Secrets of Silicon Valley:

How VCs Think About Investment

AUGUST 4, 2015 SAN FRANCISCO

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How to Make a VC Happy

1. Make a lot of money

2. With no drama
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Part 1:

Secrets of Innovative Companies

Strictly Confidential. Not for Public Distribution.

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Drivers of Value for Traditional Businesses

▪Relentless focus on financial performance

− Revenue
− Margins
− Profits

▪Valuable product or service which is differentiated

▪Solid management team and strong leadership

▪Growing market

▪Solid strategies for operations, growth, and finances

Strictly Confidential. Not for Public Distribution.

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Drivers of Value for Innovative Businesses

▪Relentless focus on financial performance

− Revenue
− Margins
− Profits

▪Valuable product or service which is differentiated

▪Solid management team and strong leadership

▪Growing market

▪Solid strategies for operations, growth, and finances

Strictly Confidential. Not for Public Distribution.

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So, What Distinguishes Innovative Businesses?

▪Looking for a natural monopoly, not a commodity

▪Looking for extreme differentiation

▪Looking for radical improvement over the old

▪Looking for technology scale, not service scale

▪Looking for platform and network effect plays

▪Near universal equity upside

▪Ideally, recurring scalable revenue

Strictly Confidential. Not for Public Distribution.

The Importance of Natural Monopolies

▪Commodity businesses drive themselves into the ground

− U.S. airline industry in 2012: $143 billion in revenue, profit of 0.1%
− 21¢ profit per passenger

▪Natural monopolies can capture extreme wealth

▪Last mover advantage

− Remember these? W3Catalog, Aliweb, JumpStation, WWW Worm,
WebCrawler, Go.com, Lycos, Infoseek, AltaVista, Daum, Magellan, Excite,
SAPO, Dogpile, Inktomi, Hotbot, Ask Jeeves, Northern Light, Yandex
− Because Google took the market – 68% to 85% today

▪Hard to discern since companies pretend they are the opposite

▪Need to see what others have not seen

Extreme Differentiation

▪Strong intellectual property, patents, trade secret, or brand

− What is a patent, trademark, trade secret?

▪The “why” or “massive transformative purpose”

− Some great brands: Apple, Google, Berkshire Hathaway, Amazon, Disney,
Southwest
− Most businesses lead with how and what

▪Importance of brand and IP

− Customers will pay more (e.g., luxury brands)
− Customers will seek you out over competitors

▪Warren Buffet: how deep and how wide is the moat?

Massive Improvement Over the Old

▪Looking to disrupt industries

− Feast on old, tired business models
− Robert Kennedy quote: some ask why…
− Rubicon owns no trucks or landfills
− Uber, world’s largest taxi company, owns no vehicles
− Airbnb, world’s largest broker of housing owns no rooms or buildings
− Facebook and Twitter produce no content

▪Usually need a 10x or better improvement to stand out

▪Usually technology enabled

− Technology does not replace jobs, it makes them easier and creates
Need to Scale

▪“Exponential Organizations”

▪Use of community, algorithms, leverage assets, measurements, autonomy

▪Looking for technology scale, not service scale

▪Traditional businesses scale only as quickly as people an be added

▪Technology companies can scale without limit

▪Rapid scale often destroys companies, however

− Need systems, processes, and controls to scale
− Build systemic plans to grow into foundation

▪Importance of being “born global”

▪Hard work to build a business

Network Effects and Platforms

▪What is a platform play?

▪Apple iPhone

▪Open innovation platforms

▪What is a network effect play?

▪Facebook, LinkedIn

▪Enables extraordinary growth

Equity Upside

▪Actors are like cattle…

▪Hallmark of innovative companies is near universal equity upside

▪Principle of good dilution

▪Creative compensation strategies

Recurring Revenue

▪Built it once and sell it a thousand times

▪Recurring revenue increases sales and loyalty

▪Paid up front and predictable

− Can plan hiring and inventory
− Capture value of money early

▪Makes value of business substantially higher to acquirer

− Reduces risk and uncertainty
− Higher multiples

▪Provides opportunities for direct customer engagement and data

analysis
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Part 2:

Investing in Innovative Companies

Strictly Confidential. Not for Public Distribution.

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In Case You Forgot Already…

1. Make a lot of money

2. With no drama
How Do VCs Evaluate Deals?

▪Review the innovation factors

▪Review the business fundamentals

▪Focus on exit

▪Focus on price and terms, which quantify risk

▪Can we add value?

▪Relentless focus
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Stage 1: Reviewing the Innovation Factors

▪Looking for a monopoly, not a commodity

− Can this company dominate its market? Create extreme wealth?

▪Looking for extreme differentiation

− How strong is its intellectual property?

▪Looking for radical improvement over the old

− How does the technology work? Will the market perceive the difference?

▪Looking for technology scale, not service scale

▪Can it scale quickly enough?

▪Looking for platform and network effect plays

▪Recurring, scalable revenue

Strictly Confidential. Not for Public Distribution.

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Stage 2: Is It a Real Business?

▪Financial performance
− Focus on revenue plan and model
− Try to extract as much value as possible
− Focus on sales, sales, and more sales. Then repeat.

▪Valuable product or service which is differentiated

− Marketing

▪Solid management team and strong leadership

− Track record of team; “wartime” CEO ability

▪Growing market

▪Solid strategies for operations, growth, and finances

− Act, think, and execute like a public company
Strictly Confidential. Not for Public Distribution.
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Stage 3: Can It Exit?

▪Hallmark of venture capital investment is growing companies to EXIT

− IPO
− Mergers and acquisitons
− Why? Have to return money to investors

▪Top investors have a systemic plan to grow to exit

− Many traditional businesses do not think about exits from beginning
− Planning is key to success in all businesses
− Decision is what is best for future value of business, not cash out today

▪Rapid scale kills companies as much as bad models

Strictly Confidential. Not for Public Distribution.

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Stage 4: Can We Add Value

▪Looking for companies where we can add value beyond money

▪Is team receptive?

▪Build a systemic plan of ways to add value

▪Extended family approach

Strictly Confidential. Not for Public Distribution.

Price and Terms: Three Core Concepts

▪Economics
− Who owns what (how much and what extra rights)
− Who get paid what, in what order, and when (now or later)

▪Control
− Who makes decisions
− Who has veto rights
− Protections

▪Exit/Risk Allocation
− What happens upon a sale, IPO, or bankruptcy
− Who can force an exit
− Other risk allocation
Hallmarks of VC Terms

▪Minority economic stake

▪Professionalized management and practices

− Adequate incentives and protections for team
− Neutral board control and active involvement
− Appropriate information reporting and controls

▪Appropriate minority stockholder protections

▪No oppressive terms
− Redemption, unduly harsh liquidation preferences, forced dividends
− No unduly harsh drag along or other terms

▪Preferred stock
− Optional, but allows minority protections to justify higher pre-money values

▪Reality is every deal is a negotiation

− Parties need each other
Key VC Terms

▪Common venture capital terms

− Valuation and Dilution Issues – Pre-Money, Raise, Allocation, Pool
− Liquidation Preference – Participating vs. Nonparticipating, Caps
− Founder Equity Issues – Vesting, Acceleration, Transfers, Drag
− Redeemable vs. Nonredeemable, Buyout Rights
− Anti-dilution, Pro-Rata Rights, and Carveouts
− Preferred Voting Thresholds – Conversion and Protections, Class or All
− Protective Covenants – Nature of Protections, Class or Board
− Board Structure
− IP Reps
− Information Rights

▪VC financings in Silicon Valley are highly efficient

Sample Capitalization – Initial Formation

▪Common Stock Shares Price Value

▪Founders shares 8,000,000 $0.001 $8,000

▪Option pool 2,000,000 $0.001 $2,000

Sample Capitalization – Series A

▪Pre-Money Valuation: $5 million

▪Invested Amount: $3 million
▪Post-Money Valuation: $8 million
▪Post Shares Fully Diluted: 16 million

▪Common Stock Shares “Price” Value Percent

▪Founders shares 8,000,000 $0.50 $4MM 50.0%

▪Option pool 2,000,000 $0.50 $1MM 12.5%

▪Preferred Stock Shares Price Value Percent

▪Series A 6,000,000 $0.50 $3MM 37.5%

Sample Capitalization – Series B

▪Pre-Money Valuation: $16 million

▪Invested Amount: $6 million
▪Post-Money Valuation: $22 million
▪Post Shares Fully Diluted: 22 million

▪Common Stock Shares “Price” Value Percent

▪Founders shares 8,000,000 $1.00 $8MM 36.4%

▪Option pool 2,000,000 $1.00 $2MM 9.1%

▪Preferred Stock Shares Price Value Percent

▪Series A 6,000,000 $1.00 $6MM 27.3%

▪Series B 6,000,000 $1.00 $6MM 27.3%

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Part 3:

The Company Side

Strictly Confidential. Not for Public Distribution.

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Are You Ready?

▪The business
− Good business with plan for profits, margins, and revenues
− Smart growth strategy (can it scale?) and intelligent use of capital
− Solid budget and plan
− Hobby or real business?

▪Right team
− Family businesses
− Professionalization

▪Deal with the devil: will you exit?

▪Can you stand out from 300 plans a month?

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Are You Ready?

▪Corporate fundamentals
− Diligence Room
− Cleanup of all books and records
− Proper structure, or at least no bad structure
− No bad deals or problems to cleanup, including bad cap structures
− Don’t skimp on professionals

▪Understand the process

▪Understand market terms

▪Reality principle on how VCs evaluate risk

− Your valuation is not equal to Google or Microsoft. Sorry.
− Portfolio theory

Strictly Confidential. Not for Public Distribution.

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Pitching the VC
▪Know your VCs ahead of time

▪Do screen calls first before you travel

▪Be realistic and understand the VC business

− Need exits and must be sober about the portfolio
− High risk, hands on, high upside

▪Be prepared practice ahead of time

▪Don’t waste time if the fit is not right

▪You are being evaluated

− Don’t be defensive; put the company first
− Be realistic; no exaggeration (clear communication always)
− Listen to feedback and listen to directions
Non-Standard: Creativity With Venture

▪Resetting valuations
− Chance to “earn” higher value (or take lower)

▪Splitting business and spinouts

− When business is not fully valued
− By line or geography

▪Management carveouts and phantom interests

− Create separate bonus pool based upon performance
− Tracking stock, or money off the top
− All from “good dilution” principle

▪Remember, unlimited upside is critical to venture capital

− And efficiency is critical, even if micro-injustice
Restructuring Bad Deals

▪Separate economics and control

▪Directly change ownership

− Restructure holdings to own 30-35% currently or keep ownership flat with new $
− Create economic interests based upon value created from here

▪Buyout

▪Upside on the exit

▪Separate new opportunities

− Committed funding for new projections or expansion with separate stock
− Committed funding for spinoff applications and services with separate stock
− Permit founders to spin off new companies for new countries/applications
themselves
Strategic Investment

▪Strategics have multiple ways to make money

− Not just capital appreciation

▪Strategic investment can be more varied

− In kind investment
− Test equipment
− Laboratory space
− Network access

▪Carries some industry weight

▪But some risks
− Competitors
− Dependence on one customer
− Do not want to educate your competitor
− Close down other potential acquisitions. Married already
− If does not work out, then poisons others
Debt Financings

▪Convertible Debt Investors

− Interest rate, discount to convert, conversion or repayment, cap
− Can have warrant coverage or other sweeteners
− Usually unsecured
− Avoid discussions of value – speed and ease
− Ability to work with smaller investors
− Documentation easy
− Can it be repaid?

▪Venture Debt
− Historically recent venture financings
− Combines best of both worlds
− How works
− Expensive, but dilution is less, so cheaper
Debt Financings – General Issues

▪Collateral, security, and covenants

− IP, Cashflow, Inventory
− POs and future agreements (especially for expansion)
− Restrictions on operations

▪Priority of debt in insolvency

− Makes company vulnerable
− Can buy out secured position
− Makes equity raising harder

▪Ability to service debt

▪Money is both expensive and cheap

− High all in, but no dilution
− Is it really expansion capital or venture capital?
A Few Last Thoughts

▪Reduce risk / chicken and egg both

− Prenegotiated revenue
− Conditional funding
− Try to avoid financing in pieces

▪Don’t suffer from dilution phobia

▪Think big enough

▪Don’t overthink – just get to market and get revenue

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Contact Information

▪For more ▪David Frazee

information, Telephone: +1 (650) 619-1631
please E-Mail: David.Frazee@rglobal.com
contact: LinkedIn: www.linkedin.com/pub/david-frazee/0/364/592

▪Peter Kellner
Telephone: +1 (305) 905-9966
E-Mail: Peter.Kellner@rglobal.com
LinkedIn: www.linkedin.com/pub/peter-kellner/0/77/56

Strictly Confidential. Not for Public Distribution.