VC 201: The Investment Memo

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VC 201: The Investment Memo (and what you should understand as
a Founder)
Drew Russ
Principal, Startup & Venture Capital, Business Development
@drewWruss

About Me

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

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!)

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

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

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

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

Part 1: The Purpose (problem & solution)

Part 1: Is it Widespread?
Market specifically targeted by your
product
Total Market Demand
Market Share of SAM

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

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

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)

Part 2: Sales & Distribution
• Monetization = how you generate
revenue
• Youtube:
– Advertising
– Pay-for distribution
– Premium content
– Premium features
Advertiser
Viewer
Content
Creator
Youtube

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…

Part 2: Team (contd.)

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

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

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

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?

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

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

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?

• 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!

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)

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%

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

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%

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…

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!

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!

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

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

Part 3: The Exit
• Acquisition? IPO?
• Use comparable exits of similar companies or multiples of publicly traded
companies
• Or, just be right, a lot…

Part 3: The Recommendation

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!

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

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@awsstartups
@drewWruss
Thanks!

VC 201: The Investment Memo

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