Introduction to Venture Funding

April 14, 2022

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Table of Contents

1) Spectrum of Capital
2) What is Venture Capital?
3) Overview of the Venture Funding Process
4) How Do I Value My Company?
5) How Venture Rounds Work
6) Key Venture Concepts Explained
7) What Do I Need to Know About a Capital Table?
8) Convertible Notes & SAFEs
9) Summary & Key Takeaways

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The Spectrum of Capital

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What is Venture Capital

Stages of Venture Capital

• Venture capital is a form of Product

financing that provides equity Development /
capital to early-stage Idea Market Fit Growth Expansion Maturity
• Venture capitalists take the risk of
investing in startup companies,
with the hope that they will earn
high returns as portfolio
Expansion
companies achieve growth
milestones and ultimately result in
successful exits in the form of
M&A or IPO
Growth
• Venture capital funds are designed
to invest in high-risk companies in
exchange for equity ownership Concept
that offer high return potential
• When choosing companies to
invest in, venture capitalists
consider the company’s growth
potential, the strength of its Pilot Test
Roll Out
management team, and the
intellectual property or Early Stage Late Stage
Pre-Seed Seed (Series A / B) (Series C+) Exit
uniqueness of a company’s
$0-$1M $1M-$5M $5M-$25M $25M-$100M+ (IPO / M&A)
products or services

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The Venture Capital Food Chain

Limited Partners VCs Entrepreneurs

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The Power Law of Venture Capital

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 The Power Law in Practice

What the power law

means for investors

-Mike Maples, Floodgate, Inside the Black Box of

Venture Capital

Key Conclusion: VCs are paid to take high risk for high return to create massive outcomes that make the model
work 7
Overview of the Venture Funding Process

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• The introductory meeting where the investors and founders meet for the first time
• The founders present the company pitch, which discusses the problem / opportunity, company solution,
Company Pitch
business model, GTM strategy, competitive landscape, financial projections etc.
• During this meeting both founders and investors determine whether there is a “fit” culturally

2 • Investor performs deep dive analysis on the target company and sector
• Investor “underwrites” all potential sources of risk (i.e., market risk, technology risk, IP risk, execution risk etc.)
Due Diligence associated with the investment to ensure that return potential is commensurate with the risk profile
• Investor performs expert interviews, customer calls, supplier calls and looks into the background of the
founders in order to determine whether or not the target company is a sound investment

3 • Once the VC investor determines that they would like to invest in the company, they will present a term sheet
to the founders indicating their offer
• Term sheets govern the parameters of a preferred equity investment including the pre-money valuation of
Term Sheet your business, investment size, liquidation preference and a number of other possible terms related to
liquidation, pro rata rights, anti-dilution rights etc.
• In order to negotiate successfully throughout the term sheet process, founders must think like investors and
know their value to strike the right balance between pre-money valuation and % dilution

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What to Include in Your Company Pitch?

1) Problem / Opportunity –is there a defined customer need that is being addressed?
2) Value Proposition – How does your company/business address that problem? What is PMI…
3) Underlying Magic (Special sauce, IP, uniqueness…) What is so compelling to our customers?
4) Business Model – how do you monetize your business? Recurring revenue?
5) Go-to-Market Plan – Direct sales / in-direct sales
6) Competitive Analysis – What are other people doing about the problem (incumbents)? What are we
doing differently (better, faster, cheaper)?
7) Management Team
8) Financial Projections & KPIs
9) Current Funding Status – Fundraising ask; what we will look like post your investment

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Valuation: How to Value Your Company?

• When VC investors think about valuation, it is often connected to some type of multiple (i.e. revenue multiple)
• Venture backed companies are almost always valued on a multiple of Revenue, so…
o Enterprise Value = Revenue X Multiple
o The Multiple will be informed by a company’s key attributes (i.e., revenue growth, margin profile, market
dynamics, business model, management team, technology / IP, capital intensity, sales cycle etc.) and how
those attributes compare to publicly traded peer companies or precedent transactions
o Industries will typically trade in a defined range on a forward revenue multiple, for example mature
Enterprise Software companies trade at (6.0x – 8.0x) 2022E Revenue, whereas high growth Software
companies trade at (10.0x – 15.0x) 2023E Revenue
o Revenue will typically reflect a 1-2 year forward estimate depending on the maturity of the industry and/or
growth profile of the companies within a given sector

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Valuation: Early Stage vs. Growth/Late Stage Companies
Early Stage Company Characteristics Late Stage Company Characteristics
• Early stage companies with very little track record • Later stage companies with historical financials
• Can be pre-revenue; definitely pre-cash flow • Generate revenue and cash flow
• Large addressable market • Generally more mature market or industry
• High growth market or industry • Stable growth and attractive margin profile
• Generally valued on Revenue multiple (EV / Revenue) • Can be valued on Revenue (EV / Revenue) or EBITDA
based on public company peers multiple (EV / EBITDA)
Early Stage Venture Capital Investor Consideration Late Stage Venture Capital / PE Investor Consideration
• What do I think the company is worth today (entry value)? • What is the least amount of equity required to achieve a
• What are my expectations for future growth (exit value) minimum 10x MOIC return?
and dilution potential (subsequent funding rounds)? • How much leverage (debt) can be put on the business to
• Can my $X investment earn a 10x MOIC return? increase the chances of achieving a min 10x return?
• Levers of Value Creation: • Levers of Value Creation:
― Team: Quality of management team ― Revenue Growth: organically or through acquisition
― Technology: Intellectual property (IP) ― Margin Expansion: Reduce COGS or SG&A to
enhance margins
― TAM: Market dynamics (Total Addressable Market)
― Cash Flow: Reduced CapEx to grow cash flow
― Traction: Business model / Go-to-Market strategy
― Multiple Expansion: Achieved by enhancing financial
profile, entering new markets or eliminating risk

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Valuation: Comparable Company Analysis

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 Valuation: Venture Capital Method
How does this work in practice from the investor perspective…

1• If we invest $1M in Company A

today, what do we have to believe
about Company A’s value at the
time of exit in order to achieve a
10x return on invested capital (i.e.,
$10M)?
2• We model out the companies
potential revenue growth, via lots of #2
analysis and assumptions, in this #1
case assuming $20M
Peer Multiple 1.5X #3
3• …and analyze and make
assumptions about a multiple of #4
revenue (1.5x)….
4• To form an opinion on a value at exit
($30M)
5• And then calculate our ownership #5
stake (33%) and the corresponding
valuation ($2M)

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How Venture Funding Rounds Work

$2.5M
Founder Ownership: 66%
New Investor Ownership: 33%
$7.5M
=$3M
$1M
invested
$2M pre-$

Thinking About Valuation, Mark

Suster
What this looks like over time
IPO, Acquisition, or Sale

Asset Sale, Bankruptcy

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A Few Key Concepts Explained TBU – JH to adjust
formatting

Dilution
I owned 66% before the round, and have just been
diluted by 25%.
New post-money valuation New Investor Ownership
My new ownership is:
66% * (1-25%) = 49.5%
$2.5M+$7.5M = $10M $2.5M/$10M =25%
Pro Rata
Some current investors might have rights to maintain their
ownership. In this case if the current investor invested their
pro rata they would invest:

33%*$2.5M =$825k of the round

Common vs. Preferred Stock

Common Stock: security typically owned by founders and
employees, does not have the same rights, preferences as
preferred which is the class of stock purchased by investors

Employee Option Pool

So far, our very simple example has not included an option pool,
which is ownership for employees, this is a pool of common stock
to be given to employees
Capital Table Example #1 – No Venture Debt
Founders must understand ownership dilution potential associated with taking on external capital…

Assumptions: Company Valuation:

• Consider the scenario under which a Enterprise Value $100,000,000
company has no external investors Total Debt $0
• Debt: $0 Equity Value $100,000,000
• Preferred Equity: $0 Total Shares Outstanding 9,200,000
Price per Share $10.87
Key Takeaways:
• Debt holders have the highest
seniority on the capital table and are Value of Employee Stock Options $7,043,478
the first to get paid out in a
liquidation scenario Company Capital Table:
• Preferred equity investors are junior Common Preferred Total Invested %
to debt holders and senior to Strike Price Shares Shares Shares Capital Ownership
common equity holders, meaning
Debt Capital:
that they get paid out after debt and
before common equity investors Senior Debt - - - $0 0.0%
Total Debt - - - $0 0.0%
• Common equity is the last security
to get paid out on the capital table
Equity Capital:
• Employee #1 maintains a 13.0%
Founder 8,000,000 - 8,000,000 87.0%
equity ownership valued at $7.0M
Employee #1 Stock Options $5.00 1,200,000 - 1,200,000 13.0%
Venture Capital Investor - - - $0 0.0%
Total Equity 9,200,000 - 9,200,000 $0 100.0%

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Capital Table Example #2 – with Venture Debt
Venture debt investors have highest seniority; venture equity investors are junior to debt holders and
senior to common equity holders and therefore dilute founder ownership
Assumptions: Company Valuation:
• Consider the scenario under which a Enterprise Value $120,000,000
company has chosen to take on Total Debt $20,000,000
external capital from debt and
Equity Value $100,000,000
venture capital investors
Total Shares Outstanding 11,600,000
• Debt: $20M
Price per Share $8.62
• Preferred Equity: $14.4M
Key Takeaways: Value of Employee Stock Options $4,344,828
• Debt holders have the highest
seniority on the capital table and are Company Capital Table:
the first to get paid out in a
Common Preferred Total Invested %
liquidation scenario
Strike Price Shares Shares Shares Capital Ownership
• Preferred equity investors are junior
Debt Capital:
to debt holders and senior to
common equity holders, meaning Senior Debt - - - $20,000,000 0.0%
that they get paid out after debt and Total Debt - - - $20,000,000 0.0%
before common equity investors
• Common equity is the last security Equity Capital:
to get paid out on the capital table Founder 8,000,000 - 8,000,000 69.0%
• Employee #1 maintains a 10.3% Employee #1 Stock Options $5.00 1,200,000 - 1,200,000 10.3%
equity ownership valued at $4.3M Venture Capital Investor $6.00 - 2,400,000 2,400,000 $14,400,000 20.7%
Total Equity 9,200,000 2,400,000 11,600,000 $14,400,000 100.0%

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A Quick Note on Convertible Notes and SAFEs

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• What we have been talking about today
Priced Equity • Comes with additional terms/rights typically related to the security: liquidation preference, anti-dilution,
Rounds investor rights, etc.
• Sets a definitive price on the value of the company

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• Debt instrument that converts into the next equity round of financing
Convertible Notes • Often carries an interest rate (~8%) and sometimes includes a cap
• Often used as a “bridge” between two rounds of equity financing

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• Simple Agreement for Future Equity
• Converts into the next round, like a convertible note, but is not a debt instrument
SAFE
• Most times has a valuation cap
• Common amongst early-stage companies due to limited expense, and minimal negotiations
Class Summary & Key Takeaways

1) Spectrum of Capital
• There is a spectrum of financing options available to early stage companies
• Different type of capital (equity vs. debt), size of investment, and type of investor (angel, venture capital fund, growth investor, etc.) as
your company scales
2) What is Venture Capital?
• Venture capital represents preferred equity ownership in a company of a specific size and profile (startups)
• Venture capital investors expect to earn a 5x-10x+ returns in order to justify the early stage risk that they are taking on
3) Venture Funding Process
• Knowing your levers of value (TAM, Team, Technology, Traction) helps you to pitch your company and is instrumental in Term Sheet
negotiations
• Understanding the tradeoffs between valuation (pre-money value) and dilution (round size) and other key negotiation points to ensure
that you A) do not give up too much of your company or B) do not price your company so high that it is no longer attractive for future
funding rounds
4) How Do I Value My Company?
• Understanding how an investor will value your business (Comps analysis, value at exit reverse engineered to today)
5) What Do I Need to Know About a Capital Table?
• Venture capital is inherently dilutive to a founder’s equity ownership
• Key concepts (Common Equity, Preferred Equity, Employee Option Pool, Employee)
Appendix

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Venture Capital Resources
General Venture Valuation
• Investors and their Incentives, Aaron Harris • Valuation, Fred Wilson
• How to be an Angel Investor, Paul Graham • Valuing Pre-Revenue Companies, Kauffman Foundation
• Elements of Enduring Companies, Sequoia Capital • Methods for Valuation of Seed Stage Startup Companies, Angel Capital
• Writing a Business Plan, Sequoia Capital Association Valuations 101: The Venture Capital Method, Bill Payne’s Blog on
• Startup Advice, Sam Altman Gust.com
• Inside the Blackbox of Venture Capital, Mike Maples of Floodgate
• Think Big But Start Small, Jim Goetz of Sequoia Capital Convertible Debt
• Series Seed: Version 3.1 standard seed term sheet and deal documents, (Links to • Everything You Ever Wanted to Know About Convertible Note Seed Financings
an external site.)Links to an external site. June 2013 (But Were Afraid To Ask), Walker Corporate Law
o Part 1 (Links to an external site.)Links to an external site.,
Financials for VC 101or VC 101: o Part 2 (Links to an external site.)Links to an external site.,
• How to Calculate a Return on Investment (ROI), Fred Wilson o Part 3 (Links to an external site.)Links to an external site.,
• Time Value of Money, Fred Wilson
• Analyzing Financial Statements, Fred Wilson Convertible Debt vs. Equity
• Opportunity Costs, Fred Wilson • Raising Angel Money, (Links to an external site.)Links to an external site. Mark
• Enterprise Value & Market Value, Fred Wilson Suster, July 2009
• Employee Equity: Vesting, Fred Wilson • Is Convertible Debt Preferable to Equity? (Links to an external site.)Links to an
• Margins, Fred Wilson external site. Mark Suster, August 2010
• Financing Options for Startups, Fred Wilson
• EBITDA, Fred Wilson
• Cap Tables, Fred Wilson
• Burn Rate, Fred Wilson
• Revenue Models, Fred Wilson
• Revisiting The Term Sheet, Brad Feld
• Convertible Debt, Fred Wilson