Rupert Pearce Principal, Atlas Venture

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Rupert PearcePrincipal, Atlas Venture
Where Angels dare and VCs also tread The
business of Venture Capital10 October 2002
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Atlas Venture a quick introduction

• Transatlantic technology venture capital (5050
  Europe/US)
• 2.4B currently under management in six
  investment funds
• Currently investing from Atlas Venture VI 850M
  fund
• Focus on three investment sectors
• Communications (33)
• Information Technology (33)
• Life Sciences (33)
• Focus (80) on early-stage, selected (20) later
  stage deals
• Diversified portfolio across geography, sector
  and stage
• Focus on operational and technology expertise in
  our investment teams (West Coast model) not
  corporate finance-driven

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Our International Advantage

• Local investment with global perspective
• Integrated, multi-national investment team
• deal-sourcing
• due diligence
• Multi-office support for international expansion
• strategy
• Recruiting, organisational development
• fund-raising, partnering
• Exit planning

Amsterdam 1980
London 1997
Paris 1993
Munich 1990
Seattle 2001
Boston 1986
Menlo Park 1998
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The Business of Venture Capital
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The dynamics of VC investing - drive a VCs
perspective

• Invest through limited life funds using Other
  Peoples Money
• Managers interests aligned through carried
  interest profit share
• Competitive landscape drives minimum investment
  returns
• High attrition rate focuses attention on
  protection of the downside and enhancement of the
  upside

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The typical VC fund structure

• Investors commit a fixed amount of capital to a
  VC fund for 10 years
• VC manages the fund throughout its life
• VC makes new investments from the fund over three
  to five years
• Cash is reserved in the fund for follow on
  investments over ten years
• Exits typically occur between 5-7 years from
  investment
• VC makes money two ways
• Management fee charged over lifetime of the fund
  - 2 - to pay the bills, but often reinvested in
  own funds
• Profit share (carried interest) 20/25 of
  fund profits the real remuneration, aligning
  the interests of managers and investors
• So VC behaviour is focused on capital gains
  realisation

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The competitive landscape of the VC marketplace
As of December 31, 2001
No guaranteed future unless top quartile 40 IRR
performance essential to be top quartile Requires
a stretch goal of 8-10X
1996
1997
1998
1999
2000
High returns are required to survive in the
industry
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High attrition rateVCs dont see 100 success
? 20-30 big winners

• 50 modest successes

? 20-30 failures
To generate high returns, high risks must be
assumed
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The dynamics of VC investing - drive a VCs
investment philosophy

• The only good investment is an ex-investment
• Downside risk management essential
• Full upside participation even more essential
• The business is founded on dynamic capital
  allocation
• Focus on all available risk mitigation strategies

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VC Investment Fundamentals I

• VCs have to get in and out within 10 years
• Upon investment, thoughts immediately turn to
  exit!
• Founders must allow rapid exit (c5 years)
• VCs have to assume each investment may fail
• Downside/marginal protection key to performance
• Early reallocation of follow-on capital behind
  winners
• Investments must have potential to win BIG (10X)
• Its the winners that deliver fund
  out-performance
• Full upside participation absolutely essential
• Moderate management performance will not be
  rewarded

Fast exits enhance IRRs Vital role of dynamic
capital allocation
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VC Investment Fundamentals II

• Investment risk and reward must be commensurate
  
• Subscription of participating preferred equity
  shares
• Commitment of funds over time against milestones
• Anti-dilution protection
• Veto right over material changes
• Right to follow an investment
• Immediately after investmentlook to exit!
• Participation in all liquidity events
• Forced exit if necessary
• Incentives to key participants in exit manufacture

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VC Investment Fundamentals III

• VC sees an early-stage company as a family
• The VC has a seat at the family dining table
• The VC gets rights to see all material
  information
• No new family members without VCs consent
• No leaving home without VCs consent
• Founders equity reverse vests
• Coverage of core transaction execution risks
• Due diligence
• Contracts (officers, customers, collaborators)
• Exclusivity

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Contrast a pure portfolio approach
Exit Multiple
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with a managed portfolio approach
Exit Multiple
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Some examples- Investment milestones

• Events which trigger slugs of VC investment
• Legal, commercial, financial or technical
  milestones
• Event-related staged financing of the company
• Tool for Shareholders to manage investment risk
• VC holds gt share of company without gt risk
• Company gains gt committed funds into the future

Drip feed approach to VC investment Permits
dynamic allocation of VC capital
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Some examples- Incentives vesting of shares

• VCs support share option plans
• Sizing of option pool c10-15 of fully
  diluted capital
• Long-term shared dilution, earned by
  performance over time
• Vesting of founders shares
• Founders must earn their rewards
• 3-4 years reverse vesting mechanism at par
  value
• Plus option to acquire vested shares at market
  value
• Good leaver/bad leaver -vesting assumes you
  are good
• Permits replacement management to have equity
  participation

Efficient incentives for key value drivers
Bad leaver decelerated vesting
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Some examples- Board and shareholder governance

• VC board representation
• Early stage VCs will want board observer rights
• VC attendance essential to board quorum
• Non-executives will predominate
• VC will want veto rights
• At board level (ordinary business issues)
  fiduciary
• At shareholder level (extraordinary issues)
  selfish

Board influence Significant negative control
over all material events
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Some examples- Nature of equity participation

• Preferred shares
• Liquidation preference protects downside
• Covers distributions and share/business sales
• IPO preference ratchet where not Qualifying IPO
• 2X full ratchet now standard to enhance downside
• Participating preferred shares
• Uncapped upside participation
• 2X full ratchet enhances upside participation
• Exit management features
• Mandatory redemption of shares after 5 years
• Conversion of preferred shares into ordinary
  shares

Participating Convertible Redeemable Preferred
Shares Full downside protection and upside
participation
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Some examples- Protection against dilution

• What is anti-dilution protection?
• Protection from subsequent share issues at lower
  price
• Mechanism of protection new issue of free
  shares
• Two principal approaches
• Weighted average anti-dilution (adjusted for
  issue size)
• Full ratchet anti-dilution (punitive)
• Pay to play becoming prevalent
• No anti-dilution without participation
• Conversion of preference shares to ordinary shares

No write downs for VC investors Re-calibration
for surprises Pay to play
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Some examples- Share issue pre-emption rights

• First right to subscribe for new share issues
• Permits VC to follow his performing investment
• Permits VC to average down under-performing
  investment
• Top up rights if others pass up opportunity
• Intra-class of shares
• Over-arching top up

Lock on external new equity investment Full
upside participation and downside
protection Enables dynamic allocation of VC
capital
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Some examples- Transfers of shares

• General prohibitions on transfer
• Control of the shareholding group
• Pre-emption rights over permitted transfers
• Tag along right over permitted transfers
• Participation on all exit opportunities
• Drag along right over approved sales
• Right to force sale of company
• Ability to exit is sine qua non of investment
• Limited legal rights to squeeze out minorities

Keeping the founding group intact Maximising
exit participation
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Some remarks on Valuation
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Some key concepts used

• Pre-money value before VC has invested
• Post-money value including VCs investment
• Fully-diluted impact of all shares and share
  rights (options, warrants, convertibles, earn
  outs etc)

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What does valuation mean?

• Usually not intrinsic expectation only (few
  assets an idea and some people)
• Largely market-driven and therefore may fluctuate
  (1999-2002 highly volatile)
• Important only as a starting point for future
  value growth
• Most important as driver of founders ownership
  dilution

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The VCs perspective on valuation

• VC must benchmark valuation to the market
• Valuation must deliver a meaningful stake for an
  early-stage investor (25)
• Valuation must permit company to raise sufficient
  cash to pass the next milestone
• Valuation plus growth must have potential to
  deliver benchmark returns
• Valuation must leave value-drivers with enough

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Advice to founders on valuation

• Research the marketplace comparators
• Raise sufficient cash
• To pass your next valuation milestone easily
• and to raise next round of funding (6 months)
• Be obsessive about cash burn (make it last 2
  years)
• Dont raise too much!
• See valuation as a longer term game
• Aim for gradual upwards valuation trajectory
• Be comfortable where you will end up on ownership

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What makes a VC a good partner?
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Statistically, VCs are a good thing

• DRI-WEFA study 2000
• For every 1,000 of assets, between 1980 and 2000
  VC backed companies
• Generated 62 more sales
• Paid 180 more federal taxes
• Generated 91 more exports
• Invested 193 more in RD
• In 2000, venture capital-backed companies
  contributed 11 to US GDP (1.1 trillion) and
  employed 27.5 million people (12.5 million
  direct)
• Intel, Federal Express, Home Depot, Boise
  Cascade, Costco, Apple, Dell Genentech, Fisher
  Scientific, FMC, Mellon, Microsoft, Sun,
  Netscape, eBay

than the average for other companies
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Should you take the VCs money?

• VC Backed
• BIG risk, BIG reward
• 24/7 existence full on
• Maximise the potential of your ideaor crash
  burn!
• You will lose control of your idea
• But you will be part of the team
• Own 5 of a 1B Co in 10 years
• Change the world with your idea
• Then do it again!

• Grow your own
• LOWER risk, LOWER reward
• Higher quality of life
• Maintain control of your idea
• Accept gradual/constrained growth
• Own 50 of a 10M Co in 10 years
• May mix business and academia
• Maybe youll get lucky and have it all

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An example of what can happen
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What you should look for in a VC

• Substantial long-term resources
• Lots of money to invest
• Lots of money to follow-on in subsequent rounds
• Committed funds for at least five years
• Long relevant experience
• Has been through business/sector cycles before
• Has domain expertise networks
• A leader, not a follower
• A VC used to leading financing rounds
• A VC proven in building investment syndicates
• An appetite for risk a true VC

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what you should look for in a VC

• Ability to help you scale your business
• Powerful proprietary networks
• A large grouping of like-minded portfolio
  companies
• International presence/capability esp in US
  markets
• Value-added skills to leverage (eg human capital,
  finance)
• Successful Reputation
• Top quality track record
• Association with success a name
• Likeable personality/ethos
• Someone youd like on your board
• Someone youd like in the trenches with you