Emerging Companies & Venture Capital:
Start-Ups 101
Presented By: Jason D. Crain, Orrick’s Silicon Valley Office
October 26, 2010
Roadmap
• Venture Capital and Liquidity Markets Statistics
• Fundamentals of Formation
• Top Ten Pitfalls
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Venture Capital & Liquidity Markets Statistics
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U.S. Venture Capital Investment: 2003 – 1H 2010
Billions ($)
35
30
25
20
15
10
5
0
2003
Source: VentureSource
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2004
2005
2006
2007
2008
2009
1H 2010
U.S. Venture Capital Investment by Industry: 2008 – 1H 2010
Billions ($)
4
3
Business
Consumer
Energy
Healthcare
IT
2
1
0
Q1 2008
Q2 2008
Source: VentureSource
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Q3 2008
Q4 2008
Q1 2009
Q2 2009
Q3 2009
Q4 2009
1H 2010
U.S. Exits by M&A: 2003 – 1H 2010
# of Deals
500
475
450
425
400
375
350
325
300
275
250
225
200
175
150
125
100
75
50
25
0
2003
Source: VentureSource
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2004
2005
2006
2007
2008
2009
1H 2010
U.S. Exits by M&A: Large Deals in 2009 and 2010
Mar 2009 - Cisco acquires Pure Digital (makers of Flip Video) for >$500 million.
Nov 2009 - Google inks deal to acquire AdMob for $750 million.
Jan 2010 - Apple acquires Quattro Wireless for $275 million.
July 2010 - Disney acquires Playdom for $763 million.
Oct 2010 – Google proposes to acquire ITA Software for $700 million.
Source: VentureSource
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U.S. Exits by IPO: 2003 – Q1 2010
# of Deals
80
70
60
50
40
30
20
10
0
2003
Source: VentureSource
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2004
2005
2006
2007
2008
2009
1H 2010
Timeline to Exit
Acquisition
• 2010 – 5.4 years after raising $19 million
• 2009 – 4.7 years after raising $16 million
IPO
• 2010 – 10.4 years after raising $156 million
• 2009 – 7.9 years after raising $32 million
Source: VentureSource
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Fundamentals of Formation
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Forming the Company
• Choice of Entity
— C Corp
— LLC
• IP Ownership
• Dual Stock Model
— Common Stock: Founders
— Common Stock Options: Employees and Consultants
— Preferred Stock: Investors
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Founders’ Stock & Stock Options
• Shares of Common Stock for Founders
• Stock Options for employees and consultants/contractors
• Each subject to Vesting
— Basic: Four-year schedule with a one-year cliff
— Change in Control: Acceleration
•
Single Trigger
•
Double Trigger
• Pricing and Consideration
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Funding Options
• What?
—Convertible Note Financing
—Preferred Stock Financing
—Other - Venture Debt, Bank Loans, Grants
• Who?
—Friends & Family / Angels
—VCs
—Banks & Government
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Convertible Note – Key Terms
• Sweetener
—Conversion Discount
—Valuation Cap
—Warrant
• Change of Control
• Maturity
• Interest Rate
• Covenants
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Preferred Stock – Key Terms
• Senior Liquidation Preference – important in acquisition
• Board Representation
• Special Voting Rights
• Rights of First Offer
• Anti-Dilution Protection
• Information Rights
• Registration Right
• Redemption
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Preferred Stock – Key Drivers
•Pre-Money Valuation
•Amount Raised
•Option Pool
Will determine resulting ownership
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Capitalization Table – Pre-Money
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No. of Shares
Percent Outstanding
Percent Fully-Diluted
Common Stock:
Founder 1
5,000,000
50%
45%
Common Stock:
Founder 2
5,000,000
50%
45%
Option Pool:
1,111,111
0%
10%
TOTAL:
11,111,111
100%
100%
Capitalization Table – Post-Money
Details:
• $5.0 million investment
• $5.0 million pre-money valuation
• 15.0% option pool
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No. of Shares
Percent Outstanding
Percent Fully-Diluted
Common Stock:
Founder 1
Founder 2
5,000,000
5,000,000
20.59%
20.59%
17.50%
17.50%
Option Pool:
4,285,714
---
15.0%
Series A Preferred
Stock:
14,285,715
58.82%
50.0%
TOTAL:
28,371,429
100%
100%
Capitalization Table – Post-Money
Details:
• $5.0 million investment
• $10.0 million pre-money valuation
• 10.0% option pool
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No. of Shares
Percent Outstanding
Percent Fully-Diluted
Common Stock:
Founder 1
Founder 2
5,000,000
5,000,000
31.48%
31.48%
28.33%
28.33%
Option Pool:
1,764,706
---
10.0%
Series A Preferred
Stock:
5,882,353
37.04%
33.33%
TOTAL:
17,647,059
100%
100%
Ten Pitfalls
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1. RUNNING OUT OF RUNWAY
Preserve Cash
– Plan for at least 24 months of runway
– Plan cash to reach a major milestone
– Will the market allow you to reach the milestone?
– Raise money early
Take the money – it always takes longer than you planned and, if
you have an option, take more.
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2. POOR CHOICE OF INVESTOR & INVESTOR REPRESENTATIVE
It’s a Marriage
– Consider lower valuation for broader choice
– Valuation is not paramount – in the first round
– Be prepared for lower valuations
– Reference Checks
– Understand investor representative’s role in partnership
– Understand the condition of the particular investment fund
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3. FOUNDER’S CLASH – with each other; with investors
The Company comes first
• Founders must acknowledge that at some point there will be:
– Dilution of shareholding
– Likely a change in role and title
• Remain Valuable:
– Maintain focus on core strength
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4.
RECRUITING MISSTEPS - Hesitation to Hire; Hiring Choice
Can’t succeed without a team that can execute
• “Slow to hire, quick to fire”
– If you can’t find the right person – wait
– Fire the wrong person – don’t wait
• A mistake can cause tremendous turmoil, but so can not filling
the gaps
• Judge the person first, the resume second
• Hire “athletes”; individuals who know their “sport”
• It is critical to maintain the team and company culture
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5. BOARD REWARD & BOARD IGNORE
Research & Recruit Board Members - then use them
• Your directors are part of your team – recruit thoughtfully and well
•
Board members:
– Open doors to strategic partners, customers and employees
•
Keep the Board informed
– Learn how to prepare for and conduct a board meeting
•
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Use other constituents (advisors, lawyers and accountants)
6.
FOCUS, FOCUS, FOCUS
Do few things and do them exceptionally well
•
Many start-ups are unfocused and seek to do too much
•
Keep it simple, measurable and achievable
– Many CEOs believe they have to set lofty goals to get funded
– Investors value CEOs who set clear goals and routinely achieve
them
EVERYONE in the company should be able to articulate the
corporate goal which allows for a dogged, unyielding focus at all
levels of the company
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7. FAILURE TO ITERATE TO THE CUSTOMER
Must understand all aspects of the customer
– What the product should do at a DETAILED level
– How it fits in the customer’s world
– What influences the customer’s opinion of the product’s value
– How does the customer want it sold to him/her
– What the product is displacing and why the customer should take a
risk on your new product
– Need to be as intimate in understanding the customer’s needs as you
are conversant with your own technology
No matter how cool the technology, nothing happens until a customer
gives you money
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8. GOT OUTCOMPETED
outcompeted
Simple past tense and past participle of outcompete.
Plan that your competition will steal your technology &
your customers
• Understanding your competition is understanding your
market
• Competitors can take your customers, employees,
market share and investors
• Track competitors’ sales and market share; monitor
their growth relative to your company’s
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9. UNDERESTIMATE THE DIFFICULTY OF ACQUIRING CUSTOMERS
It will take longer and cost more than you expect
• Very common mistake -- seriously underestimating the
time and effort necessary to get acquire customers
• It doesn’t matter how you intend to distribute (direct
sales, OEM, distributors, dealers or Internet) all
channels take a lot of effort and are always slower to
develop than planned
• Know what is the cost of customer acquisition and
focus on the valuable ones
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10. GIVE UP FLEXIBILITY
The fundamental strength of a start-up is its flexibility DON’T BE AFRAID TO USE IT
• Your initial assumptions will be wrong –
continually revise and hone
• If the market, technology, customers,
economy change – innovate to capitalize
• If necessary – make a substantial change in
your business model
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IN SUMMARY
Establish & Maintain this Focus:
Build a Company that sells what
customers will buy
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Contact
Jason D. Crain
Orrick’s Silicon Valley Office
jcrain@orrick.com
(650) 289-7114
http://www.orrick.com/practices/corporate/emergingCompanies/startup/for
ms_index.asp
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