Anatomy of Term Sheets

ANATOMY OF A TERM SHEET

VENTURE CAPITAL: AN OVERVIEW OF TRENDS,

STRATEGIES AND STRUCTURAL ISSUES

PRESENTED BY

ANDREW J. SHERMAN, ESQ.

Netpreneur Coffee and Doughnuts Event

White Flint Mall

North Bethesda, MD

May 23, 2001

ANDREW J. SHERMAN, ESQ.

McDermott, Will & Emery

600 13th Street, N.W.

Washington, DC 20005

Phone: (202) 756-8610

Fax: (202) 756-8087

ajsherman@http://wendang.chazidian.com

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Venture Capital: An Overview of Trends, Strategies and Structure

Owners and managers of early-stage growing companies often have mixed views toward the institutional venture capital industry. On one hand, they welcome the money and management support they desperately need for growth, but fear the loss of control and various restrictions that are typically placed on the company by the investment documents. In order to achieve the delicate balance between the needs of the venture capitalist and the needs of the company, business owners and managers must understand the process of obtaining venture capital financing.

In general, there are three different types of traditional institutional pools of venture capital, though in recent years the lines between the three may be blurring. These include:

organized as limited partnerships which themselves seek capital from venture investors, trusts, pension funds, insurance companies, among others. They in turn manage and invest in high-growth companies. Venture capital firms tend to specialize in particular niches, either by the business’s industry, territory or stage of development. Their investors expect a certain success Return on Investment (ROI), which is critical to the firm’s future ability to attract additional capital and track record.

national program for licensing privately owned small business investment companies (SBIC). Minority-Enterprise IBIC's were added by a 1972 amendment to the Act. Although the SBIC program has experienced some difficulty, it currently remains an integral part of the organized venture capital community. The program allows the SBA to grant licenses to certain types of venture capital firms that are eligible to borrow money from the Federal Government at very attractive rates in exchange for certain restrictions on deal structures as well as the types of businesses which the SBIC can provide capital.

established by large corporations such as Intel and Motorola, usually in hopes of funding small companies that have technology or resources that larger companies want or need. The investment is often structured more like a quasi-joint venture, because corporate venture capital often brings more to the table than just money, such as access to the resources of these large companies. Corporate venture capital efforts typically revolve around the corporation’s goals to incubate future acquisitions; gain access into new technologies; obtain intellectual property licenses; provide work for unused capacity; technology entrepreneur thinking to current corporate staff; final hours for excess cash; and break into new markets.

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NARROWING THE FIELD

Preparation is the key to obtaining an initial meeting with the institutional venture capitalist. There are three central components to the preparation process: business and strategic planning; effective networking; and narrowing the field.

A well-written Business Plan and financing proposal is a necessary prerequisite to serious consideration by any sophisticated source of capital. Effective networking means using professional advisers, commercial lenders, investment bankers and consultants who may be able to assist you to get the Business Plan into the hands of the appropriate venture capitalists. Institutional sources of capital are often flooded with unsolicited, “non-introduced” plans that are more likely to end up in a wastebasket than before an investment committee. Remember that the average venture capital firm will see thousands of business plans per year, provide a return phone call on only a few dozen candidates and may actually close only four to six deals per annum, so you need to find ways to increase your chance of survival as the field of choices rapidly narrows. Finally, most venture capitalists have certain investment preferences regarding which companies they will include in their investment portfolio. These preferences may be based on the nature of the company's products and services, geographic location, projected rates of return, stage of development or amount of capital required. Rather than waste precious resources by blindly sending business plans to any and all venture capitalists in your region, take the time to research the venture-capital industry to match the characteristics of the proposed investment with the investment criteria of the targeted firm.

It may turn out that your company’s stage of development will determine which kind of venture capital investor you’ll approach, and the structure of the financing you’ll receive, so it’s important to identify which stage of business development financing you require before embarking on the search for capital.

The first level is seed financing, in which small amounts of capital are provided to the company for initial product feasibility studies, development, market research, refinement of strategies and other preliminary analyses.

The next level of financing is start-up or early stage financing, which is generally for completion of product development, recruitment of a management team, refinement of the long-term business plan and the commencement of marketing efforts. Recent capital market trends have had most venture capitalists investing in later-stage companies and companies already in their portfolios, with a greater emphasis on the company's ability to generate current income and return to the investors.

Next is first-stage financing, which usually funds the first phase of the full-scale manufacturing, marketing and sales. It is also at this stage that any missing components of the management team are completed. Second-stage financing is typically for a company that has begun its production and distribution, has established inventories, contracts and accounts receivable, but now needs working capital to fuel expansion. Third-stage financing is usually for a company that is already operating at a profit, but needs capital to research and develop new products, expand its physical facilities or make a significant increase in sales and marketing efforts. Finally, in bridge financing, venture capitalists will provide capital to a company which expects to go public within the next 12 months, but requires WDC99 436028-1.T06139.0012

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additional working capital to bridge the gap. Firms will also consider providing capital to finance mergers and acquisitions, joint ventures, leveraged management, buy-outs or recapitalization, efforts to "go private" or other kinds of transactions, if the return on investment meets their criteria..

PREPARING FOR THE MEETING WITH THE VENTURE CAPITALISTS

If your business plan submission survives the rigid initial review of most institutional venture capital firms, then the key to your first meeting and success thereafter is PREPARATION! Keep in mind the following points:

? court.” This involves different audiences asking different questions, replicating the actual meeting that you’ll have with the managers of the venture capital firm. Make sure your rehearsal audiences (such as lawyers, accountants, business school professors, and entrepreneurs who have raised venture capital) have the background and the training to ask the right questions (including the tough ones) and be able to critically evaluate your responses. Do your homework on the venture capital firm and learn what their “hot buttons” may be so that you can address key issues in your presentation. As the saying goes, “You never get a second chance to make a first impression.” The rehearsals will help you survive the first meeting and get to the next steps. Be prepared for the tough questions and don't be scared, intimidated or upset when the really hard ones start flying at you. If the venture capital firm's team doesn’t ask tough questions, then they are not "engaged" into your presentation. If they are not engaged enough to beat you up a little, then there will probably be no next steps and no deal.

? himself either raised venture capital or been an adviser on or negotiated venture-capital transactions. The mentor or coach can help stay focused on the issues that are important to the venture capitalists and not be wasting their time. The mentor can reassure you during the difficult and time-consuming process, teach you to remain patient, optimistic and level-headed about the risks and challenges that you face.

? (usually 15 minutes is about right). Don’t attempt to “read” every word of your business plan or put every historical fact of your company on a Power Point slide. Keep it crisp and focused and be prepared for questions and to defend your key strategic assumptions and financial forecasts. Remember that every minute counts. Even the small talk at the beginning of the meeting is important because the seasoned venture capitalist is sizing you up, learning about your interests and looking for the chemistry and the glue that is key to a successful relationship.

? component of the evaluation. In many cases it can be the most important factor considered in the final decision. The four “Cs”—camaraderie, communication, commitment and control (over your ego)—may make or break the outcome of the meeting. Any experienced venture WDC99 436028-1.T06139.0012

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capitalist will tell you that, at the end of the day, the decision depends on the strength of the people who will be there day to day to execute and manage the future of the company. The venture capitalist will look for a management team that’s educated, dedicated and experienced (and ideally has experienced some success as a team prior to this venture). The team should also be balanced, with each member's skills and talents complementing each other so that all critical areas of business management are covered—from finance to marketing and sales to technical expertise.

? impression in their initial meeting with the venture capitalist because they come on too strong or not strong enough. The experienced venture capitalist wants to see that you have a passion and commitment to your company and to the execution of the business plan. However, he or she does not want to be oversold or have to deal with an entrepreneur who is so enamored of an idea or plan that he or she can’t grasp its flaws or understand its risks.

? will look to measure your personal sense of commitment to the business and its future. Generally, venture capitalists won’t invest in entrepreneurs whose commitment to the business is only part-time or where their loyalty is divided among other activities or ventures. In addition to fidelity to the venture, the investor will look for a high energy level, a commitment to achievement and leadership, self-confidence, and a creative approach to problem solving. You will also have to demonstrate your personal financial commitment by investing virtually all of your own resources into a project before you can ask others to part with their resources. Remember, any aspect of your personal life, whether it’s good, bad or seemingly irrelevant, may be of interest to the venture capitalist in the interview and due diligence process. Don’t get defensive or be surprised when the range of questions are as broad as they are deep—venture capitalists are merely trying to predict the future by learning as much as possible about your past and current situation.

? firms is if you try to hide something from your past or downplay a previous business failure.

A seasoned venture capitalist can and will learn about any skeletons in your closet during the due diligence process, and will walk away from the deal if they find something that should have been disclosed to them at the outset. A candid, straightforward channel of communication is critical. A previous business failure may be viewed as a sign of experience, provided that you can demonstrate that you’ve learned from your mistakes and figured out ways to avoid them in the future. On a related note, you must demonstrate a certain degree of flexibility and versatility in your approach to implementing your business plan. The venture capitalists may have suggestions on the strategic direction of the company and will want to see that you are open-minded and receptive to their suggestions. If you’re too rigid or too stubborn, they may view this as a sign of immaturity or that you’re a person with whom compromise will be difficult down the road. Either one of these can be a major deal “turn-off” and a good excuse to walk away.

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