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VC 201: The Investment Memo

by Drew Russ, Principal, Startup & Venture Capital, AWS Business Development

VC 201: The Investment Memo

  1. 1. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Pop-up Loft VC 201: The Investment Memo (and what you should understand as a Founder) Drew Russ Principal, Startup & Venture Capital, Business Development @drewWruss
  2. 2. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved About Me
  3. 3. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Today’s Agenda • Quick review of what we covered in VC 101 • The Investment Memo: A mechanism for us to examine what VCs assess – Part 1: The Problem & The Solution (The Purpose) – Part 2: The Details & Terms – Part 3: The Recommendation • Concluding remarks
  4. 4. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Quick Review of VC 101 • Venture Capital: The Definition, The Theory • Venture Capital Mechanics: Fund Structure, Time as a Factor, How VCs Make Money, Roles and Responsibilities and Deal Sourcing • Venture Capital: The Deal and the Bargain • The Other Flavors of Venture Capital and Corporate VC • A Glimpse of VC 201 (no need, because you are here!)
  5. 5. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved What is an investment memo, really? • A mechanism to provide an OBJECTIVE, FACT based assessment of an investment opportunity • Enlightens pessimists and optimists in equal measure – it both the defense and the prosecution
  6. 6. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved But, why are we talking about Investment Memos? • I know. I know. Memos = boring • Act as a reference architecture of a potential investment • For example: – Product – what is it and why does it matter? – Business model -- how do they (or plan to) make money? – Financial health – and what do they do with this (and their investors) money? – Management pedigree – have they done it before? What makes them suitable? – Risk & Concerns – what goes wrong? – Valuation and Exit – when do we lose money? When do we make money? • We are going to use that reference architecture to help us understand why VCs decide to invest or not invest* * Not all investment decisions are made equally
  7. 7. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Real World Example: YouTube Memo, 2005 • Pros: – Publically available example of how one of the best VC firms reviews investments (and one of the best individual investors) – Detailed and well structured – perfect for our needs • Con: No detail on internal debate; had to move quickly on deal • Will supplement where needed • YouTube raised a seed round in November 2005, then raised only $11.5mm and sold to Google in August 2006 for $1.7bn
  8. 8. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 1: The Purpose • The Problem – Is it real? – Is it painful? – Is it widespread (or will be)? • The Solution – How does it work? – Why does it work? – Why is it better? & - Roelof Botha
  9. 9. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 1: The Purpose (problem & solution)
  10. 10. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 1: Is it Widespread? Market specifically targeted by your product Total Market Demand Market Share of SAM
  11. 11. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 1: Who else is doing this? • Competitors and existing players • Size, strategy, product differentiation • SWOT Analysis of competition – Strengths, Weakness, Opportunities, Threats • Relative positioning
  12. 12. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: The Details • Product Roadmap and Development • Revenue / Sales & Distribution • Team • The Deal & Terms: Valuation and Capitalization • Other: hiring plans, need for re-organization, company location etc
  13. 13. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Product Development & Roadmap • Going beyond core functionality • Dive deeper on how the product interacts with users • Getting from Point A to Point B (to Point C)
  14. 14. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Sales & Distribution • Monetization = how you generate revenue • Youtube: – Advertising – Pay-for distribution – Premium content – Premium features Advertiser Viewer Content Creator Youtube
  15. 15. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: The Team • The earlier the investment the more important the team • What have they done? Who vouches for them? Where do they come from? • Are they familiar to the VC firm or a trusted colleague of the VC firm? • PayPal Mafia…
  16. 16. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Team (contd.)
  17. 17. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Valuation and Capitalization • Three topics – Premoney vs. Postmoney – Cap Table – Investor preferences • Definitions – Valuation: process of determining the current worth of an asset or a company; there are many techniques used to determine value – Capitalization: sum of a corporation's stock, long-term debt and retained earnings. Capitalization also refers to the number of outstanding shares multiplied by share price – Liquidity/Exit: event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an exit strategy for an illiquid investment. Liquidity events are typically used in conjunction with venture capital/angel investors or private equity firms, which will aim to reach one within a reasonable amount of time after initially making an investment
  18. 18. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Pre-money vs. Post-money Pre-money The valuation of a business prior to any additional investment of capital Post-money The valuation of the business PLUS additional capital invested
  19. 19. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Valuation & Capitalization (a few equations) (1) Pre-money Valuation = Post-money Valuation – Venture Capital Investment (2) Post-money Valuation = Venture Capital Investment Example: Fund invests $1mm into a company with premoney valuation of $4mm. The Venture fund owns 20% of the company. 1,000,000 / 0.20 = 5,000,000 (3) Share Price = Pre-money Valuation (4) New Shares Issued = Venture Capital Investment Venture Capital Fund Ownership % # Pre-money shares # Shares
  20. 20. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: An Example • StartupZee is a newly formed business and is seeking to raise $1mm seed round in the form of Venture Capital • StartupZee has authorized 10,000,000 shares and have allocated those shares between two co-founders 50/50 • A term sheet is accepted from VeeCee Capital and VeeCee Capital has put the pre-money value of StartupZee at $3mm • So…. – What is the post money? – What % of the company will VeeCee Capital own? – What is the share price? – How many shares will be issued to VeeCee Capital?
  21. 21. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: An Example (contd.) Share Price = Pre-money Valuation/Number of Pre-money shares. 3,000,000 / 10,000,000 = 0.30/share New Shares Issued = Venture Capital Investment/Share Price 1,000,000 / 0.30 = 3,333,333.33 shares Ownership % = shares owned / shares outstanding 3,333,333 /(10,000,000) + (3,333,333) = 25% Post-money Valuation = Venture Capital Investment/Venture Capital Fund Ownership Percentage 1,000,000 / 0.25 = 4,000,000
  22. 22. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Convertible Debt (sidebar) • There are two types of capital: debt & equity • Traditional VC is equity (shares) • Convertible note is technically a primisorry note (debt) • Why use a convertible note? – Bridge loan – simpler way to extend runway for later stage deals – First financing – defers discussion of valuation and retain control • Characteristics – “Converts” from debt to equity in next round of financing – Discount – Valuation Cap
  23. 23. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Example (convertible note) • StartupZee is a newly formed business and is seeking to raise $1mm seed round in the form of Venture Capital • StartupZee has authorized 10,000,000 shares and have allocated those shares between two co-founders 50/50 • A term sheet for a convertible note is accepted – $5mm valuation cap – 20% discount • So…. – What happens when StartupZee raises $3mm Series A at a $6.5mm premoney 18 months later? • How much do the convertible note investors own? • How much do the new Series A Investors own? • How much do the founders own?
  24. 24. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Example (convertible note) • First need to determine the valuation at which the holders of the convertible note convert their debt into equity… • Convert at the lower of either – Series A pre-money with the discount OR – The valuation cap • Discount is 20% – $6.5mm x (1-0.20) = 5.2mm • Valuation Cap = $5mm $5mm valuation for convertible note!
  25. 25. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Example (convertible note) 41% 41% 59% 19% 41% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1 2 New Series A Converted to Series A Total Series A Total Founder Common Note converts into Series A at valuation of $5mm pre-money New Equity (70% of Series A) Converted Equity (30% of Series A)
  26. 26. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Convertible Note, Series A % Ownership Shares outstanding 10,000,000 Valutaion Cap 5,000,000 Series A Premoney 6,500,000 Convert Investment 1,000,000$ Series A Investment 3,000,000$ Convert PPS 0.50$ Series A 0.65$ Convert Shares 2,000,000 12% Series A Shares 4,615,385 28% Total New A Issued 6,615,385 Shares post financing 16,615,385 Founders Shares 10,000,000 60% Series A Share (including convert) 6,615,385 40% TOTAL 16,615,385 100% Seed Equtiy, Series A % Ownership Shares outstanding 10,000,000 Seed Valuation 5,000,000 Seed Investment 1,000,000.00$ Seed Price per Share 0.50$ Seed Shares Issued 2,000,000 17% Founders Common Shares 10,000,000 83% Total Shares Outstanding 12,000,000 100% Series A Valuation 6,500,000$ Series A Investment 3,000,000$ Series A Price per Share 0.54$ Series A Issued 5,538,462 Shares post financing 17,538,462 Founder Shares 10,000,000 57% Seed Shares 2,000,000 11% Series A Shares 5,538,462 32% TOTAL OUTSTANDING 17,538,462 100%
  27. 27. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: YouTube Valuation & Terms • Going to invest $5mm over a two-tranche investment • Milestone specific • Can we back into the valuation? • 5,000,000/0.30 = $16.6mm post-money • $11.6mm pre-money
  28. 28. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Cap Table as a Mathematical Proof EXAMPLE: Cap Table Name Money Shares Current % Post % Founder 1 $ - 3,333,333.33 33% Founder 2 $ - 3,333,333.33 33% Founder 3 $ - 3,333,333.33 33% Total $ - 10,000,000 100% Pre-money $11,600,000.00 Pre-money Price per Share $ 1.160 Investment $ 5,000,000.00 Post Money $ 16,600,000.00 New Investors VeeCee $ - - 0% Total $ - 10,000,000 100% - The knowns or the assumed: - 10mm authorized shares (assumed) - $5mm investment (known) - Investor will own 30% of company after $5mm investment (known) - Option Pool will be 17% of common shares outstanding after investment (known) - Only investor participating in the round (assumed) Post Financing VeeCee $ 5,000,000.00 4,310,345 30% Founder 1 2,523,810 18% Founder 2 2,523,810 18% Founder 3 2,523,810 18% Option Pool 2,428,571 17% Total $ 5,000,000.00 14,310,344.83 100%
  29. 29. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Terms of a deal (things to look for in a term sheet) • Liquidation Preference: – is frequently used in venture capital contracts to specify which investors get paid first and how much they get paid in the event of a liquidation event, such as the sale of the company. • Participating Preferred & Cap: – A cap on participation limits the amount received by the preferred stock to a fixed amount. The cap is typically fixed as a multiple of the original investment, such as 2x or 3x. Once holders of preferred stock have received the cap amount, they will stop participating in distributions with the common stock, or convert. • All preferred shares have the right to convert to common shares on a 1:1 basis • Wait…don’t you just own part of a company and just get that percentage? – Well, sometimes…
  30. 30. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: The Waterfall • Not all exits are as straightforward as they appear • Example: • VC invested $5mm • 1x Liquidation preference • Participation rights with 2x cap • VC owns 40% of company • Company sells for $20mm • What is the return to VC? $10mm!
  31. 31. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 2: Waterfall (contd). • Here is why: Scenario 1: Convert to Common • Always an option • You convert at the rate of 1:1 preferred for common • VC would receive 40% of sale • 40% of $20mm is… $8mm! Scenario 2: Participate Fully • Take your liquidation preference off the top: $5mm • THEN YOU CONVERT and own 40% of remaining common stock or 40% of 15mm. • But capped at 2x of total investment, so… $10mm! Scenario 2: Imagine no cap! • Take your liquidation preference off the top: $5mm • THEN YOU CONVERT and own 40% of remaining common stock (40% of 15mm = $6mm) • But not capped, so VC gets $5mm + $6mm… $11mm!
  32. 32. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 3: The Risks, The Exit & The Recommendation • Should we invest? • What needs to happen to make this work? • What goes wrong? • What type of return can we approximate if all goes well? • What are the factors to closing the deal? – Timing? • Competitive deal • Capital requirements
  33. 33. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 3: The Risks • The 10-k principle – many risks are characterized as the absence of achieving goals • Generic risk vs. specific risk • The known unknowns
  34. 34. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 3: The Exit • Acquisition? IPO? • Use comparable exits of similar companies or multiples of publicly traded companies • Or, just be right, a lot…
  35. 35. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Part 3: The Recommendation
  36. 36. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Conclusion (and some things I did not touch on) • Board of Directors • Term sheet (a deeper dive) • Lead investor vs. Syndicate? • Maybe good content for VC 301? • And….we are done!
  37. 37. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Sources & Recommended Resources References: • YouTube Memo https://www.slideshare.net/zebs/sequoias-investment-memo-on-youtube • Sequoia Capital website: https://www.sequoiacap.com/ Books & Posts • Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist • Term Sheets & Valuations: A line by line look at the Intricacies of Term Sheets and Valuations • Chris Dixon’s Blog post http://cdixon.org/2015/06/07/the-babe-ruth-effect-in-venture-capital/ Blogs & Newsletters • Dan Primack’s Term Sheet • Mark Suster’s Both Sides of the Table • Fred Wilson’s AVC • CB Insights • Product Hunt • The Creator’s Code by Amy Wilkinson • A16z Newsletter Tweets • @awsstartups • @firstround – solid early stage fund, platform • @karaswisher– Re/Code, breaks a lot of news • @benedictevans – A16Z, data hound
  38. 38. © 2017, Amazon Web Services, Inc. or its Affiliates. All rights reserved Pop-up Loft aws.amazon.com/activate @awsstartups @drewWruss Thanks!

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