Some Basics of Venture CapitalMichael KearnsChief Technology OfficerSyntek CapitalOutline• The basics: how VC works• Case study: DDoS defense companiesWhat is Venture Capital?• Private or institutional investment (capital) in relatively early-stage companies (ventures)• Recently focused on technology-heavy companies:– Computer and network technology– Telecommunications technology– Biotechnology• Types of VCs:– Angel investors– Financial VCs– Strategic VCsAngel Investors• Typically a wealthy individual• Often with a tech industry background, in position to judge high-risk investments• Usually a small investment (< $1M) in a very early-stage company (demo, 2-3 employees)• Motivation:– Dramatic return on investment via exit or liquidity event:• Initial Public Offering (IPO) of company• Subsequent financing rounds– Interest in technology and industryFinancial VCs• Most common type of VC• An investment firm, capital raised from institutions and individuals• Often organized as formal VC funds, with limits on size, lifetime and exits• Sometimes organized as a holding company• Fund compensation: carried interest• Holding company compensation: IPO• Fund sizes: ~$25M to 10’s of billions• Motivation:– Purely financial: maximize return on investment– IPOs, Mergers and Acquisitions (M&A)Strategic VCs• Typically a (small) division of a large technology company• Examples: Intel, Cisco, Siemens, AT&T• Corporate funding for strategic investment• Help companies whose success may spur revenue growth of VC corporation• Not exclusively or primarily concerned with return on investment• May provide investees with valuable connections and partnerships• Typically take a “back seat” role in fundingThe Funding Process: Single Round• Company and interested VCs find each other• Company makes it pitch to multiple VCs:– Business plan, executive summary, financial projections with assumptions, competitive analysis• Interested VCs engage in due diligence:– Technological, market, competitive, business development– Legal and accounting• A lead investor is identified, rest are follow-on• The following are negotiated:– Company valuation– Size of round– Lead investor share of round– Terms of investment• Process repeats several times, builds on previous roundsDue Diligence: Tools and Hurdles• Tools:– Tech or industry background (in-house rare among financials)– Industry and analyst reports (e.g. Gartner)– Reference calls (e.g. beta’s) and clients– Visits to company– DD from previous rounds– Gut instinct• Hurdles:– Lack of company history– Lack of market history– Lack of market!– Company hyperbole– Inflated projections– Changing economyTerms of Investment• Initially laid out in a term sheet (not binding!)• Typically comes after a fair amount of DD• Valuation + investment à VC equity (share)• Other important elements:– Board seats and reserved matters– Drag-along and tag-along rights– Liquidation and dividend preferences– Non-competition– Full and weighted ratchet • Moral: These days, VCs extract a huge amount of control over their portfolio companies.Basics of Valuation• Pre-money valuation V: agreed value of company prior to this round’s investment (I)• Post-money valuation V’ = V + I• VC equity in company: I/V’ = I/(V+I), not I/V• Example: $5M invested on $10M pre-money gives VC 1/3 of the shares, not ½• Partners in a venture vs. outright purchase• I and V are items of negotiation• Generally company wants large V, VC small V, but there are many subtleties…• This round’s V will have an impact on future rounds• Possible elements of valuation:– Multiple of revenue or earnings– Projected percentage of market shareBoard Seats and Reserved Matters• Corporate boards:– Not involved in day-to-day operations– Hold extreme control in major corporate events (sale, mergers, acquisitions, IPOs, bankruptcy)• Lead VC in each round takes seat(s)• Reserved matters (veto or approval):– Any sale, acquisition, merger, liquidation– Budget approval– Executive removal/appointment– Strategic or business plan changes• During difficult times, companies are often controlled by their VCsOther Typical VC Rights• Right of first refusal on sale of shares• Tag-along rights: follow founder sale on pro rata basis• Drag-along rights: force sale of company• Liquidation preference: multiple of investment• No-compete conditions on founders• Anti-dilution protection:– Recompute VC shares based on subsequent “down round”– Weighted ratchet: use average (weighted) share price so far– Full ratchet: use down round share price– Example:• Founders 10 shares, VC 10 shares at $1 per share• Founder issues 1 additional share at $0.10 per share• Weighted ratchet: avg. price 10.10/11, VC now owns ~10.89 shares (21.89 total)• Full ratchet: VC now owns 10/0.10 = 100 shares (out of 111)– Matters in bridge rounds and other dire circumstances• Right to participate in subsequent rounds (usually follow-on)• Later VC rights often supercede earlierWhy Multiple Rounds and VCs?• Multiple rounds:– Many points of valuation– Company: money gets cheaper if successful– VCs: allows specialization in stage/risk– Single round wasteful of capital• Multiple VCs:– Company: Amortization of control!– VCs:• Share risk• Share DD– Both: different VC strengths (financial vs. strategic)So What Do VCs Look For?• Committed, experienced management• Defensible technology• Growth market (not consultancy)• Significant revenues• Realistic sales and marketing plan (VARs and OEMs vs. direct sales force)Case Study: DDoS Defense Technology• DDoS: Distributed Denial of Service• Web server, router, DNS server, etc. flooded with automated, spurious requests for service at a high rate• Outcomes:– Resource crashes– Legitimate requests denied service– Bandwidth usage and expense increase• Attack types:– SYN flood– ICMP echo reply attack– Zombie attacks– IP spoofing– Continually evolving!• Attack characteristics:– Distributed– Statistical– Highly adaptive• Not defendable via cryptography, firewalls, intrusion detection,…• An arms raceMarket Landscape• Victims include CNN, eBay, Microsoft, Amazon• > 4000 attacks per week (UCSD study)• Recent “Code Red” attack on White House foiled, but > 300K
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