think it helps to be cocky, there is no doubt about it. You can be too
Through Networks
sometimes we’re a little bit mindful of that… but if you’re not cocky
–“InThrough
early stages ITechnology
enough, you’re not going to be successful in selling your idea.”
invest behind a entrepreneur, not behind a professional manager
• Team
as the CEO. Often, the person who can professionally manage as a CEO in the later
stages of a company is not as effective in the earlier stages.”
– Strong technical founder and
– A sales oriented entrepreneurs
 How do you evaluate the business
model
• Type 1: Market/Product is somewhat understood.
– The co. is doing a better execution or a better version of
an existing product or service-with a twist in a existing
market.
• Type 2: Completely new markets or business
models ..
– High risk (second life, friendsters, iridium etc..)
 Due Diligence
• Technical due diligence (researchers,consultants
etc.)
• Customer due diligence (need assessent, willingness
to pay)
• Industry due diligence (run the idea through
industry experts)
• Diligence on the entrepreneur and team.
(References blind references. Spend time with
them.. Honesty.. Team spirit..)
 Financial Analyses
• List the 3 or 4 key risks you want to mitigate
• Stage the investment (does not always work)
– 40% post tax margin
 Introduction to Early stage investments
"Hedge
"Angel" "Venture Capital" "Growth" "Buyouts" "Distressed Investing"
Funds"

2nd & 3rd Emerging Leveraged Mezzanine Distressed Distressed

Seed 1st Round Hedge Funds
Round Growth Buyouts Debt Equity Debt

Age of
0 years 0-1 year 1-3 years 3-10 years 10-50 years 10-50 years 10-50 years 10-50 years 5+ years
Company

2nd or 3rd
Stage of 1st generation Established, Established,
Idea Prototype generation Stressed Stressed Public
Company product slow growth slow growth
product

Public or Private or Private or Private or Private or Private or

Private Private Private Public
Private? Public Public Public Public Public

Equity
$0.2-0.5m $1-2m $2-5m $5-20m $10 - 250m $10 - 250m $10 - 250m $10 - 250m N/A
Requirement

Return
70%+ 50-70% 50-60% 40-50% 25-40% 20-30% 30-50% 30-40% 20%
Expectations
 Strange case of Anoop Ramchandran
• Anoop Ramchandran, a IIM Calicut Graduate decides to start a
Company to develop algorithms for biosciences. He prepares an
interesting business plan and approached various venture capitalists
including Mr. S P Varma, KVFL (Kerala Venture Finance Ltd.). Mr.
Varma agrees to fund the project to the tune of Rs. 15 lakh (which
will take the Company to the next level) and agreed for a 51/49 a split
with Anoop holding the majority stake. However, may be due to
immense competition to fund the project Mr. Varma agrees to a all
common stock structure.

• The deal was fixed on 5th November 2008 on his way back Anoop met
his best friend in undergraduate days, Sumit Arora. Sumit works as
country head of Wolfgang Life Sciences a German Company. The
Company was infact thinking to opening a biotech software Company
in Calicut IT Park. So Mr. Arora makes a deal with Anoop and offers
him Rs. 20 lakh for the Company + a bungalow, Chauffeur driven car
and permanent employment with Wolfgang Life science with a
package of Rs. 10 lakh per annum.
 Expected Returns and Holding period in
Early Stage Investments
Stage Annual Expected Retur Typical Holding Period
Seed & startup 50%-100% or more More than 10 years
First stage 40%-60% 5-10 years
Second stage 30%-40% 4-7 years
Expansion 20%-30% 3-5 years
Bridge and mezzanine 20%-30% 1-3 years
LBOs 30%-50% 3-5years
Turnaround 50%+ 3-5 years

Jeffrey A Timmons, New Venture Creation, 4th ed

 How do investors determine what
percentage ownership they seek
• Expected returns are high
• Only initial and terminal cash flows considered in
analysis
• Eg. A investor is contemplating investing $1.5
million today and foresees five years from today an
exit of $50 million. If s/he expects 50% rate of
return, then what should be the stake that the
founders need to be given.
 How do investors determine how many
new shares are to be allotted to the VC
• Expected returns are high
• Only initial and terminal cash flows considered in
analysis
• Eg. A investor is contemplating investing $1.5
million today and foresees five years from today an
exit of $50 million. If s/he expects 50% rate of
return, then what should be the stake that the
founders need to be given.
• Say the firm has 500,000 share outstanding prior to
this round of investment, how many new shares are
to be issued.
 What is the price per share
• Post money val divided by the total no. of shares
– 6.58432/0.647511=10.16873
• Pre money val
– 5.08432/0.5=10.16873
• Value of the new shares
– 1.5/.147511=10.16873
 Popular Investment instruments

Equity shares at a premium Traditional pricing. Ratchet rights may not be

involved
Optionally Convertible Preference ECB guidelines apply and foreign PE / VC may not
Shares find it attractive.
Pricing can be in favour of PE. Ratchet rights may
be stipulated.

Fewer no of equity shares (with Market pricing. Deal in favour of PE. Voting control
disproportionately higher voting is provided to PE with the differential voting rights.
rights) and substantial portion in (Present version of new Companies bill bans
Preference shares DVRs)

Cumulative Compulsory Prospective pricing. Participating rights in

Convertible Preference Shares residual income. Very popular instrument and
with participating rights widely used in the recent past.

Mix of Equity + convertible equity Multiple convertible instruments. Very complex to

warrants + preference shares structure. Pricing can be manipulated as per the
agreement between the parties.

Debentures convertible into equity Pricing can be fair and neutral. Comfort to PE with
shares at the time of IPO at the IPO the periodical interest cash flows and comfort to
price Investee Company with the non-equity control by
PE (till conversion into equity)
 ECB guidelines
• About 30% of PE investments are made by subscribing to
preference shares of the cos.

• This leads to easy interest rate arbitrage PE money can be raised

at cheap rates (6-8%) and invested in Indian cos. Pref share at
15-16%.

• As per ECB guidelines (since 2006) any PE investment in

Preferential instruments will be treated as debt which has a cap
of libor+300 bps which would end up at 9% or so.

• Thus, the interest rate arbitrage looks less attractive.

 Liquidity Preference
• Liquidity preference right applies for liquidation,
merger, acquisition, takeover, sale of asset of company,
IPO, or any other exit

• If company is liquidated the PE investors (holding

liquidity preference rights) will be entitled to get their
money back in 1 or more multiples as per the liquidity
preference right
(ex: Invst x 1; invst x 1.5; invst x 2)
 Liquidity Preference distribution

Liquidity preference distribution if liquidity realization is Rs. 14000 lacs

Liquidity Liquidity pref Capital share

PE Invst PE % prefer amt distributed Total
Rs lacs shareholding X distributed# * distributed
2500 5% 1 2500 575 3075
2500 5% 2 5000 450 5450
2500 11% 1 2500 1265 3765
2500 11% 2 5000 990 5990
2500 26% 1 2500 2990 5490
2500 26% 2 5000 2340 7340
# PE invst x Liquidity Pref
* PE shareholding % x (Liquidity realization – Liquidity pref amt distributed)
Equity Ratchet Rights (and Risks)
 Anti-dilution price protection provision (Equity
ratchets)

• Ratchet is the structure of resetting (adjustment) of equity

price and shares allocations depending on subsequent
equity allotment price, future performance of company or
the rate of growth etc.

Viz. protection against

– subsequent offerings at a lower price. (Later round price is
considered as lower if it is lower than the share value projected to
prevail at the later round price)
– Corporate structure and proportion of the company originally
purchased
 Types of equity ratchets

• Weighted ratchet anti-dilution price protection

• Narrow based weighted average anti-dilution price protection
provision
• Broad based weighted average anti-dilution price protection
provision

• Full ratchet anti-dilution price protection

 Nature of ratchets
• Weighted ratchet: The resetting allotment price is
lowered to a price that is a weighted average of the
price at which the company issued shares valuing the
company at the pre-adjusted price. It has two sub-types
viz., narrow based weighted average ratchet and broad
based weighted average ratchet

• Full ratchet: The resetting allotment price is lowered to

the lowest price, that is lower than PE’s purchase price,
regardless of the number of shares issued (but not
weighted average price)
 Kinds of weighted average ratchets

• Narrow based weighted ratchet: Narrow based

weighted average anti-dilution price protection
provision might include only equity share capital and
convertible preferred shares then outstanding

• Broad based weighted ratchet: Broad based weighted

average anti-dilution price protection provision includes
equity shares outstanding and issuable upon
conversion, warrants, convertible debt, options and any
other contingent right to equity shares or equity share
capital
 Share price adjustments with Ratchets

Share price adjustments with weighted average ratchets

No of Allot Before adj % After adj After adj %

Investor shares price Invest amt shareholding no of shares shareholding

Promoters 10,00,000 80 8,00,00,000 64.52% 10,00,000 63.73%

Private
Equity 50,000 125 62,50,000 3.23% 69,095* 4.40%

New Invst - 1 2,00,000 90 1,80,00,000 12.90% 2,00,000 12.75%

New Invst - 2 3,00,000 85 2,55,00,000 19.35% 3,00,000 19.12%

Total 15,50,000 12,97,50,000 100.00% 15,69,095 100.00%

* Rs. 62,50,000/90.45; Rs. 90.45 = (Sum invst amt of PE + NI 1 & 2)/(Sum of no. of shares to PE, NI 1& 2)
 Share price adjustments with Ratchets
Share price adjustments with Full ratchets

No of Allot Before adj % After adj After adj %

Investor shares price Invest amt shareholding no of shares shareholding

Promoters 10,00,000 80 8,00,00,000 64.52% 10,00,000 63.55%

Private
Equity 50,000 125 62,50,000 3.23% 73,529* 4.67%

New Invst - 1 2,00,000 90 1,80,00,000 12.90% 2,00,000 12.71%

New Invst - 2 3,00,000 85 2,55,00,000 19.35% 3,00,000 19.07%

Total 15,50,000 12,97,50,000 100.00% 15,73,529 100.00%

* Rs. 62,50,000/85; Rs. 85 = Lower of Allot price to PE, NI 1 & 2)

 Pre-money and post-money valuation

• The following are the two valuation concepts in connection with

computing the % of shareholding a PE gets for its investment in
the company:

• Pre-money valuation (Valuation of the company

before the PE injects money into the venture)

• Post-money valuation (PE Investment/PE

ownership %)
 Pre & post money valuation equations
Pre-money valuation Post money valuation – PE investment

Post money valuation PE investment / PE ownership percentage

or
Pre-money valuation + PE investment
Share price Pre money valuation / no of pre money
shares; or
Post money valuation / no of post money
shares
New shares issued PE investment / share price

Total outstanding Pre money shares + new shares issued

shares
Pre money and post money valuation
- illustration - 1

Pre money Rs. 100 crores

valuation
Investment Rs. 25 crores
amount proposed

Post money Rs. 125 crores

valuation
PE’s percentage Rs. 25 / 125 x 100 = 20%
shares
Pre money and post money valuation
- illustration - 2

Post money Rs. 100 crores

valuation
Investment Rs. 25 crores
amount of PE

Pre money Rs. 75 crores

valuation
PE’s 25 / 100 x 100 = 25%
percentage
share
Clauses of PE investment Agreement -1

Dividend Rights:

• Dividend policy of the investee company during the period

of PE investment is influenced by PE.
• The dividend policy is formulated in a tax efficient way
• Usually, on account of taxation, PEs do not encourage
periodical dividend payments
• PE investor holds an overriding right to veto the payment
of any dividend.
Clauses of PE investment Agreement -2

Nature (kind) of shares for PE investors:

• PE investors usually invest in either Equity or preference

depending on the legal provisions prevailing in the host country

• Since ratchet rights have to be accommodated, generally PE

investors prefer convertible preference shares over equity shares.
However, since veto rights are available only for equity
shareholders, PEs prefer to hold a mix of preference and equity.

• PEs also prefer to hold golden shares (with additional rights).

• Differential Voting Right (DVR) shares are considered in India.

Clauses of PE investment Agreement -3
Liquidation Preference:

• Liquidation preference accords a right to the PE

investors to receive certain amount of the realized
amount out of liquidation of the Company in
preference to other shareholders.

• This preference amount may be equal to the amount

of the original amount invested by the PE investor or
a multiple of it.

• In India liquidation preference rights may not be

possible on equity shares and hence PE investors
prefer ‘cumulative participating preference shares’
Clauses of PE investment Agreement -4

Redemption Rights (Equivalent to sell-back right in India):

• PEs demand that the Company shall buy back its own shares
from investors. PEs insist that the other shareholders
(usually promoters) should not participate in the buy back
scheme thereby facilitating their shares to be bought back
by the Company.

• Valuation of the buy back of the shares is subject to the

guidelines issued by the competent authorities.

• Alternately and / or simultaneously, as per the terms of the

investment agreement, promoters will have the obligation
to purchase the shares from PE investor at a price to yield
the required rate of return
Clauses of PE investment Agreement -5

Anti dilution (Price protection ratchets /

Price protection rights):

• PEs hold anti-dilution protection rights to protect the

value of their stake in the Company if new shares are
issued at a valuation which is lower than that at which they
have originally invested. Such subsequent or follow on
issue round is termed as ‘down round’.

• These rights are termed as ratchet rights. Ratchets

could relate to price of follow on issue price or valuation of
the equity share even in the absence of a subsequent
equity issue.
Clauses of PE investment Agreement -6

Right of first refusal (ROFR):

• ROFR right provides that if any shareholder

(usually promoter) intends to dispose of shares,
such shares must be first offered to the PEs (if
ROFR right is held) at the same terms and
conditions the shares are intended to be sold.
• These rights ensure that the promoters do
not sell their shares to persons whom PE would
not like to be shareholders of the Company.
• These rights also ensure that the promoters do
not sell their shares at unusual terms to their
preferred persons
Clauses of PE investment Agreement -7

Drag along (Bring along) rights:

• A drag along provision creates an obligation on the other

shareholders (usually promoters) of the Company to sell
their shares to a potential purchaser if and when PE
shareholder votes to sell its shares to the potential
purchaser
• These rights will be useful in the context of a sale where
potential purchasers intend to acquire substantial majority
(usually 100%) of the shares of the Company in order to
avoid having responsibilities towards minority shareholders
after the acquisition.
Clauses of PE investment Agreement -8

Tag along (Co sale) rights:

• A tag along provision creates an obligation on

the other shareholders (usually promoters) of
the Company to ensure that the potential
purchaser agrees to purchase an equivalent
percentage of PE’s shares at the same price and
under the same terms and conditions.

• This right may have the effect of making the

shares more difficult to sell.
Clauses of PE investment Agreement -9

Pre-emption right :

• Preemption is the right of PE investor to participate in a

financing to the extent necessary to ensure that, if
exercised, its percentage ownership of the Company’s
shares will remain the same after the financing as it
was before.

• In Indian term sheets, it could even mean rights of PE

to decide whether certain items can be taken up by the
Board or General Meeting in the agenda.
Clauses of PE investment Agreement -10
Representations:

PE investors insist on representations from the issuer Company (and from the
Promoters) to be included in the investment agreement / term sheet
confirming about the information disclosed and that the deal (investment by
PE) is subject to the facts, information, statements furnished by way of
representations.

Representations are also stated as recitals. Recitals usually form part of the
agreement. PE investors prefer to include the representations in the
agreement rather than in recitals since as per the legal interpretation,
recitals are considered as jointly agreed upon statements / situations than a
cover to the other party.

If any representation is found inaccurate subsequently, PE will have a right to

initiate corrective action including accelerating the investment as per the
terms of the investment.
Clauses of PE investment Agreement -11
Warranties:

PE investors insist on warranties from the issuer Company (and from

the Promoters) to be included in the investment agreement / term
sheet to provide the investors with a complete and accurate
understanding of the current condition of the Company and the
past history so that the investors can evaluate the risks of investing
in the Company prior to investing in the Company.

The warranties typically cover areas such as legal existence of the

Company, financial statements, business plan, assets, liabilities,
material contracts, employees and litigation.

If any warranty is found inaccurate subsequently, such an event will be

considered as breach of the agreement and the PE will have a right
to be reimbursed for the loss / expenses etc with an additional
right to rescind the investment agreement itself.
Clauses of PE investment Agreement -12

Consent Rights:

PE investors normally hold consent rights which provides that

that certain actions cannot be taken by the Company
without the consent of the PE investors or of a majority %
(as specified)

These consent rights need not confine to only board agenda

items
Clauses of PE investment Agreement -13

Board Seats:

PE investors will require a right to nominate one or more

directors to be appointed on the Board of the investee
Company.

PE investors may also require a right to appoint a Board

Observer who can attend all Board Meetings but will
not participate in any board decisions.
Clauses of PE investment Agreement -14

Information Rights:

PE investors will require right to receive information on

a regular basis concerning the financial condition and
budgets along with a general right to visit the
company and examine its books and records.
Clauses of PE investment Agreement -15

Registration Rights:

These are specific only to USA since SEC requires the registration of the
securities to be eligible for offering for public sale (Offer for Sale). The
registration process involves the Company providing significant information
about its operations and financial condition which can be time consuming
and expensive.

In India this clause is non-existent. However a corresponding clause to this in

India is that PE investors insist that the Company do not recognize PE
investors under promoter group and also should endeavor to avoid PE
investors being recognized as promoters under law. This will help PE
investors not to be subject to the lock-in requirement of the promoters’
shares (3 years) at the time of IPO of the Company.
 Clauses of PE investment Agreement -16

Conditions Precedent:

Term Sheet / Investment agreement of PE investors will include

a full list of conditions to be satisfied before investment
will be disbursed.

Conditions to be fulfilled
in advance Usually Conditions Precedent to signing of the investment
agreement and Conditions precedent to releasing of the
investment amount to the investee Company will be
separately laid down clearly in the term sheet and the
investment agreement respectively.
Clauses of PE investment Agreement -17

Tranche Disbursements:

PE investors will have a right to release the investment amount in one or

more tranches (stages / phases) dependant on achievement of targets
or milestones claimed to be achieved in the business plan of the
Company.

While the investment price may be determined at the time of signing of the
investment agreement itself, the investment amount is structured to be
released in tranches (stages) to ensure that the Company is growing as
per the growth guidance issued by the Company / Promoters.
Clauses of PE investment Agreement -18

Exit Options / Rights:

PE investors will reserve right to exist in various ways including:

- Initial Public Offer (IPO)
- Offer For Sale (OFS)
- Merger
- Take Over
- Strategic Sale
Clauses of PE investment Agreement -19

Non Compete Clause:

PE investors will require the promoters to sign non-compete

agreements so that the promoters will not nurse their
interests to promote and develop other companies which may
eat in to the business of the investee Company or which may
stand competition to the investee company.

Usually the Non-Compete agreements will carry a tenure of about

5 years from the date of investment.
Clauses of PE investment Agreement -20

Special Audit:

PE investors will require the Company’s financials to be audited by a special

auditor usually appointed by them in addition to the statutory auditor
of the Company.

The costs of the audit and the audit fee for the special auditor have to be
borne by the Company.

Special Auditor submits his audit report to the PE investor with a copy of
the audit report to the Company. In addition to the usual financial
audit, he may also comment on the status of the compliance of the
conditions of the terms and conditions of the investment agreement
signed by the Company with the PE investor.