Some Basics of Venture Capital

1. Some Basics of Venture Capital

2. Outline • The basics: how VC works • Case study: DDoS defense companies

3. What 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 VCs

4. Angel 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 industry

5. Financial 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)

6. 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 funding

7. The 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 rounds

8. 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 economy Due Diligence: Tools and Hurdles

9. Terms of Investment • Initially laid out in a term sheet (not binding!) • Typically comes after a fair amount of DD • Valuation + investment  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.

10. 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 share

11. Board 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 VCs

12. Other 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 earlier

13. Why 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)

14. 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)

15. 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 race

16. Market Landscape • Victims include CNN, eBay, Microsoft, Amazon • > 4000 attacks per week (UCSD study) • Recent “Code Red” attack on White House foiled, but > 300K client zombies infected • Costs: • Downtime, lost productivity • Recovery costs (personnel) • Lost revenue • Brand damage • Attack costs $1.2B in Feb. ’00; 2005 market estimate $800M (Yankee Group)

17. Who Can and Will Pay? • Internet composed of many independently owned and operated autonomous networks • Many subnets embedded in larger networks • Detecting/defending DDoS requires a minimum network footprint • Must solve problem “upstream” at routers with sufficient bandwidth to withstand attack traffic! • May simply trace attack source to network edge • Target customers: • Large and medium ISPs, MSPs, NSPs • Large and medium data centers • Backbone network providers • Future: wireless operators; semi-private networks (FAA, utilities) • Making target customers care; cannibalization • Key points: • Problem did not exist until recently on large scale • No product available for its defense • No historical analysis of market possible (firewall and IDS)

18. The Companies • Four early-stage companies focused specifically on DDoS • All with strong roots in academia • Headcounts in 10’s; varied stages of funding and BD • Larger set of potential competitors/confusers: • Router manufacturers (e.g. Cisco) • IDS and firewall companies • Virus detection companies (e.g. McAfee) • Technology: • All four solutions involve placing boxes & SW “near” routers • Differing notions of “near” • Boxes monitor (some or all) network traffic • Boxes communicate with a Network Operations Center (NOC) • Key issues: • Detection or Defense? • Intrusiveness of solution?

19. Some Specifics • Company Detect: • Emphasis on detection tools provided to NW engineer • Claim more intrusive/automated solutions unpalatable • Emphasis on GUI and multiple views of DDoS data • More advanced in BD (betas), PR, partnerships • More advanced in funding (>>$10M capital taken) • Company Defend-Side: • Emphasize prevention of attacks by filtering victim traffic • Box sits to the side of router over fast interface • Claim there is a “sweet spot” of intrusiveness • Box only needs to be fast enough for victim traffic, not all • Don’t need perfect filtering to be effective • No GUI emphasis; behind in BD; less advanced in funding • Company Defend-Path: • Also emphasizing prevention, but box sits on “data path” • Need faster boxes and more boxes (scalability) • Concerns over router integration

20. Due Diligence • No company has any revenue yet • Some have first-generation product available • All have arranged beta trials with some ISPs • Have roughly similar per-box pricing model and ROI argument • Due diligence steps: • Repeated visits/conversations with companies: technical, sales strategy • Multiple conversations with beta NW engineers • Development of financial model for revenue projections & scenarios • Compare with firewall and IDS market history: winners & losers, mergers • Conversations with previous round VCs: DD and commitment • In the end, a decision between: • More conservative technology with a slight lead in BD and R&D • More ambitious technology with less visibility, but a better deal • Contemplating both investments… • …then came September 11.

21. Venture Capitalists • Venture capital firms specialize in providing equity financing for firms that are in an early stage of development (start-ups). • Examples of companies that received venture capital funding in their early development include Apple, Federal Express, Microsoft, Genentech, and Google. • Venture capital (a.k.a. private equity) is a pool of capital most commonly organized as a limited partnership. The venture capital firm serves as the general partner and investors are the limited partners. Limited partners can include pension funds, university endowment funds, wealthy individuals, and other financial institutions and corporations.

22. Managers of venture capital firms (venture capitalists) closely follow the technology and market developments in their area of expertise (e.g., computer software, communications, computer hardware, medical/health, industrial/energy, biotechnology, retailing, restaurants, etc.) • They screen entrepreneurs and their business concepts prior to making an investment. To diversify risk, they create a venture fund that is a portfolio of investments in young companies. • Venture capitalists are not passive equity investors. They structure a financing deal with great attention to creating the right incentives and compensation for the start-up firm’s owners. They are also instrumental in raising additional financing during future stages of the firm’s lifecycle.

23. Types of venture capital financing provided to companies: • Seed: prior to a product being developed or to the start-up being organized. • Early Stage: after a company has expended initial capital in development and market testing and is now ready to begin full-scale operations and sales. • Expansion Stage: the company is producing and shipping and has growing inventories and accounts receivable. • Later Stage: company is now breaking-even or profitable and requires funds for plant expansion, full-scale marketing, and working capital. • MBO/Acquisition: This situation occurs when managers wish to purchase an independent company or a division or product line of their employer, thus creating a new independent firm.

24. Venture capitalists (VCs) continuously monitor their companies. • VCs typically serve on the company’s Board of Directors. • VCs provide mentoring and strategic advice to the company’s managers. • VCs often provide business contacts to company managers. • VCs help recruit additional managers for the company. • VCs set company performance targets. If these targets are not met, VCs may have the option of replacing the company founder as the CEO. • Empirical evidence finds that • Companies with innovative, rather than imitator, business plans are more likely to receive VC financing. • Ceteris paribus, companies obtaining VC financing bring their products to market more quickly.

25. A venture capital firm typically raises money for a venture capital fund by obtaining commitments from limited partner investors. Based on the fund’s prospectus, limited partners agree to make investments for a period that is often 10 years. • After commitments are obtain, the VC begins making investments in young companies. VCs make “capital calls” to the limited partners as funds are dispersed to the start-up companies. • The most common way that the VC obtains a return from its investment in a start-up company is by the company being acquired by a mature corporation. In other cases, the VC obtains a return when the company issues an IPO. After the IPO, the stock held by the VC is given to the partners who can continue to hold it or liquidate it.

26. Most commonly VCs are private independent firms. However, sometimes a VC firm is a • Subsidiary of a commercial bank holding company (BHC). This allows the BHC to provide (high-risk) equity financing that could not be made by BHC’s commercial bank subsidiary. • Subsidiary of an investment bank. Investment banks see VC investing as a way to groom companies for an IPO. • Subsidiary of a non-financial corporation (a.k.a. direct investing). The parent company’s capital is used to invest in young companies that may produce synergies or cost savings for the parent.

27. The major alternatives to venture capital financing are • Angels: These are wealthy individuals (often former corporate executives) who mentor a company and provide financing and expertise to start-ups. • Commercial banks: often in the form of lines of credit. • Government: Through grants or Small Business Administration financing and loan guarantees. • Self-financing: including family members and friends.

28. VC financing grew tremendously during the 1990s. The recession and decline in technology firms (a major source of VC investment), led VCs to reduce their investments because prospects for making profits in start-ups was greatly reduced. Total Venture Capital Disbursements $M

29. Number of Venture Capital Deals • While it may be some time before VC activity returns to the level of the “bubble” years of 1999-2000, VC financing will remain an important source of funding for entrepreneurs with innovative business strategies.

30. Questions?