What Drives Venture Capital?
A Perspective From Both Sides of the Table
Paul Vroomen
1
Agenda
1. Introduction
2. How Venture Capital Works
– The Impact of Internal Rate of Return Expectations
3. Case Study: Sandbridge Technologies, Inc.
– A $15M Powerpoint Presentation
4. The Future of Venture Capital
– Big Changes Coming….
2
Thought Experiment
You are an entrepreneur….
– You have worked for 10 to 12 hours per day, often 7 days a
week for the past 3 years,
– You have risked your entire personal savings,
– You have endangered your marriage,
– You see your kids mostly just before they fall asleep,
– You have questioned your own sanity,
But, you finally have a working prototype….
3
The Entrepreneur’s View
What??
– They want 10X return on their money?
– They want 65% ownership of my company?
– They want a controlling vote on the Board of Directors?
– They want to be paid their money first before anyone else
gets anything, even me, the founder, if we sell the company?
Vulture Capitalists!!
4
The Venture Capitalists View
This guy has a good idea , BUT:
– He has no CEO track record and has never run a company before
– His executive team has significant holes (especially in marketing)
– The company’s business plan is way too optimistic, especially given
that it has missed critical milestones, twice
– They have one significant customer, but that customer is known for
collaborating with innovative start-ups and then doing their own thing
I will ensure that our term sheet enables me to protect my
capital and is structured so that I can direct the CEO to
correct the issues with the company or replace him with
someone that can if he does not!
5
The Primary Reason
Cumulative Cash Generated/Consumed
15
10
5
$Million
0
0 1 2 3 4 5 6 7 8 9 10
-5
-10
-15
Years from Initial investment
Entrepreneur's View Venture Capitalist's View
The Entrepreneur, by definition, is an optimist
The Venture Capitalist, by experience, is a pessimist
The partnership of the two can work, sometimes spectacularly,
if each understands what is driving the other. 6
How Venture Capital Firms Work
Limited Partners Venture Fund Private Equity
All Accredited Committed Capital Portfolio
Investors $(x+y+…+z)
Investor 1 Mgt. Fee ~2%p.a.
$xM $aM Company 1
Investor 2 $yM $bM
Venture Company 2
Capital
Firm
Managed by
$zM General Partners $uM
Investor n Company k
c.Surplus
Liquidity Event
Base+(1-c).Surplus
C = “Carry” = 20% - 35% 7
EBO and VC Historical
Performance
Source: US Venture Capital Index and Selected Benchmark Statistics, June 2014, Cambridge Associates, LLC
IRR: Net cash on cash returns to Limited Partners (after deduction of management fees and carry percentages)
AVERAGE IRR (1999-2009) AVERAGE IRR (1999 -2009)
Electronics: -0.54% Information Technology: 24.23%
Financial Services: 14.42% - Internet-Business: 23.2%
BioTech: 16.04% - Internet-Commerce: 37.8%
8
Implications of IRR Expectations
Required capital growth to achieve IRR:
Time from 5 Years 7 Years 10 Years
investment:
IRR: 25% 3.0X 4.8X 9.3X
IRR: 33% 4.2X 7.4X 17.3X
IRR: 50% 7.6X 17.1X 57.7X
To achieve 33% IRR, a $1 investment needs to grow to $7.40 in 7 years.
9
Typical VC Fund Performance
Ten year VC fund that returned 3X net to limited partners
from a portfolio of 20 companies:
• Received proposals from >1,000 companies per year
• Agreed to view presentations from 300+ companies per year
• Performed Due Diligence on 30 companies per year
• Invested in 3 - 4 companies per year (during first 5 years of fund)
• 10 companies were shut down within 3 years of initial investment
• 6 companies were acquired within 3-7 years and returned sufficient to
recover capital
• 3 companies were acquired within 3-7 years and returned 1.5X to 5X
• 1 company returned >38X in 8 years (IPO - Home Run!)
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Sandbridge Technologies, Inc.
Company/Team:
- Fabless semiconductor company based in White Plains, NY
- Founded in 2002 by 2 veteran IBM TJ Watson Research Center engineers
- Team of 55 experienced semiconductor and software engineers
• Product:
- Multi-threaded, multi-CPU DSP chip for mobile phone baseband applications
- Automatically adapts to the protocol in which the phone was operating.
• Customers:
- Multi-million dollar contractual partnership with one of the world’s top three cell
phone makers.
• Intellectual Property:
- 25 granted patents and 20 pending or provisional patents
11
By late 2008, Sandbridge had consumed $53M
in 3 VC funding rounds and needed a further
$15M for the commercialization phase
The $15M Presentation…
12
Sandbridge Technologies, Inc.
But things change quickly! By late 2009:
• The company’s primary customer and software partner had withdrawn from the
partnership – it had quietly built its own chip in parallel with the partnership
• The software team was behind schedule in delivering the broadband communications
software stack; PC dongle and femtocell markets were well below forecast
• The company was scrambling to identify and negotiate partnership agreements with
software partners for cellular protocol software development
• To generate short term revenue the company was negotiating license agreements
with several interested parties.
• The Board of Directors had decided that the company should focus on identifying
potential M&A transactions
13
Sandbridge Technologies, Inc.
Conclusion
• Company was sold for an aggregate of $55M in several transactions in late 2009
and early 2010.
• All employees were hired by two licensees of the company’s technology
• One licensee also acquired the right to deploy the original chip in electronic
systems in China and is using it in “home gateway” applications
• Management received a “carve out” from the proceeds of the sale
• C Round Investors received a 1.6X return on their investment of $35M in 3 years,
for an IRR of 16%; Venture Funds in the Electronics industry returned (4.9%) in
2010.
• Everyone was happy.
14
Big Changes Are Coming to the
Private Equity Investment World….
15
Why?
Security Token Offerings (STO) create a
new asset class in private equity:
Crowd Funding (CF)
16
Crowd Funding Growing Rapidly
Crypto-token (ICO + STO) Crowd Funding
2015 2016 2017 2018 (to
9/21)
No. of 0 50 371 785
ICOs/STOs
Amount - 0.098 6.24 20.033
Raised ($B)
Source: coinschedule.com/stats
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Why ECF/ICO Growth?
• REACH:
– Online – investors and issuers worldwide can participate
– Not limited to accredited investors – access to larger amount of
capital
• LIQUIDITY:
– ECF smart contracts/ICO tokens can be bought & sold at will (for
now)
– JOBS Act mandates 1 year holding period
• TRANSACTION COST
– Standardized terms – reduces legal expense
– Smart contracts – reduces investor management expense
– Transaction fees lower than traditional financing cost
• TIME TO MONEY
– Financing campaign can be completed in days, even hours.
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Private Equity Model Changing
Limited Partners Venture Fund Private Equity
All Accredited Committed Capital Portfolio
Investors $(x+y+…+z)
Investor 1 Mgt. Fee ~2%p.a.
$xM $aM Company 1
Investor 2 $yM $bM
Private Company 2
Equity
Firm
Managed by
$zM General Partners $uM
Investor n Company k
c.Surplus
Liquidity Event
Base+(1-c).Surplus
C = “Carry” = 20% - 35% 19
The New Private Equity Investment Model
Investors Online Intermediary CF
Accredited and
Non Accredited Transaction Portfolio
Investors Fee
Intelligent
Investor Decision $xM - TF Issuer 1
Group 1 $xM Support
System
Investor $yM $yM - TF Issuer 2
Group 2
Dividends
ICO/ECF
Web
Platform
$zM $zM - TF
Investor
Group n Issuer k
c.Surplus
Base + Surplus Liquidity Event
c = “Intermediary Commission %” 20
The Problem
How to enable a large, diverse set of non-expert
investors to identify investment opportunities that
are likely to succeed, from a large, diverse set of
privately held companies of different size, stage
and quality?
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A Solution
• Create an Intelligent Decision Support
System (IDSS) drawing on:
• Private Equity Investment Practice
• Finance Theory
• Statistical Learning Algorithms & Processes
• Decision Support Systems Engineering
• Deploy the IDSS as a tool to support
investors and issuers on a web based
Crowd Funding Platform (CFP)
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IDSS Overview
Stage 1 Can the enterprise yield an
Evaluate acceptable rate of return?
No Revise
/Reject
Yes
Does the enterprise have the
Stage 2
team, market and products to
Verify credibly achieve the rate of
return?
No
Revise
/Reject
Yes
Accept 23
What is an “Acceptable Rate of
Return”?
• Apply:
– Finance Theories
• Modern portfolio theory
• The theory of efficient markets
– Statistics:
• The central limit theorem
– Historical IRR data for large datasets of: Equity Funds, VC Funds
(Cambridge Associates), Angel Investments (AIPP)
• To Determine:
– The optimum risk-reward “frontier” for the Private Equity market
• The efficient frontier
– The target IRR for an efficient CF portfolio and consequently,
individual CFF investments
24
Efficient Frontier: Equity Market
At 10% higher risk for ECF, the expected IRR target for an
efficient portfolio of ECF assets is >= 28% with 99% confidence
25
CF Investment Risk
Angel • 2 out of 3 angel investments lose money
Investments • 1 out of 2 angel investments written off
are Risky….
1,137 AIPP exited
angel investments:
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IRR = -100%: 46.7%
-100%<IRR <= 0%:
20.1%
CF Investments are riskier than Angel Investments:
•Reduced Control – “micro” shareholders
•Reduced Visibility – information asymmetry
•Possible (Likely?) Regulatory Constraints – JOBS Act
•Increased Moral Hazard 26
Implications
Bio-Sciences Start-Up
Accelerated Growth Plan
•Seed Round ($0.5M in Q1)
•2 VC rounds ($2.5M Q3, $5M Q6; 1X liquidation
preference)
•Target portfolio IRR is 35%; 45% productive =>
target investment IRR = 58%
•Valuation: 12x rolling average of future 4 quarter
cash flow
Demonstration: Stage 1 27
IDSS Overview
Stage 1 Can the enterprise yield an
Evaluate acceptable rate of return?
No Revise
/Reject
Yes
Does the enterprise have the
Stage 2
team, market and products to
Verify credibly achieve the rate of
return?
No
Revise
/Reject
Yes
Accept 28
IDSS Functional overview
Industry Metrics Issuer
Issuer Industry Database:
Business Plan
Database •Public company valuation
Stage 1 data
Evaluate Modified
•Industry TAM, ratios
Industry Calculate IRR
Business Plan
Database
YES
NO NO
Adjust
Feasible? Reject
Plan?
YES Issuer Database:
•4 +year revenue, cash flow
Classifier Classifier Issuer forecast
Database Attributes Database •20 attributes
Stage 2
Verify Optimal Classify
Modified Classifier Database:
Classifier Attributes •Training and test set
YES NO, Red
Green Red, Adjust Reject
Yellow Attributes?
NO, Yellow Review
Accept
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Statistical Learning Process
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Attribute Selection
1. Create preliminary set based on domain knowledge (15 attributes)
1. Interview domain experts (3 VC General Partners, 3 CFOs (1 large, 2
small companies) and add if not identified in 1. (18 attributes)
1. Extract attributes from the research literature and add if not identified
in 1, 2. (31 attributes)
a. Identify research papers from peer reviewed journals containing statistically
significant correlation between attributes and success
b. Rank research papers by citation rate (citations/year)
c. Starting at highest ranked article extract attributes if not already identified in 1,2
d. Repeat until no new attributes are found
2. Analyze attributes to eliminate redundancy or correlation (21
attributes)
31
Attribute set
32
Attribute Quantification
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Performance
Accuracy (true positives plus false yellows): 64%
Room for performance
improvement with
more data
At ~ 60 instances,
Error Rate
(17,20)
synthetic model error
rate approaches Bayes
error within 5%
(current dataset has 17
balanced instances)
Sam rib utes
p le S e r of Att
ize b
Num
Learning curves for kNN algorithm
(synthetic model, uncorrelated attributes) 34
Vroomen Capital, Inc. Proprietary & Confidential
Key Outcomes
1. Accuracy (true positives plus false yellows):
64%
2. Accuracy will improve with a larger training
set – learning curve
3. 94.5% confidence that IDSS performs better
than random selection
4. Stage 1: 99% confidence that IRR target for
CF assets is >= 28% at 10% higher risk
5. Stage 2: >98% confidence kNN (k=1)
performs best for current data set
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Conclusion
The private equity industry is on the verge of
facing the same disruption that the Internet has
brought to the music industry, the airline
industry, the hotel industry, the car rental
industry,…...
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Appendix
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Initial Coin Offerings: Background
• Issuer offers a pre-determined quantity of its own crypto-currency
“tokens” (mostly on Ethereum) – these are NOT share certificates
• Investors offer to buy a fixed number of tokens at a fixed price in a
Dutch auction
• Transaction is recorded on a blockchain (again, mostly the Ethereum
blockchain) – significantly reduces transaction cost
• The tokens are liquid and so can be bought and sold directly between
sellers and buyers
• So far ICOs not regulated by JOBS Act or SEC in the US (but see: https
://www.nytimes.com/2017/07/25/business/sec-issues-warning-on-initial-coin-offerings.html)
• ICOs experiencing rapid growth: >$1.2B raised so far in 2017 (>10X
entire 2016)
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JOBS Act, Title III: Background
• Passed in both Houses of Congress in early 2012 with large bipartisan and
private equity industry support
– Signed into law by President Obama on April 5, 2012
– Recorded in Federal Register on January 30, 2016
• Enables privately held companies to publicly solicit up to $1M per year in equity
financing by issuing securities to an unlimited number of investors.
• Opens up private equity investment to non-accredited investors
– Accredited investor: Net worth >$1M; Annual Income >$300K
– Only 2.6% of the US population qualify as accredited investors
• Caps the amounts that non-accredited investors can invest
– $5,000 per year if Net Worth <$100K; Annual Income <$100K
– $10,000 per year if Net Worth >$100K per year; Annual Income >$100K per year
• Requires ECF transactions to be conducted by a web based Intermediary that
ensures transactions conform to the requirements of the Act and the SEC
regulations governing such transactions.
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Biography – Paul Vroomen
• MSEE, MBA, PhD (Technology & Information Management, UCSC)
• Chip Designer - first 7 years out of college
• Business Unit VP/GM - 3 Public Companies
Zilog, Inc. – Microprocessors; VLSI Technology, Inc. – Satellite TV.; Oak
Technology, Inc. – HDTV/DVD.
• President/CEO - 3 Venture funded Start-ups
SandCraft, Inc. - Datacom; Connex Inc. - HDTV; Sandbridge Inc. – Mobile Phone
• Executive-In-Residence
Tallwood Venture Capital, LLP
• Raised $73M in Venture Capital funding
• Co-Board and Board member at 7 companies
• Currently working on next start-up – Fintech (ICO/Equity
Crowdfunding Platform); Member of Sand Hill Angels
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