VC 201: The Investment Memo

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VC 201: The Investment Memo (and what you should understand as
a Founder)
Drew Russ,
Startup & Venture Capital, Business Development

About Me

Today’s Agenda
• Quick review of what we covered in VC 101
• The Investment Memo: A Mechanism for us to examine what VCs assess
– Part 1: The Problem & The Solution (The Purpose)
– Part 2: The Details
– Part 3: The Recommendation
• Concluding remarks

Quick Review of VC 101
• Venture Capital: The Definition, The Theory
• Venture Capital Mechanics: Fund Structure, Time as a Factor, How VCs Make
Money, Roles and Responsibilities and Deal Sourcing
• Venture Capital: The Deal and the Bargain
• The Other Flavors of Venture Capital and Corporate VC
• A Glimpse of VC 201 (no need, because you are here!)

What is an investment memo, really?
• A mechanism to provide an OBJECTIVE, FACT based assessment of an
investment opportunity
• The good, the bad and the ugly – it all goes in
• Enlightens skeptics and the dupes in equal measure – it both the defense and
the prosecution

Why are we talking about Investment Memos?
• I know. Memos = boring. Super lame topic and I am really surprised you are all here 
• Reference architecture of a potential investment
• For example:
– Product – what is it and why does it matter?
– Business model -- how do they (or plan to) make money?
– Financial health – and what do they do with this (and their investors) money?
– Management pedigree – have they done it before? What makes them suitable?
– Risk & Concerns – what goes wrong?
– Valuation and Exit – when do we lose money? When do we make money?
• We are going to use that reference architecture to help us understand why VCs decide to invest
or not invest*
* Not all investment decisions
are made equally

Real World Example: Roelof Botha YouTube Memo, 2005
• Pro: Publically available example of how one of the best VC firms reviews
investments (and one of the best individual investors)
• Pro: detailed and well structured – perfect for our needs
• Con: No detail on internal debate; had to move quickly on deal
• I will supplement this example where needed

Part 1: The Purpose
• The Problem
– Is it real?
– Is it painful?
– Is it widespread (or will be)?
• The Solution
– How does it work?
– Why does it work?
– Why is it better?
&

Part 1: The Purpose (problem & solution)

Part 1: Is it Widespread?
Market specifically targeted by your
product
Total Market Demand
Market Share of SAM

Part 1: Who else is doing this?
• Competitors and existing
players
• Size, strategy, product
differentiation
• SWOT Analysis of competition
– Strengths, Weakness,
Opportunities, Threats
• Relative positioning

Part 2: The Details
• Product Roadmap and Development
• Revenue / Sales & Distribution
• Team
• The Deal: Valuation and Capitalization
• Other: hiring plans, need for re-organization, company location etc

Part 2: Product Development & Roadmap
• Going beyond core
functionality
• Dive deeper on
how the product
interacts with users
• Getting from Point
A to Point B (to
Point C)

Part 2: Sales & Distribution
• Monetization = how you generate
revenue
• Youtube:
– Advertising
– Pay-for distribution
– Premium content
– Premium features
Advertiser
Viewer
Content
Creator
Youtube

Part 2: The Team
• The earlier the investment
the more important the team
• What have they done? Who
vouches for them? Where
do they come from?
• Are they familiar to the VC
firm or a trusted colleague of
the VC firm?
• PayPal Mafia…

Part 2: Team (contd.)

Part 2: Valuation and Capitalization
• Three topics
– Premoney vs. Postmoney
– Cap Table
– Investor preferences
• Definitions
– Valuation: Valuation is the process of determining the current worth of an asset or a
company; there are many techniques used to determine value
– Capitalization: In finance, capitalization is the sum of a corporation's stock, long-term
debt and retained earnings. Capitalization also refers to the number of outstanding
shares multiplied by share price.

Part 2: Premoney vs. postmoney
Premoney
The valuation of a business prior to
any additional investment of capital
Postmoney
The valuation of the business PLUS
additional capital invested

Part 2: Valuation & Capitalization (a few equations)
(1) Pre-money Valuation = Post-money valuation – Venture Capital Investment
(2) Post-money Valuation = Venture Capital Investment/Venture
Capital Fund Ownership Percentage (or premoney + investment)
(1) Example: Fund invests $1mm into a company with premoney valuation of $4mm. The
Venture fund owns 20% of the company. 1,000,000 / 0.20 = 5,000,000
(3) Share Price = Pre-money Valuation/Number of Pre-money shares.
(4) New Shares Issued = Venture Capital Investment/Share Price

Part 2: An Example
• StartupZee is a newly formed business and is seeking to raise $1mm seed
round in the form of Venture Capital
• StartupZee has authorized 10,000,000 shares and have allocated those shares
between two co-founders 50/50
• A term sheet is accepted from VeeCee Capital and VeeCee Capital has put the
pre-money value of StartupZee at $3mm
• So….
– What is the post money?
– What % of the company does VeeCee Capital own?
– What was the share price?
– How many shares were issued to VeeCee Capital?

Part 2: An Example (contd.)
Share Price = Pre-money Valuation/Number of Pre-money shares.
3,000,000 / 10,000,000 = 0.30/share
New Shares Issued = Venture Capital Investment/Share Price
1,000,000 / 0.30 = 3,333,333.33 shares
Ownership % = shares owned / shares outstanding
3,333,333.33 /(10,000,000) + (3,333,333.33) = 25%
Post-money Valuation = Venture Capital Investment/Venture Capital Fund Ownership
Percentage
1,000,000 / .25 = 4,000,000

Part 2: Youtube Valuation
• Going to invest $5mm over a
two-tranche investment
• Milestone specific
• Can we back into the valuation?
• 5,000,000/0.30 = $16.6mm
postmoney
• $11.6mm premoney

Part 2: Cap Table as a Mathematical Proof
EXAMPLE: Cap Table
Name Money Shares Current % Post %
Founder 1 $ - 3,333,333.33 33%
Founder 2 $ - 3,333,333.33 33%
Founder 3 $ - 3,333,333.33 33%
Total $ - 10,000,000 100%
Pre-money $11,600,000.00
Pre-money Price per Share $ 1.160
Investment $ 5,000,000.00
Post Money $ 16,600,000.00
New Investors
VeeCee $ - - 0%
Total $ - 10,000,000 100%
- The knowns or the assumed:
- 10mm authorized shares
(assumed)
- $5mm investment (known)
- Investor will own 30% of
company after $5mm
investment (known)
- Option Pool will be 17% of
common shares outstanding
after investment (known)
- Only investor participating in
the round (assumed)
Post Financing
VeeCee $ 5,000,000.00 4,310,345 30%
Founder 1 2,523,810 18%
Founder 2 2,523,810 18%
Founder 3 2,523,810 18%
Option Pool 2,428,571 17%
Total $ 5,000,000.00 14,310,344.83 100%

Part 2: Definitions within the Deal
• Liquidation Preference:
– is frequently used in venture capital contracts to specify which investors get paid first
and how much they get paid in the event of a liquidation event, such as the sale of
the company.
• Participating Preferred & Cap:
– A cap on participation limits the amount received by the preferred stock to a fixed
amount. The cap is typically fixed as a multiple of the original investment, such as 2x
or 3x. Once holders of preferred stock have received the cap amount, they will stop
participating in distributions with the common stock, or convert.
• Wait…don’t you just own part of a company and just get that percentage?
– Well, sometimes…

Part 2: The Waterfall (last part I promise)
• Not all exits are as straightforward as they
appear
• Example:
• VC invested $5mm
• 1x Liquidation preference
• Participation rights with 2x cap
• VC owns 40% of company
• Company sells for $20mm
• What is the return to VC?
$10mm!

Part 2: Waterfall (contd).
• Here is why:
Scenario 1: Convert to
Common
• Always an option
• You convert at the rate of
ownership
• VC would receive 40% of
sale
$8mm!
Scenario 2: Participate
Fully
• Take your liquidation
preference off the top:
$5mm
• THEN YOU CONVERT and
own 40% of remaining
common stock or 40% of
15mm.
• But capped at 2x of total
investment, so…
$10mm!
Scenario 2: Imagine no
cap!
• Take your liquidation
preference off the top:
$5mm
• THEN YOU CONVERT and
own 40% of remaining
common stock or 40% of
15mm.
• But not capped, so VC gets
$5mm + $6mm…
$11mm!

Part 3: The Risks, The Exit & The Recommendation
• Should we invest?
• What needs to happen to make this work?
• What goes wrong?
• What type of return can we approximate if all goes well?
• What are the factors to closing the deal?
– Timing?
• Competitive deal
• Capital requirements
– Lead the deal?
– Take a board seat?
• Observer seat?

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Thanks!

VC 201: The Investment Memo

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